FINANCIAL MANAGEMENT

Time Allowed – 3 hours

Total Marks – 100

[N.B – The figures in the margin indicate full marks. Questions must be answered in English. Examiner will
take account of the quality of language and of the manner in which the answers are presented.
Different parts, if any, of the same question must be answered in one place in order of sequence.]

Marks

1. Assume you have just been hired as business manager of Subway Pizza Limited, a pizza restaurant
located adjacent to the commercial hub of Dhaka. The company's EBIT was Tk.500,000 last year,
and since the area is restricted, EBIT is expected to remain constant (in real terms) over time. Since
no expansion capital will be required, Subway Pizza Limited plans to pay out all earnings as
dividends. The management group owns about 50 percent of the stock, and the stock is traded in the
stock exchanges.
The company is currently financed with all equity; it has 100,000 shares outstanding; and current
market price P0= Tk.25 per share. When you apply your knowledge of finance, you believe that
most company owners would be financially better off if the company used some debt. When you
suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that
you obtained from the firm's investment banker the following estimated costs of debt for the firm at
different capital structures:

Financed With Debt (%) Cost of Debt %

0 ---
20 8.0
30 8.5
40 10.0
50 12.0

If the company were to recapitalize, debt would be issued, and the funds received would be used to
repurchase stock. Subway Pizza Limited is in the 40 percent corporate tax bracket, its beta is 1.0,
the risk-free rate is 6 percent, and the market risk premium is 6 percent.
Requirements:
(a) Provide a brief overview of capital structure effects. Be sure to identify the ways in which
capital structure can affect the weighted average cost of capital and free cash flows. 4
(b) What is business risk? What factorsinfluence a firm's businessrisk? Whatisoperating leverage,
and how does it affect a firm's business risk? Showthe operatingbreak-
evenpointifacompanyhasfixed costsof Tk.200,asalespriceof Tk.15,and variablecosts of Tk.10. 6
(c) Now, to develop an examplewhichcan be presented to Subway Pizza Limited’s management to
illustratetheeffectsoffinancialleverage,considertwohypotheticalfirms: firmU,which
usesnodebtfinancing,andfirmL,whichusesTk.10,000of12%debt. BothfirmshaveTk.20,000
inassets, a40percenttaxrate,and an expected EBITof Tk.3,000.
(i) Construct partial income statements, which start with EBIT,forthe two firms. Then,
calculate ROE forbothfirms. What does this example illustrate about the impact of financial
leverage on ROE? 4
(ii) Explain the difference between financial risk and business risk.
NowconsiderthefactthatEBIT isnotknownwithcertainty,butrather hasthefollowing
probability distribution:
Economic State Probability EBIT
Bad 0.25 Tk.2,000
Average 0.50 Tk.3,000
Good 0.25 Tk.4,000
Finally, calculatethestandarddeviationandcoefficientofvariationofROE.What doesthis
exampleillustrateabout the impactofdebt financing onrisk andreturn? 6
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 (d) What does capital structure theory attempt to do? What lessons can be learned from capital
structure theory? Be sure to address the Modigliani–Miller (MM) models. With the above
points inmind, now considerthe optimalcapitalstructure forSubway Pizza Limited. 15
(e) Foreachcapitalstructureunderconsideration,calculatethelevered/geared beta,thecostofequity, and
theWACC. Then, calculatethecorporatevalue,thevalueofthedebtthatwillbeissued,andtheresulting
marketvalue of equity. 10
2. (a) Maricom Ltd is considering whether to set up a division in order to manufacture a new product,
the Aroma Kit. The following statement has been prepared, showing the projected profitability
per unit of the new product.
Tk. Tk.
Selling Price 22.00
Less: Direct labour 5.00
Material 3 kg @Tk.1.50 per kg 4.50
Variable overheads 2.50
(12.00)
Net contribution per unit 10.00
It is expected that 10,000 Aroma Kits would be sold each year at the above selling price.
Demand for Aroma Kits is expected to cease after five years. Direct labour and material costs
would be incurred only for the duration of the product.
Other overheads have been calculated as follows:
Tk.
Rent 8,000
Salary 5,000
Manufacture of the Aroma Kit would require a specialized machine costing Tk.250,000.
The cost of capital of Maricom Ltd is estimated at 5% pa in real terms. Assume all costs and
prices given above will remain constant in real terms. All cash flows would arise at the end of
each year, with the exception of the cost of the machine which would be payable immediately.
Requirements:
(i) Prepare net present value calculations, based on the estimates provided, to show whether
Maricom Ltd should proceed with the manufacture of Aroma Kits. 5
(ii) Prepare a statement showing the sensitivity of the net present value of manufacturing
Aroma Kits to errors of estimation in each of the three factors: material per unit, annual
sales volume and product life. (ignore taxation) 15
(b) You are the Chief Financial Officer of a large local group of companies, which owns a
brokerage house among a host of other concerns. The owners of the group think that the
prospect of a brokerage house in Bangladesh will continue to remain bleak for many more
years to come and therefore thinking of disposing of their brokerage company. In order to know
the fair value of their brokerage house, they asked you to come up with a fair value that will
guide them in taking a final decision. The latest statement of comprehensive income of the
brokerage house is as under:
2014 2013
Operating Income
Brokerage income 318,314,273 222,819,991
Direct charges (7,309,485) (9,526,350)
Net Brokerage Income 311,004,788 213,293,641
Interest income 498,744,900 523,379,104
Interest expense (497,745,445) (491,655,692)
Net interest income 999,455 31,723,412
Other operating income 2,251,612 2,531,236
Total Operating Income 314,255,855 247,548,289
Operating expenses
Salaries and allowances 31,171,404 27,776,567
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 Rent, taxes, insurance and electricity 14,288,504 15,784,249
Legal expenses 550,000 280,480
Postage, stamp, telecommunication etc 919,039 867,741
Stationary, printing, advertisement etc 1,360,894 1,242,308
Directors' fees & meeting expenses 394,937 469,964
Auditors fees 66,122 142,700
Depreciation and repair of assets 8,762,342 8,979,039
Other expenses 10,331,044 7,847,808
Total Operating Expenses 67,844,286 63,390,856
Total Profit before provision 246,411,569 184,157,433
Provision for unrealized loss in dealer account (1,282,900) 11,805,619
Provision for contingency 2,720,000 2,720,000
Total Profit after provision 244,974,469 169,631,814
Tax expenses 16,687,015 34,145,180
Net Profit after taxation 228,287,454 135,486,634
As per brokerage industry jargon, the revenue of a brokerage comprises of brokerage income,
interest income and other operating income. From your experience, you know that the
maximum growth rate to be expected in the brokerage revenue will not exceed 6 percent per
year for next 2 years and 8 percent for subsequent 3 years. You do not need to consider any
revenue stream beyond next 5 years. From your historical estimates, you know that cost of
services of the house is 60 percent of the revenue. Therefore, you believe that cost of services
may remain 60 percent of revenue in next 2 years and will go up to 62 percent of revenue in
subsequent 3 years. You believe that the operating income will remain 1 percent in next 2 years
and will go up to 1.5 percent in subsequent 3 years. Operating expenses are around 8 percent of
revenue now. You believe operating income may remain 8 percent of revenue in next 2 years
and will be 10 percent of revenue in subsequent 3 years. The prevailing tax rate is 37.50
percent. Since your brokerage house is not a listed company, you thought of using the Capital
Asset Pricing Model (CAPM) to estimate discount rate for the brokerage house valuation. For
discount rate calculation, you have got the following information from market.

Risk free rate of return 11%

Market return 12.87%
Equity risk premium 1.87%
Equity beta factor 1.0692
Requirement:
What would be the fair price of the brokerage house using Discounted Cash flow Method
(ignore the effect of inflation)? 10

3. Your division is considering two investment projects, each of which requires an up-front
expenditure of Tk 25 mn. You estimate that the cost of capital is 10% and that the investments will
produce the following after-tax cash flows (in Mn BDT):
Year Project A Project B
1 BDT 5 BDT 20
2 10 10
3 15 8
4 20 6
(i) What is the regular payback period for each of the projects? 2
(ii) What is the discounted payback period for each of the projects? 2
(iii) If the two projects are independent and the cost of capital is 10%, which project or projects
should the firm undertake? 2
(iv) If the two projects are mutually exclusive and the cost of capital is 5%, which project the
firm should undertake? 2
(v) If the two projects are mutually exclusive and the cost of capital is 15%, which project the
firm should undertake? 2
(vi) What is the crossover rate? 2

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 (vii) If the cost of capital is 10%, what is the Modified IRR (MIRR) of each project? 3

4. Kazal Press and Azad Publishing company had the following balance sheets as of December 31,
2014 (thousands BDT):
Kazal Press Azad Publishing
Current assets 100,000 80,000
Fixed assets (net) 100,000 120,000
Total assets 200,000 200,000

Current Liabilities 20,000 80,000

Long-term debt 80,000 20,000
Common stock 50,000 50,000
Retained earnings 50,000 50,000
Total liabilities and equity 200,000 200,000

Earnings before interest and taxes for both firms are Tk. 30mn and the effective tax rate is 40%.
(i) What is the return on equity for each firm if the interest rate on current liabilities is 10% and
the rate on long term debt is 13%. 3
(ii) Assume that the short term rate rises to 20%, while the rate on new long term debt rises to
16%, and rate on existing long term debt remains unchanged. What would be the return on
equity for Kazal Press and Azad Publishing under these conditions? 3
(iii) Which company is in a riskier position? Why? 4

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