Financial Management

' May-Jue-20l1

Question No. 1

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 20X9

.Tk.'000 Tk. ' 000 Tk.'000
280 260 410
Profit after tax
(0so) (160) (I8sy
Dividends
Retained profit 130 100 225

Statement of Financial Position us at 31 December

20X7 20X8 20X9

Tk.'000 Tk.'000 Tk.'000
1,365 1,405 1,560
Non)current assets
Working capital 810 870 940
2,175 2,275 2,500
Share capital 100 I00 100
Retained earnings 875 975 1,200
I 0% loan debenture 20X 12 1,200 1,200 1,200
2,175 2,275 2,500

□
The non current assets include an unused property which has a market value ofTk.100,000. The
□
debentures pay a semi amrnal coupon and are redeemable at the end of20Xl2. The gross redemption
yield on 20X9 gilts paying a similar level of coupon is 11%.

The PIE ratio for the quoted company sector in which Chris Limited's activities fall is around 15 times
and the sector's gross dividend yield is around 11 %. The of the sector is around 0.8 and the return on
the market is around 21%.

Requirements:

(i) Estimate the value of Chris Limited, using four different methods of valuation. I0
(ii) Explain the rationale 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 to 4
conduct a more informed valuation.

Answer_to the Question no.]

I (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 limited though it seems that they are the owners of the company. 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 maximize each benefit. The shareholders want to
see higher profits as more dividends can be yield from it whilst the managers are more interested in higher
revenue because it means more expenses can be made that are beneficial to them. Managers may wish to
hold more cash and receive more perks that would be the expenses of the company and this may reduce
the profit. Both managers and shareholders have different attitude towards risk in which the shareholders
may ·want to invest in many companies so that they arc 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 bi<l 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 that
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'.
1 (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) current retained earnings and future earning capacity to provide satisfactory and consistent
growth of dividend (d) requirement of capital expenditures and investment: appraisal (e) protection the
interest of the existing shareholders (f) 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 structure decision (b)
cost of debt (c) cost of equity (d) loan covenants (e) interest coverage ratio (f) indifferent point of EBIT
(g) earning capacity and growth of EBIT (h) security and company law regarding conversion of debt into
equity (i) net assets per share (NAPS) (j) impact of high gearing on profitability (k) · cash flow
management (I) outstanding interest on loan (m) solvency to pay debts (n) current & quick ratio (o)
underlying convertible scheme etc.

l (c) Before takeover, the number of shares of D pie is 20 milEcn. Ti,le scheme consists of one share in D
pie for every three shares held in S pie plus Tk.1.00 in cash for every three shares held in S pie.

After takeover, the total number of shares would be:

= 20 million + (6 million x 1/3)
= 22 million
The takeover is expected to increase the value of the firm to the extent of the present value of Tk.12
million due to research and development savings.
Value of the firm after takeover:
= (22 million- x Tk.I 0) + Tk.12 million
= Tk. 232 million

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 Value per share after takeover:
= Tk. 232 million / 22.million
= Tk.10.55 1

Determination of the change of wealth of a shareholder who owns 3000 shares in S pie if the takeover
was successful:
Shares of D pie in exchange of shares of S pie (3000.x 1/3) = 1,000 shares

Value of I 000 shares in D pie after takeover ( 1000 x Tk. 10.55) = Tk. 10,550
Cash received (Tk. 1.00 x 1/3 x 3000 shares) = Tk. 1,000
Tota} = Tk.11.550
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 10% as it has the same operating and risk characteristics as M pie. P's
capital structure consists of 30% loan capital and 70% equity. The cost of the loan capital is 4% (risk free
rate) subject to corporation tax @ 20%. Hence the cost of the loan capital (ka) is [4% x (I - 0.20)] =
3.2%.

Therefore, the equation is as follows:

0.10 = 0.70 k, + 0.30 (0.032)
0.10 = 0.70 k, + 0.0096
0.70 k,= 0.10- 0.0096
k,= 0.0904 /0.70
k,= 0.1291 i.e 12.91%
The cost of equity capital of P Ltd is 12.91%.

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> k, of tvl (12.9 19% > 10%) though overall cost of capital (WACC) is same ( l 0%) for both of
the company.

Question No. 2
2. (a) Genesis Ltd. a listed company operating in the tourism industry, has recently appointed a new
finance director who is about to consider the merits of a potential investment opportunity in one of
the company's existing market sectors. The company has grown rapidly in recent years, with
dividends (paid annually) growing at a rate of 8% 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 long term debt as a
discount rate. The new finance director believes that it would 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:
(I) The ordinary shares of Genesis Ltd. arc currently quoted at Tk.1.50 ex□dividcnd. The recently
paid dividend was Tk.0.05 per share.
(2) The company has issued 20m 8.4% preference shares, each with a nominal value of Tk. I. The
current ex□dividend market value of these preference shares is Tk.0.80 per share.
(3) The company has also issued Tk.40m of 5% irredeemable debentures, which have a current
market price of Tk.50m.

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The finance director is satisfied that if the new investment goes alead, then the funding for it will be
such that the historic financing mix of the company will remain unchanged.

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

Balance sheet as at 31 December 2008

Tk. m Tk.m
Net assets 410 Ordinary Tk.I shares 200
Preference shares 20
Irredeemable debentures 40
Reserves 150

410 410

Profit after tax, interest and preference dividends for the year ended 31 December 2009 was Tk.30m.
Dividends for the year ended 31 December 2009 were Tk.1 Om.

Corporation tax is 30%.

Requirements:

(i) Calculate the company's weighted average cost of capital (using the company's dividend growth 5
forecast).
(ii) The finance director has cxplicitly assumed that the current 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 retcnticr. (g = r x b) to 4
calculate an alternative dividend growth rate of the company.

(b) The share of Crack Ltd. have a current market price of Tk.74 each, exdividend. It is expected
that the dividend in one year's time will be Tk.8 per share. Thc_requircd rate of return from net
dividends on these shares is 16% per annum.

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

(c) A firm has a dividend cover of 2, a PIE ratio of 9.3 (both based on its ex□dividend price). The
most recent financial statements indicated growth in shareholders' funds of 10%, 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.2,500,000 12% loan stock 300,000
700,000
Tax at 30% 210,000
Earnings and Dividend 490,000

The loan stock has a market price at par, and cost of equity is 19 .6%. There are 1,000,000 shares
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 in issue.
The company, is now considering a project costing Tk.1,000,000 which would add to profits by
Tk.200,000 int 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 will remain t 30%

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 22%?
6

Answer to the Question # 2

(ai) Forecast profit and loss account for the forthcoming year: (Tk.'000)
By adopting By Adopting
Financing Option-I Financing Option-II
Sales (W2) 7,900 7,900
Operating profit @ 12.4% (WI) 980 980
Debentures interest payable (W3) 160 280
Net profit before taxation 820 700
Corporation tax (209%) [64 140
Net profit after taxation 656 560
Dividend proposed (W4) 328 280
Retained profit for the year 328 280

Workings:
WI: Existing percentage of operating profit on sales = 12.4% (800/6450). Assumed this rate of
operational profit is also maintained consistently for forecasted additional sales.
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 10%) = Tk.280,000
W4: Existing dividend payout ratio= 50% (256/512). The BOD has already announced that they would
maintain the same dividend payout ratio in future years irrespective 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-II
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.0.233

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

(a)(iii) 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/ (Equity + Debt)
-Debt/ Equity
By adopting Financing Option-I:
Debt/ (Equity + Debt)= (2,000,000)/ (3,400,000 + 2,000,000) = 37.04%
Debt/ Equity= 2,000,000 / 3,400,000 = 58.82%
By adopting Financing Option-II:
Debt/ (Equity + Debt) = (3,200,000) / (2,200,000 + 3,200,000) = 59.26%
Debt/ Equity= 3,200,000 / 2,200,000 = 145.45%
It is assumed that the full amount of creditors (Tk.2,000,000) falling due after more than one , car
is the debenture. '

(b) The 'Indifferent Point' is the level of operating profit (EBIT) at which the earnings per share will
be the same under each financing option. The equation of indifferent point under this
circumstance is as follows:
Existing Cap Structure+ Proposed Option-I = Existing Cap Structure+ Proposed Option-II
> (EBIT- Interest) (1- Tax rate) /N,= (EBIT- Interest) (I- Tax rate) /N
> (EBIT- 160,000) ( I- 0.2)/ 2,000,000 = (EBIT- 280,000) ( I - 0.2) I 1,200,000
By solving the above equation, we can find out the value of EBIT which is Tk.460,000.

Therefore, Tk.460,000 is the Indifferent Point or level of EBIT at which both the financing
options show the same EPS which can be proved as below:

Option-I Option-II
EBIT (Indifferent) 460,000 460,000
Interest on debentures 160.000 230,000
Net profit before taxation 300,000 180,000
Corporation tax (20%) 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 of EBIT 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 then Option-II will show more EPS than
Option-I as Option-II 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 as before. If the company can
demonstrate the prospect of achieving higher growth of earnings in foreseeable future it is better
to choose the high geared option. On the other hand, if the expected EBIT is less than Tk.460,000
then it is better to choose Option-I that will provide higher EPS than Option-IL

Therefore, under the, existing forecasted operating profit of Tk.980,000 [see a(i) above], the
comparative earnings per share of Option-I and Option-II would be:

Option-I Option-II
Net profit after 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-II is superior to Option-I from the point of view of profitability.

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 Question No. 3
3. Briefly discuss the problems of using future contracts to hedge exchange rate risks. 4
(a) !
(b) Identify and explain the key reasons why small versus large companies may differ in terms of
both 4
the extent of foreign 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 the mining of kilbe in Bangladesh.
Kilbe is a new metal that used in the construction industry. The demand for kilbe is highly
dependant on the state of the housing market and the price is highly volatile. Kobler would like
to hedge its exposure but there arc 110 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 copper. She explained that the price of Kil be 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 the risks that 4
Kobler Ltd. may face if it adopts the recommendation and use copper futures contracts as a
hedging instrument.

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

Answer to the Question # 3:

(i) The price of the share would be Tk. 100 irrespective of payment of dividend. As per M-M theory,
dividend policy has no impact on changes in the share price as well as the value of the firm. It is merely a
distribution of profit splitting up between pay-out and retention. Once shareholder gets dividend in cash
he sacrifices his proportion of claim on company's net assets. Therefore, it does not 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.I 00,000
Balance of fund required by issuing new shares = 1,000,000 - l 00,000 = Tk.900,000
No. of new shares to be issued = 900,000 / 100 = 9,000,

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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 = 59,000
Value of the firm = 59,000 x Tk. 100 = Tk.5,900,000
(b) Value of the firm if dividend is not declared:
The amount of investment is financed by the retained earnings/current earnings to the maximum available
extent (Tk.500,000); the balance shortfall (Tk.500,000) would be arranged by issuing new shares. So the
number of new shares are 5,000 (500,000/100).
Total no. of shares = 50,000 + 5,000 = 55,000
Value of the firm = 55,000 x Tk. 100 = Tk.5,500,000

Question No. 4

4. Following is the EPS record of AB Ltd. over the past 10 years:

Year EPS(Tk.) Year EPS (Tk.)

10 20
9 19
8 16
7 15
6 16
5 12
4 6
3 9
2 (2)
1

Required:

(i) Determine the annual dividend paid each year in tire following cases: 8
(a) If the firm's dividend policy is based on a constant dividend payout ratio of 50 percent for all
years.
(b) If the firm pays dividend at Tk.7 per share each year except when EPS exceeds Tk.I4 per share,
then an extra dividend equal to 80 percent of earnings beyond Tk.14 would be paid.
(ii) Which type of dividend policy will you recommended to the company and why? 6

Answer to the Question No. 4:

(a) When the market is efficient in the semi-strong form, it implies that all public information is
calculated into a stock's current price. Neither fundamental nor technical analysis can be used to achieve
superior gains by the investors.
(b) Portfolio risk is of.two types - systematic risk (market risk) and unsystematic risk (firm specific risk).
Unsystematic risk can fully be diversified or eliminated through investment in a market portfolio. Market
portfolio means investment in every share/stock of the market. So in market portfolio there is only
systematic risk which remains beyond the control of the investor. Thus the investor demands risk
premium for systematic risk. Refer to the statement given it not clear whether these 20 companies are the
whole players of the market; so we can't say this portfolio is the market portfolio. Had this portfolio been
a market portfolio, the premium for systematic risk should have been added to the risk free rate in order to
determine the required rate of return of the portfolio, Therefore, in no circumstances this statement is true
that if an investor holds shares in about 20 different companies all of the risk is eliminated and the
portfolio will give a return equal to the risk-free rate.
(c) A graph of the daily price of a share moving up or down randomly docs not necessarily mean that the
market is not price efficient. The premise that asset prices are efficient to the extent that they already

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 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 to
"beat the market" on,a consistent basis. The statement given is not clear about the lacking of elements of
EMH so how can we say the market is not price efficient?

(d) Quarterly UK interest rate= I% (4%/4) and USA interest rate = 2.5% ( I 0%/4)
Interest rate parity = Ky /K,= 1.01 / 1.025 = 0.9854
Therefore, three month forward rate of exchange = $ 1.4400/ 0.9854 = $ 1.46 I 3
(e) Total borrowing costs: Tk.
Interest on loan (10,000,000 x 5.2%) 250,000
Premium for option (sunk cost) 10.000
Total 260,000
Note: Actual interest rate at the expiry date of the option is 5.29% ( LIBOR plus 0.2% i,e 5.0% +0.2%)
which is less than the strike rate of 5.5%. So T Ltd shall not exercise the option but the premium it had
already paid at the time of entering the contract of the option being the sunk cost.

Question No. 5

5. The initial investment outlay for a capital investment project consists of Tk.I 00 lakhs for plant and
machinery and Tk.40 lakhs for working capital. Other details are summarized below:

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

Selling price (per unit) 120
Variable cost (per unit) 60
Fixed overheads (excluding depreciation) (lakhs per annum for years 1 to 5) 15
Rate of depreciation on plant and machinery (percent on WDV) 25
Salvage value of plant and machinery (Equal to the WDV at the end of year 5)
Applicable tax rate (percent) 40
Time horizon (years) 5
PostCtax cut off rate (percent) 12

Required:

(i) Indicate the financial viability of the project by calculating the net present value. l0
(ii) Determine the sensitivity of the project's NPV under each of the following conditions: 10
(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 percent.

Answer to the Question No. S:

(a) Any company can borrow from the lender(s) committing to pay a fixed interest periodically
irrespective 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 not participating in any policy making and
operational decisions rather want their fixed charge. On the other hand, the shareholders through their
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.
Sometimes these decisions significantly affect the interest of loan holder. These can be protected by the
'Covenants' applied by the loan holders at the time ·of entering the contract for providing Joan 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:

(i) (ii) (iii) (iv)

Plan
EBIT (given) 8c0,000 800,000 800,000 800,000
- 80,000 45,000 -
Interest
EBT 800.000 720,000 755,000 800,000
Tax @ 50% 400,000 360.000 378,000 400,000
EAT 400,000 360,000 377,000 400,000
Pref. Div le - - 50,000
Earnings 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
Ranking 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 their debt; they may also be unable to find new lenders in the future. On the
other hand, financial leverage can improve profitability due lo the effect of tax shield on loan interest
resulting lower WA CCC and higher ROI. 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 outside 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 the advantage that they
cause far less disruption to the division's existing suppliers, customers and workforce than a completely
new change of ownership.

(ii) The 'sell-off is the rapid selling of securities, such as stocks, bonds etc. The increase in supply leads
to a decline in the value of security. A sell-off may occur for many reasons. For example, if a company
issues a disappointing earnings report, it can spark a sell-off or that company's share.
'Spin-off happens 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 minority shareholding in
the new company. Such an arrangement is most common in high tech industries. The parent company
gains from high returns from its investment, but does not have to be involved in the development of the
new product, which may be outside its normal area of activities.

The End

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