UNIVERSITY OF COLOMBO, SRI LANKA

FACULTY OF MANAGEMENT AND FINANCE

Postgraduate & Mid-career Development Unit

Master of Business Administration (Trimester III) Examination – January, 2022

MBA 5109 – Financial Management

Three (03) Hours
Instructions:
1. Answer all questions.
2. Use of calculators is permitted.
3. This is an Online Open Book Examination

1
i. Since 2020, financial managers have had a complex and challenging role due to the
global pandemic situation, while ethical practices in finance are also essential to
achieve the long term financial goal. In this situation, how can financial managers
take wise financial management decisions by adopting relevant strategies? Explain.
(05 Marks)

ii. Mr Herath is saving for the college education of his two children. They are two years
apart in age; one will begin college 10 years from today, and the other will begin 12
years from today. He estimates his children’s college expenses to be Rs. 450, 000
per year per child, payable at the beginning of each school year. The annual interest
rate is 7 percent.
(a) How much money must Mr. Herath deposit in an account each year to fund
his children’s education?
(b) Mr. Herath deposits begin one year from today. He will make his last deposit
when his oldest child enters college. Calculate the total cost of children’s
expenses today. (Assume four years of college education).
(06 Marks)

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 iii. XYZ limited wishes to select the best alternative from the two mutually exclusive
projects A and B, of equal risk. The initial investment and after-tax cash flows are
shown in the following table.
Cash flows Project A Project B
Initial investment Rs.600,000 Rs.1,000,000
After tax cash inflows – 1 to 5 each year Rs.200,000 Rs.315,000

The firm’s cost of capital is 11 %.

(a) Calculate NPV and Internal Rate of Return (IRR) for each project?
(b) Discuss any conflict in the ranking of two projects based on NPV and IRR.
(c) Which project would you recommend? Explain your answer.
(08 Marks)

iv. After extensive research and development, Omicron Company has recently
developed a new computer-based order entry system. The company must make
decisions whether to invest in this project. The Research and Development (R& D)
costs so far have totaled Rs. 1 million. The cost of the computer-based order entry
system is Rs. 860,000 with an installation cost of Rs. 240,000. The system will be
depreciated straight line to zero over its five year life. It will be worth Rs. 62, 000 at
the end of that time. Labour costs will be saved Rs. 265,000 per year. In addition, the
new system will reduce working capital by Rs. 85,000 (this is a one-time reduction).
If the corporate income tax rate is 24 % and the appropriate discount rate is 12%.
(a) Estimate the relevant cash flows of the project.
(b) What is the Net Present Value (NPV) of this project?
(c) What is the profitability index (PI) of the project? Write your
recommendation to the CEO of the Omicron Company.
(09 Marks)
(Total 28 Marks)
2.
i. Jehan Ltd. is a major oil and gas exploration company, which has most of its operations
in the Middle East and South-East Asia. Recently, the company acquired rights to
explore for oil and gas in the Gulf of Maxico. Jehan Ltd. proposes to finance the new
operations from the issue of equity shares. At present, the company is financed by a
combination of equity capital and loan capital. The equity shares have a nominal value
of $10 and a current market value of $52. The current level of dividend is $3.2 per share
and this has been growing at a compound rate of 6 per cent per annum in recent years.
The loan capital issued by the company is irredeemable and has a current market value
of $94 per $100 nominal. Interest on the loan capital is at the rate of 12% and interest
due at the year end has recently been paid. At present, the company expects 60% of its

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 finance to come from equity capital and the rest from loan capital. In the future, however,
the company will aim to finance 70% of its operations from equity capital.

When the proposal to finance the new operations via the rights issue of shares was
announced at the annual general meeting of the company, objections were raised by two
shareholders present.

Shareholder A argued: “I fail to understand why the company has decided to issue shares to
finance the new operation. Surely, it would be better to reinvest profit as this is, in effect, a
free source of finance to the company”.

Shareholder B argued: “I also fail to understand why the company has decided to issue shares
to finance the new operation. However, I do not agree with the suggestion made by
shareholder A. I do not believe that shareholder funds should be used at all to finance the
new operation. Instead, the company should issue more loan capital as it is cheap relative to
equity capital and would, therefore, reduce the overall cost of capital of the company”.
Corporation tax is at the rate of 30 percent.
Required:
(a) Calculate the weighted average cost of capital of Jehan Ltd. which should
be used in future investment decisions.
(08 Marks)
(b) Comment on the remarks made by Shareholder A and Shareholder B.
(05 Marks)

ii. Consider the following information on two assets and three states of the economy.

State of the economy Probability Rate of return if state occurs

Company A Company B
Recession 0.2 - 0.15 0.20
Normal 0.5 0.20 0.30
Boom 0.3 0.60 0.40

(a) What are the expected returns and standard deviations for these two stocks?
(b) Which company you rank as high-risk company?
(c) Suppose you have Rs. 200,000 total. If you put Rs.150, 000 in Stock A and the
remainder in Stock B, what will be the expected return of your portfolio?
(d) What is the expected risk premium on the portfolio if the expected Treasury bill rate
is 8 percent?
(12 Marks)
(Total 25 Marks)

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3.
i. “You are the CFO of a non-dividend paying firm that currently has excess cash reserves.
You are preparing for an internal management meeting where dividends are on the
agenda. You know that the CEO favors the commencement of a dividend program. You,
however, oppose any dividend plan at this time. Write a good argument that you can
use in the meeting to support your position.
(06 Marks)

ii. In December 2021, Fly paper’s stock sold for about Rs. 73. Security analysts were
forecasting a long-term earnings growth rate of 8.5 percent. The company is expected
to pay a dividend of Rs. 1.68 per share.
(a) Assume dividends are expected to grow along with earnings at g = 8.5 percent per
year in perpetuity. What is the rate of return (r) expected by the investors?
(b) Fly paper was expected to earn about 14 percent on book equity (ROE) and to pay
out 50% earnings as dividends. What do these forecasts imply growth rate of
dividends and expected rate of return?
(06 Marks)

iii. James Furniture Company currently has 100,000 shares of common stock outstanding
with a market price of Rs.60 per share. It also has Rs.2 million in 6 percent bonds. The
company is planning to expand its business by investing in a Rs.3 million project that it
can finance with all common stock at Rs.60 a share (option 1), bonds at 8 percent interest
(option 2), and preferred stock at 7 percent (option 3). Assume a tax rate of 35 percent.
(a) For an expected EBIT level of Rs.1 million after the expansion program, calculate
the earnings per share for each of the alternative methods of financing.
(b) Calculate the indifference points between alternative plan 1 and plan 2. What is
your interpretation of the indifference point?
(c) Compute the Degree of Financial Leverage for each alternative at an expected
EBIT level of Rs.1 million.
(d) Which financing alternative do you prefer? Why?
(13 marks)
(Total 25 Marks)
4.
i. Beauty Pvt Ltd. is a recently established manufacturing company established in 2011.
The company was managed by CEO, Anil an Engineer. The company usually acquired
its raw material from Lucknow, India, produced perfumes and sold them to the local

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market. The price of the raw material fluctuates widely. The company follows the
low-cost strategy by using lower investment in fixed assets, and the product is also of
inferior quality. However, the cost advantage enables Beauty Pvt Ltd. To maintain its
position in the market. Further, the company sells the product mainly on credit and is
a preferable option for buyers.

Beauty Pvt Ltd. followed a conservative approach to working capital management.

Since its assets are more than 10 times its liabilities, these assets are primarily in
inventories and account receivables. The company is very keen to repay the loan
immediately before the credit period while extending the credit sales for a longer
period. On the other hand, the company maintains a high inventory level to avoid the
stock-outs and manufacturing delays, which had led to wastage of Beauty Pvt Ltd
working capital. CEO knew that company’s sales had gradually decreased. Immediate
action has required the situation of loss of sales would negatively impact on
profitability and liquidity of the company in the future.

You are a management accountant who joined the company last week. CEO Anil, an
Engineer, informed you that he is preparing to make a presentation to the Board of
Directors next week on the Working Capital status of the company. He also gave the
following data and information prepared by the accounts assistant as per the instruction
given by him. The following information is provided regarding the working capital
management of Beauty Pvt Ltd and a leading peer company in the same industry for
the year ended 31st March 2021.

Details Beauty Ltd. Peer company

Inventory Conversion Period (Days)
Raw Material 78 50
Work in Progress 20 10
Debtors Conversion Period (Days) 100 60

Creditors Deferral Period (Days) 31 75

Current assets Rs. 540,000 Rs. 660,000
Quick assets Rs. 320,000 Rs. 400,000
Fixed assets Rs. 930,000 Rs. 1,200,000
Current Liabilities Rs. 180,000 Rs. 290,000
Earnings Before Interest and Tax Rs. 170,000 Rs. 380,000
Comment and discuss the working capital status of beauty Ltd. ( Hint: estimate the
gross operating cycle and the cash conversion cycle, current ratio, quick ratio, net
working capital etc.)
(11 Marks)

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ii. Explain how does the existence of financial distress costs and agency costs affect
Modigliani and Miller‘s (MM) theory in a world where firms pay taxes.
(05 Marks)

iii. Royal company has expected earnings before interest and taxes is Rs. 2,400,000.
Currently, it is all equity financed. It will issue Rs. 2million in perpetual debt at 11
% interest to repurchase the stocks, thereby recapitalizing the company. Assume
corporate tax is 24 %, and there are no personal taxes.
(a) The required rate of return of the company’s common stock is 15 % while it
remains equity financed. What is the value of the firm if it remains all equity
financed? What is the firm value if it is recapitalized?
(b) According to the MM approach, what would be the firm’s weighted average
cost of capital (WACC) after recapitalization?
(06 Marks)
(Total 22 Marks)

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