Karachi Institute of Economics and Technology, North Campus

Course: Advanced Financial Management (P4)

Faculty: Muhammad Sikander Iqbal Time Allowed: 02 hours
Class ID: 106876 Total Marks: 15
Examination: Mid-term (Spring 2021)

Instructions: 1. Attempt ALL questions in the same sequence it is given.

2. Give concise and to the point answer. Assume suitable value for any
missing data, giving reason for selection
3. No FURTHER clarification is required to attempt this paper.
Q 1. (10 marks)

Smith Ltd. is a US company which is considering setting up a manufacturing operation to make fishing
equipment in Pakistan. If the operation were to be set up the plant would be purchased in Pakistan
costing PKR 6,000,000 now and some equipment would be sent from the US immediately. This
equipment is fully written off in the US but has a market value of USD 12,500 or PKR 2,000,000. All plant
and equipment is written off on a straight-line basis by Smith Ltd over 5 years.

The fishing equipment will sell for an initial price of PKR ,1600 but this price will increase in line with
inflation in Pakistan which is expected to continue at its current rate of 10% p.a. It is also expected that
4,000 fishing equipment will be sold in the first year increasing at a rate of 5% each year. The costs of
making fishing equipment consist of local variable costs of PKR 800 per unit and selling and
administration costs of PKR 400,000 p.a., both of which will increase in line with inflation in Pakistan. The
equipment also requires some specialist parts sent over from the US each year. These will be transferred
at the beginning of the first year of production at a cost of PKR 400,000 ($2,500) which includes a 25%
mark-up on cost. The transfer price and cost of these items are expected to increase by 5% p.a., and they
will be billed to the Pakistan operation at the beginning of the year and paid for at the end of the year.
The working capital for this project will be required at the beginning of each year and will be equal to
10% of the expected sales value for the year.

Smith plc estimates that it will lose some of its own exports worth $5,000 now and increasing by 5% p.a.
due to the setting up of the operation in Pakistan. However, Smith Ltd will be receiving a license fee from
the Pakistan operation equal to 10% of sales each year. Government of has reduced corporate taxes for
such FDI to only 20% and operating costs, license fees and depreciation at 25% on a straight-line basis are
all tax-allowable expenses. Corporation tax in the US is at 33%. There is a one-year tax delay in both
countries.

Smith Ltd wishes to assess this project from the point of view of both investors in Pakistan (required
return 15%) and investors in the US (required return 10%). The assessment will take place using Smith's
usual five-year time 'horizon' and valuing the Pakistan operation at three times its net cash inflow during
the fifth year. If the operation were to be sold at this value, tax would be payable at 30% on the proceeds.

It is expected that the PKR will depreciate against the USD by 4% p.a. from year 2, the first
depreciation affecting year 2 cash flows. Assume that all prices have just altered, and that all cash flows
occur at the end of the year unless specified otherwise.

Required:
Calculate whether the operation would be worthwhile for investors based in Pakistan.

Q 2. (5 marks)
A European call option on shares has 3 months to expiry. The exercise price of the option is $2.50,
and the current price of the share is $3. The standard deviation of the share is 20% and the risk-free
rate is 5%.

Required:
Calculate the value of the call option per share using the Black-Scholes formula.