Financial Management

Nov-Dec 2011
1.
·1

Answer to the Question 1 (a)

Particulars »A'; '+,

" " '±'
2011 2012 2013 2014
Capital Equipment (cost)/disposal value (3,000,000) . . 600,000
Sales (Ref. to WI) . 2,310,000 2,668,050 3,081,598
Variable costs (W2) so
(1,296,000) (1,539,648) 1,829,102)
Fixed costs (W3) - (442,800) (478,224) (516,482)
Tax on profit (W4) - (159,936) (I 82,050) (206,084)
Tax saved on equipment (Ref. to W5) 168,000 134,400 107,520 262,080
Changes in Working capital (W6) (231,000 (35,805) (41,355) 308,160
Net cash inflows/outflows (3,063,000) 509,859 534,293 1,700,170
PV factor @ 14% 1.0000 0.8772 0.7665 0.6750
Present Value (3,063,000) 447,245 411,121 1,147,566
Net Present Value (NPV) (1,057,068)

The NPV is negative; therefore RA's management should not proceed with the investment proposal. The
investment will not enhance shareholders' wealth.

Workings:

WI: Calculation of Sales 2011 2012 2013 20 14

Base sale 2011 -
Sale increased to: 20 I 2.2,200,000 x 1.05 = 2,310,000
2,310,000
2013: 2,310,000 x 1.05 x 1.10 = 2,668,000 2,668,050
2014: 26,68,000 x 1.05 X 1.10 = 3,081,598 3,081,598
Total Sales 2,310,000 2,668,050 3,081,598

W2: Calculation of variable Costs (VC) 2011 2012 2013 2014

Base sale 2011 o

VC increased to 2012: 12,00,000 x 1.08 1,296,000

2013: 1,296,000 x 1.08 X 1.10 1,539,648
2014: 1,539,648 X 1.08 x 1.10 1,829,102
Total variable costs 1,296,000 1,539,648 1,829,102

W3: Calculation of Fixed Costs (FC) 2011 2012 2013 2014

FC increased to: 2012: (427,000-17,000) 442,800
X 1.08

2013: 442,800 x 1.08 478,224

Page47
2014: 478,224 x 1.08 516,482

Total Fixed costs 442,800 478,224 516,482

W4: Calculation of Tax on extra profit 2011 2012 2013 2014

Sales as per working# WI o 2,310,000 2,668,050 3,081,598

Less: variable costs # W2 - (1,296,000) (1,539,648) (1,829,102)
Less: Fixed costs # W3 - (442,8000 (478;224) (516,482)
Profit a 571,200 650,178 736,014
Tax on profit @ 28% - 159,936 182,050 206,084

WS: Calculation of tax savings on 2011 2012 2013 2014

capital equipments
Written down value b/f 3,000,000 2,400,000 1,920,000 1,536,000
Deoreciation @ 20% (600,000) (480,000) (384,000) (936,000)
Carrying value 2,400,000 1,920,000 1,536,000 600,000
Tax Savings on depreciation @28% 168,000 134,400 107,520 262,080
307,200 (Capital allowance)+ 628,800 (Additional tax relief)

W6: Calculation of Working Capital 2011 2012 2013 2014

Sales as per working# WI o 2,310,000 2,668,050 3,081,598
Working capital requirement @ 10% of 23 1,000 266,805 308,160 e

sales
Working Capital 231,000 266,805 308,106 -
Working capital - (injection)/release (231,000) (35,8050 (41,355) 308,160

Answer to the Question l(b)

2011 2012 2013 2014

Sales (Ref. to WI) 2,310,000 2,668,050 3,081,598
Variable costs (W2) - (1,296,000) (1,539,648) (1,829,102)
Contribution Margin - 1,014,000 1,128,402 1,252,496
Less taxation @28% - (283,920) (315,953) (350,699)
Net cash flow 730,080 812,4.49 901,797
PV factor 0.8772 0.7695 0.6750
Total present value 640,421 625,153 608,687

Total present value (640,421 + 625,153+ 1,874,262

608,687)

... Ol fSI I 269•281

. ==->= 144°'/o
S eISiivity iales voluneis <e

I 8,73,767

So, ignoring the impact on working capital, if sales volume is 14.4% lower than estimated, the NPV will

Page48
 be Negative and RA could not proceed with e investment.

1(c) Impact of scrap value of' TE. 100,000

I

Loss on scrap sales (600,000 - 100,000)

(500,000)
Increase in balancing allowance (500,000 x 28%)
140,000
Net decrease in cash flow in 2014
(360.000)
PV of loss of cash flow in 2014 (360,000 x 0,6750)
242.790
Thus the NPV of the proposed scheme would decrease further by Tk. 242,990
RA director will not proceed on further,

l(d): Time value of money concept has been considered while discounting cash nows, Interest expenses
on borrowed fund will be dealt with as part of weighted average cost of capital, Hence, interest
payments will be ignored.

l(e) Shareholders Value Analysis (SVA):

It refers to the ability of the company to generate value and increase shareholders wealth, Value of the
is
business the total present value of all activities. A business has following 7 value divers:
l, Life of projected cash flows
2. Sales growth rate
3. Operating profit margin
4. Corporate tax rate
5. Investment in noncurrent assets
6. Investment in working capital
7. Costs of capital

The value of the business is calculated from the cash flows generated by the drivers # 1-6 which are then
discounted by the driver # 7, In the case of RA, all of the seven value drivers are relevant and are used in the
calculation. RA's 3 years strategy of expanding its solar panel market.

Answer to the Question 2 (a)

(i) Expected spot rates at 31 December 2012

9.230 x 10% 0.923
9.330 x 10% 0.933
9.430 X 40% 3.772
9.530 x 409% 3.812
Expected spot rate at 31 Dec. 2012 (NKT)
= 9,440
· i'f
S. o Tak ca receipt t
d · c·
no h edging(i.e.spot 16,750,000
rate at 3 +1/12/12)=', = Tk. 1,774,364
• 9440
(ii) Forward contract

Page49
 ., share
.16.75m = 16,/50,000 = Tk. 1,771,549
5 -0.13) 9,455 " NPV

·t hedge NPY

16,750,000 _ ! 6,750,000 = Tk. 15,712,945 y

==
(1 +6.6%) 1.066 " ' 0
1
2
rted at spot rate ± 15.712,945_ ·r,, 1,685,034 3
9,325 " "
4
,
,% pa Tk. 1,685,034 x (I + 4.3%) = Tk. 1,757,490
NP
1ption (sell NK) exchange rate is 9.300 NKT.
Ye
750,000 _ 7. 1.801.075 0
1,3000 ' ' I-

.Tk. 25,000 x 1.043 (assumed on deposit) (26,075)

IR
Tk. (1,801,075 - 26,075) = Tk. 1,775,000
IR
e considered whi!e DDS entered into _agreement for hedging IR

rectors' attitude towards risk Bo

cceipt with current spot rate (9.325NKITk.) = 16.75m NK -;.-9.325 = Tk. 1,796,246 so

Answer to
ct produces a higher taka receipt than the money market hedge. Both of these hedging
ice a fixed taka amount, known at the start of the hedging period. (a) Fir
(i)
d for is accurate then it would be better to not hedge at all as the spot rate in twelve (ii;
produce a taka receipt of Tk.1,77 4, 364. If the current spot rate remains constant (iii
n mind the comparative interest rates in Bangladesh and Norway) this would produce (iv
a receipt of Tk. 1,796,246. However, if the future spot rate is 9.53 (as per the question)
Tk. 1,757,608 i.e. worse than the forward contract. Con
()
the strike price of 9.30NK/fk. produces an attractive amount of taka Tk. 1,775,000 and (ii)
1t consider paying the Tk. 25,000 premium and also have the chance to benefit from a (iii
in December 2012. At a future spot rate of 9.23 (as per the question) the option would (iv
1 a receipt of (Tk. 1,814,735 - 26,075) Tk. 1,788,660.
I The
hedging and its effectiveness I Cor]
(i)
Effectiveness (ii)
fethods of hedging
• It will fix the rate of interest receivable by DDS. Upside (iii
RA
potential is therefore removed.
• It can be tailored to the exact amount to be invested by 1 (iv

Page50
 J
-
DDS
. ,
\.
.. - I®gl
-
(ii) Interest rate future I
DDS would buy interest rate futures, but these are for
standardised amounts, which could be impractical.
(iii) Interest rate option I DDS would have the right to deal at an agreed interest rate
at maturity date, i.e. March 2012.
p
DDS would buy tradcd call options, but these arc for
standardised amounts anJ may not be suitable.
I
For more flexibility, DOS could purchase a tailored over
the counter (OTC) option.
(iv) Interest rate swap I
It would be impractical as a long term hedge for a large
deposit
• The hedge is only for six months. it would be difficult to
find a counterparty.

Answer to the Question 3

a) Calculation of Cost of equity

D, (I+ g)
Cost of equity = ---- + g
P,
Where g=rb

Retention rate (b) = 489/922 x 100 = 53%

Retention capital (r) = 922/4,250 - 489) = 24.5%
g = 0.53 x 0.245 = 139%
Do= 433/2/000 = 2 l .6Sp
Po= 400
Cost of equity= 21.65 ( 1.13)/400 + 0.13= 0.191 = 19. l %

Assumptions used:

Ci The dividend valuation model has been used to calculate the cost of capital because there is no debt
and the firm is all-equity financed.
Ci The dividend growth rate is determined by using the Gordon growth model.
Ci The proposed expansion has no consequent change in business risk so that the current cost of equity
capital is appropriate. Tk. 4 per share is a recent valuation and is therefore approximate to current
market value
b) Advantages & Disadvantages of right issue to fund proposed expansion:

i) Right issue:
Advantage • No change in control if fully taken up by existing shareholders
• Flexible nature of dividend payments as opposed lo a fixed interest
commitment

Page5l

20
 • Any new sharchw\ders might find the fi±:i's unlisted status unattractive
• No listing and reporting :equirements

Lisadvantage • Hov» will existing shareiiaers react and do they have access to the
required funds?
•ii) DSE Iistl;:
Advantage • No change in control if fully taken up by existing shareholders.
a Flexible nature of dividend payments as opposed to a fixed interest
coninitment
• Any new shareholders might find the firm's unlisted status unattractive
• No listing and reporting requirements
Disadvantage • Lengthy process
• Listing and reporting requirements
• Cost involved
• Dilution of control

(c) ( i)

• HH would obtain finance at a lower rate of interest than an ordinary bank loan, provided that the
firm's prospects were considered to be good post-expansion.
• This might encourage future outside investors with the prospect of a future share in profits.
= This would also introduce an element of short-term gearing, with potential' beneficial cost of capital
implications.
• If the debt was subsequently converted it would also avoid subsequent redemption problems
II I{ the debt was subsequently converted it would enable HI-I to issue equity relatively cheaply
• There may be an argument that a convertible loan would come with fewer covenants than a bank loan

(ii)

• The revised debt/equity ratio is not to be changed in future

• The firm's operating and business risk is not to be changed in future
·• The cost of capital of new finance is not project specific rather it is similar to existing operation
(d)

• Historic cost valuation

• Net realisable value of assets less net realisable value of liabilities (market value)
• Replacement cost
• Income-based approaches:
(i) the present value of future cash flows
(ii) use of the PIE ratio of similar quoted firms (PIE ratio x earnings)
(ii) dividend valuation method.

Page52