'j*

Financial Management
MaY'June'2O11

Question No. I
Wilkinson Ltd. has identified Chris Limited as a potential acquisition target' It has approached you as

its financial adviser to ask for assistance in valuing the company. You have obtained the following
information about Chris Limited.

statement of changed in Equity for the years ended 31 December

20x7 20x8 2AX9

Tk.'000 Tk.'000 Tk.'000
Profit after tax 280 260 410
il60) (1 85)
Dividends 050)
Retained profit lru r00 225

Statement of Financial Position as at 31 December

20x7 20x8 20x9

Tk.'000 Tk.'000
1,365 1,405 1,560
Nonncunent assets
Working capital 810 ru 940
2.175 2.275 2.500
Share capital 100 r00 100
Retained earnings 875 975 1,200
l09o loan debenture 20X12 r.200 1.200 1.200
2.1'15 ) 11< 2.500

The nongcunent assets include an unused property which has a market value of Tk.100,000. The
debentures pay a seminannual coupon and are redeemable at the end of 20X12. The gross redemption
yield on 20X9 gilts paying a similar level of coupon is 117o'
',.j1 1rr tir .

The p/E ratio for the quoted company sector in which Chris Limited's activities fall is around 15 times
and the sector' s gros dividend yield is around llTo . The p of the sector is around 0.8 and the return on
0re market is around 217o.

Requirements:

(i) Estimate rhe value of Chris Limited, using four different methods of valuation. 10
(ii) Explain the rarionale behind each valuation, when it would be useful and why each method 6
gives a different value.
(iii) Discuss the limitations of your analysis and what further information you would require 4 to
conduct a more informed valuation.

Answer to the Ouestion no. I

1 (a) Directors have always been known to lead and direct an organization or a company by. deploying
and manipulating of resources i.e. the human, capital, natural, intellectual and intangible. Shareholders, on
the other hand, hold one or more shares or stocks in a company. The actual power of the shareholders
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tends to be very linrited though it seems that they are the owners of the comp3ny. They are not
participating in day-to-day affairs of the company and have no influence on operational policy decisions.
Conflict of interest happens when both parties want to maiimize each benefit. The shareholders want to
see higher profits as more dividends can be yield from it whilst the managers are more inreresred in higher
revenue beiause it means more expenses can be made that are beneficiai to them. Managers may wish to
hold more cash and receive more perks that would be the expenses of the company and this miy reduce
the profit. Both managers and shareholders have different attitude towards risk in which the shareholders
rlls/ r1ry3n1 to invest in many companies so that they are holding less risk if one company might go into
liquidation and so the shareholders financial security are not threatened. The manager's financial security
on the other hand relies on what happen to companies that employ them which therefore consequent them
to not favor the shareholders of investing the companies' fund in risky investment. Conflict between both
can also arise when there is takeover bid to the company. This therefore will lead the managers to lose
their job whilst the shareholders will normally gain from this takeover since they will receive above
normal gain from the share price.
Directors tend to increase debt in order to reduce the cost of fund that results in boosting-up profitability
as well as boosting-up their remuneration. But increase in debt may decrease the degree of influence and
control of shareholders over the organization. Shareholders are more concerned about the end result of the
period (time horizon) but the directors want continuous benefit (perks) throughout the period; so rhar
without evaluation by the shareholders on a time horizon point directors' benefits cannot be enhanced.
Therefore, directors might pursue an agenda backed by their personal interest which is sometimes
detrimental to the objective of 'maximization of shareholders wealth'.
I (b) (i) Stakeholders are existing shareholders, creditors, employees, potential investors, banks,
regulatory authorities etc. The financial management issues are: (a) capital structure decision (b) cost of
capital (c) cunent retained earnings and future earning capacity to provide satisfactory and consistent
growth of dividend (d) requirement of capital expenditurcs and investrnent appraisal (e) protection the
interest of the existing sharehotders (l) ROE & ROCE before and after public (g) cash flow management
etc.

(ii) Stakeholders are debt holders/debenture holders/lenders, existing shareholders, creditors, taxation
authority, banks and other financial institutions (if any), potential investors, stock market regulators,
company managers/directors etc. The financial management issues are: (a) capital strucrure decision (b)
cost of debt (c) cost of equity (d) loan covenants (e) interest coverage ratio (f) indifferent point of EBIT
(g) earaing capacity and growth of EBIT (h) security and company law regarding conversion of debt into
equity (i) net assets per share (NAPS) (i) impact of high gearing on profitability (k) cash flow
management (l) outstanding interest on loan (m) solvency to pay debts (n) cunent & quick ratio (o)
underlying convertible scheme etc,

1 (c) Berbre takeover, the number of shares of D plc is 20 million. The scheme consists of one share in D
plc for every three shares held in S plc plus Tk.1.00 in cash for every three shares held in S plc.

After takeover, the total number of shares would bc:

= 20 million + (6 million x l/3)
= 22 million

The takeover is expected to increase the value of the firm to the extent of the present value of Tk.l2
million due to research and development savings.
Value of the firm after takeover:
= (22 million x Tk,10) + Tk.12 million
=Tk.232 million

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Value per share after takeover:
=Tk.232 million / 2? million
= Tk,10.55

Determination of the change of wealth of a shareholder who owns 3000 shares in S plc if the takeover
was successful:
Shares of D plc in exchange of shares of S plc (3000 x l/3) = 1.0Q0 shares

Value of 1000 shares in D plc after takeover (1000 x Tk.10.55) = Tk.10,550

Cash received (Tk. 1.00 x 1/3 x 3000 shares) = Tk. I .000
Total = Tk.l l,550
Value of 3000 shares in S plc before takeover (3000 x Tk.3.00) = Tk, 9.000
Change of wealth = Tk.2.550 Increase
I (d) Assuming WACC of P Ltd is l\Vo as it has the same operating and risk characteristics as M plc. P's
capital structure consists of 3070loan capital andTOVo equity. The iost of the loan capital is 47o (risk free
rate) subject to corporation tax @ 20V0. Hence rhe cost of the loan capital (ka) is [47o x (1 0.20)] =
-
3.TVo.

Therefore, the equation is as follows:

0.10 = 0.70 h + 0.30 (0.032)
0.10=0.70Iq+0.0096
0.70h=0.10-0.0096
k=0.0904/0.70
h= 0.1291 i.e 12.9lTo
The cosr of equity capital of P Ltd is t2.9l%o.

MM theory (including taxation) reveals that the existence of higher debt ievels makes the investment in
the company more risky so that shareholders demand a higher risk premium on the company's stock;
hence k" of P > lQ of M (l29lVo > l\Vo) though overall cost of capital (WACC) is same (10%) for both of
the company. '

Question No.2
2' (a) Genesis Ltd' a listed company operating in the tourism indusrry, has recently appointed a new"-
finance director who is about to consicler the merits of a potential investment oppoitunity in one of
the company's existing market sectors. The company has grown rapidly in iecent years, with
dividends (paid annually) growing at a rate of 8?o per annum for the past-two years. The finance
director has been advised that such a rate of growth in dividends is expected to continue in the
foreseeable future.
In the past, when undertaking net present value appraisals of such investment opportunities, the
company's financial analysts have used the rate of interest on the company's longlterm debt as a
discount rate. The new finance director believcs that it woulcl be more accurate to use the
company's weighted average cost of capital as a discount rate.
Information regarding the capital structure of the company is as follows:
(l) The ordinary shares of Cenesis Ltd, are currently quoted at Tk.l.50 extrdividend. The recenrly
paid dividend was Tk.0.05 per share.
(2) The company has issued ZAm8.4Vo pref'erencc shares, each with a nominal value of Tk.l. The
current exlldividend market value of these preference shares is Tk.0.80 per share,
(3) The company has also issued Tk.40m of 5Vo irredeemable debentures, which have a current
market price of Tk.50m.

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 The finance director is satisficd that if thc ncw invcstmcnt gocs ahead, thcn the funding for it will be
such that the historic financing mix of the company will rentain unchanged.

The finance director also has the following summarized opening balance sheet for 2009 for Genesis Ltd.

Balsnce sheet as at 31 December 2008

Tk.m Tk.m
Net assets 410 Ordinary shares
Tk.l 200
Preference shares 20

H:*X*,.debentures i!,
410 410

Profit after tax, interest and preference dividends for the year ended 31 December 2009 was Tk.30m.
Dividends for the year ended 3l December 2009 were Tk.10m

Corporation lax is 3OVo.

Requirements:

(i) Calculate the company's weighted average cost of capital (using the company's diviclend growth 5
forecast).
(ii) The finance director has explicitly assumed that the cunent capital structure will be 5
maintained. Discuss and evaluate the other assumptions that are implicitly being made when
using the weighted average cost of capital as the discount rate for appraising investment
projects.
(iii) Use the version of the Gordon growth model based on earnings retenticr: (g = r x b) to 4
calculate an alternative dividend growth rate of the company.

(b) The share of Crack Ltd. have a eunent market price of Tk.74 each, extrdividend. It is expected
that the dividend in one year's time will be Tk.8 per share. The required rate of return from net
dividends on these shares is 167o per annum.

If the expected growth in future dividend is a constant annual percentage, what is the expected 5
annual dividend growth?

(e) A firm has a dividend cover of 2, a P/E ratio of 9.3 (both based on its exldividend price). The
most recent financial statements indicated growth in shareholders' funds of l1Vo, resulting from
retained earnings.

What is firm's cost of equity? 5

(d) Sundarban Ltd. has been achieving the following annual results:

Taka
Profit before interest 1,000,000
Interest on Tk.2,500,00A l27o loan stock 300.000
700,000
Tax at 3A7o 210.000
Earnings and Dividend 490,000

The loan stock has a market price at par, and cost of equity is 19 .6Vo. There are 1 ,000,000 shares

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ii'iis
 tn lssue.
The company is now considering a project costing Tk,1,000,000 which would add to profits by
Tk.200,000 in perpetuity before interest and tax.

All earnings would continue to be paid as dividends.

The share price will respond immediately to any change in expected future dividend. Tax on
profits willremain t 307o

By how much will the share price change if the project is undertaken, financed entirely by new
debt capital, so that the cost of debt remains unchanged but the cost of equity rises to 7270?

Answer to the Question # 2

(a)(i) Forecast profit and loss account for the forthcoming year: (Tk.'000)
: By adoPting By Adopting
Financing OPtion-I Financing Option-Il.
Sales (W2) 7.900 7.900
Operating profit @ 12,47o (Wl) 980 980
Debentures interest payable (W3) 160 280
Net profit before taxation 820 700
Corporation tax (207o) 164 140
Net profit after taxation 656 560
Dividend proposed (W4) 328 280
Retained profit for the year 328 280

Workings:
Wl: Existing percentage of operating profit on sales - l2.4%o (800/6450). Assumed this rate of
operational profit is also maintained consistently for forecasted additional sales. .:,i
W2: Sales = Existing + Additional forecasted = 6,450,000 + (180,000 x 100 / 12.40) = Tk.7,900,000
W3: Existing 160,000 + New 120,000 (1,200,000 x l07a) = Tk.280,000
W4: Existing dividend payout ratio = 5A7o (2561512), The BOD has already announced that they worild
maintain the same dividend payout ratio in future years inespective of the form of finance raised.

(a)(ii) Forecast earnings per share for the forthcoming year:

By adopting By Adopting
Financing Option-I Financing Option-Il
Net profit attributable to
The ordinary shareholders Tk.328,000 Tk.280,000
No. of outstanding shares (W5) 2,000,000 1,200,000
Forecast EPS Tk,0.164 Tk.o.233

Workings:
W5:Number of ordinary shares under the two options:
- Option-I: Existing shares (600,000/0.50) + New shares (1,200,000i1.50) = 2,999,000 shares.
- Option-Il: Existing shares 1,200,000

(aXiii) Projected level of gearing at the end of the forthcoming year:

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 Gearing can be calculated by the following two ratios:
:- Debt I (Equity + Debt)
- Debt / Equity
By adopting Financing Option_I:
PrP, { lEquity + Debt) =
(2,000,000) / (3,400,000 + 2,000,000)
= 37 .04Vo
Debt / Equity = 2,000,000 / 3,400,000
= s;g.g?Eo
By adopting Financing Option_Il:
!e!t / (Equity +_Debt) = (3,200,000) t (2,200,000 + 3,200,00 0) = 5g,26?o
Debt / Equity = 3,200,000 I 2,200,000
= 145.45Vo
: It is assumed that the full amount of creditors (Tk.2,000,000) falling due
after more than one \ ear
is the debenture.

(b) The 'lndifferent Point' is the level of operating prol'it (EBIT) at which
rhe earnings per share will
be the same under each financing optionl 'The equation of indifferent
circumstance is as follows:
fiint uncler ttris
Existing Cap Structure + Proposed Option-l
> (EBIT * Inrerest) (l - Tax rate) / Nr (EBIT _
= Existing Cap Structure + proposed Option-lI
= - Interesi; (l - Tax rate) / Nz
> (EBIT- I60,000) (r - 0.2) / 2,000,000 (EBIT ZSO,bOo) (l _
= -
By.solving the above equation, we can find out the vatuc tf rdtr
0.2) z t,z6o,ooo
wnicn i, rt.+oo,ooo.
Therefore, Tk.460,000 is the Indifferent Point or level of EBIT at which borh the financing
options show the same EpS which can be proved as below:

Option-l Option-II
EBIT (Indifferent) 460,000 460,000
Interest on debentures 160.000 280.000
Net profit before taxarion 300,000 190,000
Corporation tax (20Vo) 60.000 36.000
Net profit after tax (Tk.) 240.000 144.000
No. of ordinary shares 2.000.000 1.200.000
Earnings per share (Tk.) 0.12 0.12
(c) The indifferent point ofEBIT or operating Profit is Tk.460,000
at which both the plans show the
same EPS' If the EBIT becomes more than Tk.460,000
tr,.n opiion-ll will show more Eps than
Option-I as option-Il is more geared than Option-I. It is
due to the total effect of increasing tax
shield on income and maintaining the number of shares
demonstrate the prospect of achieving higher growth
as before. If rh; .ffiny .un
of earnings in foreseeable future it is better
the expe'ct.J pstr is less than Tk.460,000
to choose the high geared option. on the other hand, if
then it is betrer to choose option-I that will provicle higher
rps trran option_Il.
Therefore, under the. existing forecasted operating profit
of rk.9g0,000 [see a(i) above], the
comparative earnings per share of option-I ana optLn-rt
wouto uei

Option-l Option-ii
Net profit afrer tax (Tk,) 656,000 560,000
No. of shares 2,000,000 1,200,000
EPS (Tk.) 0.328 0,467

Hence it is concluded that option-Il is superior to option-I from the point of view of profitability.

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a

Question No.3

3. Briefly discuss the problems of using future contracts to hedge exchange rate risks.
(a)
(b) Identify and explain the key reasons why small versus large companies may differ in terms of
both
the extent offoreign exchange and interest rate hedging that is undertaken, and the tool used by
management for such purposes.
(c) Kobler Ltd. is a mining company with exclusive rights to rhe mining of kilbe in Bangladesh.
Kilbe is a new metal that used in the construction industry. The demand for kilbe iJ trigtrty
dependant on the state of the housing market and the price ii highly volatile. Kobler wouldlike
to hedge its exposure but there are no traded derivatives for kilbe. The treasurer of Kobler has
approached a number of banks but have found the OTC market is expensive, as Kilbe is
considered to be too risky, and the company is therefore reluctant to use forward contracts for
hedging. One of the bankers they have sought advice from, suggested that they should use
futures contracts on eopper. She explained that the price of Kilbe is highly correlated with the
price of copper and therefore copper futures contracts are good substitutes,

Requirements:

(i) Explain why the company should care about hedging its risks and comment on rhe risks that
Kobler Ltd. may face if it adopts the recomnrendation and use copper futures contracts as a
hedging instrument.

(ii) The management of Kobler is cunently reviewing its funding strategies. All its borrowing is at 4
variable rate and there are strong indications that interest rates will' increase. Advii the' ,
management of Kobler on how they might reduce the impact of higher rates on the company's -"'
interest payments.

Answer tg the Ouestion # 3:

(1) rne price of the share would be Tk.l00 irrespective of payment

of dividend. As per M-M theory,
dividend policy has no impact on changes in the share price as well as rhe value of the firm. It is
merely a
distribution of prpfit splitting up betwien pay-out and retenrion, once shareholder gets dividend
in cash
he sacrifices his proportion of claim on company's net assets. Therefore, it does noi lead to
increase the
net wealth of the shareholders,

(ii) The information is provided:

- Net income = Tk.500,000
- New investment required Tk.1,000,000
=
'Dividend needs to be paid @Tk.8 for 50,000 outstanding shares Tk.400,000
=

Determination of number of new shares that must be issued:

Balance profit after dividend = 500,000 - 400,000 Tk.100,000
=
Balance of fund required by issuing new shares 1,000,000
=
No. of new shares to be issued = 900,000 / 100 = 9,000,
- 100,000 = Tk.900,000

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 (iii) (a) Value of the firm if dividend is declared:
Total no, of shares = Existing outstanding shares + New shares
Total no. of shares = 50,000 + 9,000 S9,OOO
=
of the firm = 59,000 x Tk.l00 = Tk.5,900,000
]at19
(b) Value of the firm if dividend is nor declared:
The amount of investment is financed by the retained earnings/cunent
earnings to the maximum available
extent (Tk'5CI,000); the balance shortfall(Tk.500,000;
wouia be arranged b! issuing new shares. So rhe
number of new shares are 5,000 (500,000i 100).
Total no. of shares = 50,000 + 5,000 55,000
=
Value of the firm = 55,000 x Tk.l00 Tk.5,500,000
=

Question No.4

4. Following is the Eps record of AB Ltd. over the past r0 years:

Year EpS (Tk,) ' year' V EPS (Tk.)

10 20
9 t9
8 t6
7 l5
6 l6
5 t2
4 6
J 9
2 (2)
I I

Required:

(i) Determine the annuar dividendpaid each year in the foilowing

(a) If the firm's dividend policy is based
cases: g
on u oiviaeni p'ay"ui rurio of 50 percent for all
yea$. "onrtunt
(b) irthe firm pays dividend atTk,7 per share each year except
when Eps exceeds Tk. 14 per share,
then an extra dividend equar to g0 percent of earnings
u.yono ir.. r+ would be paid.
(ii) which type of dividend poricy wiriyou recomrnendid to the
company and why? 6

Answer to the Ouestion No.4:

(a) when the market is efficient in the scm^i-strong form, it
irnplies that all public inforrnation is
calculated into a stock's current price' Neither fundamintal
nor technical analysis can be used to achieve
superior gains by the investors.

(b) Portfolio risk is of ,{prr,. systematic risk (marker risk) and unsysremaric risk (firm specific
unsystematic risk can Y,?fully be diveisified or eliminated ttrrouin investment in
risk).
a market portfolio. Market
portfolio means investment in every share/stock
systematic risk which remains beyond the control
of the malker. so i" ,rrk; ;;;;iiJ tirere is only
of the invesror. rrrus irr. ir;;r;;; demanrts risk
premium for systematic risk. Refer io the statement given
it not clear whether these 20 companies are the
whole players of the market; so we can't say this poifolio
is ttre murt et portfolio. Had this portfolio been
a market portfolio, the premium for systematic risi
should have been added to the risk free rate
determine the required rate.of return Lf the portfolio. in orcler to
that if an investor holds shares in about i0 diff"r.nt
Therefor", l; ;; circumstances this statement is true
portfolio will give a retum equat to the risk-free rate.
oll of the risk is eliminated and the
"o*puri"r
(c) A graph of the daily price of a share rnoving
up or down randomry does not necessarily mean
market is not price efficient. The premise that asset prices that rhe
are effiiient to the extent,tu,,t.y already

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4
$
t
factor in or discount all available information. The theory of price efficiency follows the efficient market
hypothesis (EMH) which holds that since market are efficient, it is nearly impossible for investors ro
"beat the market" on a consistent basis. The statement given is not clear about tlie lacking of elements of
EMH so how can we say the market is not price efficieni?

(d) Quarterly uK interest rare I vo (4vot4)and uSA inreresr rate z.Svo (l0rol4)
= =
Interest rate padty = Kr, / Kr= L0l / 1.025 0.9854
=
Therefore, three month forward rate of exchange = $ 1.4400 /o.g154 $ 1.4613
=
(e) Total borrowing costs: Tk.
Interest on loan ( I 0,000,000 x 5.27o) 250,000
Premium for option (sunk cost) 10,000
Total 260,000

Note: Actual interest rate at the expiry date of the option is 5.2Vo ( LIBOR plus 0.2V0 i.e S.OVo +O.2Vo)
which is less than the strike rute oi 5.5Vo. So T Ltd shall not exercise the option but the premium it had
already paid at the time of entering rhe contract of the option being the sunk cost.

Question No.5

5. The initial investment outlay for a capital investment project consisrs of Tk.l00 lakhs for plant and
machinery and Tk.40 lakhs for working capital. Otfrei deiaits are summarized below:

Sales (lakh units per annum for years I to 5) I

Selling price (perunit) LZO
Variable cost (per unit) 60
Fixed overheads (excluding depreciation) (lakhs per annum for years I to 5) l5
Rate of depreciation orr plant and machinery (percent on WDV) 25
salvage value of plarrt and machinery @qual ro the wDV at the end of year 5)
Applicable tax rare (percenr) 40
Time horizon (years) 5
PostDtax cut otf rate (percent) t2
Required:

(i) Indicate the financial viability of the project by calculating the net present value. I0
(ii) Determine the sensitivity of the project's NPV under eachof the foilowing conditions: l0
(a) Decrease in selling price by 10 percent and decrease in variable cost by 5 percent.
(b) Increase in variable cost by 5 percent and increase in selling price by 5 pei..nt.

Answer to the Question No. 5:

(a) Any company can bomow from the lende(s) comrnitting to pay a fixed interest periodically
inespective of profit/loss from the operation. The lenders are privileged for priority payments of principal
and interest over all payments due from the company. They are nor participaiing inanypolicy
mating inA
operational decisions rather want their fixed charge. On the othei hanO, the iharehlliers throrghlhei,
representatives, the management, run the organization and claim residual income as
dividend. The
shareholders as well as the management are supposed to take various decisions that include
the matters of
cash dividend, debt/equity mix, further substantial loan arrangement, reduction/conversion
of share
capital, conversion of company status from private to public or vice versa, merger, acquisition etc.
Sometinnes these decisions significantly affect the interesi of loan holder. These caribe protected
by the
'Covenants' applied by the loan holders at the time of entering the contract for providing loan to the

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company' Covenants are the terms & conditions protecting the interest of the lenders from the detrimental
decisions made by the shareholders or management.
(b) EPS in each alternative:

Plan I u lil (iv)

EBIT (siven) 800,000 800,000 800,000 800,000
Interest 80,000 45,000
EBT 800,000 720,000 755,000 800,000
Tax @ 50Vo 400,000 360,000 378,000 400,000
EAT 400,000 360,000 377.040 400,000
Pref. Div 50,000
Eamings 400,000 360,000 377,000 350,000
attributable to the
Ord.Shareholders
No. of shares 20,000 10,000 15,000 10,000
EPS (TK.) 20 36 25.13 35
Rankine 4 I 3 2

Implications of financial leverage: Financial leverage denotes the degree to which an investor or business
is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are
unable to make payments on theirdebt;they may also be unable to find new lenders in thJfuture. On the
other hand, financial leverage can improve profitability due to the effect of tax shield on loan interest
resulting lower WACCC and higher ROL Therefore the shareholders are benefited by higher EpS turning
to higher dividend payout.

(c) (i) Management 'buy-in' occurs when a group of managers from outsicle the company purchase it and
become the new owners, instead of managers from within the company.
Management 'buy-out' (MBO) happens when a group of a company's management purchase part of the
company which they work for in order to own and run it by themselves, MBO has theadvantagl that they
cause far less disruption to the division's existing suppliers, customers and workforce than acompletely
new change of ownership.

(ii) The 'sell-off is the rapid seliing of securities, such as stocks, bonds etc. The increase in supply leads
to a decline in the value of security. A sell-off n-ray occur for nrany reasons. For example, if a iornpany
issues a disappointing earnings report, it can spark a sell-ofT of that iompany's share,

'Spin-offhappens when a group of employees set up an independent company to exploit a new idea or
some new technology that they have developed. Often the parent company has a minoiity shareholding in
the new company. Such an arrangement is most common in high tech industries. Thg parent company
gains from high returns from its investment, but does not have to be involved in the devilopment of tne
new product, which may be outside its normal area of activities.

The End

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