FINANCIAL I\{ANAGEMENT

May-June 2016

(a) Aaban Technologies Ltd. is considering a major expansion progrcm that has been proposed by the
company's infonnation technology group. Before proceeding with the expansion, the company must
estimate its cost of capital.

Assume that you are an assistant to the Chief Financial Ofticer. Your first task is to estimate Aaban's cost
of capital.CFo has provided you with the following data; which he believes may be relevant to your task:

o The firm's tax rate is 40%

r The current price of Aaban's 120/o coupot, semiannual pa),ment, non-callable bonds with 15
years remaining to maturity is Tk.1,153.72

Aaban does not use short term interest bearing debt on a permanent basis. New bonds would be
privately placed with no flotation cost.

o The current price of the firm's 10%, Tk.100 par value, quarterly dividend, perpetual preferred
stock is Tk.1 1 1. 10.
. Aaban's common stock is currently selli
. ng for 50 taka per share. Its last dividend (Do) was Tk.4.19 and dividends axe expected to grow at
a constant rate of 5% in the foreseeable future. Aaban's beta is 1.2, the yield on T-bonds is 7ya,
and the market risk premium is estimated to be 60/o. For the bond-yield-plus-risk premium
approach, the firm uses a risk premium of 47i,.
r Aaban's target capital structue is 30% debt, 10% preferred stock and 60% common equity.

To structure the task somewhat, CFO has asked you to answer the following questions.

(i) What sources of capital should be included when you estimate Aaban's WACC? Should the
component costs be figured on a before-tax or an after-tax basis? Should the costs be historical
(embedded) costs or new (marginal) costs? J
(ii) What is the market interest rate on Aaban's debt and its component cost of debt? 3
(ii, Why is there a cost associated with retained earnings? tr4rat is Aaban's estimated cost of
cornmon equily using the CAPII{ approach? J
(iv) \Vhat is the estimated cost of common equity using the DCF approach? J
(v) What is the bond-yieid-plus-risk-premium estimate for Aaban's cost of common equity? 3
(ri) What is your final estimate for re (cost of retained eamings)? 3
(vii) Aaban eslimates that if it issues new common stock, the flotation cost will be l5%. Aaban
incorporates the flotation costs into the DCF approach. What is the estimated cost of newly
issued common stock, considering the flotation cost?
(viii) What is Aaban's overall or weighted average cost of capital (WACC)? Igrore flotation cost?
Wlat factors influence Aaban composite WACC? Should the company use the composite
WACC as the hurdle rate for each of its projects?

(b) You u,ere recently appointed by a iarge manufacturing company as the Financial Analyst at one
of the divisions of the compary, which is located in Chift.agong. You have received the following
e-mail frorn the Divisional Manager.

Pagel4T
Quote

I have to go to a meeting at head office on Sunday about the "Technology Upgradation" project. We sent
to head offrce the projected cash flow figures for it. Apparently one ofthe head office finance people has
discounted our figures, using a rate which was calculated from the capital asset pricing model. I do not
know why they are discounting the figures, because inflation is predicted to be negligible over the next
few years - I think that this is all aploy to stop us going ahead with the project and let another division
have the cash.

I looked up capital asset pricing model in a finance boolg but I could not make head nor tail of it, and
anyway it ail seemed to be about buying shares and notl,ing about our project. We always use payback for
the smaller projects which we do not have to refer to head office. I am going to argue for it now because
the project has a payback of less than five years, which is our normal yardstick.

Iam very keen to go ahead with the project because I feel that it will secure the medium{erm future of
our division. Could you please make few notes for me which I can read on the Flight on Sunday moming?

I want to know how the capital asset pricing model is supposed to work, plus any other things which you
feel I ought to know for the rneeting. I do not want to look like a fool or lose the project because they
blind me with science.

As you have probably discovered I do not know much about finance, so please do not use any technical
jargon or complicated math's.

Unquote

Requirement:

Prepare notes for the divisional manager which will provide helpful background for the meeting. 10

Answer to the Ouestion No. l(a):

i. The WACC is used primarily for making longterm capital investment decisions, i.e. for capital
budgeting. Thus, the WACC should include the types of capital used to pay for long term assets, and
this is typically long term debt, preferred stock and comrnon stock, Short-term sources of capital
consist of (l) spontaneous, non-interest bearing liabilities such as accounts payable and accrued
liabilities and (2) short-terrn interest-bearing debt, such as notes payable. Ifthe flrm uses short terrn
interest bearing debt to acquire fixed assets rather than just to finance working capital needs, then
WACC should include a short terrn debt component since it has often been observed that short term
sources offinance such as bank overdraft are more permanent than long term loans.

Stockholders are concerned primarily with those corporate cash flows that are available for their use,
namely those cash flows dvailable to pay dividends or for reinvestnent. Since dividends are paid
from and reinvestment is made with after tax takas, all cash flow and rate of return calculations
should be done on an after tax basis.

ln financial management, the cost of capital is used primarily to make decisions that involve raising
new capital. Thus, the relevant component costs are today's marginal costs rather than historical
costs.

Page | 48
11. Aaban's 12%bond with 15 years to maturity is currently selling for TK 1,153.72. Thus, its yield to
marurity is 10%.
:
Approximately YTM (Coupon payment+(Face value-market value)ino of years to maturity))/(Face
value* Market value)/2
= (120+ (1000- 1 153.72y1 5y(1000+11s3.7 2)t2
= rc.lgY'o

Since interest is tax deductible, the authority, in effect, pays part of the cost, and Aaban's relevant
component cost of debt is the after-tax cost:

Ru(r-T)= r}%(t -0.4)= 6%.

111. Aaban's eamings can either be retained and reinvested in the business or paid out as dividends. If
eamings are retained, Aaban's shareholders forgo the oppornrnity cost to receive cash and to reinvest
it in stocks, bonds, real estate, and so on. Thus, it should earn on its retained earnings at least as much
as its stockholders themselves could eam on alternative investments of equivalent or similar risk.
Further, the company's stockholders could invest in Aaban's own common stock, where they could
expect to earn rc, We conclude that retained earnings have an opportunity cost that is equal to r., the
rate of return investors expect on the firm's common stock
The CAPM estimate for Aaban's cost of cornmon equit-v is 14.2o/o

1"= sf+(rm_rrf) .F7 %+ (6%) 1.2= I 4.2%

lV. Since Aaban is a constant grorath stoclg the constant gro*'th model can be used:
r.=DlPo+g
r"=4. 19(l+0.05y50+0.05
r"=13.804.

v. The bond-yield-plus-risk- prernium estimate is 14%

r"= Bond y,ield+ Risk premium=10%+4o/A4o/o
Note that the risk premiurn required in this method is difficult to estimate, so this approach only
provides a ballpark estimate of r,. It is useful, though, as a check on the DCF and CAPM estimates,
which can, under certain circumstances, produce unreasonable estimates.

Yl. The follou.ing table summarizes the r" estimates:

Method Estimate
CAPM 14.20%
DCF 13.80%
Rd+Rp 14.00%
Average t4.00%

At this point, considerable judgement is required. If a rnethod is deemed to be inferior due to the
"quality" of its inputs, then it might be given a little weight or even disregarded. In the above
example, though, the three methods produced relatively close results, so it has decided to use the
average, l4Yo, as an estimate for Aaban's cost of common equify.

vii. r.= Dl/(Po-F)+g = Do(l+g)/(Po-F)+g

= 4.19(1+0.5)i50(l -0.15)+0.05 = 15.35%

Pagel49
 viii. Aaban's WACC is 11.1%'
Capital stucture weight x Components cost : product
0.3 6% 1.8%
0.1 9% a.9%
0.6 14% 8.4%
1.0 WACC 11.1%

WACC =Wd.rd(l -T)+Wp.rp+We.R.

= 0.3( r 0%x I -0.4)+0. I (e%) +0.6(14%)
= ll.lo/o

There are factors that the firm cannot contol and those they can control that influence WACC.
Factors that firm cannot control:
. lnterest rates;
o Tax rates

Factors the firm can control:

o Capital struchre policy
. Dividend policy
. hvestrnent policy

No. The composite WACC reflects the risk of an average project undertaken by the finn. Therefore, tle
WACC only represents the "hurdle rate" for a tlpical project with average risk Different projects have
different risks. The project's WACC should be adjusted ro reflecr the project's risk.

Answer to the Ouestion No. I (b):

Notes for the divisional manager

Discounting

Discounting of future cash flows is a technique used to place less value on cesh fl6q,5 which are received
further into the future. This reflects the fact that investors would rather receive money now than in the
future. This preference for money now, which is known as the time value of money, is increased if there
is inflation in the economy, as investors also need to be compensated for the buyingpower of their money
being reduced in the future.

Therefore the discount rate is a combination of both the time value of money. This will depend upon the
required rate of return, the riskiness of the project and inflation. Even if inflation is negligibl., flo*,
are still needed to discount to reflect the time value of money. "*L
CAPM

Finding the correct discount rate can be a difficult exercise and this is where the capital asset pricing
model (CAPM) can be very useful.

CAPM look
at the returns paid on shares on the stock market coerpared to the risk in returns of those
shares. Because investors in general are risk averse, they will expect a higher average retum by way of
dividends and capital gains to cornpensate for a higher risk.

Page | 50
The logic then follows that if shareholders can earn a given return on the stock market for a certain level
of rislqthen any projects which we may undertake must at least satisfy that target return. Where CAPM is
special, however, is in the way it considers rish A company or project looked at on its own may have a
viry high level of risk. However, if it is added to the shareholders' portfolio of investments, some of that
risk will be removed or diversified away.

This is because two different causes of the total risk of a company can be identified.

Systematic risk Due to the economy, such as,interest rates, exchange rates, etc that affect all companies
-
Unsystematic risk Due to events specific to a company, such as new product developments, flres,
-
strikes, management ineffi ciency etc.

Systematic risk cannot be diversified away however, the unsystematic risk will cancel out across
companies, as bad events in one company are evened out by good events in another.

-- Unsystematic risk

Systematic risk

I
I5-20
Nurnber of investments in the pordolio

Therefore as shareholders suffer only systematic risk if they hold a wide-ranging or welldiversified
a company only needs to pay a retum based on that risk.
porrfolio,

CAPM measures the systematic risk as a beta. A beta of I indicates that the company has the same level
of risk as the average of the market portfolio. A beta of 0.5 would indicate that it has only half the risk of
the market portfo[o. and therefore does not need to give such a high retum.

This can be expressed in 6e following equation.

:
Required retum Rr+ KRm - R,

il'here Rf = return on risk-free investments such as teasury bills; Rm: average return on the market
portfolio.

Payback

Payback is a good technique in that it uses earlier cash flows which are more certain and useful if a
company is short of cash. Ia a sense a short payback also indicates less risk for the project since the
longer period cash flows are fraught with risk. However, it has the following drawbacks.

(i) It ignores the time value of money

(i0 It ignores cash flows after the payback period
(iiil It does not measure the change in shareholder wealth
(ir) Target paybacls are chosen subjectively
The technique of using discounted cash flou,s, although more complicated, overcomes all of these
problems.

Page | 51
 Question No.2

(a) Differentiate between sensitivity and scenario analyses. What advantage does scenario analysis has
over sensitivity analysis? 5

(b) Tista Cement Ltd. has a fixed rate loan of BDT 125 Million at l3%o,which must be redeemed one
year hence. The Company is considering an interest mte swap with Gomoti Steel Ltd., which has a
floating rate loan of the same size at LTROR plus 1o,6. If the swap goes ahead, Gomoti Ltd. will pay
Tista Lid. t2% andTista Ltd. will pay Gomoti Ltd. LIBOR ptus irlr:N. Tista Lld. could issue no"tini
rate debt at LIBOR plus 2o/o andGomoti Ltd could issue fixed rate debt at 12%%.

There would be legal fees of 0.10% for each company on the amount of swap if the swap is made.

Requirement:

(i) Would the swap benefit Tista Ltd:

. if LIBOR is ll% for the next year. 3

o if LIBOR is 11% for the next four months, and9.5% thereafter? 3

(ii) Could an aiteration in the terms of the swap make it beneficial to both companies? Any benefit would
be shared equally between them. 4

(c) You should assume that it is now 30 November 2014.

American Adventures Ltd (AA) is a family owned company based in the tIK. AA organises walking,
cycling and climbing holidays in the United States of America for both British and American customers.
AA has the following receipts and payments due in four months'time:

Receipts due from American customers on 3l March 2015 $2.25 million

Payrnents due to American supplien on 3l March 2015 $3.50 million
You work fot Zeta Corporate Finance u'hich has been asked to give advice to AA on hed.ging its
exchange rate risk. You have available the following data on 30 November 2014:

Exchange rates:

Spot rate ($/f) t.5i 54 _ 1.5157

4-month forward contract premium ($if) 0.0c12 - 0.0011

March currency futures price (standard contract size f62,500): $1.514gif

March traded sterling currency options (standard contract size f,10,000):

The premiums are quoted in cents per f, md ae payable up front.

Skike price Call premium Putpremium

$ 1.56 1.04 6.r5

Annual borrowing and depositing interest rates:

Sterling 4.10% -
350%
Dollar 3.51% -
2.25% \,/'
Pagel52
Requirement:

Assuming the spot exchange rate on 31 March 2015 will be $1.5150 l.5156ll and that the sterling
-
currency-futures price will be $1.515310, calculate AA's net sterling payment if it uses the following to
hedge its foreigrr exchange risk:

. a forward contract 4
. curency futures 4
r omoney market hedge 4
c curoncy options 4

Answer to the Ouestion No. 2 (a):

Sensitivity analysis is a technique that indicates how much NPV will change in response to a glven
change in an input variable, other things remaining constant.

Sensitivity analysis begins with a base-case situation, which is developed using the expected values for
each input. In a sensitivify analysis, each variable is changed by several perc_entage points above and
below tire expected value, holding all other variables comtant. Then a new NPV is calculated using each
of these valuis. Finally, the set of NPVs is plotted to show how sensitive NPV is to changes in each
variable. Sensitivity analysis can provide useful insights into the riskiness of a project.

Aithough sensitivity analysis is probably the most widely used risk analysis technique, it does have
limitations.

Scenario is a risk in which the best and worst case NPVs are wirh

more than one rble at a scenano yst begins

case, or.most set values input variables. Then, he or she asks marketing,
engineenng and other operating managers to speciff a worst case scenario and a best case scenario. Often, . . '::
the best case and worst case are set so as to have a 25o/o probabilify of conditions being that good or bad
and 50% probabiliry is assigned to the base case conditions.

Scenario analysis provides useful information about a project's stand-alone risk. However, it is limited in
that it considers only a few discrete outcomes, even though there are an infinite number ofpossibilities. Ia
recent years, mathematical modeling allows for sensiviry analysis for infinite number of possibilities that
gives a betterpicture ofthe riskiness ofthe project.

Answer to the Ouestion No. 2 (b):

(i)
With LIBOR at llo/o for the next year, the cost with the swap would be as follow:
Interest ( 1 2 5, 000. 000 X (1 3o/o' 1 20,o+ I lvo+ | .5%) 16,875,000
Legal fee 125,000
Total Cost 17,000,000

With LIBOR zt lloh for four months and at 9.5olo thereafter, the cost with the swap would be as
follows:
Interest ( 1 2 5,000,000 X (l 3% -120/0+ 1 1%l 3 +9.5 I 3* 2+ | .5%) 15,625,000
Legal fee 125,000
Total Cost 15,750,000

Without the swap, the cost would be BDT 16,250,000.

The swap would therefbre be disadvantageous to Tista Ltd if LIBOR were to remain at llo/o throughout
the year, but advantageous were LtsOR to fall to 9.5o/o afrer four months.

Page | 53
 (ii)
Possible new terms would be for Tista Ltd to receiv e 12% and pay LIBOR +0.75%.
The net cost would
be LIBOR + 0.75% + (13 -l2)% = LIBOR + t.isyo, which is'0.25% less than the rate at which the
company could raise floating rate debt.

Gomoti Ltd would then effectively have fixed rate debt at 12% + (l - O.'15)% = 12.25%,which is A.ZS%
less than the rate at which it could othenvise have such debt.

Answer to the Ouestion No. 2 (c):

The net exposure to FOREX should be hedged by matching pa,rynents

and receipts: $3.5 - $2.250 : $1.25
miilion payment.
A forward contract:
The exchange rate for the four month forward contract is calculated by
adjusting the spot rate by the
premium: $1.5154 - $0.0012 = $1.5142.
The cost of the pay'ment in f is: $1,250,000 million I $1.5142= fg25,5lg
This will be the cobt of the payment no matter what the spot rate is on
31 March 20 14
Currency futures:
To hedge an unexpected shengthening of the $ against the f the tvlarch 2014
futures will be sold on 30
November 2013 at $1.5148.
The number of conhacts to sell is:
($1,?'s0,000i$1,5148y&62,500 = 13,20 Round to 13 contracts resulting in a slightly under hedged
pos!tion,
At 31 March 2014 the crurency futures contracts will be closed out and the
$1.?.5 million purchased on
the spot market.

Closing out the contracts:

The futures price at closelut is $1.5153. To buy back at this pnce will
result in a loss on our fufr:res trade
of: $1.5148 - $1.5153 = -$0.0005
The total loss is: $0.0005(f"6Z,SAO x 13): $406.25.
The releyant spot exchange rate on 3 I March 2013 is $ 1 .5 1 50.
The total cost of the payment plus rhe loss on,furures is: ($1,250,000 + g496.25)/$1.5150
= fg25,351
.A money market hedge:
A.money market hedge is achieved by borrowing in f and making a deposit
in $:
The amount to deposit in $ is: $1,250,000(t + 0.0225.3) = $1,2i0,695'

This amount will be purchased at the spot rate on 30 November 2013:

$1,240,695/$ 1.51 54 = tBtB,724
The total cost together with interest is: [81g,724(l+0.047/3)= Ig31,551

Currency options:
since we-are a uK company using sterling options priced in $ we will
hold put options (i.e To sell f,).
The number of contracts i.s: ($1,250,000/$1.56)/Ii0,000 = 80.13 nourJi"
S0';";d;o,.rri,i"g i*
slightly under hedged position.
The premium is: (80 x $0.0615 x fl0,000)/$t .5154 = f32,467
since this is payable upfront the total cost plus interest is: f32,467(l+0 :
.047 13) [32,97 6
The options will be exercised since the spot rate on 3l lr{arch zot+
rs $1.5150 is worse than the exercise
price of $1.5600

Page | 54
since we slightly irnder hedged our position this will result in a shorrfall of:

$1,250,000 - (80 x $1'5600 x f10,000) = $2,000' This can be purchased on the spot market:
$Z,oOoiSt.StSO:fl,32o.Thiswillresulti:ratotalgcostof:(80x110,000)+L32,9'16+f1,320:
L834,296

Question No.3
The Shabib Company plans to raise a net amount of Tk 270m to finance new equipment
and working
per
capital in earty ZtitO.-fio alternatives are being considered: Common stock may be sold to net Tk 60
share or bonis yieldinglZ% may be issued.lhe bal*.. sheet and income statement for
the Shabib
Company prior to financing are as follows:

Mn Taka Mn Taka
Cunent assets 900.00 Accounts payable t72,50
Net fixed assets 450.00 Notes payable to bank 255.00
Other curent liabilities 225.A0
Total current liabilities 6s2.54
Long term debt (100/0) 300.00
Common stoclg Tk 3 per share 60.00
Retained eamings 337.s0
Total assets 1.350,00 Total liabilities and equity 1.350.00

The Shabib CompanY

Income statement for the year ended Decernb er 31, 2Al5
Mn Taka
Sales 2,475.00
Ooerating costs 2.227.s0
: -i'.
Earninss before interest and taxes (10%) 247.54,
Ilterest on short term debt i5.00
Interest on long term debt 30.00
Eamings before taxes 202.s0
Taxes (40ori,) 81.00
Net income 121.s0

Probability Probabili8 Arurual sales Mn Taka

0.3 2254
0.4 21AA
0.3 3150

Requirement:

Assuming that EBIT is equal to l0% of sales, calculate eamings per share under both the debt financing
and the stock hnancing alternatives at each possible level of sales. Then calculate expected earnings per
share and Coeffrcient of variation of EPS under both debt and stock financing altematives. Also, calculate
the debt ratio and the times-interest -earned (TiE) ratio at the expected sales level under each altemative.
The old debt will remain outstanding.

Which financing method do you recommend? l4

Page | 55
 Alswer to the Ouestion No.3:

o)
Use of debt (Mn Taka)
Probability
Fig Mn Taka
0.3 0.4 0.3

Sales 2,250.0 2,7A0.0 3,150.0

EBrT (10%) 225.0
270.0 315.0
Interest* 77.477.4 77.4
EBT t47.6
192.6 237.6
Taxes (40%) 59:077.0 95.0
Net lncome 88.6
115.6 142.6
Eanrings per share (20m shares) Tk4.43 Tk 5.78 Tk 7.13
*Illelelt on ggbl (t!?zqx0. I 2) + cu.rrent interest expense
=Tk32.4 +Tk45
I =Tk77.4
.

Erye91e! EPS.= (0.3) (rk 4.43) + (0,4xtk 5.78)+(0.3)(tk 7,r3)

= tk 5.78 if debt is used.

?^2 Debt= (0. 3XTk 4,43 -5.7 8)"2+(0.4XIk 5.7 8-5.7 8)"2+ (0. 3XTk 7. 1 3 _s.7 8)^2
= 1,094

? DebF ?1.094 = Tk 1.05

= Standard deviation ofEPS ifdebt financing is used.

cv= (tk 1.05/Tk 5.78) = 0. 18

E (TIE debt) = E(EBITTI= TK270tTK77.4 = 3.49x
Debt/Assets = (tk 652.50+tk 300+tk 270y(Tk 1350+tk 270):75.5%

Use of stock (Mn Taka)

Probability
Fig Mn Taka
0.3 0.4 0.3

Sales 2,25A.0 2,700.0 3,150.0

EBrT (10%) 225.0 270.0 315.0
Interest* 45.0 45.0 4s 0
EBT
Taxes (40%)
ffi72.0 90.0 108.0
Net Income 108.0 l35T----162.0
Earnings per share (24,5 mshares) Tk 4.41 Tk 5.51 Tk 6.61

Number of shares = (tk 270mltk 60)+ 20 m= 4.5m+lQ6= 24.5*

EP! (0.3) (tk 4.41)+(0.4)(tk 5.51)+(0.3xrk 6.61)
Fgyry:
= tk 5.5 l.

?2 *y;V= (0.3XTk 4.41-s.st) 2+(0.4XTk s.5I-5.5I)^2+ (0.3XTk 6.61_s.st)^2

= 0.7260

? Equity= ?0.7260 = Tk 0.85

CV = Tk0. 85/Tk 5.51 = 0.15
E (TIE) =Tk27DIK45= 6.00x

DebVAssets =( Tk 652.5+& 300XTk 1350+ tk270)= 58.8%

Page | 56
Under debt financing the expected EPS is Tk 5.78, the standard deviation is Tk 1.05, the CV is 0.18 and the debt
ratio increases o 7 5.5%. Under equity financing the expected EPS is tk 5.51, the standard deviation is Tk 0.85, the
CV is 0.15 ad the debt ratio decreases to 58.8%. At this interest rate, debt financing provides a higher expected EPS
than equity financing; however, the debtratio is significantly higherunder the debt financing situation as compared
with the equity financing situation. Because EPS is not significantly greater under debt financing, while the risk is
noticeably greater, equity financing should be recommended.

Question No.4

(a) You are presented with the following different views of stock market behaviour.

(l) If a company publishes an eamings figure higher than the market expects the shares of that
company to experience an abnormally high return both on the day of the earnings announcement
and over the lwo or three days following.

(2) The retum on professionally managed porffolios of equities is likely to be no better than that
which could be achieved by a naive investor who holds the market portfolio.
(3) Share prices usually seem to rise sharply in the first few days of a new fiscal year. However, this
can be explained by the fact that many investors sell losing stocks immediately prior to the fiscal
year end in order to establish a tax loss for capital gains tax purposes. This causes abnormal
dovnward pressure which is released when the new fiscal year begins.

Requirement:

(i) Briefly describe the three forrns of the effrcient markets hypothesis. 4
.:.r
(ii) Consider what each of the above three statements tells you about the efficiency of the stock market.
Where appropriate, relate your comments to one or more forms of the efficient markets hlpothesis. 6

(b) Padma Limited, a quoted company on The Dhaka Stock Exchange (DSE), has 50,000,000 shares in
issue. Their cunent market price is BDT8 per share. Meghna Limited, another DSE quoted company
has 40,000,000 shares in issue currently trading at BDT 20 each. This may be taken as the situation
on day 0.

On day 3 the Board of N{eghna Limited decides at a private meeting to make a takeover bid for Padma
Limited. At the Board meeting, Meghna Limited's Chairman informs his fellow board members that a
detailed assessment of the synergistic benefits of the takeover is estimated at having a Net Present Value
of BDT 200,000,000. The Board agrees to propose a cash offer to shareholders in Padma Limited of BDT
10 per share. There will be no Share consideration.

On day 6 the Board of Meghna Lindted pubiicly announces the terms of their offer. They do not release
details as to the potential synergisnc benefrts.

On day 10 Meghna Limited's Board announces publicly details of the potential synergistic benefits.

Requirement:

Ignoring tax and the time value of money between day 0 and 10, and assuming that no other factors have
influenced the share price of both Meghna Linrited and Padma Liited, determine the:

. Day0
. Day3
o Day6
o Day 10

Page | 57
 share price ofboth companies ifthe Dhaka Stock Exchange is considered to display:

(i) Semi-strong Form Efficiency 8

(ii) Strong Form Efiiciency 2

Answer to the Ouestion No. 4 (a):

(i) Three forms of EMH

The efficient market hypothesis considers how efficient the market is at adjusting in prices information
available to investorl, Three possible levels ofefficiency bave been postulated.

\Yeak form
A market is weak form efficient if all the information *'hich has been gleaned from a security's past price
movement has been reflected in the cunent market value of that security.

Semi-strong form
A market is:semi-strong form efficient if all publicly-known information abour a company, including its
plans, together with infornation about the security's past price movements, is refleited in the current
market value of that security.

Strong form
A market is said to be shong form efficient if the current market value of a security reflects all past
information, publiciy available information al d insider information.

(ii) First statement

Having released information regarding a company's earnings, this has resulted in a rel-ision.of investors,
expectations which leads to an increase in the market value of the security because the information was
favourable.

Because this high return was experienced over two or three days following the announcement, it suggests,.
that the market transmission mechanism is not efficient. Had it been efficient there would ha'e been
no
time delay: all investors would have received the hformation at the same time and acted upon it.

This scenario is characteristic of a semi-strong form efficient market, in that inyestors are rev'ising their
expgctations regarding_future earnings as soon as the information is publicly knou,n, although asstated
there is-a time delay. Having acted upon this inforrnation, a new equitibrium is achieved overZ period of
two to tkee days following the announcement.

Second statement

A professionally-managed porrfolio may give a return which is no better than that which can be achieved
by a naive investor, because both have access to the sarne information.

This may accord with the view that the market is shong form efficient, all investors having access to
all
relevant information. Therefore no parfy is in a more favourable position relative to the otter party,
and
neither parfy can make a gain.

It is also consistent with semi-strong efficiency, i.e. fund managers do not have access to better (inside)
information.

Third statement
This suggests that it is possible to earn abnorrnal retums by adopting a shategy ('buy just before tt:e fiscal
year end and sell a week or so later'), which is based on intbrmation contained-in the
iast time series. This
Page | 58
 the inefficiency' If the
implies inefliciency. The fact that there is an identi{iable cause does not elimirate
retum at the start of the fiscal year
*"rk t *.r" *."fiy efficient, arbitageurs would eliminate the excess
by creating buying pressures ibr tne rirOer-priced shares being sold at the end
ofthe previous fiscal year'

4oxi)

Form

Note
1 1

) 8',
3
3
10
6
10' 4
'10

Form J-
Padma Limited

Note Price Der share

I 8
/
+
:: 10

4 10

4
' r,' 10

Note- I: As the proposal u.as discussed on day 3, the day 1 price of each share price of each company
will remain unchanged.

Note 2: As the proposal was discussed in pnvate on day 3 and the Dhaka Stock Exchange is conside.red
-
to display semi sirong form eflficiency, the day 3 share price of each company wiil remain unchanged as
the detail discussed is not publicly available.

Note - j:
Day 6 value of Meghna Limited BDT
lntinsic value of Meghna Limitgd (40mihar"s at 20 Ta1<a 800,000,000
Intinsic vulue of Padma Lirnited (50m shares at 8 Taka e49!l 400.000.000
(s00.000,000)
Lers Castr Pavment to Padrna Li*ited Sh*.holde.s (5
INDICATftE DAY 6 VAIUE OI Meghna Limited 700,000,000
Dir"ided by: Meghna Limited qlqes-lgjssgg 40,000,000
nroteFrrw DAY6 VATLEOFEACHB4tg&Y PLC SHARE 17.50

Note - 4:
Dev l0 value of Meghna Limite! BDT
Intrinsic value of Meghna Lmuted (40m sha.es 800,000,000
Int'insic value of Padma l,@ 400,000,000
Less: Cash Palment to Padrna Limited Shareholders (50m shares @ Taka 10) (s00.000,000)
Net Present Value of Synergetic ten""fits 200,000,000
nntcerrW DAY 10 VAIUE ql4eehnq!4qlgq 900,000,000
Dirided by: Meghna Limited shares in issue 40,000,000
OlOlClffVe DAY 10 VefUE OF EACH Megh"a Limfted 22.50

Page | 59