Financial Management

Suggested Answers

Answer to the Question No: 1(a)

Optimum capital structure
The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company's
market value while minimizing its cost of capital. Thus, companies have to find the optimal point at which the
marginal benefit of debt equals the marginal cost It is useful to analyse the situation and attempt to determine
the optimal structure; but in practice it is difficult to do this with a great deal of precision. As a result, in practice,
many managers think of the optimal capital structure more as a range rather than as a precise number. Other
firms study the situation; reach a conclusion as to the optimal structure; and then set a target capital structure.
MM study was based on some unrealistic assumptions and those are listed below:
• There are no brokerage costs
• There are no taxes
• There are no bankruptcy costs
• Investors can borrow at the same rate as corporations
• All investors have the same information as management about the firm’s future investment
opportunities
• EBIT is not affected using debt
Even though some of these assumptions are obviously unrealistic, MM’s irrelevance result is extremely
important. By indicating the conditions under which capital structure is irrelevant, MM also provided us with
clues about what is required for capital structure to be relevant and hence to affect a firm’s value.
Answer to the Question No: 1(b)
i)
BDT
EBIT 4,000,000
Interest ( Tk 2,000,000 X 0.10) 200,000
Earnings before Taxes (EBT) 3,800,000
Taxes (35%) 1,330,000
Net Income 2,470,000

EPS = Tk 2,470,000/600,000 = TK 4.12

Po = Tk 4.12/0.15 = Tk 27.47
ii)
Equity = 600,000 X Tk 10 = Tk 6,000,000
Debt = Tk 2,000,000
Total capital = Tk 8,000,000
WACC = WdKd (1-T) + WcKs
= (2/8)(10%)(1-0.35) + (6/8) (15%)
= 1.63% + 11.25%
= 12.88%
iii)

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 EBIT 4,000,000
Interest (Tk 8,000,000 x 0.12 960,000
Earnings before Tax (EBT) 3,040,000
Taxes (35%) 1,064,000
Net Income 1,976,000

New Debt:
Old Debt 2,000,000
Additional 8,000,000
Less repayment of old debt (2,000,000)
Net Debt 8,000,000

No of shares:
Net proceeds from raising debt 6,000,000
No of shares:(6,000,000/27.47) 218,420
New outstanding shares (600,000 - 218,420) 381,580
New EPS (1,976,000 / 381,580) 5.18
New Price per share (5.18 / 0.17) 30.47

As the new share price of Tk 30.47 is higher than the earlier price of Tk 27.47, ABC should change
its capital structure

iv) If the old debt is not required to be refunded, the position is as follows:

EBIT 4,000,000
Interest (Tk 8,000,000 x 0.12 + 2,000,000 x 0.10) 1,160,000
Earnings before Tax (EBT) 2,840,000
Taxes (35%) 994,000
Net Income 1,846,000

No of shares:
Net proceeds from raising debt 8,000,000
No of shares:(8,000,000/27.47) 291,227
New outstanding shares (600,000 - 291,227) 308,773
New EPS (1,846,000 / 308,773) 5.98
New Price per share (5.98 / 0.17) 35.18

This is a better capital structure compared to the situation where the old debt needs to be refunded
since the new share price of BDT 35.18 is higher than the earlier figures of Tk 30.47 and Tk 27.47.

In the first case, in which debt had to be refunded, the bondholders were compensated for the increased
risk of the higher debt position. In the second case, the old bondholders were not compensated; their
10% coupon perpetual bonds would now be worth:

Tk 100/0.12 = Tk 833.33. Or, Tk 1,666,667 in total, down from the old Tk 2mn or a loss of TK
333,333. The stockholders would have a gain of: (Tk 35.18 – Tk 30.47) x 308,773 = Tk 1,454,321

The gain would be, of course, at the expense of the old bondholders. (There is no reason to think that
bondholders’ losses would exactly offset stockholders’ gains.)

v)
TIE = EBIT/I
Original TIE = Tk 4,000,000/Tk 200,000 = 20 times
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 New TIE = Tk 4,000,000/Tk 960,000 = 4.17 times

Answer to the Question No: 1(c)

i) You will only sell your shares if you feel the takeover attempt will fail. If the attempt succeeds, each
share will be worth Tk 100, so you won’t be willing to sell for Tk 75. If it fails, each share will only
be worth the current market price of Tk 50

ii) This implies that tender offers will only succeed if everyone thinks they will fail, but if everyone thinks
they will fail, then they will succeed but everyone should realize they will succeed and hence, hang
on to their shares, etc.

iii) The underlying reason for the paradox above is that the bid price is lower than the post-takeover value
per share. Normally, successful bid must be set above the expected value per share, so that the
shareholders who sell profit more than shareholders who do not. That is why enough shareholders will
tender their shares. In fact, all shareholders will want to tender their shares, but in order for the bidders
to make money on the deal, they also set a restriction on how many shares they will buy.
Answer to the Question No: 1(d)
i) The question does not specify the Market Return. Let us assume the Market Return is 12% in which
case the risk premium is 4% (12% -8%)

Ke = Rf + Market Premium x Beta

8% + 4 x1.5 =14%
Market Value of Debt 200 million
Market Value of Equity 500 million
Total Market Value 700 million
Kd = 0.11 x (1 – 0.46) = 0.0594

WACC without additional borrowing = (200 x 0.0594 + 500 x 0.14) / 700 = 11.70%

Market Value of Debt 300 million

Market Value of Equity 500 million
Total Market Value 700 million
Kd = 0.125 x (1 – 0.46) = 0.0675

WACC with additional borrowing = (300 x 0.0675 + 500 x 0.14) / 800 = 11.28%
ii) The data in the question is incomplete to estimate the new market price per share
iii) The data is incomplete. However, if we assume a WACC of 11%, the cash flow till perpetuity is 20 /
0.11 = 182 million which is more than the initial investment. The project therefore becomes
acceptable.
iv) The decision will remain unchanged.

Answer to the Question No: 2(a)

The market value of an option is typically higher than its exercise value due to the speculative nature of the
investment. Options allow investors to gain a high degree of personal leverage when buying securities. The
option allows the investor to limit his or her loss but amplify his or her return. The exact amount this protection
is worth is the premium over the exercise value.

Swaps allow firms to reduce their financial risk by exchanging their debt for another party’s debt, usually
because the parties prefer the other’s debt contract terms. There are several ways in which swaps reduce risk.
Currency swaps, where firms exchange debt obligations denominated in different currencies, can eliminate the
exchange rate risk created when currency must first be converted to another currency before making scheduled
debt payments. Interest rate swaps, where counterparties trade fixed-rate debt for floating-rate debt, can reduce
risk for both parties based on their individual views concerning future interest rates.

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Answer to the Question No: 2(b)
i) The current exercise value of the call option is Max (Tk 60-Tk 55) = Tk 5. Since the market value of
the call option is Tk 9.29, the premium associated with the call is Tk 4.29. The current exercise value
of the put option is Max (Tk 55-Tk 60) = Tk 0. Since the market value of the option is Tk 3.06, the
premium associated with the put option is Tk 3.06.

ii) Remember that the options will be exercised only if they yield a positive pay off. In this case, the put
option will not be exercised. In addition, the initial investments for the options will be the market
values of the options. The returns under each of the scenarios are summarized below:

Investment Returns Results

Own stock ((Tk 70 - Tk 60)/Tk 60) 16.67%
Buy call option ((Tk 70 - Tk 55)/Tk 9.29)-1 61.46%
Buy put option ((Tk 0)/ - Tk 3.06)-1 -100%

iii) In this case, the call option will not be exercised. The returns under each of the scenarios are
summarized below:
Investment Returns Results
Own stock ((Tk 50 - Tk 60)/Tk 60) -16.67%
Buy call option ((Tk 0)/ Tk 9.29)-1 -100%
Buy put option ((Tk 55 - Tk 50)/Tk 3.06)-1 63.40%

iv) Recall, that the stock price is expected to be either Tk 50 or Tk 70, with equal probability. If Safwan
buys 0.6 shares of stock and sells one call option, his expected payoffs are:

Ending price X 0.60 = Ending stock value Ending option value

Tk 50 X 0.60 = Tk 30 Tk 0
Tk 70 X 0.60 = Tk 42 Tk 15

Safwan’s investment strategy would yield a payoff of Tk 30 – Tk 0 = Tk 30, if the ending stock price
is Tk 50. His strategy has a payoff of Tk 42- Tk 15 = Tk 27, if the ending stock price is TK 70. This
is not a riskless hedged portfolio.

v) Recall, that the stock price is expected to be either Tk 50 or Tk 70, with equal probability. If Safwan
buys 0.75 shares of stock and sells one call option, his expected payoffs are:

Ending price X 0.75 = Ending stock value Ending option value

Tk 50 X 0.75 = Tk 37.50 Tk 0
Tk 70 X 0.75 = Tk 52.50 Tk 15

Safwan’s investment strategy would yield a payoff of Tk 37.50 – Tk 0 = Tk 37.50, if the ending stock
price is Tk 50. His strategy has a payoff of Tk 52.50- Tk 15 = Tk 37.50, if the ending stock price is
TK 70. Since his payoff is guaranteed to be Tk 37.50, regardless of the ending stock price, this is a
riskless hedged portfolio.

Answer to the Question No: 3(a)

SC should buy August put option contracts as follows: BDT 18.225m / (6750 x BDT 10) = 270 contracts.
Portfolio & Index falls Portfolio & Index falls
BDT BDT
Portfolio value at 1 August 17,955,000 18,360,000
Option exercised
(6750 - 6650) X 270 X 10 270,000 -
18,225,000 18,360,000
Cost of option (135 X 270 X 10) (364,500) (364,500)
17,860,500 17,995,500
Current value of portfolio 18,225,000 18,225,000
Decrease in portfolio value 364,500 229,500
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Answer to the Question No: 3(b)

SC should sell futures BDT 18.225m / (6720 x 10= 272 contracts rounded up

Portfolio value at 1 August 17,955,000

Gain on future ([6720 - 6630] x 272 x 10) 244,800
18,199,800
Current value of portfolio 18,225,000
Decrease in portfolio value 25,200

Answer to the Question No: 4(a)

Net present value
Year 0 1 2 3 to 14 14
BDT’m BDT’m BDT’m BDT’m BDT’m BDT’m
Investment cost (120) (75) - - 45
Revenue (W.1) - - 44.64 96 -
Operational costs - - (20.09) (43.2) -
@45%
Cash flow (120) (75) 24.55 52.8 45
before tax
Taxation @37.5 - - (9.21) (19.8) -
%
Net cash flow (120) (75) 15.34 33 45
Discount @13% 1.000 0.885 0.783 4.634 0.181
Present values (120) (66.38) 12.02 152.92 8.15
NPV (13.29)

Based on the NPV computation, the proposed investment should not be undertaken because it gives a
negative NPV of (BDT 13.29m)

Workings:

1. Revenue Year one of operations

Medium = 40 x 60% x BDT 65, 000 x 12 = BDT 18, 720,000

Large = 30 x 40% x BDT 180, 000 x 12 = BDT 25, 920,000
Total BDT 44, 640,000

Revenue after Year one of operations

Medium = 40 x BDT 65, 000 x 12 = BDT 31, 200,000
Large = 30 x BDT 180, 000 x 12 = BDT 64, 800, 000
Total BDT 96, 000,000

2. Annuity under NPV (13%)

Year 3 to 14 Annuity value at Y2 = 5.918

Present Value Factor of Y2 Value = 0.783
PV of Revenue for Year 3 to 14 = 4.634

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Answer to the Question No: 4(b)
To : Best Hotel Management
From : Financial Consultant
Date : December, 2019
Subject : Report on the proposed Shopping Mall Investment
The report discusses non financial factors that could be considered when making the decision of investing in
the shopping mall. The decision to invest in a major project must be evaluated using both financial and non-
financial information. From the financial perspective, using the NPV approach, the investment shows that it
cannot add value to the shareholders wealth. Non-financial considerations will include the strategic fit of the
investment with the company and its future plans.
Non- financial information
The methods used to evaluate the proposed investment from the financial perspective are subject to
considerable inaccuracy. For instance the operating costs are assumed to be 45% of revenue throughout the
investment life but prices and cost changes according to the economic conditions. The accuracy of the
discount rate estimate is subjective considering it is based on industrial averages.

Its might be important not to rely on a single estimate of net present value and Management should consider
using Sensitivity analysis or simulations. This analysis could be used to ascertain the impact of changes of
key cash flow variables as rent charges, shop occupancy on the NPV. It might also be important to consider
the real options.
The strategic importance of the investment must be established as it will influence to a large extent the final
decision. Best Hotel’s core competence is in the hotel industry and therefore, has no experience in running a
real estate business. It might be better to consider first the opportunities within the hotel industry before
diversifying into a foreign business. The hotel must also consider recruiting appropriate skilled labour force
that can run the shopping mall. The hotel should also thoroughly investigate the competition in the real estate
business and the likely reaction of competitors if it enters this new market. The Hotel should consider the
possibility of acquiring an already established business for quicker entry into the market and also reducing
competition in a way.

-sd-/
Financial consultant
Answer to the Question No: 5(a)
It would be worth purchasing new equipment – the NPV is higher (BDT 3.769m compared to BDT 2.517m).

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Answer to the Question No: 5(b)

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Answer to the Question No: 5(c)

Shareholder value analysis (SVA) is one of several nontraditional metrics being used in business today.
SVA determines the financial value of a company by looking at the returns it gives its stockholders and is
based on the view that the objective of company directors is to maximize the wealth of company
stockholders. SVA has seven value drivers:

• Life of projected cash flows

• Sales growth rate
• Operating profit margin
• Corporate tax rate
• Investment in non-current assets
• Investment in working capital
• Cost of capital

The value of the business is calculated from the cash flows generated by drivers 1 to 6 which are then
discounted at the company's cost of capital (driver 7).

The Marketing Director's statement implies that he has superior knowledge than do those who, by their
actions (i.e. buying and selling in the stock market) influence share prices.. Evidence on the efficiency of
the capital market suggests that this is only likely to be true if the person making the statement has 'inside
knowledge'. Otherwise the evidence shows that the market knows best on average. It is feasible that, as the
market is 'semi-strong form' efficient the director and his colleagues will have information that gives a more
accurate figure of the value of C14.
---The End---

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