FINANCIAL MANAGEMENT

May June 20 I4
t.
Question No. l(a} i

I. (a) What is the relationship between risk and return as per CAPM? 4

Answer to the Question No. l(a}

Risk is virtually present in every decision. Assessing risk and incorporating the same in the final decision is an
integral part of financial decision. Every investment ( other than Govt. bond) is risky because their return is
uncertain.
The most commonly used measure of risk on variability is standard deviation. There arc. two types of risks,
systematic and unsystematic risk;_ systematic risk is not avoidable/diversifiable thus called as market or
relevant risk but unsystematic risk is divcrsifiablc to various cxtents and known as firm specific risk.
Since beta is the relevant measure of a security risk, the next logical question is: what is the relationship
between risk of a security and its required return. The Capital Asset Pricing model (CAPM), a seminal theory
has answered this. According to the CAPM risk and return arc related in a linear fashion.
As: E(Rj)= Rj+DBj[E(Rm)-Rj].
Where: E(Rj)= Risk free return
Bj= Beta of Security J
E(Rm)= expected return on the market portfolio.
As per the above relationship, required return increases with the increase of relevant risk (beta). The investor
requires adequate risk premium as compensation against relevant risk of investment he owns.
Question No. l(b}
The risk free rate of return is 8 percent. The expcetcu rate of return on the market portfolio Km is I 2 percent.
The expected rate of growth for the dividend of firm A is Tk. 2.00. The beta of firm A's equity stock is 1.2.
(i) What is the equilibrium price of the equity stock of firm A'! 3
(ii) How would the equilibrium price change when (a) the inflation premium increases by 2 percent, and
(b) the beta of A's equity rises to 1.3. 3
Answer to the Question No. l(b}
(i) Required rate of return of stock A is
I. Ka=Rj+Ba(Km-Rj)=8+(12-8)x1.2
=12.8 percent
Ka= 12.8%, dividend gro_wlh= Tk.2 i.c 2% assuming immediate past dividend (Do) is Tk.100
Do;1+g) Tk. 100;1.02)
Pa= 7,, 7oTzs-oo? Tk944.44

(ii)
t New Ka considering inflation premium increased by 2% and the beta of A's equity rises to 1.3:
Ka (before inflation) = 8 +(12-8)x 1.3 =13.2%
I

-
Ka (incorporating inflation) = 13.2 + 2 =15.2%
Do:)+ g) Tk. 100,1.02)
Tk. 772.73
Ka- g 0.152- 0.02

Question No. l(c)

X's equity stock is currently selling for Tk. 30 per share. The dividend expected next year is Tk. 2.00. The
investors required rate of re tum on this stock is 15%. If the constant growth model applies to X limited, what is
the expected growth rate? 5

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 Answer to the Question No. l(c) ,

,
According to the constant growth model

D
PA =-
Ks- 9
lI
D1
g =Ks-
j
Po

HENCE THE GROWTH IS:

2.00
s =0.1755,p5 =-083 or 8.35

Question No. l(d)

Y Limited's earnings and dividends have been growing at a rate of 18 percent per annum. This growth rate is
expected to continue for 4 years. After that the growth rate will foll to 12 percent for the next 4 years. There
after the growth rate is expected to be 6 percent forever. If the last dividend per share was Tk. 2.00 and the
investors required rate of return on Y's equity is 15 percent, what is the intrinsic value per share'! 10
Answer to the Question No. l(d)
Given that
Do =2.00, Ks = 15%, g (1-4 yrs)= 18%, g (S-8 yrs)= 12%, g (from 9 yrs to indefinite period) = 6%
We have to determine the cash flows (CFs) from YR I to YRS and thereafter convert the same ink> the present
value at the discount rate of 15%.
Step 1: Determination of cash flows (CFs)
Dl = 2.00 (1.18) = 2.360
D2 = 2.00 (1.18)2 = 2.785
D3 = 2.00 (1.18)3 = 3.286
D4 = 2.00 (1.18)4 = 3.878
I,
D5 =3.878 (1.12) = 4.343
D6 = 3.878 (1.12)2 = 4.865
D7 = 3.878 (1.12)3 = 5.448
D8 =3.878 (1.12)4 = 6.102
Therefore, the value per share at YRS would be as follows:
P8 = D8 {l+g)/(Ks-g) =6.102 (1.06) / (0.15 - 0.06)= Tk.71.868
S tep 2 : C on version ol r ClEs
F into
.
Year CFs (Tk.) DFs (@ 15%
present valuc
Discounted cis (Ty
I:
,I
I
I 2.360 0.870 2.053
2 2.785 0.756 2.105
3 3.286 0.658 2.162
\
4 3.878 0.572 2.218 I
5 4.343 0.497 2.159
6 4.865 0.432 2.102
7 5.448 0.376 2.048
8 6.102 0.327 1.995
8 71.868 0.327 23.501
Intrinsic value ocr slwrc 40.343

Hence, the intrinsic value per share (Pu) is Tk,40.34

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Question No. 2(a)
W hat determines the optimal mix .of debt and equity for a growth company? Based on the Modigliani & Miller
theorem, briefly explain the market value of a levered company in terms of the market valuc of an unlevered
company. 5
Answer to the Question No. 2{a)
Growth companies arc those which generate significant positive cash· Hows or earnings, increasing at
significantly faster rates than the overall economy. The ideal example of a growth company is Google.
There is no definite optimal factor for an optimal DIE ratio to a growth company viz. it could vary according to
the industry or line of business stage of development etc. The clcbt-equity relationship could vary according to
industries involved a company's line of business and its stage of development. However, because investors arc
better off putting. their money into companies with strong balance sheets, common sense tells us that these
companies should have generally speaking lower debt and higher equity levels.
Growth rate positively affects the capital structure of ii company. The growth opportunity will require more
capital to finance the growth. However, companies will tend to take the course of least resistance, obtaining
financing from sources that arc readily available and then steadily moving on to sources that may be more
difficult to utilize (Pecking Order Thcory).
According to the Modigliani and Miller tlieorcm, the Value or levered firm is higher than value of unlcvcrcd
firm because of the tax shield on the debt used.

MV(g) =MV(u)+DT
Market value of a geared company is greater than an unlevered company, and the difference is clue to the debt
tax shield (OT).
Question No. 2(b)
There arc two paint manufacturing companies listed on the Dhaka Stock Exchange Ltd., whose earnings
and capital structures are given below.
Zheelmill Paints Asian Paint
No. of shares issued 10 million 8 million
Current share rice Tk. 75 100
Conorate dcbentures 'Tk. millions 3,000
Debenture interest rate 12%
Co orate tax rate 35% 35%
Estimated net earnings arter tax for the year 600 150
2013 k. millions
It is believed that the current market price of Asian Paint is in equilibrium and the Zheelmill Paints
debt is also at its equilibrium level. However analysts arc of the opinion that Zheclmill Paints share
price may not be at its equilibrium level'
Required: Determine whether Zhcclmill Paints shares are over/under valued on the market. 7
Answer to the Question No. 2(hl
Market Value of Asian Paint (ungeared firm) = 8 million shares x Tk. l 00 = Tk. 800 million
Since Zheelmill Paints earnings arc 4 times greater, the market value of Zhcclmill Paints would be: Tk 800x4
=Tk 3,200 million.
Market Value (MV) of geared company= MV of ungearcd company + DT*
= (800x4) + (3,000x35%)
= Tk. 4,250 million
Tax shicd on clcbt (OT) where Tis the corporation tax rate and D is the market value of the geared firm's debt
MV(D)= Tk. 3,000
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qq
 .,
MV(E)== Tk. 4,250-Tk. 3,000= Tk. l,250 million
MV of share= Tk. 1,250 million I IO million shares= Tk. 125 per share
Since Zheclil! Paint's current share price is Tk. 75 and is curn;ntly lracJing al an undervalued of Tk. 50 (125-
75) per share.
Question No. 2c]

The CEO of Zhcclmill Paints has sold the company's controlling stake (51.%) to a high net worth businessman
at Tk. 75 per share. He continues to hold 15% of the equity ancJ enters into a contract to be its CEO for the next
3 years. ·

In an attempt to improve financial performance, recently tlie company made a successful rights issue of 4 : 5 at
Tk. 50 per share to infuse funds, and the entire proceeds had been used to retire the debt. The company offered a
redundancy package to some of its workforce and 1,000 workers aeccplcd the compensation package o( 6
months' salary (average worker salary is Tk. 35,000 per month). The company reduces its working capital by
going for a sub-contractor model; thereby the company would increase its operating profit to Tk. 1.5 billion
(before the compensation costs).
Post rights shares arc trading at Tk. 65 per share and Zheclmill Paints declares a 60% dividend.
Required:
(i) Determine the new capital structure of Zheclmill Paints immediately after the rights issue., 4
(ii) What would be the dividend yield of the high net worth investor? 4
(iii) Assuming the dividend growth is 5% and the cost of equity is 20%, calculate the share price of
Zhcclmill Paints using Gordon's dividend growth model. 5
Answer to the Question No. 2(c)

(i) Capital structure ofZheclmill Paints immciliatcly after the right issue
== IOmn + 8mn (10x4/5) = 1811111
Cnpitnl structure nrtcr right issue
'Equity Tl<. in Million
c=} 18mn shares @ Tk. 65 1,170
Debt c=p (3,000-400) 2,600
(ii) Dividend yield 3 770
Operating profit
Redundancy (35000x6x1,000) 1,500
Finance cost (Tk.2,600 @12%) (210)
Profit before tax (312)
Tax @ 35% 978
Profit after tax (342.30)
Dividend @ 60% = 635.70 x 60% = 381.42 635.70
High net worth investor's dividend= Tk, 381.42 x 51% = Tk,194,52
High net worth individual investment= (51 % x I OmnxTk. 75)+(5 I% x 8mn x Tk.50)= 382. 5+204
Dividend yield = 194.52/ 586.5 =33% = Tk. 586.5 million

(iii)New share price using Gordon's dividend growth model

Dividend per share= Tk. 381.42 million / 18 million shares= Tk. 21.19
p = DO :J + g)
Ke- g
21.191.05) .
7zo-cos = Tk 148.33 per share
The share price of Zheclmill Paints using Gordon's model is Tk. 148.33 (assuming dividend growth rate = 5%
and cost of cquity = 20%)

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 In total there will be a commitment to pay approximately Tk. 476,000 per annum.
This will be first priority of the new company. The management team will need to
generate sufficient fund from the only available source- operations- in order to meet
this commitment.
Other cash Apart from the need to generate cash to satisfy the parts of financing scheme, the
commitments company will also need to generate funds to invest in working capital and non-
current assets as required. At the moment these capital needs are unknown. In the
context of 10% annual growth in revenue, however, they might exceed the unused
clement of the overdraft facility.
Institutional By virtue of their 60% interest in the ordinary shares of the company, the financial
involvement institutions hold the controlling stake. They will also hold all, the preference shares.
Consequently, the institutions will be able to determine many aspects of the
company's management, including the appointment of directors. Institutional boar of
representation is also responsible.
The institutions arc likely to have two overriding objectives.
(i) The security of loan and interest repayments
Any breach of the loan arrangements might trigger the appointment of
administrators or receivers, and the investment of the institutions would almost
(ii) Realizing their equity investments
The institutional investors will probably expect to realize their investment in a
relatively short time frame. This is commonly set at between five and seven
years, and management need to make plans for an exit route, probably by
planning floatation at that time.
Profit growth Apart from the need to generate cash as noted above, the company must also
generate steady profit growth. The institutional investors will require a history of
profit growth in order to enable the disposal of their stake through flotation or a
trade sale.

Conclusion

The financing scheme will place a heavy cash burden on the company, particularly in the early years. The
involvement of the institutions will perhaps prove unwelcome, but the MBO would be impossible without
accepting it.

The End

Page55
 Question No, 3(3]
Toyota Motor Corp.j likc most inajor multinational corporations, enjoys easy access to .world financial
markets. Explain why the NPV approach is the most appropriate tool for Toyota's investment project selection
process. 3
Answer to the Question No. a)
An investment project is attractive and should be pursed so long as the discounted net present value of cash
'inflows is greater than the discounted net present value of the investment requirement, or net cash outlay.
Because the attractiveness of individual projects increases with the magnitude of this difference, high NPV
projects. Any investment project that is incapable of generating. suflicicnt cash inflows to cover necessary cash
outlays, when both are expressed on a present value basis, should not be undertaken.
In the case of a proj_cct with a NPV=0, project acceptance would neither increase nor decrease the value of the
firm. Management would be indifferent to pursuing such a project, Nl'V analysis represents a practical
application of the marginal concept, where the marginal revenues and marginal costs of investment projects arc
considered on a present value basis. Use of the NPV technique in the evaluation of alternative investment
projects allows managers to apply the principles of marginal analysis in a simple and clear manner. The
widespread practical use of the NPV technique also lends support to the view of value maximization as the
prime objective pursued by managers in the capital budgeting process.
Just as acceptance of NPV>0 projects will enhance the value of the firm, so loo will acceptance of projects
where the Pl> I, and the IRR>k. Conversely, acceptance of projects where NPV<0, or IRR<k would be unwise
and reduce tl1e value of the finn. Because each of these project evaluation techniques shares a common focus
on the present value of net cash inflows and out flows, they display a high degree of consistency in tenns of
the project accept/reject decision.
Therefore1 tl1e NPV approach is the most appropriate loo! for Toyota's investment project selection process
because it indicates the acceleration of wealth of shareholders in terms of absolute taka value instead of any
other terms used in other methods i.e. percentage, ratio etc and is also easily understandable and readily
measurable in decision making process.
Question No. 3(b)
(i) Net present value (NPV):
NPV (Project A) = -9200 + 4000(0.909) + 4000(0.826) + 4000(0.751) = 744
NPV (Project B) = -9500 + 6000(0.909) + 3000(0.826) + 3000(0.751) = 685
NPV (Project C) = -10000 + 1000{0.909)+ 1000(0.826) + 13000 (0.751) = 1498
Internal rate of return (IRR):
IRR (Project A)
Required PV ifNPV=0: 9200
PV@ 12%: 9608
PV @ 15%: 9136
IRR= 12%+ (15%- 12%) [(9608:-9200)/(9608-9136)) = t4.59%
IRR (Project B)
Required PV ifNPV=0: 9500
PV@ 12%: 9885
PV@ 15%: 9462
IRR = 12% + (15% - 12%) [(9885- 9500/(9885 - 9462)] = 14.73%
IRR (Project C)
Required PVifNPV=0: 10000
PV@ 12%: 10946
PV@16%: 9938
IRR= 12% + (16% - 12%) [(10946-10000)/(10946-9938)) =15.75%

Page j 45
 (ii) Project acceptance decision:
Ranking of projects as per NPV
Project NPV Ranking
C 1498 I
A 744 2
B 685 3
Ranking of projccts as per IRR
Project IRR Ranking
C 15.75% I
B 14.73% 2
A 14.59% 3

The NY_ andRR

I rojct
ofC arc.hight, than that of,ProjctA and Project B, Hence,ProjectCshouldbe
assuming all thregects arc
acccpId proj
utuallyexclum
sive,
.Question No, 3(c)
An efficient finn employs inputs in such proportions that the marginal product/price ratios for all inputs arc
equal. In tcrms of capital budgeting, this implies that the marginal cost or debt should equal the marginal cost
of equity in the optimal capital structure. In practice, firms often issue <lcbt at interest rates substantially below
the yield that investors require on the firm's equity shares. Docs this mean that many firms arc not operating
with optimal capital structures? Explain. 3
Answer to the Question No. 3(c)
No, the phenomenon of lower observed yields for debt versus equity instruments docs not imply suboptimal
capital structures. The explanation lies in ht (cs directly observed impact of a given method of financing on the
cost of other forms of capital funding. For example, the use of debt instruments to acquire capital increases the
leverage ofa firm. This increases risk lo both debt and equity holders and hence, increases the marginal cost of
both fonns of capital. This indirect cost of debt financing must be added lo the observed yield on debt
instruments to obtain a measure of the trnc economic cost of debt. similarly, increased use of equity
instruments reduces leverage and risk and increases the firm's ability to issue more debt. When these added
benefits of equity financing arc properly accounted for the true marginal cost of equity financing is reduced to
a level equal to the economic cost of debt. This assumes, of course that the firm employs an optimal capital
structure.
Question No, 4fa}
What is a derivative and how it helps in minimizing financial risk? 3
!
Answer to the Qucstion No, 4a]
Derivative is a financial Security whose sale is derived from the value and characteristics of an underlying
security. Option, futures, swaps arc types of securities.
In business there arc different types of risks and um:crtainlies. To hedge these risks the derivatives arc used to
minimize or safeguard the risks. Risk of price fluctuation, short supply of materials, price fluctuation of foreign
currency, increase of interest rate etc.
Question No, 4{b)fil
F Limited needs to borrow Tk 150 million in three months time for a period of six months. Present rate of
interest if borrowed from a financial institute is 13%. There is a chance of interest rate fluctuation in future and
the Finance Controller is exploring the following possibilities:
(i) Forward rate agreements
(ii) Interest rate futures
(iii) Interest rate guarantees
Explain how these alternatives might be useful.to F Ltd. 6

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o
 Answer to the Qucs(ion No, 4(b)
Forward rate agrcemc\ts (FRA)
Entering into on FRA with a bank will allow the finance controller of effectively to lock in an interest rate for
the six months of the loan, This agreement is in<lcpcn<lcnt of the loan, upon which the previous ling rate would
be paid, If the FRA were negotiated to be at a rate of 13% and the actual rate is higher than this, the bank will
pay the difference between Lhc rate paid and 13% to F Ltd, Conversely, if the interest paid by F Ltd, tum out to
be lower than I3% they would have to pay the difference to the bank, thus the cost of F Ltd, will be 13%.
Interest rate future's: Interest rate futures have the same elTcet as the FRA in cf1i:clivcly looking in an interest
rate, but they arc standardized in terms of size, duration and terms. They can be traded on an exchange and
they will generally be closed out before the maturity dale yielding a profit or loss that is off set against the loan
or profit on the money transaction that being hedged.
Interest rate guarantees: Gives F Ltd lhc opporlunily to bencfit from favorable interest rates movement as well
as protecting lhem for their effects on adverse movements. This provides the holder the right but not the
obligation to deal at an agreed interest rate at a future·malurity dale. This means that if interest rate rises the
finance controller would exercise the options and lock in IQ the prcdctcnnincd borrowing rate. If however,
interest rate falls then the option would simple lapse and F Ltd would enjoy the benefit of lower interest rate.
Question No, 4(c)
What arc the trading risks in overseas business? I-low can the risk of bad debt be reduced? 3

Answer to the Question Yo. 4(©)

Both importers and exporters will face trading risks which arc greater than those faced by domestic traders as a
consequence of political and cultural risk as well as the increased distance and time, involved. Type of trading
risk include:
Physical risk - the risk of goods being lost or stolen in transit or the documents accompanying the
goods going astray.
Credit risk - The possibility of payment default by customer.
Trade risk- The risk of customer rcfusin•• to accept the goods on delivery (due lo <lcfcctivd sub-
standard goods
Liquidity risk- the inability to finance the credit given to·thc customers.
But debt risk can be reduced in foreign trade by following methods:
Bill of exchange: A bill of cxchange is drawn up by the exporter lo the overseas customers, who
accept the obligation tp pay the bill by signing it.
Export factoring - It is an arrangement to have debts collected by a factor company, which advance
money and get a commission on the bill. Subsequently the factor company would collect the money
from the debtors.
Documentary credit (Letter of credit) provides the method of payment in international trade which
gives the exporter a risk frcc method of obtaining payment. Under this system banks will act in
between the importer and lhc exporter. For the importer the issuing bank issues a letter of.credit
guarantee payment to the beneficiary.
Export credit insurance: is insur,mec against the risk of non-payment by foreign customer for export
debt.
Question No. 4d)
MJ Garments Ltd. has completed a contract and exported goods worth € 5 million lo Europe. They will receive
the payment in three months time. Its Finance Director is worried that the Euro will be weaker than Taka and
hence affect the cash flow. Four alternative options arc avaiiable to deal with the foreign cunency exposure:
(i) Do nothing now and convert € 5 million at the spot rate prevailing in three months time;
(ii) Use the forward market to sell € 5 million for Taka al today's three-month forward rate;
(iii) Buy today a three-month €5 million put option at a strike price equal to the three month forward
rate. The option will cost Tk. 125,000, which will be paid from that company's surplus cash currently
in a bank deposit account.
(iv) Use the money market to cover the position.
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 <
".--77
The following relevant information an: available:
The spot rate is Tk. 1/€1.5575-1.5625
The three month forward premium is€ 0.0047-0.0015
The current bank interest rules per annum arc:
LEuro zone Bangladesh
Prime lending ratc 3.2% 4%
Three month deposit rate 2.8% 3.6%

Calculate the efTccls of each of the four approaches, assuming that the spot rate prevailing in three months time
is Tk. 1/€ 1.50 and Tk. 1/€1.70.' 12
Answer to the Oncstioo No. 4Cd}
Effect of the four approaches are worked below:
(i) Convert at spot in three months time:
lf exchange rate is Tk. 1/1.50
US$ 5 m/1.50 = Tk 3,333,333 (rcccivable in their months' lime)
lfcxchangc rate is Tk. I/€1.70
€ 5 m/1.70 = Tk 2,941,176 (receivable in their months' time)

(ii) Use the forward market rate:

3 months forward sell rate 1.5626-0.0015= 1.561
€5m/ 1.561 = Tk. 3,203,075 (receivable in three months timc)
(iii) Buy a 5m put option
(i) Exchange rate in three months time Tk. 1/€ 1.50; in this case the company will not exercise the
option but will convert at spot '
5m/1.50 = Tk. 3,333,333
(ii) Exchange rate in three months time Tk. 1/€1.70; in this case the company will exercise the
option and convert at the strike price of 1.561
€5m/1.561 = Tk. 3,203,075
In both cases the Company will pay Tk. 125,000 for the option. It is assumed that this is currently invested at
the three months taka deposit rate of 3.6% pa, this will effectively cost 125000xl .009 = 126,125
(iv) Monthly market cover:
€5m
og3j =€4,960.317
Borrow=-
1+- ---- -
4
Convert at spot = €4,960,317/ 1.5625
= Tk. 3,174,603
Invest for 3 months= Tk. 3,174,603 x (1+0.009)
. =Tk.3,203,174
SUMMARY OF EFFECTS OF EACH OF THE FOUR APPROACHES:
Cash receipts in three months' time:
Tk. 1/€1.50 Tk. 1/€1.70
(i) Conversion at spot 3,333,333 2,941,176
(ii) Using the forward market 3,203,075 3,203,075
(iii) Buying €5m part option
Before interest cost 3,333,333 3,203,075
After interest cost 3,459,458 3,329,200
(iv) Borrowing and investing taka 3,203,174 3,203,174

The End

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