BFD Two Pages

(2)
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 6 years TFCs were issued on January 1, 2007. The coupon rate is 6% payable annually
and the expected IRR is 10%. These TFCs were issued to fund a medium term project.
The prevailing commercial rate for similar risk bonds is KIBOR plus 2%. The
Final Examinations Summer 2008 accounting policy of the company states that TFCs and other Held to Maturity Liabilities
are carried at the amortized cost.
June 4, 2008 KIBOR is currently 9% which can be considered as risk free. FL has an equity beta value
of 1.6 with market equity premium of 6.25%. The rate of income tax is 35%.
BUSINESS FINANCE DECISIONS (MARKS 100) The dividend paid in the year 2007 was 12.5% and current year’s dividend will be paid
(3 hours) shortly. The dividend is expected to grow at a constant rate of 10%.
Q.1 Mr. Faraz, a large investor, wants to invest Rs. 100 million in the stock market by Required:
developing a portfolio consisting of those shares which have a track record of good Compute the following as on December 31, 2007:
performance. (a) Market price of Faiz Limited’s Equity Shares and TFCs; and
(b) Weighted Average Cost of Capital. (12)
He contacted a Stock Analyst to identify such stocks. After a detailed study, the Stock
Analyst recommended investments in shares of five different companies. Based on his Q.3 Jalib Limited (JL) is planning to invest in a project which would require an initial
recommendation, Mr. Faraz invested the amount on January 1, 2008. The relevant details investment of Rs. 399 million. The project would have a positive net present value of
are as follows: Rs. 60 million if funded only from equity. There are no internal funds available for this
Price per investment and the company wants to finance the project through debt. However, JL’s
Share on Expected Covariance existing TFCs contain a covenant that at any point in time, the debt to equity ratio in
Investment Jan 1, 2008 Dividend Standard with terms of Market Values should not exceed 1:1.
Company (Rs.) (Rs.) Yield Deviation KSE 100 Currently, the market values of JL’s equity (40 million shares are outstanding) and debt
A 15,000,000 60 3.50% 24% 2.10% are Rs. 672 million and Rs. 599 million respectively. Markets can be assumed to be
B 18,000,000 245 3.00% 22% 3.00% strong form efficient.
C 22,000,000 225 2.50% 18% 2.60%
Required:
D 25,000,000 130 8.00% 15% 1.90%
(a) Using Modigliani & Miller theory relating to capital structure, calculate the
E 20,000,000 210 5.00% 20% 2.80% minimum amount of equity that the company will have to issue to comply with the
TFCs’ covenant.
The stock analyst also informed him that the standard deviation and market return of the
(b) Advise the Board of Directors as regards the following:
KSE-100 Index is 15% and 20% respectively. The risk free rate of return is 8%.
the right share ratio and the price at which right shares may be issued to raise
Required: the amount of equity as determined in (a) above, without affecting the market
(a) Assuming that Mr. Faraz estimates his cost of equity by using the Capital Asset price of shares.
Pricing Model, compute the required rate of return on each security. What would be the impact on the market price of the company’s shares if the
(b) As at December 31, 2008, compute the following: required amount of equity is arranged by issue of shares at Rs. 14 per share? (15)
Estimated value of portfolio. (Round off all the amounts to nearest millions and price computations to two decimal places)
Portfolio beta.
Estimated total return on portfolio. (18) Q.4 Mohani Limited (ML) has decided to acquire an additional machine to augment its
production. The cost of the machine is Rs. 3,200,000 and the expected useful life of the
Q.2 The Share Capital and Term Finance Certificates (TFCs) of Faiz Limited (FL) are listed machine is 5 years. The salvage value at the end of its useful life is estimated at
on the Karachi Stock Exchange. An extract from the company’s latest balance sheet as Rs. 400,000.
on December 31, 2007 is as follows:
To finance the cost of machine, the company is considering the following options:
Rs. in million
(A) Enter into a leasing arrangement on the following terms:
Ordinary share capital of Rs. 10 each 400
Revenue reserves 350 Lease term 5 years
Other reserves 150 Security deposits 10% of the cost of machine
900 Insurance costs payable by lessor
6% TFCs of Rs. 100 each 595 Installment Rs. 860,000 payable annually at the beginning
Short term loan – At KIBOR + 3% 80 of the year.
Total debt and equity 1,575 Purchase Bargain Option At the end of lease term against security deposit.
(B) Obtain a 5 year bank loan at an interest of 11% per annum. The loan including
interest would be repayable in 5 equal annual installments to be paid at the end of
each year.
(3) (4)
The company plans to depreciate the machine using straight-line method. The insurance Q.6 Momin Industries Limited (MIL) is engaged in the business of export of superior quality
premium is Rs. 96,000 per annum. The corporate tax rate is 35%. For the purpose of basmati rice to USA and EU countries. On May 15, 2008, MIL negotiated an order from
taxation, allowable initial and normal depreciation is 50% and 10% respectively under TLI Inc. (TLI), a USA based company, for the supply of 10,000 tons of rice at the rate of
the reducing balance method. The weighted average cost of capital is 14%. US$ 2,000 per ton. Immediately after acceptance of the order by MIL, the Government
imposed a ban on the export of rice. In view of the long standing relationship, MIL has
Required: offered to supply rice through Thailand which has been accepted by TLI. After due
Which of the two methods would you recommend to the management? Show all relevant consultation with the Thai Company, MIL and TLI agreed to the following terms and
calculations. (18) conditions on May 31, 2008:
The quantity and price per ton will remain unchanged.
Q.5 Hali Ltd. (HL) is listed on the stock exchange of Country X and has its operations in First consignment of 4,000 tons will be shipped in the last week of June 2008 and
Country X and Country Y. The functional currency of both the countries is Rupee (Rs.). the balance will be shipped during the last week of July 2008.
In the latest balance sheet of the company, net assets were represented by the following: Shipment will be made directly to TLI.
TLI will make payment to MIL after one month of shipment.
Rupees in million
Ordinary share capital of Rs. 10 each 50 It was agreed with the Thai Company that MIL shall make the payment on shipment, at
Retained earnings 170 the rate of Thai Bhat 50,000 per ton.
220
10% Debentures 30 MIL has a policy to hedge all foreign currency transactions in excess of Rs. 25 million
10% Long term loans 40 by obtaining forward cover. MIL’s bank has arranged the forward cover and advised the
290 following exchange rates on May 31, 2008:
Thai Bhat US $
The current market price of ordinary shares and debentures are Rs. 90 per share and
Buy Sell Buy Sell
Rs. 130 per certificate respectively. In view of various legal and taxation issues, HL is
Spot Rs. 2.33 Rs. 2.36 Rs. 65.12 Rs. 65.24
considering a demerger scheme whereby two different companies, HX and HY will be
formed. Each company would handle the operations of the respective country. 1 month forward Rs. 2.30 Rs. 2.33 Rs. 65.45 Rs. 65.57
Mr. Bader, a director of HL, has proposed the following demerger scheme: 2 months forward Rs. 2.28 Rs. 2.31 Rs. 65.77 Rs. 65.89
3 months forward Rs. 2.26 Rs. 2.29 Rs. 66.10 Rs. 66.22
(i) The existing equity would be split equally between HX and HY. New ordinary
shares would be issued to replace the existing shares. The bank charges a commission of 0.01% on each transaction.
(ii) The debentures which are redeemable at par value of Rs. 100 in 2012, would be Required:
transferred to HX as these were issued in Country X. Calculate the profit or loss on the above transaction under each of the following options:
(iii) The long term loan was obtained in Country Y and will be taken over by HY. (a) the shipments are made according to the agreed schedule;
Demerger would require a one time cost of Rs. 17 million in year one, which would be (b) on July 31, 2008, the parties agree to delay the second shipment for a period of two
split between the two companies equally. The finance director has submitted the months. The rates expected to prevail on July 31, 2008 are as follows:
following projections in respect of the demerged companies: Thai Bhat US$
HX HY Spot – July 31, 2008 Rs. 2.29 Rs. 2.32 Rs. 65.61 Rs. 65.73
Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 1 months forward Rs. 2.27 Rs. 2.30 Rs. 65.84 Rs. 65.96
-------------------Rupees in million ------------------- 2 months forward Rs. 2.25 Rs. 2.28 Rs. 66.16 Rs. 66.28
Profit before tax and depreciation 39 42 44 26 34 36 3 months forward Rs. 2.23 Rs. 2.26 Rs. 66.38 Rs. 66.50
Depreciation 12 11 13 9 10 11
(c) the second shipment is cancelled on July 31, 2008. The exchange rates are expected
The projections for year 3 are expected to continue till perpetuity. to be the same as in (b) above. (17)
Accounting depreciation is equivalent to tax depreciation and therefore it is allowable for (THE END)
tax purposes. HX and HY will be subject to corporate tax at the rate of 30% and 25%
respectively. Over the next few years, the rate of inflation in Country X and Country Y is
expected to be 5% and 7% respectively.
Required:
Assuming your name is XYZ and HL’s weighted average cost of capital is 18%, prepare
a brief report for the Board of Directors discussing:
(a) the feasibility of the demerger scheme for the equity shareholders of Hali Limited,
based on discounted cash flow technique. Your answer should be supported by all
necessary workings.
(b) the additional information and analysis which could assist the Board of Directors in
the process of decision making. (20)
BUSINESS FINANCE DECISIONS BUSINESS FINANCE DECISIONS
Suggested Answer Suggested Answer
Final Examinations – Summer 2008 Final Examinations – Summer 2008
Ans.1 (a) COST OF EQUITY OF MR. FARAZ (UNDER CAPM MODEL)

OR
CAPM=RF+(RM-RF) x Beta Portfolio Value on Total
Company Required
January 1 Return
Name return
Co  variance with Market Rs. Rs.
Beta = A 15,000,000 19.16% 2,875,000
Market Variance
B 18,000,000 23.96% 4,312,538
C 22,000,000 21.92% 4,822,949
Market
Company Market Co-variance Required. D 25,000,000 18.08% 4,519,275
Standard Beta RF RM-RF
Name Variance with market Return % E 20,000,000 22.88% 4,576,167
Deviation
100,000,000 21,105,929
A B=A2 C C/B 20%-8%
A 15% 0.0225 2.10% 0.93 8% 12% 19.16%
B 15% 0.0225 3.00% 1.33 8% 12% 23.96%
Ans.2 (a) Market Price of Share
C 15% 0.0225 2.60% 1.16 8% 12% 21.92%
D 15% 0.0225 1.90% 0.84 8% 12% 18.08%
E 15% 0.0225 2.80% 1.25 8% 12% 22.88% K e  R f  Equity Premiumx Equity Beta
= 9% + 6.25% x 1.6
(b) (i) Estimated Value of portfolio as at December 31, 2008 = 19%
Rupees
Price on *Price at Dec Portfolio Current dividend expected (Rs. 1.25 x (1+10%) 1.375
Co. Dividend Required
Jan. 1, 08 31 No. of Shares Value on Dec
Name yield Return Present value of all future dividends
(Rs.) (Rs.) 31 (Rs.)
(A) (B) AXB D o (1  g)
A 60 3.50% 19.16% 69.40 15m/60 = 250,000 17,350,000

Ke - g
B 245 3.00% 23.96% 296.35 18m/245 = 73,469 21,772,538
1.375 x (1  10%)
C 225 2.50% 21.92% 268.70 22m/225 = 97,778 26,272,949  16.806
D 130 8.00% 18.08% 143.10 25m/130 = 192,308 27,519,275 19% - 10%
E 210 5.00% 22.88% 247.55 20m/210 = 95,238 23,576,167
116,490,929 Market price of share 18.181
(ii) Portfolio beta as at December 31, 2008 Market Price of TFCs
Compan New Investment Weighted Calculation of TFCs Market Price (cum interest)
Portfolio Value on Dec 31 Beta Amount PV
y Name Weightage Beta Factor
Rs. A B AXB (Rs.) (Rs.)
A 17,350,000 14.89% 0.93 0.14 PV of 1st Coupon today 1.000 6.00 6.00
B 21,772,538 18.65% 1.33 0.25 PV of 5 Coupons today @ 11% 3.696 6.00 22.18
C 26,272,949 22.55% 1.16 0.26 PV of Redemption today @ 11% 0.593 130.98 77.67
D 27,519,275 23.62% 0.84 0.20 (W-1)
Market Price today (cum interest) 105.84
E 23,576,167 20.24% 1.25 0.25
*KIBOR + 2% i.e. prevailing commercial rate
116,490,929 1.10
W-1 Calculation of Redemption Price
(iii) Estimated Total return on portfolio
Rs.
Beg. Price End Price Capital Gain Dividend Issue Price 100.00
Compan Total Return
(A) (B) B-A A x Div. yield Less: Present Value of Coupons at 10% (4.355[Factor] x Rs. 6) 26.13
y Name
Rs. Rs. Rs. Rs. Rs. Hence PV of Redemption Price must be 73.87
A 15,000,000 17,350,000 2,350,000 525,000 2,875,000
Price on redemption @ 10% (Rs. 73.87 / 0.564 [Factor]) 130.98
B 18,000,000 21,772,538 3,792,538 540,000 4,312,538
C 22,000,000 26,272,949 4,272,949 550,000 4,822,949
D 25,000,000 27,519,275 2,519,275 2,000,000 4,519,275
E 20,000,000 23,576,167 3,576,167 1,000,000 4,576,167
16,490,929 4,615,000 21,105,929
Page 1 of 9 Page 2 of 9
Hence, number of new total shares 54,880,952

(b) Weightage Average Cost of Capital Existing shares (given) 40,000,000
New shares to be issued 14,880,952
Price Value
No. of shares Cost %
Rs. Rs. Million Right shares ratio (14,880,952 / 40,000,000) 3.72:10
Equity (Ex-Dividend) 16.806 40,000,000 672 19.00%
TFCs (Ex-Interest) *99.84 **5,410,000 540 11.00% Amount to be raised through equity Rs. 77,000,000
Bank Loan (equals to book value) 80 12.00%
1,292 Right share price (Rs. 77,000,000 / 14,880,952) Rs. 5.17
* Rs. 105.84 – 6 = 99.84
** Rs. 595/1.1 = 541m / Rs. 100 = 5.41 million shares
(ii) Value of equity after investment is taken up Rs. 922,000,000
WACC = Weks + Wdkd (1-T) + Wdkd (1-T)
No. of shares already issued 40,000,000
672 540 80
 x 19%  x 11% x 65%   12% x 65% = 13.35% New issue of ordinary shares (Rs. 77,000,000 / Rs. 14) 5,500,000
1292 1292 1292 45,500,000
Market value of shares after new share issue Rs. 20.26

Ans.3 (a) Rs. in million
Existing value of equity 672
Existing value of debt 599
Total MV of the company before investments 1,271 Ans.4 I would recommend to the management of the company to consider option B as this option
provides NPV of cash outflow of Rs. 1,988,750 to the company which is lower by Rs. 455,798
Increase in MV if the new project to be undertaken in comparison to option A. Detailed computation is as follows:
NPV of new project, if funded from all equity 60
Tax
Investment required 399 Security Salvage Lease Net cash
benefits PV Factor PV
Total Market Value of the company after investment (ungeared) 1,730 Year deposits value payment outflow
35% 14%
---------------------------R u p e e s --------------------------- Rs.
Benefit of tax shield on debt funding (D x t) 0 320,000 860,000 - 1,180,000 1.000 1,180,000
(Assume the value of debt = X) 35% of X 1 860,000 (301,000) 559,000 0.877 490,243
2 860,000 (301,000) 559,000 0.769 429,871
Total market value of the company after investments (geared) Rs. 1,730 + 35% of X 3 860,000 (301,000) 559,000 0.675 377,325
4 860,000 (301,000) 559,000 0.592 330,928
Maximum debt will be half of the above i.e. Rs. 865 + 17.5% of X 5 (400,000) - (301,000) (701,000) 0.519 (363,819)
2,444,548
Existing debt 599
OR
Hence, new debt should be Rs. 266 + 17.5% of X
PV
Description Rupees PV factor
Rupees
New debt will be (Rs. 266 / 82.5%) 322
Security deposit 320,000 1 320,000
Lease paymentS 860,000 3.913 3,365,180
Less: Total investments required 399
Tax benefit @35% 301,000 3.432 (1,033,032)
Salvage value 400,000 0.519 (207,600)
Minimum increase in equity required 77
2,444,548
(b) (i) Rs. in million
Existing equity 672
New equity 77
NPV of the new project (ungeared) 60
Benefit of tax shield on debt funding (Rs. 322 x 35%) 113
Value of equity after investment is taken up 922
Price to remain the same Rs. 16.8
BUSINESS FINANCE DECISIONS
Suggested Answer
Final Examinations – Summer 2008
Ans.5 (a) To: Board of Directors

From: XYZ
Date: June 4, 2008
Sub: Report on Demerger Scheme
Dear Sirs,
My comments on demerger scheme are as follows:
a) If the company opts for demerger scheme, the ordinary shareholder will get a surplus of
BUSINESS FINANCE DECISIONS Rs.28.64 million details of which are as follows:
Suggested Answer
Final Examinations – Summer 2008 Rupees
in million
Value of OCX 276.59 Annexure ‘A’
Rs. 3,200,000
Installmen t Amount   865,825 Value of OCY 281.05 Annexure ‘B’
1  (1  i)  n
R Total value of both the companies 557.64
i
Loan
Principal
Interest
Depreciation Tax
Salvage PV Current market value of HL
Year Repayme Balance Insurance Shield @ Outflow PV
payment @ 11%
nt
Initial Normal
35%
value Factor
(Rs.)
Equity (5 million shares of Rs. 90) 450.00
@14% Debt (40+30*130/100) 79.00
-------------------------------- R u p e e s --------------------------------
0 - - - 3,200,000 96,000 - - - - 96,000 1.000 96,000 Surplus 529.00
1 865,825 352,000 513,825 2,686,175 96,000 1,600,000 160,000 (772,800) - 189,025 0.877 165,775 28.64
2 865,825 295,479 570,346 2,115,829 96,000 - 144,000 (187,418) - 774,407 0.769 595,519
3 865,825 232,741 633,084 1,482,023 96,000 - 129,600 (160,419) - 801,406 0.675 540,949
4 865,825 163,102 702,723 780,023 96,000 - 116,640 (131,510) - 830,315 0.592 491,547 As the demerger of two separate divisions has increased the value of two companies by
5 865,825 85,802 780,023 0 - - 104,976 *(291,081) 400,000 190,674 0.519 98,960 approx. 5.4% as compare to current market value, it appears that HL should float the two
1,988,750 divisions separately.
*This includes tax benefit / loss on disposal amounted to Rs. 190,674. Computation of this tax benefit is as follows:
Rs. (b) The following additional information and analysis would be relevant in the process
Cost of machine 3,200,000
Less: Initial and normal depreciation 2,255,216
of decision making:
Tax WDV 944,784 (i) Other details of items included in the profit and loss statement and
Less: Sales value 400,000 information such as expected future growth could have been useful in
Tax loss 544,784
determining the operating cash flows more accurately.
Tax benefits @35% 190,674 (ii) The model uses operating cash flows. A more reliable estimate of value
might be free cash flows, taking into account the investment needs of both
divisions.
(iii) The cash flow forecasts as they stand, appear to take no account of
uncertainty. It would have been helpful to see best-worst estimates,
simulations or other techniques that incorporate uncertainty.
Page 5 of 9 (iv) The risk profiles of the companies have not been considered.
(v) Individual divisions might be more vulnerable to takeovers because of their
smaller size.
(vi) The views of the shareholders shall be important in reaching a final
decision.
(vii) How will the decision impact on the company’s ability to negotiate better
terms with the suppliers, financial institutions, etc?
(viii) The interests of other stakeholders may have to be taken into account –
what will employees feel about the split, will there be fewer management
opportunities available, and how will creditors view their security?
Page 6 of 9
Annexure A – Value of HX
Year 1 2 3 onward Total Ans.6 (a) If shipment is made in accordance with the Schedule
---------- Rupees in million -----------
Profit before tax and depreciation 39.00 42.00 44.00 Purchases
Depreciation 12.00 11.00 13.00 Per Ton
Qty. Amount Conv.
Month Cost Rupees
Profit before tax 27.00 31.00 31.00 (Ton) (Bhat) Rate
(Bhat)
Tax (30%) (8.10) (9.30) (9.30)
June (Buy one month forward) 50,000 4,000 200,000,000 2.33 466,000,000
Profit after tax 18.90 21.70 21.70
July (Buy two month forward) 50,000 6,000 300,000,000 2.31 693,000,000
Add back depreciation 12.00 11.00 13.00
1,159,000,000
One time costs (8.50) - -
Net cash inflow 22.40 32.70 34.70
Sales
Per Ton
Discount factors (12% [W-1]) 0.8929 0.7972 6.6432 W-2 Qty. Amount Conv.
Month Revenue Rupees
Present value of net cash inflows 20.00 26.07 230.52 276.59 (Ton) (US$) Rate
(US $)
July (Sell two month fwd.) 2,000 4,000 8,000,000 65.77 526,160,000
W-1: Adjustment of inflation in the discount rate Aug. (Sell three month fwd.) 2,000 6,000 12,000,000 66.10 793,200,000
1  money rate 1.18 1,319,360,000
  12.38% say 12%
1  inf lation rate 1.05
Profit on transactions (sales minus purchases) 160,360,000
W-2: Present value factor from year 3 to infinity
1 Less: Commission costs (0.01%) (247,836)
  0.8929  0.7972  6.6432 160,112,164
0.12
Annexure B – Value of HY (b) If the shipment is delayed for a period of two month
Year 1 2 3 onward Total
Purchases
---------- Rupees in million -----------
Per Ton
Profit before tax and depreciation 26.00 34.00 36.00 Qty. Amount Conv.
Month Cost Rupees
Depreciation 9.00 10.00 11.00 (Ton) (Bhat) Rate
(Bhat)
Profit before tax 17.00 24.00 25.00 June (Buy one month forward) 50,000 4,000 200,000,000 2.33 466,000,000
Tax (25%) (4.25) (6.00) (6.25) July (Buy two month forward) 50,000 6,000 300,000,000 2.31 693,000,000
Profit after tax 12.75 18.00 18.75 July (Cancelled at spot) 50,000 (6,000) (300,000,000) 2.29 (687,000,000)
Add back depreciation 9.00 10.00 11.00 July (Buy 2 months forward) 50,000 6,000 300,000,000 2.28 684,000,000
One time costs (8.50) - - 1,156,000,000
Net cash inflow 13.25 28.00 29.75
Sales
Discount factors (10% [W-3]) 0.9091 0.8265 8.2644 W-4 Per Ton
Qty. Amount Conv.
Present value of net cash inflows 12.05 23.14 245.87 281.05 Month Revenue Rupees
(Ton) (US$) Rate
` (US $)
July (Sell two month forward) 2,000 4,000 8,000,000 65.77 526,160,000
W-3: Adjustment of inflation in the discount rate Aug. (Sell three month forward) 2,000 6,000 12,000,000 66.10 793,200,000
1  money rate 1.18 July (Buy 1 month forward) 2,000 (6,000) (12,000,000) 65.96 (791,520,000)
  10.28% say 10%
1  inf lation rate 1.07 July (Sell 3 month forward) 2,000 6,000 12,000,000 66.38 796,560,000
1,324,400,000
W-4: Present value factor from year 3 to infinity
1
  0.9091  0.8265  8.2644
0.1 Less: Commission costs (0.01%) (475,044)
167,924,956
Suggested Answer
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN
(c) If shipment is cancelled on July 31, 2008 Final Examinations Winter 2008
Purchases
Per Ton
Qty. Amount Conv. December 3, 2008
Month Cost Rupees
(Ton) (Bhat) Rate
(Bhat)
June (Buy one month forward) 50,000 4,000 200,000,000 2.33 466,000,000 BUSINESS FINANCE DECISIONS (MARKS 100)
July (Buy two month forward) 50,000 6,000 300,000,000 2.31 693,000,000 (3 hours)
July (Cancelled at spot) 50,000 (6,000) (300,000,000) 2.29 (687,000,000)
472,000,000 Q.1 Shoaib Investment Company Limited is a listed company having a share capital of
Rs. 1,000 million consisting of 100 million shares of Rs. 10 each. It’s net equity at book
Sales value, as of March 31, 2008 was Rs. 2,000 million. The company maintains a debt equity
Per Ton ratio of 70:30 based on market value. Long term debt constitutes 90% of total liabilities of
Qty. Amount Conv.
Month Revenue Rupees the company. It is the policy of the company to invest 60% of its total assets in listed
(Ton) (US$) Rate
(US $) securities. The correlation between the market value of these listed securities held by the
July (Sell two month forward) 2,000 4,000 8,000,000 65.77 526,160,000 company and KSE-100 Index is 1.1. On March 31, 2008, the company’s shares were
Aug. (Sell three month fwd.) 2,000 6,000 12,000,000 66.10 793,200,000 traded at price to book value ratio (P/B ratio) of 1.4.
July (Buy 1 month forward) 2,000 (6,000) (12,000,000) 65.96 (791,520,000)
527,840,000 During the quarter April 1, 2008 to June 30, 2008, KSE-100 Index fell by 20%. This fall
in Index also affected the market price of the company’s shares and as of June 30, 2008,
they were being traded at P/B ratio of 0.9. There was no significant change in the amount
of liabilities and other assets of the company, during the quarter.
Less: Commission costs (0.01%) (326,988) Required:
(a) Compute the amount of fresh equity required to be injected as of June 30, 2008 in
55,513,012 order to maintain the debt equity ratio.
(b) The company has been approached by Mr. Alam, a large investor, who has offered
(The End) to provide the required capital as computed in (a) above at a discount of 10% of
market value. Compute the % holding of Mr. Alam in the company, if his proposal
is accepted. (13)
Q.2 Waseem Limited is engaged in manufacture and sale of consumer products. It’s
management is in the process of developing the sales plan for the next year. The Sales
Director is of the view that the main hurdle in increasing the sales is the availability of
finance.
The summarized Balance Sheet as of November 30, 2008 is shown below:
Rs. in million
ASSETS
Fixed assets 950
Current assets 730
1,680
LIABILITIES AND EQUITIES
Ordinary share capital 250
Retained earnings 450
700
Long term debts 465
Current liabilities 515
1,680
Page 9 of 9
(2) (3)
Following additional information is available: Q.5 Zaheer Ltd is a manufacturer of auto parts and is currently operating at below capacity
(i) It has been established from the company’s past record that any increase in sales due to slump in the demand for automobiles. The company has received a proposal from a
require an investment of 140% of the additional sales amount, in inventories and truck assembler for supply of 40,000 gear boxes per annum for five years at Rs. 1,900 per
accounts receivable. Further, the accounts payable of the company also increase by gear box .
25% of the additional sales amount.
(ii) The current sales of the company is Rs. 1,100 million while the net profit after tax is The cost of each gear box is as follows:
10% of sales. Rupees
(iii) It is the policy of the company to distribute 20% of its profit after tax among the Material costs 800
shareholders of the company. Labour costs 500
Required: Variable production overheads 150
Assuming that you are the Chief Financial Officer of the company, advise the Variable selling overheads 200
management on the following: Fixed overheads (allocated) 150
(a) How much additional finance would be required to achieve 20% increase in sales in 1,800
the next year?
(b) What would be the maximum growth in sales that the company can achieve if: Company has already incurred a cost of Rs. 5 million on the preparation of technical
external finances are not available? feasibility. The additional cost for setting up the facility for this order would be Rs. 20
the additional financing is limited to an amount which will maintain the existing million.
debt equity ratio? (14)
The company maintains a debt equity ratio of 60:40. Cost of debt and cost of equity of the
company is 16% and 19% respectively. The rate of tax applicable to the company is 30%.
Q.3 Imran Limited wants to borrow Rs. 70 million for two years with interest payable at six
monthly intervals. Due to recent hike in inflation, the company expects that the rate of Required:
interest is likely to rise over the next 2 years. The company can borrow this amount from (a) Evaluate whether the proposal is financially feasible for the company. Assume that
a local bank at a floating rate of KIBOR plus 2% but wants to explore the use of swap to revenue and cost of gear box will remain the same during the next five years.
protect it from any interest rate increase, during the next two years. (b) Carry out a sensitivity analysis to determine which of the following variables is most
sensitive to the feasibility of the order:
Another bank has offered the company that it will be willing to receive a fixed rate of Material costs
11% in exchange for payments of six month KIBOR. Labour costs
Required: Additional cost of setup (20)
(a) Calculate the six monthly interest payments if the swap arrangement is in place.
(b) Calculate the net amount receivable/payable by each party to the swap at the end of Q.6 Javed Limited is a listed company and is engaged in the business of manufacture and
the first 6 months if: export of garments. 100% of the company’s revenue comes from exports which are
KIBOR is 13.5%. taxable @ 1% under final tax regime.
KIBOR is 9%. (10)
An extract of the company’s latest balance sheet as on June 30, 2008 is as follows:
Q.4 Hafeez Ltd is planning to bid for a contract to supply a machine under an operating lease Rs. in million
arrangement, for 5 years. The terms of proposed contract include a special arrangement
Ordinary Share capital (Rs. 10 each) 100
whereby the supplier / lessor will have to operate and maintain the machine, during the
term of lease. Hafeez Ltd is required to quote a consolidated annual fee consisting of Capital Reserves 40
lease rentals and operating changes which shall be payable in arrears. The following Retained Earnings 85
relevant information is available: 225
Term Finance Certificates (Rs. 100 each) 150
(i) The cost of machine is Rs. 50 million and the expected useful life is 10 years. The
residual value at the end of five years is estimated to be 25% of the cost of 375
machine.
Term Finance Certificates (TFCs) are due to be redeemed at par on June 30, 2010. TFCs
(ii) Operating cost for the first year is estimated at Rs. 6 million and is expected to
carry floating mark up i.e. 6 months KIBOR plus 2% which is payable at half yearly
increase at the rate of 10% per annum.
intervals. Currently, TFCs with similar credit rating are available at six months KIBOR
(iii) The tax rate applicable to the company is 35% and the tax is payable in the same
plus 1%.
year. The company can claim initial and normal depreciation at 25% and 10%
respectively under the reducing balance method. During the year ending June 30, 2009, the company expects to post a net profit of Rs. 15
(iv) The weighted average cost of capital of the company is 14%. million. Cost of equity of a similar ungeared company is 19%. The shares of other
Required: companies in this sector are being traded at P/E ratio of 8. On June 30, 2008 the six
(a) Calculate the annual consolidated fee to be quoted for the contract if the company’s monthly KIBOR was 14%.
target is to achieve a Pre-tax Net Present Value of 15% of total capital outlay. Required:
(b) Using the fee quoted above, calculate the project’s internal rate of return (IRR) to Compute the Weighted Average Cost of Capital of the company as at July 1, 2008. (13)
the nearest percent. (18)
(4)
Q.7 Mushtaq Limited is considering two possible investment projects. Both the projects have Final Examinations – Winter 2008
a life of one year only. The returns from new projects are uncertain and depend upon the Suggested Answers
growth rate of the economy. Estimated returns at different levels of economic growth are
shown below:
Ans.1 (a) Fresh equity required to be injected on June 30, 2008
Economic Probability Returns (%)
Growth of Rupees in million
Project 1 Project 2 Market Market value of equity on March 31, 2008 2,800 Working 1
(Annual Avg.) Occurrence
Market value of equity as at June 30, 2008 700 Working 2
1% 0.25 20 22 30
Fresh equity required 2,100
3% 0.50 30 28 25
5% 0.25 40 40 40
Since the market value of debt on June 30, 2008 is the same as the market value of debt on March 31,
Risk free rate of return is 10%. 2008, the company has to maintain the same level of equity also.
Required: Working 1: Market value of net equity and debt as of March 31, 2008
Evaluate the above projects using the Capital Assets Pricing Model. (12) Rupees in million
Net equity at book value 2,000
(THE END)
Market value of the company's shares (2,000 x 1.4) 2,800
Existing debt (2,800 x 70/30) 6,533
Working 2: Market value of net equity as at June 30, 2008

Book value of net equity as of March 31, 2008 2,000
Less: Loss on listed securities portfolio 1,222 Working 3
Net Equity as at June 30, 2008 778
Market value of equity as at June 30, 2008 (Rs. 778 x 0.9) 700
Working 3: Loss on listed securities portfolio

Decline in Stock 20%
Correlation 1.1
Decline in company’s portfolio value 22%
Listed portfolio value as at March 31, 2008 (Rs. in million) 5,555 Working 4
Loss on portfolio (5,555 x 22%) (Rs. in million) 1,222
Working 4: Listed portfolio value as at March 31, 2008 Rupees in million
Value of long term debt 6,533 Working 1

Value of other liabilities (6,533 ÷ 90 x 10) 726
Value of equity 2,000 Given
9,259
Listed securities (60% of total assets) 5,555
(b) % holding of Mr. Alam

Market value of required new equity (Rs. in million) 2,100
Current market price (700 ÷ 100) (Rs.) 7.00
Number of shares [2,100 ÷ (7 x 90%)] (shares in million) 333.33

Already issued shares (shares in million) 100.00
Total number of shares (shares in million) 433.33
Equity stake of new owner (333.33 ÷ 433.33) 76.92%
Page 1 of 7
Final Examinations – Winter 2008 Final Examinations – Winter 2008
Suggested Answers Suggested Answers
Ans.4 (a) Bid amount of annual fee

Ans.2 (a) Additional Finance Required: Rupees in million Rupees
Expected increase in assets (1,100 x 20% x 140%) 308.00 NPV of costs (W-1) 50,074,626
Expected increase in liabilities (1,100 x 20% x 25%) (55.00) Target NPV (Rs. 50 million x 15%) 7,500,000
Retained earnings for the year (1,100 x 120% x 10% x 80%) (105.60) NPV of fees 57,574,626
Additional finances required 147.40
NPV of fees (W-1)
Annual Fees =
(b) In this case, increase in assets less liabilities must be equal to the increase in retained earnings. Cum disc factor
i.
Let x be the required growth rate 57,574,626
= = 16,770,937
3.433
(1,100x × 140%) – (1,100x × 25%) = 1,100 × (1+x) × 10% × (1 – 20%)
1,540x – 275x – 88x= 88
W-1: NPV of Costs
x = 7.48%
Tax Allowance on
ii. Existing debt equity ratio = 465 / 700 = 66.43% Capital Operating Depreciation Total Cash Discount
Year Operating PV of Costs
Cost Costs and Disposal Outflows Factor (14%)
Costs
In this case, the company must obtain an additional loan of 66.43% of the additional earnings in order (W-2)
to maintain the current debt equity ratio. --------------------------------- Rupees ---------------------------- (Rupees)
0 (50,000,000) (50,000,000) 1.000 (50,000,000)
Now, the revised equation is as follows: 1 (6,000,000) 5,687,500 2,100,000 1,787,500 0.877 1,567,638
2 (6,600,000) 1,181,250 2,310,000 (3,108,750) 0.769 (2,390,629)
(1,100x × 140%) – (1,100 x × 25%) = [1,100 × (1 + x ) × 10% (1 – 20%)] + [1,100 × (1 + x) × 10% ×
3 (7,260,000) 1,063,125 2,541,000 (3,655,875) 0.675 (2,467,716)
(1 – 20%) x 66.43%]
4 (7,986,000) 956,813 2,795,100 (4,234,087) 0.592 (2,506,580)
1,540x – 275x – 88x – 58.46x= 88 + 58.46 5 12,500,000 (8,784,600) 4,236,312 3,074,610 11,026,322 0.519 5,722,661
(50,074,626)
x = 13.09% W-2: Tax Allowance
Depreciation Tax
Tax
Ans.3 (a) Rate of interest is KIBOR+2 Allowance
Year WDV Allowance Total Allowance
Since KIBOR is swapped at 11% Initial Normal on
@35%
Disposal
So the fixed rate of interest to Imran Limited (11% + 2%) 13%
-------------------------------------------------------- Rupees ----------------------------------------------------------
Monthly payment = 70 million x 13% x 6/12 4,550,000 1 50,000,000 12,500,000 3,750,000 5,687,500 - 5,687,500
2 33,750,000 3,375,000 1,181,250 - 1,181,250
(b) (i) If KIBOR is 13.5% then: Rupees 3 30,375,000 3,037,500 1,063,125 - 1,063,125
4 27,337,500 2,733,750 956,813 - 956,813
The bank which has provided the credit will receive (70 million x 15.5% x 6/12) 5,425,000 (A) 5 24,603,750 2,460,375 861,131 3,375,181 4,236,312
(W-3)
The bank which has offered the Swap arrangement will pay to Imran Limited W-3: Tax Allowance on Disposal
(70 million x 2.5% x 6/12) 875,000 (B)
Rupees
Disposal value (Rs. 50,000,000 x 25%) 12,500,000
Imran Limited
Net payable by Imran Limited A-B 4,550,000 WDV 22,143,375
Loss on disposal (9,643,375)
(ii) If KIBOR is 9% then Rupees Tax allowance @ 35% (3,375,181)
(b) IRR of the Contract
The bank which has provided the credit will receive (70 million x 11% x 6/12) 3,850,000 (A)
The bank which has offered the Swap arrangement will receive from Imran IRR = a + [ (A/A-B) (b-a) ]%
Limited (70 million x 2% x 6/12) 700,000 (B) a= 14%
b= 20%
Imran Limited A= 7,500,000
B= (426,261) (W-5)
Net payable by Imran Limited A+B 4,550,000
IRR = 14% + [7,500,000/ [(7,500,000+426,261) (20%-14%)] %
= 19.7%
Page 2 of 7
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W-5
Inflows/ (iii) Additional cost of set up
Inflows from fee Net Cash Flows Disc Factor NPV
(Outflows) NPV of the order 3,849,000
excluding fee
Rupees Rupees 20% Rupees Sensitivity = = = 19.25%
PV of additional set up cost 20,000,000
(50,000,000) (50,000,000) 1.00 (50,000,000)
1,787,500 16,770,937 18,558,437 0.83 15,403,503 Conclusion:
(3,108,750) 16,770,937 13,662,187 0.69 9,426,909 Based on above working, material is the most sensitive variable to the feasibility of the order.
(3,655,875) 16,770,937 13,115,062 0.58 7,606,736
(4,234,087) 16,770,937 12,536,850 0.48 6,017,688
11,026,322 16,770,937 27,797,259 0.40 11,118,903 Ans.6 Weighted Average Cost of Capital
(426,261) Value Cost Cost
Rupees % Rupees
Equity (W-3)120,000,000 (W-1)24.09 28,905,120
Ans.5 (a) Financial Feasibility of the Proposal
Rupees Debt (W-5)152,538,000 15.00 22,880,700
PV of Net Incremental Profit for five year [7,000,000 (W-1) x 3.407 (W-2)] 23,849,000 272,538,000 51,785,820
Less: Capital cost for setting up the dye (20,000,000)
51,785,820
Net Present Value 3,849,000 WACC =
272,538,000
Conclusion: = 19%
The proposal is financially feasible for the company as it has a positive net present value.
W-1: Cost of Equity
W-1: Profit for the year
Rupees Ke(g) = Ke(u) + [(Ke(u)-Kd) x D/E)]
Profit per unit (1,900 – 800 – 500 – 150 – 200) 250 Ke(g) = 19% + [(19% - 15%) x 1.27115 (W-2)
Ke(g) = 24.09%
No. of units 40,000
W-2: Debt Equity Ratio
Net Profit before Tax (40,000 x 250) 10,000,000 152,538,000 (W-5)
=
Less: Taxation @ 30% (3,000,000) 120,000,000 (W-3)
Net Profit after Tax 7,000,000 = 1.27115
W-2 Cumulative Discount Factor W-3: Market Value of Equity

E D
WACC = ke × + k d (1 − T ) × Market value of equity = Profit × P/E ratio
E+D E+D = 15,000,000 × 8 = 120,000,000
40 60
= 19% × + 16%(1 − 0.3) × W-4: Market Value of TFC’s
100 100
= 7.6% + 6.72% Cost of debt (6 months KIBOR +1%) i.e. (14% + 1%) 15.00%
= 14.32% Actual Markup (6 months KIBOR + 2%) i.e. (14% + 2%) 16.00%
Cumulative Discount Factor at WACC i.e. 14.32% = 3.407
W-5 Present value of outflows against TFCs
(b) Sensitivity analysis Markup at Discount Factor
Date Description PV
(i) Material costs: 16% 15.00%
31-Dec-08 Markup payment 12,000,000 0.930 11,160,000
NPV of the order 3,849,000 30-Jun-09 Markup payment 12,000,000 0.865 10,380,000
Sensitivity = = = 5.045%
PV of material cost (800 × 40,000 × (1 − 0.3) × 3.406) 31-Dec-09 Markup payment 12,000,000 0.805 9,660,000
30-Jun-10 Markup payment 12,000,000 0.749 8,988,000
(ii) Labour Costs 30-Jun-10 Redemption 150,000,000 0.749 112,235,000
NPV of the order 3,849,000 152,538,000
Sensitivity= = =8.072%
PV of labour cost (500 x 40,000 x (1-0.3) x 3.406)
Page 4 of 7
Page 5 of 7
ß (project2) = 30 / 37.5 = 0.8

Ans.7 Computation of Market Variance
Probable Deviation
Market Market Required Return from new project = Risk free rate + ß (Market rate – Risk free rate)
Probability Market from
Return Variance = 10% + 0.8 (29.5% - 10%)
Return Mean
1 2 3 =1 x 2 4 5 = 1x (4)2 = 25.6%
p(Rm - Rm)2 Conclusion:
p1 Rm pRm Rm − R m
Since the project 1 has higher return over its cost of capital worked out under CAPM, the company should
0.25 30 7.5 0 0 undertake this project.
0.5 25 12.5 -5 12.5
0.25 40 10 10 25 (THE END)
30 37.5
Return and Cost of Project 1

Probable Deviation
Project Market
Probability Project from Covariance
Return Variance
Return Mean
1 2 3=1 x 2 4 5 ( above) 1x 4 x 5
p1 Rp1 pRp1 Rp1 − Rp1 p(Rm- Rm)2 *
0.25 20 5 -10 0 0
0.5 30 15 0 12.5 0
0.25 40 10 10 25 25
30 37.5 25
* p(Rm - Rm) (Rp1 - Rp1)
Covariance between project and market

ß (project1) =
Variance market
ß (project1) = 25 / 37.5 = 0.67

Required Return from new project = Risk free rate + ß (Market rate – Risk free rate)
= 10% + 0.67 (30% - 10%)
= 23.4
Return and Cost of Project 2
Probable Deviation
Project Market
Probability Project from Covariance
Return Variance
Return Mean
1 2 3=1 x 2 4 5 (above) 1 x 4 x 5
p2 Rp2 pRp2 Rp2 − Rp2 p(Rm- Rm)2 *
0.25 22 5.50 -7.5 0 0
0.50 28 14.00 -1.5 12.5 3.75
0.25 40 10.0 10.5 25 26.25
29.50 37.5 30.00
* p(Rm - Rm) (Rp2 - Rp2)
Covariance between project and market

ß (project2) =
Variance market
Page 6 of 7
Page 7 of 7
(2)
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN Following information relating to the generator is available:
(i) Written Estimated
Current Replacement
Cost Down Cost of
Final Examinations Summer 2009 Disposal Value Cost
Value Overhauling
--------------------------------Amount in Rupees-------------------------------------
3,900,000 1,750,000 2,200,000 945,000 5,250,000
June 3, 2009
(ii) It is expected that after overhauling:
the generator can be used for another two years. However, running cost of
BUSINESS FINANCE DECISIONS (MARKS 100) overhauled generator would be Rs. 440 per hour which is 10% higher in
(3 hours) comparison with the running cost of the new generator.
the overhauled generator would be sold after two years at a value of 15% of
Q.1 ABC Limited is engaged in manufacture and sale of spare parts of heavy vehicles. current replacement cost while the new generator is expected to fetch 25% of
Presently, the company is planning to raise Rs. 2,000 million to replace its existing current replacement value, after three years.
production machines with the latest machines. All machines will be imported from UK. (iii) The company rents out the generator at Rs. 2,000 per hour and such generators are
The company is considering the following two options to raise the finance: hired for approximately 2,500 hours per annum, irrespective of their age.
(iv) The company’s cost of capital is 17% per annum before adjustment for inflation.
(I) The company can issue Term Finance Certificates (TFCs) in the local market for a The rate of inflation is 8%.
period of three years at a rate of 6-months KIBOR plus 1.5%. Interest and principal (v) The company receives all payments after deduction of tax at the rate of 6% which is
repayment will be made in six semi-annual installments. The company will be considered full and final settlement of it’s tax liability.
required to pay 0.25% commitment fee at the time of raising the TFCs.
Required:
(II) UK Ex-Im bank has offered to provide the required amount for a period of three (a) Advise whether the management should replace the generator or overhaul and
years at a rate of 6-months LIBOR + 2.5%. Principal and interest will be payable in continue to use the existing one.
six semi-annual installments. (b) Calculate the % change in estimated cost of overhauling at which the management
would be indifferent between the two options. (17)
It is anticipated that interest rates will vary in line with inflation forecasts in each country.
The forecasted interest rates expected at the beginning of half year for the next three years
are as follows: Q.3 DEF Securities Limited (DEF) is a medium size investment company. During the month of
February 2009, the Research Department of DEF forecasted an increase in oil prices by
6-months KIBOR 6 months LIBOR June 2009 which would have a positive impact on the share prices of oil marketing
July 2009 13.00% 5.00% companies and negative impact on the share prices of power generation companies. Based
January 2010 12.50% 5.25% on this research, the company entered into the following transactions on April 1, 2009:
July 2010 12.00% 5.50%
January 2011 11.50% 5.75% (I) Purchased a three month American call option of 100,000 shares of Silver
July 2011 11.00% 6.00% Petroleum Limited (SPL), an oil marketing company, at Rs. 3 per share. The
January 2012 10.50% 6.25% exercise price is Rs. 155 per share.
July 2012 10.00% 6.50% (II) Purchased a three month European put option of 5,000,000 shares of Diamond
Electric Supply Corporation Limited (DESC), a power generation company, at
It is expected that the exchange rate on July 01, 2009 would be £1 = Rs. 105. The Re. 0.50 per share. The exercise price is Rs. 3.50 per share.
company’s cost of capital is 13%.
However, when the price of oil actually increased on May 21, 2009, DESC revised its
Required: power tariff upward while due to tough competition SPL’s margins are expected to
Which of the two options would you recommend to the management? Show all relevant decline. As a result, the company feels that it is now advisable to reconsider the situation.
calculations. (20) While evaluating various options, the management has gathered the following information:
(i) As of June 1, 2009, the ready market price per share and one month future price per
Q.2 UVW Rental Services, a partnership concern, is in the business of providing power back-
share were as follows:
up solutions to its corporate clients. At present, it is the policy of the company to replace
the old power generators with the new ones after every three years. Ready market prices 1-month future prices
During a recent management meeting, the operation manager informed that a 350KVA SPL Rs. 170 per share Rs. 173 per share
generator has reached its replacement period. He suggested that since the replacement cost DESC Rs. 4.25 per share Rs. 4.35 per share
of this generator has significantly increased due to depreciation of rupee, the company (ii) DEF can obtain finances at the rate of KIBOR plus 2%. Presently, the rate of
should not dispose of the generator at the end of its replacement period and rather get it KIBOR is 12.5%.
overhauled and continue. (iii) Transaction costs are immaterial.
Required:
Based on the available information, recommend the best strategy to the management. (12)
(3) (4)
Q.4 MNO Chemicals Limited is a fertilizer company. The company is planning to diversify Q.5 GHI Limited is an all equity financed company with a cost of capital of 14%. For last
into the food business and has identified two companies, PQ (Pvt.) Limited and RS several years, the company has been distributing 70% of its profits to the ordinary
Limited (a listed company), as potential target for acquisition. MNO Chemicals Limited shareholders and is expected to continue to do as in future. The company plans to enter
intends to buy one of these companies in a share exchange arrangement. into a new line of business. Taking it as an opportunity to reduce the cost of capital, it is
considering to issue debt to finance the expansion. The Corporate Consultant of GHI has
Extracts from the latest financial statements of the three companies are given below: provided the following industry data relating to different levels of leverage:
STATEMENT OF FINANCIAL POSITION Debt/Assets 0% 10% 40% 50%
Cost of Debt - 8% 10% 12%
MNO PQ (Pvt.) RS Equity Beta 1.20 1.30 1.50 1.70
Chemicals Limited Limited
---------Rupees in millions----------- The following information is also available:
Share capital (Rs 10 each) 1,500 800 1,200 (i) The estimated value of assets after the investment in new line of business would be
Retained earnings 700 300 350 Rs. 250 million.
(ii) The forecasted revenue for the next year is Rs. 200 million.
TFCs 1,000 400 500 (iii) Fixed costs for the next year are estimated at Rs. 40 million whereas variable costs
will be 60% of the revenue.
Current liabilities 300 100 200
(iv) The par value of GHI’s ordinary share is Rs. 10.
3,500 1,600 2,250
(v) The tax rate applicable to the company is 35%.
Non-current assets 3,000 1,400 1,800 The rate of return on 1-year Treasury Bills is 6% and the market return is 10%.
Investment held for trading - - 300
Current assets 500 200 150 Required:
3,500 1,600 2,250 Advise the optimal capital structure which GHI Limited should formulate. Show all
relevant workings. (15)
STATEMENT OF COMPREHENSIVE INCOME
MNO PQ (Pvt.) RS Q.6 JKL Phone Limited is a cellular service provider. The Marketing Director has recently
Chemicals Limited Limited proposed a marketing strategy which envisages the introduction of a new package for pre-
---------Rupees in millions----------- paid customers, to gain market share. He has carried out a market research and suggests
Sales 2,500.00 800.00 1,200.00 that the call rates forming part of the proposed package should either be Re. 0.75 or
Operating profit before interest, Re. 1.00 or Rs. 1.25 per minute.
depreciation and income tax 1,250.00 400.00 540.00 Based on market research, sales demand at different levels of economic growth is
Interest (100.00) (48.00) (55.00) estimated as follows:
Depreciation (450.00) (180.00) (270.00)
Other income 200.00 20.00 45.00 Call Rates
Net profit before tax 900.00 192.00 260.00 Probability Rs. 0.75 Re. 1 Rs. 1.25
Tax @ 35% (315.00) (67.20) (91.00) ----- Subscribers in million -----
Net profit 585.00 124.80 169.00 Recession 0.30 0.70 0.50 0.30
Moderate 0.50 0.80 0.60 0.40
Dividend payout (50%:70%:50%) 292.50 87.36 84.50 Boom 0.20 0.90 0.80 0.60
Additional information: He foresees that the average airtime usage per subscriber would be 1800 minutes or 1600
(i) All companies maintain a stable dividend payout policy. minutes with a probability of 40% and 60% respectively. In order to cater to the increased
(ii) It is estimated that earnings of PQ and RS will grow by 4% and 5% respectively. subscriber base, the company would need to commission new cell sites, details of which
(iii) The risk free rate of return is 8% per annum and the market return is 13% per are as follows:
annum. The market applies a premium of 300 basis point on the required returns of No. of subscribers Cost of new sites
unlisted companies. (in million) (Rs. in million)
(iv) RS Limited’s equity beta is estimated to be 1.20. Up to 0.5 million 180.00
(v) Synergies in administrative functions arising from merger would increase after tax Between 0.5 – 0.8 million 300.00
profits by 5% in the case of PQ and 6% in the case of RS. Between 0.8 – 1.0 million 540.00
Required: It is assumed that the present customers of the company would continue to use the existing
Which of the two companies should be acquired by MNO Chemicals Limited? Show packages.
necessary computations to support your answer. (21)
Required:
Evaluate the proposal submitted by the Marketing Director and advise the most suitable
call rates. (15)
(THE END)
Ans.1 Conclusion: W-1 : Forward rates

Discounted net cash outflow (based on Rupees) in case of option 1 is lesser, hence the company should opt for LOCAL currency loan. Spot Rate (Rs. / £) Exchange Rate (Rs. / £)
6-month 6-month
at the beginning at the end
KIBOR LIBOR
Option 1: Local Currency Loan Rs. / £ Rs.
Principal Discount Jul-09 105.00 6.5% 2.5% 109.10
Interest rate Financial charges Cash outflow Discounted cash flow
Installment Opening Payment Closing @ 6.5% Jan-10 109.10 6.25% 2.63% 112.95
[(KIBOR + 1.5%)/2)
--- Rupees in million --- --- Rupees in million --- (13 ÷ 2) --- Rs. in million --- Jul-10 112.95 6% 2.75% 116.52
A B A+B Jan-11 116.52 5.75% 2.88% 119.77
Jul-09 - 2,000 × 0.25% = 5 5 1.000 5.00 Jul-11 119.77 5.5% 3% 122.68
Jan-10 2,000 333 1,667 (13+1.5)/2=7.25% 2,000 × 7.25% = 145 478 0.939 448.84 Jan-12 122.68 5.25% 3.13% 125.20
Jul-10 1,667 334 1,333 (12.5+1.5)/2=7.00% 1,667 ×7% = 117 451 0.882 397.78
Jan-11 1,333 333 1,000 (12+1.5)/2=6.75% 1,333 × 6.75% = 90 423 0.828 350.24
1 + Interest Rate (Pak)
Jul-11 1,000 333 667 (11.5+1.5)/2=6.50% 1,000 × 6.5% = 65 398 0.777 309.25 Conversion rate (Rs. / £) = Spot Rate Rs/£ x
Jan-12 667 334 333 (11+1.5)/2=6.25% 667 × 6.25% = 42 376 0.730 274.48 1 + Interest Rate (UK)
Jul-12 333 333 - (10.5+1.5)/2=6.00% 333 × 6.00% = 20 353 0.685 241.81
PV 2,027.40
Option II: Foreign Currency Loan

Principal Net Discount
Interest Exchange
Interest rate cash Net cash flow @ 6.5% Discounted cash flow
Installment amount rates
Opening Payment Closing [(LIBOR + 2.5%)/2] flow (13 ÷ 2)
(W-1)
£ in million £ in million Rs. in million Rs. in million
Jul-09
Jan-10 19.048 3.175 15.873 (5.00%+2.5%)/2=3.75% 0.714 (3.889) 109.10 424.290 0.939 398.408
Jul-10 15.873 3.175 12.698 (5.25%+2.5%)/2=3.88% 0.616 (3.791) 112.95 428.193 0.882 377.666
Jan-11 12.698 3.175 9.523 (5.5%+2.5%)/2=4.00% 0.508 (3.683) 116.52 429.143 0.828 355.330
Jul-11 9.523 3.175 6.348 (5.75%+2.5%)/2=4.13% 0.393 (3.568) 119.77 427.339 0.777 332.042
Jan-12 6.348 3.175 3.173 (6.00%+2.5%)/2=4.25% 0.270 (3.445) 122.68 422.633 0.730 308.522
Jul-12 3.173 3.173 - (6.25%+2.5%)/2=4.38% 0.139 (3.312) 125.20 414.662 0.685 284.043
PV 2,056.011
Page 1 of 6
Page 2 of 6
Suggested Solution Suggested Solution
Ans.2 Option – 1: Overhaul and continue Ans.3 Conclusion:

(a) Cost of Net Residual Net cash The best strategy for the company is:
Discount rate @ Net present value
Year overhauling Revenue value flow - to square position in SPL shares at future price as it gives the highest return.(Working I)
8.33% (W-1)
------------------- Rupees -------------------- --- Rupees --- - NOT to exercise option of DESC shares as it is clearly evident from the available data that both
0 (2,200,000) - (2,200,000) 1.0000 (2,200,000) purchasing at spot or future rate will result in more loss to the company.
1 - *13,600,000 - 3,600,000 0.9231 3,323,160
2 - 3,600,000 787,500 4,387,500 0.8521 3,738,589 Working I
4,861,749 Option – 1: Computation of gain/ loss if shares are squared on SPOT rate
SPL
*1 (2,000 × 0.94 – 440) × 2,500 Rupees
Sale proceed
Cum discount factor for two years (0.9231 + 0.8521) 1.7752 (Rs. 170 x 100,000) 17,000,000
Annual equivalent Net Present Value Rs. 2,738,705

Less: Cost of acquisition
Option – 2: Replacement (Rs. 155 x 100,000) (15,500,000)
Residual Discount rate Net present
Capital Cost Net Revenue Net cash flow
Year value @ value
----------------------Rupees---------------------- 8.33% (W-1) Rs. Gain/ (loss) if option exercises 1,500,000
1
0 * (4,305,000) - (4,305,000) 1.0000 (4,305,000)
1 - *23,700,000 - 3,700,000 0.9231 3,415,470 Option 2: Computation of gain/ loss if shares are squared on Future rate
2 - 3,700,000 - 3,700,000 0.8521 3,152,770 SPL
3 3,700,000 1,312,500 5,012,500 0.7866 3,942,833 Rupees
6,206,073 Sale proceed
(Rs. 173 × 100,000) 17,300,000
1
* 5,250,000 – 945,000 = 4,305,000
*2 (2,000 × 0.94 – 400) × 2,500 = 3,700,000 Less: Cost of acquisition
(Rs. 155 × 100,000) (15,500,000)
Cum discount factor for three years (0.9231 + 0.8521 + 0.7866) 2.5618
Gain/ (loss) if option exercises 1,800,000
Annual equivalent Net Present Value Rs. 2,422,544
Present Value of the gain (1/1.0121 * 1,800,000) 1,778,480
W – 1: Calculation of Real Rate for discounting
⎡ (1 + Nominal Discount Rate) ⎤
Real Discount Rate = ⎢ ⎥ −1 Ans.4 Merger with Merger
⎣ (1 + Inflation Rate) ⎦ PQ with RS
⎡1 + 17% ⎤ Rupees in million
=⎢ ⎥ − 1 = 8.33%
⎣ 1 + 8% ⎦ Investment required to be made (W – 1) 848.00 1,888.75
Conclusion: Net profit after tax 124.80 169.00

Since annual equivalent NPV of overhaul and continue option is higher, this equipment should be Synergy impact (W-5) 37.05 47.39
overhauled. 161.85 216.39
(b) Rupees Return on investment 19.09% 11.46%

Total required NPV of replacement option (Rs. 2,422,544× 1.7752) 4,300,500
Less: NPV of overhauling and continue option 4,861,749 Conclusion:
Difference (561,249) By acquiring PQ (Pvt.) Ltd., the shareholders of MNO Chemicals will earn a higher return on investment as
compared to the acquisition of RS. Hence, acquisition of PQ is financially feasible for the shareholders of
MNO Chemicals.
% change in overhauling cost at which management would be indifferent
(Rs. 561,249 ÷ Rs. 2,200,000) 25.51%
W – 1: Value of equity i.e. investment required to be made by MNO
PQ RS
Rupees in million
Page 3 of 6
Page 4 of 6
Total value of the company (W – 2) 1,248.00 2,388.75 Rm 10.00% 10.00% 10.00% 10.00%
Less: Value of TFCs (400.00) (500.00)
Value of equity i.e. investment to be made by MNO 848.00 1,888.75 Re = Rf + β(Rm - Rf) 10.80% 11.20% 12.00% 12.80%
W-2: Total value of company

Yo x (1 + g) Ans.6
incremental
incremental
incremental
Cost of cell
subscribers in
Selling Price
Expected
Expected
Expected
earnings
Probability
Probability
revenue
Re - g
Costs
minutes
Airtime
sites
million
No. of
156 (W - 3) x (1 + 4%)
Total Value of PQ (Pvt.) Ltd. = = 1,248
17% (W - 4) - 4%
------------Rupees in million-------------
204.75 (W - 3) x (1 + 5%)
Total Value of RS Ltd. = = 2,388.75 A B C D E AxBxCxDxE H HxCxE ETR - ECOS
14% (W - 4) - 5% 0.7 0.3 1,600 0.6 151 300 54 97
0.7 0.3 1,800 0.4 113 300 36 77
W-3: Maintainable earnings (Yo) PQ RS
Rupees in million 0.8 0.5 1,600 0.6 288 300 90 198
Net profit after tax 124.80 169.00 0.8 0.5 1,800 0.4 216 300 60 156
0.75
Add Interest (PQ : 48 × 0.65) (RS : 55 × 0.65) 31.20 35.75
Maintainable earnings 156.00 204.75 0.9 0.2 1,600 0.6 130 540 65 65
0.9 0.2 1,800 0.4 97 540 43 54
W-4: Cost of equity (Re) 995 348 647
Re = Rf + (Rm – Rf)β
Cost of equity of RS = 8% + (13% – 8%) x 1.2 = 14% 0.5 0.3 1,600 0.6 144 180 32 112
Cost of equity of PQ (Pvt.) Ltd. = Re of RS Ltd. + Illiquidity premium 14% + 3% = 17% 0.5 0.3 1,800 0.4 108 180 22 86
W-5 Synergy Impact PQ RS
0.6 0.5 1,600 0.6 288 300 90 198
Rupees in million
0.6 0.5 1,800 0.4 216 300 60 156
Net profit after tax of MNO 585.00 585.00 1.00
Maintainable earnings of PQ (W – 3) 156.00
0.8 0.2 1,600 0.6 154 300 36 118
Maintainable earnings of RS (W – 3) 204.75
0.8 0.2 1,800 0.4 115 300 24 91
Combined profit of merged entities 741.00 789.75
1,025 264 761
Synergies impact on profitability 5% 6%
Synergy impact 37.05 47.39 0.3 0.3 1,600 0.6 108 180 32 76
0.3 0.3 1,800 0.4 81 180 22 59
Ans.5 Advise: 0.4 0.5 1,600 0.6 240 180 54 186
Debt ratio of 40% is the optimal debt structure as at this level the WACC is at the lowest.
0.4 0.5 1,800 0.4 180 180 36 144
1.25
Weighted Average Cost of Capital (WACC)
0.6 0.2 1,600 0.6 144 300 36 108
Debt ratios
0.6 0.2 1,800 0.4 108 300 24 84
0% 10% 40% 50%
861 204 657
Wd 0.00% 10.00% 40.00% 50.00%
Kd 0.00% 8.00% 10.00% 12.00%
We 100.00% 90.00% 60.00% 50.00% Conclusion:
Ke (Working 1) 10.80% 11.20% 12.00% 12.80% Tariff of Re. 1 is most suitable because it gives the highest value of pay off.
Tax 35.00% 35.00% 35.00% 35.00%
WACC = WdKd (1-t) + WeKe 10.80% 10.60% 9.80% 10.30% (The End)
Working 1: Cost of equity

Debt ratios
0% 10% 40% 50%
Beta 1.20 1.30 1.50 1.70
Rf 6.00% 6.00% 6.00% 6.00%
Page 5 of 6
Page 6 of 6
(2)
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN Q.2 Kohat Limited (KL) is considering to set-up a plant for the production of a single product
IGM3. The initial capital investment required to set up the plant is Rs. 15 billion. The
expected life of the plant is only 5 years with a residual value of 20% of the initial capital
investment. The plant will have an annual production capacity of 1.0 million tons.
Final Examinations Winter 2009
A local group has offered to purchase all the production for Rs. 8,000 per ton in year 1 and
thereafter at a price to be increased 5% annually. Other relevant information is as under:
December 9, 2009
(i) In year 1, operating costs (other than wages and depreciation) per annum would be Rs.
2,000 per ton. They are expected to increase in line with Producer Price Index (PPI).
BUSINESS FINANCE DECISIONS (MARKS 100) Annual wages would be Rs. 1.0 billion and are linked to Consumer Price Index (CPI).
(3 hours) (ii) KL’s cost of capital for this project, in real terms is 6%. General inflation rate is 11%.
(iii) The tax rate applicable to the company is 30% and the tax is payable in the same year.
Q.1 Attock Index Tracker Fund (AITF) is an open-end mutual fund and was incorporated in The company can claim normal tax depreciation at 20% per annum under the reducing
2004. However, since inception, its performance has remained unimpressive and it has balance method.
generally been outperformed by KSE-100 index. Price indices of the last six years are given below:
You have recently joined AITF as its Fund Manager and have been asked by the Year 2003 2004 2005 2006 2007 2008
management to review the current composition of the portfolio. Details relating to the shares PPI 107 119 130 142 160 175
currently held in the portfolio are as follows: CPI 112 125 139 155 173 195
Price The costs linked to the above indices are expected to grow at their historic compound
Market Dividend
No of forecast annual growth rate.
Name of price per Standard per share
shares Covariance after one
company share deviation next year Required:
year
Rupees in 000 Rupees Rupees Advise whether KL should invest in the project. (14)
A 25 150 0.150 0.024 27 2.00
B 15 230 0.240 0.039 17 1.00 Q.3 Tarbella Enterprises (Pvt) Limited (TEPL) is the manufacturer and supplier of chemical X.
C 46 190 0.160 0.044 52 2.50 Due to an internal conflict, the directors of TEPL have offered to sell the company to
D 106 50 0.320 0.033 111 4.00 Chakwal Limited (CL) which is one of its largest customers.
E 75 100 0.190 0.018 85 2.00
F 114 120 0.220 0.041 125 3.00 CL has hired you to determine the value at which it would be feasible for it to acquire
G 239 60 0.190 0.032 220 5.50 TEPL. The relevant information is as follows:
H 156 80 0.210 0.040 168 3.00 (i) CL would consider TEPL as a separate cash generating unit and it will have a useful
I 145 35 0.180 0.034 170 2.50 life of five years. The normal capacity of TEPL’s plant is 22,000 tons.
J 67 45 0.220 0.033 75 1.00 (ii) During the year ended June 30, 2009, CL consumed 15,000 tons of chemical X.
(iii) Summary of TEPL’s profit and loss account for the year ended June 30, 2009 is as
Following information is also available: follows:
Rs. in million
(i) The average market return of the KSE-100 Index companies is 12% and the standard Sales (20,000 tons) 240
deviation is 18%. Variable costs (80)
(ii) The risk free rate of return is 8%. Fixed costs (50)
(iii) The correlation between the market value of securities held by AITF and KSE-100 Operating profit 110
Index is 0.737.
(iv) The average return on AITF’s shares is 11% with standard deviation of 22%. (iv) CL’s planning department has provided the following projections related to the next
five years:
Required: CL’s demand for chemical X would increase by 5% each year.
(a) Compute the AITF's systematic risk and assess the extent to which AITF has matched The annual increase in the price of chemical X would be 10%.
the performance of KSE-100 Index. The variable costs per ton of production of chemical X would increase by 12%
(b) Determine whether AITF achieves the return according to its risk profile. per annum.
(c) Identify those shares in AITF’s portfolio which are expected to underperform and Fixed costs would increase by 8% each year.
should be removed.
(d) Compute the revised beta of AITF i.e. after excluding the underperforming shares. (v) CL intends to use the entire production of chemical X for its internal use only.
Assume that cash generated from disposal of underperforming shares will be used to (vi) CL maintains a debt equity ratio of 50:50. Its cost of debt and cost of equity is 14%
buy the remaining shares in proportion to their current holdings. (20) and 20% respectively. Tax rate applicable to both the companies is 30%.
Required:
Compute the maximum price which CL may offer for the acquisition of TEPL. (13)
(3) (4)
Q.4 The directors of Bannu Holdings Limited (BHL) have decided to sell off its wholly owned Q.5 Sajawal Sugar Mills Limited (SSML), a medium sized listed company, is planning to
subsidiary, Ziarat Engineering Limited (ZEL). Following information has been extracted expand its production capacity. The management has estimated that the expansion would
from the last audited financial statements of ZEL: require an outlay of Rs. 300 million.
Rs. in million
Sales 2,958 Following figures have been extracted from SSML’s financial statements for the year ended
June 30, 2009.
Less: Cost of sales 1,928
Gross Profit 1,030 Statement of Financial Position
Allocated expenditures of BHL (255)
Operating expenses (388) Rs. in million
Other income 216 Paid up capital (Rs. 10 each) 400
Financial charges (119) Retained earnings 150
Profit before tax 484 Non-current liabilities 600
Tax @ 30% (145) Current liabilities 100
Net profit 339 1,250
A team of executives and employees, lead by the CEO of ZEL is also interested in the Fixed assets 1,100
acquisition of the subsidiary. They plan to form a new company, Sibbi Engineering Current assets 150
(Private) Limited (SEL), which will acquire all the assets of ZEL. After intense negotiations 1,250
the directors of BHL have finally agreed to sell ZEL to the employees, under the following
terms and conditions: Statement of Comprehensive Income
(i) The value of ZEL will be Rs. 2,100 million.
(ii) BHL would pay off all the existing debts of ZEL. Rs. in million
(iii) BHL would acquire 10% shareholding in SEL. Net profit after tax 125
The employees would invest Rs. 270 million in SEL in the form of equity. In order to EPS 3.13
arrange the balance amount, they intend to accept any one of the following offers:
To finance the expansion, SSML is considering a right issue. However, the management of
I A commercial bank has offered a loan on the following terms: SSML wants to maintain its existing debt equity ratio, return on total assets ratio and
(i) Loan will carry markup @ KIBOR + 3% and would be payable annually. KIBOR dividend payout percentage. Moreover, they wish to keep the ex-right price to be the same
is currently at 8%. as current market price.
(ii) The tenure of the loan would be 5 years and it would be repayable at maturity.
(iii) SEL will have to comply with the following debt equity ratio: SSML follows a policy of retaining 30% of its profits. The current market price of its shares
is Rs. 20 whereas its share price beta is 1.23. Presently, market return is 16% whereas yield
Year 1 2 3 4-5 on one year treasury bills is 12%. Market is assumed to be strong form efficient.
Debt equity ratio 75% 70% 60% 50%
Required:
In case of failure to comply with the above condition, the bank would reserve the Under the circumstances referred to in the above situation, what should be:
right to demand repayment of the entire amount within a period of 30 days. (a) The right ratio
II An investment bank is willing to provide a convertible loan to SEL. The loan carries (b) The right offer price
interest at the rate of 10% per annum. The principal is repayable in four equal annual (c) Theoretical ex-right price
installments commencing from the end of year 2. The investment bank will have the (d) Value of each right (17)
option to convert the balance amount of loan into shares of SEL at Rs. 25 each and the
conversion option will be exercisable at the commencement of year 4 or year 5. SEL Q.6 Qalat Industries Limited (QIL) is a medium sized company which carries out extensive
would not be allowed to issue any dividend during the tenure of the loan. trading (imports as well as exports) with various German companies. The management of
QIL is concerned about the recent fluctuations in the exchange rate parity between Pak
SEL’s revenues/expenses are expected to grow in the following manner: Rupee (Rs.) and Euro (€) and is considering to hedge the following transactions which it
(i) Gross profit would increase at the rate of 3% per annum. expects to undertake, on December 15, 2009:
(ii) Operating expenses would increase by Rs. 100 million in year 1 and thereafter @3%
per annum. Due date of
(iii) 75% of the profit earned by SEL would be available in the form of cash, for Nature of transaction Amount
payment / receipt
repayment of debt. In the case of option 1, SEL plans to invest it in various schemes, (i) Import of IT equipment € 223,500 Jun. 15, 2010
till the loan becomes payable and consequently, the other income is expected to grow
(ii) Export of sports goods € 98,500 Mar.15, 2010
@ 10% per annum.
(iii) Export of medical instruments € 77,000 Jun. 15, 2010
Required: (iv) Import of machinery Rs. 22,500,000 Mar.15, 2010
(a) Analyse the two financing options to evaluate whether SEL would be in a position to
comply with the terms of the respective loans.
(b) Which offer should SEL accept and why? (24)
(5) BUSINESS FINANCE DECISIONS
Suggested Answers
Final Examinations – Winter 2009
Other relevant information is as follows:
A.1 (a) Systematic risk is measured by Beta.
(i) According to QIL’s bank the following exchange rates are expected to prevail on
December 15, 2009: Beta = Co-relation of returns x σ of the fund ÷ σ of the market
= 0.737 × 0.22 ÷ 0.18 = 0.9
€1
Buy Sell
Assessment of AITF Performance
Spot Rs. 124.22 Rs. 124.52
Beta of 0.9 shows that AITF substantially (90%) matches the performance of KSE 100 Index.
3 months forward Rs. 123.62 Rs. 123.96
6 months forward Rs. 123.21 Rs. 123.54
(b) AITF's actual return is 11% which is less than the return which AITF should achieve according to its
(ii) Interest rate on borrowing and lending in respective currencies are as follows: risk profile i.e. 11.6% (W-1) as per its current systematic risk.
Rs. € W-1: Required return of the fund

3-months / 6 months borrowing 11% 5% The required return of AITF in terms of CAPM would be
3-months / 6 months lending 6.5% 3% R = Rf + (Rm – Rf) × β
= 8% + (12% - 8%) × 0.901
Required: = 11.60%
(a) Calculate the net rupee receipts/payments that QIL should expect from the above
transactions under each of the following alternatives:
Name of company
(c)
Forecasted price
return (W-1)
next year (Rs.)
(i) Hedging through forward cover
Current price
after one year
Dividend per
Co-variance
Required
Variance
Market
per share
(ii) Hedging through money market
share
(Rs.)
Total
Beta Remarks
(b) Determine which would be the better alternative for QIL. return
(Ignore transaction costs) (12)
(σ)2 =Rf+β(Rm-Rf)
(THE END) a b c d=(b+c-a)÷a (e) (f) g=f ÷ e h
A 25 27 2.0 16.0% 0.0324 0.024 0.741 11.0% -
B 15 17 1.0 20.0% 0.0324 0.039 1.204 12.8% -
C 46 52 2.5 18.5% 0.0324 0.044 1.357 13.4% -
D 106 111 4.0 8.5% 0.0324 0.033 1.019 12.1% under performing
E 75 85 2.0 16.0% 0.0324 0.018 0.556 10.2% -
F 114 125 3.0 12.3% 0.0324 0.041 1.265 13.1% under performing
G 239 220 5.5 -5.6% 0.0324 0.032 0.988 12.0% under performing
H 156 168 3.0 9.6% 0.0324 0.040 1.235 12.9% under performing
I 145 170 2.5 19.0% 0.0324 0.034 1.049 12.2% -
J 67 75 1.0 13.4% 0.0324 0.033 1.019 12.1% -
(d) No. of shares Value Rs. in Weighted

Name of Current price Beta
‘000’ ‘000’ beta
company
A b c=axb d (c) x d / ∑(c)
A 25 150 3,750 0.741 0.088
B 15 230 3,450 1.204 0.132
C 46 190 8,740 1.357 0.376
E 75 100 7,500 0.556 0.132
I 145 35 5,075 1.049 0.169
J 67 45 3,015 1.019 0.097
31,530 0.994
18-Mar-10 7:25:42 PM Page 1 of 7

A.2 Inflation Years A.3 Maximum price would be the NPV of series of net savings during the 5-year period
factor 0 1 2 3 4 5 Annual
Rs. in million 2009 Change 2010 2011 2012 2013 2014
Investment (15,000) %
Revenue (Rs.8,000×1 million) 5% 8,000 8,400 8,820 9,261 9,724 CL Demand (in tons) A 15,000 5% 15,750.00 16,537.50 17,364.38 18,232.60 19,144.23
Operating costs(excluding wages) (W-1)10.34% (2,000) (2,207) (2,435) (2,686) (2,965) ------------------------------------ Rupees Saving/(Spending) ---------------------------------
Wages (W-2)11.73% (1,000) (1,117) (1,248) (1,395) (1,558)
Chemical X open market price
Profit before taxation 5,000 5,076 5,137 5,180 5,201
(Rs. 240 m / 20,000) – per ton 12,000 10% 13,200.00 14,520.00 15,972.00 17,569.20 19,326.12
Residual value (Rs.15,000×20%) 3,000
Less: Variable cost per ton
Tax @ 30 % (W-3) (600) (803) (965) (1,093) (617)
(Rs. 80m / 20,000) 4,000 12% (4,480.00) (5,017.60) (5,619.71) (6,294.08) (7,049.37)
Net inflows (15,000) 4,400 4,273 4,172 4,087 7,584
Net per ton saving B 8,720.00 9,502.40 10,352.29 11,275.12 12,276.75
Discount factor (W-4) 1 0.850 0.722 0.614 0.522 0.444
Gross saving (A × B) 137.34 157.15 179.76 205.57 235.03
(15,000) 3,740 3,085 2,562 2,125 3,367 Less : Fixed costs 50 8% (54.00) (58.32) (62.99) (68.03) (73.47)
83.34 98.83 116.77 137.54 161.56
Net present value (121) Less: Tax impact 30% (25.00) (29.65) (35.03) (41.26) (48.47)
Net savings 58.34 69.18 81.74 96.28 113.09
Conclusion:
Discount factor (W-1) 14.90% 0.8703 0.7575 0.6592 0.5737 0.4993
Since the Net Present Value of the project is negative, KL should not invest in the project.
Discounted saving 50.77 52.40 53.88 55.24 56.47
W-1: Compound annual growth rate for CPI
175 Maximum offer price 268.76
CAGR for CPI = = (1 + i) 5
107
1/5
(1.6355) = 1+i Assuming that depreciation already included in variable and fixed costs will not be significantly different
1+i = 1.1034 from the depreciation allowable on the value of Rs. 268.76 million.
i = 10.34%
W-1: Discount Rate
W-2: Compound annual growth rate for SPI WACC = We × Ke + Wd × Kd × (1 - t)
195 = 20% × 0.5+0.14 × 0.5 × (1-30%)
CAGR for SPI = = (1 + i) 5 = 14.90%
112
1/5
(1.7411) = 1+i Assuming that the rates are inflation adjusted.
1+i = 1.1173
i = 11.73% A.4 Analysis of Commercial Bank’s Offer
YEARS
1 2 3 4 5
W-3: Tax Computation: -------------------Rupees in million--------------------
YEARS
1 2 3 4 5 Operating profit excluding other income (For Year 1 see W-1
Profit before taxation 5,000 5,076 5,137 5,180 5,201 and for year 2-5 growth at 3%) 572.9 590.1 607.8 626.0 644.8
Depreciation (3000) (2400) (1920) (1536) (1229) Add: Other income growing at 10% 237.6 261.4 287.5 316.3 347.9
Loss on disposal (1,915) Less: Interest on loan (1,800 (W-2) × 11%) (198.0) (198.0) (198.0) (198.0) (198.0)
Profit before tax 612.5 653.5 697.3 744.3 794.7
Taxable profit/loss 2,000 2,676 3,217 3,644 2,057
Tax at 30% (183.8) (196.1) (209.2) (223.3) (238.4)
Tax@ 30% 600 803 965 1,093 617 Profit after tax 428.7 457.4 488.1 521.0 556.3
W-4: Share capital 300.0 300.0 300.0 300.0 300.0

Discount Rate = Required return nominal Reserves 428.7 886.1 1,374.2 1,895.2 2,451.5
1 + nominal return = (1+real return) × (1+inflation) 728.7 1,186.1 1,674.2 2,195.2 2,751.5
= 106% × 111% Total debt at year end 1,800.0 1,800.0 1,800.0 1,800.0 1,800.0
= 117.7% 2,528.7 2,986.1 3,474 .2 3,995.2 4,551.5
= 17.7%
Gearing – Projected 71.18% 60.28% 51.81% 45.05% 39.56%
Gearing – Required 75% 70% 60% 50% 50%
Meeting the required D/E ratio (Yes / No) Yes Yes Yes Yes Yes
Available in the form of cash for debt payment (2,451.5×75%) 1,838.6
18-Mar-10 7:25:42 PM Page 2 of 7 18-Mar-10 7:25:42 PM Page 3 of 7

Analysis of Investment Bank’s Offer:

YEARS
1 2 3 4 5 A.5 (a) Right Ratio
-------------------Rupees in million-------------------- Market value of the company after expansion (W-1) Rs. 1,076.39
Current market price of SSML’s Share (given) Rs. 20.00
Operating profit excluding other income (For Year 1
see W-1 and for year 2-5 growth at 3%) 572.9 590.1 607.8 626.0 644.8
Other income 216.0 216.0 216.0 216.0 216.0 Number of shares to be issued to maintain Market Value Rs. 1,076.39 at Rs. 20
Less: Interest on loan desired price:
Year 1 (1,800 (W-2) × 10%) (180.0) Share in million
Year 2 (1,800 × 10%) (180.0)
Total number of shares after right issue (Market value / Price) 53.82
Less: Present number of shares 40.00
Year 3 (1,350 ×10%) (135.0)
Number of right shares to be issued 13.82
Year 4 (900 × 10%) (90.0)
Year 5 (450 × 10%) (45.0)
Right ratio - one right share will be issued for every 2.89 (40÷13.82) shares held.
Profit before tax 608.9 626.1 688.8 752.0 815.8
Tax at 30% (182.7) (187.8) (206.6) (225.6) (244.7)
(b) Right offer price
Profit after tax 426.2 438.3 482.2 526.4 571.1
To maintain Debt : Equity ratio, amount to be raised as equity (Rs. 300
million × (100% - 52%) [W-7]) Rs. 144 Million
Share capital 300.0 300.0 300.0 300.0 300.0
Reserves 426.2 864.5 1346.70 1873.10 2444.2
Offer price of right shares (Rs. 144 ÷ 13.82) Rs. 10.42 per share
Total equity 762.2 1164.5 1646.7 2173.10 2744.2
(c) Theoretical Ex-Rights price
Opening balance of cash - 319.65 198.38 110.03 54.83 Rs. in million
Available cash for debt repayment (Profit×75%) 319.65 328.73 361.65 394.80 428.33 The market value of 40 million shares (already issued todate) 800
Payment of principle to investment bank (Rs.1,800÷ 4) - (450.0) (450.0) (450.0) (450.0) Capital to be raised through right issue 144
Closing balance of available cash 319.65 198.38 110.03 54.83 33.16 944
944
Based on the above information, we may conclude as follows: Theoretical Ex - rights price = = 17.54
53.82
(i) In either case, the SEL would be able to meet the debt covenants and payment requirement.
(ii) In option 1, the company will earn slightly higher profits. (d) Value of Right
(iii) In option 2 the break-up value of shares at the commencement of year 4 would be Rs. 54.89 (W-3) and Ex - right price − issue price
at the commencement of year 5 it would be 72.43 (W-3). Therefore, it is likely that bank will decide to Value of right =
No. of rights required to buy one share
opt for conversion of loan into shares @ Rs. 25 per share, it would reduce the break-up value for the
current owners. Moreover, the bank will also be in a position to obtain control over the company.
20 - 10.42
Value of right (applicable to each existing share) =
In view of the above, it is concluded that it would be advisable for SEL to go for option-1. 2.89
W-1: Operating profit excluding other income at year 1 = 3.31

Rs. in million
Gross profit (1,030 × 1.03) 1,060.9 WORKINGS
Less: Operating expenses (388 + 100) (488.0)
572.9 W-1 : Market value after expansion
W-2: Required debt financing
d1
Agreed price 2,100 MV =
Less: Equity financing by r-g
 Team of employees (270)
 BHL (270 × 10 ÷ 90) (30) Rs. 155 (W-2 ) × 70%
(300) MV = = 1,076.39
16.9% (W-5 ) - 6.82% (W-6 )
Debt financing required 1,800
W-2: Expected profit
W-3: Break up value
YEARS
Expected Profit = Total assets × ROA
1 2 3 4 5 = 1,550 (W-3) × 10% (W-4) = 155
Total value of equity ÷ No. of shares (Rs.) 25.41 38.82 54.89* 72.44* 91.47
W-3: Total assets after capital increase Rs. in million
Existing assets 1,250 Invest for three months now which after 3 months would amount to:
Total capital to be raised 300 Rs. 12,084,618 × (1 + 6.5% ÷ 4) 12,280,993
Total assets after capital increase 1,550
W- 4 : Existing return on assets

Net profit 125 Six month payments
Existing ROA = = = 10.00% Since the company is expecting to pay €. Therefore, to hedge currency rate risk we need to convert
Total Assets 1,250
this payable into definite Rupee payables.
W-5: Required return (r)
r = Rf + (Rm-Rf) × B
Borrow in Rupee a sum equivalent to the present value of € 146,500. Invest that Euro sum, so that at the
= 12% + (16% - 12%) × 1.23 end of sixth month Euro will be available for net import payment and we will have a definite Rupee payable.
= 16.9%
Investment required for a sum which has compound value
W-6: Growth (g) of € 146,500 at the end of sixth month: €
g=rxb 146,500 ÷ (1 + 3% ÷ 2) 144,335
Net Profit
= × (1 - pay out%)
Equity Rs.
125 To invest, borrow equivalent Rupee to buy Euro at spot (€ 144,335× Rs.
= × (1 - 70%) 124.52) 17,972,594
550
= 6.82% Rs. 17,972,594 used for buying € 145,335 would require a definite rupee
repayment of compound value at the end of sixth month:
W-7: Debt Equity Ratio 17,972,594 × (1 + 11% ÷ 2)) 18,961,087
Debt 600,000
D/E ratio = = = 52%
Debt + Equity 600,000 + 550,000 Recommendation:
Feasible option for 3 month net payment -------------------------------> Money Market
Feasible option for 6 month net payment -------------------------------> Forward Cover
A.6 Net Position Three months Six months
Export – Receivable € 98,500 € 77,000 (THE END)
Import - (Payable) € (223,500)
Net position – Receivable/(Payable) € 98,500 € (146,500)
(i) Forward Market

Three months contract
Rs.
Receipt of export amount at the end of third month € 98,500 x 123.62 12,176,570
Six months contract
Net payment at the end of sixth month € 146,500 x 123.54 18,098,610
(ii) Money Market

Three months payment
Since the company is expecting to receive €. Therefore, to hedge currency rate risk we need to convert
the same into definite Rupee receivables.
Borrow in Euro and invest in Rupee, so that at the end of third month repay Euro borrowing from
export proceeds and receive a definite Rupee amount.
€
Borrow a sum which has a compound value of € 98,500 at the end of third
month: 98,500 ÷ (1 + 5% ÷ 4) 97,284
Rs.
Convert € to Rupees at spot (€ 97,284 × Rs. 124.22) for investment 12,084,618

(2)
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN Q.2 MK Limited is presently considering a proposal to acquire 100 % shareholdings of ZA
Limited which is engaged in the same business. The financial data extracted from the latest
audited financial statements and other records of the two companies is presented below:
Final Examinations Summer 2010 MK ZA
-----Rs. in million-----
Sales revenue 12,000 8,460
June 9, 2010 Operating expense excluding depreciation (7,695) (4,905)
Depreciation (1,305) (990)
Profit before interest and tax 3,000 2,565
BUSINESS FINANCE DECISIONS (MARKS 100)
Interest (644) (1,494)
(3 hours) Profit after interest 2,356 1,071
Taxation (35%) (825) (375)
Q.1 YB Pakistan Limited is engaged in the manufacture of pharmaceutical products. On April 1,
2010 the Board of Directors approved a plan which envisages an investment of Rs. 300 Profit after taxation 1,531 696
million on account of capital expenditures over the next five years. Following information
Dividend payout 50% 55%
has been extracted from the management accounts of the company which have been
Capital expenditure during the year (Rs. in million) 700 650
prepared in respect of the year ended March 31, 2010:
Debt ratio 40% 55%
Rs. in millions Market rate of interest on debentures 6.5% 7.5%
Sales revenue 190.00 Number of shares issued (in million) 100 90
Cost of goods sold 110.00 Market price of share (Rs.) 20 12
Operating expense 30.00 Equity beta 1.1 1.3
Interest expense 15.00
The following further information is available:
Property plant and equipment 100.80
(i) Both the companies follow the policy of maintaining stable dividend payouts and debt
Shareholders’ equity 135.00
ratios.
The following information is also available: (ii) Annual growth in sales, operating expenses, depreciation and capital expenditures are
estimated as under:
(i) Annual outlay of investment in next five years is estimated to be 13%, 16%, 22%,
22% and 27% respectively of the total amount. Year 1 – 2 Year 3 onward
(ii) The company expects that the operating profit (excluding depreciation) generated by MK 4.0% 5.0%
the existing assets will grow at the rate of 12% per annum. In addition, the new ZA 5.5% 5.0%
investments would yield pre-tax cash flows of 15% per annum.
(iii) Accounting depreciation is the same as tax depreciation.
(iii) The company follows a policy of maintaining a debt equity ratio of 40:60.
(iv) The prevailing risk-free rate of return is 8% whereas the market return is 13%.
(iv) Interest rates on existing and future long term debts are expected to be the same and
are not expected to change during the next five years. The current debt is repayable at
The key aspects of the feasibility study carried out by MK are as follows:
the end of five years. All future debts would be repayable on or after six years.
(v) The company has a short term financing facility of Rs. 50 million. The outstanding MK would issue 7 shares in exchange for 9 shares of ZA.
balance as of March 31, 2010 was Rs. 20 million. Assume that interest @ 16% is A rationalization of administrative and operational functions after takeover would
payable at the end of each year on the closing balances. reduce operating expenses including depreciation, from 75% to 70% of total sales.
(vi) The company invests its surplus funds into highly secured investments which yield The annual growth in sales, operating costs, depreciation and capital expenditures in
8% per annum. the merged company would be as follows:
(vii) The additional working capital requirements are estimated at 10% of additional capital
expenditures. Year 1 – 2 5.0%
(viii) Accounting depreciation is calculated at the rate of 15% of written down value. It is Year 3 onward 5.5%
equal to tax depreciation and therefore is allowable for tax purposes. The current
corporate tax rate is 40%. To promote corporate business, the Government has Required:
announced an annual reduction of 2% in tax rate till it is reduced to 34%. (a) Based on an analysis of Free Cash Flows, calculate the value of MK Limited, ZA
(ix) The company follows the residual dividend policy for payment of dividends. Limited and the company which would be formed after the merger.
(b) Estimate the synergy effect which is expected to accrue to MK Limited on account of
You may assume that all cash flows are incurred at year end. acquisition of ZA Limited. (25)
Required:
(a) Calculate the expected dividend for the next five years in accordance with the existing Q.3 (a) Briefly explain the Adjusted Present Value (APV) method and identify its advantages
payout policy of the company. over the Weighted Average Cost of Capital method. (04)
(b) Ascertain whether the company would be able to pay off its existing loan at the expiry
of five years. (22)
(3) (4)
(b) NS Technologies Limited is in the business of developing financial software. The Q.5 The Directors of PSD Engineering Limited, a listed company, are planning to raise Rs. 100
directors of the company believe that the scope of future growth in the software sector is million for a new project. They are considering two possible options of fund raising. The
limited and are considering to diversify into other activities. An option available with first is to make a two-for-five right issue of ordinary shares priced at Rs. 12.50 per share.
the company is to sign an eight year distribution contract with a leading manufacturer of The second option is to issue 9% Term Finance Certificates (TFCs) at par, redeemable in
telecommunication equipments. 2020.
Some of the important information related to the above proposal is as follows: The following information has been extracted from the financial statements of PSD for the
year ended March 31, 2010:
(i) Total investment is estimated at Rs. 600 million. It includes developing the
necessary infrastructure, purchase of equipment and working capital Rs. in million
requirements. Issued ordinary shares Rs. 10 each 200
(ii) The investment is expected to generate pre-tax net cash flows of Rs. 180 million Retained earnings 390
per year. 590
(iii) Presently NS is paying interest @ 9% on its long term debt. 10% TFCs at par, repayable in 2012 350
(iv) NS maintains a debt equity ratio of 55:45 whereas its equity beta is 0.9. 940
(v) Average debt ratio, overall beta and debt beta of telecommunication equipment
distribution segment is 40%, 1.5 and 1.3 respectively. The shares of the company are currently traded at Rs. 16 per share. The profit before interest
(vi) The market rate of return is 14% whereas yield on one year treasury bills is 6%. and taxation of PSD for the year ended March 31, 2010 is Rs. 95 million.
(vii) Costs associated with the issuance of debt and equity instruments are estimated
at 1% and 3% respectively. It is expected that the right issue will not affect PSD’s current price earnings ratio. However,
(viii) Tax rate applicable to the company is 35%. Tax is paid in the same year as the the issue of TFCs would result in fall in price earnings ratio by 30%.
income to which it relates.
The tax rate applicable to the company is 35%.
(ix) In case the contract is not renewed upon expiry, after tax cash flows of Rs. 90
million would be generated from disposal of allied resources. Required:
(a) Make appropriate calculations in each of the following independent situations:
Required:
Evaluate the above proposal using the APV method. (i) Assuming a right issue of shares is made, calculate:
(12)
the theoretical ex-rights price of an ordinary share.
the value of the right. (03)
Q.4 DS Leasing Company Limited has been approached by BP Industries Limited, with a (ii) Assuming the market is strong form efficient and it is expected that new project
request to arrange a 4-year lease contract in respect of a state of the art machine. The cost of would generate positive net present value of Rs. 96 million. Calculate the
machine is Rs. 20 million and the expected useful life is 4 years. The residual value at the theoretical ex-right price in this case. (02)
end of lease term is estimated at 10% of cost. (iii) Assuming that the new project would increase the company’s profit before
DS would finance the purchase of machine by borrowing at 16% per annum. The interest interest and tax for the next year by 10%. Calculate the price of an ordinary share
would be payable annually and the principal amount would have to be repaid in four equal in one year’s time under each of the two financing options. (09)
annual installments commencing from the end of first year.
(b) Briefly discuss why issue of term finance certificates is expected to result in fall in
DS provides free-of-cost maintenance services for all its leased assets. These services are price earnings ratio. (03)
provided by the company’s Maintenance Department whose costs are mostly fixed. If BP
acquires this service from any other vendor, it would have to pay an annual fee of 3% of the (THE END)
cost of machine. Insurance cost will be borne by BP and is estimated at 4% of the cost of
machine.
The tax rate applicable to both companies is 35% and the tax is payable in the next year.
Allowable initial and normal deprecation on the machine is 25% and 10% respectively. The
weighted average cost of capital of DS and BP are 18% and 20% respectively.
Both companies follow the same financial year. It may be assumed that the purchase would
be finalized on the last day of the financial year.
Required:
(a) Calculate the annual rental (payable in advance) which DS should charge in order to
break even on the lease contract. (08)
(b) Assume that BP has the following two options for financing the cost of machine:
(i) DS has offered to lease the machine at an annual rental of Rs. 7 million, payable
in advance.
(ii) EFT Bank has offered to finance the machine at 18% per annum. The loan
including interest would be repayable in 4 equal annual installments to be paid at
the end of each year. Insurance costs would be borne by BP.
Determine which course of action BP should follow. (12)
Business Finance Decisions Business Finance Decisions
A.1 (a) YEARS

1 2 3 4 5
---------------Rupees in million--------------- A.2 (a) VALUE OF MK LIMITED
Existing operating profit from current projects [67.79(W-1)x1.12] 75.92 85.03 95.23 106.66 119.46
Years
Operating profit from new investment plan (W-2) - 5.85 13.05 22.95 32.85
Less: Depreciation for the year (W-3) (15.12) (18.70) (23.10) (29.53) (35.00) 1 2
Less: Interest on debt (W-5) (12.58) (13.05) (14.10) (15.73) (16.92) Rupees in million
Net profit before tax 48.22 59.13 71.08 84.35 100.39 Sales 4% 12,480 12,979
Tax (38%, 36%, 34%, 34%, 34%) (18.32) (21.29) (24.16) (28.68) (34.13) Operating costs including depreciation 75% (9,360) (9,734)
Net profit after tax 29.90 37.84 46.91 55.67 66.26
Less: Retained for CAPEX (A × 60%) (23.40) (28.80) (39.60) (39.60) *(48.60)
Residual income for dividend distribution 6.50 9.04 7.31 16.07 17.66 Taxation 35% (1,092) (1,136)
*(Rs. 300 m x 27% x 60%) Add back depreciation 4% 1,357 1,411
Annual capital expenditure 4% (728) (757)
(b) The company would have surplus cash of Rs. 79.55 million (W-5) which is less than Rs. 90 million. Free cash flow 2,657 2,763
However, the company may pay the amount by obtaining the balance amount from its short term
running finance facility. Discount factor (W1) 9.8% 0.911 0.830
WORKINGS Present value 2,421 2,292

W-1: Existing operating profit
Rs. in millions Present value 1 - 2 years 4,713
Net profit before tax and interest (190 - 110 - 30) 50.00
Add: Depreciation for current year (100.8 × 15 ÷ 85) 17.79 2,763(1.05)
Operating profit 67.79 Free cash flow after year 2 = x 0.83 = Rs. 50,166 million
0.098 − 0.05
W-2: Operating profit from new projects Total free cash flows = (4,713 + 50,166) Rs. 54,879 million
YEARS
1 2 3 4 5 W1: Weighted Average Cost of Capital
Year wise outlay for CAPEX in percentage terms 0% 13% 16% 22% 22%
--------------------Rs. in million-----------------
Year wise planned CAPEX (Rs. 300m × CAPEX %) A - 39.00 48.00 66.00 66.00 D/E Ratio Rate WACC
Cumulative new CAPEX B - 39.00 87.00 153.00 219.00 k e (8% + (13% -8%) x 1.1) 60% 13.50% 8.1%
Yield from new projects : (B) × 15% pre-tax cash flow - 5.85 13.05 22.95 32.85 k d (6.5% x 0.65) 40% 4.23% 1.7%
W-3: Depreciation for the year WACC 9.8%
WDV at the beginning of year 100.80 85.68 105.98 130.88 167.35
Addition during the year (A) - 39.00 48.00 66.00 66.00 VALUE OF ZA LIMITED Years
Depreciable value 100.80 124.68 153.98 196.88 233.35 1 2
Depreciation for the year 15.12 18.70 23.10 29.53 35.00
WDV at the end of year 85.68 105.98 130.88 167.35 198.35 Rupees in million
Sales 5.5% 8,925 9,416
W-4: Interest on debts Operating costs including depreciation 5.5% (6,219) (6,561)
Long term debt at the beginning of year Profit before interest and tax 2,706 2,855
(Rs.135m÷60×40) 90.00 90.00 105.60 124.80 151.20 Taxation 35% (947) (999)
New debt during the year (A × 40%) - 15.60 19.20 26.40 26.40
Long Term debt at the end of year 90.00 105.60 124.80 151.20 177.6 Add back depreciation 5.5% 1,044 1,101
Annual capital expenditure 5.5% (686) (724)
Interest on long term debt (15- (20 x 0.16)) ÷ 90= 13.11% 11.80 13.84 16.36 19.82 23.28 Free cash flow 2,117 2,233
Interest on short term debt (W-5) 0.78 - - - -
Interest income (W-5) - (0.79) (2.26) (4.09) (6.36)
Discount factor (W2) 9.2% 0.916 0.839
12.58 13.05 14.10 15.73 16.92
(W-5) Interest on short term running finance Present value 1,939 1,873
Opening outstanding balance / (Cash) 20.00 4.88 (9.92) (28.22) (51.15)
Additional working capital (10% of additional CAPEX) - 3.90 4.80 6.60 6.60
Present value 1 - 2 years 3,812
Less: Additional cash flow generated (Depreciation) (15.12) (18.70) (23.10) (29.53) (35.00)
Debt / (balance) at the end of year 4.88 (9.92) (28.22) (51.15) (79.55)
2,233(1.05)
Free cash flow after year 2 = x 0.839 = Rs. 46,837 million
Interest on short term running finance 0.78 - - - -
0.092 − 0.05
Interest income - (0.79) (2.26) (4.09) (6.36)
Total free cash flows = (3,812 + 46,837) Rs. 50,649 million
W2: Weighted Average Cost of Capital than WACC.

Rate D/E % WACC (ii) Miscalculation in WACC, sometimes, produces large errors in the estimates of value. APV is
k e - (8% + (13% - 8%) x 1.3 14.5% 45% 6.5% less prone to such miscalculations.
k d - (7.5% x 65%) 4.9% 55% 2.7% (iii) Show better result when there are significant changes in capital structure.
WACC 9.2%
VALUE OF PROPOSED MERGED COMPANY
Years (b) Adjusted present value Rs in million
1 2 Net present value on the basis of revised K e
Rupees in million Cash flows Discount @ Present value
Years
(Rs. in million) 18.72% (W-1) (Rs. in million)
Combined Sales 5% 21,483 22,557
Investments 0 (600.00) 1.00 (600)
Operating costs including depreciation 70% (15,038) (15,790)
After tax cash flows (180 x 0.65) 1-8 117.00 *13.99 467
Residual value 8 90.00 0.30 27
Taxation 35% (2,256) (2,368)
Add back depreciation 5% 2,410 2,531 Net present value on the basis of revised K e (106)
Annual capital expenditure 5% (1,418) (1,489)
Tax shield [(600 x 55% x 9% x 35% x *26.21] 65
Free cash flow 5,181 5,441
Issue costs - Right shares (3% x 600 x 45%) (5)
Discount factor (W3) 9.8% 0.911 0.830 - Loan (1% x 600 x 55%) (2)
(48)
Present value 4,720 4,516
1 − (1 + 0.1872) −8 1 − (1 + 0.06) −8
*1 *2
Present value 1 - 2 years 9,234 0.1872( W − 1) 0.06
5,441(1.055)
Free cash flow after year 2 = x 0.83 = Rs. 110,800 million
0.098 − 0.055 Conclusion
The project is not feasible for the company as the APV of the project is negative.
Total free cash flows = (9,234 + 110,800) Rs. 120,036 million
W-1: Cost of equity
W3: Weighted Average Cost of Capital K e = R f + (R m – R f ) x β e
Equity - MK (100 x 20) 2,000 13.50% 270.00 K e = 6% + (14% – 6%) x 1.59 (W-2)
Equity - ZA (90 x 7/9 x 20) 1,400 14.5% 203.00 = 18.72%
Debt - MK (2,000 x 40% / 60%) 1,333 4.23% 56.00
W-2: Calculating Equity Beta for Telecommunication Industry
Debt - ZA (90 x 12 x 55% / 45%) 1,320 4.98% 65.00
E D (1 - t)
Total equity + debt of merged company 6,053 594 βa = βe + βd
E + D(1 − t) E + D(1 − t)
WACC = 594 ÷ 6,053 9.8% 60 40(1 − 0.35)
1.5 = β e + 1.3
(b) Synergy effect of acquisition 60 + 40(1 − 0.35) 60 + 40(1 − 0.35)
Rupees in million β e = 1.59
Total free cash flow of Merged Co. 120,036
Total free cash flow of MK Limited 54,879 A.4 (a) Years

Total free cash flow of ZA Limited 50,649 0 1 2 3 4 5
105,528 ---------------Rupees in million---------------
Synergy effect of acquisition 14,508 Principal repayment 5.00 5.00 5.00 5.00 -
Interest (Principal outstanding x 16%) 3.20 2.40 1.60 0.80 -
Tax savings (W-1) - (3.40) (1.31) (0.99) (3.41)
A.3 (a) APV separates project value into one component associated with the unlevered operating cash flows
Recovery of residual value (Note) - - - (2.00) -
and another associated with financing the project. Each component is evaluated separately.
Net cash outflow to DS 8.20 4.00 5.29 2.81 (3.41)
The disaggregation of cash flows is undertaken so that different discount rates may be used. As Discount @ 18% 1.00 0.85 0.72 0.61 0.52 0.44
operating cash flows are more risky, they are discounted at higher rate. PV of net cash outflow 6.97 2.88 3.23 1.46 (1.50)
Total PV of net cash outflow 13.04
Comparative advantages of APV over WACC
NPV factor of tax rental income (W-2) 2.236
(i) Unbundles major components of value – drivers of value are much more apparent under APV
Annual rental 5.83 Tax allowance as computed above 6.50 1.35 1.22 8.93 -
10.70 4.86 3.90 10.66
Tax savings (in next year) C - (3.75) (1.70) (1.37) (3.73)
W-1: Tax savings Years Recovery of residual value - - - (2.00) -
0 1 2 3 4 5 Cash outflow to BP A+B+C - 8.03 4.29 6.33 4.67 (3.73)
---------------Rupees in million--------------- Discount at 20% - 0.833 0.694 0.578 0.482 0.402
WDV at start of year 20.00 13.50 12.15 10.93 PV of cash outflow - 6.69 2.97 3.66 2.25 (1.50)
Initial depreciation (25%) 5.00 - - -
NPV of purchase option 14.07
Normal depreciation (10%) 1.50 1.35 1.22 1.09
Loss on disposal (Note) - - - 7.84 W-1:
Total tax allowance 6.50 1.35 1.22 8.93 Rs. 20 million
WDV at end of year 13.50 12.15 10.93 2.00 Installment amount = = 7.43
1 − (1 + 0.18) − 4
Note: Disposal value i.e. Rs. 2 million (10% of Rs. 20 million) - WDV at the end of year 4 i.e. 9.84 0.18
= Rs. 7.84 million (Loss on disposal)
Conclusion:
Years
The feasible option is the outright purchase.
0 1 2 3 4 5
---------------Rupees in million---------------
Note: Insurance costs are ignored in our computation as these are the same in both options.
Total tax allowance as computed above 6.50 1.35 1.22 8.93
Interest payment computed above 3.20 2.40 1.60 0.80
9.70 3.75 2.82 9.73 A.5 (a) (i)  Theoretical ex-right price
Rupees
Tax savings @ 35% in next year 3.40 1.31 0.99 3.41 Value of 5 original shares @ Rs. 16 80.00
Value of 2 right share @ Rs. 12.5) 25.00
W-2 : NPV factor of after tax rental income 105.00
Years
0 1 2 3 4 5 Ex-right price (Rs. 105 ÷ 7) 15.00
---------------------Rupees ----------------------
Income 1.00 1.00 1.00 1.00  Value of the right
Tax savings (0.35) (0.35) (0.35) (0.35)
Ex-right share price 15.00
1.00 0.65 0.65 0.65 (0.35)
Cost of acquiring right share 12.50
Discount factor @ 18% 1.000 0.850 0.720 0.610 0.520
2.50
PV factor of income 1.000 0.553 0.468 0.397 (0.182)
Total PV of income 2.236 Value of right per original share (Rs. 2.5 ÷ 5 share) 0.500
(b) Leasing Years

0 1 2 3 4 5 (ii) Theoretical ex-right price Rupees in million
----- Rupees in million ----- Current shares market value (20 million share of Rs. 16 each) 320
Annual rental 7.00 7.00 7.00 7.00 Value of right shares (8 million shares of Rs. 12.5 each) 100
Tax savings (rental x 35%) (2.45) (2.45) (2.45) (2.45) NPV 96
7.00 4.55 4.55 4.55 (2.45) 516
Discount at 20% 1 0.833 0.694 0.578 0.482
PV of cash flow 7.00 3.79 3.16 2.63 (1.18) 15.4 Theoretical ex-right price including NPV (Rs. 516 million ÷ 28 million shares) 18.43
(iii) Current earnings per share
NPV of leasing option 15.40 Profit before interest and taxation 95.00
Less: Interest on debentures (Rs. 350 million @ 10%) (35.00)
Profit before taxation 60.00
Purchase Outright Years Less: taxation @ 35% (21.00)
0 1 2 3 4 5 39.00
Principal outstanding ------------- Rupees in million ---------------
(Opening - Loan payment + Interest) 20.00 16.17 11.65 6.30 0.00 Earnings per share (Rs. 39 million ÷ 20) Rs.1.95
Price earnings ratio (Rs. 16 ÷ Rs. 1.95) 8.21
Loan payment (W-1) A 7.43 7.43 7.43 7.43
Interest (@18% of opening principal) 3.60 2.91 2.08 1.13
Maintenance costs B 0.60 0.60 0.60 0.60
Business Finance Decisions
Suggested Answers
Final Examinations – Summer 2010 The Institute of Chartered Accountants of Pakistan

New earnings per share and share price
Final Examinations – Winter 2010 December 8, 2010
Right issue Debenture issue
Module F 100 marks - 3 hours
---------Rupees in million------
Profit before interest and taxation (95.00 x 1.1) 104.50 104.50
Less: Debenture interest (10% × 350) (35.00) (35.00)
(9% × 100) - (9.00) Q.1 (a) Briefly discuss the possible synergistic effects which are the primary motivation for most
Profit before tax 69.50 60.50 mergers and takeovers. (05 marks)
Less: Taxation at 35% 24.33 21.18
45.17 39.32 (b) The board of directors of Platinum Limited (PL), a leading manufacturer of electrical goods, is
considering to takeover Diamond Limited (DL), a competitor of an important product line, by
EPS (Rs. 45.17 million / 28 million shares) Rs. 1.61 offering seven ordinary shares for every six ordinary shares of DL.
New share price (Rs. 1.61 x 8.21) Rs. 13.22
The summarized statement of financial position and summarized income statement of the two
companies for the latest financial year are given below:
EPS (Rs. 39.32 million / 20 million shares) Rs. 1.97
New share price (Rs. 1.97 x 8.21 x 70%) Rs. 11.31 Summarized Statement of Financial Position
(b) PSD already has a gearing level of 37% (350 ÷ 940). If it is at or near its optimal level of gearing, PL DL
shareholders may take negatively to the additional debt which would push the gearing level up to 43% Rupees in million
(450 ÷ 1,040). Accordingly the cost of equity would rise and the ordinary share price would fall. Total assets 4,535 959
Shareholders equity
(THE END) Ordinary shares (Rs. 10 each) 900 192
Reserves 1,089 121
1,989 313
Total liabilities 2,546 646
Total equity and liabilities 4,535 959
Summarized Income Statement
PL DL
Rupees in million
Turnover 3,638 901
Profit before tax 312 86
Tax 81 28
Profit after tax 231 58
The current price earnings ratios of PL and DL are 15 and 19 respectively.

In case of successful bidding, the directors envisage that:
after tax savings in administrative costs would be Rs. 24 million per annum.
the price earnings ratio of the merged company would be 18.
the dividend payout ratio of PL would not be affected.
Required:
(i) Total value of the proposed bid based on PL’s current share price.
(ii) Expected earnings per share and share price of PL following the successful acquisition of
DL.
(iii) The board of directors is also considering the alternative to offer three zero coupon
debentures (redeemable in 8 years at Rs. 100) for every 2 DL shares. PL can currently
issue new 8 year loan at an interest rate of 11% per annum. Discuss whether this proposal
is likely to be viewed favourably by DL’s shareholders. (15 marks)
Page 7 of 7
Business Finance Decisions Page 2 of 4 Business Finance Decisions Page 3 of 4
Q.2 Silver Limited (SL) is a large manufacturing concern in Malaysia. It deals in four major product Required:
lines. As the financial controller of the company, you are faced with the following situations: (a) Evaluate which of the above projects may be selected for investment by Iron Limited. Rank the
selected projects in order of preference.
(I) SL has made arrangements to export leather shoes to a major customer in USA. It has been (b) Determine the overall systematic risk that would be associated with the above investments if IL
agreed that one consignment would be shipped in each quarter and payment thereof would be decides to invest in all the projects selected in (a) above. (13 marks)
made at the end of the quarter. SL’s sole supplier of leather is in Pakistan and it has also agreed
to supply on 3 months credit. The estimated sales and purchases for the first two quarters of
2011 are as follows: Q.4 Gold Limited (GL) manufactures textile machinery. The management has explored opportunities in
Purchases from various South Asian countries and is optimistic that there is considerable demand for GL’s
Sales to US Customer machines in the region. However, exports from Pakistan are not financially viable on account of
Pakistani Supplier
First quarter ending March 31, 2011 USD 1,020,000 USD 775,000 higher input costs. Therefore, GL intends to establish a subsidiary either in Bangladesh or in Sri
Second quarter ending June 30, 2011 USD 1,224,000 USD 1,347,000 Lanka. Based on initial studies, the management projections, at current prices, are as follows:
Alternative 1: Subsidiary in Bangladesh (SIB)

The management is considering to hedge the foreign currency transactions. In this regard SL’s
(i) SIB would require immediate outlay of BDT 110 million for the construction of a new
bank has provided the following information:
factory, i.e. BDT 80 million for acquisition of land and BDT 30 million as advance payment
USD 1 for construction of factory. Balance payment of BDT 75 million would be made in year 1.
Exchange Rates (ii) The installation and commissioning of plant and machinery would be completed in year 1 at
Buy Sell
Spot rate MYR 3.030 MYR 3.110 a cost of BDT 115 million.
3 months forward rates premium MYR 0.071 MYR 0.073 (iii) The estimated working capital requirement in year 1 and year 2 is BDT 20 million and BDT
6 months forward rates premium MYR 0.160 MYR 0.164 110 million respectively.
(iv) Production and sales in year 2 are estimated at 3,000 units and in years 3-5 at 4,000 units per
Interest Rates Lending Borrowing annum. The average price in year 2 is estimated at BDT 300,000 per unit.
MYR 6.6% p.a. 7.9% p.a. (v) Total variable costs in year 2 are expected to be BDT 165,000 per unit.
USD 5.8% p.a. 7.2% p.a. (vi) Fixed overhead costs excluding depreciation, in year 2 are estimated at BDT 350 million.
(vii) Allowable tax depreciation on all fixed assets except land is 20% per annum on a reducing
(II) SL has sold one of its product lines for MYR 15 million. The proceeds are expected to be balance method.
received at the end of February, 2011. SL plans to use these funds in September, 2011 for one (viii) Applicable tax rate on SIB is 35%.
of its major expansion project. Consequently, the management wants to invest this amount in a
fixed deposit account for a period of six months at 6% per annum. Alternative 2: Subsidiary in Sri Lanka (SISL)
(i) The investment would involve the purchase of an existing factory via a takeover bid. The
The management is considering to hedge the interest rate risk by using interest rate futures. The estimated cost of acquisition is LKR 90 million.
current price of March six months’ futures is 95.50 whereas the standard contract size is MYR (ii) Additional investment of LKR 18 million in new plant and machinery and LKR 36 million in
3 million. working capital would be required immediately after the acquisition.
(iii) Pre-tax net cash flows (including tax savings from depreciation) are estimated at LKR 27
Required: million in year 1 and LKR 35 million in year 2.
(a) Determine which of the following options would be more beneficial to the company: (iv) Applicable tax rate on SISL is 25%.
(i) Hedging through forward cover
(ii) Hedging through money market All the above projections are based on current prices and are expected to increase annually at the
current rate of inflation. Inflation rates for each of the next five years in Pakistan, Bangladesh and
(b) Determine how beneficial would it be for SL to use interest rate futures to hedge the interest Sri Lanka are expected to be 12%, 10% and 8% respectively.
rate risk if at the end of February, 2011 interest rates:
(i) fall by 0.75% and future price moves by 1%; or The after-tax realizable value of the investment at the prices prevailing in year 5, is estimated at
(ii) rise by 1% and future price moves by 1%. (20 marks) BDT 145 million and LKR 115 million in case of Bangladesh and Sri Lanka respectively.
Ignore transaction costs. Current exchange rates are as follows:

BDT /PKR Rs. 0.83 – Rs. 0.85
LKR/PKR Rs. 1.31 – Rs. 1.34
Q.3 Iron Limited (IL) is considering four projects for investing the excess liquidity available with the
company. Each project will last for three years. The details are as follows: GL’s cost of equity is 18%. It would finance the investment by borrowing at 12% per annum in
Projects Pakistan after which its debt equity ratio would be approximately 30:70.
A B C D The tax rate applicable to GL in Pakistan is 30%. Pakistan has double taxation treaty agreements
Net annual cash flows (Rs. in millions) 85 87 90 95 with both the countries.
Expected return 16% 14% 17% 15% Required:
Standard deviation of returns 20% 18% 27% 30% Evaluate which of the two subsidiaries (if any) should be established by GL. (Assume that tax in all
Estimated correlation of returns with market returns 0.82 0.85 0.91 0.78 countries is payable in the same year and that all cash flows arise at the end of the year) (24 marks)
The current market returns are 14% with a standard deviation of 16%. Risk free rate of return is
10%.
Business Finance Decisions Page 4 of 4
Suggested Answers
Q.5 The management of Copper Industries Limited (CIL) intends to raise financing for the company’s Final Examinations – Winter 2010
expansion project but is concerned about the impact of proposed additional financing on the
company’s existing capital structure and values. A.1 (a) Synergistic effects can arise from five sources:
The management is aware that there is an inverse relationship between interest cover and cost of
long term debt and the following relationship exist between interest cover and cost of debt: (i) Operating economies, which result from economies of scale in management, marketing,
production, or distribution.
Interest cover (times) >8 6 to 8 4 to 6 2 to 4 (ii) Financial economies, including lower interest costs etc.
Cost of long term debt 8% 9% 11% 13% (iii) Tax effects, where the combined enterprise pays less in taxes than the separate firms
would pay.
The management has found that the following two debt equity ratios are usually prevalent in the (iv) Differential efficiency, which implies that management of one firm is more efficient and
industry and are also acceptable to the company’s banker. that the weaker firm’s assets will be more productive after the merger.
(v) Increased market power, due to reduced competition.
(i) 70% equity, 30% debt by market values
(ii) 50% equity, 50% debt by market values (b) (i) The number of shares in Platinum Limited offered to shareholders of Diamond Limited are:
No. of shares to be issued to DL (7/6 x 19.2) = 22.4 million shares
The latest audited financial statements depict the following position:
Existing earnings per share of PL (Rs. 231m / 90m) = Rs. 2.57
Rs. in million Value of shares in PL (Rs. 2.57 x 15) = Rs. 38.55
Net profit before tax 272 Total value of bid (22.4 million shares x Rs. 38.55) = Rs. 863.52 million
Depreciation 50
Interest @ 9% 55 (ii) EPS of PL following a successful acquisition: Rs. in million
Capital expenditure 150 Earnings of PL before acquisition 231.00
Earnings of DL before acquisition 58.00
Market value of existing equity and debt is Rs. 825 million and Rs. 550 million respectively. CIL’s Post takeover synergy 24.00
equity beta is 1.25 and its debt beta may be assumed to be zero. The risk-free rate of return and 313.00
market return are 7% and 15% respectively. Applicable tax rate is 35%.
Shares in issue following acquisition (90+22.4) (in million) 112.40
Assume that:
CIL’s cash flow growth rate would remain constant and would not be affected by any change in capital EPS after acquisition (Rs. 313m / 112.4m) = Rs. 2.78
structure. Share price after acquisition (Rs. 2.78 x 18) 50.04
Market value of the company at the existing weighted average cost of capital, after the proposed
expansion, would remain the same. (iii) Cost of each debenture
Rupees
Required: EPS of DL before acquisition (Rs. 58 ÷ 19.2) 3.02
(a) Calculate the following under the current as well as each of the above debt equity ratios being Value of a share in DL (Rs. 3.02 x 19) 57.38
considered by the company: Value of 2 shares of DL (2 X 57.38) 114.76
(i) Weighted average cost of capital Present Value of 3 redeemable debentures of Rs. 100 each (W-1) 130.17
(ii) Value of the company
Since the present value of debentures is greater than the current market price of DL
(b) Compare the three options and give recommendations in respect thereof to the company. shares, the offer is expected to be worth considering by shareholders of DL. In case
(23 marks) these debentures are marketable, there will be high chance that it will satisfy those
shareholders too who are interested in equity instrument. Such shareholders will be
(THE END) able to swap debentures with PL’s shares in market.
W-1
Redeemable value 8 year discounting
(Rs.) factor at 11% PV
Present Value of 3 debentures
of Rs. 100 each 300 0.4339 130.17
Page 1 of 7
A.2 (a) Net receipt due at the end of first quarter Gain on hedging through interest rate futures 18,750
US $ (ii) If interest rates rise by 1% and March Futures price decreases by 1%, the net hedging
Receipt due 1,020,000 position of the interest rate future would be as follows:
Payment due (775,000) MYR
245,000
(i) Net receipt under forward contract Future outcome 15,000,000 x 6/12 x 1% (75,000)
= 245,000 x (MYR 3.03 – MYR 0.071) Receipt in spot market (MYR 1,500,000 x 7% x 6/12) 525,000
= 245,000 x 2.959 Net outcome 450,000
= 724,955 Target outcome 450,000
(ii) Net receipt under money market hedge No gain or loss (100% efficient) -
245,000 245,000
= = 240,668
Borrowed in US $ =  7.2%  1.018
1+   A.3 (a) Projects
 4 
A B C D
Received now in MYR = 240,668 x 3.03 = MYR 729,224 Required rate of return (W-1) 14.12% 13.84% 16.16% 15.84%
Received in 3 months time = 729,224 (1+(6.6%/4) = MYR 741,256 Expected return 16% 14% 17% 15%
Decision Invest Invest Invest Not to invest
Net payment due at the end of second quarter
US $ Excess return index (Expected /Required return) 1.13 1.01 1.05
Receipt due 1,224,000 Preference 1 3 2
Payment due (1,347,000)
(123,000) W-1: Required rate of return
(i) Net payment under forward contract Risk free rate of return (R f ) 10% 10% 10% 10%
= 123,000 x (MYR 3.11 – MYR 0.164) Market return (R m ) 14% 14% 14% 14%
= 123,000 x 2.946 β (W-2) 1.03 0.96 1.54 1.46
= 362,358 Required rate of return Rf + (R m - R f )β 14.12% 13.84% 16.16% 15.84%
(ii) Net payment under money market hedge W-2: Computation of β
123,000 123,000 Estimated correlation of returns with market
= = 119,534 return a 0.82 0.85 0.91 0.78
Lent in US $ =  5.8%  1.02900
1+   Project standard deviation of returns b 20% 18% 27% 30%
 2  Market Standard Deviation c 16% 16% 16% 16%
β (a x b ÷ c) 1.03 0.96 1.54 1.46
Paid now in MYR = 119,534 x 3.11 = 371,751
  7.9%   (b) Combined portfolio beta

Paid in 6 months time = 371,751 x 1 +    = 386,435 Project PV β Weighted β
  2  A 197.20 1.03 0.34
Conclusion: B 202.71 0.96 0.32
 For the first quarter, SL would be better off with money market hedge as it would receive
C 201.60 1.54 0.52
more MYR than with a forward contract.
601.51 1.18
 For the second quarter, forward exchange contract produces a lower net payment in
MYR.
Net annual cash flows (Rs. in millions) 85.00 87.00 90.00
*Cumulative discount factor at required rate of
(b) SL wishes to lend and so will buy 5 (MYR 15,000,000 / MYR 3,000,000) interest rate return 2.32 2.33 2.24
February Futures. Present value of cash flows (Rs. in millions) 197.20 202.71 201.60
(i) If interest rates fall by 0.75% and March Futures price increases by 1%, the net hedging
position of the interest rate future would be as follows: 1 − (1 + i) − n
*
MYR i
Future outcome MYR 15,000,000 x 6/12 x 1% 75,000
Receipt in spot market (MYR 15,000,000 x 5.25% x 6/12) 393,750
Net outcome 468,750
Target outcome (6% x 6/12 x MYR 15,000,000). 450,000
A.4 Years 0 1 2 3 4 5
Evaluation of investment in Bangladesh Years 0 1 2 3 4 5
----------- BDT in million ---------- W-3: Tax depreciation (BDT in million)
Total contribution (W-1) 490.05 718.74 790.62 869.68 Opening balance 30.00 239.00 191.20 152.96 122.37
Less: Fixed overhead (Expense x Inflation %) (423.50) (465.85) (512.44) (563.68)
Operating cash flows 66.55 252.89 278.18 306.00
Machinery - 126.50
Tax at 35% (23.29) (88.51) (97.36) (107.10) Building 30.00 82.50
Tax savings on depreciation (W-3) 16.73 13.38 10.71 8.56 30.00 239.00 239.00 191.20 152.96 122.37
Land (80.00) Less: 20% depreciation allowance 47.80 38.24 30.59 24.47
Building (30.00) (82.50) 30.00 239.00 191.20 152.96 122.37 97.90
Plant and machinery (126.50)
Working capital (W-4) (22.00) (111.10) (13.31) (14.64) (16.11) Tax saved at the rate of 35% 16.73 13.38 10.71 8.56
After tax realizable value (W-7) 322.16
Net cash flow (110.00) (231.00) (51.11) 164.45 176.89 513.48 W-4 : Working capital
Exchange rate BDT / PKR (W-2) 0.8400 0.8250 0.8103 0.7958 0.7816 0.7676 Bangladesh ----- BDT in million -----
Net cash flow (PKR in million) (130.95) (280.00) (63.68) 206.65 226.32 668.94 Working capital × inflation factor 22.00 133.10 146.41 161.05 177.16
Discount factor (@ 15.12%)
(PKR in million) (W-5) 1.00 0.87 0.75 0.66 0.57 0.49 Increase in working capital 22.00 111.10 13.31 14.64 16.11
Present value (PKR in million) (130.95) (243.22) (47.76) 136.39 129.00 327.78 Sri Lanka ----- LKR in million -----
Net present value (PKR in million) 171.24 Working capital × inflation factor 36.00 38.88 41.99 45.35 48.98 52.90
Increase in working capital 36 2.88 3.11 3.36 3.63 3.92
Evaluation of investment in Sri Lanka
---------------------------------- LKR in million -------------------------------- W-5: WACC as discount factor
Pre-tax cash flow
(annual increase by 8% from year 0) 29.16 40.82 44.09 47.62 51.43
Cost of equity 0.70 x 18% = 12.60%
Tax @ 25% (7.29) (10.21) (11.02) (11.91) (12.86) Cost of debt 0.30 x 12% x 70% = 2.52%
Cost of acquisition (90.00) WACC 15.12%
Plant and machinery (18.00)
Working capital (W-4) (36.00) (2.88) (3.11) (3.36) (3.63) (3.92) W-6 : Additional tax for income from Sri Lanka
After tax net realizable value 167.9 Tax rate applicable in Pakistan is 5% higher than Sri Lanka. So income from Sri Lanka will be
Net cash flow (144.00) 18.99 27.50 29.71 32.08 202.55
Exchange rate LKR / PKR (W-2) 1.3250 1.2777 1.2320 1.1880 1.1456 1.1047
subject to 5% additional tax.
Net cash flow from SISL in (PKR in million) (108.68) 14.86 22.32 25.01 28.00 183.35
Additional tax @ 5% (W-6) (PKR in million) - (1.14) (1.66) (1.85) (2.07) (2.34) ----- LKR in million -----
Net cash flow (PKR in million) (108.68) 13.72 20.66 23.16 25.93 181.01 Pre-tax cash flow in LKR (as above) - 29.16 40.82 44.09 47.62 51.43
Discount factor (@ 15.12)(W-5)(PKR in Exchange rate (W-2) 1.33 1.28 1.23 1.19 1.15 1.10
million) 1.00 0.87 0.75 0.66 0.57 0.49
Present value (PKR in million) (108.68) 11.94 15.49 15.29 14.78 88.70 Pre-tax cash flow in PKR - 22.78 33.19 37.05 41.41 46.75
Net present value (PKR in million) 37.52 Additional Tax in Pakistan @ 5% 1.14 1.66 1.85 2.07 2.34
W-1: Contribution margin – Bangladesh W-7: After tax realizable value

Sales price 300,000 Bangladesh Sri Lanka
Less: Variable costs (165,000)
(BDT) (LKR)
Contribution margin per unit (BDT) 135,000 - 163,350 179,685 197,654 217,419 After tax realizable value of investment 145.00 115.00
Production / sales units 3,000 4,000 4,000 4,000 Realization of working capital 177.16 52.90
Total contribution (BDT in million) 490.05 718.74 790.62 869.68 322.16 167.90
Conclusion:
W-2: Computation of exchange rates for the next 5 years Gold Limited should invest in Bangladesh as it gives higher NPV.
BDT / PKR 0.8400 0.8250 0.8103 0.7958 0.7816 0.7676
LKR / PKR 1.3250 1.2777 1.2320 1.1880 1.1456 1.1047
Average mid market exchange rate BDT / PKR

Year 0: 0.8300 + 0.8500 = 1.680 ÷ 2 = 0.8400
Year 1-5: Previous year x 1.10/1.12
Average mid market exchange rate LKR / PKR

Year 0: 1.3100 + 1.3400 = 2.650 ÷ 2 = 1.3250
Year 1-5: Previous year x 1.08 / 1.12
A.5 (a) (i) Weighted average cost of capital W-3 : Cost of debt
 Existing WACC = (Equity % (W-1) x K e (W-2)) + (Debt % (W-1) x K d (1-t))  At 70% equity 30% debt
= (60% x 17%(W-2) ) + (40% x 9% x 65%) = 12.54% Since interest cover has an inverse relationship, we assume decline in debt moves the CIL
to lower category of interest rate:
 70% equity 30% debt 30% debt in existing market value of the company (30% x 1375) = 412.5
WACC = (70% x 15.9% (W-2)) + (30% x 8% (W-3) x 65%) = 12.70% Cost of debt = (8% x 412.5) = 33
Interest cover = (327* ÷ 33) = 9.91
 50% equity 50% debt ∴K d = 8%
WACC = (50% x 18.5% (W-2)) + (50% x 11% (W-3) x 65%) = 12.83% * Profit before interest and tax
(ii) Value of the company  At 50% equity 50% debt

 Current value of the company (825+550) = Rs. 1.375 million Since interest cover has an inverse relationship, we assume increase in debt moves the
CIL to upper category of interest rate:
 Value of the company at 70% equity 30% debt 50% debt in existing market value of the company (50% x 1375) = 687.5
WACC (Computed above) = 12.70% Cost of debt is = (11% x 687.5) = 75.63
112.55 x 1.0403 Interest cover = (327 ÷ 75.63) = 4.32
Valuation = = 1350 million K d = 11%
0.1270 − 0.0403(W − 5) W-4: Current Free cash flow (FCF o ) Rs. in million
Profit before tax 272.00
 Value of the company at 50% equity 50% debt Add: Interest 55.00
WACC (Computed above) = 12.83% Profit before tax and interest 327.00
112.55 x 1.0403 Less: Income tax @ 35% 114.45
Valuation = = 1330 million
0.1283 − 0.0403( W − 5) Profit after tax 212.55
Add: Depreciation 50.00
W-1: Existing debt equity ratio Less: Capital expenditures (150.00)
Equity =
825
= 60% Free cash flow 112.55
1375
550 W-5 Computation of growth factor
Debt = = 40%
1375 FCF1
Current valuation = 1375 =
(k - g)
W-2: Cost of equity FCF1 112.55(1 + g )
 Existing 1375 = ⇒ 1375 =
K e = r f + (r m - r f )β (k - g) 0.1254 − g
K e = 7% + (15% - 7%) x 1.25 = 17%
1375 (0.1254 g) = 112.55 (1 + g) ⇒ 59.88 = 1488γ ⇒ γ = 4.03%
 At 70% equity 30% debt
K e = 7% + (15% - 7%) x 1.115 = 15.9% (b) Evaluation of the above options
(i) The existing debt equity structure gives the lowest WACC i.e. 12.54%.
E + D(1 - t) 70% + 30% x 65% (ii) If debt equity ratio is decreased, some of the benefits of tax shield on debt are lost.
βe = βa = * 0.872 = 1.115
E 70% (iii) If debt equity ratio is increased, the financial risks cause an increase in the cost of debt.
 At 50% equity 50% debt Since the existing debt equity ratio gives the lowest WACC and resultantly the highest
K e = 7% + (15% - 7%) x 1.439 = 18.5% valuation to the company, the capital structure of the company should not be changed.
E + D(1 - t) 50% + 50% x 65%
βe = βa = * 0.872 = 1.439 (THE END)
E 50%
* E D(1 − t)
βa = βe + βd
E + D(1 − t) E + D(1 − t)
825
= 1.25 + 0 = 0.872
825 + 550 x 65%
Q.2 The Trustees of FR Co-operative Housing Society are planning to invest its surplus funds in
The Institute of Chartered Accountants of Pakistan different open end mutual funds. Details of proposed investments along with market information
gathered from a stock analyst are as follows:
Business Finance Decisions Mutual Funds

A B C
Final Examinations June 8, 2011  Information on proposed investment
Module F – Summer 2011
Reading time – 15 minutes 100 marks – 3 hours Date of investment 1-Jul-11 1-Aug-11 1-Sep-11
Amount of investment Rs. 500,000 Rs.1,000,000 Rs. 500,000
Estimated net asset value on acquisition Rs. 10.50 Rs. 10.00 Rs. 9.70
Q.1 (a) GER Auto Parts Limited is engaged in the manufacture of automobile spare parts. GER’s Estimated net asset value as on December 31, 2011 Rs. 10.40 Rs. 10.00 Rs. 9.90
summarised financial statements for the year ended December 31, 2010 are as follows:
 Expected dividends
Balance Sheet (during the investment holding period)
Equity and Liabilities Rupees Assets Rupees Cash dividend to be received Rs. 9,500 Rs. 15,000 -
Share capital (Rs. 10 each) 1,250,000 Fixed assets 7,500,000 Bonus to be received 10% 5% 5%
Reserves 5,250,000 Inventory 750,000
Long term debt 2,500,000 Receivables 875,000  Funds characteristics
Current liabilities 625,000 Cash 500,000 Front end load (Buying load) 3.00% 2.00% 1.50%
9,625,000 9,625,000 Back end load (Selling load) 1.00% 0.00% 2.00%
Sharpe ratio 0.71 0.31 0.16
Income Statement Correlation with benchmark indices 0.75 0.92 0.83
Rupees
Sales of 12,500 units 11,718,750  Expected performance of benchmark indices
Variable costs (7,812,500) Benchmark index KSE 100 KSE 30 KMI 30
Fixed costs (1,750,000) Total annual return % 16 17 12
Interest expense (10%) (250,000) Standard deviation of annual returns 0.10 0.18 0.13
Profit before tax 1,906,250
Tax (35%) (667,188) The yield on 1-year treasury bills is 9%.
Net profit 1,239,062
Required:
Owing to competitive pressures, GER plans to reduce the prices of existing products by 6%. (a) Estimate the effective annual yield which FR would earn, from the date of investment up to
However, variable and fixed costs (excluding interest) are expected to increase by 5% and 10% December 31, 2011.
respectively. Interest rate is floating and is expected to increase to 10.6% per annum. (b) In respect of each fund, evaluate whether it would achieve the return in accordance with its
risk profile. (15 marks)
Required:
Calculate the amount of sales that GER should achieve in the following year to enable it to
maintain its existing total leverage. Show how this change would affect the operating and Q.3 In order to reduce the cost of electricity consumption, HIN Textile Mills Limited has decided to
financial leverages. (07 marks) install a gas generator and discontinue the power supply being obtained from a utility company.
The gas generator which would meet their requirements would cost Rs. 80 million. The following
(b) GER’s management is also considering to launch a new product. Based on market research, it two proposals are being considered by HIN:
has identified the following options:
Option 1 Option 2 Option 1: Offer from BAL Leasing Company Limited
Product X Product Y BAL has offered a three year lease at a quarterly rent of Rs. 7.46 million payable in arrears. In
Investment required (Rs.) 3,000,000 7,000,000 addition, HIN would be required to pay a security deposit of Rs. 10 million at the time of signing
Unit price (Rs.) 15,000 5,000 the lease agreement. Generator will be transferred to HIN at the end of the lease term, against the
Fixed cost (Rs.) 200,000 300,000 security deposit.
Expected sales (units) 200 1,000
The fair value of the generator, at the end of lease period is estimated at Rs. 20 million.
Variable costs (% of sales) 78% 73%
The management plans to invest in any one of these options. The investment would be Operating and maintenance costs of the generator are estimated as follows:
financed through long term debt which is available at 12% per annum.
Costs Frequency Rs. in million
Required: Staff salary Monthly 0.50
Calculate the impact of each of the above options on GER’s operating and financial leverages Lubricants and filters Quarterly 1.00
for the year ending December 31, 2011. Which option would you recommend and why? (You
Parts replacement Half yearly 3.00
may assume that implementation of the above options would have no impact on the sales of existing
Overhaul At the end of 2nd year 15.00
products as computed in (a) above). (08 marks)
Option 2 : Offer from PUS Rental Services Q.5 ARA Venture Capital Limited specialises in acquiring loss making companies and converting them
PUS has also offered to sign a three year contract according to which HIN would pay quarterly into profitable entities with the objective of disposing them subsequently.
rent of Rs. 11 million in arrears, with a 10% increase in each subsequent year. The lease rental
would include the cost of maintenance and overhauling of the generator, which will be borne by Presently, ARA is planning to acquire 60% shareholdings in PUN Electric Supply Company. Its
PUS. Financial Analyst has obtained the following information about PUN’s operations:
It may be assumed that HIN’s cost of capital is equal to the IRR offered by BAL. (i) During the year ended December 31, 2010, total electricity demand and supply was Mwh 2.0
million, whereas the cumulative generation capacity of all the existing plants was Mwh 2.1
Required: million. The demand for electricity is expected to grow at the rate of 5% per annum.
Evaluate which of the above proposals should be accepted by HIN. (Ignore taxation) (12 marks) (ii) Cost of power generation per Kwh is Rs. 7 which is expected to increase by 8% per annum.
(iii) PUN’s line losses for the year were 30%.
(iv) The Power Tariff Regulatory Authority has allowed PUN to determine the tariff so as to sell
Q.4 The management of JAP Recreation Club is evaluating the option to launch a restaurant that electricity at a margin of 10% above the average cost of generation. PUN is allowed to
would serve complete meal to its members. Presently, it has a snack bar shop which sells snacks include line losses of up to 20% in the cost of generation. The price per unit is determined by
and drinks only. the following formula:
A management consultant firm was hired at a fee of Rs. 85,000 to prepare the feasibility of the (Total Cost + 10%) ÷ {Number of units produced × (1 – Permissible line losses %)}
project. JAP’s Accountant has extracted the following information from the consultant’s report: where, one unit = 1 Kwh and 1 Mwh = 1,000 Kwh
(i) The restaurant will be launched on the first day of the next year. (v) Revenue collection ratio for the year 2010 was 90% of the aggregate billing.
(ii) The club membership has been increasing at the rate of 5% per annum. As a result of this (vi) Other expenses, excluding depreciation and financial charges for 2010 amounted to Rs. 300
facility, it is expected that the rate would increase to 10% per annum. million and are expected to increase by 8% per annum.
(vii) Depreciation is charged on straight line method over the useful life of 20 years. Depreciation
(iii) The cost of equipment for the restaurant is estimated at Rs. 7,000,000. It would have a for the year 2010 amounted to Rs. 75 million.
residual value of Rs. 510,000 at the end of its estimated useful life of four years. (viii) PUN has running finance facilities of Rs. 3,000 million from various banks at an average
(iv) It is estimated that during the first year, an average of 100 customers would visit the mark-up of 13% per annum. The facilities utilized as of December 31, 2010 amounted to Rs.
restaurant, per day. The number would increase in line with the increase in membership. The 2,785 million.
average revenue from each customer is estimated at Rs. 400 whereas variable costs per (ix) In order to meet the future requirements of electricity, PUN’s management has already
customer would be Rs. 260. started work on a new generation plant that will be commissioned into operation by the end
of 2012 and will increase the present capacity by 15%. Total cost of the new project will be
(v) Four employees would be appointed in the first year at an average salary of Rs. 200,000 per
Rs. 1,500 million and PUN had issued TFCs on January 1, 2011 at 14% per annum, to
annum. A fifth employee would be hired from the third year.
finance the project.
(vi) The annual fixed overheads for the current year are estimated at Rs. 4.8 million. 15% of the (x) The issued share capital of PUN as at December 31, 2010 consisted of 500 million shares of
fixed overheads are allocated to the snack bar. As a result of the establishment of the Rs. 10 each.
restaurant the annual expenditure would increase as follows:
ARA intends to invest in PUN’s infrastructure facilities to reduce line losses. It also plans to
Rupees broaden the Recovery Department with the objective of improving the recovery ratio. The
Electricity and gas 340,000 projected figures for the next five years are as follows:
Advertising 170,000
Repair and maintenance 85,000 Year ending December 31 2011 2012 2013 2014 2015
Capital expenditures (Rs. in million) 500 600 500 - -
After the establishment of restaurant, 20% of the overheads would be allocated to the Additional staff cost in recovery
restaurant whereas allocation to snack bar would reduce to 10%. department (Rs. in million) 15 17 18 20 22
(vii) The snack bar is presently serving an average of 250 customers per day and the number is Line losses 28% 25% 22% 20% 18%
increasing in proportion to the number of members. If the restaurant is launched, the number Recovery ratios 92% 94% 96% 97% 97%
of customers would reduce by 40% in the first year but would continue to increase in
subsequent years in line with the member base. The average contribution margin from snack The planned capital expenditures would be incurred at the end of the year. ARA would provide a
bar is Rs. 50 per customer. loan to PUN to finance the capital expenditures. The loan will be disbursed as required and carry a
mark up of 10% per annum. It would be repayable on December 31, 2015.
(viii) The tax rate applicable to the company is 35% and it is required to pay advance tax in four
equal quarterly instalments. JAP can claim tax depreciation at 25% under the reducing In addition, ARA would provide guarantees to different banks to secure additional running finance
balance method. Any taxable losses arising from this investment can be set off against profits facilities for PUN amounting to Rs. 8,000 million, at a mark up of 13% per annum.
of other business activities.
(ix) JAP’s post tax cost of capital is 17% per annum before adjustment for inflation. The rate of ARA requires an IRR of 20% from its investment and expects to exit from this venture by selling its
inflation is 10%. shareholdings at the P/E multiple of 16.
Required:
Required:
Determine the purchase consideration that ARA should be willing to pay for the acquisition of 60%
Advise whether JAP should invest in the project. Assume that each year has 360 days. (16 marks)
shares in PUN. (Ignore taxation) (25 marks)
Suggested Answers
Q.6 URD Pakistan Limited, a listed company, is presently considering to acquire 100% shareholdings Final Examinations – Summer 2011
of CHI Limited, an unlisted company, which is engaged in the same business.
A.1 (a) Computation of existing operating, financial and total leverage
The following information has been extracted from the latest audited financial statements of the
two companies:
Contribution margin 11,718,750 − 7,812,500
Total leverage = = = 2.05
URD CHI Income before tax 1,906,250
----------Rs. in million----------
Non-current liabilities – Term Finance Certificates 1,500 - Determination of sales value where total leverage remains intact
Share capital (Rs. 10 each) 400 200 Contribution margin
Combined leverage =
Retained earnings 100 100 Income before tax
Net profit after tax 300 250
Contribution margin% x Sales
Tax rate applicable to both the companies is 35%. 2.05 =
(Contribution margin% x Sales) - (Fixed cost + Interest Expense)
The directors of URD believe that a cash offer for the shares of CHI would have the best chance of
success. They are considering various options to finance this acquisition. The initial negotiations (sales x 937.5x94%) - (salesx625x105%)
suggest that interest rate on debt financing would depend upon the debt equity ratio of the 2.05 =
company as shown below: (salesx937.5x94%) - ( salesx625x105%) - (Rs.1,750,000x110% + Rs.2,500,000x10.6%
Debt equity ratio (up to) 40:60 50:50 60:40 70:30

Interest rate 16% 17% 18% 20% 461.25 sales - 4,489,500 = 225 Sales
The shares of URD are currently traded at Rs. 52.50. According to the prevailing practice in the 4,489,500
market, price earning ratios of unlisted companies are 10% less than those of listed companies. Sales = = 19,003 units
236.25
Required:
Write a report to the Board of Directors, on behalf of Mr. Shah Rukh, the Chief Financial Officer Sales amount= 19,003x937.5x94% = 16,746,397 (rounded off)
of the company, discussing the following:
(a) Which of the following financing option should the company adopt? Effect on Operating and Financial Leverage
(i) The acquisition of CHI Limited is entirely financed by debt.
(ii) The acquisition is financed by issue of debt and equity in the ratio of 60:40. The equity Existing Revised
is to be generated by the issue of right shares at Rs. 45 per share. 11,718,750 − 7,812,500 4,275,675 (W - 1)
* Operating leverage = = 1.81 = 1.82
(b) What other matters should be considered and what impact these may have on the decision 1,906,250 + 250,000 2,350,675 (W - 1)
arrived in (a) above? (17 marks)
1,906,250 + 250,000 2,350,675 (W - 1)
** Financial leverage = = 1.13 = 1.13
(THE END) 1,906,250 2,085,675 (W - 1)
*Operating leverage = contribution margins ÷ income before interest and tax
**Financial leverage = income before interest and tax ÷ income before tax
W-1: Forecasted Income Statement for the year ending December 31, 2011
Rs. %
Sales 16,746,394 100
Variable costs (19,103 units x Rs. 625 x 105%) (12,470,719) 74
Contribution margin 4,275,675 26
Fixed costs (Rs. 1,750,000 x 110%) (1,925,000)
Income before interest and tax 2,350,675
Interest expense (Rs. 2,500,000 x 10.6%) (265,000)
Income before tax 2,085,675
Page 1 of 8
(b) Comment on the behaviour of operating and financial leverages ratio in relation to launching (b) Evaluation of each investment
of either Product X or Product Y A B C
Required rate of return (W-1) 12.15% 11.08% 10.92%
Forecasted Income Statement Effective annual yield (Computed in (a) above) 13.19% 10.66% 10.58%
Existing Existing Existing Over Under Under
Product X Product Y Decision
Operations operation + X operation + Y performed performed performed
A B A+B C A+C
-----------------------------------Rupees-----------------------------------
Sales 3,000,000 5,000,000 Calculation of required rate of return A B C
Variable Cost (2,340,000) (3,650,000) Rm 16% 17% 12%
Contribution margin 4,275,675 660,000 *4,935,675 1,350,000 *5,675,675 Sharpe Ratio 0.71 0.31 0.16
Fixed Cost (200,000) (300,000) Rp (effective annual yield, computed above) 13.19% 10.66% 10.58%
Income before interest & tax 2,350,675 460,000 *2,810,675 1,050,000 *3,450,675
Interest expense (360,000) (840,000)
Rf 9% 9% 9%
Income before tax 2,085,675 100,000 *2,185,675 210,000 *2,345,675 Investment SD=[(Rp - Rf)÷Sharpe Ratio] 0.06 0.05 0.10
Correlation with Index 0.75 0.92 0.83
Operating leverage Market SD 0.10 0.18 0.13
Existing (See (a)) 1.83 β = Inv. SD × Corr. with index ÷ Market SD 0.45 0.26 0.64
4,935,675 ÷ 2,810,675 1.76 Required Return=Rf + β (Rm - Rf) 12.15% 11.08% 10.92%
5,675,675 ÷ 3,450,675 1.64
Financial Leverage A.3 Proposal of BAL Leasing Company Limited

Total no. of Discount
Existing (See (a)) 1.13 Amount Interest rate PV
payments factor
2,810,675 ÷ 2,185,675 1.29 Cash flow (Rs. in Frequency /period (Rs. in
(Rs. in (annuity
million) (W-1) million)
3,450,675 ÷ 2,345,675 1.47 million) factor)
Security deposit 10.00 1.000 10
Comment: Lease rentals 7.46 Quarterly 12 4.00% *9.385 *70
(i) Operating leverage is declining under each of the two options, which is a favourable Lubricants and filters 1.00 Quarterly 12 4.00% *9.385 *9
condition. Parts replacement 3.00 half yearly 6 8.00% *4.623 *14
(ii) Financial leverage would be considerably high, in case the company opts for launching Staff cost 0.50 monthly 36 1.33% *28.460 *14
product Y, although it is also accompanied by a substantial higher profit. Overhaul 15.00 End of 2nd year 0.731 11
(iii) If GER is willing to accept the higher risk as referred to in (ii) above, it would prefer to Residual value (20.00) End of 3rd year 0.625 (13)
launch Product Y. Otherwise, it would opt to launch Product X. Total present value 115
Proposal of PUS Rental Services

A.2 (a) Computing the effective annual yield
Quarter 1 2 3 4 5 6 7 8 9 10 11 12 Total
A B C
Quarterly
Investment a 500,000 1,000,000 500,000 rental
Public Offer Price per unit (NAV at (Rs. in m) 11.0 11.0 11.0 11.0 12.1 12.1 12.1 12.1 13.31 13.31 13.31 13.31
acquisition × (1 + Buy Load) b 10.82 10.20 9.85 Discount
factor
(W-1) 4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625
No of units acquired c=a÷b 46,210.72 98,039.22 50,761.42 Present
Bonus units received (10%, 5%, 5%) d 4,621.07 4,901.76 2,538.07 value
(Rs. in m) 10.58 10.18 9.78 9.41 9.95 9.56 9.20 8.85 9.36 9.00 8.65 8.32 112.84
Total units at year end e=c+d 50,831.79 102,940.98 53,299.49
Redemption value per unit (NAV at 31-
Mar-2011 ÷ (1 + Sales Load)) f 10.30 10.00 9.71 Conclusion
PUS’s option is better as it gives lower overall cost in present value terms
Value of investment at year end g= e x f 523,567 1,029,410 517,538 W-1 : Finding the rate offered by BAL
PV of inflow = Present value of outflows (annuity) = R × Annuity Factor (AF)
Increase in NAV h=g-a 23,567 29,410 17,538 Hence, 80 − 10 = 7.46 × AF
Cash dividend received i 9,500 15,000 - AF = 70 ÷ 7.46 = 9.383
Total return j=h+i 33,067 44,410 17,538
No. of days k 183 152 121 IRR is 4% per quarter i.e. the figure corresponding to annuity factor of 9.383 and 12 periods, on the
Effective annual yield (j ÷a)x365÷k 13.19% 10.66% 10.58% annuity table.
Net profit/(loss) 653.90

A.4 2011 2012 2013 2014 2015
-----------------------------------------Rupees----------------------------------------- W-2: Earnings before interest and tax
Initial investment (7,000,000) Year ending Dec'11 Dec'12 Dec'13 Dec'14 Dec'15
Residual value 510,000 --------------------Rupees in million--------------------
1Restaurant contribution 5,040,000 5,544,000 6,098,400 6,708,240 Revenue from sale of energy
2Snack bar contribution – in (Price per unit (W-3) x Rs. 1,000 x Units Sold (W-4) 15,696.45 17,753.46 22,065.35 25,538.78 28,134.45
proposed structure 2,700,000 2,970,000 3,267,000 3,593,700 Cost of generation (W-3) 15,876.00 17,161.00 20,569.20 23,169.20 25,008.40
3Snack bar contribution – in current Other operating & admin exp. (LY × 1.08) (324.00) (349.92) (377.91) (408.14) (440.79)
structure (4,725,000 ) (4,961,250) (5,209,313) (5,469,779) Additional staff costs for recovery dept. (15.00) (17.00) (18.00) (20.00) (22.00)
Salaries (800,000) (800,000) (1,000,000) (1,000,000) Prov. for non recoverability (Sales - Unrecovered %) (1,255.72) (1,065.21) (882.61) (766.16) (844.03)
Additional overheads (595,000) (595,000) (595,000) (595,000) (Loss)/ earnings before interest (1,774.27) (839.67) 217.63 1,175.28 1,819.23
Net cash flows (7,000,000) 1,620,000 2,157,750 2,561,087 3,747,161
Tax payment (W-1) - 45,500 (295,838) (551,849) (456,413)
Net cash flow after tax (7,000,000) 1,665,500 1,861,912 2,009,238 3,290,748 W-3: Determination of price
Demand (million Mwh) (LY Demandx5%) A 2.10 2.21 2.32 2.44 2.56
Discount factor (W-3) 1 0.940 0.884 0.831 0.781 Capacity (million Mwh) B 2.10 2.10 2.42 2.42 2.42
Units produced (million Mwh) (Lower of A or B) C 2.10 2.10 2.32 2.42 2.42
Present value (7,000,000) 1,565,570 1,645,930 1,669,677 2,570,074
Existing cost of generation per Kwh (Re)
Net present value 451,251 (LY × 8%) D 7.56 8.16 8.81 9.51 10.27
1 Rs. 140 × 100 × 360
2 Rs. 50 × 250 × 60% × 360 Existing cost of generation (D × C × 1,000) E 15,876.00 17,136.00 20,439.20 23,014.20 24,853.40
3 250 × 360 × 1.05 × Rs. 50 Depreciation on new plant + Infrastructure F - 25.00 130.00 155.00 155.00
Total costs 15,876.00 17,161.00 20,569.20 23,169.20 25,008.40
Conclusion:
The company should invest in the project as it would generate higher net cash flows as compare to Price = 110% of cost ÷ #of units produced ÷ 0.8 10.40 11.24 12.19 13.16 14.21
existing business.
W-4: Determination of units sold
W-1: Tax payments Line losses 28% 25% 22% 20% 18%
2012 2013 2014 2015 Units sold (million Mwh) (C × (1 – line losses) 1.51 1.58 1.81 1.94 1.98
---------------------------------Rupees---------------------------------
Net cash flows 1,620,000 2,157,750 2,561,087 3,747,161 W-5: Mark up on running finance
Less: Depreciation for the year (W-2) (1,750,000) (1,312,500) (984,375) (2,443,125) Opening balance of running finance 2,785.00 5,304.53 7,123.75 7,933.87 7,795.41
Taxable profit 4,595,000 5,806,500 6,786,025 6,773,815 Loss / (earnings) before interest and tax (W-2) 1,774.27 839.67 (217.63 ) (1,175.28 ) (1,819.23 )
Tax payments (Taxable profit x 35%) (45,500) 295,838 551,849 456,413 Mark up on TFCs (Rs. 1,500m x 50% x 14%) 210.00 210.00 210.00 210.00 210.00
Mark up on loan from ARA (@10%) - 50.00 110.00 160.00 160.00
Depreciation (Rs. 75 million + F) (75.00) (100.00) (205.00) (230.00) (230.00)
W-2 : Depreciation for the year
Opening WDV of equipment 7,000,000 5,250,000 3,937,500 2,953,125 4,694.27 6,304.20 7,021.12 6,898.59 6,116.18
Less: Depreciation for the year (WDV x 25%) (1,750,000) (1,312,500) (984,375) *(2,443,125) Mark up on running finance (13%) 610.26 819.55 912.75 896.82 795.10
Closing WDV of equipment 5,250,000 3,937,500 2,953,125 510,000 Closing balance of running finance 5,304.53 7,123.75 7,933.87 7,795.41 6,911.28
* Loss on disposal
W-3: Adjustment of inflation in cost of capital

Real discount rate = ((1+nominal discount rate)/(1+inflation rate))-1
= 6.36%
A.5 Year ending Dec'11 Dec'12 Dec'13 Dec'14 Dec'15

Determination of value/bid price ---------------------Rupees in million---------------------
Loan to be given (500) (600) (500) - -
Interest on loan (@10%) 50 110 160 160
Loan amount recovered 1,600
Terminal value (Rs. 653.90m (W-1) × 16×60%) 6,277
(500) (550) (390) 160 8,037
Discount factor (@20%) 0.833 0.694 0.578 0.482 0.402

Present value of annual cash flows (416.50) (381.70) (225.42) 77.12 3,230.87
Net present value (Purchase consideration) 2,284.37
W-1: Determination of net profit and loss for year 2015

Earnings before interest, tax and depreciation (W-2) 1,819.23
Financial charges (W-5) (1,165.10)
audited accounts show a true and fair view, it is not necessary that CHI would be in a position to
repeat the performance in future years. It is therefore recommended that URD should carry out a
A.6 To : The Management proper due diligence exercise before making a final decision.
From : Chief Financial Officer ANNEXURE TO THE REPORT
Date : June 8, 2011
Subject : Report on selection of financing option W-1: Debt equity ratio after acquisition
Existing (Without Option 1 (acquisition Option 2 (acquisition thru
In response to your advice to explore the financing options for the acquisition of 100 % shareholding in acquisition) thru 100% debt) 60% debt and 40% equity)
CHI Limited, we have carried out an analysis to determine the debt equity ratio and price of our shares Debt (Rs. in million) 1,500 *13,075 *22,445
after the acquisition under the following options: Equity (Rs. in million) (W-2) 2,100 2,100 *32,730
Debt equity ratio 42 : 58 59 : 41 47 : 53
 Where the acquisition is financed through debt only *1 1,500 + 1,575 (W-2)
 Where the acquisition is financed by debt and equity in the ratio of 60:40. *2 1,500 + 1,575 (W-2) x 60% = 2,445
*3 2,100 + 1,575 (W-2) x 40% = 2,730
Analysis of financing options

W-2: Value of URD and CHI Rs. in million
The following calculations suggest that both the options are feasible to the company as the acquisition of URD CHI
CHI Limited would result in increase in the shareholders wealth as shown below. Net profit after tax 300.00 250.00
Number of shares outstanding (Rs. 400m ÷ Rs. 10) 40.00
Option 1 Option 2 Earnings per share (300 ÷ 40) 7.50
Existing
Working (acquisition (acquisition thru P/E ratio (Rs. 52.5m/Rs. 7.5) 7.00 x 90% 6.30
(Without
note thru 100% 60% debt and 40% Value of the company 2,100.00 1,575.00
acquisition)
debt) equity)
Debt equity ratio after acquisition W-1 42 : 58 59 : 41 47 : 53 W-3: Post acquisition price under each option
Per share price (Rs.) W-3 52.50 64.00 57.75 If the acquisition is financed by debt only
Increase in shareholders’ wealth because Rs. in million
of acquisition (Rs. in million) W-4 - 460.00 388.50 Net profit after tax-URD 300.00
Net profit after tax-CHI 250.00
The relevant workings are enclosed as annexure. Additional Interest expense (Rs. 1,575m (W-2) x 18% x 65% (184.28)
Revised profit after tax 365.72
Under option 1, the shareholders’ wealth would increase by Rs. 460 million as compared to the projected
position under the existing conditions. However, accepting option 1 would increase the debt equity ratio of Value of URD after acquisition (Rs. 365.72 x 7 (W-2)) 2,560.04
the company.
Post acquisition value per share after (Rs. 2,560.04m ÷ 40m shares) 64.00
If we are willing to accept the higher gearing level, option 1 should be selected. Otherwise, we should opt
for option 2 as in that case there is only a slight increase in debt equity ratio which is more than adequately
If the acquisition is financed by debt and equity in the ratio of 60:40.
compensated by a significant increase in the shareholders’ wealth.
Rs. in million
Net profit after tax-URD 300.00
Other factors to be considered
Net profit after tax-CHI 250.00
Additional interest expense (Rs. 1,575 (W-2) x 60% x 17% (W-4) x 65%) (104.42)
Besides the increase in profitability and shareholders wealth, URD should also consider the following
Revised profit after tax 445.58
aspects:
Stability of cash flows/high risk due to financial leverage Shares in million

A company with stable cash flows can handle more debt because there is constant stream of cash inflows to Existing shares in issue 40.00
cover periodic interest payments. Hence, in case the company is satisfied with the stability of future cash Number of right shares to be issued (Rs. 1,575 (W-2) × 40% ÷ 45) 14.00
flows, it can opt for option 2. Total number of shares to be outstanding after right issue 54.00
Future plans Revised EPS after right issue (Rs. 445.58 million (W-4) ÷ 54m shares) PKR 8.25
The company may have future plans of further expansion. While comparing the option (i) and (ii) the
management should assess that if it plans to obtain further financing in the near future, it may not be Revised market value after right issue (Rs. 8.25 x 7) PKR 57.75
feasible to opt for 100% debt financing at this stage.
W-4: Market Capitalization
Stock market conditions Option 1 Option 2 (acquisition
In case the company decides to go for option 2, it should study the stock market conditions to ensure that it (acquisition thru thru 60% debt and
would be able to generate sufficient interest in the right issue, before making any commitments as regards 100% debt) 40% equity)
investment in the new venture. Market capitalization – Option 1: (40 x 64) 2,560.00
Option 2: (54 x 57.75) 3,118.50
Due Diligence Less: Funds injected by the Shareholders (14 × 45 ) - (630.00)
It seems that URD is relying on the audited accounts for making the above decision. Even if the Less: Existing market capitalization (2,100.00) (2,100.00)
Suggested Answers
The Institute of Chartered Accountants of Pakistan
Increase in shareholders wealth 460.00 388.50
(The End) Business Finance Decisions

Final Examination 7 December 2011
Module F 100 marks – 3 hours
Winter 2011 Additional reading time – 15 minutes
Q.1 (a) Briefly discuss the Dividend Irrelevance Theory developed by Miller and Modigliani (MM).
State three arguments against the validity of this theory. (05 marks)
(b) Al-Ghazali Pakistan Limited (AGPL) is a listed company whose shares are currently traded at
Rs. 80 per share. AGPL’s Board has approved a proposal to invest Rs. 600 million in a project
which is expected to commence on 31 December 2012. There are no internal funds available
for this investment and the company would have to finance the project from the profit for the
year ending 31 December 2012 and through right issue.
AGPL has a share capital consisting of 20 million shares of Rs. 10 each and its profit for the
year ending 31 December 2012 is projected at Rs. 250 million.
The annual return on 1-year treasury bills, the standard deviation of returns on AGPL’s shares
and the estimated correlation of returns with market returns are 7.5%, 8% and 0.8 respectively.
The current market return is 12.9% with a standard deviation of 5%.
Required:
Using MM Theory of Dividend Irrelevance, estimate the price of AGPL’s shares as at 31
December 2012, if the company declares:
(i) 20% dividend
(ii) Nil dividend (05 marks)
(c) Justify the MM Theory of Dividend Irrelevance, based on your computation in (b) above.
(05 marks)
Q.2 The directors of Khayyam Limited (KL) are considering an investment proposal which would need
an immediate cash outflow of Rs. 500 million. The investment proposal is expected to have two
years economic life with salvage value of Rs. 50 million at the end of second year.
KL’s Budget and Planning Department anticipates that Net Cash Inflows After Tax (NCIAT) are
dependent on exchange rate of the US $ and has made the following projections:
Exchange Rate Exchange Rate Exchange Rate
Rs. 84-87 Rs. 88-91 Rs. 92-95
NCIAT Probability NCIAT Probability NCIAT Probability
Year 1 250 65% 320 35% - -
Year 2:
− If Year 1 exchange rate is Rs. 84-87 280 20% 330 65% 360 15%
− If Year 1 exchange rate is Rs. 88-91 340 5% 380 50% 400 45%
All NCIATs are in millions of rupees
KL uses a 14% discount rate for investments having similar risk levels.
Required:
(a) Draw a decision tree to depict the above possibilities. (04 marks)
(b) Determine whether it would be advisable for Khayyam Limited to undertake this project.
(10 marks)
Page 8 of 8
Q.3 Ibn-Seena Limited (ISL) is a reputable unquoted company engaged in the business of Q.4 Khaldun Corporation (KC) is a Pakistan based multinational company and has number of inter-
manufacturing and sale of pharmaceutical products. It is presently considering a proposal to group transactions with its two foreign subsidiaries KA and KB, which are located in USA and UK
acquire Al-Biruni Pharmaceuticals (Private) Limited (APPL) which is a wholly owned subsidiary respectively. Details of receipts and payments which are due after approximately three months are
of Al-Biruni International (ABI). as follows.
Summarised income statements of ISL and APPL for the latest financial year are given below: Receiving Company
Paying
KC (Pak) KA (USA) KB (UK)
ISL APPL Company
------------in million------------
Rs. in million KC (Pak) - Rs. 131 £ 5.10
Sales 2,500 1,800 KA (USA) US $ 1.50 - US $ 4.50
Less: Cost of sales - Variable (1,350) (630) KB (UK) £ 4.00 £ 1.80 -
- Fixed * (150) (190)
Gross profit 1,000 980 The current exchange rates and interest rates are as follows:
Selling expenses (375) (360)
Administration expenses (125) (90) Exchange Rates
Profit before tax 500 530 US $ 1 UK £ 1
Tax (35%) (175) (186) Buy Sell Buy Sell
Profit after tax 325 344 Spot Rs. 86.56 Rs. 86.80 Rs. 134.79 Rs. 135.13
* includes depreciation of Rs. 70 million and 100 million respectively 3 months forward Rs. 87.00 Rs. 87.20 Rs. 135.87 Rs. 136.18
Other Information Interest Rates

(i) APPL’s sales consist of Generic Medicines (40%) and Patented Products (60%). Presently, Borrowing Lending
20% of the revenue from Patented Products is contributed by a product Z-11. All patents are KC (Pak) 10.50% 8.50%
owned by ABI; however, no royalty or technical fee is presently claimed by it. KA (USA) 5.20% 4.40%
KB (UK) 5.90% 5.00%
(ii) The variable costs of Patented Products are 30% of the sales amount. Product Z-11 will
complete its patent period after three years and thereafter its price would have to be reduced. Required:
Consequently, the ratio of variable costs of production to sales would fall in line with that of (a) Calculate the net rupee receipts/payment that KC (Pak) should expect from the above
Generic Medicines. transactions under each of the following alternatives:
Hedging through forward contract
(iii) After acquisition the costs and revenues of APPL are projected as follows: Hedging through money market (08 marks)
Total sales and variable costs would grow at 10% per annum except in Year 4 when the
growth rate of sales would decline on account of reduction in price of product Z-11. (b) Demonstrate how multilateral netting might be of benefit to Khaldun Corporation. (06 marks)
Fixed costs other than depreciation would increase at the rate of 5% per annum. However,
depreciation would remain constant over the next five years.
Selling expenses and administration expenses would be reduced by 30% and 80% Q.5 Ghazali Limited (GL) operates a chain of large retail stores in country X where the functional
respectively. However, from Year 2 onwards, selling expenses would increase at 7% per currency is CX. The company is considering to expand its business by establishing similar retail
annum whereas administration expenses would increase by 5% per annum. stores in country Y where functional currency is CY. As a policy, GL evaluates all investments
ABI will charge 15% royalty on sale of Patented Products whereas 3% technical fee will be using nominal cash flows and a nominal discount rate.
levied on the sales of all products. The required investments and the estimated cash flows are as follows:
(iv) Free cash flows of APPL are expected to grow at 3% per annum after Year 5. (i) Investment in country X
CX 7 million would be required to establish warehouse facilities which would stock
(v) ISL intends to finance this project through debt carrying interest at the rate of 10% per annum. inventories for supply to the retail stores in country Y at cost. At current prices, the annual
The principal would be re-payable at the end of Year 6. expenditure on these facilities would amount to CX 0.5 million in Year 1 and would grow
@ 5% per annum in perpetuity.
(vi) ISL would discount this project at its existing weighted average cost of capital of 20%.
Investment in country Y
Required: Investment of CY 800 million would be made for establishing retail stores in country Y.
(a) Calculate the bid price that ISL may offer for the acquisition of APPL. (17 marks) At current prices, the net cash inflows for the first three years would be CY 170 million,
250 million and 290 million respectively. After Year 3, the net cash inflows would grow at
(b) Assess the impact of the acquisition on the wealth of ISL’s shareholders at the end of Year 5 the rate of 5% per annum, in perpetuity.
assuming that the shares at that time would be priced at 7 times its PE ratio and ISL’s profit
after tax would increase at 8% per annum. (03 marks) (ii) Inflation in country X and Y is 7% and 20% per annum respectively and are likely to remain
the same, in the foreseeable future. Presently, country Y is experiencing economic difficulties
and consequently GL may face problems like increase in local taxes and imposition of
exchange controls.
(iii) The current exchange rate is CX 1 = CY 45.
(iv) GL’s shareholders expect a return of 22% on their investments. GL uses this rate to evaluate
all its investment decisions.
Suggested Answers
Required: Final Examination – Winter 2011
Prepare a report to the Board of Directors evaluating the feasibility of the proposed investment.
Your report should include the following: A.1 (a) Under dividend irrelevance theory, Modigliani and Miller argued that the value of the firm
(a) Computation of net present value of the project and a recommendation about the viability of depends only on the income produced by its assets, not on how this income is split between
the project. (12 marks) dividends and retained earnings.
(b) Identification of the risk and uncertainties involved. (03 marks)
(c) Brief discussions on management strategies which may be adopted to counter the risks of Arguments against the theory
increase in local taxes and imposition of exchange controls. (05 marks) (i) Differing rates of taxation on dividends and capital gains can create a preference for a
high dividend or one for high earnings retention.
Q.6 Skill Enhancement Centre (SEC) is an established institution with a mission to impart training to (ii) Dividend retention should be preferred by companies in a period of capital rationing.
the youth by developing their job-related technical skills. It offers industry-specific one year (iii) Due to imperfect markets and the possible difficulties of selling shares easily at a fair
diploma courses to students. price, shareholders might need high dividends in order to have funds to invest in
opportunities outside the company.
In the recent past, several other institutions have started offering a wide range of new courses with (iv) Markets are not perfect. Because of transaction costs on the sale of shares, investors who
the result that the number of students enrolled in SEC’s Textile Designing Course (TDC) has want some cash from their investments will prefer to receive dividends rather than to
declined to 175 students per annum. SEC is developing its 5-year plan and an important sell some of their shares to get the cash they want.
consideration is to replace TDC with Advanced Textile Graphics Course (ATGC). (v) Information available to shareholders is imperfect and they are not aware of the future
The following related information is available: investment plans and expected profits of their company. Even if management were to
provide them with profit forecasts, these forecasts would not necessarily be accurate or
(i) Several computers would need to be upgraded at a cost of Rs. 350,000. However, if ATGC is believable.
not introduced 30 such computers may be sold at Rs. 12,000 each. The current book value of (vi) Perhaps the strongest argument against the MM view is that shareholders will tend to
each computer is Rs. 15,000. prefer a current dividend to future capital gains (or deferred dividends) because the
future is more uncertain.
(ii) ATGC would require new textile designing software which costs Rs. 1,200,000.
(iii) The new course would be taught and managed by the existing staff which receives total (b) Market price per share
remuneration of Rs. 6,000,000 per annum. However, if the enrolment in ATGC program Calculation of market price per share under MM dividend irrelevance theory
exceeds 225 students per annum, two new technical instructors would have to be engaged at
a cost of Rs. 1,800,000 per annum which would be payable in advance. P1 + D1
Po = OR P1 = Po × (1 + Ke) - D1
1 + Ke
(iv) Details relating to income from fees and other costs are as follows:
Market price if dividend
Timing of TDC ATGC Declared Not declared
cash flows Rupees Po Rs. 80.00 Rs. 80.00
Course fee per student In advance 42,000 43,200 D1 Rs. 2.00 -
Cost of training material per student In advance 6,000 7,400 K e (W-1) 14.4% 14.4%
Directly attributable costs (per annum) In arrears 120,000 230,000 P 1 {80x(1+0.144)-2} {80x(1+0.144)-0} Rs. 89.52 Rs. 91.52
Apportionment of overheads excluding staff costs In arrears 2,400,000 3,000,000
Preliminary costs (including training of instructors) In advance - 750,000 W1: Cost of equity under CAPM
Ke = Rf + (Rm – Rf) β
(v) On an average, a new student enrolled in a course brings additional revenue of Rs. 2,400 per = 0.075 + (0.129 – 0.075) 1.28 (W-2)
annum on account of other activities. = 14.4%
(vi) Being an educational institution, SEC is exempted from income tax.
W2: β Computation
(vii) SEC assesses the viability of a course using a discount rate of 7%. AGPL's Standard Deviation with Market Return
β= × Correlation of Return with Market Returns
Market Standard Deviation
(viii) It is assumed that the number of students enrolled would remain constant throughout the
five-year period.
8%
= × 0.8 = 1.28
Required: 5%
Determine the minimum annual enrolments which would make it financially viable for SEC to
introduce ATGC. (17 marks)
(THE END)
Page 1 of 6
Final Examination – Winter 2011 Final Examination – Winter 2011
(c) Justification of MM Dividend Irrelevance Theory A.3 (a) Growth FY00 FY01 FY02 FY03 FY04 FY05
No of shares to be issued Sales % ----- Rs. in million -----
Generic 10% 720 792.00 871.20 958.32 1,054.15 1,159.57
Declared Not declared
Patented other than Z-11 10% 864 950.40 1,045.44 1,149.98 1,264.98 1,391.48
Rs. in million Z-11 (Note 1) 10% 216 237.60 261.36 287.50 223.24 245.56
Net income 250.00 250.00 Less: Variable costs of production
Less: Dividend paid 40.00 - Generic 10% (336.60) (370.26) (407.29) (448.01) (492.82)
Retained earnings 210.00 250.00 Patented other than Z-11 10% (285.12) (313.63) (344.99) (379.49) (417.44)
Less: New investments (600.00) (600.00 ) Z-11 10% (71.28) (78.41) (86.25) (94.88) (104.36)
Amount to be raised through right issue A 390.00 350.00 Less: Fixed costs other than depreciation 5% 90 (94.50) (99.23) (104.19) (109.40) (114.87)
Less: Depreciation (100.00) (100.00) (100.00) (100.00) (100.00)
Less: Selling expenses (Y1: Cost red. by
Market price per share (as computed in (b) above B 89.52 91.52 30%) 7% 360 (252.00) (269.64) (288.51) (308.71) (330.32)
Less: Admin. Expenses (Y1: Cost red. by
Number of new shares to be issued (in million) C=A÷B 4.36 3.82 80%) 5% 90 (18.00) (18.90) (19.85) (20.84) (21.88)
Already issued share capital D 20.00 20.00 Less: Royalty on patented products (W2)
(Note 2) (178.20) (196.02) (215.62) (189.75) (208.72)
Total number of shares to be outstanding E=C+D 24.36 23.82
Less: Technical fee (Total sales x 3%) (59.40) (65.34) (71.87) (76.27) (83.90)
Adjusted profit before tax 584.90 666.57 757.23 815.02 922.30
Market capitalization B×E 2,180 2,180 Taxation (35%) (204.72) (233.30) (265.03) (285.26) (322.81)
Profit after tax 380.18 433.27 492.20 529.76 599.49
Add: Depreciation 100.00 100.00 100.00 100.00 100.00
A.2 (a) 480.18 533.27 592.20 629.76 699.49
Cash Terminal value (Note 3) 4,238.09
Outflow (Rs. Total cash flows 480.18 533.27 592.20 629.76 4,937.58
500 million)
Discount factor at WACC of 20% 0.833 0.694 0.578 0.482 0.402
Rs. 250 Rs. 320 Discount cash flows 400 370 342 304 1,985
million (65%) million (35%)
Maximum bid price 3,401
Notes
1 Sales of Z-11 in Year 4: 94.88 ÷ 42.5% [W-1]
Rs. 280 Rs. 330 Rs. 360 Rs. 340 Rs. 380 Rs. 400
2 Up to Year 3, 15% royalty would be charged on all patented products from year 4 onward, royalty
million (20%) million (65%) million (15%) million (5%) million (50%) million (45%)
would be charged on patented products other than Z-11.
3 {(1+FCF growth rate after year 5) x FCF in year 5} ÷ (Cost of capital – FCF growth rate after year 5)
= {(1+0.03) × 699.49}÷(20% - 3%) = 4,238.09
Path 1 Path 2 Path 3 Path 4 Path 5 Path 6
(b) All amount are in million rupees
PV of NCIAT of Year 1 PV of NCIAT of Year 2 W1: Determination of variable costs to sales %
Probability
Sale
PV of total
Expected
outflow
inflow
Discount
Discount
Amount
Amount
Cash
Joint
Path
NPV
NPV
Patented Generic Total

factor
factor
PV
PV
Sales in Year 0 Rs. 1,080 Rs. 720 Rs. 1,800

Variable cost of production Rs. 324 Rs. 306 Rs. 630
(26.76
1
250
0.8772 219.30 *330 0.7695 253.94 473.24 500 ) 0.1300 (3.48)
Variable costs to sales % 30.00% 42.50% 35.00%
2 250 0.8772 219.30 *380 0.7695 292.41 511.71 500 11.71 0.4225 4.95
3 250 0.8772 219.30 *410 0.7695 315.50 534.80 500 34.80 0.0975 3.39 (b) Rs. in million
4 320 0.8772 280.70 *390 0.7695 300.11 580.81 500 80.81 0.0175 1.41 Value of combined entity (855.96 [W-1] x 7) 5,991.70
5 320 0.8772 280.70 *430 0.7695 330.89 611.59 500 111.59 0.1750 19.53 Value of ISL if not combined (477.53 x 7) 3,342.71
6 320 0.8772 280.70 *450 0.7695 346.28 626.98 500 126.98 0.1575 20.00 Additional value 2,648.98
45.80
W-1: Value of combined entity
*including salvage value of Rs. 50 million
Year 5: Profit after tax - ISL (325 x (1+0.08)^5 477.53
Comment: Since the expected net present value of project is positive, it is suggested to accept investment proposal. Year 5: Profit after tax - APPL 599.49
Less: Additional interest on debt (3,401 × 10%) × 65% (221.07)
Combined earnings at Year 5 855.96
Final Examination – Winter 2011 Final Examination – Winter 2011
A.5 To: Board of Directors

Date: 7 December 2011
A.4 (a) USA Subject: Evaluation of proposed investment in Country Y
The full receipt i.e. US $ 1.50 will be hedged.
(a) Net present value of the investment
Hedging through Forward Contract The financial evaluation of the Country Y Project is based on estimates of the future nominal
KC would sell US $ 1.5 million three months forward at Rs. 87.0 per US $ and receive Rs. cash flows of the investment, in both Country X and Y. All foreign cash-flows are converted to
130.5 million. CX and total is discounted at a shareholders' required rate i.e. 22% per annum. The theory of
purchasing power parity has been used to estimate future currency exchange rates. This
predicts that if currencies are allowed to float freely on the market, they will adjust in the long
Hedging through Money Market
run to compensate for differences in countries' inflation rates.
To obtain US $ 1.5 million, borrow now: (1.5 million ÷ [1+(5.20%x3/12)] = $ 1.48
The results show that the investment has an expected net present value of approximately CX
US $ will be converted into Rs. at spot: US $ 1.48 million x Rs. 86.56 = Rs. 128.11 81.252 million, which indicates that it is worthwhile and should add to shareholder value.
Calculations
Rs. 128.11 million will be invested in Pakistan: Rs. 128.11x[1+(8.5%x3/12)] Rs. 130.83 Growth Inflation YEARS
0 1 2 3
UK Exchange rate (PY x 1.2 / 1.07) 45.000 50.470 56.600 63.480
----- CX in million -----
The receipts and payments can be netted off : (£ 5.10 - £ 4.0) = £1.10 Cash flows in Country X 5% 7% (7.000) (0.535) (0.601) (0.675)
Cash flows in Country Y 20% (17.778) 4.042 6.360 7.894
Hedging through Forward Contract Total nominal cash flows (24.778) 3.507 5.759 7.219
KC should buy £ 1.1 million three months forward at Rs. 136.18 per £ and pay Rs. 149.8
million. Discount factor @ 30.54% [(1.22x1.07)-1] 1.000 0.766 0.587 0.450
Present value (24.778) 2.686 3.381 3.249

Hedging through Money Market
Net present value as computed above (15.462)
To earn £ 1.1 million, invest now: £ 1.1 million ÷ [1+(5.00% x 3/12)] = £1.09 Country X - NPV from Year 2 to perpetuity
[(0.675 x 1.1235) ÷ (0.3054 - *0.1235)] × 0.450 (1.876)
Purchase £ at spot rate : £ 1.09 x Rs. 135.13 Rs. 147.29 Country Y - NPV from Year 4 to perpetuity
[(7.894 x 1.26) ÷ (0.3054 - **0.26)] x 0.450 98.59
Borrow Rs. 147.29 million in Pak at 10.5%: Rs. 147.29m x [1+(10.5% x 3/12) = Rs. 151.16 81.252
*Growth rate for Country X from year 4 to perpetuity [(1.07x1.05)-1]=12.35%
**Growth rate for Country Y from year 4 to perpetuity [(1.20x1.05)-1]=26%
(b) Payments Receipts Total (b) Risks and uncertainties

KC-(Pak) KA-(USA) KB-(UK) (i) Large margins of potential error in the exchange rate prediction
---------- Rs. in million ---------- (ii) A slow payback: in present value terms the project will probably not break even until
KC-(Pak) - 131.00 688.30 819.30 Year 8 or 4.
KA-(USA) 130.02 - 390.06 520.08 (iii) The economic uncertainties in Country Y which may affect adversely on rate of
KB-(UK) 539.84 242.93 - 782.77 inflation.
Total receipts 669.86 373.93 1,078.36 2,122.15 (iv) Inappropriate projection of future cash flows specially the cash flows to be generated
Total payments (819.30 ) (520.08 ) (782.77 ) (2,122.15) in Country Y and cash flows expectation to perpetuity.
Net payment / (receipts) 149.44 146.15 (295.59) -
(c) Management Strategies
Without multilateral netting, the group companies would have required to pay Rs. 2,122.15 To counter the increase in local taxes
million as shown in the above table. On account of multilateral netting, the amounts payable (i) Negotiate tax concessions in advance
and receivable were netted and as a result the amount required to be paid/received was (ii) Use transfer price strategies including royalties and management, to minimize the
reduced to Rs. 295.59 million i.e. 13.93% of the gross amount, resulting in savings of impact of variation in Country Y taxable profits and dividends
transaction/hedging costs.
To counter the imposition of exchange controls
(i) Make extensive use of local currency loans for financing
(ii) Arranging currency swaps
(iii) Back to back loans with other multinational companies and banks with complimentary
cash needs
Suggested Answers
Final Examination – Winter 2011
The Institute of Chartered Accountants of Pakistan
A.6 Timing of Cash

Discount
Amount
Students<
225 Students>225
Year factor @
flows Present value Present value
7% Final Examination 6 June 2012
------------ Rupees ------------
Investment costs (W-1) 0 1.000 (2,660,000) (2,660,000) (2,660,000) Summer 2012 100 marks - 3 hours
Additional fee from existing capacity Advance Module F Additional reading time - 15 minutes
(175 × (Rs. 43,200 - Rs. 42,000) 0-4 4.387 210,000 921,270 921,270
Additional cost for the existing capacity Advance
(175 ×(Rs. 7,400 - Rs. 6,000) 0-4 4.387 (245,000) (1,074,815) (1,074,815) Q.1 Mac Fertilizer Limited (MFL) is a listed company and is engaged in the business of manufacturing of
Additional directly attributable course costs Arrears
(Rs. 230,000 - Rs. 120,000) 1-5 4.100 (110,000) (451,021) (451,021.72) phosphate fertilisers. MFL intends to diversify its operations by manufacturing and distributing steel
Additional staff costs Advance 0-4 4.387 (1,800,000) (7,896,600) products. This diversification would require an investment of Rs. 3,600 million for establishing the
(3,264,566) (11,161,166) plant and meeting the working capital requirement. MFL plans to finance the investment as follows:
A A
Incremental benefit per student (over 175 Advance
students) (W-2) 0-4 4.387 38,200.00 167,583 167,583  55% of the investment would be financed by issuing Term Finance Certificate (TFCs) carrying
B B interest at 12% per annum and repayable in 2018.
The number of additional students over 175 to cover the investment and incremental costs 19 67  The balance amount would be generated by issuing right shares at Rs. 65 per share.
C=A÷B C=A÷B
No. of students required on ATGC for it to be financially viable 194 242
Extract of MFL’s statement of financial position as at 31 December 2011 is given below:
175 + C 175 + C
Equity and liabilities Rs. in million Assets Rs. in million

Conclusion: If the enrolments are less than 225 then new course would be viable at 194 or above Share capital (Rs. 10 each) 7,000 Non-current assets 50,000
students. However, if the enrolments exceed 225 students then the new course would be viable at Retained earnings 23,000
242 or above students.
TFCs (Rs. 100 each) 28,000 Current assets 40,000
Current liabilities 32,000
WORKINGS
90,000 90,000
W1: Initial investment cost Rupees
Sale of computers foregone (30 x Rs. 12,000) 360,000 The existing TFCs carry mark up @ 11.5% per annum and are due for redemption at par in 2016.
Upgrade of computers 350,000
Software acquisition 1,200,000 Currently, MFL’s shares and TFCs are traded at Rs. 80 and Rs. 102.50 respectively. Equity beta of
Preliminary costs 750,000 the company is 1.3.
2,660,000
The proposed investment has been evaluated at a discount rate of 17% which is based on existing cost
W2: Incremental revenues/costs per student over 175 students of equity plus a premium that takes cognisance of the risks inherent in the steel industry. However,
Fees 43,200 there are divergent views among the directors regarding the discount rate that has been used.
Additional benefit to SDS 2,400  Director A is of the view that the premium charged to reflect the risk in the steel industry is too
low. He is of the opinion that the company’s existing weighted average cost of capital is more
Books and consumables (7,400)
appropriate discount rate for evaluation of this investment.
38,200
 Director B suggests that the discount rate should be representative of the steel industry. He has
provided the following data pertaining to a listed company, Pepper Steel Limited (PSL).
(The End)
− 900 million shares of Rs. 10 each are outstanding which are currently being traded at Rs. 35.
− Long term loan amounted to Rs. 8,000 million obtained from local banks at the average rate
of 13%.
− Equity beta of the company is 1.5.
You have been appointed as the Lead Advisor by an Investment Bank working on this transaction.
You have obtained the following information:
Interest rate for 6-months treasury bills 8%

Market return 13%
Applicable tax rate for all companies 30%
Debt beta of MFL and PSL is assumed to be zero.
Required:
Compute the discount rate based on suggestions given by Directors A and B and discuss which
suggestion is more appropriate. (19 marks)
Page 6 of 6
Q.2 CB Investment Limited (CBIL) has identified various projects for investments. Details of the projects Q.4 FF International (FFI) is considering the opportunity to acquire CS Limited (CSL). You have been
are as follows: appointed as a consultant to advise the FFI’s management on the financial aspects of the bid.
Projects A B C D E F The latest summarized annual financial statements of CSL are given below:
Initial investment required now (Rs. in million) (300) (120) (240) (512) (800) (400)
Forecasted annual net cash inflows (Rs. in million) 150 50 140 256 440 300 Summarized Statement of Financial Position
Discount rate (based on risk involved in the project) 10% 11% 12% 11% 13% 14% Rs. in million
Project duration (years) 4 5 3 6 3 2 Total assets 5,000
Year from which net cash inflows would commence 1 2 1 3 1 1
Share capital 2,000
Accumulated profit 150
(i) Project A and B are mutually dependent and are non-divisible.
Long term loan 700
(ii) Project C can be scaled down but cannot be scaled up.
Short term loan 1,300
(iii) Project D, E and F are mutually exclusive. They cannot be scaled down but can be scaled up.
Other current liabilities 850
Total financing available with the company is Rs. 1,000 million. It may be assumed that all cash 5,000
flows would arise at the beginning of the year.
Summarized Income Statement
Required: Rs. in million
Determine the most beneficial investment mix. (20 marks) Sales 1,000
Less: Cost of sales (430)
Q.3 Beta Limited (BL) is engaged in the business of manufacturing and marketing of high quality plastic Gross profit 570
products to the large departmental stores in Pakistan and United Arab Emirates. BL is presently Selling and administration expenses (250)
experiencing a decline in sales of its products. Market research carried out by the Marketing Financial charges (280)
Department suggests that sustained growth in sales and profits can be achieved by offering a wide Profit before taxation 40
range of products rather than a limited range of quality products. In this regard, BL is considering the Taxation (14)
following two mutually exclusive options: Profit after taxation 26
Option I : Introduce low quality products in the market You have also gathered the following information:
(i) CSL produces a single product X-201 and has a market share of 30%. A market survey
Following information has been worked out by the Chief Financial Officer of the company: conducted to identify the impact of increase or decrease in price has revealed the following
relationship between price of X-201 and market share:
Net present value using a nominal discount rate of 13% Rs. 82 million
Discounted payback period 3.1 years Increase / (decrease) in price Market share
Internal rate of return 10.5% (10%) 45%
Modified internal rate of return 13.2% approximately 5% 23%
10% 20%
Option II : Import variety of plastic products from China
BL would buy in bulk from Chinese suppliers and sell it to the existing customers. The projected net (ii) In order to increase production, CSL would have to invest Rs. 150 million in plant and
cash flows at current prices after acceptance of this option are as follows: machinery which would be financed through long term loan on terms and conditions similar to
those of the existing long term loan, as specified in point (v) below.
Year 0 Year 1 Year 2 Year 3 Year 4 (iii) Fixed production costs amount to Rs. 100 million which include depreciation of Rs. 75 million.
Against import from China (US$ in million) (25.00) (20.00) (21.33) (22.33) (20.67) (iv) 80% of selling and administration expenses are fixed. Fixed costs include depreciation of Rs. 25
From operation in UAE (US$ in million) - 22.47 24.15 25.23 23.37 million and salaries of Rs. 160 million. After acquisition, FFI expects to reduce the staff in sales
From operations in Pakistan (Rs. in million) - 333 350 414 450 and administration by making one-time payment of Rs. 100 million. It would reduce the
department’s salaries by 25% and the remaining fixed costs by 30%.
The following information is also available: (v) Long term loan carries markup @ 15% per annum. The balance amount of principal is
(i) The current spot rate is Re. 1=US$ 0.0111. repayable in five equal annual instalments payable in arrears.
(ii) BL evaluates all its investment using nominal rupee cash flows and a nominal discount rate. (vi) Mark up on short term loan is 14% per annum. CSL has failed to meet certain debt covenants
(iii) Inflation in Pakistan and USA is expected to be 10% and 3% per annum respectively. and therefore its bankers have advised CSL to reduce the short term loan to Rs. 1,000 million.
(vii) It is the policy of the company to depreciate plant and machinery at 20% per annum using
Tax may be ignored. straight line method. Accounting depreciation may be assumed to be equal to tax depreciation.
(viii) Working capital would vary at the rate of 40% of increase / decrease in sales.
Required: (ix) Tax rate applicable to both companies is 30% and tax is payable in the same year. CSL has
Evaluate the two options using net present value, discounted payback period, internal rate of return unutilized carry forward tax losses of Rs. 80 million.
and modified internal rate of return. Give brief comments on each of the above methods of evaluation (x) All costs as well as sales are expected to increase by 10% per annum.
and their relevance in the given situation. For the purpose of evaluation, assume that BL has a four year (xi) Free cash flows of CSL are expected to grow at 5% per annum after Year 5.
time horizon for investment appraisal. (17 marks) (xii) Based on the risk analysis of this investment, the discounting rate is estimated at 18%.
Suggested Solution
Required: Final Examinations – Summer 2012
(a) Discuss any two advantages and disadvantages of growth through acquisition. (04 marks)
(b) Determine the following: A.1 DIRECTOR A's RECOMMENDATION : Evaluation on the basis of Existing WACC
• Optimal sales level at which CSL’s profit would be maximised. (05 marks)
• Amount of cash flow gap at optimal level of sales during the first five years of acquisition.
(14 marks)
(c) Calculate the bid price that FFI may offer for the acquisition of CSL assuming that cash flow
gap identified in (b) above would have to be filled by FFI by way of an interest free loan.
(07 marks)
Q.5 Assume that the date today is 1 June 2012. Alpha Automobiles Limited (AAL) has imported CNG
kits from Japan and has to repay an amount of JPY 175 million in three months time. ( ) ( )
AAL intends to hedge the contract against adverse movements in foreign exchange rates and its
foreign exchange exposures. The following data are available: W-1: Cost of equity
( )
Exchange rates quoted on 1 June 2012 ( )
JPY 1 W-2: Cost of debt
Buy Sell Cash Discount Discount
Spot rate Rs. 1.9223 Rs. 1.9339 Yea PV PV
Description flows factor factor
One month forward rate Rs. 1.9335 Rs. 1.9451 r (Rs.) (Rs.)
(Rs.) (6%) (9%)
Three month forward rate Rs. 1.9410 Rs. 1.9493 0 Price of TFC (102.50) 1.000 (102.50) 1.000 (102.50)
Interest rates available to AAL 1-5 Interest (Rs. 100 × 11.5% × (1-30%) 8.05 4.212 33.91 3.890 31.31
5 Repayment 100 0.747 74.70 0.650 65.00
Borrowing Investing 6.11 (6.19)
Japan 5% 3%
Pakistan 8% 5% Calculating the cost of debt using IRR
JPY currency futures ( )

Futures have a contract size of JPY 100,000 and the margin required is Rs. 1,000 per contract.
Contract prices (Rupee per JPY) are as follows:
DIRECTOR B's RECOMMENDATION: Evaluation on the basis of Project Specific Cost of Capital
JPY 1 ( )
July 2012 Rs. 1.9365
October 2012 Rs. 1.9421
( ) ( )
January 2013 Rs. 1.9490
The contracts can mature at the end of the above months only.
W-3: Cost of equity
Currency options ( ) ( )
Options have a contract size of JPY 250,000. The premiums (paisa per Rupee) payable on various
options and the corresponding strike prices are shown below: W-4: Cost of debt
( )
Calls Puts
Strike W-5: Computation of project specific beta
price 31 July 31 October 31 July 31 October
2012 2012 2012 2012 Un-geared Steel Company Beta
Rs. ----------------------------Paisas---------------------------- ( )
1.90 2.88 3.55 0.15 0.28 ( ) ( )
1.91 1.59 2.32 1.00 1.85 where,
1.92 0.96 1.15 2.05 2.95 ,
Options are exercisable at the end of relevant month only. ( )
Required:
Illustrate four methods by which Alpha Automobiles Limited might hedge its currency exposure.
Recommend which method should be selected. (14 marks) ( )
(THE END)
14-Nov-14 8:26:33 AM Page 1 of 7

Get the project beta on the basis of steel company un-geared beta By utilizing the entire available amount the company may be in a position to increase its
( ) NPV. Hence we should consider other options. While selecting other options the basic
( ) presumption should be to select the last project (balancing amount) which can be scaled
down i.e. Project C. Considering the above, there can be three more options as shown
below:
Option 2: Invest in Rank 4 ahead of Rank 2 which can be scaled down

If we consider the rank 4 project which requires lesser investment as compare to rank 5
Appropriateness of discount rate
project, we would be able to utilize about 75% of rank 2 project, as against option 3 in
which Project C is only 28% utilized.
The view expressed by the Director A is not worthwhile because:
 existing WACC only reflects the current business and financial risk. It does not Investment NPV
incorporate the additional risk of the new sector as well as additional return required Rs. in million
by the company's shareholders. Rank 1 420.00 258.15
 the proportion of debt in the investment i.e. 55% is quite high as compare to existing
Rank 4 400.00 163.10 Because it cannot be scaled down.
debt proportion i.e. 34%. The financial risk has therefore increased and it could
Rank 2 (balance) 180.00 102.45
therefore be argued that current WACC is not an acceptable discount rate.
1,000.00 523.70
 rate used for evaluation of the project i.e. 17% is too high as it is based only on the
relatively high cost of equity and ignores the amount of debt that will be used to Option 3 : Invest in Rank 5 ahead of Rank 2 which can be scaled down
finance the project.
Investment NPV
The suggestion given by the Director B is worthwhile as the project specific cost of capital Rs. in million
(based on steel industry's risk) incorporates the business and financial risk of the new sector, Rank 1 420.00 258.15
in which MFL intends to invest and also incorporates the higher return expectation of the Rank 5 512.00 203.55 Because it cannot be scaled down.
shareholder because of increase in financial risk. Rank 2 (balance) 68.00 38.70
1,000.00 500.40
A.2 A B C D E F
Project duration 4 5 3 6 3 2
Options 4: Invest in Rank 3 and Rank 2 which can be scaled down
Forecasted net cash inflows start from year 1 2 1 3 1 1
Investment NPV
Discount rate 10% 11% 12% 11% 13% 14%
Rs. in million
Annuity factor for total period 3.487 4.102 2.690 4.696 2.668 1.877 Rank 3 800.00 373.92 Because it cannot be scaled down.
Less: Annuity factor for zero cash inflow period - (1.000) - (1.901) - - Rank 2(balance) 200.00 113.83
Adjusted annuity factor 3.487 3.102 2.690 2.795 2.668 1.877 1,000.00 487.75
Forecasted annual net cash inflows 150.00 50.00 140.00 256.00 440.00 300.00 Conclusion:
Present value of inflows 523.05 155.10 376.60 715.55 1,173.92 563.10 The most beneficial mix for the company is to invest in Projects A, B, F and C (balancing
Adjustment for mutually compulsory projects 678.15 376.60 715.55 1,173.92 563.10
amount) which gives the highest NPV to the company.
Less: Initial investment required today (300.00) (120.00) (240.00) (512.00) (800.00) (400.00)
Adjustment for mutually compulsory projects

(a) (420.00) (240.00) (512.00) (800.00) (400.00) A.3 (a) The summary of investment appraisal results are as follows:
Net present value (b) 258.15 136.60 203.55 373.92 163.10
Profitability index (b ÷ a) 0.615 0.569 0.398 0.467 0.408 Option I Option II
Ranking 1 2 5 3 4 Net present value (Rs. in million) 82 107.41 (W-1)
Payback period (years) 3.10 3.83 (W-2)
Option 1 : Invest in the highest ranked projects
Internal rate of return 10.50% 15.11% (W-3)
In this option, CBIL can invest only up to Rs. 660 million only as all other projects requires Modified internal rate of return 13.20% 14.30% (W-4)
larger investment as compare to the funds available with the company. On financial ground, the project to be accepted should be the one with the higher NPV, i.e.
Option 2. NPV shows the absolute amount by which the project is forecast to increase
Investment NPV
shareholders' wealth and is theoretically more sound than the IRR and MIRR. However, In
Rs. in million this case, both IRR and MIRR back up the NPV.
Rank 1 420.00 258.15
Rank 2 240.00 136.60 The discounted payback period shows that Option II is more risky as it takes longer to
660.00 394.75 recover the present value.
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WORKINGS (ii) A larger company with a better spread of products, customers and markets faces a
W-1: Net present value Year 0 Year 1 Year 2 Year 3 Year 4 lower level of operating risk than a small company which may be more dependent on
------------------------Rs. in million------------------------ a small number of customers and suppliers. Acquisition will therefore allow the
Outside Pak nominal cash flows (W-1.1) (2,252.25) 244.23 308.25 348.35 357.65 company to reduce its operating risk more quickly. This effect is enhanced if the
Pak nominal cash flows (10% inflation) - 366.30 423.50 551.03 658.85 company is using acquisition as a mean of diversification into new product/market
Total nominal cash flows (2,252.25) 610.53 731.75 899.38 1,016.50
areas.
Discount factor at 13% 1.000 0.885 0.783 0.693 0.613 (iii) Acquisition may permit the company to make operating economies through the
rationalization and elimination of duplication in areas such as research and
Present value (2,252.25) 540.32 572.96 623.27 623.11 development, debt collection and corporate relations.
(iv) Acquisition may allow the company to achieve a better level of asset backing if it has
Net present value 107.41
a high ratio of sales to assets.
W-1.1: US$ nominal cash flows in Rupees Advantages of growth by acquisition
Year 0 Year 1 Year 2 Year 3 Year 4 (i) If the acquisition is being made for strong strategic reasons, there may be competition
Exchange rate forecast (PY × 1.03 ÷ 1.10) A 0.0111 0.0104 0.0097 0.0091 0.0085
------------------------in million------------------------
between bidding companies which may force the price to rise to a level which may
US$ cash flows at current prices (25.00) 2.47 2.82 2.90 2.70 not be justifiable on financial grounds.
US$ nominal cash flows (3% inflation) B (25.00) 2.54 2.99 3.17 3.04 (ii) Acquisition may involve significant reorganizations cost which may result in lower
US$ nominal cash flows (Rs.) B÷A (2,252.25) 244.23 308.25 348.35 357.65 earnings at least in the short term.
W-2 : Discounted payback period (iii) The acquisition may lead to inequalities in returns between the shareholders of the
Year 0 Year 1 Year 2 Year 3 Year 4 bidding and the target companies. Quite often the shareholders in the target company
Present value of cash flow (Rs. in m) (2,252.25) 540.32 572.96 623.27 623.11 do disproportionately well as compared to the shareholders in the bidding company.
Cumulative discounted cash flows (2,252.25) (1,711.93) (1,138.97) ( 515.70) 107.41
( ) (b) Determination of Optimal Sales Level

( )
( ) Existing Price
Price increased by
sales decreased by
Discounted payback period = 3.83 years
5% 10% 10%
W-3 : Internal rate of return Market share 30% 23% 20% 45%
Year 0 Year 1 Year 2 Year 3 Year 4 -------------------Rs. in million------------------
------------------------in million------------------------ Market size (Rs. 1,000 ÷ 30%) x 1.1 3,667 3,667 3,667 3,667
Nominal cash flows in million Rs. (2,252.25) 610.53 731.75 899.38 1,016.50
Discount factor at 16% 1.000 0.862 0.743 0.641 0.552 Sales (Market Share × Market Size) x 1.1 1,100.00 843.41 733.40 1,650.15
Present value (2,252.25) 526.28 543.69 576.50 561.11 Add/(Less): Effect of price change - 42.17 73.34 (165.02)
Net present value (44.67)
Net sales 1,100.00 885.58 806.74 1,485.13
By Interpolation, the IRR is : 15.11% per annum Less: Variable cost of sales
(363.00) (278.33) (242.02) (544.55)
(Rs. 363 ÷ 1,100) × Sales without price effect
W-3 : Modified Internal rate of return Less: Variable selling and admin exp
(55.00) (42.17) (36.67) (82.51)
(Rs. 250 × 20% *1.1) ÷ 1,100 × Sales
( ) ( ) 682.00 565.08 528.05 858.07
Less: Incremental fixed costs
where,
Depreciation - New plant & mach. (150m ÷ 5) - - - (30.00)
(return phase) (Years 1 - 4) 2,359.66
Interest expense (Rs. 150m × 15%) - - - (22.50)
(investment phase) (Year 0) 2,252.25
Incremental profit 682.00 565.08 528.05 805.57
13%
* (Rs. 430m - Rs. 100m)
MIRR = 14.3% The company can achieve the optimal sale level by reducing 10% price.
(Subject to maximum of 17 marks)
A.4 Advantages of growth by acquisition

(a) (i) The company may be able to grow much faster than would be possible through
purely organic development. This is particularly true if the company is seeking to
expand into a new product or market area when acquisition will allow the company
to gain technical skills, goodwill and customer contracts which would take it a long
time to develop by itself.

Determination of cash flow gap to be filled by injecting cash (c) Determination of maximum bid price
Cash flow Year 1 Year 2 Year 3 Year 4 Year 5 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Growth rate 10% 10% 10% 10% 10% Net operating cash flows (from above) - 249.91 358.18 424.89 496.48 573.46
Operating profit excluding depreciation (W-1) 634.52 697.97 767.77 844.55 929.01 Add: Financial charges 267.50 242.00 216.50 191.00 165.50
One time cost of employees lay off (100.00) - - - - Add: Cash flow deficit - (414.14) 128.78 189.55 95.81 -
Net operating cash flow 534.52 697.97 767.77 844.55 929.01 Add: Changes in working capital (194.05) (59.40) (65.34) (71.88) (79.07)
Fin. charges - Long term loan (W-2) (127.50) (102.00) (76.50) (51.00) (25.50) Terminal value* - - - - - 5,968.52
Financial charges - Short term loan (1,000 × 14%) (140.00) (140.00) (140.00) (140.00) (140.00) Cash flows - (90.78) 669.56 765.60 711.41 6,628.41
Net cash flow before taxation 267.02 455.97 551.27 653.55 763.51 Discounting factor at 18% 1 0.8475 0.7182 0.6086 0.5158 0.4371
Taxation (W-3) (17.11) (97.79) (126.38) (157.07) (190.05) PV - (76.94) 480.88 465.94 366.95 2,897.28
Net cash flow 249.91 358.18 424.89 496.48 573.46 NPV (Maximum bid price) 4,134.11
Reduction in short term debt (300.00) - - - -
Reduction in long term debt (W-2) (170.00) (170.00) (170.00) (170.00) (170.00) *(573.46 + 165.5) x (1+5%) ÷ (18% - 5%)
Increase in working capital (W-4) (194.05) (59.40) (65.34) (71.88) (79.07)
(Deficit ) to be filled in by cash (414.14) 128.78 189.55 254.60 324.39 A.5 Temporarily removed for second review
Net deficit (414.14) (285.36) (95.81)
W-1: Determination of operating profit at optimal sales level (THE END)

Rs. in million
Contribution margin 805.57
Less: Fixed costs of sales (other than depreciation) (Rs. 25m ×1.1) (27.50)
Less: Selling and admin expenses
Payroll costs [Rs. 160m × 75% × 1.1) (132.00)
Other fixed costs ((Rs.250m × 80%) - 25m - 160m) × 1.1 × 70% (11.55)
Operating profit (excluding depreciation) 634.52
W-2: Financial charges on long term loan

Year 1 Year 2 Year 3 Year 4 Year 5
Opening balance – principal 700.00 680.00 510.00 340.00 170.00
Addition 150.00 - - - -
850.00 680.00 510.00 340.00 170.00
Repayment (170.00) (170.00) (170.00) (170.00) (170.00)
Closing balance 680.00 510.00 340.00 170.00 -
Mark-up expense @ 15% 127.50 102.00 76.50 51.00 25.50
W-3: Taxation
Year 1 Year 2 Year 3 Year 4 Year 5
Net cash flow before taxation 267.02 455.97 551.27 653.55 763.51
Less: Depreciation (75+25+30) (130.00) (130.00) (130.00) (130.00) (130.00)
Taxable income 137.02 325.97 421.27 523.55 633.51
Carry forward tax losses (80.00) - - - -
Tax profit/(loss) 57.02 325.97 421.27 523.55 633.51
Tax @ 30% 17.11 97.79 126.38 157.07 190.05
W-4: Increase in working capital

Existing Year 1 Year 2 Year 3 Year 4 Year 5
Sales 1,000.00 1,485.13 1,633.64 1,797.00 1,976.70 2,174.37
Increase in sales 485.13 148.51 163.36 179.70 197.67
Additional working capital
194.05 59.40 65.34 71.88 79.07
required (40% of increased sales)

Q.3 (a) GHP Limited is a fast growing business which operates a chain of petrol pumps across the
country. The company is committed to an aggressive strategy of expansion through
The Institute of Chartered Accountants of Pakistan acquisition. It is considering to acquire 100 percent shareholding in IJQ Limited that operates
a chain of CNG stations on the highways. GHP is contemplating to offer 1 share for every 3
shares held in IJQ.
Business Finance Decisions Latest financial data of GHP and IJQ are summarised below:
Final Examination 5 December 2012
Winter 2012 100 marks - 3 hours Statement of Financial Position
Module F Additional reading time - 15 minutes GHP IJQ
Rs. in million
Q.1 ABM Limited is contemplating a major capacity expansion project that will require an investment Non-current assets 5,220 2,340
of Rs. 6,000 million. It plans to raise this amount on 01 January 2013 from a combination of debt Current assets minus current liabilities 1,640 900
and equity in such a way as to arrive at a debt equity ratio of 60:40 in terms of market value. 6,860 3,240
Less: Non-current liabilities 1,240 120
The projected capital structure of ABM on 31 December 2012 is as follows:
5,620 3,120
Rs. in million Ordinary share capital (Rs. 10 each) 3,000 2,000
Ordinary share capital (Rs. 10 each) 2,500 Retained earnings 2,620 1,120
Retained earnings 2,000 5,620 3,120
4,500
Term finance certificates (Rs. 100 each) 5,000 Statement of Comprehensive Income
GHP IJQ
Earnings per share of the company for the year ending 31 December 2012 is projected at Rs. 3.50 Rs. in million
per share whereas the price of its shares on the above date is expected to be Rs. 19.55 per share. Revenue 11,280 4,840
ABM plans to offer shares at 80% of their market value.
Net profit after taxation 6,580 3,760
Existing TFCs were issued on 01 July 2009 and carry a coupon rate of 12% payable semi-annually.
Principal repayment is due on 30 June 2014. Due to increase in market interest rates, the TFCs are Dividend 1,316 1,880
currently trading at a discount providing an yield to maturity of 14%. Consequently, the new debt
would be offered at a coupon rate of 14% per annum. All other terms and conditions would remain Average share price for each company in recent years has been as follows:
the same.
2009 2010 2011 2012
Required: --------------------Rupees---------------------
(a) Calculate the amount to be raised by issue of debt and equity. (08) GHP 70 96 138 186
(b) Compute the number of right shares to be issued and the ex-right price. (03) IJQ 48 64 68 58
(c) Assess whether the debt equity ratio would remain within the threshold, on 30 June 2013, if:
• the yield to maturity comes down to 13%; and GHP’s board of directors feel that there is a strong synergy between the two businesses which
• the net profit and P/E ratio increase by 15% and 5% respectively. (07) will lead to an increase of Rs. 300 million per year in combined after tax profit, following the
(Ignore taxation) acquisition. Both GHP and IJQ are listed companies and their cost of capital is 13% and 18%
respectively.
Q.2 (a) Discuss any five limitations of NPV technique when applied generally to investment appraisal. (05)
Required:
(b) CDN Limited uses a machine for manufacturing some of its products. The machine is (i) Calculate the share price of GHP following the takeover, assuming price earnings ratio of
replaced every three years. Considering the high maintenance costs in the third year, CDN is the company is maintained and the synergy is achieved as expected. (05)
considering to revise its replacement policy from three years to two years. Details of purchase (ii) Calculate the cost of equity of the merged entity. You may use any reasonable
price, maintenance costs and net realizable value at current prices are as follows: assumption wherever necessary. (05)
Year 0 Year 1 Year 2 Year 3 (b) Mr. Danish, a shareholder of IJQ, has expressed concern over the bid. He claims that,
Purchase price (Rs.) 3,200,000 - - - following the acquisition, the annual dividends are likely to be lower as GHP normally pays
Maintenance costs (Rs.) - 130,000 245,000 480,000 small dividends. As he relies on dividend income to cover his living expenses, he is concerned
Net realizable value (Rs.) - - 1,280,000 700,000 that he will be worse off following the acquisition. He also believes that price offered for the
shares of IJQ is too low.
Annual increase in purchase price, maintenance costs and net realizable value is estimated at
10%, 15% and 8% respectively. The weighted average cost of capital of the company is 18%. Required:
Discuss the bid from the point of view of shareholders of IJQ including the concerns raised by
Required: Mr. Danish. (08)
Determine whether CDN should revise its replacement policy. (15)
Q.4 KLR Limited has two operating segments viz. Paints and Chemicals. Break-up of its shareholders’ Q.5 EFO Pakistan Limited intends to make an investment of Rs. 3,000 million. Besides Pakistan, EFO
equity is as follows: has the option to invest either in UAE or in Bangladesh. The total market value of the company’s
existing share capital is Rs. 9,000 million.
Rs. in million
Share capital (Rs. 10 each) 2,000 Estimates of returns on investment are presented below:
Retained earnings 11,765
Current and Expected Return %
Latest segment-wise financial information of KLR is summarized below: Economic Expected on investment in
Probability
Performance Return in
Pakistan % UAE Bangladesh
Chemicals Paints
Rs. in million Low growth 0.3 2 5 3
Revenue 3,150 2,500 Average growth 0.5 8 9 11
Gross profit 378 650 High growth 0.2 14 13 19
Net profit after tax 220 330
Assets Standard deviation of expected returns are as follows:
Non-current assets 6,610 5,250
Current asset 7,930 6,300 UAE 5.12
Liabilities Bangladesh 8.05
Non-current liabilities - 12% Debentures (Rs. 100 each) 2,100 1,950 Pakistan 1.34
Current liabilities 4,770 3,505
Co-variances of expected returns are as follows :
KLR’s current share price is Rs. 13 per share and the market value of its debenture is Rs. 101.50.
The risk free interest rate and market return are 8% and 14% respectively. KLR’s equity beta is 1.15. Pakistan/UAE 5.96
Debentures are redeemable at par in ten years. Pakistan/ Bangladesh 10.66
The company is considering a demerger whereby the two segments would be listed separately on the Directors of EFO have different viewpoints about the proposed investment which are summarised
stock market. The existing equity would be split between the segments based on the net assets held below:
by each segment. The following information is relevant for the purpose of demerger:
(i) Since the company does not have any prior experience of investment abroad, it should focus
(i) Transfers to the Paint Segment account for 25% of the revenues of the Chemicals Segment. exclusively on exploring opportunities within Pakistan because investment abroad carries
The transfers are made at cost. After the demerger, all transactions would be made on an ‘arms inherent risks.
length basis’. (ii) Investment abroad will offer the company the opportunity to achieve a much better
(ii) Common expenses amounting to Rs. 100 million are shared by the two segments on the basis combination of risk and return than purely domestic investments, and will open up new
of their revenues. After the demerger, cost of such expenses for Chemicals and the Paints opportunities.
entities would be Rs. 70 million and Rs. 30 million respectively. (iii) Since expected returns are high in Bangladesh, the company should invest there and
(iii) The average equity betas of the companies associated with the Chemicals and Paints business subsequently increase the company’s investment in Bangladesh.
is 1.2 and 1.5 respectively and the average debt equity ratios are 60:40 and 70:30 respectively.
(iv) Projected cash flows for Year 1 are as follows: Required:
(a) Calculate the anticipated risks and returns on the proposed investment. (11)
Chemicals Paints (b) Briefly discuss the viewpoints of the directors about the proposed investment. (04)
------Rs. in million------ (c) What other factors, in your opinion, would have a bearing on the investment decision? (04)
Pre-tax operating cash flows 280 360
Tax deprecation 70 40 (THE END)
From Year 2, projected cash flows and profit after tax are expected to grow at 5% per annum
in perpetuity.
Tax rate is 35%. Tax is payable in the year in which the relevant cash flows arise.
Required:
(a) Calculate the weighted average cost of capital of both companies after demerger. (10)
(b) Using cash flows, evaluate whether the demerger would be financially advantageous for
KLR’s existing shareholders. (15)
Final Examination - Winter 2012 Final Examination - Winter 2012
A.1 (a) No. of shares Price Value

Existing market value of W-1: Determination of market value of debt at 13% after one year.
(in million) (Rs.) (Rs. in million)
Equity 250.00 19.55 4,887 Dates Description Cash outflow Rs. DF @13% PV Rs.
Debt (W-1) 50.00 97.45 4,873 Old debt
9,760 Dec-13 Interest 300 0.939 282
New investment to be made 6,000 Jun-14 Interest 300 0.882 265
Revised capital size 15,760 Jun-14 Principal 5000 0.882 4,410
4,957
New Debt
Amount to be raised through debt/equity Dec-13 Interest 320.81 0.939 301.24
D/E Ratio New Existing Further issue 320.81
Jun-14 Interest 0.882 282.95
------------Rs. in million---------------
Dec-14 Interest 320.81 0.828 265.63
Equity 40 6,304 4,887 1,417
Debt 60 9,456 4,873 4,583 Jun-15 Interest 320.81 0.777 249.27
100 15,760 9,760 6,000 Dec-15 Interest 320.81 0.730 234.19
Jun-16 Interest 320.81 0.685 219.75
Dec-16 Interest 320.81 0.643 206.28
Jun-17 Interest 320.81 0.604 193.77
W-1: Determination of market value of debt
Dec-17 Interest 320.81 0.567 181.90
Interest Present value
Dates Discount factor @ 14%
Rs. in million Rs. in million Dec-17 Principal 4,583.00 0.567 2598.56
Dec-12 6 - - 4,733.54
Jun-13 6 0.935 5.61 Market value of debt 9,689.54
Dec-13 6 0.874 5.24
Jun-14 6 0.817 4.90
Jun-14 100 0.817 81.70
A.2 (a) Limitation of NPV technique
97.45
(i) NPV is based on the assumption that the primary aim of the organization is to
maximize the wealth of the ordinary shareholders. This is valid for many
companies, but in some investment decisions there may be other overriding
(b) No. of right shares to be issued and ex-right price factors that make the NPV approach less relevant. This is particularly true
when the investment under consideration is fundamental to the strategic
Right issue price (19.55 × 80%) (in Rs.) 15.64 direction of the business.
(ii) A major problem in the use of NPV is the choice of the discount rate. The
No. of right shares to be issued (Rs. 1,417 ÷ 15.64) (in million) 90.60
problem is particularly tricky when the size of the investment means that the
Ex-right price [6,304 ÷ (250 + 90.60)] (in Rs.) 18.51 company will need to acquire a significant amount of additional capital, and
there is uncertainty about the cost of new funds and what impact would it
have on the risk associated with the organization.
(c) Debt equity ratio on 30 June 2013 (iii) The technique assumes that all cash flows arise at the end of the time period
Market value (which is usually one year). This is obviously untrue, and large fluctuations in
Debt equity ratio
(Rs. in million) this pattern may distort the results. Breaking the analysis down into small
Equity (6,304 × 1.15 × 1.05) 7,612 44% periods leads to complication, and may be unsatisfactory due to the problems
Debt (W-1) 9,535 56% of forecasting in such a precise way.
17,142 100% (iv) Although the NPV approach may lead to the correct financial decision in the
long-term, this timescale may be too long to be appropriate for the business to
After the reduction YTM yield to 13% and increase of P/E ratio and EPS, the debt use in practice.
equity ratio would still be within the threshold. (v) Some costs and benefits that arise are not quantifiable. There may be
important non-financial factors that are relevant to the decision, but which are
difficult to quantify. For example, undertaking a new investment may enhance
the standing of the company, making it more attractive to customers, investors
and potential employees. This could have an important impact on the
performance of the company, but cannot be quantified in an NPV analysis.
(vi) The technique is difficult to apply in the public sector, partly due to methods
of accounting, and partly because public sector organization aims will be more
important than the maximization of profit.
Suggested Answers
Final Examination - Winter 2012
A.3 (a) (i) Share price of GHP after the takeover
EPS of GHP before the takeover (Rs. 6,580 ÷ 300) 21.93

P/E ratio of GHP before the takeover (Rs. 186 ÷ 21.93) 8.48
EPS after takeover (W-1) 29.02
Share price of GHP after the takeover (8.48 x Rs. 29.02) 246.09
W-1: EPS after takeover
Profit after tax - GHP 6,580

Suggested Answers Profit after tax - IJQ 3,760
Final Examination - Winter 2012 Increase due to synergy 300
Combined earnings after takeover 10,640
A.2 (b) In order to compare the replacement policies, we must calculate the costs of each approach over a number of complete cycles. The
timescale to be used will be the lowest common multiple of the machine life i.e. 2 x 3 = 6 years. No. of GHP's share in issue (300) 300.00
Replace every two years Shares to be issued to IJQ's shareholders (200 ÷ 3) 66.67
Annual
366.67
YEARS
Increase %
0 1 2 3 4 5 6 EPS after the takeover (10,640 ÷ 366.67) 29.02
Purchase price 10% 3,200,000 - 3,872,000 - 4,685,120 -
Maintenance costs 15% - 149,500 324,013 197,714 428,507 261,476 566,700
Net realizable value 8% - - (1,492,992) - (1,741,426) - (2,031,199) (ii) The cost of equity of the two companies prior to acquisition reflects the
Total cash flow 3,200,000 149,500 2,703,021 197,714 3,372,201 261,476 (1,464,499) different risk/uncertainty associated with the forecasted cash flows of the two
Discount factor 18% 1 0.847 0.718 0.608 0.515 0.436 0.369 companies. Assuming that these margins of errors are perfectly correlated (i.e.
PV cash flow 3,200,000 126,627 1,940,769 120,210 1,736,684 114,004 (540,400)
there are no favourable ‘portfolio effect’), the cost of equity capital after
Net present value over 6 years 6,697,894 merger would be somewhere between the two.
Replace every three years
Annual The precise weighting is a moot point, but in any case, GHP is the bigger
YEARS
Increase % business. One of the following basis may be used for the determining the cost
0 1 2 3 4 5 6
Purchase price 10% 3,200,000 - - 4,259,200 - - -
of equity of the merged entity:
Maintenance costs 15% - 149,500 324,013 730,020 227,371 492,783 1,110,269
Net realizable value 8% - - - (881,798) - - (1,110,812) On the basis of pre-bid market capitalization
Total cash flow 3,200,000 149,500 324,013 4,107,422 227,371 492,783 (543)
Cost of capital
Discount factor 18% 1 0.847 0.718 0.608 0.515 0.436 0.369 Rs. in million
PV cash flow 3,200,000 126,627 232,641 2,497,313 117,096 214,853 (200) allocation
Pre bid market capitalization of GHP 55,800 10.76%
Net present value over 6 years 6,388,330 (Rs. 186 × 300) (55,800 ÷ 67,400 × 13%)
Conclusion Pre bid market capitalization of IJQ 11,600 3.10%
A three year replacement cycle is to be preferred since this costs least in present value terms. (Rs. 58 × 200) (11,600 ÷ 67,400 × 18%)
Total 67,400 13.86%
On the basis of price paid for IJP

Page 3 of 9
Cost of capital
Rs. in million
allocation
Market capitalization of GHP 55,800 10.64%
(Rs. 186 × 300) (55,800 ÷ 68,200 × 13%)
Capitalization of IJQ based on bid price 12,400 3.27%
(Rs. 62 × 200) (12,400 ÷ 68,200 × 18%)
Total 68,200 13.91%
(b) IJQ's shareholders are being offered shares in GHP, currently valued at Rs. 186, in
exchange of every 3 shares they hold in IJQ, currently valued at Rs. 174 (3 × 58).
The offer price represents a premium of Rs. 12 per share to the current market price
which is about 6%. This bid premium seems very low. A fall in share price of about
6% would mean that IJQ's shareholders would suffer loss by agreeing to the
takeover offer.
Page 4 of 9
On the other hand, IJQ’s shareholders might take the view that GHP’s shares are 𝑉𝑉𝑒𝑒 30
𝛽𝛽𝑎𝑎 = 𝛽𝛽𝑒𝑒 � � = 1.50 × � � = 0.596
likely to rise further in value after the takeover because of the effect of synergy. 𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇) 30+70 (1−0.35)
Accepting the offer from GHP would therefore enable them to make a further
capital gain after the takeover has occurred. Regearing
𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 (1 − 𝑇𝑇) 1,157 +1,979.50 (1−0.35)
𝛽𝛽𝑒𝑒 = 𝛽𝛽𝑎𝑎 � � = 0.596 × � � = 1.259
The current share price of GHP is Rs. 186 having risen from Rs. 138 last year. The 𝑉𝑉𝑒𝑒 1,157
increase in price may be on account of market knowledge about the merger or
market speculation about the company’s profit. The possibility that share price will W-3: Cost of debt
remain at this level or rise further may be questioned.
Cash Discount Discount
Year PV PV
Existing EPS and P/E ratio of the two companies are as follows: flows factor factor
Rs. 6% Rs. 10% Rs.
Market value 0 (101.50) 1.000 (101.50) 1.000 (101.50)
EPS P/E ratio
Interest 1-10 7.80 7.360 57.41 6.145 47.93
GHP (See req. (a)) Rs. 21.93 (See req. (a)) 8.48 Capital repayment 10 100.00 0.558 55.80 0.386 38.60
IJQ (Rs. 3,760 ÷ Rs. 200) Rs. 18.80 (Rs. 58 ÷ Rs. 18.8) 3.09 11.71 (14.97)
Moreover, there is a small difference in the profitability of the companies and a very 𝑁𝑁𝑁𝑁𝑁𝑁𝑎𝑎 11.71
𝑘𝑘𝑑𝑑 (1 − 𝑡𝑡) = 𝑎𝑎 + �� (𝑏𝑏 − 𝑎𝑎)� = 6% + × (10% − 6%)
large difference between the P/E ratios at which the two companies are being 𝑁𝑁𝑁𝑁𝑁𝑁𝑎𝑎 − 𝑁𝑁𝑁𝑁𝑁𝑁𝑏𝑏 11.71 − (−14.97)
valued, adding weight to the concern that either GHP's shares are currently over = 7.76%
valued or IJQ’s shares are undervalued by the market.
W-4: Net assets of each company
IJQ shareholders who want high dividends have the option to sell their shares and Chemicals Paints
invest in a different company after the merger has taken place and synergy effect has -----------Rs. in million----------
been absorbed in the share price of the merged entity. Moreover, concerns about Non-current assets 6,610.00 5,250.00
dividend policy may not be relevant for many IJQ shareholders. + Current assets 7,930.00 6,300.00
- Long term debt (2,100.00) (1,950.00)
- Current liabilities (4,770.00) (3,505.00)
A.4 (a) Calculation of WACC Net assets 7,670.00 6,095.00
Shares to be split (7670 : 6095) A (Shares in million) 111 89

𝑉𝑉𝑒𝑒 (𝑾𝑾 − 𝟒𝟒) 𝑉𝑉𝑑𝑑 (𝑾𝑾 − 𝟒𝟒)
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 𝑘𝑘𝑒𝑒 (𝑾𝑾 − 𝟏𝟏) � � + 𝑘𝑘𝑑𝑑 (𝑾𝑾 − 𝟑𝟑)(1 − 𝑇𝑇) � � Market price per share B Rs. 13 13
𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 𝑉𝑉𝑒𝑒 + 𝑉𝑉𝑑𝑑 Market value of equity A× B Rs. in million 1,443 1,157
Market value of the debt
1,443 2,131.50 Rs. in million
WACC (Chemicals) = 15.2% �1,443+2,131.50 � + 7.76% �1,443+2,131.50 � = 10.76% Chemicals : 2,100 × 101.5 ÷ 100 2,131.50
Paints : 1,950 × 101.5 ÷ 100 Rs. in million 1,979.25
Debt equity ratio 60 : 40 63 : 37
1,157 1,979.50
WACC (Paints) = 15.55% �1,157+1,979.50 � + 7.76% �1,157+1,979.50 � = 10.63%
(b) Chemicals
Paints segment
segment
Year 1 Year 1
W-1: Cost of equity --------Rs. in million--------
𝑘𝑘𝑒𝑒 = 𝑟𝑟𝑓𝑓 + �𝑟𝑟𝑚𝑚 − 𝑟𝑟𝑓𝑓 �𝛽𝛽 Net operating cash flows (W-1) 391.75 248.25
𝒌𝒌𝒆𝒆 (Chemicals) = 8% +[14% – 8%]1.2 = 15.2% Less: Tax depreciation (70.00) (40.00)
𝒌𝒌𝒆𝒆 (Paints) = 8% +[14% – 8%]1.259 (W-2) = 15.55% 321.75 208.25
Tax @ 35% (112.61) (72.89)
Debt equity ratio of Chemicals is same as industry (W-4). Therefore, we use 209.12 135.36
the market beta for determination of cost of equity. Add: Tax depreciation 70.00 40.00
279.14 175.36
W-2: Determination of 𝜷𝜷 of Paints
Since the debt equity ratio of Paints i.e. 63:37 (W-4) differ from the industry Discount factor [Chemicals @10.76%(part (a));
gearing level, we must ungear the industry beta and must regear the asset beta Paints @10.63%(part (a)] *
.3611 *
.7620
to take into account the differing capital structure. Here it is assumed that
debt is risk free. PV cash flows (Value of the company) 4,846.17 3,114.74
*1
1 ÷ (10.76% − 5 %)
*
1 ÷ (10.63% − 5%)
W-1: Determination of Portfolio Return %

Conclusion: UAE Bangladesh Pakistan
Probab-
Rs. in million Growth Return Expected Return Expected Return Expected
ility
% value % % value % % value %
Total value of two companies (Rs. 4,846.17 + Rs. 3,114.74) 7,960.91 Low 0.3 5.0 1.5 3.0 0.9 2.0 0.6
Less: Cost of debt (Rs. 2,131.50 + Rs. 1,979.25) (4,111.75) Average 0.5 9.0 4.5 11.0 5.5 8.0 4.0
Value of equity after demerger 3,849.16 High 0.2 13.0 2.6 19.0 3.8 14.0 2.8
Less: Value of equity before demerger (Rs. 13 × 200) (2,600.00) 8.6 10.2 7.4
Gain to existing shareholders due to demerger (1,249.16)
Expected return Pakistan / UAE (0.75 × 7.4) + (0.25 × 8.6) = 7.7%
As the existing shareholders would have a gain due to demerger, it would be Expected return Pakistan / Bangladesh (0.75 × 7.4) + (0.25 × 10.2) = 8.1%
financially advantageous for the KLR to separately float the company.
W-2: Determination of Portfolio Risk %
Chemicals Paints
Pakistan / UAE
Rs. in million
W-1: Net operating cash flows σ = �σa 2 x 2 + σb 2 (1 − x)2 + 2x(1 − x)ρab σa σb
Net operating cash flow (as given) 280.00 360.00
= �1.342 0.752 + 5.122 0.252 + 2(0.75)(0.25)5.96
Adjustments:
= 2.21
Impact of common expenses
Common expenses shared (3150 : 2500) 55.75 44.25 Pakistan / Bangladesh
Actual common expenses (70.00) (30.00)
(14.25) 14.25 σ = �σa 2 x 2 + σb 2 (1 − x)2 + 2x(1 − x)ρab σa σb
Gross profit (net of tax) on sale of raw materials to Paints
(W-2) 126.00 (126.00) = �1.342 0.752 + 8.052 0.252 + 2(0.75)(0.25)10.66
391.75 248.25 = 3.01
(b) First viewpoint

W-2: Gross profit on sale of raw material to Paints
This viewpoint seems correct as EFO's lack of experience in serving overseas
Sales to markets may handicap it. Nevertheless, there may be other overseas investments
Total Other
Paints opportunities, where relative risk may be lower than further investment in Pakistan.
revenues revenue
Segment
--------Rs. in million-------- Second viewpoint
Revenue 3,150.00 787.50 2,362.50 In the given situation it doesn't seem worthwhile to invest outside Pakistan.
Less: Cost of sales (2,772) (787.50) (1,984.50) However, the company should keep on exploring other opportunities with lower
Gross profit 378.00 relative risk. Risk and return vary depending upon the type of investments and
prevailing investment climate.
Gross profit % (378.00÷2,362.50) 16%
Third viewpoint
Gross profit to be earned on sales to Paints Segment Calculation in (a) suggests that Bangladesh offers much higher potential returns, but
(787.50×16%) 126.00 at a much higher risk. Since relative risk of above investment in Bangladesh is
higher, it doesn't seem feasible to invest there. However, investment in Bangladesh
may offer geographical diversification and unexplored opportunities. Hence, it may
A.5 (a) Portfolio Portfolio Coefficient of be advisable to start investing there at a lower level and then consider investing in a
Risk and return major project after getting the experience of Bangladesh business environment.
return % risk % variation
(W-1) (W-2)
Pakistan only 7.40 1.34 18%
Pakistan / UAE 7.70 2.21 29% (c) Other factors which have a bearing on the investment decision
Pakistan / Bangladesh 8.10 3.01 37%
(i) The basis on which estimates of returns have been made or the basis on
As risk increases, so does return. The coefficient of variation is the lowest for the which probabilities have been assigned.
Pakistan investment, indicating that offers the best value. (ii) Assessment of various risks, including political and exchange risks and how
these would be handled.
Suggested Answers
Final Examination - Winter 2012
(iii) Consistency of the investment strategy with the company’s overall business
strategy; For example:
• Investment overseas may only produce significant returns in the longer- Final Examination 5 June 2013
term, which may not fit in with the demands of shareholders for Summer 2013 100 marks - 3 hours
dividend levels to be maintained. Module F Additional reading time - 15 minutes
• A strategy of vertical integration (for example buying up suppliers) may
be better than the horizontal integration (for example formation of a new
factory). Q.1 Haala Car Rental Service (HCRS) owns and operates a large fleet of vehicles. It is
considering whether to dispose of the five cars which were purchased two years ago or to
retain them for a further period of two years as these cars are not popular among the
(THE END) customers.
Following further information is available:
(i) HCRS had acquired these cars under lease financing arrangements on the following
terms and conditions:
Lease period 4 years

Security deposit 10% of cost
Interest rate implicit in the lease 1-year KIBOR + 2%
Payment of lease rentals Annually (payable in arrears)
Early termination penalty 5% of principal outstanding
KIBOR rates in Year 1 and Year 2 were 12% and 11% respectively. In Year 3, KIBOR
is expected to be 10% and is likely to remain at the same level for the next two years.
(ii) At the time of acquisition, HCRS had estimated that the cars would be rented out for
approximately 180 days in a year and had fixed the rental amount to achieve an IRR
of 20%. However, the cars were rented out for an average of 120 days per year in each
of the first two years. HCRS expects the demand to remain at the same level during
the following two years.
Actual/estimated annual maintenance expenditures on each car are as follows:

Actual Estimated
Year 1 2 3 4
Annual maintenance expenditures (Rs.) 60,000 80,000 100,000 120,000
(iii) The cars are estimated to have a residual value of 50% of cost at the end of their useful
life of 4 years. Depreciation is charged on straight line basis.
(iv) The cost of each car is Rs. 1,850,000 and their present realisable values are as follows:
Cars A B C D E
Realizable value (Rs.) 1,200,000 1,300,000 1,150,000 1,350,000 1,250,000
(v) Applicable tax rate for the company is 35%.
Required:
Advise HCRS about the cars which need to be disposed of. (20)
Page 9 of 9
Q.2 (a) Briefly explain any seven factors that are considered for establishing the credit rating of Required:
a debt instrument. (07) SHL estimates that on 30 September 2013, GBP 1 would either be equal to Rs. 154 or Rs.
155 or Rs. 156. Under each of the three possibilities, determine which method should be
(b) Harappa Pakistan Limited (HPL) wishes to invest Rs. 400 million in a project which selected by SHL. (11)
would be financed by issuing debentures of Rs. 250 million and the balance amount
would be financed through excess cash available with the company. HPL anticipates
that the project itself will generate sufficient cash flows to be able to redeem the Q.4 Katkhair Engineering Limited (KEL) is a 100% equity-financed company. The company
debentures in five years. The directors are considering the following three alternatives designs and assembles a wide range of made-to-specification mechanical appliances for
for raising the finance: industrial customers. The actual manufacturing of the components used in appliances is
usually outsourced but KEL ensures that the components conform to its specifications in
(i) Issuance of debentures at a discount with fixed interest rate of 8%. terms of design and metallurgy. The individual components are finally assembled and
(ii) Issuance of zero coupon debentures which would be redeemed at the end of tested at KEL’s own facilities.
year 5 at face value.
(iii) Issuance of debentures at face value at market interest rate. KEL has recently developed a new appliance ‘EN-43’ and is in the process of deciding as to
whether it would be financially feasible to produce EN-43 on commercial basis. The
HPL had also issued debentures amounting to Rs. 150 million previously. These are following information is available:
due to be redeemed in three years and carry mark up at the rate of 10% payable
annually and are being traded at Rs. 94.80. The face value of existing as well as Sales revenue and marketing expenses
proposed debentures is Rs. 100 each. (i) EN-43 would generate cash flows for five years. It is estimated that each EN-43 will
be sold for Rs. 9,000 and annual production and sales of the appliance will be 1,500
The credit rating of existing debentures is ‘A+’. The directors anticipate that after the units in each of the five years.
new issue, the credit rating for both debentures would be ‘A’. (ii) An expenditure of Rs. 3 million was incurred on the designing, testing and market
The investors are expected to invest in the debentures if the following rates are offered: research of EN-43. It includes amount of Rs 1.2 million incurred on materials and
services.
Credit rating Year 1 Year 2 Year 3 Year 4 Year 5
A+ 7.45% 8.62% 9.78% 11.13% 11.84% Outsourcing costs
A 7.70% 8.92% 10.14% 11.60% 12.34% (iii) Manufacturing of components would be outsourced at a total cost of Rs. 4,000 for
each EN-43. It includes Rs. 1,200 for component L-17.
Required:
Analyse each of the above three alternatives relating to issuance of debentures and KEL already has 1,000 units of L-17 in stock. These were acquired for Rs. 800 each.
discuss the circumstances under which each alternative would be advisable. (13) If EN-43 is not produced, the existing units of L-17 would be returned to the vendor
at Rs. 700 each.
Q.3 Shahriq Holdings Limited (SHL) is a subsidiary of a UK based company. It entered into an Assembling costs
agreement to acquire 60% shareholding in a local company for which it received an advance (iv) Assembly of EN-43 would require separate premises whose rent is estimated at Rs.
of GBP 2.5 million from its parent company. The advance is repayable on 30 September 450,000 per annum, payable in advance.
2013. (v) Assembly of each EN-43 would require 15 and 35 man hours of skilled and unskilled
SHL is exploring various options to hedge against any adverse movements in foreign workers respectively. The rate of wages is Rs. 100 per hour for skilled workers and
exchange rates, for which the following data is available: Rs. 60 per hour for unskilled workers. KEL pays 50% for idle hours. If EN-43 is not
produced, 5,000 hours of unskilled workers would remain idle in years 1 and 2.
(i) Exchange rates on 1 June 2013 (vi) Incremental overheads excluding depreciation are estimated at Rs. 500,000 per year.
(vii) The assembling of EN-43 would require machines which would cost Rs. 4,400,000.
GBP 1 The machines would have a useful life of five years after which these may be sold at
Buy Sell 20% of their original cost.
Spot Rs. 153.65 Rs. 153.90
4-months forward contract Rs. 157.49 Rs. 157.75 Other information
(viii) Tax rate applicable to the company is 35% and tax is payable in the same year.
(ii) Currency futures (GBP) on 1 June 2013 Allowable initial and tax depreciation on the machine is 40% and 20% respectively.
(ix) KEL evaluates its investment using a nominal discount rate of 15%.
Futures have a contract size of GBP 5,000 and the margin required is Rs. 7,500 per
(x) The rate of inflation is estimated at 10% per annum and would affect all costs and
contract. Contract prices (Rupee per GBP) are as follows:
revenues.
GBP 1
Required:
June 2013 Rs. 154.67
(a) Recommend whether or not KEL should proceed with the EN-43 project. Assume
September 2013 Rs. 157.36
that working capital requirements are immaterial and all cash flows arise at the end of the
The contracts can mature at the end of the above months only. It is expected that the year unless specified otherwise. (17)
difference between futures and spot prices would continue to remain the same. (b) Carry out a sensitivity analysis to assess and compare the sensitivity of the project, to
the following variables:
SHL’s incremental rate of borrowing is 10% per annum. Sales price
Nominal discount rate (07)
Business Finance Decisions Page 4 of 4 Suggested Answers
Q.5 The Board of Directors of Taxila Power Limited (TPL) is considering to acquire the entire
shareholding of Digari Power Limited (DPL) in a share exchange arrangement. TPL’s
Board is of the opinion that the proposed acquisition would enable TPL to: A.1 Vehicle A Vehicle B Vehicle C Vehicle D Vehicle E
(i) immediately increase the combined profits of the two companies by Rs. 12 million; ----------------------------Rupees-----------------------------
NPV of vehicle if disposed off now
(ii) sell DPL’s surplus fixed assets. These assets can be sold for Rs. 20 million; and
Lease termination cost
(iii) reduce TPL’s risk factor as perceived by its shareholders which would result in decline
(Rs. 937,259 (W-1) × 1.05) (984,122) (984,122) (984,122) (984,122) (984,122)
in their annual return expectations by 2%. Disposal value 1,200,000 1,300,000 1,150,000 1,350,000 1,250,000
Gain on disposal 215,878 315,878 165,878 365,878 265,878
DPL has maintained a steady level of profitability and dividend performance in the Tax thereon (75,557) (110,557) (58,057) (128,057) (93,057)
preceding years and its existing shareholders expect that this trend would continue in the NPV of disposal 140,321 205,321 107,821 237,821 172,821
future. Current market value of DPL’s ordinary shares is Rs. 25.60 per share.
NPV of keeping in rental fleet (W-3) 174,226 174,226 174,226 174,226 174,226
Following information has been extracted from the financial statements of both the
companies for the year ended 31 May 2013: Conclusion:
Since NPV of disposal value of Vehicles B and D is higher than NPV of keeping them in rental
TPL DPL fleet, these vehicles should be disposed off. Other three vehicles should be continued to be kept in
Rs. in million the fleet.
Non-current assets 600 100
W-1 : Repayment Schedule
Current assets, less current liabilities 200 20
Principal Rental Markup Principal Principal
Share capital (Rs. 10 each) 100 50 Period Interest %
at start (W-2) payment payment ending
Reserves 700 70 Year 0 1,850,000 0.00% *185,000 1,665,000
Net profit for the year 80 16 Year 1 1,665,000 571,436 14.00% 233,100 338,336 1,326,664
Dividend for the year (paid on 31 May 2013) 40 16 Year 2 1,326,664 561,871 13.00% 172,466 389,405 937,259
* Security deposit
The current market value of TPL’s ordinary shares is Rs. 56 per share. At present, the
expected growth rate in net profits is 12% per annum which is expected to be maintained
W-2: Computation of lease rental payment
after acquisition. The Board intends to continue to maintain the same dividend payout ratio.
[ ]
Required:
(a) Calculate the maximum price that TPL may pay for the acquisition of DPL. (08)
(b) The financial consultant of TPL is of the opinion that DPL’s shareholders may be [ ]
persuaded to sell the entire shareholding at a premium of 20% over the current market
price. Based on this assumption:
(i) Calculate the number of shares which TPL would be required to issue to the
[ ]
shareholders of DPL as price consideration. (04)
(ii) What benefits, if any, would accrue to the existing shareholders of TPL and
DPL through the proposed acquisition? (03)
(iii) Discuss other relevant factors that the directors/shareholders of both companies [ ]
may consider in assessing the proposed acquisition. (10)
Ignore taxation.
W-3: NPV (if continues to keep the vehicle in the fleet)
Year 3 Year 4
(THE END)
-----------Rupees------------
Expected rental income [Rs. 3,490 (W-4) × 120] 418,800 418,800
Maintenance expense (100,000) (120,000)
Lease rental (W-2) (554,575) (554,575)
Disposal value - 925,000
Net profit/(loss) (235,775) 669,225
Tax @35% 82,521 (234,229)
Profit after tax (153,254) 434,996
Discount factor @ 20% 0.833 0.694
Present value (127,661) 301,887
NPV (if continues to keep the vehicle in the fleet) 174,226
Page 1 of 7
W-4: Determinations of daily rental amount of each vehicle (xi) Retirement benefit liability
Year 0 Year 1 Year 2 Year 3 Year 4 Does the company have unfunded pension / gratuity liability that could pose a
----------------------------Rupees------------------------------- problem in the future?
Cost of vehicle (1,850,000) - - - -
Maintenance costs - (60,000) (80,000) (100,000) (120,000) (xii) Accounting policies
Disposal value - - - - 925,000 If a company uses relatively conservative accounting policies, its reported
(1,850,000) (60,000) (80,000) (100,000) 805,000 earnings will be of ‘higher quality’ than if it uses less conservative procedures.
Discount factor @ 20% 1.000 0.833 0.694 0.578 0.482 Thus, conservative accounting policies are a plus factor in debt ratings.
Present value (1,850,000) (49,980) (55,520) (57,800) 388,010
Net present value to be recovered (1,625,290)
Cumulative discount factor 2.587
(b) Temporarily removed for second review
Yearly rental amount 628,253
Per day rental (÷ 180 days) 3,490
A.3 Hedge using forward contract
A.2 (a) Debt instrument rating are based on qualitative and quantitative factors, some of SHL will have to buy GBP to make this payment.
which are listed below:
Amount to pay in four months time GBP 2,500,000
(i) Debt ratios Forward contract amount (GBP 2,500,000 × 157.7500) Rs. 394,375,000
Various ratios including the debt equity ratio, the times-interest-earned ratio
Hedge using futures market
and the EBITDA coverage ratio. The better the ratios, the higher the rating.
No. of futures contracts to buy (GBP 2,500,000 ÷ GBP 5,000) 500
(ii) Mortgage provision
Is the debt instrument secured by a mortgage? If it is, and if the property has a W-1 : Futures market (profits) / losses ----------------Rupees----------------
higher value in relation to the amount of debt, the debt instrument rating is Opening September futures price 157.3600 157.3600 157.3600
enhanced. Closing September futures price (W-2) 157.4600 158.4600 159.4600
Difference (0.1000) (1.1000) (2.1000)
(iii) Guarantee provision
Some debt instruments are guaranteed by other firms. If a weak company’s Futures (profits) / losses [Difference × GBP 2.5m) (250,000) (2,750,000) (5,250,000)
debt is guaranteed by a strong company, the debt instrument will be given the
strong company’s rating. Net outcome Spot Price (Rs.)
154.00 155.00 156.00
(iv) Sinking fund Spot market payment 385,000,000 387,500,000 390,000,000
Does the debt instrument have a sinking fund to ensure systematic repayment? Financing cost on margin (500 × 7,500 × 10% × 4/12) 125,000 125,000 125,000
This feature enhances the rating.
Futures market (profits)/losses (W-1) (250,000 ) (2,750,000 ) (5,250,000 )
(v) Maturity 384,875,000 384,875,000 384,875,000
Other things remaining the same, a debt instrument with a shorter maturity is
considered less risky than a longer-term debt instrument, and this is reflected W-2: Closing September futures price
in the ratings. As told futures price is in the same relationship to spot price, futures price, in each
scenario, at the end of September
(vi) Stability (i) 154 + (157.3600 - 153.9000) = 157.460
Are the issuer’s revenue and profit streams stable? (ii) 155 + (157.3600 - 153.9000) = 158.460
(vii) Regulation (iii
Is the issuer regulated, and could an adverse regulatory climate cause a decline ) 156 + (157.3600 - 153.9000) = 159.460
in the issuer’s economic position? Conclusion
(viii) Antitrust In all cases, hedging through futures is financially beneficial for the company.
Are any antitrust actions pending against the company that could erode its
position?
(ix) Overseas operations
What percentage of the firm’s sales, assets and profits are from overseas
operations, and what is the political climate in the host countries?
(x) Product liability

Are the company’s profits safe? e.g. the tobacco companies today are under
pressure and so are their debt instrument ratings.
A.4 Y E A R S A.5 (a) Estimated post acquisition market value of TPL

(a) 0 1 2 3 4 5 Rs. in million
-------------------------------Amount in Rupees------------------------------- PV of the future expected dividend flow (W-1) 1,008
Sales (9,000 × 1,500) - 13,500,000 13,500,000 13,500,000 13,500,000 13,500,000
Cost of research and development - - - - - -
Add: Proceeds from sale of surplus assets 20
Component L-17 Post acquisition market value of TPL 1,028
Opportunity cost of L-17 in stock Less: Existing market value of TPL (10 × 56) (560)
(1,000 × 70) - (700,000) - - - -
New components to be bought Maximum price that TPL should pay 468
(2,800 × 1,000) + (500 × 4,000) (4,800,000) (6,000,000) (6,000,000) (6,000,000) (6,000,000)
Rent (450,000) (450,000) (450,000) (450,000) (450,000) -
Wages
W-1: PV of the future expected dividend flow
Opportunity costs of idle workers - (150,000) (150,000) - - - Revised annual cash profit
Unskilled workers (35 × 1,500 × 60) - (2,850,000) (2,850,000) (3,150,000) (3,150,000) (3,150,000) TPL's existing profit 80
Skilled workers (15 × 1,500 × 100) - (2,250,000) (2,250,000) (2,250,000) (2,250,000) (2,250,000)
Overheads - (500,000) (500,000) (500,000) (500,000) (500,000) DPL's existing profit 16
Incremental accounting profit before Synergy effect 12
depreciation (450,000) 1,800,000 1,300,000 1,150,000 1,150,000 1,600,000
Effect of inflation (10%) - 180,000 273,000 380,650 533,715 976,816
108
Net cash flows at current price (450,000) 1,980,000 1,573,000 1,530,650 1,683,715 2,576,816
Tax on incremental profit - 107,800 (402,710) (417,456) (494,683) (577,760) Revised dividends (50% of profit) 54.00
Machines (4,400,000) - - - - 1,417,249
Total nominal cash flows (4,850,000) 2,087,800 1,170,290 1,113,195 1,189,032 3,416,305 Revised cost of equity [20% (W-2)  2%] 18.00%
Discount factor at 15% 1.000 0.870 0.757 0.658 0.572 0.497
Present value (4,850,000) 1,816,386 885,910 732,482 680,127 1,697,904
Net present value 962,808 Using dividend growth model, the PV of future expected dividend will be as follows:
*
Rent recorded on accrual basis and consequently no rent in year 0.
Conclusion
Since NPV of the production is positive, KEL should go for the production of EN-43.
W-2: Cost of capital of TPL using dividend growth model
(b) (i) Sales revenue

= 2.50%
(b) (i) Number of shares to be issued to DPL's shareholders
Rs. in million
(ii) Nominal discount rate
Post acquisition market value of TPL 1,028.00
= 53% Less: Acquisition price to be paid to DPL's shareholders (5 × Rs. 25.6 × 1.2) (153.60)
Post acquisition market value of the current shareholders 874.40
W-1: IRR of the cash flows

Existing number of TPL's shares in issue 10.00
NPV at 15% (computed above) 962,807
Post acq. market price per share [Rs. 730.40 million ÷ (10 + 2.12 (W-1)] 60.26
Years 0 1 2 3 4 5
Total nominal cash flows (Rs.) (4,850,000) 2,087,880 1,170,290 1,113,194 1,189,032 3,416,305 Therefore, number of shares to be issued to DPL's shareholders (153.6 ÷ 60.26) 2.55
Discount factor at 25% 1 0.800 0.640 0.512 0.410 0.328
PV at 25% (Rs.) (4,850,000)) 1,670,240 748,986 569,955 487,503 1,120,548
W-1: Number of shares to be issued to DPL
NPV at 25% (252.768) Number of shares to be issued to DPL =
Total number of shares after acquisition = 10 +
[( ) ] [( ) ]
874.4 = (10 + ) × V 874.4 = 10V + XV
Conclusion
Based on above working, sales revenue is more sensitive variable than nominal Since XV is equal to 153, our revised equation will be
discount rate.
720.8 = 10V
V = 72.08
Since XV = 153 and V=72.08, so X = 2.12.
(ii) Benefits to TPL's shareholders DPL’s shares. A holder of 500 shares in DPL would currently be receipt
of a dividend of a Rs. 1,600 (500 × 3.2). However, after acquisition, the
Post acquisition market value of current shareholders 874.40 expected dividend from 284 TPL shares would be only Rs. 1,304 [54 ÷
Less: Pre-acquisition market value of current shareholders (560.00) (10 + 1.76) × 284].
Gain as a result of acquisition 314.40
To balance against this reduction are the future dividend growth
Benefits to DPL's shareholders prospects which they would gain as a result of the takeover.
20% Premium over market for DPL's shareholders (Rs. 25.6 × 20% × 5) 25.60 (THE END)
(iii) Other factors to be considered are as follows:
The directors and shareholders of TPL

1. They should consider:
 whether there are any other companies that they might take over
instead of DPL;
 whether they could acquire a collection of assets similar to DPL on
a cheaper, piecemeal basis; or
 the assessment of performance forecasts that have been made about
the enlarged companies, especially in relation to the relatively high
synergy profits that are expected to be generated and the reduction
in operating risk.
2. The earning of TPL appears to be growing at a rapid annual rate and it

seems somewhat doubtful that this same growth rate could be achieved
after acquisition of DPL which, as an independent company, shows no
sign of such dynamism.
3. The issuance of shares to DPL may have an effect on the company’s
existing share voting power.
4. Serious consideration should be given to the likely degree of compatibility
of the combined workforces and managements – incompatibility in such
aspect has caused many takeovers to founder in past.
5. They should consider the possible monopoly aspects of the proposed
acquisition
The directors and shareholders of DPL

1. They should consider whether:
 the price offered by TPL is equivalent to the value of the company’s
assets.
 there are any other potential bidders for their company’s share
capital.
 a higher price should be sought from TPL, so that DPL’s
shareholders may get some more synergy benefits which presently
go mostly to the shareholders of TPL.
2. The directors should also examine the future prospects for DPL acting an
independent unit and consider how compatible would be the two sets of
workforces and managements.
3. Finally, of direct importance to the shareholders of DPL, is that they will

suffer a substantial cut in, at least, their current dividend prospects if the
takeover goes ahead.
After acquisition, 5 million shares of DPL would be exchanged for 1.76

million shares in TPL i.e. approximately 284 TPL’s shares for every 500
Q.2 After the increase in tax rates for salaried individuals in the Finance Act, 2013, the
executives of Supreme Group of Companies (SGC) has requested the management to
provide them with company maintained cars in lieu of car allowances to reduce the tax
burden.
The relevant information regarding the staff in management cadre is as follows:
Management cadre Head count Car allowance (Rs.)
Final Examination 4 December 2013 Senior Manager 80 40,000
Winter 2013 100 marks - 3 hours DGM 16 65,000
Module F Additional reading time - 15 minutes GM 8 90,000
Q.1 Premier Airline Company Limited (PACL) has incurred losses during the past several A survey of similar companies has revealed that on average, their car policies involve the
years. Recently, a new management team has taken over the operations of PACL. The following:
new management has observed that there is substantial over-staffing in the non-core Maximum Monthly Monthly
functions. The excess staff is also being paid overtime under the union's pressure. The Management Car value of estimated fuel maintenance
preliminary findings have revealed the following information about employees engaged cadre entitlement car reimbursement allowance
in non-core functions: (Rs.) (Rs.) (Rs.)
Senior Manager 1000cc 1,000,000 15,000 5000
Average annual staff cost Departmental DGM 1300cc 1,500,000 20,000 7000
No. of GM 1800cc 2,000,000 25,000 10000
Non-core functions per head (including 25% overheads
staff
overtime allowance) *1 (variable) The finance department has informed that the cars can be obtained from a leasing
(Rs.) (Rs.) company under the following terms and conditions:
Flight kitchen staff 100 390,000 30,356,097
Janitorial staff 120 240,000 - IRR 12%
Van drivers 80 360,000 12,000,000 Lease period 5 years, rent payable on monthly basis
Other support staff 150*2 270,000 - Insurance 3% annually on cost of vehicle payable in equal
1
* basic salary constitutes 75% of gross salary excluding overtime monthly installments
*2 number of other support staff is 3 times of the actual requirements Down payment 10% of cost
Residual value 20% of cost at which employee would be able to
In order to resolve the problem, a committee consisting of HR and finance professionals purchase the car at the end of the lease period
has proposed the following scheme of restructuring : SGC can obtain financing from the bank at the rate of 13% per annum.
Flight kitchen may be outsourced to a leading hotel chain which would provide
in-flight meals at an average cost of Rs 350 per meal. About 150,000 meal servings Required:
are required annually. Advise whether it would be worthwhile for the company to adopt the proposed vehicle
The required support staff may be provided by an independent human resource policy. Substantiate your answer with all necessary calculations. (15)
management company at a rate equivalent to existing gross salaries plus 15%.
Janitorial services may be outsourced to a firm at an annual contract price of
Rs. 12,000,000. Q.3 Finest Holding Company Limited (FHCL) carries out a number of inter-group
A transport service provider may be engaged to provide the required number of transactions with its three foreign subsidiaries FAL, FBL and FCL which are located in
vehicles with drivers at monthly rental of Rs. 45,000 per vehicle. The present fleet Saudi Arabia, UAE and UK respectively. Details of receipts and payments which are due
which comprises of 40 vehicles, would be disposed of. after approximately three months are as follows.
Golden Handshake Plan (GHP) in the form of 36 basic salaries would be offered to Receiving Company
the redundant staff. Paying
FHCL (Pak) FAL (SA) FBL (UAE) FCL (UK)
Company
------------------------in million------------------------
The committee has indicated that the labour union may agitate strongly against the FHCL (Pak) - SAR 4.21 AED 3.15 UK£ 0.98
restructuring proposal which may create difficulties in the implementation of the scheme. FAL (SA) Rs. 225.30 - US$ 2.86 UK£ 1.64
Therefore, only 20% of the staff is expected to avail the GHP facility when the scheme FBL (UAE) Rs. 105.80 US$ 1.85 - -
becomes effective. The remaining 80% staff is expected to opt for GHP at the end of first FCL (UK) UK£ 1.32 UK£ 2.10 - -
year (40% probability) or at the end of 2nd year (60% probability). On the commencement
of the scheme, such staff would be transferred to a surplus pool. The current spot exchange rates for each unit of foreign currency in equivalent Rupees
are as follows:
Company's cost of capital is 15%. Currency Buy Sell
US$ 107.00 107.20
Required: UK£ 171.09 171.41
Evaluate the financial feasibility of the above restructuring scheme in terms of net present SAR 28.53 28.58
value. (23) AED 29.13 29.19
Required:
Demonstrate how multilateral netting might be of benefit to FHCL. (07)
Q.4 The board of directors of Prime Automobile Limited (PAL) intends to raise Rs. 1,500 Q.5 (a) Differentiate between conservative and aggressive strategies for financing the
million for the company’s expansion project which is expected to generate profit before working capital requirements. What actions should a company take if it decides to
interest and tax amounting to Rs. 325 million. Following options are under consideration follow aggressive working capital strategy? (07)
of the Board:
(b) Top Generators Pakistan Limited (TGPL) is a medium size company which
Option I – 100% debt financing imports and sells a leading brand of generators. Presently, TGPL’s board of
Option II – debt and equity financing in the proportion of 50:50 directors is considering to acquire a plant from China to manufacture a different
brand of generators. The acquisition, installation and commissioning of the plant
Financial information from PAL’s latest audited financial statements is presented below would result in estimated cash outflows of Rs. 600 million. The plant is expected to
in a summarised form: become operational in 6- 8 months.
Summarized Statement of Financial Position TGPL’s bankers have agreed to provide long-term financing for the acquisition of
Rs. in million plant, to the extent of Rs. 300 million. The balance amount is proposed to be raised
Non-current assets 2,358 by revising its working capital strategy.
Current assets 353
TGPL presently follows a conservative policy in the management of its working
Total assets 2,711
capital. Projected assets and liabilities at the end of the current year are as follows:
Share capital (Rs. 10 each) 750 Rs in 000
Reserves 913 Property, plant and equipment 187,500
14% term finance certificates (Rs. 100 each) 526 Trade debtors 375,000
Current liabilities 522 Stock in trade 300,000
Capital and liabilities 2,711 Cash and bank 75,000
Trade creditors (210,000)
Summarized income statement Short-term borrowings (127,500)
Rs. in million
The effect of adopting the proposed working capital strategy, would be as follows:
Sales 1,544
Cost of goods sold (949) Decrease in trade debtors 20%
Gross profit 595 Decrease in stock in trade 30%
Admin. & selling expense (63) Decrease in cash and bank 75%
Operating profit 532 Increase in trade creditors 40%
Interest expense (80) Increase in short-term borrowings 30%
Profit before tax 452
The short-term borrowings limit available to the company is Rs. 200 million. The
Tax (155)
bankers have informed that they would consider increasing this facility after the
Profit after tax 297
new plant would commence operations.
Profit on TFCs are payable on half yearly basis. TFCs are currently being traded at
Required
Rs. 98 each and are to be redeemed at the end of 3rd year.
Being the CFO of the company, prepare a report for the board of directors
PAL has proposed a cash dividend of 30% and issuance of 10% bonus shares to its analyzing and discussing the proposed financing strategy and its consequences on
shareholders. PAL’s shares are currently being traded at Rs. 30 (cum dividend). the business prospects of the company. (12)
Marks for analytical clarity and logical presentation of the report (02)
The average ungeared beta of companies associated with similar business is 1.20. KSE
100 Index can be considered as a representative of market return which has moved from
15530 to 18325 points during the last year. 1-year treasury bills are currently being Q.6 Paramount Industries Limited (PIL) has identified three projects for investment
offered at 11% per annum. purposes. Due to shortage of funds, PIL can opt for only one of the identified projects.
Details of returns and standard deviation of returns from existing operations and
Tax rate applicable to the company is 30%. proposed investments are as follows:
Co-relation of Ratio of existing
Required: Average Standard
returns with operations with
(a) Determine whether PAL has the borrowing capacity to raise the entire investment Description annual deviation
existing proposed
through debt sources as per the Prudential Regulations which requires a minimum returns of returns
operations investment
debt equity ratio of 60:40. (03) Existing operations 17% 25% - -
(b) Compute the existing weighted average cost of capital of PAL. (05) Project A 11% 17% 0.20 85:15
(c) Compute the revised weighted average cost of capital of PAL under each of the two Project B 20% 30% 0.10 80:20
financing options, assuming that the effective cost of existing and new debt would Project C 14% 28% 0.30 90:10
increase as follows:
Option I – by 200 basis points (05) Market returns are 12% with a standard deviation of 19%.
Option II – by 100 basis points (05) Required:
(d) Advise which of the above options would maximize the shareholders’ value. (04) Determine the most beneficial project for investment. (12)
(THE END)
Ans.1 Year 0 Year 1 Year 2 Year 3 onward W-2: Cost after restructuring
----------------------Amount in Rupees---------------------- Rupees
Saving in overheads (30,356,097 + Flight kitchen staff 52,500,000 (150,000 × 350)
12,000,000) - 42,356,097 42,356,097 42,356,097 Janitorial staff 12,000,000 Given
Savings in expected staff salary (W-2) - 49,356,000 84,453,600 137,100,000 Van’s drivers 21,600,000 45,000 × 40 × 12
Payment of GHP (W-1) (49,356,000) (78,969,600) (118,454,400) - Other support staff 12,420,000 (32,400,000 ÷ 3 × 1.15)
Cost after restructuring (W-3) - (98,520,000) (98,520,000) (98,520,000) 98,520,000
Net savings (49,356,000) (85,777,503) (90,164,703) 80,936,097
Discount factor at 15% 1.0000 0.8696 0.7562 5.0413 Ans.2 (All amount in Pak Rupee)
Discounted value (49,356,000) (74,592,117) (68,182,548) 408,023,146
SM DGM GM
Net present value 215,892,481 Car value 1,000,000 1,500,000 2,000,000
Less: PV of residual value 113,485 170,228 226,971
Conclusion [200,000÷(1+0.12)5 [300,000÷(1+0.12)5 [400,000÷(1+0.12)5
Since NPV of the scheme is positive, it is feasible for the company to announce the restructuring scheme proposed
by the Committee. Less: Down payment (10%) 100,000 150,000 200,000
PV of all lease rentals (A) 786,515 1,179,772 1,573,029
WORKINGS
W-1 : Payment of GHP Annuity factor (B) 44.9550 44.9550 44.9550
Flight Janitorial Van’s Other [1-(1+0.01)-60]÷0.01
Total
kitchen staff staff drivers support staff
--------------------------Amount in Rupees--------------------------
Lease rental (A ÷ B) 17,496 26,243 34,991
Cost of Golden handshake
Monthly insurance (3% of car value ÷ 12) 2,500 3,750 5,000
Average staff cost 390,000 240,000 360,000 270,000
Total rental amount 19,996 29,993 39,991
Less: Overtime (25÷125) A (78,000) (48,000) (72,000) (54,000)
Add: Financing cost of down payment 1,083 1,625 2,167
Gross salary B 312,000 192,000 288,000 216,000 Add: Monthly maintenance allowance 5,000 7,000 10,000
Add: Fuel reimbursement 15,000 20,000 25,000
Monthly gross salary 26,000 16,000 24,000 18,000 41,079 58,618 77,158
Basic salary (75% of gross salary) 19,500 12,000 18,000 13,500 Existing allowance 40,000 65,000 90,000
Monthly (savings) / additional cost per
GHP cost per head (basic salary 36) 702,000 432,000 648,000 486,000 management cadre 1,079 (6,382) (12,842)
No. of staff C 100 120 80 150
Total GHP 70,200,000 51,840,000 51,840,000 72,900,000 246,780,000 Head count 80 16 8
Total overtime (A×C) 7,800,000 5,760,000 5,760,000 8,100,000 27,420,000 Total additional costs/ (Savings) 1,035,840 (1,225,344) (1,232,832)
Total gross annual salaries (B×C) 31,200,000 23,040,000 23,040,000 32,400,000 109,680,000 Conclusion:
It is advisable for SPL to adopt the proposed policy as it would save Rs. 1.4 million per annum.
Payment of GHP in Year 0 (246,780,000 × 20%) 49,356,000
Payment of GHP in Year 1 (246,780,000 × 80% × 40%) 78,969,600
` Payment of GHP in Year 2 (246,780,000 × 80% × 60%) 118,454,400 Ans.3 Payments
FHCL (Pak) FAL (SA) FBL (UAE) FCL (UK) Total
Receipts
W-2: Saving in Staff Salaries ------------------All amounts in Rupees------------------
Year 1 Year 2 Year 3 FHCL (Pak) - 120.24 91.85 167.83 379.92
Total gross annual salaries (W-1) 109,680,000 109,680,000 109,680,000 FAL (SA) 225.30 - 306.31 280.85 812.46
Less: Not opt out for GHP (80%, 48%, 0%) (87,744,000) (52,646,400) - FBL (UAE) 105.80 198.14 - - 303.94
Savings in gross salaries 21,936,000 57,033,600 109,680,000 FCL (UK) 226.05 359.63 - - 585.68
Savings in overtime 27,420,000 27,420,000 27,420,000 Total payments 557.15 678.01 398.16 448.68 2,082.00
Total savings in staff salaries 49,356,000 84,453,600 137,100,000 Less: Total receipts (379.92) (812.46) (303.94) (585.68) (2,082.00)
Net payments / (receipts) 177.23 (134.45) 94.22 (137.00) -
Without multilateral netting, the group companies would have required to pay Rs. 2,082.00 million as shown in
the above table. On account of multilateral netting, the amounts payable and receivable were netted and as a result
the amount required to be paid/received was reduced to Rs. 271.45 million i.e. 13.04% of the gross amount,
resulting in savings of transaction/hedging costs.
Ans.4 Temporarily removed for a second review Annexure-1: Working capital requirements and impact on current ratio
% reduction under Proposed Finance released
Existing strategy
Ans.5 (a) Under conservative strategy, working capital is financed through long term loans or share capital whereas proposed strategy strategy from WC
under aggressive strategy, working capital is financed through bank overdrafts, short term loans, factoring Rs. in 000 ------------Rs. in 000------------
arrangement, invoice discounting, etc. Trade debtors 375,000 20% 300,000 75,000
Stock in trade 300,000 30% 210,000 90,000
Furthermore, short term finance obtained under aggressive strategy is cheaper than finance obtained Cash and bank 75,000 75% 18,750 56,250
through long term finance / share capital obtained under conservative strategy. Current assets 750,000 528,750 221,250
Finances obtained under aggressive strategy may easily be withdrawn in the event of a cash crisis which Short term borrowings (127,500) 30% (165,750) 38,250
may not happen under conservative strategy. Trade creditors (210,000) 40% (294,000) 84,000
Current liabilities (337,500) (459,750) 122,250
Action that a company takes if it decides to follow aggressive strategy
Working capital 412,500 69,000 343,500
In order to implement the aggressive working capital strategy, the company should adopt the modern supply
chain and manufacturing techniques so as to reduce the inventory levels.
Current ratio 2.22 1.15
Furthermore, the company should move towards aggressive working capital position by:
Quick ratio 1.33 0.69
 tightening up its debt collection procedures;
 negotiating longer credit periods from supplier. Cash ratio 0.22 0.04
However, if all the above decisions are taken together or abruptly, it may lead to serious reaction from the
affected parties and therefore such a change should be gradual and very well planned.
Ans.6 Expected Market Excess Combin- Market Excess Ratio b/w risk and
(b) To: Board of Directors Projects
return return return ed SD SD Risk return
From: Chief Financial Officer W-1 (A) W-2 (B) (B÷A) ×100
Date: 5 December 2013 A 16.10% 12.00% 4.10% 21.90% 19% 2.90% 71%
Subject: Working capital strategy B 17.60% 12.00% 5.60% 21.45% 19% 2.45% 44%
C 16.70% 12.00% 4.70% 23.49% 19% 4.49% 96%
Dear Sirs,
I have carried out an analysis of the proposal of the Board of Directors regarding adoption of revised
Conclusion:
working capital strategy. The details of my analysis are explained as follows:
Project B should be opted because it is showing better tradeoff between risk and return.
TGPL can release Rs. 343,500 (Annexure-1) presently invested in the working capital by adopting the
W-1 : Average return after adding on new project
proposed working capital strategy. However, adoption of this strategy would significantly affect the current
ratio (reduced from 2.22 to 1.15), quick ratio (reduced from 1.33 to 0.69) and cash ratio (reduced from 0.22
to 0.04). With Project A With Project B With Project C
Weight Return W. Avg Weight Return W. Avg Weight Return W. Avg
TGPL may face serious cash flow problems if proposed working capital strategy is adopted, in case of any of Return
the following eventualities: (Existing) 0.85 17% 14.45% 0.8 17% 13.60% 0.9 17% 15.30%
Return (New) 0.15 11% 1.65% 0.2 20% 4.00% 0.1 14% 1.40%
 Any delay/default in payment from debtors; 16.10% 17.60% 16.70%
 Inventory stock-outs as there would be very little cushion for any unforeseen circumstances.
 Non-availablity of further borrowing limit when required. W-2: Combined standard deviation
√
Furthermore, I am of the view that before acquisition of plant, TGPL should consider whether:
If project A is selected
 The company’s resources under the plan would be squeezed and there seems to be no plan in case the = √
new business does not achieve the desired results. = 21.90%
 the sale of present generators would continue to generate the same level of revenue after the
introduction of new generator. If project B is selected
 The company may face difficulty in financing the working capital requirements of the new business,
specially in meeting the requirement for providing the security. = √
 If the management decides to move gradually towards the aggressive working capital strategy then = 21.45%
how the differential amount would be financed.
If project C is selected
-sd- = √
= 23.49%
Chief Financial Officer
(THE END)
Q.2 Innovative Builders & Developers (IBD) is planning to launch its new residential project
which would offer three different categories of apartments to the prospective customers. The
project is estimated to be completed in four years. Details of the project are as follows:
(i) Plot of land measuring 5000 square yards has been purchased at the rate of Rs.
Business Finance Decisions 50,000 per square yard.
(ii) Documentation fees for transfer of the plot, land levelling costs and architect’s fees
Final Examination 3 June 2014 are estimated at Rs. 20 million, Rs. 40 million and Rs. 15 million respectively.
Summer 2014 100 marks - 3 hours (iii) Details of different categories of apartments are as follows:
Module F Additional reading time - 15 minutes
Apartment No. of Covered area No. of
Q.1 Modern Garments Limited (MGL) operates in Country A whose functional currency is Categories rooms (sq. feet) apartments
CA$. MGL is evaluating a proposal to acquire the entire shareholding (consisting of 100 A 6 1,800 20
million shares) of Elegant Textile Mills Limited (ETML) in Country B in view of the B 5 1,250 32
upsurge in demand for its products in Country B. The functional currency of Country B is C 4 900 50
CB¥. (iv) The common amenities for the above three categories would be equivalent to 20%,
Following information is available relating to the proposed acquisition: 18% and 16% respectively, of the covered area of the apartments.
(v) The aggregate cost of the project would be apportioned on the basis of covered area
(i) ETML has a rated capacity to manufacture 8 million garment pieces per annum. of each category of the apartments including the common amenities.
However, MGL would need to spend CB¥ 2 million on the balancing and (vi) Down payment on booking of the apartment would be 10% of the price. The balance
modernisation of plant. Subsequent to the modernisation, the plant would have a would be payable in 16 equal quarterly instalments.
remaining useful life of 5 years. (vii) The estimated construction cost at the prevailing prices is Rs. 3,000 per square feet of
(ii) Projections for the first year of ETML’s operations after MGL’s takeover are as the aggregate covered area which is envisaged to increase by 15% per annum.
follows: (viii) The construction work is expected to be completed as per the following schedule:
CB¥ in million Year 1 20%
Sales (CB¥ 100 per piece) 500 Year 2 30%
Less: Variable costs (CB¥ 25 per piece) (125) Year 3 35%
Less: Fixed costs (include depreciation of CB¥ 18 million) (30) Year 4 15%
Profit before tax 345
Less: Taxes @ 20% (69) (ix) IBD’s target IRR for such projects is 18%.
Profit after tax 276 (x) It may be assumed that all payments against construction works would be made at
the beginning of the year.
(iii) Contribution margins are expected to increase by 10% per annum, whereas fixed
costs other than depreciation would increase by 5% per annum. Required:
(iv) ETML would be allowed to repatriate only 60% of profit after tax every year. At the Suggest the target price for each apartment in categories A, B and C which IBD should
end of year 5, ETML would be allowed to repatriate the entire amount of profit after recover to earn the target IRR on its investment in the project. (17)
tax including the amount of profit withheld during the past four years. The
withholding tax on repatriation is 10%.
Q.3 Grand Power Limited (GPL), an independent power project, is planning to expand its
It is planned to invest the excess funds in a deposit account at 6% per annum. The installed capacity by establishing a 250 megawatt coal-based power plant. The project is
interest would be paid annually after deduction of 10% income tax which would be expected to become operational in three years. The plant would be set up by a foreign
treated as final tax. company at a cost of Rs. 12 billion which would be payable in 3 equal instalments at the
end of each year.
(v) Tax rate applicable to MGL is 40%. Since there is no double taxation treaty between
Country A and Country B, the amount received from ETML would be subject to the GPL is considering the following two alternatives to meet the financing needs of the
applicable tax rate. However, MGL would be allowed a tax credit by applying expansion project:
ETML’s average rate of tax on the amount repatriated plus tax deducted at the time
Alternative I : Withholding dividends for 3 years;
of repatriation.
(vi) The current exchange rate is CA$ 5 per CB¥ and the CA$ is expected to depreciate Alternative II : Borrowings from market to the extent of debt equity ratio of 60:40.
by 3% per annum.
(vii) Additional working capital requirements are estimated at CB¥ 10 million. Following information has been obtained from the latest audited financial statements:
(viii) In Country B, accounting depreciation is allowed for tax purposes also. Shareholders’ equity Rs. 20 billion
(ix) MGL has a five year time horizon for investment appraisal and required rate of Borrowings Rs. 22 billion
return from the project is 25%.
Profit before interest and tax (PBIT) Rs. 6 billion
Required: Depreciation Rs. 1 billion
Suggest the maximum price that MGL may offer for the acquisition of entire shareholdings Dividend payout ratio 80% of profit after tax
of ETML. (18) Effective tax rate 25%
GPL anticipates PBIT of Rs. 6 million per megawatt per annum from this project whereas Required:
PBIT from existing operations would increase by 10% per annum. It is also anticipated that (a) Make a comparative analysis of existing and proposed options for each vehicle
the amount of borrowing for the existing business operations will continue to remain the category and give appropriate recommendations. (Assume a 30 day month) (14)
same. (b) Calculate and comment upon the sensitivity of the feasibility of the
recommended model to a change in each of the following:
Cost of borrowings would depend on the debt equity ratio, as follows: Average running per day
Fuel efficiency
Debt /equity Cost of borrowing
Fuel price (09)
Less than 50:50 9%
More than 50:50 10%
Q.5 Salient Engineering Limited (SEL) is a leading supplier of auto parts in the country. Its
The current price of the GPL’s stock is Rs. 30 per share. The directors envisage that if financial year ends on 31 May. Extracts from financial statements for the year ended 31
Alternative I is adopted, the price earnings ratio of GPL’s shares would decline to 8 times. May 2014 are as follows:
Required: Statement of financial position
Analyze the two alternatives and give appropriate recommendation to the management. (17)
Rs. in million
Ordinary share capital (Rs. 10 each) 2,400
Q.4 Pioneer Steel Mills Limited (PSML), a listed company, owns and operates a steel re-rolling Retained earnings 952
plant located in an industrial zone. The plant is situated at a distance of 75 kilometres from
8% Term Finance Certificates (TFCs) (Rs. 100 each) 960
the main city and remains operational on 24 × 7 basis during the entire year. (redeemable at Rs. 101 in May 2018)
PSML has made arrangements with a transport service provider for pick and drop of its 11% non-redeemable debentures (Rs. 100 each) 640
staff. The daily rentals agreed with the transport provider are as follows: Income statement
Vehicle No. of Rental per vehicle per day Rs. in million
category vehicles (inclusive of fuel cost) Profit before interest and tax 757
24-Seat Coasters 10 Rs. 8,200 Less: Interest on TFCs and debentures (125)
Cars 8 Rs. 3,000 Profit before tax 632
Less: Tax @ 30% (190)
The transport service provider has recently demanded that PSML should increase the
Profit after tax 442
rentals by 15% because of increase in fuel prices and other operating costs.
Less: Dividends (114)
The CEO of PSML has directed Manager Administration to explore other options available Transfer to retained earnings 328
to the company. PSML has received a proposal from another transport service provider in
which the same number of vehicles would be provided. However, the fuel costs under this The market prices of SEL’s shares and debt instruments on 31 May 2014 were as follows :
proposal would be borne by PSML. The details of monthly rentals per vehicle are as Ordinary shares Rs. 18.4 each, cum-dividend
follows:
TFCs Rs. 97.5 each, ex-interest
24-Seat Coasters Rs. 160,000 per month Non-redeemable debentures Rs. 99.0 each, cum-interest
Cars Rs. 70,000 per month The dividend paid for the year ended 31 May 2013 was 4.4%. It is anticipated that dividend
rate would continue to increase in the foreseeable future at the same rate, year on year.
Following information is also available:
(i) Both the transport service providers offer credit period of 60 days. Credit period Required:
allowed by the fuel supplier would be 15 days. (a) Calculate SEL’s weighted average cost of capital on 31 May 2014. (09)
(ii) The Manager Administration has determined that the fuel efficiency and average
running based on last six months data are as follows: (b) The Board of Directors of SEL are considering an investment of Rs. 450 million
in new production facilities which would increase the profit before interest and
Average running tax by 15%. Following financing options are available:
Vehicle category Fuel efficiency per day per
vehicle Option I : 1 for 8 right issue at a premium of Rs. 5 per share.
24-Seat Coasters 7 km per litre 250 km Option II : Issue of 11% non-redeemable debentures at a discount of 2 percent.
Cars 12 km per litre 130 km
Required:
(iii) Fuel rate per litre is Rs. 108, including 17% general sales tax. PSML is allowed to Evaluate the investment and discuss the implications on SEL of selecting the equity
adjust the sales tax paid on fuel against the output tax of the company. vis-à-vis the debt option of financing. (11)
(iv) PSML purchases fuel through Fuel Cards which entail a service fee of 2%.
(v) PSML obtains financing facilities @ 9% per annum. (c) Explain how quickly the markets would adjust the effect of the above investment
(vi) The vehicle rentals under the existing as well as proposed arrangement would be on SEL’s share price under each of three types of market hypothesis. (05)
valid for one year. (THE END)
Ans.1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Ans.2 Total price for all apartments (W-3) Rs. 1,007 million
CB¥ in million Total covered area of the apartments (W-1) 142,600 square feet
Contribution margin (500-125) 375.00 412.50 453.75 499.13 549.04 Price per sq feet Rs. 7,062
Fixed costs other than
depreciation - (12.00) (12.60) (13.23) (13.89) (14.58) Prices of apartments --------Rs.--------
Depreciation - (18.00) (18.00) (18.00) (18.00) (18.00) Category A (7,062 × 43,200 ÷ 20) 15,253,920
Profit before tax A - 345.00 381.90 422.52 467.24 516.46 Category B (7,062 × 47,200 ÷ 32) 10,416,450
Tax @ 20% B - (69.00) (76.38) (84.50) (93.45) (103.29) Category C (7,062 × 52,200 ÷ 50) 7,372,728
Profit after tax C - 276.00 305.52 338.02 373.79 413.17
W-1: Determination of total covered area
Income from Fixed Deposit Apartment Covered No. of Total covered Common
Total area in sq. ft.
Amount blocked (40% of LYs type area apartments area in Sq. ft. amenities %
PAT & H) + previous year dep. D - - 110.40 253.38 412.45 589.26 A 1800 20 36,000 20% 43,200
Add: Depreciation - - 18.00 18.00 18.00 18.00 B 1250 32 40,000 18% 47,200
Excess funds E - - 128.40 271.38 430.45 607.26 C 900 50 45,000 16% 52,200
Total covered area 142,600
Interest income (6%) F - - 7.70 16.28 25.83 36.44
Less: 10% tax deducted at source G - - (0.77) (1.63) (2.58) (3.64) W-2: Computation of total cost of project in present value terms
H - - 6.93 14.65 23.25 32.79 Rs. in million
Land 250.00
Amount to be repatriated Land transfer fee 20.00
(C+H)x60% - 165.60 187.47 211.60 238.22 981.23
Land leveling cost 40.00
Tax on repatriated amount (10%) - (16.56) (18.75) (21.16) (23.82) (98.12)
Architect fee 15.00
Net amount to be repatriated - 149.04 168.72 190.44 214.40 883.11
PV of construction cost (W-2.1) 412.27
Total cost of the project in present value terms 737.27
Exchange rate 5.00 5.15 5.30 5.46 5.62 5.79
W-2.1 : PV of construction cost
% of Covered Rate Amount PV factor at PV
CA$ in million Year
Net amount to be received in completion area (Sq.ft.) (Rs.) (Rs.) 18% (Rs.)
Country A I - 767.56 894.22 1,039.80 1,204.93 5113.23 2015 20% 28,520 3,000 85,560,000 1.000 85,560,000
Tax to be payable in country A 2016 30% 42,780 3,450 147,591,000 0.847 125,077,119
(40%) - (307.02) (357.69) (415.92) (481.97) (2,045.29) 2017 35% 49,910 3,968 198,042,880 0.718 142,231,313
Tax credit to be available to 2018 15% 21,390 4,563 97,602,570 0.609 59,403,937
MGL (W-1)142,600 528,796,450 412,272,369
Paid on profit / interest
[(B+G)/(A+F) *I] - 153.51 177.08 204.10 234.67 988.89 W-3: Total price for all apartments
Paid on repatriation - 85.28 99.38 115.53 133.87 568.11 Let the total price of apartments be = x
Cash flow from operation in Down payment =0.1x
Country B - 699.33 812.99 943.51 1,091.50 4,624.94 16 quarterly installments = 16R
Working capital to be invested (50.00) - - - - - x = 0.1x + 16R
Cost on the upgradation of x – 0.1x = 16R
machines (10.00) - - - - - 0.9x = 16R
R = 0.0563x
(60.00) 699.33 812.99 943.51 1,091.50 4,624.94 1 � �1 � ��
Discount factor (25%) 1.00 0.800 0.640 0.512 0.410 0.328 ��
Present value (60.00) 559.47 520.31 483.08 447.51 1,516.98 �
�.��
��
�
737.27 (W-2) – 0.1x = 0.0563 × �.��
Value of the company (Total of all discounted value) 3,467.35 �
�.��
⟹ 737.27 � 0.1x � 0.0563x �
�.��
Maximum price that MGL should pay, is CA$ 3,467.35 ��.�� .��
⟹ 0.0563x �
��.��
⟹ 0.6324x � 737.27 � 0.1x
⟹ 0.7324x � 737.27
737.27
⟹x� � 1,007
0.7324
Page 1 of 7
Page 2 of 7
Ans.3 Alternative (I) - No dividend payment Year 1 Year 2 Year 3 Year 4 W-3: Amount to be borrowed
Rs. in billion Funds required 4.00 4.00 4.00
PBIT from existing operations 6.60 7.26 7.99 8.79 Depreciation (1.00) (1.00) (1.00)
Profit from new project [(20-14)*250/1000] - - - 1.50 Profit after tax (3.30) (3.61) (3.99)
Interest @ 9% (W-1) (2.20) (1.98) (1.98) (1.98) Less: Dividend (80%) 2.64 2.89 3.19
4.40 5.28 6.01 8.31 Transferred to RE (0.66) (0.72) (0.80)
Less: Tax @ 25% (1.10) (1.32) (1.50) (2.08) Amount to be borrowed 2.34 2.28 2.20
Profit after tax 3.30 3.96 4.51 6.23
Add: Depreciation 1.00 1.00 1.00 1.00 Additional interest @ 25% less tax - 0.18 0.35 0.52
Cash flow available 4.30 4.96 5.51 7.23
Funds required 4.00 4.00 4.00 -
Excess funds 0.30 0.96 1.51 - Conclusion:
Price earnings ratio 8.00 8.00 8.00 *21.05 In the short term, the alternative II seems more attractive as the shareholders wealth are
higher in all three years. However, after three years, when PSML would restart its
Market value per share of company (EPS x PE Ratio) 13.2 15.84 18.04 65.57 dividend payout and would regain the price earnings ratio of 21.05 times, it would
significantly increase the shareholders wealth. Therefore, it is recommended that the
W-1 management should opt for alternative I.
Debt: Equity 22:20 22:23.3 22:27.26 22:31.77
Interest Rate 10% 9% 9% 9%
Interest 2.2 1.98 1.98 1.98 Ans.4 (a) Feasibility
New rental cost of vehicles Yearly cost Existing
Fuel (Total×12×No. Saving
Vehicles Rental Total of Vehicles) cost (W-3)
*Existing PE ratio is as follows: (W-1)
30 -----------------------------Amount in Rupees-----------------------------
� 21.05 Coaster 160,000 102,503 262,503 31,500,360 33,948,000 (2,447,640)
�6 � 2.2� � 0.75/2
Car 70,000 31,105 101,105 9,706,080 9,936,000 (229,920)
Existing debt equity ratio 52% : 48%. So, the existing cost of borrowing would be 10%. 41,206,440 43,884,000 (2,677,500)
Debt equity ratio over the period of the financing the project
The new proposal is feasible for both types of vehicles.
Debt 22.00 22.00 22.00 22.00
Equity 23.30 27.26 31.77 38.00 W-1: Fuel cost estimate
Debt equity ratio 48.56% 44.6% 40.9% 36.67% Sales tax Financial
Fuel cost
Monthly Cost of @17% and other
Since debt equity ratio is lower than 50% in all three years, the company would save 1% by Mileage Fuel excluding Total
mileage fuel cost
Vehicles efficiency litres sales tax* F+G
adopting this option. estimate D=C×108 E = (17%×D)
F=D-E
(W-2)
[B] C=A÷B
÷ (1+17%)
[A] [G]
Alternative 2 : Borrowing Year 1 Year 2 Year 3 Year 4 ------------------------Amount in Rs.------------------------
Rs. in billion Coaster 250×30=7,500 7 1,071 115,668 16,806 98,862 3,641 102,503
Car 130×30=3,900 12 325 35,100 5,100 30,000 1,105 31,105
Profit after tax 3.30 3.96 4.51 6.23
Additional interest on existing borrowings (1%) (W-2) - (0.17) (0.17) (0.17)
Additional Interest expense (W-3) - (0.18) (0.35) (0.52)
*As sales tax on fuel would be allowable as input tax adjustment against sales tax payable,
Profit after tax 3.30 3.61 3.99 5.54
it should not be part of cost.
Market value per share of company (EPS x PE Ratio) 34.73 38.00 41.99 58.31
W-2: Financial cost on lesser credit period on fuel
W-2: Determination of interest rate Financial
Total Financial
Debt (Existing debt + W-3) 24.34 26.62 28.82 Gross fuel No. of monthly
Annual
Service fee cost
Total and service
Equity (Existing equity + W-3) 20.6 21.38 22.18 Cost cost cost per
Vehicles cost [A] vehicles cost E=D×2% F=(D+E) ×
D=C×12 G=E+F vehicle
Debt Equity ratio 54.09% 55.5% 56.6% (Rs.) [B] C=A×B 9% × 45 ÷ 360
G÷12
------------------------------Amount in Rs.------------------------------
Since debt equity ratio is greater than 50% in all years, the company would continue to pay interest
Coaster 115,668 10 1,156,680 13,880,160 277,603 159,275 436,878 3,640.65
at 10%.
Car 35,100 8 280,800 3,369,600 67,392 38,666 106,058 1,104.77
Page 3 of 7
Page 4 of 7
W-3: Existing rental cost with increment W-2: Cost of TFCs

Rental per day No. of vehicle Rental per annum Rental cost Cash flow Factor @ Factor @
Vehicles Year PV (Rs.) PV (Rs.)
(Rs.) [A] [B] C=A×360 (Rs.) C×B (Rs.) (Rs.) 5% 10%
Coaster 9,430 10 3,394,800 33,948,000 2014 (97.50) 1 (97.50) 1 (97.50)
Car 3,450 8 1,242,000 9,936,000 2015-18 5.60 3.546 19.86 3.17 17.75
43,884,000 2018 101.00 0.823 83.12 0.683 68.98
5.48 (10.77)
(b) Coasters Cars
Daily savings per day per vehicle A 679.93 79.83 5.48
Fuel price with service charge and IRR � 5% � �5% � � � 6.69%
without sales tax B=108 ÷1.17+108× 2% 94.47 94.47 �5.48 � 10.77�
Mileage per day C 250.00 130.00
Mileage efficiency D 7.00 12.00 W-3: Cost of Non-redeemable debenture
Daily consumption E=C÷D 35.71 10.83
 Sensitivity of actual mileage �1 � 30%�

⟹ �11 � � � 8.75%
Maximum further consumption after 88
which there would not be any savings F=A÷B 7.20 0.85
Sensitivity percentage F ÷ E × 100 20% 8%
 Sensitivity of mileage efficiency (b) SEL’s predicted earnings per share figures, Rs. 1.88 and Rs. 1.96 respectively (W-1),
Maximum decline in efficiency after are both higher than its current figure of Rs. 1.84 (W-1), and therefore the project
which there would not be any savings G = C ÷ (E+F) 5.83 11.13 may be accepted.
Sensitivity percentage [(D − G) ÷ (D) × 100] 17% 7%
 Sensitivity of fuel price Right issue:
Maximum increase in fuel price over
after which there would be no savings A÷E 19.04 7.37 This has a lower EPS figure than the debenture issue. However, the level of gearing
Sensitivity percentage Above ÷ B × 100 20% 8% is much lower than debenture issue option [28% compared to 36% (W-2)]. It’s also
lower than SEL’s current level of gearing (30% W-2). The interest cover ratio of (5.91
W-2) is significantly higher than existing (5.14 W-2) and debenture option (4.4 W-2).
Ans.5 (a) Calculation of weighted average cost of capital (WACC)
Market
Number of Total Weighted
The right issue is comparatively small (Rs. 450 million to raise with a market
value per Cost of capitalization of Rs. 4,416 million at present) and so shareholders could be enticed to
shares/ Market average cost
share / equity / debt
debentures Value of capital invest additional funds.
debenture
Equity (18.4−0.475) 17.93 240.00 4,303.20 10.81% W-1 8.02%
Redeemable debentures 97.50 9.60 936.00 6.69% W-2 1.08% Debenture issue:
Non-redeemable This has a high level of gearing (36% W-2) and low interest cover (4.40 W-2). So the
debentures (99−11) 88.00 6.40 563.20 8.75% W-3 0.85% additional financial risk taken on might concern the shareholders.
5,802.40 9.95%
Comments
W-1 : Cost of equity In view of the above, the right issue seems more attractive for SEL’s shareholders
Dividend per share in 2014 4.75% 0.4750 because:
Dividend per share in 2013 4.40% OR 0.4400  Returns are more than existing but only slightly lower as compared to debenture
Growth rate 7.95% 7.95% option.
 Financial risk is at the lowest. Gearing level is lower and interest cover is
d� 0.475 � 1.0795 significantly higher than debenture option.
Cost of equity � �g ⟹
MV�Ex div� 17.93
0.513 W-1: Determination of earnings per share
⟹ � 7.95% ⟹ 10.81% Debenture
17.93
Existing Right issue issue
--------------Rs. in million--------------
Profit before interest and taxation (757×1.15) 870.55 870.55
Less: Interest on debt instrument
Existing (960X8%+640X11%) (147.20) (147.20)
Further issue of debentures (450/0.98×11%) - (50.51)
Profit before taxation 723.35 672.84
Less: Tax @ 30% (217.01) (201.85)
Page 5 of 7
Page 6 of 7
Suggested Answers Final Examination
Module F
The Institute of 2 December 2014
Chartered Accountants 3 hours – 100 marks
Profit after taxation 442.00 506.34 470.99 of Pakistan Additional reading time – 15 minutes
Number of shares outstanding
Existing
Right issue (450÷15)
240.00
-
240.00
30.00
240.00
-
240.00 270.00 240.00
Q.1 Kailash Limited has recently disposed of one of its long-term investments for Rs. 1.5 billion.
EPS 1.84 1.88 1.96 The treasurer of the company has come up with various projects for investment of the said
amount. Details of the projects are as follows:
W-2: Revised gearing ratio
----------------- Projects -----------------
Equity at the end of Year 1 A B C D E
Share capital − Existing 2,400.00 2,400.00 2,400.00 Initial investment (Rs. in million) (400) (450) (600) (550) (800)
Share capital − Right issue - 300.00 - Expected annual cash inflows (Rs. in million) 200 180 220 175 500
Share premium - 150.00 - Discount rate
Retained earnings (952+PAT−Div) 1,280.00 1,344.34 1,308.99 11% 10% 15% 12% 22%
(based on risk involved in the project)
3,680.00 4,194.34 3,708.99
Project duration (years) 4 5 6 7 10
Year from which net cash flows would
1 1 1 2 5
commence (arise at the end of year)
Debt at the end of Year 1
8% TFCs 960.00 960.00 960.00
Non-redeemable debenture
Existing 640.00 640.00 640.00 (i) Project A and B are mutually exclusive.
New (450÷0.98) - - 459.18 (ii) Project C and E can be scaled up by 20% and scaled down by 50%.
1,600.00 1,600.00 2,059.18 (iii) Project A, B and D cannot be scaled up but can be scaled down.
Debt equity ratio 30.30% 27.61% 35.70% Required:

Determine the most beneficial investment mix. (14)
Interest cover (PBIT ÷ Interest) 5.14 5.91 4.40
(c) There are 3 levels of market efficiency hypothesis. The effect of the proposed investment on
Q.2 ARQ (Private) Limited is a small size company whose shares are held by three directors.
the share price at each level of market efficiency hypothesis would be as follows:
ARQ manufactures and sells garments for children. There is considerable demand for its
 Weak form – share prices reflect information about past price movements and future products. The main hurdle in fulfilling the market demand is the working capital constraint.
price movements cannot be predicted from past movements. In the SEL’s case, the share It is anticipated that measures to increase sales would require additional financing as
price should rise / fall when the actual result from the new investment would disclose to follows:
the market. (unlikely)
 Semi-strong form – share prices incorporate all publicly available information rapidly Debtors Stock Creditors
and accurately. In the case of SEL, when the project is announced to the market e.g. in Expected increase in working capital (% of sales) 80% 100% 40%
the newspapers, press release etc., the share price should rise (+NPV project) or fall (-
NPV). Following information has been extracted from ARQ’s latest financial statements:
 Strong form – share prices reflect all information whether published or not. In the case of
SEL, the share price should remain unaltered as the +NPV or –NPV will already be Rs. in million
reflected in the share price i.e. as soon as the decision is made. (unlikely)
Fixed assets 105
(THE END) Current assets 91
Long term liabilities (75)
Current liabilities (64)
Sales 60
Profit after tax 15
60% of profit after tax is distributed as dividends. The company’s bankers have agreed to
provide finance subject to a debt equity ratio of 60:40 or lower.
Required:
(a) Determine the maximum growth in sales which could be achieved in the above
Page 7 of 7
situation. (08)
(b) Calculate the financing requirements in the event the sales are projected to increase to
Rs. 100 million. (04)
Q.3 ZC Limited (ZCL) manufactures metal containers for the paints industry. Presently, ZCL The following information is also available:
has eight machines which were purchased 3 years ago at a cost of Rs. 1.8 million each (i) SSG earns contribution margin of Rs. 45,000 per tonne of product X23.
having useful life of 8 years with zero salvage value. The production capacity of these (ii) It is expected that only 50% of new plant capacity will be utilized in the first
machines is 300,000 containers per annum which is sufficient to meet the existing demand. year of operation which will be increased by 10% in each subsequent year
subject to maximum of 80% capacity.
ZCL anticipates that the demand would increase to 540,000 containers next year and would (iii) Incremental fixed costs other than plant depreciation are estimated at Rs. 300
remain stable in the foreseeable future. The new demand can be met by replacing all the million per annum.
existing machines with 3 hi-tech machines that are available in the market at a cost of (iv) At the end of fifth year, the plant will have a salvage value of Rs. 180 million.
Rs. 10 million each. The new machines will have an estimated useful life of 5 years with (v) Company’s shares are presently being traded at Rs. 47.50 each. Equity beta of
salvage value of Rs. 2 million each. the company is 1.3 and equity risk premium is 5%.
(vi) Cost associated with the issuance of TFCs is estimated at 2.5%.
The following information is also available: (vii) Applicable tax rate is 35%. SSG can claim initial and normal depreciation at
(i) Selling price of each container is Rs. 50 which is expected to increase by 10% per 50% and 10% respectively under the reducing balance method.
annum from year 2 onwards. (viii) Yield on one year treasury bills is 8%.
(ii) Existing raw material cost is 45% of sales which is anticipated to reduce to 42% of
sales by using the new machines. Required:
(iii) The introduction of new machines would reduce the monthly labour cost by Evaluate the above investment by using APV method. (16)
Rs. 146,000 but would increase the overhead expenses, excluding depreciation by
Rs. 2 million per annum.
(iv) All expenses are expected to increase by 8% from year 2 onwards. Q.5 Energy Gen Limited (EGL), an independent power producer, has obtained a foreign
(v) The existing machines can be sold at Rs. 1.2 million each excluding disposal costs of currency loan of USD 100 million to meet the cost of expansion of its generation capacity.
Rs. 60,000 per machine. The principal is repayable equally in quarterly installments along with interest for the
(vi) The increased production capacity will require additional working capital of quarter. Further details of the loan are as follows:
Rs. 3 million. Number of
Loan Amount Installment due
(vii) ZCL follows a policy of charging depreciation using straight line method. Pricing quarterly
(US $) First Last
(viii) It evaluates cost of investment by applying the discount rate of 20%. installments
(ix) Applicable tax rate for ZCL is 35%. Tranche A 45 million 3-month Libor + 2.85% 29 30-Sep-10 30-Sep-17
Tranche B 55 million 3-month Libor + 4.25% 22 30-Jun-12 30-Sep-17
Required:
EGL had hedged the FCY loan on the date each tranche was received on the following
(a) Calculate the Net Present Value (NPV) if the existing machines are replaced with the
terms:
new hi-tech machines. (10)
Hedge Pak Rupee Floating Termination
(b) Assume that the NPV of the incremental cash flows is negative and the management Amount (US $)
Hedge @
Rate Date
is considering to shelve the plan of replacing the machines. Discuss other financial and Tranche A 45 million Rs. 72.11 3-month Kibor + 0.10% 15-Oct-17
non-financial factors which should be taken into consideration before management Tranche B 55 million Rs. 85.40 3-month Kibor + 0.10% 15-Oct-17
takes a final decision. (05)
However, the hedging covers the principal repayment and Libor portion of interest rate
only. The interest portion consisting of margin over Libor was not hedged.
Q.4 (a) Discuss the situations under which adjusted present value (APV) might be a better
method of evaluating a capital investment than net present value (NPV) method. (03) EGL has recently issued 5-year bonds at a fixed rate of 13%. The mark up is payable at the
end of each quarter whereas the principal amount will be repaid in lump sum at the end of
(b) SSG Limited is engaged in the manufacturing and marketing of product X23 in loan period. The par value and current market price of each bond is Rs. 100 and Rs. 103.70
Pakistan. SSG is on course to install new plant costing Rs. 600 million which is respectively.
expected to increase its production by 15,000 tonnes per annum. SSG intends to
finance new plant by issuing new term finance certificates (TFCs). The management After the successful issue of the bonds, EGL is presently considering an option to pay off the
of the company believes that the new issue will not alter the company’s credit rating. entire foreign currency loan by issuing a new series of bonds. Due to the envisaged decline
in interest rates, EGL plans to offer new bonds whose interest rate would be linked to
Following information has been extracted from the company’s latest statement of 3-month Kibor and in line with the current market price. In case of early termination of
financial position: foreign currency loan, EGL will be required to pay 1.5% of outstanding principal amount as
penalty.
Rs. in million
Paid up Capital (Rs. 10 each) 300 Existing Libor and Kibor rates are 2.3% and 11.3% respectively and it may be assumed that
Retained Earnings 1,200 these rates would not change in the year 2015. The spot rate of Pak Rupee/US $ is Rs. 102.
1,500 Exchange rate is expected to change in line with interest rate parity.
Term Finance Certificates (TFCs) (Rs. 1,000 each) 1,500
It may be assumed that today is 1 January 2015.
3,000
Required:
TFCs are due to be redeemed at par in three years and carry mark-up at the rate of Analyse the loan substitution option and give appropriate recommendations. For the
12% payable quarterly and are being traded at Rs. 950 each. purpose of simplicity, you may restrict your calculations to the calendar year 2015. (20)
Q.6 The Board of Directors of Insaaf Chemicals Limited (ICL) is considering to acquire the
entire shareholdings of Mustehkam Chemicals Limited (MCL) in a share exchange
arrangement. The expected share exchange arrangement envisages exchange of 8 shares of
ICL for every 7 shares of MCL.
Summarized statements of financial position and extract of income statements for the latest
year are presented below:
Summarized statements of financial position

ICL MCL
Rs. in million
Non-current assets 12,660 593
Current assets less current liabilities (1,940) 129
Long term liabilities (6,280) -
4,440 722
Share capital (Rs. 10 each) 1,500 200

Reserves 2,940 522
4,440 722
Income statements
Turnover 22,600 1,810
Earnings before interest and tax 2,300 280
Interest (800) (40)
Profit before tax 1,500 240
Taxation (500) (80)
Profit after tax 1,000 160
Dividend to ordinary shareholders (480) (100)
Retained earnings 520 60
Following additional information is also available:
ICL MCL
Expected dividend growth 9% 7%
Current market value of share Rs. 80 Rs. 84
Weighted average cost of capital 12.5% -
Cost of equity 15.5% 13.5%
ICL’s Board is of the opinion that the proposed acquisition would enable ICL to dispose of
surplus buildings for Rs. 110 million and also reduce the staff costs by Rs. 23 million per
year over a period of four years. However, ICL would have to pay Rs. 35 million
immediately to the outgoing staff.
The shares of chemical companies are presently trading at an average multiple of 12 times in
the stock market. The stock market is assumed to be semi-strong form efficient.
Required:
Evaluate the factors that would influence the decisions of the respective shareholders and
discuss the response of the respective shareholders to the offer of acquisition. Substantiate
your answers with relevant financial calculations. (20)
(THE END)

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(2)

Ans.1 (a) COST OF EQUITY OF MR. FARAZ (UNDER CAPM MODEL)

(ii) Portfolio beta as at December 31, 2008 Market Price of TFCs

Hence, number of new total shares 54,880,952

Market value of shares after new share issue Rs. 20.26

Price to remain the same Rs. 16.8

Ans.5 (a) To: Board of Directors

Existing debt (2,800 x 70/30) 6,533

Working 2: Market value of net equity as at June 30, 2008

Working 3: Loss on listed securities portfolio

Working 4: Listed portfolio value as at March 31, 2008 Rupees in million

Value of long term debt 6,533 Working 1

(b) % holding of Mr. Alam

Current market price (700 ÷ 100) (Rs.) 7.00

Number of shares [2,100 ÷ (7 x 90%)] (shares in million) 333.33

Ans.4 (a) Bid amount of annual fee

W-2 Cumulative Discount Factor W-3: Market Value of Equity

ß (project2) = 30 / 37.5 = 0.8

Return and Cost of Project 1

Covariance between project and market

ß (project1) = 25 / 37.5 = 0.67

Return and Cost of Project 2

Covariance between project and market

Ans.1 Conclusion: W-1 : Forward rates

Option II: Foreign Currency Loan

Ans.2 Option – 1: Overhaul and continue Ans.3 Conclusion:

Annual equivalent Net Present Value Rs. 2,738,705

Conclusion: Net profit after tax 124.80 169.00

(b) Rupees Return on investment 19.09% 11.46%

W-2: Total value of company

Working 1: Cost of equity

Rs. € W-1: Required return of the fund

after one year

(d) No. of shares Value Rs. in Weighted

18-Mar-10 7:25:42 PM Page 1 of 7

W-4: Share capital 300.0 300.0 300.0 300.0 300.0

18-Mar-10 7:25:42 PM Page 2 of 7 18-Mar-10 7:25:42 PM Page 3 of 7

Analysis of Investment Bank’s Offer:

W-1: Operating profit excluding other income at year 1 = 3.31

W- 4 : Existing return on assets

(i) Forward Market

Six months contract

Net payment at the end of sixth month € 146,500 x 123.54 18,098,610

(ii) Money Market

18-Mar-10 7:25:42 PM Page 6 of 7 18-Mar-10 7:25:42 PM Page 7 of 7

A.1 (a) YEARS

WORKINGS Present value 2,421 2,292

W2: Weighted Average Cost of Capital than WACC.

Total free cash flow of MK Limited 54,879 A.4 (a) Years

(b) Leasing Years

Business Finance Decisions

Summarized Income Statement

The current price earnings ratios of PL and DL are 15 and 19 respectively.

Alternative 1: Subsidiary in Bangladesh (SIB)

Ignore transaction costs. Current exchange rates are as follows:

  7.9%   (b) Combined portfolio beta

W-1: Contribution margin – Bangladesh W-7: After tax realizable value

Average mid market exchange rate BDT / PKR

Average mid market exchange rate LKR / PKR

(ii) Value of the company  At 50% equity 50% debt

Business Finance Decisions Mutual Funds

Debt equity ratio (up to) 40:60 50:50 60:40 70:30

Financial Leverage A.3 Proposal of BAL Leasing Company Limited