FINANCIAL MANAGEMENT

Nov-Dec 2021
Time allowed- 3:30 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. (a) Describe the risks and returns of a leveraged buyout. Explain how changes in capital structure
affect a firm’s value. 3
(b) Discuss the effects of the three approaches to working capital financing policy. 3
(c) MM Company Ltd has a debt-equity ratio of 0.35. The required return of the company’s unlevered
equity is 13% and the pretax cost of the firm’s debt is 7%. Sales revenue for the company is
expected to remain stable indefinitely at last year’s level of Tk 17,500,000. Variable costs amount
to 60% of sales. The tax rate is 40% and the company distributes all its earnings as dividends at
the end of each year.
Requirements:
i) If the company were financed entirely by equity, how much would it be worth? 3
ii) What is the required return on the firm’s levered equity? 2
iii) Use the weighted average cost of capital method to calculate the value of the company. What
is the value of the company’s equity? What is the value of the company’s debt? 4
iv) Use the flow to equity method to calculate the value of the company’s equity? 3
2. (a) You are presented with the following different views of stock market behaviour.
(1) If a company publishes an earnings figure higher than the market expectation, the shares of
that company will usually experience an abnormally high return, both on the day of the earnings
announcement and over the two or three days following.
(2) The return on professionally managed portfolios of equities is likely to be no better than that
which could be achieved by a naive investor who holds the market portfolio.
(3) Share prices usually seem to rise sharply in the first few days of a new fiscal year. However,
this can be explained by the fact that many investors sell losing stocks immediately prior to the
fiscal year end in order to establish a tax loss for capital gains tax purposes. This causes
abnormal downward pressure which is released when the new fiscal year begins.
Requirement:
Comment on what each of the above three statements tells you about the efficiency of the stock
market. Where appropriate, relate your comments to one or more forms of the efficient markets
hypothesis. 5
(b) Seven Star Furniture Limited (SSFL) produces and sells two luxury furniture items bed and chair.
The company expects growth in the business during 2022. Sales projections are as follows:

Projected Sales Q1 Q2 Q3 Q4
2022 2022 2022 2022
Bed 5,000 7,000 9,000 10,000
Chair 2,500 3,500 5,000 6,000

The price of each bed is BDT 15,000 and will remain fixed for the next two years. Clients pay in
full when purchasing the bed.

Each chair presently sells for BDT 5,000. This will increase by 20% per chair effective from 1st
January 2022.

Clients pay a 20% cash deposit and pay the remainder three months from the date of order. SSFL
is owed BDT 3,500,000 from chairs sold in the last quarter of 2021.
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 SSFL has projected that on 1 January 2022 it will have:
- BDT 5,000,000 cash on hand; and
- 100 beds in stock.

The ongoing inventory policy is to produce enough bed to meet 20% of the following quarter’s
estimated sales demand. The chairs are produced to order i.e. each quarter’s sales will be produced
in that quarter.

The wood used to produce the company’s products costs BDT 12,000 per bed and BDT 3,000 per
chair. The company purchases raw material on a just-in-time basis. Creditors allow SSFL three
months after their date of purchase to settle their account. SSFL owes creditors BDT 70,000,000
for purchases in the quarter ended 31st December 2021.

It is anticipated that 20 staff members will be employed from 1st April 2022 onwards at a monthly
cost of BDT 100,000 each. This will remain fixed for one year.

Two directors of SSFL are paid a quarterly fee of BDT 50,000 each. This will increase by 20%
from 1st January 2022. All wages and fees are paid in the month to which they relate.

Factory rental is payable (in even instalments) three month’s in advance on the quarter days 1st
January, April, July and October. The annual rental for the year ended December 2022 has been
fixed at BDT 60,000,000.

To increase production, the company will purchase a new moulding machine at a cost of BDT
100,000,000. This will be paid for in March 2022.
Requirements:
i) Prepare a quarterly cash budget for SSFL for the year ended 31st December 2022. 10
ii) Comment on your findings and suggest three steps that Wood Limited’s management could
take to manage their cash position for the year ended 31st December 2022. 2

3. Ringtel Communications Ltd (RCL) supplies headphones to airlines for use with movie and stereo
programs. The headphones, which use the latest in electronic components, sell for Tk 28.80 per set and
this year’s sales are expected to be 450,000 units. Variable production costs for the expected sales
under present production methods are estimated at Tk 10,200,000 and fixed production (operating)
costs at present are Tk 1,560,000. RCL has Tk 4,800,000 of debt outstanding at an interest rate of 8%.
There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend
payout ratio is 70% and RCL is in the 40% tax bracket.
The company is considering investing Tk 7,200,000 in new equipment. Sales would not increase, but
variable costs per unit would decline by 20%. Also fixed operating cost would increase from Tk
1,560,000 to Tk 1,800,000. RCL could raise the required capital by borrowing Tk 7,200,000 at 10%
or by selling 240,000 additional shares at Tk 30 per share.

Requirements:
(a) What would be RCL’s EPS (i) under the old production process (ii) under the new process if it
uses debt, and (iii) under the new process if it uses common stock? 3
(b) At what unit sales level would RCL have the same EPS, assuming it undertakes the investment
and finances it with debt or with stock? 3
(c) At what unit sales level would EPS = 0 under the three production/financing set ups – that is,
under the old plan, the new plan with debt financing, and the new plan with stock financing? 3
(d) On the basis of the analysis in parts a through c, and given that operating leverage is lower under
the new setup, which plan is riskiest, which has the highest expected EPS, and which would you
recommend? Assume here that there is a fairly high probability of sales falling as low as 250,000
units and determine EPS debt and EPS stock at that sales level to help assess the riskiness of the
two financing plans. 3

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4. Assume that the current date is 31 December 2021
You are a Financial Analyst working for Soft Apparels (SA) which is a Bangladeshi Company that
exports apparels to Srilanka. The Chairman of Risk Management Committee of SA is wary of its
exposure to foreign exchange rate risk (‘forex risk’) and the need to hedge it.

The Chairman asked you to advise the board on how to hedge the forex risk associated with its trading
activities in Srilanka. You have the following information available to you at the close of business on
31 December 2021:

One of SA’s client owes to SA LKR 35,000,000 which will become due on March 31, 2022.

Exchange rates
Spot rate (LKR/BDT) 2.36 – 2.38
Three-month forward contract discount (LKR/BDT) 0.0031 - 0.0034
March currency futures price (standard contract size BDT 1,000,000): LKR 2.41/BDT

Annual borrowing and depositing interest rates

BDT 9.00% - 6.00%
LKR 10.5% - 5.50%

Three-month over-the-counter currency options

Call options to buy BDT have an exercise price of LKR/BDT 2.42 and premium of BDT 0.03 per LKR
converted.
Put options to sell LKR have an exercise price of LKR/BDT 2.41 and a premium of BDT 0.02 per
LKR converted.
Requirements:
(a) Assuming that the spot exchange rate on 31 March 2022 will be LKR/BDT 2.425 – 2.445 and that
the BDT currency futures price will be LKR 2.443/BDT, calculate SA’s BDT receipt if it uses the
following to hedge its forex risk:
• a forward contract
• a money market hedge
• currency futures contracts
• an over-the-counter currency option 8
(b) Describe the relative advantages and disadvantages of each of the hedging techniques in (a) above
and advise SA on which would be most beneficial for hedging its forex risk. 6
(c) Identify and explain overseas trading risks (other than forex risk) that SA is exposed to and discuss
how they might be mitigated. 4
5. Best GPS System (BGS) manufactures and sells GPS devices. Recently BGS has developed a new
GPS for cars tracking (GCT). It intends to set up a manufacturing facility in Bangladesh, although the
board of BGS had planned setting up in an overseas country. The GCT project will have a life of four
years.
The selling price of the GCT will be BDT 10,000 per unit, and sales in the first year to 31 December
2022 are expected to be 5,000 units per month, increasing by 4% pa thereafter. Relevant direct labor
and materials costs are expected to be BDT 7,600 per unit and incremental fixed production costs are
expected to be BDT 35 million pa. The selling price and costs are stated in 31 December 2021 prices
and are expected to increase at the rate of 2% & 7% pa respectively. Research and development costs
to 31 December 2021 amounted to BDT 10 million.
Investment in working capital will be BDT 5 million on 31 December 2021 and this will increase in
line with sales volumes and inflation. Working capital will be fully recoverable on 31 December 2024.
BGS will need to rent a factory for the life of the project. Annual rent of BDT 12 million will be
payable in advance on 31 December each year and will not increase over the life of the project.

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 Plant and machinery will cost BDT 250 million on 31 December 2021. The plant and machinery is
expected to have a resale value of BDT 50 million (in 31 December 2024 prices) at the end of the
project. The plant and machinery will attract 20% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year. In the
final year, the difference between the plant and machinery’s written down value for tax purposes and
its disposal proceeds will be treated by the company either:
(i) as an additional tax relief, if the disposal proceeds are less than the tax written down value, or
(ii) as a balancing charge, if the disposal proceeds are more than the tax written down value.
Corporation tax will be 35% pa for the foreseeable future and that tax flows arise in the same year as
the cash flows which gave rise to them.
The project will be financed from the company’s pool of funds and there will be no change in current
gearing levels. An appropriate weighted average cost of capital for the project is 14% pa.
BGS’s directors are concerned that there are rumours in the industry of research by a rival company
into a much cheaper alternative to the GPS devices currently available. However, the rumours that the
directors have heard suggest that this research will take another year to complete and, if it is successful,
it will be a further year before any new devices are operational.
Requirements:
(a) Calculate, using money cash flows:
i) The net present value of the GCT project on 31 December 2021;
ii) Advice BGS’s board as to whether it should proceed; and 8
iii) Submit the workings on calculation of contributions, fixed costs, capital allowances and 2
working capital. 4
(b) Calculate and comment upon the sensitivity of the project to a change in the annual rent of the
factory and the weighted average cost of capital. 4
(c) Assume now that the project had been financed entirely by debt and that this had caused the gearing
of BGS to change materially. Describe how you would have appraised the project in such
circumstances. 2
(d) If the board of BGS decided to set up the manufacturing facility overseas, advise the board on how
political risk could change the value of the project and how it might limit its effects. 2
(e) Identify and discuss the real options available to BGS in relation to the GCT project. 3
6. Your broker offers to sell you some shares of B Ltd that paid a dividend of Tk 2 yesterday. You expect
the dividend to grow at the rate of 5% per year for the next 3 years, and, if you buy the stock, you plan
to hold it for 3 years and then sell it.
Requirements:
(a) Find the expected dividend for each of the next 3 years; that is, calculate D1, D2 and D3. 2
(b) Given that the appropriate discount rate is 12% and that the first of these dividend payments will
occur 1 year from now, find the present value of the dividend stream; that is, calculate the PV of
D1, D2 and D3 and then sum these PVs. 2
(c) You expect the price of the stock 3 years from now on to be Tk 34.73; that is you expect P3 to
equal Tk 34.73. Discounted at a 12% rate, what is the present value of this expected future stock
price? In other words, calculate the PV of Tk 34.73. 1
(d) If you plan to buy the stock, hold it for 3 years and then sell it for Tk 34.73, what is the most you
should pay for it today? 1
(e) Using constant growth valuation, calculate the present value of this stock. Assume that g=5%, and
it is constant. 2
(f) Is the value of this stock dependent upon how long you plan to hold it? In other words, if your
planned holding period were 2 years or 5 years rather than 3 years, would this affect the value of
the stock today, Po? 2

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