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Gurukripa’s Guideline Answers for May2016 CA Final Strategic Financial Management Exam

Gurukripa’s Guideline Answers for May 2016 Exam Questions

CA Final –Strategic Financial Management
Question No.1 is Compulsory. Answer any 5 Questions from the remaining 6 Questions. Answer any 4 out of 5 in Q.7.

Note: Page Number References are from “Padhuka’s Students’ Referencer on Strategic Financial Management”

Question 1(a): Reward to Variability / Volatility Ratio 5 Marks

The following are the data on five Mutual Funds: [Assume the Risk–Free Rate is 6%]
Fund A B C D E
Return 15 18 14 12 16
Standard Deviation 7 10 5 6 9
Beta 1.25 0.75 1.40 0.98 1.50
You are required to compute Reward to Volatility Ratio and Rank these portfolio using Sharpe Method, and Treynor’s Method.

Solution: Same Pg. 8.27 Qn. 21 of Padhuka’s Students’ Referencer on Strategic Financial Management [RTP]

Note: Reward to Variability Ratio = Sharpe’s Ratio and Reward To Volatility Ratio= Treynor Ratio
Particulars Fund A Fund B Fund C Fund D Fund E
RP − RF 15 − 6 18 − 6 14 − 6 12 − 6 16 − 6
Sharpe’s Ratio = = 1.29 = 1.20 = 1.60 = 1.00 = 1.11
σP
7 10 5 6 9
Rank based on Sharpe’s Ratio 3 2 1 5 4
RP − RF 15 − 6 18 − 6 14 − 6 12 − 6 16 − 6
Treynor Ratio =
βP
= 7.20 = 16.00 = 5.71 = 6.12 = 6.67
1.25 0.75 1.40 0.98 1.5
Rank based on Treynor Ratio 2 1 5 4 3

Question 1(b): Bond Valuation 5 Marks

Bright Computers Ltd is planning to issue a Debenture series with a Face Value of ` 1,000 each for a term of 10 years with the
following Coupon Rates:
Years 1–4 5–8 9 – 10
Rates 8% 9% 13%
The Current Market Rate on similar Debenture is 15% p.a. The Company proposes to price the Issue in such a way that a yield
of 16% Compounded Rate of Return is received by the Investors. The Redeemable Price of the Debenture will be at 10%
Premium on maturity. What should be the Issue Price of Debenture?

Solution: Same Pg. 11.11 Q. 15 of Padhuka’s Students’ Referencer on Strategic Financial Management [M 03]

Year Nature ` Disc. Factor @ 16% Disc. Cash Flow

1–4 Interest 8% × ` 1,000 = ` 80 0.862 + 0.743 + 0.641 + 0.552 = 2.798 ` 223.84
5–8 Interest 9% × ` 1,000 = ` 90 0.476 + 0.410 + 0.354 + 0.305 = 1.545 ` 139.05
9 – 10 Interest 13% × ` 1,000 = ` 130 0.263 + 0.227 = 0.490 ` 63.70
10 Maturity Proceeds ` 1,000 + 10% = ` 1,100 0.227 ` 249.70
Total ` 676.29

Question 1(c): Growth Model Variant – Free Cash Flows – Current Market Price 5 Marks
Calculate the Value of Share of Average Ltd from the following information:
Equity Capital of Company ` 1,200 Crores Beta 0.1, Risk Free Interest Rate 8.7%
Profit of the Company ` 300 Crores Market Returns 10.3%
Par Value of Share ` 40 each Change in Working Capital per Share `4
Debt Ratio of Company 25 Depreciation per Share ` 40
Long Run Growth Rate of the Company 8% Capital Expenditure per Share ` 48
Solution: Same Pg. 10.20 Q. 17 of Padhuka’s Students’ Referencer on Strategic Financial Management [M 09]

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1. Computation of EPS
1200 PAT 300
Number of Shares = = 30 Crores Earnings Per Share = = = ` 10
40 Number of Shares 30

2. Computation of Free Cash Flows to Equity Holders (FCFE) and Share Valuation
Particulars Principle Computation `
(a) Earnings Per Share (WN 1) 10
(b) Change in WC per Share (assumed increase) Change × (1 – Debt Ratio) 4 × (1 – 0.25) 3
(c) Depreciation attributable per Share Depreciation × (1 – Debt Ratio) 40 × (1 – 0.25) 30
(d) Cash Flow attributable per Share EPS – Working Capital Increase + Depn. 10 – 3 + 30 37
(e) Capital Expenditure Per Share Total Capex × (1–Debt Ratio) 48 × (1 – 0.25) 36
(f) Free Cash Flow per Equity Share Cash Flow – Capital Expenditure 37 – 36 1

3. Computation of Value of Share

(a) Cost of Equity Ke = Fair Return under CAPM computed as follows = Rf + ß ×(Rm – Rf) = 8.7 + 0.1 × (10.3 – 8.7) = 8.86%
FCFE(1 + g) 1(1.08) 1.08
(b) P0 = Current Expected Price of Share = = = = ` 125.58
Ke − g 0.0886 − 0.08 0.0086

Question 1(d): Pay Off Computation – Effect of Tie–up on Options 5 Marks

Fresh Bakery Ltd’s Share price has suddenly started moving both upward and downward on a rumour that the Company is
going to have a Collaboration Agreement with a Multinational Company in Bakery Business. If the rumour turns to be true, then
the Stock Price will go up but if the rumour turns to be false, then the Market Price of the Share will crash. To protect from this,
an Investor has purchased the following Call and Put Option:
(i) One 3 Months Call with a Striking Price of ` 52 for ` 2 Premium per Share.
(ii) One 3 Months Put with a Striking Price of ` 50 for ` 1 Premium per Share.
Assuming a lot size of 50 Shares, determine the followings:
1. The Investor’s position, if the Collaboration Agreement push the Share Price to ` 53 in 3 months.
2. The Investor’s ending position, if the Collaboration Agreement fails and the price crashes to ` 46 in 3 months time.

Solution: Same Pg. 15.20 Q. 7 of Padhuka’s Students’ Referencer on Strategic Financial Management [M 06]

Position if Price increases to ` 53 Position if Price falls to ` 46

Particulars Time ` Particulars Time `
Cost of Call & Put Options T0 `2+`1=`3 Cost of Options T0 `2+`1=`3
Action on Options T1 ‘Put’ Lapse, ‘Call’ Exercise Action on Options T1 ‘Call’ Lapse, ‘Put’ Exercise
Gain on Call T1 ` 53 – ` 52 = ` 1 Gain on Put T1 ` 50 – ` 46 = ` 4
Net Loss on Options T1 `3–`1=`2 Net Gain on Options T1 `4–`3=`1

Question 2(a): Risk Adjusted Discount Rate 10 Marks

MNL Ltd is considering investment in one of three mutually exclusive projects: AB, BC, CD. Company’s Cost of Capital is 15%.
Risk–Free Rate is 10%. Tax Rate is 34%. MNL has gathered the following basic Cash Flows & Risk Index data for each project:
Projects AB BC CD
Initial Investment 12,00,000 10,00,000 15,00,000
Year 1–4 Yr 1 Yr 2 Yr 3 Yr 4 Yr 1 Yr 2 Yr 3 Yr 4
Cash Inflows 5,00,000 5,00,000 4,00,000 5,00,000 3,00,000 4,00,000 5,00,000 6,00,000 10,00,000
Using Risk Adjusted Discount Rate, determine risk adjusted NPV for each of the project. Which project should be accepted?

Solution: Same Pg. 2.55 Qn. 42 of Padhuka’s Students’ Referencer on Strategic Financial Management [N 09]

1. Computation of Market Return and Risk Adjusted Discount Rate based on CAPM
Under CAPM, Expected Return = Risk Adjusted Discount Rate= Market Return + (Risk Index × Risk Premium)
Risk Premium = Cost of Capital of the Company – Risk Free Rate of Return = 15% – 10% = 5%
Project AB BC CD
Risk Adjusted Discount Rate 10% + (1.8 × 5%) = 19% 10% + (1.0 × 5%) = 5% 10% + (0.6 × 5%) = 3%

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2. Computation of NPV of the Projects

Project P – AB Project P – BC Project P – CD
PVAF @ Cash PVF @ Cash PVF @ Cash
Year DCF Year DCF Year DCF
19% Flows 15% Flows 13% Flows
1 – 4 2.6385 5,00,000 13,19,250 1 0.8696 5,00,000 4,34,800 1 0.8849 4,00,000 3,53,960
– – – – 2 0.7561 4,00,000 3,02,440 2 0.7831 5,00,000 3,91,550
– – – – 3 0.6575 5,00,000 3,28,750 3 0.6931 6,00,000 4,15,860
– – – – 4 0.5718 3,00,000 1,71,540 4 0.6134 10,00,000 6,13,400
PV of Cash Inflows 13,19,250 12,37,530 17,74,770
Less: Initial Investment 12,00,000 10,00,000 15,00,000
Net Present Value 1,19,250 2,37,530 2,74,770
Conclusion: Since the NPV of Project CD is greater than that of the other projects, it is the best.

Question 2(b): Computation of NAV 16 Marks

Calculate NAV of a Regular Income Scheme on per unit basis of Red Bull Mutual Fund from the following information:
Particulars ` in Crores Particulars ` in Crores
Listed Shares at Cost (ex–dividend) 30 Expenditure accrued 1.00
Cash in Hand 0.75 Value of Listed Bonds & Debenture at NAV date 10
Bonds & Debentures at cost (ex–interest) 2.30 Number of Units (` 10 Face Value) 30 Lakhs
Of these, Bonds not listed & not quoted 1.0 Current Realizable Value of Fixed Income 106.50
Other Fixed Interest Securities at Cost 2.50 Securities of Face Value of ` 100
Dividend Accrued 0.8 Listed Shares were purchased when Index was 7100
Amount payable on Shares 8.32 Present Index is 9000
Unlisted Bonds and Debentures are at cost. Other Fixed Interest Securities are also at cost.
Solution: Same Pg. 8.12 Qn. 2 of Padhuka’s Students’ Referencer on Strategic Financial Management [M 10]

Particulars `Crores
Present Index 9,000
1. Listed Shares (Cost 30.00 × ) 38.02
Previous Index 7,100

2. Cash in Hand 0.75

3. Bonds and Debentures
(a) Unlisted / Unquoted Bonds (at Cost) 1.00
(b) Listed Bonds and Debentures (at Market Value) 10.00
(c) Other Fixed Interest Securities (Cost ` 2.50 Cr. × Current Realizable Value 106.50 ÷ FV `100.00) 2.66
4. Dividend Accrued 0.80
Total of Assets 53.23
1. Amount Payable on Shares 8.32
2. Expenditure Accrued 1.00
Total of Liabilities 9.32
Net Asset Value (` Crores) 43.91
No. of Units Outstanding (in Crores) 0.30
Net Assets of the Scheme 43.91
NAV Per Unit = = = ` 146.37
Number of Units outstandin g 0.30

Question 3(a): Sale & Lease Back vs Purchase New Asset 8 Marks
Hi–Tech Software Ltd (HSL) has a complete “Software Developing Unit” costing ` 70 Lakhs. It is this type of block of Assets
that have no Book Value as at 31st March 2016 as it entitled to 100% Rate of Depreciation under Income Tax Act, 1961. The
Company is facing acute Fund Crunch as it lacks order from Middle East and was toying with the idea of taking Term Loan.
Eastern Financier (EF), a reputed Finance Company, gave the idea of “Buy & Lease Back” to tide over the Fund Crunch. EF
agreed to buy the Software Developing Unit at ` 50 Lakhs and lease it back to HSL for Lease Rental of ` 9 Lakhs p.a. for a
period of 5 years. HSL decides to put the entire Net Proceeds in a Fixed Deposit at a Nationalized Bank at yearly Interest of
8.75% for 5 years to generate Cash Flow much needed for day to day operation.

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Central Financier (CF), another Financier, gave a proposal of selling a similar Software Developing Unit at ` 30 Lakhs to HSL
and they will buy back after 5 years at a price of ` 5 Lakhs provided the Annual Maintenance Contract (AMC) @ ` 1.50 Lakhs
p.a. is entrusted to them. New Machine is also entitled to 100% rate of Depreciation under Income Tax Act, 1961. CF also
agreed to buy the existing Software Developing Unit at ` 50 Lakhs. HSL would utilize the Net Sale Proceeds to finance this
Machine. Marginal Rate of Tax of HSL is 34% and its Weighted Average Cost of Capital is 12%. Which offer HSL should accept?
Solution: Similar Pg. 3.32 Q. 22 of Padhuka’s Students’ Referencer on Strategic Financial Management [M 11]

Option I Sell the Asset to EF, Invest the Proceeds in Risk Free Deposit, and take the asset back on Lease.
Option II Sell the Asset in the Open Market. Purchase a New Asset from CF.

Option I
Nature Cash Flow Cash Flow Years DF @ 12% DCF
1. Sale of Machine: Proceeds (Inflow) 50,00,000
Less: Taxes at 34% (Book Value = Nil) (17,00,000)
Net Cash Flow 33,00,000 0 1.000 33,00,000
2. Investment in Risk Free Deposit (Outflow) (33,00,000) 0 1.000 (33,00,000)
3. Interest from Risk Free Deposit [33,00,000 × 8.75%] 2,88,750
Less: Taxes (2,88,750 × 34%) (98,175) 1,90,575 1 to 5 3.605 6,87,022
4. Lease Rentals (Outflow) 9,00,000
Less: Tax Shield (9,00,000 × 34%) (3,06,000) (5,94,000) 1 to 5 3.605 (21,41,370)
5. Maturity Proceeds of Deposit (Inflow) 33,00,000 5 0.567 18,71,100
Net Present Benefit 4,16,752
Option II
Nature Cash Flow Cash Flow Years DF @ 12% DCF
1. Sale of Machine: Proceeds (Inflow) 50,00,000
Less: Taxes at 34% (Book Value = Nil) (17,00,000)
Net Cash Flow 33,00,000 0 1.000 33,00,000
2. Investment in New Machine (Outflow) (30,00,000) 0 1.000 (30,00,000)
3. Tax Savings on Depn. (30,00,000 × 34%) (Inflow) 100% in 1st Yr 10,20,000 1 0.893 9,10,860
4. Maintenance Cost (Outflow) 1,50,000
Less: Taxes (1,50,000 × 34%) (51,000) (99,000) 1 to 5 3.605 (3,56,895)
5. Sale Proceeds (Inflow) 5,00,000 5 0.567 2,83,500
Net Present Benefit 11,37,465
Conclusion: Net Present Benefit under Option II is higher, and hence, HSL should accept the Offer of CF.

Question 3(b): Valuation of Securities – Dividend Growth Model 8 Marks

SAM Ltd has just paid a Dividend of ` 2 per share and it is expected to grow @ 6% p.a. After paying dividend, the Board
declared to take up a project by retaining the next three annual Dividends. It is expected that this Project is of same risk as the
existing Projects. The Results of this Project will start coming from the 4th year onward from now. The Dividends will then be
` 2.50 per Share and will grow @ 7% p.a. An Investor has 1,000 Shares in SAM Ltd and wants a receipt of atleast ` 2,000 p.a.
from this Investment. Show that the Market Value of the Share is affected by the decision of the Board. Also show as to how
the Investor can maintain his target receipt from the Investment for first 3 years and improved Income thereafter, given that the
Cost of Capital of the Firm is 8%.
Solution: Similar Pg. 2.81 Q. 64 of Padhuka’s Students’ Referencer on Strategic Financial Management [M 12]

Effect on Market Price of the Share

Market Price if Project is Chosen Market Price if it is not Chosen
Nature Year Cash Flow DF @ 8% DCF
Dividend 1–3 0 0 0 D1 ` 2 × (1.06)
Dividend 4 2.5 0.735 1.84 P0 = =
Ke − g 8% - 6%
Terminal D5 ` 2.50 × (1.07)
4 = = 267.50 0.735 196.61 = ` 106.00
Value (P4) Ke − g 8% - 7%

Market Price (Assumed to be Intrinsic Value) 198.45 So, Increase of ` 92.45

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If the Project is accepted, the Company will not declare Dividend for the next 3 Years. Hence, the Investor should sell the Shares
now and invest in Risk–Free Securities to maintain his target receipt for first 3 years. Thereafter, he can sell the Risk–Free
Securities and purchase these Shares to earn improved income. Sale Proceeds = 1,000 × ` 106 = ` 1,06,000. Required Rate of
` 2,000
Return of the Investor = = 1.89%, which is very less when compared to Risk Free Rate (in general).
` 1,06,000

Question 4(a): Calculation of Beta & Expected Return 8 Marks

XYZ Ltd paid a Dividend of ` 2 for the current year. Dividend is expected to grow at 40% for the next 5 years and at 15% per
annum thereafter. The Return on 182 days T–Bills is 11% per annum and the Market Return is expected to be around 18% with
a Variance of 24%. The Co–Variance of XYZ’s Return with that of the Market is 30%. You are required to calculate the required
Rate of Return and Intrinsic Value of the Stock.

Solution: Refer Pg. 7.25 & 10.16, Q. 6 of Padhuka’s Students’ Referencer on Strategic Financial Management

1. Computation of Required Rate of Return

Cov AM 30%
1. Computation of Beta (β) = 2
= = 1.25 Ö βXYZ = 1.25
σM 24%
2. Required Rate of Return = CAPM Return, [Risk Free Return = Return on 182 days T–Bills = 11%]
RXYZ = RF + βA× (RM – RF) Ö RXYZ = 11% + 1.25 × (18% – 11%) Ö RXYZ = 19.75%

2. Computation of Intrinsic Value of the Stock

Year Nature Cash Flow PVF @ 19.75% DCF
1 Dividend (` 2 + 40%) = 2.80 0.835 2.34
2 Dividend (` 2.80 + 40%) = 3.92 0.697 2.73
3 Dividend (` 3.92 + 40%) = 5.48 0.582 3.20
4 Dividend (` 5.48 + 40%) = 7.68 0.486 3.74
5 Dividend (` 7.68 + 40%) = 10.76 0.406 4.37
D7 ` 10.76 × (1.15)
6 MP at end of Y6 = = 260.51 0.339 88.31
Ke − g 19.75% - 15%
Intrinsic Value ` 104.68

Question 4(b): CAPM – Investing Decisions 8 Marks

Abinash is holding 5,000 Shares of Future Group Limited Presently the rate of Dividend being paid by the Company is ` 5 per
Share and the Share is being Sold at ` 50 per Share in the Market. However, several factors are likely to change during the
course of the year as indicated below:
Risk Free Rate Market Risk Premium Expected Growth Rate Beta Value
Existing 12.50% 6% 5% 1.5
Revised 10% 4.8% 8% 1.25
In view of the above factors whether Abinash should buy, hold or sell the Shares? Narrate the reason for the decision to be taken.

Solution: Same as Pg. 7.55, Q. 42 of Padhuka’s Students’ Referencer on Strategic Financial Management [M 03]

Particulars Existing Revised

Rate of Return = Rf + β (Rm – Rf) 12.50% + 1.5 × (6%) = 21.50% 10% + 1.25 × (4.8%) = 16%

D 0 (1 + g) 5 × (1.05) 5.25 5 × (1.08) 5.40

Price of Share P0 = = = = ` 31.82 = = = ` 67.50
Ke −g
0.215 − 0.05 0.165 0.16 − 0.08 0.08
Current Market Price ` 50 ` 50
Inference Over–Priced Under–Priced
Decision Sell Buy

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Question 5(a): Interest Rate Parity – Arbitrage 8 Marks

Information on rates: Exchange Rate Canadian Dollar 0.666 per DM (Spot): Canadian Dollar 0.671 per DM (3 months)
Interest Rates: DM = 7.5% p.a. Canadian Dollar = 9.5% p.a.
To take the possible arbitrage gains, what operations would be carried out?

Solution: Same as Pg. 17.30, Q. 11 of Padhuka’s Students’ Referencer on Strategic Financial Management [N 10]
3 Months
1 + 0.095 ×
1 + Canadian Dollar Interest Rate 12 Months = 0.669
Forward Rate (Can $ / DM) = Spot Rate × = 0.666 ×
1 + DM Interest Rate 3 Months
1 + 0.075 ×
12 Months

Actual Forward Rate 0.671 > Theoretical Forward Rate 0.669. Hence, for arbitrage gain Buy Spot, Sell Forward as follows –
Now (Action at T0) Later (Action at T3)
(a) Borrow in Canadian Dollars at 9.5% p.a. for 3 months (a) Realize Maturity Proceeds of DM Deposits
(b) Convert Canadian Dollars into DM at Spot Rate (b) Sell / Convert DM into Canadian Dollars under Forward
(c) Invest DM at 7.5% p.a. for 3 Months Contract
(d) Enter into forward at T0 for selling DM into Canadian (c) Repay Canadian Dollar Liability
Dollars at T3. (d) Balance in Hand would be profit. (Arbitrage Gain)

Question 5(b): Hedging of Risk using Forward Contract 8 Marks

ABC Ltd of UK has exported Goods worth Can $ 5,00,000, receivable in 6 months. The Exporter wants to hedge the receipt in
the Forward Market. The following information is available:

(a) Spot Exchange Rate = Can $ 2.5/£ (b) Interest Rate in UK = 12% (c) Interest Rate in Canada = 15%

The Forward Rates truly reflect the Interest Rates differential. Find out the Gain / Loss to UK Exporter if Can $ Spot Rates
(i) declines 2%, (ii) gains 4%, or (iii) remains unchanged over next 6 months.

Solution: Same as Pg. 17.41, Q. 29 of Padhuka’s Students’ Referencer on Strategic Financial Management [RTP]
6 Months
1 + 0.12 ×
1 + Canadian Dollar Interest Rate 12 Months = 2.5 × 1.06 = Can $ 2.4651
Forward Rate = Spot Rate × = 2.5 ×
1 + GBP Interest Rate 6 Months 1.075
1 + 0.15 ×
12 Months

Particulars Spot Rate declines by 2% Spot Rate gains by 4% Spot Rate remains Stable
Amount Receivable based on GBP 2,02,831.53 GBP 2,02,831.53 GBP 2,02,831.53
Forward Rate [A] (Can $ 5,00,000 ÷ 2.4651) (Can $ 5,00,000 ÷ 2.4651) (Can $ 5,00,000 ÷ 2.4651)
Exchange Rate on the date of Can $ 2.45 Can $ 2.6
Can $ 2.5
receipt of Invoice Value [Can $ 2.5 × (100 – 2)%] [Can $ 2.5 × (100 + 4)%]
Amount Receivable on conversion GBP 2,04,081.63 GBP 1,92,307.69 GBP 2,00,000
on the date of receipt [B] [Can $ 5,00,000 ÷ 2.45] [Can $ 5,00,000 ÷ 2.6] [Can $ 5,00,000 ÷ 2.5]
Gain / (Loss) on Hedging [A – B] (GBP 1,250.10) GBP 10,523.84 GBP 2,831.53

Question 6(a): Effect of New Marketing Strategy on the Value of Business 8 Marks
Kanpur Shoe Ltd is having sluggish Sales during the last few years resulting in drastic fall in market share and Profit. The
Marketing Consultant has drawn out a New Marketing Strategy that will be valid for next four years. If the new strategy is
adopted, it is expected that Sales will grow @ 20% per year over the previous year for the coming two years and @ 30% from
the third year. Other parameters like Gross Profit Margin, Asset Turnover Ratio, the Capital structure and the Rate of Income
Tax @ 30% will remain unchanged. Depreciation would be 10% of Net Fixed Assets at the beginning of the year. The Targeted
Return of the Company is 15%. The Financials of the Company for the just concluded FY 2015–2016 are given below –

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Income Statement Amount (`) Balance Sheet Information Amount (`)

Turnover 2,00,000 Fixed Assets 80,000
Gross margin (20%) 40,000 Current Assets 40,000
Admin, Selling & Distribution Expenses (10%) 20,000 Equity Share Capital 1,20,000
PBT 20,000
Tax (30%) 6,000
PAT 14,000
Assess the Incremental Value that will accrue subsequent to the adoption of the new Strategy & advise the Board accordingly.

Solution: Same as Pg. 2.25, Q. 12 of Padhuka’s Students’ Referencer on Strategic Financial Management [N 11]

1. Computation of PAT
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
2,00,000 + 2,40,000 + 2,88,000 + 3,74,400 +
(a) Sales 20% = 20% = 30% = 30% = 4,86,720
2,40,000 2,88,000 3,74,400 4,86,720
(b) Profit Before Tax = 10% of Sales 24,000 28,800 37,440 48,672 48,672
(c) Profit After Tax = 70% of PBT 16,800 20,160 26,208 34,070 34,070
(d) Fixed Assets:
(i) Closing Balance = 40% of Sales = 40% 2,40,000 × 2,88,000 × 3,74,400 × 4,86,720 × 4,86,720 ×
of (a) 40% = 96,000 40% = 40% = 40% = 40% =
1,15,200 1,49,760 1,94,688 1,94,688
(ii) Opening Balance 80,000 96,000 1,15,200 1,49,760 1,94,688
(iii) Depreciation = 10% of Opg. Bal. (8,000) (9,600) (11,520) (14,976) (19,469)
(iv) Balance before Purchase = (ii) – (iii) 72,000 86,400 1,03,680 1,34,784 1,75,219
(v) Assets Purchased = (i) – (iv) 24,000 28,800 46,080 59,904 19,468
(e) Current Assets:
(i) Closing Balance = 20% of Sales = 20% 2,40,000 × 2,88,000 × 3,74,400 × 4,86,720 × 4,86,720 ×
of (a) 20% = 48,000 20% = 20% = 20% = 20% =
57,600 74,880 97,344 97,344
(ii) Opening Balance (40,000) (48,000) (57,600) (74,880) 97,344
(iii) Invest. in Current Assets = (i) – (ii) 8,000 9,600 17,280 22,464 0
(f) Total Investment in Assets during the 24,000 + 8,000 28,800 + 46,080 + 59,904 + 19,468
year = (d) + (e) = 32,000 9,600 = 17,280 = 22,464 =
38,400 63,360 82,368

Note: Present Asset Turnover Ratio, i.e. Assets as % of Sales is computed as under –
Fixed Asset ` 80,000 Current As set ` 40,000
Fixed Assets: = 40% Current Assets: = 20%
Turnover ` 2,00,000 Turnover ` 2,00,000

2. Computation of Present Value of the Strategy

Net Cash Disc. Disc. Cash
Particulars Years PAT Depn. Invt. In Assets
Flow Factor Flow
Cash Flow for the year 1 16,800 8,000 (32,000) (7,200) 0.870 (6,264)
2 20,160 9,600 (38,400) (8,640) 0.756 (6,532)
3 26,208 11,520 (63,360) (25,632) 0.658 (16,866)
4 30,070 14,976 (82,368) (37,322) 0.572 (21,348)
30,070 19,469 19,468
= = =
Residual Value (Note) 4 0.15 0.15 0.15 2,00,467 0.572 1,14,667
2,00,467 1,29,793 (1,29,793)
Present Value of the Strategy 63,657
Less: Value of Existing Strategy (PAT ` 14,000 ÷ Expected Return 0.15) (93,333)
Incremental Value (29,676)

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Year 5 Values
Note: Residual Value is computed as
Cost of Capital 15%
Advise: Incremental Value due to adoption of strategy is negative. So, the Company should not opt for the new strategy.

Question 6(b): M&A – Maximum Buying Price to maintain EPS 8 Marks

The CEO of a Company thinks that shareholders always look for EPS. Therefore he considers maximization of EPS as his
Company’s objective. His Company’s current Net Profit are ` 80.00 Lakhs and P/E multiple is 10.5. He wants to buy another
firm which has current income of ` 15.75 Lakhs & P/E multiple of 10. What is the maximum exchange ratio which the CEO
should offer so that he could keep EPS at the current level, given that the Current Market Price of both the Acquirer and the
Target Company are ` 42 and ` 105 respectively? If the CEO borrows funds at 15% and buys out Target Company by paying
Cash, how much should he offer to maintain his EPS? Assume tax rate of 30%.

Solution: Refer Pg. 18.42, Q. 22 of Padhuka’s Students’ Referencer on Strategic Financial Management [M 12]

1. Computation of Present EPS

Particulars Acquirer Company Target Company
(a) Market Price per Share (given) ` 42 ` 105
(b) PE Ratio = MPS ÷ EPS (given) 10.5 10
(c) Earnings Per Share = MPS ÷ PE Ratio ` 42 ÷ 10.5 = ` 4 ` 105 ÷ 10 = ` 10.5
(d) Total Earnings, i.e. Net Profit ` 80 Lakhs ` 15.75 Lakhs
(e) Number of Shares = Net Profit ÷ EPS ` 80 Lakhs ÷ ` 4 = 20 Lakhs ` 15.75 Lakhs ÷ ` 10.5 = 1.5 Lakhs

2. Exchange Ratio to retain Acquirer Company’s Pre–Merger EPS

EPS of Selling Co. 10.50

(a) EPS based Exchange Ratio = = = 2.625 Share for 1 Share
EPS of Buying Co. 4
(b) No. of Shares Issued in such case = 2.625 × 1,50,000 Shares = 3,93,750 Shares
` 80,00,000 + ` 15,75,000
(c) Acquirer’s Post Merger EPS in such case = = = ` 4 per Share
(20,00,000 + 3,93,750)

3. Cash Consideration to maintain Pre–Merger EPS

Particulars Result
(a) Post Merger Net Profit (80 Lakhs + 15.75 Lakhs) ` 95,75,000
(b) After Tax Cost of Borrowing (Let the Cash Consideration offered be X) 0.15X × (1 – 30%) = 0.105X
(c) Net Profit after considering Additional Cost of Borrowing ` 95,75,000 – 0.105X
(d) Post Merger Number of Shares if Consideration is paid by way of Cash 20,00,000
(e) Post Merger EPS (= Pre Merger EPS) `4
(f) So, Cash Consideration that can be offered [See Note] ` 1,50,00,000
` 95,75,000 − 0.105X
Note: = ` 4, ` 95,75,000 – 0.105X = ` 80,00,000, 0.105X = ` 15,75,000, X = 1,50,00,000.
20,00,000

Question 7: Write short notes on any four of the following: 4 × 4 = 16 Marks

Question Reference
(a) Distinguish between Investment Bank and Commercial Bank. Page No. 5.11, Qn. No.18
(b) Horizontal Merger and Vertical Merger. Page No. 18.1, Qn. No.2
(c) Distinguish between Money Market and Capital Market. Page No. 12.2, Qn. No.4
(d) Operations in Foreign Exchange Market are exposed to number of risks. Page No. 17.8, Qn. No.16
(e) Interface of Financial Policy and Strategic Management. Page No. 1.4, Qn. No.9

May 2016.8

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