Financial Management | Cost Of Capital | Preferred Stock

Financial Management

Time allowed–3 hours Maximum marks–100 [N.B. – Questions must be answered in English. The figures in the margin indicate full marks. Examiner will take account of the quality of language and of the way in which the answers are presented. Different parts, if any, of the same question must be answered in one place in order of sequence.] Marks 1. (a) What is Efficient Market Hypothesis (EMH)? Explain the differences between three forms of EMH. (b) Konika Ltd. is considering manufacturing a new product. This requires machinery costing Tk. 20,000 with a life of four years and a terminal value of Tk.5,000. Profits before depreciation from the project will be Tk.8,000 per annum. An investment of working capital of Tk.2,000 will be required for the duration of the project. Tax allowances on the machine are 25% p.a. reducing balance. At the end of the project’s life a balancing charge or allowance will arise equal to the difference between the scrap proceeds and the tax written down value. Tax is payable at the rate of 35%. Tax cash flows on profits occur in the same year as the profits giving rise to the tax charge. The cost of capital is 15%. Should the project be accepted? Show your justifications. (c) Tarana Pharmaceutical Company may buy DNA testing equipment costing Tk.60,000. This equipment is expected to reduce clinical staff labour costs by Tk.20,000 annually. The equipment has a useful life of 5 years, but falls in 3-year property class for cost recovery (depreciation) purposes. No salvage vale is expected at the end. The corporate tax rate for Tarana is 38 percent, and its required rate of return is 15 percent. (If profits before taxes on the project are negative in any year, the firm will receive a tax credit of 38 percent of the loss in that year.) On the basis of this information, what is the net present value of the project? Is it acceptable? (d) In Problem 1(c), suppose 6 percent inflation in labour cost savings is expected over the last 4 years, so that savings in the first year are Tk.20,000, savings in the second year are Tk.21,200 and so forth. (i) (ii) If the required rate of return is still 15 percent, what is the net present value of the project? Is it acceptable? If the working capital requirement of Tk.10,000 were required in addition to the cost of the equipment and this additional investment were needed over the life of the project, what would be the effect on net present value? (All other this are the same as in part i.) 6

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2. Star Products Company is a growing manufacturer of automobile accessories whose stock is actively traded on the over-the-counter exchange. During 2003, the company experienced sharp increases in both sales and earnings. Because of his recent growth, Mr. Russel, the company’s treasurer, wants to make sure that available funds are being used to their fullest. Management policy is to maintain the current capital structure proportions of 30% long-term debt, 10% preferred stock, and 60% common stock equity for at least the next 3 years. The firm is in the 40% tax bracket. Star’s division and product managers have presented several competing investment opportunities to Mr. Russel. However, because funds are limited, choices of which projects to accept must be made. The investment opportunities schedule (IOS) is shown in the following table:

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2 Investment Opportunities Schedule (IOS) For Star Products Company Investment opportunity A B C D E F G Internal rate of return (IRR) 15% 22 25 23 17 19 14 Initial investment Tk.400,000 200,000 700,000 400,000 500,000 600,000 500,000

To estimate the firm’s weighted average cost of capital (WACC), Mr. Russel contacted a leading investment banking firm, which provided the financing cost data shown in the following table: Financing Cost Data Star Products Company Long-term debt: The firm can raise Tk.450,000 of additional debt by selling 15-year, Tk.1,000 parvalue, 9% coupon interest rate bonds that pay annual interest. In expects to net Tk.960 per bond after floatation costs. Any debt in excess of Tk.450,000 will have a before-tax cost of debt 13%. Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a Tk.70 par value and a 14% annual dividend rate and will net Tk.65 per share after floatation costs. Common stock equity: The firm expects dividends and earnings per share to be Tk.0.96 and Tk.3.20, respectively, in 2004 and to continue to grow at a constant rate of 11% per year. The firm’s stock currently sells for Tk.12 per share. Star expects to have Tk.1,500,000 of retained earnings available in the coming year. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting Tk.9 per share after underpricing and floatation costs. Required: (a) Calculate the cost of each source of financing, as specified: (1) Long-term debt, first Tk.450,000. (2) Long-term debt, greater than Tk.450,000. (3) Preferred stock, all amounts. (4) Common stock equity, first Tk.1,500,000. (5) Common stock equity, greater than Tk.1,500,000. (b) Find the break-even points associated with each source of capital, and use them to specify each of the ranges of total new financing over which the firm’s weighted average cost of capital (WACC) remains constant. (c) Calculate the weighted average cost of capital (WACC) over each of the ranges of total new financing specified in part (b). (d) Using your findings in part (c) along with the investment opportunities schedule (IOS), draw the fims’s weighted marginal cost of capital (WMCC) and IOS on the same set of axes (total new financing or investment on the x axis and weighted average cost of capital and IRR on the y axis). (e) Which, if any, of the available investments would you recommend that the firm accepts? Explain your answer. 3. (a) What is an efficient portfolio? What are the limitations of portfolio theory analysis? (b) You have identified two quoted shares which you believe will exhibit negative correlation in their possible returns over the next year, as follows: State A B C Probability 0.30 0.45 0.25 Predicted rate of return X 25% 22% 12% Y 14% 18% 20% 5

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3 Required: (i) Calculate the expected return, variance, and standard deviation of each security. 3 (ii) Construct a portfolio consisting of 70% by value of X shares and 30% Y shares. What are the returns of this portfolio for each of the possible states, A, B & C? 5 (c) Why and how CAPM is most useful in project appraisal? (d) Camplan Ltd. is an all equity company with a beta of 0.8. It is appraising a one-year project which requires an outlay now of Tk.1,000 and will generate cash in one year with an expected value of Tk.1,250. The project has a beta of 1.3, rr=10%, rm=18%.. i) What is the firms current cost of equity capital? ii) What is the minimum required return of the project? iii) Is the project worthwhile? 4. (a) A company funds itself with cash from operations in excess of its profitable investment needs and well in excess of its dividend payment in the prior year. It must decide what to do with the surplus money and a reasonable choice may be to: (i) Declare an extra-dividend to shareholders. (ii) Retain the cash and invest in government bonds. (iii) Retire some long-term debt. Advise the Company as to the action to be undertaken. (b) Write short notes on the following: (i) Forward exchange rates (ii) Derivatives (iii) Financial engineering (iv) Sub-prime mortgage. 5. (a) What is management buyouts? What are the reasons for buyout? (b) What are the issues to be addressed when preparing for a buyout proposal? (c) The following information relates to the proposed financing scheme for a management buyout of a manufacturing company: Share capital held by Management: Institutions 10% redeemable preference shares (redeemable in ten years time) Loans Overdraft facilities % 40 60 Tk. (000) 100 150 250 1200 1450 700 700 2850 12 2x4=8 3

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Loans are repayable over the next five years in equal installments. They are secured on various specific assets including properties. Interest is 12% p.a. The manufacturing company to be acquired is at present part of a much larger organization, which considers this segment to be no longer compatible with its main line of business. This is despite the fact that the company in question has been experiencing a turnover growth in excess of 10% per annum. The assets to be acquired have a book value of Tk.2,250,000, but the agreed price was Tk.2,500,000. You are required to write a report to the buyout team, appraising the financing scheme. (d) Your company is considering an investment whose characteristics indicate that it will provide a 10% rate of return (IRR). Your investment banker advises you that the Company can raise enough money to undertake the entire investment with a debenture – debt issue, the after tax cost of which is 8%. Does this sound like a good deal? Explain other options available to you. The End 6 8

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