;* Financial Management

{ May-June 2012

Answer to the ques. no.1

(a) Capital rationing is the situation where not all positive NPV projects can be selected due to fund
constraint, so a choice must be made between projects. In one period capital rationing situation,
the profitability index (PI) rule can be used for divisible projects. PI rule breaks in the case of
multi-period funds constraint and project indivisibility. A more sophisticated approach linear
programming can also be used to select investment under capital rationing.

The steps to be followed to select a project under capital rationing:

initial cash outlay. It reveals PV of cash inflow per taka investment.

(b) (i) Payback period considering nominal cash flows:

ProjectX: I + [(1,000,000-676,000)/ 324,450] = 2 years

:i;:

Project Y: 2 +[(1,000,000 - 700,000) / 350,000] = 2.86 years

l:-

r'll

Assumed that the cost of capital of l57o is in nominal (money) term.

NPV of Project X:

Year Cash flows (W1) DF at 15Vo PV of cash flows

0 (1,000,000) 1.000 (1,000,000)
I 676,000 0.870 588, I 20
2 324,480 0.756 245,307
J 337,460 0.658 222,049
4 116,986 0.572 66.916
NPV = 122392

NPV of Project Y:

Year Cash flows DF at l1%o PV of cash flows

0 (1,000,000) 1.000 (1,000,000)
t-4 350,000 2,856 999.600
NPY = (400)

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 Internal rate of return:

Project X:

Taka Difference,(Tk.\
lri; ,'i PV required (A) 1,000,000

PV at lower rate l4%o (B) 1,139,743 139,743 (B - A)

PV at higher rate 24Vo (C) gg3,0g6 156,647 (B - C)

Hence, IRR of Project X= l4bo + (Z4Vo - l4%o) x (139,743 / 156,647) = 22.92Vo

Project Y:

Taka Difference (Tk.)

PV required (A) 1,000,000

PV at lower rate 14Vo (B) 1,019,900 19,900 (B - A)

PV at higher rate t6Vo (C) 979,300 40,600 (B - C)

Hence, iRR of Project Y = l4Vo + (16To - l4Vo) x (19,900 / 40,600) 14.987o

=

Workinss:

wl: Project X - cash flows converted into the nominal (rnoney) tcnns:

Year Cash flows at real terms Cash flows at nominal terms @ 4Zo inflation
0 (1,000,000) (1,000,000)
I 650,000 650,000 x 1.04 =676,000
2 300,000 300,000 x (1,04)2 =324,480
3 300,000 300,000 x (1.04)3 =337,460
4 100,000 100,000 x (1,04)a = 116,986

(b) (ii) Project X shows NPV of Tk.l 22,392 but Project Y shows negarive NpV of Tk.(400). Each
of
the projects is independent. Project Y will not bring any addition in the
wealth of the shareholders.
Therefore only Project X should be accepted.

(b) (iii) The NPV of X is positive whereas the NPV of Y is negarive.

The IRR of projecr X is higher
than that of Project Y' Therefore Project X should be accepted u-nder
mutually exclusive decision.
(b) (iv) For mutually exclusive projects, if the cost of capital ('K')
is less than the cross over rare the n
a conflict exists between NPV and IRR. The cross over
rate is the discount rate at which the- NpV of
two projects are equal. Two basic conditions lead to conflict bcrween '
NpV and IRR;
(i) difference in project size (or scale)
(ii) timing difference of cash fiows.

While conflict exists, NPV decision should be accepted as it maximizes

the taka wealth of

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 shareholders.

NPV at discount 57ol

NPV of Project X:

Year Cash flows (W1) DF at l1%o PV of cash flows

0 ( 1,000,000) 1.000 (1,000,000)
I 676,000 0.952 643,552
2 324,480 0.907 294,303
3 337,460 0,864 291,565
4 116,986 0.823 96.279
NPV = 325.699

NPV of Project Y:

Year Cash flows DF at157o PV of cash flows

0 (l,000,000) 1.000 (1,000,000)
t-4 350,000 3.546 lqq
Npv =_*tF("4s
'.?1!
{.Y \
LhRARy
IRR:

IRR of Project X = 22.92Vo

IRR of Project Y = 14987o

Both appraisal methods (NPV & IRR) show that Project X should be accepted at 57o discount rate
so that no conflict exists. Therefore the cross over point would be below than 5Vo discount rate.

Answer to the ques. no.2

(a) Financing overseas subsidiaries depends on the following four key factors:
(i) Country law regarding expatriation of profit
(ii) Government taxation policies regarding foreign investors
(iii) Currency exchange ratio
(iv) Source and costs of raw materials and labour

Consideration for choosing a country for overseas investment:

(D Political stability and nature of government
(ii) Country infrastructure
(iii) Market condition
(iv) Foreign Direct Investment (FDI) policy.

The following measures are to take to prevent the exploitation of the country by Multi National
. Corporation (MNC):
(i) Minimum share capital to be brought up by the overseas investors
(ii) Conditions for employment of foreign employees
(iii) Certain restrictions on expatriation of profit, technical know-how fees, royalty,
management fees etc,
(iv) Assessment of impact on competitions with local players in the same industry

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 (v) Compliance with other related rules and regulations of Board of Irivestment (BOI),
National Board of Revenue (NBR), Registrar of Joint Stock Companies, Bangladesh
Security and Exchange Commission (BSEC), Bangladesh Bank etc.

(b) (i) D's pay-out ratio is 1007o so there is no retention for future dividend growth. In the future
years D's dividend payments will be decrease than that of company G which is potential for
growth having two-third retention ratio. So it does not necessarily mean that the investor of D
will get his or her money back faster than the investor of G. Because after certain stage G's
dividend amount exceeds D. Further in the demand of economy to increase the return, the

',
required rate of return of G will be higher than that of D due to higher risk associated with G than
D. If we assume that the expected streams of dividends from D & G remain constant, the share
value of G will be more declined than that of D. Therefore I do not agree with the statement given
in the question.

(ii) Yes I agree with the statement. Investors retain their money in G for long term benefit. G's
dividend growth is equivalent to its rate of return multiplied by the retention ratio. So G's
expected return will be higher than D.

(iii) The best estimate of G's growth rate is calculated below:

*
Where r =6 /40 100 = l5Vo as G and D are equally risky.
I agree with the statement.

(c) (i) Calculation of swap ratio:

Earning

Efficient Ltd:

Where Po = 500 / l0 = 50

Health Ltd:

Where Po = ?50 /7.5 = IOO

Book Value

Efficient Ltd:
Share Capital (Tk.l0 x l0lakhs shares) = Tk,l00lakhs
Reserve andSurplus ' = Tk.300lakhs
Net Assets = Tk.400 lakhs
No. of Shares = l0 lakhs
Book Value per share = Tk.40

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 (c) (iv) Free float market capitalization of the merged firm

Many different types of investors hold the shares of a company. The shareholders include
promoters, directors, govemment, financial institutions and general public. Hence only the "open
market" shares that are free for trading by any one of public are called the "free float" shares.
Therefore a particular company may have certain shares in the open market and certain shares
that are not available for'trading in the open market,
In this problem, free float shares mean the total shares less shares held by the promoters.
Total no. of free float shares = 4.75 + 8.65 = 13.4 lakhs
MP per share = Tk.87.10
Free float market capitalization = Tk.87.10 x 13.4 lakhs shares = 1167.14 lakhs

Answer to the ques. no.3

(a) Given that,

Cunent share price = Tk.100
Cost ofcapital= 10Vo
Expected dividend payment of Tk.5 per share at the end of the year.

As per M-M Hypothesis, dividend policy has no impact in determining the value of the firm as
well as increasing the wealth of the shareholders, The hypothesis suggests the following equation:

Po= (DIV1 + Pr) / (l+k)

Hence, Pr = Po (l+k) - DIVr

If dividend is paid then the share value would be:

Pr = 100 (1.10) - 5 = Tk.l05

The share holder's weatth:

Share value (right on equity) = Tk.l05

Increase of personal cash flow (dividend received) =Tk. 5
Total wealth = Tk.l l0

If dividend is not paid then the share value would be:

Pr = 100 (1.10) - 0 = Tk.1l0

The share holder's wealth:

Share value (right on equity) l

= Tk.l l0
Receive of dividend = Nit
Total wealth = Tk,l l0

The wealth of the shareholder remains unchanged inespective of payment of dividend. Therefore
it is proved that payment of dividend does not affect the value of the firm using M-M Hypothesis.

(b) (l) a) Determination of annual dividend payment if the firm's dividend policy is based on a
constant dividend pay-out ratio af 50Vo for all years:

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 Iiealth Ltd:
Share Capital(Tk.l0 x 7.5 lakhs shares) Tk. 75 lakhs
=
Surplus
Reserve and
= Tk.165 lakhs
Net Assets = ft :+Olutt,
No. of Shares 7,5 lakhs
Book Value per share
= Tk.32

Market Price

Efficient Ltd;

Health Ltd:

Criterion Taka in lakhs Weight WAV

Efficient Health Efficient Health
Eamings 5.00 20.00 40Vo 2.00 8.00
Book value 40.00 32.00 257o 10.00 8.00
Market price 50.00 100.00 357o i7.50 35.00
Weighted average value 29.50 5 1.00

swap ratio = 5l.00 t 29,5a = I .73 (For I share of Health 1,73 shares of Efficient)
Calculation of Promoter's holding Vo after acquisition

Total share capital after acquisition i0 lakhs + (7.5 lakhs x

= l.?3) = 22.97 laths

Promoters of Efficient Ltd - 4.7 S lakhs 22.97/ lakhs = 2O.6gVo

Promoters of Health Ltd = (5.00 rakhs x r.73) 122.97 rar&s =37.,;;;;
Total Promoters' shares holdings
= 5g.34Vo
(c) (ii) EPS of Efficient Ltd after acquisition

Total Eamings = [(5 x l0) + (20 x 7.5)] Tk.200 takhs

=
No. of shares =?2.97 lakhs
EPS = Tk.200 lakhs / 22.97 lakhs shares = Tk.g.7l

(c) (iii) Expected market price per share after acquisition

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Yeu Opening Retained EPS Dividend Payments Closing Retained Earnings
Earnings
(A) G) (c) (D) (E=B+C-D)
I r.00 0.50 .o.50
2 0.s0 (2.00) 1.s0)
3 1.50) 9.00 4.50 3.00
4 3.00 6.00 3.00 6.00
5 6.00 12.00 6.00 12.00
6 12.00 16.00 8.00 20.00
1 20.00 15.00 7.50 27.50
8 27.50 16.00 8.00 35.50
9 35.50 19.00 9.50 45.00
l0 45.00 20.00 10.00 55.00

b) Determination of annual dividend payment if the firm's dividend policy is that 'pay dividend
Tk.8 per share and increase to Tk.l0 when earnings exceed Tk.l4 per share for two consecutive
years':

Year Opening Retained EPS Dividend Closing Retained

Earninss Payments Earnings
(A) (B) (c) (D) (E=B+C-D)
I 1.00 1.00
) 1.00 (2.00) (1.00)
J (l,00) 9.00 8.00
4 6.00 6.00
5 6.00 12.00 8.00 10.00
6 10.00 r6.00 8.00 18.00
7 18.00 15.00 10.00 23.00
8 23.00 16.00 8.00 31.00
9 31.00 19,00 10.00 40.00
10 40.00 20,00 8.00 52.00

c) Determination of annual dividend payment if the firm's dividend policy is that 'pay dividend
Tk.7 per share each year except when EPS exceeds Tk.14 per share, when an extra dividend equal
to 807o of earnings beyond Tk.14.00 would be paid' :

Year Opening Retained EPS Dividend Closing Retained

Earninss Payments Earnings
(A) G) (c) (D) (E=B+C-D)
I l.00 1.00
a (2.00) (1.00)
L 1,00
3 r.00) 9.00 7.00 1.00
4 1.00 6.00 7.00
5 12.00 7,00 s.00
6 5.00 16.00 8.60 12.40
7 12.44 15.00 7.80 19.60
8 19.60 r6.00 8.60 27.A0
9 27.0A 19.00 11.00 35.00
l0 3s.00 20.00 11.80 43.20

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 (b")(2)I would like to recommend the dividend policy on a corstant dividend pay-out rario. By
adopting this policy, the shareholders would be knowing rhe pattern of dividend piyments
in the
foreseeable future which might be considered as 'prediciable ipproach' from the
of view of
ioint
existing and potential shareholders. Moreover, this policy focuses the payments.on the basis
of
financial performance of the company as well as the reiention of profit for oesired future growth.
This
policy also makes a balance between dividend and capital gain in the hands of the
shareholders. So
the shareholders would be happy; rhe company is beneiited is well.

Answer to the ques. no.4

(a) Report for Lip's directors as to the valuation of Bengal;

Date:12.3.2014

To: The Board of Directors

From: Corporate Finance Manager

Sub: Valuation of Bengal Ltd (a 'Target' by Lip)

Dear Sirs,

Please refer to earlier Board's meeting decision on 9 February 2014 asking a valuation
of Bengal Ltd, a
Target of Lip Ltd for prospective acquisition in future,

Back ground

Recenlly Lip Ltd (the company) has received a proposal from its invesrnrcnt bank that the
company might
consider the acquisition of Bengal Ltd (Bengal), as a route to both further expansion
and diversification of
the company's activities.

Bengal is involved in a different area of pharmaceutical sector from the company

as it is primarily a
research-driven company involved in the development of new drugs arising
irom the latest academic
research, often working. wilh research departments of universiti.r-*o
trrJhing t ospit.t, to turn the
research into commercial reality.

The majority of Bengal's shares are owned by members of the three founding
families and they are
willing to sell their shares upon suitable bid,

Scope and Limitations

The valuation is largely based on the audited financial statemenrs for the year ended
3l December2013
along with forecasted earnings for 2014 submitted by Bengal for the purpose. As
assumptions, estimates,
accounting principles, accuracy of figures are solely Iying with the management
of Bengal so that if it
changes under any circumstance may influence the changeln valuation as
well as decision.

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Valuation of Bengal

The following three valuation models are used in valuing Bengal:

(i) Net assets
(ii) Dividends
(iii) Current and fbrecast earnings
/"rPss
(i) Net assets: h'(rr,**.,rI
Book value of equity / net assets (Taka million) (A)
Shares in issue (million) (B)
Net assets per share (A / B)
22.50
0.75
30.00
(.t*"#
Book value is the historical cost (net of depreciation) of assets. The assets may or may not be realizable at
this value. The target company might have different depreciation policy coverings useful lives, charge of
depreciation at the beginning and ending years of assets etc. The question may arise regarding the
credibility of revaluation in any case. The important point is to review the impairment judgments if it
occurred for any class of assets.

The model is derived from the following equation commonly known as 'Dividend Valuation Model'.

Po= Divo (l + g) lk- g

Where, Po = Present price of share, Divo = Cunent dividend per share, g = Dividend growth rate
and k = Cost of equity.

Hence, the value per share:

= 0.50 (1.06) / 0.08 - 0,06

= Tk.26.50

It is noted that in absence of information of Bengal's own cost of equity, we considered the average cost
of equity for listed companies in the same sector which is 87o,

The important point is that we did not get any information regarding the cost of equity of Bengal. In
absence of this information, we considered the average for listed companies operating in the same sector.
As Bengal is a small company and not listed, its cost of equity is not identical io other listed companies in
the same sector.

We have received no analysis from Bengal on forecasting the future dividend growth of 6Vo.

Any changes of the above factors may lead to change the valuation under rhis method.

(iii)Cunent and forecast earnings:

Due to the unavailability of specific PiE ratio of Bengal, we used here the cunent P/E ratio of Lip in order
to estimate the value of Bengal under this method.

PE of Lip would be 1099.56 (618.50 t 0.5625).

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 Value per share of Bengal based on current earnings -
= 1099.56 x 0.7650
= Tk.84l.16

Value per share of Bengal based onforecast earnings

-
Forecasted EPS of Bengal = Tk.2.00 million / 0.75 million shares
=Tk.2.67
I{ence the value per share would bc
= 1099.56 x?.67
= Tk.2935.83
Here we used Lip's current price-earnings ratio. As Bengal is involved in a different area of
pharmaceutical sector (research-driven company) from Lip sJ P/E of Lip may not fully
be related to
Bengal. However, we have not received the basis on the calculation of iorecast earnings for the
next
financial year from Bengal. Any changes of these factors may lead to change the valuaiion under rhis
method.

Regards.

ISignature]

(b) if tne fund is

?na-ng_ed
through right issue the existing shareholders are entitled to ger further
shares at the price below the underlying market price. This privilege goes to existing
shareholders
and the control remains protected from other potential invesiors e.g ,i*
shareholdeis, lenders etc.
The problem is that eamings per share may decline or may ,oi so incline due to increase
of
number of shares compared to the incremental present vaiue for the new project/acquisition.
Another problem is that the cost of equity is genirally higher than the effective rate of cost
of
debt (interest rate n-et of tax shield) so ttrai it leads to increise the WACC of the
company. Right
issue is a matter of time consuming as it requires the permission from the shareholclers'
annual
general meeting and subsequent approval from the Seiurity Exchange
Commission (as Lip is a
listed company),

Term loan is generally regarded as cost effective method of source of finance

due to the impact of
tax shield' It increases the profitability as well as earnings per share. The problem
is that
sometimes control is hampered due to stringent covenants impoied by
the lenders. If debt-equity
ratio is excessively high then the cost of equity and cost of dibt mayincrease
due to increase of
related risk' Another problem is to obtain the fund from the financial institutions.
In the question
it is given that Lip already has debt-equity ratio of 25vo so rhat lenders might focus on rhe
risk
factors which turns the issue into a difficult level for Lip.

(c) Relative advantages: organic growth vs. acquisition

Organic growth

companies).

disruption andbehavioral problems that can be associated with acquisition.

the company has the potential to grow.

D The existing management is familiar about the operation so that they can put
the valuable
inputs in the expansion process which turns intoi good team work as wetj.

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Acquisition

economies of scale and operational efficiency. Sometimes

this effect is more than the
organic growth.

bankruptcy and the cost of borrowings, and hence the

- WACC.

acquired company.

business.

The End

a
t

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