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Final Examination

Module F
2 December 2014
3 hours 100 marks
Additional reading time 15 minutes

The Institute of
Chartered Accountants
of Pakistan

Business Finance Decisions


Q.1

Kailash Limited has recently disposed of one of its long-term investments for Rs. 1.5 billion.
The treasurer of the company has come up with various projects for investment of the said
amount. Details of the projects are as follows:

Initial investment (Rs. in million)


Expected annual cash inflows (Rs. in million)
Discount rate
(based on risk involved in the project)
Project duration (years)
Year from which net cash flows would
commence (arise at the end of year)

----------------- Projects ----------------A


B
C
D
E
(400)
(450)
(600)
(550)
(800)
200
180
220
175
500
11%

10%

15%

12%

22%

10

Other relevant information is as follows:


(i)
Project A and B are mutually exclusive.
(ii)
Project C and E can be scaled up by 20% and scaled down by 50%.
(iii)
Project A, B and D cannot be scaled up but can be scaled down.
Required:
Determine the most beneficial investment mix.
Q.2

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ARQ (Private) Limited is a small size company whose shares are held by three directors.
ARQ manufactures and sells garments for children. There is considerable demand for its
products. The main hurdle in fulfilling the market demand is the working capital constraint.
It is anticipated that measures to increase sales would require additional financing as
follows:
Debtors
Stock Creditors
Expected increase in working capital (% of sales)
80%
100%
40%
Following information has been extracted from ARQs latest financial statements:
Fixed assets
Current assets
Long term liabilities
Current liabilities
Sales
Profit after tax

Rs. in million
105
91
(75)
(64)
60
15

60% of profit after tax is distributed as dividends. The companys bankers have agreed to
provide finance subject to a debt equity ratio of 60:40 or lower.
Required:
(a) Determine the maximum growth in sales which could be achieved in the above
situation.
(b) Calculate the financing requirements in the event the sales are projected to increase to
Rs. 100 million.

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Business Finance Decisions

Q.3

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ZC Limited (ZCL) manufactures metal containers for the paints industry. Presently, ZCL
has eight machines which were purchased 3 years ago at a cost of Rs. 1.8 million each
having useful life of 8 years with zero salvage value. The production capacity of these
machines is 300,000 containers per annum which is sufficient to meet the existing demand.
ZCL anticipates that the demand would increase to 540,000 containers next year and would
remain stable in the foreseeable future. The new demand can be met by replacing all the
existing machines with 3 hi-tech machines that are available in the market at a cost of
Rs. 10 million each. The new machines will have an estimated useful life of 5 years with
salvage value of Rs. 2 million each.
The following information is also available:
(i)
Selling price of each container is Rs. 50 which is expected to increase by 10% per
annum from year 2 onwards.
(ii) Existing raw material cost is 45% of sales which is anticipated to reduce to 42% of
sales by using the new machines.
(iii) The introduction of new machines would reduce the monthly labour cost by
Rs. 146,000 but would increase the overhead expenses, excluding depreciation by
Rs. 2 million per annum.
(iv) All expenses are expected to increase by 8% from year 2 onwards.
(v) The existing machines can be sold at Rs. 1.2 million each excluding disposal costs of
Rs. 60,000 per machine.
(vi) The increased production capacity will require additional working capital of
Rs. 3 million.
(vii) ZCL follows a policy of charging depreciation using straight line method.
(viii) It evaluates cost of investment by applying the discount rate of 20%.
(ix) Applicable tax rate for ZCL is 35%.
Required:
(a) Calculate the Net Present Value (NPV) if the existing machines are replaced with the
new hi-tech machines.
(b) Assume that the NPV of the incremental cash flows is negative and the management
is considering to shelve the plan of replacing the machines. Discuss other financial and
non-financial factors which should be taken into consideration before management
takes a final decision.

Q.4

(a)
(b)

Discuss the situations under which adjusted present value (APV) might be a better
method of evaluating a capital investment than net present value (NPV) method.
SSG Limited is engaged in the manufacturing and marketing of product X23 in
Pakistan. SSG is on course to install new plant costing Rs. 600 million which is
expected to increase its production by 15,000 tonnes per annum. SSG intends to
finance new plant by issuing new term finance certificates (TFCs). The management
of the company believes that the new issue will not alter the companys credit rating.
Following information has been extracted from the companys latest statement of
financial position:

Paid up Capital (Rs. 10 each)


Retained Earnings
Term Finance Certificates (TFCs) (Rs. 1,000 each)

Rs. in million
300
1,200
1,500
1,500
3,000

TFCs are due to be redeemed at par in three years and carry mark-up at the rate of
12% payable quarterly and are being traded at Rs. 950 each.

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Business Finance Decisions

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The following information is also available:


(i)
SSG earns contribution margin of Rs. 45,000 per tonne of product X23.
(ii) It is expected that only 50% of new plant capacity will be utilized in the first
year of operation which will be increased by 10% in each subsequent year
subject to maximum of 80% capacity.
(iii) Incremental fixed costs other than plant depreciation are estimated at Rs. 300
million per annum.
(iv) At the end of fifth year, the plant will have a salvage value of Rs. 180 million.
(v)
Companys shares are presently being traded at Rs. 47.50 each. Equity beta of
the company is 1.3 and equity risk premium is 5%.
(vi) Cost associated with the issuance of TFCs is estimated at 2.5%.
(vii) Applicable tax rate is 35%. SSG can claim initial and normal depreciation at
50% and 10% respectively under the reducing balance method.
(viii) Yield on one year treasury bills is 8%.
Required:
Evaluate the above investment by using APV method.
Q.5

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Energy Gen Limited (EGL), an independent power producer, has obtained a foreign
currency loan of USD 100 million to meet the cost of expansion of its generation capacity.
The principal is repayable equally in quarterly installments along with interest for the
quarter. Further details of the loan are as follows:

Tranche A
Tranche B

Loan Amount
(US $)

Pricing

45 million
55 million

3-month Libor + 2.85%


3-month Libor + 4.25%

Number of
quarterly
installments
29
22

Installment due
First
30-Sep-10
30-Jun-12

Last
30-Sep-17
30-Sep-17

EGL had hedged the FCY loan on the date each tranche was received on the following
terms:
Tranche A
Tranche B

Hedge
Amount (US $)
45 million
55 million

Hedge @
Rs. 72.11
Rs. 85.40

Pak Rupee Floating


Rate
3-month Kibor + 0.10%
3-month Kibor + 0.10%

Termination
Date
15-Oct-17
15-Oct-17

However, the hedging covers the principal repayment and Libor portion of interest rate
only. The interest portion consisting of margin over Libor was not hedged.
EGL has recently issued 5-year bonds at a fixed rate of 13%. The mark up is payable at the
end of each quarter whereas the principal amount will be repaid in lump sum at the end of
loan period. The par value and current market price of each bond is Rs. 100 and Rs. 103.70
respectively.
After the successful issue of the bonds, EGL is presently considering an option to pay off the
entire foreign currency loan by issuing a new series of bonds. Due to the envisaged decline
in interest rates, EGL plans to offer new bonds whose interest rate would be linked to
3-month Kibor and in line with the current market price. In case of early termination of
foreign currency loan, EGL will be required to pay 1.5% of outstanding principal amount as
penalty.
Existing Libor and Kibor rates are 2.3% and 11.3% respectively and it may be assumed that
these rates would not change in the year 2015. The spot rate of Pak Rupee/US $ is Rs. 102.
Exchange rate is expected to change in line with interest rate parity.
It may be assumed that today is 1 January 2015.
Required:
Analyse the loan substitution option and give appropriate recommendations. For the
purpose of simplicity, you may restrict your calculations to the calendar year 2015.

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Business Finance Decisions

Q.6

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The Board of Directors of Insaaf Chemicals Limited (ICL) is considering to acquire the
entire shareholdings of Mustehkam Chemicals Limited (MCL) in a share exchange
arrangement. The expected share exchange arrangement envisages exchange of 8 shares of
ICL for every 7 shares of MCL.
Summarized statements of financial position and extract of income statements for the latest
year are presented below:
Summarized statements of financial position
ICL
MCL
Rs. in million
Non-current assets
12,660
593
Current assets less current liabilities
(1,940)
129
Long term liabilities
(6,280)
4,440
722
Share capital (Rs. 10 each)
Reserves

1,500
2,940
4,440

200
522
722

Income statements
Turnover
22,600
Earnings before interest and tax
2,300
Interest
(800)
Profit before tax
1,500
Taxation
(500)
Profit after tax
1,000
Dividend to ordinary shareholders
(480)
Retained earnings
520

1,810
280
(40)
240
(80)
160
(100)
60

Following additional information is also available:

Expected dividend growth


Current market value of share
Weighted average cost of capital
Cost of equity

ICL
9%
Rs. 80
12.5%
15.5%

MCL
7%
Rs. 84
13.5%

ICLs Board is of the opinion that the proposed acquisition would enable ICL to dispose of
surplus buildings for Rs. 110 million and also reduce the staff costs by Rs. 23 million per
year over a period of four years. However, ICL would have to pay Rs. 35 million
immediately to the outgoing staff.
The shares of chemical companies are presently trading at an average multiple of 12 times in
the stock market. The stock market is assumed to be semi-strong form efficient.
Required:
Evaluate the factors that would influence the decisions of the respective shareholders and
discuss the response of the respective shareholders to the offer of acquisition. Substantiate
your answers with relevant financial calculations.
(THE END)

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