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INSTITUTE OF CERTIFIED
MANAGEMENT ACCOUNTANTS OF SRI LANKA
Incorporated by Parliament Act No.23 of 2009

SUGGESTED SOLUTIONS
Published by CMA Sri Lanka Business School

Disclaimer Notice
The copyright of this Suggested Solutions is reserved by the Institute of Certified Management Accountants
of Sri Lanka (CMA Sri Lanka) and Suggested Solutions either in whole or in part may be reproduced with
the prior written approval from the Institute. The purpose of the suggested solutions is to provide only a
guidance and not to be constructed as complete answers.

402 - FSV – Financial Strategy & Valuation

Strategic Level
November 2018

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PART - I

ANSWER 01 - [Total 40 marks]

a
To estimate WACC, it is required to identify the market value of funds and their respective
weights:
Rs. (million)
Common equity 77
Preferred equity 10.3
Long term debt 35
Total capital 122.3

Cost of Capital comprises Equity and Debt

Capital Weight Cost

Equity W(e) K(e)
Debt W(d) K(d)

T= Corporate Tax = 30%

Weighted Average Cost of Capital (WACC) = W (e) ×K (e) + W (d) × K (d) (1-T)
Capital MV Weight Cost
Rs(Mn)
Equity 77 12%
Preferred Equity 10.3 10%
Debt 35 8%
Total 122.3

We=77/122.3 , Wp = 10.3/122.3 and Wd =35/122.3

i. WACC = 77/122.3 x 12% + 35/122.3 x 8% x (1-30%) + 10.3/122.3 x 10%
= 10%
Note that the weight for each capital is estimated as the value of each capital divided by
the total capital.

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ii. Present Value of Net Cash Flows (PVCF) =

(CF1)/(1+k) 1+(CF2)/(1+k)2+(CF3)/(1+k)3
CF1=CF2=CF3= Rs.10 Mn
K= Discount Factor = WACC =10% (Computed in above (i)

PV of net CFs = 10/1.10 + 10/1.12 + 10/1.13

= Rs. 24.869 million
Investment =Rs. 25.0 million
Then, NPV of the investment =25-24.869 = (0.131)

As NPV gives negative figure, investment does not add value to the firm, this investment
is not recommended.

b.
Market Value of Equity = Number of Shares and Market Price
10 Mn * Rs.30 = Rs. 300 Mn
Market Value of Debt = Rs .100 Mn

V= Mkt value of equity + market value of debt

=300+100
Enterprise Value of Capital = Rs.400Mn

Capital MV (Rs) Weight

Equity 300 300/400
Debt 100 100/400
Total MV = (V) 400 1
Debt finance = 100/400 = 25%
K(d )= Cost of debt
- Kd(1-t)= 0.80 (1-0.35) = 5.2%

Ks = Cost of EQUITY ( levered )

K0 = Cost of equity unlevered (all equity financed)
D = Market Value of Debt Capital
E =Market value of Equity Capital
- Ks = Ko+(Ko-Kd)(1-t)D/E
=0.103+(0.103-0.08)(1-0.35)100/300=10.8%

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i.
present at 25%,
K(WACC) =(D/V) kd + (E/V)K S
=100/400 (0.052)+300/400(0.108)=9.4%

(a) At 20%,
K (WACC) =(D/V) K(d) (1-t)+(E/V)Ks
=20/100 (0.077)(1-0.35)+80/100(0.125)=11%

(b) At 40%,
K (WACC) =(D/V)kd(1-t)+(E/V)Ks
=40/100(0.093)(1-0.35)+60/100(0.14)=10.88%

( c ) At 50%,
K (WACC =(D/V)Kd(1-t)+(E/V)Ks
=50/100(0.104)(1-0.35)+50/100(0.16)=11.38%

ii.

At present the company maintains best debt to total funds ratio. It is 25% debt ratio with
9.4% cost of capital.
iii.
The after-tax cost of debt decreases as the tax rate increases. Resulting weighted average
cost of capital also reduces.

C.
i.
Financing strategy is life blood of any business firm that indicates the principles to follow
before any financing decision.

ii.
Approaches:
• Maturity approach: As per this financing strategy, the organization matches the
expected life of the current asset with the estimated life of the source of fund to
raise these financial assets.
• conservative approach: As per this financing strategy, the organization relies on
the long-term funds to acquire permanent assets and a part of temporary assets.

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• Aggressive approach: As per this financing strategy, the organization uses its
short-term funds to finance a part of its permanent assets. This is a very risky
approach as there are chances that the organization might have a hard time dealing
with its short-term obligations.

d. I. Free cash Flow Estimation from year 1 to year 4

Year 1 2 3 4

EBITDA 100 125 156 164

Tax (40) (50) (62.4) (65.6)
CAPEX (30) (37) (46) (32)
Changes in WC (8) (10) (12) (6)
FCF 22 28 35.6 60.4

Note 1
Year Current 1 2 3 4
Working Capital
(WC) Rs(Mn) 52 60 70 82 88
Changes in WC (60-52) (70-60) (82-70) (88-82)
Rs (Mn) =8 =10 =12 =6

II. Cost of Capital estimation for the firm

Cost of Capital = WACC
Weighted Average Cost of Capital (WACC) = W (e) ×K (e) + W (d) × K (d) (1-T)
Ke- 12%, Kd=8%(1-.4)=4.8%
We=75% Wd=25%
WACC= (0.12x.75)+(0.048x.25)=10.2%

III. Terminal value of the firm at the end of year 4

TV = Free Cash flow of the starting of constant growth in this case 4th year , the firm
will grow at 5% forever. (g=5%)
K = WACC =10.2% computed above
TV=FCF4(1+g)/(K-g)=60.4(1+0.05)/(0.102-0.05)=Rs. 1,219.62 million

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IV. Firm value

FCF= Free Cash Flow = as per the computation done in d(i)
Year 0 1 2 3 4 5
FCF {d(i)} 22 28 35.6 60.4 63.42
PV factor 10.2%
(Note 1) 0.907 0.823 0.747 0.678
Terminal Value 1219.61
(TV){d(iii)}

PV of Cash Flows 22*0.907 28*0.823 35.6*0.747 60.4*0.67 1219.61

19.95 23.04 26.6 8 *0.678=
40.95 826.9
Sum of PV of FCF
& TV Firm value 937.44

PV of FCF &TV = 19.95+23.04+26.6+40.95+826.9=937.44

Note 1: DF 9.2%
Year 0 1 2 3 4 5
9.2% 1/1 1/(1.092)1 1/(1.092)2 1/(1.092)3 1/(1.092)4 1/1.092)5
1 0.9157 0.8386 0.7679 0.7033 0.6440

e.
i.

Rs. million
Investment requirement 2,700
Net profit 1,200
funds for 40% equity capital 1,080
residual profit (Rs 1200-Rs1080) 120

Payout ratio = 120/1200=10%

ii.
Variable dividends send conflicting signals, increase risk, and do not appeal to any specific
clientele. Results in higher required return.
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PART - II

ANSWER 02 - [Total 20 marks]

a. Sufficient capital is always a business issue, from the start-up stage to the exit stage.
Financing need – product research and development, market validation, operations,
growth – and the typical sources of that financing vary depending on where the business
is in its financing lifecycle.
Concept Financing/initial validation of a business concept. Financial resources will be
minimal, often consisting of self-funding or loans from friends and family members.
Seed Financing. Funding options at this stage typically include government grants and
loans and investments from friends, family and close business associates.
Launch Financing. Financing through strategic investors while continuing to raise
money from established investors.
Growth Financing. Once a product has been successfully accepted by the market, the
business will be looking to grow and expand its reach. Larger venture capital funding,
sometimes in multiple rounds is common at this stage or a public offering.
Maturity/Exit Financing. Once the business has grown and matured, the company
might decide to undertake an initial public offering to raise money in the public markets
and achieve liquidity for its investors. At this stage, the company might also move
forward with an exit transaction through an acquisition by or a merger with another
company.

b. i.
P/E multiple
Company A: Market value of equity/Earnings = 5,000,000/850,000 = 5.88 times
Company B: = 10,000,000/1,000,000 =10 times

ii.
Company A: Enterprise Value/EBIT =10,000,000/2,000,000 =5 times
Company B: =10,000,000/2,000,000 =5 times

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iii.
P/E multiple is more appropriate from the shareholder point of view. Then Company B
performs better in this respect.
EV/EBIT is not affected by any change in capital structure of two companies. So it is more
accurate comparison as those two companies differ in respect of capital structure
changes. Results indicate that both companies performance is same.

c. I growth rate from 2015 to 2017: (15.5/9)1/2-1 =0.312 or 31.2%

Predicted growth rate from 2017 to 2019 is: (20.20/15.5)1/2-1 =0.142 or 14.2%

II cont. value of dividend at the end of 2019:

Dividend Growth Model = D0 (1+g)/ (Ke-g)
D0= Current Dividend at the end of year 2019
g= Div Growth Rate ( pls refer part 1 14.2%)
Ke = Cost of Equity (required rate of return by investor)

D2019=20.20(1+0.142)/(0.16-0.142)= Rs. 1281.57

ANSWER 03 - [Total 20 marks]

a. i. FL
100,000 capacity: 2/1.6=1.25
80,000 capacity: 0.8/0.4=2.0
When production capacity decreases without changing fixed cost it leads to decrease
return to shareholders.

ii. OL=S-V/S-V-F
When fixed cost is Rs.4 million: 10-4/10-4-4=3
When fixed cost is Rs.5 million: 10-4/10-4-5=6
When production capacity remains same and fixed cost increases it leads to increase
operating risk

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b. i. Adjusted Present Value = Present Value of Cash Flows + Present Value of Tax Savings.
We need to find ungeared cost of equity which is;
Ke=Rf+β(Rm-Rf)
Ke= Cost of Equity (Required rate of Return by Investors)
Rm= Market Return
Rf-= Risk free Return
Ke= 3% + 1.5*(12% − 3%) = 16.5%.
Using this rate the present value of cash flows
=Rs 10 million/0.165 = Rs. 60.61 million.

Initial investment is Rs. 50 million no net present value of future cash flows using
ungeared cost of equity is Rs. 10.61 million (Rs.60.61 million-Rs.50 million).
Present value of tax savings = 2 million × 0.4 / 0.08 = Rs.10 million

ii.
Adjusted present value = present value of cash flows + present value of tax savings
= Rs.60.61 million + Rs.10 million = Rs.70.61 million.

c.
i.
Economic Profit
Based on the definition of economic profit, the general equation for its calculation is as
follows:
Economic Profit = Revenues − Expenses − Opportunity Costs

Therefore an economic profit is the difference between the revenue received from the sale
of an output and the opportunity cost of the inputs used. In calculating economic profit,
opportunity costs are deducted from revenues earned. Opportunity costs are the
alternative returns foregone by using the chosen inputs, and as a result, a person can have
a significant accounting profit with little to no economic profit.

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ii.

i. Invested capital
Debt and debt equivalents + Equity and equity equivalents - Non-operating assets

2018= 9,450 + 10,250 -1,500= 18,200

2019= 9,900+ 10,700- 1,575 = 19,025

ii. Economic Profit = IC x (ROIC-WACC)

2018= 18,200x(0.15-0.13) = 364
2019= 19,025 x (0.15-0.13)=380.5

ANSWER 04 - [Total 20 marks]

a) An acquisition is: An asset, object or property bought or obtained typically by another

party. There are two types of acquisitions;

Horizontal - Two companies that are in direct competition and share the same product
lines and markets.

Vertical - A customer and company or a supplier and company.

Key drives to consider acquisition:
• Increasing capabilities
• gaining competitive advantage
• diversify product or service
• replacing leadership
• cutting cost surviving

b) i.
low end of range: RS. 40x 1.25=Rs 50
High end of range: Pmax=(P/E)1(EPS)2
=10X6
= Rs. 60

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ii.

𝐸𝐴𝑇1+𝐸𝐴𝑇2+𝐸𝐴𝑇1,2
EPSc = 𝑁𝑆1+𝑁𝑆2(𝐸𝑅)

= 30+12+0/6+2
=42/8
= Rs. 5.25

c) [(1.10)2/ (1.08)1] - 1 = 12.04%

d) i.
big Mac = LKR 420
big Mac = USD 2.49
big Mac = LKR 420 = USD 2.49
Hence
LKR 420 = USD 2.49
USD 1= LKR 420
LKR 420/2.49=Rs .168.67

ii.
Comment: on the date of the survey, the actual exchange rate was SLR 150 a dollar.
Therefore, the SLR is overvalued by:
SLR/SLR=168.67/150=1.1245 or ≈+12.45%

S=PISLR/PI$
If the basket of goods cost SLR 1500 in Sri Lanka and 10$ in the United
States, the PPP exchange rate would be:
SLR/$=1500/10=15

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ANSWER 05 - [Total 20 marks]

a I.
a. direct and indirect quotes
The exchange rate quote where the amount of domestic currency per unit of foreign
currency is shown. The domestic currency is on the numerator while quoting exchange
rate. Indirect quote means that the exchange rate quote when the amount of foreign
currency is expressed per unit of domestic currency.

b.
i. Direct quote in Sri Lanka: SLR/$
150/$ 145/$ internal value of US$

ii. Indirect quote in US:$/SLR

1/150 1/145 external value of Sri Lankan rupee

iii. Percent change in foreign currency (US$):

𝑒𝑛𝑑𝑖𝑛𝑔 𝑟𝑎𝑡𝑒−𝑏𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 0.00689−0,00667
⸓∆= 𝑏𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑒
𝑥100 = 0.00667
𝑥100 = −3.29%(02 Marks)

II. a. A cross rate is an exchange rate of two currencies expressed in a third different currency,
such as the exchange rate between the euro and the yuan expressed in yen

b. i. SLR/Russian ruble cross rate?

Simple method of calculating Cross Rate (using the concept)
Student should know that there should be common currency to calculate cross rate
1$ = LKR 150
I$ = R 30.962
R 30.962 = LKR 150
Hence
1R = LKR 150/30.962
Ruble 1 = Rs.4.8446

Alternative method using formula

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𝑆𝐿𝑅 𝑆𝐿𝑅150
𝑈𝑆$ $ 4.8446
𝑥 = 𝑆𝐿𝑅
𝑅𝑢𝑏𝑙𝑒𝑠 30.962 𝑅
𝑈𝑆$ $
1
𝑜𝑟 𝑡ℎ𝑒 𝑟𝑒𝑐𝑖𝑝𝑟𝑜𝑐𝑎𝑙 4.8446 = 𝑅 0.2064/𝐿𝐾𝑅

ii. rubles will you obtain for your Rs. 3000,000?

300,000x.2064=R 61,920.00

III. a. forward quotations in percentage.

𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒−𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 365 151−150 365

b. f= 𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒
𝑥 𝑛 𝑥100 = 150
𝑥 90
𝑥 100 = 2.65%

This indicates that the forward is selling at 2.65% per annum premium over the
dollar.

b. Rp= (40%x14%)+(60%x18%)=16.4%

` ******

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