CMA SEPTEMBER-2022 EXAMINATION

Intermediate Level II
Subject: EF232. Financial Management

Model Solution
Solution of the Question 1
(i) (a)
(ii) (a)
(iii) (b)
(iv) (b)
(v) (c)
(vi) (c)
(vii) (d)
(viii) (d)
(ix) (d)
(x) (e)
Solution of the Question 2
(a) False. The operating break-even point is the point at which operating profits equal ZERO
(revenues equal operating costs).
(b) True.
(c) False. A call provision allows the ISSUER of a security to demand repayment of the principal.
(d) True.
(e) False. The security market line (SML) describes the relationship between a security's expected
return and systematic risk.

Solution of the Question 3

1. (b)
2. (d)
3. (f)
4. (g)
5. (j)
Solution of the Question 4
(b)
(i) On the surface, annuity Y looks more attractive than annuity X because it provides Tk. 1,000
more each year than does annuity X. Of course, the fact that X is an annuity due means that the
Tk. 9,000 would be received at the beginning each year, unlike the Tk. 10,000 at the end of each
year, and this makes annuity X more appealing than it otherwise would be.
(ii) Future value of annuity X = Tk. 90,603.90
Future value of annuity Y = Tk. 87,540.00
(iii) Annuity X is more attractive because its future value at the end of year 6, Tk. 90,603.90 is
greater than annuity Y’s end-of-year-6 future value, Tk. 87,540.00. The subjective assessment in
part (i) was incorrect. The benefit of receiving annuity X’s cash inflows at the beginning of each
year appears to have outweighed the fact that annuity Y’s annual cash inflow, which occurs at
the end of each year, is Tk. 1,000 larger (Tk. 10,000 vs. Tk. 9,000) than annuity X’s.

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(c)
D0 = Tk. 1.80/share
rs = 12%
(i) Zero growth:
P0 =D1/rs = (D1 = D0 = Tk. 1.80)/0.12 = Tk. 15/share
(ii) Constant growth, g = 5%
D1 = D0 × (1 + g) = Tk. 1.80 × (1 + 0.05) = Tk. 1.89/share
P0 = D1/(rs – g) = Tk. 1.89/(0.12 – 0.05) = Tk. 27/share
(iii) Variable growth, N = 3, g1 = 5% for years 1 to 3 and g2 = 4% for years 4 to infinity
D1 = D0 × (1 + g1)1 = Tk. 1.80 × (1 + 0.05)1 = Tk. 1.89/share
D2 = D0 × (1 + g1)2 = Tk. 1.80 × (1 + 0.05)2 = Tk. 1.98/share
D3 = D0 × (1 + g1)3 = Tk. 1.80 × (1 + 0.05)3 = Tk. 2.08/share
D4 = D3 × (1 + g2) = Tk. 2.08 × (1 + 0.04) = Tk. 2.16/share
P3 = D4/(rs – g2) = Tk. 2.16/(0.12 – 0.04) = Tk. 27/share
P0 = D1/(1 + rs)1 + D2/(1 + rs)2 + D3/(1 + rs)3 + P3/(1 + rs)3
= Tk. 1.89/(1+0.12)1 + Tk. 1.98/(1+0.12)2 + Tk. 2.08/(1+0.12)3 + Tk. 27/(1+0.12)3
= Tk. 23.97/Share
(d)
(i) Dividend cover = Earnings available to equity holders/Ordinary dividend
= (40,000(1 – 0.25) – 5,400)/6,750
= 24,600/6,750 = 3.64 times
(ii) Earnings per share = Earnings available to equity holders/No. of ordinary shares
= 24,600/15,000 = Tk. 1.64
(iii) Price-earnings ratio = Price/EPS = 45/1.64 = 27.44 times

Solution of the Question 5

(a)
(i) NPV can be computed by discounting the real cash flows with the company’s real rate of return.
Discounting the project real cash flows with the real rate of return produces an NPV of Tk. 150,026:
End of year NCF Discount factor at 8.7% PV
0 (150,000) 1 (150,000)
1 5,000 0.92 4,600
2 10,500 0.846 8,883
3 25,000 0.779 19,475
4 28,000 0.716 20,048
5 30,000 0.659 19,770
6 and every year thereafter 30,000 7.575 227,250
NPV = 150,026

Comment: Since the NPV of the project is positive, the value of the firm will increase when the project
is implemented. The project should therefore be accepted for implementation.
Workings:
1. Discount rate
The real rate of return is estimated using the Fisher’s equation as under:
1+𝑖=(1+𝑟)(1+ℎ)
Nominal rate, i = 25%
Inflation rate, h = 15%
Therefore, the real rate of return is 8.7%

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2. Discount factor for equal cash flows occurring every year from year 6 to infinity
The equal annual cash flow of Tk. 30,000 from year 6 to infinity is first discounted as a perpetuity to
obtain the terminal value at end of year 5. The terminal value is then discounted as a single amount to
obtain the PV at time zero: The aggregate discount factor is therefore 7.575.
(ii) Project selection under single period capital rationing
1. If projects are independent and divisible:
When a firm faces capital rationing for a single period and projects are independent and divisible,
funds may be allocated to projects based on the profitability index rankings.
Project Investment NPV PI = NPV/Investment Rank

PA201 50,000 85,200 1.70 1

PA202 75,000 98,500 1.31 3
PA203 48,000 65,950 1.37 2
PA204 85,000 95,400 1.12 4
PA205 150,000 150,026 1.00 5
Fund allocation to projects based on PI rankings and respective NPV follow:
Project Investment required Fund allocation NPV
PA201 50,000 50,000 85,200
PA203 48,000 48,000 65,950
PA202 75,000 75,000 98,500
PA204 (balance) 85,000 27,000 30,299*
PA205 150,000 - -
200,000 279,949
That is the company should invest fully in projects PA201, PA203, and PA202; 31.76% in PA204
(27,000/85,000); and nothing in PA205 which is at the bottom of the ranking. The optimum aggregate
NPV is Tk. 279,949.
Workings:
* NPV from PA204 is its NPV multiplied by the proportion of the investment requirement the company
will allocate funds to (i.e. Tk. 95,400 x 31.76%).
2. If projects are independent and indivisible
Here we consider a combination of the projects and select the combination that will produce the
highest combined NPV. Any unused funds may be invested externally (e.g. in securities).
Combination of Projects Combined Unused Combined
Investment required Funds NPV
PA201, PA202, and PA203 173,000 27,000 249,650
PA201, PA203, and PA204 183,000 17,000 246,550
PA201 and PA205 200,000 0 235,226
PA203 and PA205 198,000 2,000 215,976
The company should invest in projects PA201, PA202 and PA203 to earn the highest combined NPV
of Tk. 249,650. The unused funds of Tk. 27,000 should be invested externally.

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(iii) Practical ways of dealing with capital constraints so as not to lose opportunities to further
increase the value of the company further include the following:
(1) Seek joint venture partners with which to share projects investment requirement
(2) Use licensing or franchising arrangement with other entities to get the product produced
and sold. The firm will earn royalties while avoiding financing of the investment
requirements.
(3) Contract out parts of the project to subcontractors who would finance the project in advance.
(4) Seek alternative financing such as venture capital and asset securitization.
(b)
i. Cost of retained earnings = rr = [Tk.1.26(1 + 0.06)]/ Tk.40 + 0.06
= 9.35%
ii. Cost of new common stock = rs = [Tk.1.26(1 + 0.06)]/ Tk.40.00 - Tk.7.00) + 0.06
= 10.06%
iii. Cost of preferred stock = rp = Tk.2.00/ (Tk.25.00 - Tk.3.00)
= 9.09%
iv. rd = 5.98%
ri = 5.98% (1- 0.40) = 3.59%

Solution of the Question 6

(b)
(i) The degree of operating leverage (DOL)
The DOL may be computed as under using figures from the previous year (but not the new year)
The DOL of Firm A = Contribution margin/NOI = (480-288)/152 = 1.26
The DOL of Firm B = Contribution margin/NOI = (372-74.4)/169.6 = 1.76
Implication:
The DOL assesses the volatility in operating profit to changes in revenue. It is high when the firm
uses more fixed costs than variable costs in its operating cost structure. Firm B, which has a
higher DOL, presents a higher business risk to Trojan than Firm A, which has the lower DOL.
The implications for the capital structure decision is that Firm A, which has the lower DOL, could
have higher debt in its capital structure than Firm B, which has a higher DOL.
(ii) The degree of financial leverage (DFL)
The DFL may be computed as under using figures from the previous year (but not the new year)
The DFL of Firm A = NOI/NOI – Interest = 152/(152 – 35) = 1.30
The DFL of Firm B = NOI/NOI – Interest = 169.6/(169.6 – 110) = 2.85
Implication:
The DFL assesses the volatility in net income to changes in operating profit. It indicates the level
of financial risk. Firm B, which has a higher DFL, presents a higher business risk to
334fr55Trojan than Firm A, which has the lower DFL. The implications for the capital structure
decision is that Firm A, which has the lower DFL, could have higher debt in its capital structure
than Firm B, which has a higher DFL.
(c)
i) All equity Debt and Equity
EBIT Tk.1,000,000 Tk.1,000,000
Interest to debt holders 0 450,000
EBT Tk.1,000,000 Tk. 550,000
Taxes (.40) 400,000 220,000
Incomes available to common shareholders Tk. 600,000 Tk. 330,000
Income to debtholders plus income available to
shareholders Tk. 600,000 Tk. 780,000
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ii) Present value of tax-shield benefits = (Market value of debt) (tax rate) = (Tk.3,000,000) (.40)
= Tk.1,200,000
iii) Value of all-equity financed firm = EAT/ke = Tk.600,000/(.20) = Tk.3,000,000
Value of recapitalized firm = Tk.3,000,000 + Tk.1,200,000 = Tk.4,200,000

Solution of the Question 7

(b)
(i) The original expectation would have been that the amount to payback would be $280,000 x Tk.
4.2 = Tk. 1,176,000. However, during the time that it was exposed to the currency risk, the
exchange rate has moved in an adverse direction, and the actual payments are $280,000 x Tk.
4.6 = Tk. 1,288,000. The ‘FX loss’ has been Tk. 112,000.
(ii) Currency risk arises from exposure to the consequences of a rise or fall in an exchange rate.
Here, the Bangladeshi buyer was exposed to the risk of a fall in the value of Taka. Currency risk
is a two-way risk, and exposure to risk can lead to either losses or gain from movements in an
exchange rate. In this example, the exchange rate could have moved the other way. For
example, if the exchange rate after three months had been $1= Tk. 4.0, the Bangladeshi buyer
would have paid Tk. 1,120,000 instead of Tk. 1,288,000.
(c)
Old policy New policy
(Tk. 000) (Tk. 000)
Sales 24,000 30,000
Variable cost 16,800 21,000
Contribution margin 7,200 9,000
Cost of debtors:
Interest foregone (1/12*24m*20%) (2/12*30m*20%) 400 1,000
Bad debt (1%*24m) (1.5%*30m) 240 450
Net contribution 6,560 7,550
Net benefit from new policy = (Tk. 7,550 – Tk. 6,560) = Tk. 990,000.
Decision:
The company should pursue the policy of taking in the new customers.

= THE END =

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