Suggested Answers: Financial Management

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Suggested Answers

Financial Management
® \ Nov-Dec 2013
t.
1
Ans. to the Question No. I(a)

A normal cash flow sho"YS all the cash inflow and outflow for a particular period but relevant cash flow is used for evaluating
a project which can affect the decision whether to accept or reject the project. Relevant cash flow includes all related opportu-
nity costs set in the time line of the project which arc not considered in normal cash flow. Relevant cash flow conveys the
earning streams in foreseeable fut~rc discounted at the present value but normal cash flow shows historical data of cash
inflow/outflow. The relevant cash flow is future incremental cash flow arising from the decision being made. The relevant cash
I
} flow is the difference between the cash flow if the course of action taken and if not taken.

Ans. to the Question No. 1(b)

The following arc the relevant cost:

Relevant Cost
Taka
(i) Cost to date Tk.15,00,000 are sunk cost and not relevant
(ii) Materials: Purchase price of Tk.600,000 is sunk cost,
There is an opportunity of saving disposal cost 50,000
(iii) Labour cost: The direct cost of 400,000 is not relevant. Opportunity cost
Lost contributi_on Tk.1500,000 - (1,000,000 - 400,000)
(iv) Research staff cost:
Wages for the year (600,000)
Increase in redundany (Tk.350,000 - 150,000) (200,000)
(v) Equipment:
Deprival value
(80,000)
Disposal proceeds in one year 60,000
(vi) Building :
Opportunity cost of rental forgone (70,000)
Total increment cost I (17,40,000)
Increased contribution from the project 30,00,000
Net revenue 12,60,000

Advise: As the net revenue/proceeds is positive management should proceed with the project.

••
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Ans. to the Question No. 1(c)


(Tk'000)
c(a) Investment decision:
. I . t3 t4
Cash flows I · to ti 2
Tk. Tk. Tk. Tk.
Tk.
. ,,
i (5,000)
Cost of plant
j Revenue 7,000 7,000 5,000 5,000
(4,000) (4,000) (4,000) (4,000)
Incremental costs
3,000 3,000 1,000 1,000
Taxable cash flows
(1,200) (1,200) (400) (400)
Tax (40%)
500 375 281 211 633
Tax saved on TDAs (WI)
(4,500) 2,175 2,081 811 1,233
Relevant cash flows
1.00 0.909 0.826 0.751 0.683
DCF (10%)
(4,500) 1,977 1,719 609 842
Present value
Net present value = Tk.647
The project should be accepted as the NPV is positive.

WI: Tax saved on TD As


I
Tax saved @ 40%
·1 Time
to Cost 5,000
to TOA (1,250) 500
3,750
ti TOA (938) 375
2,812
t2 TDA (703) 281
2,109
t3 TDA (527) 211
1,582
t4 Scapvalue
t4 Balance allowance 1,582 633

c(b) Different timing of initial purchase


PV of tax saved on TDAs (plant purchased at beginning of the accounting period):
(500 x 0.909)+ (375 x 0.826) + (281 x 0.751) + (844 x 0.683) =1,552
PV of tax saved on TDAs (plant purchased at the end of the accounting period):
(500 x 1.000) + (375 x 0.909) +(281 x 0.826) + (211 x 0.751) + (633 x 0.683) =1,664
:: : (112)
Differential effect
No effect on the change of decision as the NPV is still positive which - Tk.535 (647- 112).

Wisdom-

I - Fine ifthere is a balancing charge


.Not so if there is a balancing allowance

,
io. 2(a) ,
(b) Going
·eement whereby the parties exchange interest rate commitments. stock
: principle of comparative advantage. This allows two companies to work together to their mutual prefere

ps:
Advantages:
sk that co.unterparty to swap will default before completion of agreement. This risk is lessened by
iary,
j

k: Risk of unfavorable market movements of interest or exchange rates after the company enters a I

!, Disadvantag,
k that swap activity may lead to accounts of party involved being misleading.
·I

(b)

if loan with the biggest difference in rates

at can borrow this type of loan the cheapest.


Pran Lt
(c)
,
i) D
mow fixed, company B variable, reflecting their comparative advantages.
J
s cheaper borrowing in both filled and variable. Interest rate differentials are 3% for fixed and M
:. The difference between these (2%) is the potential gain from the swap.
:iually between the two counter parties, each should gain by 1%. W
of achieving this is for A to pay B LIBOR (variable) and for B to pay A 10%. ((
(a,
A B
(10%) (LIBOR + 2%)
(LIBOR) LIBOR
10% (10%)
(LIBOR) (12%)
(LIBOR + 1%) (13%)
I% 1%

Ke

=]

'},% 36 /94
,
( =
Ans. to the Question No. 2(¢c)
t
(i) At the various level ol gearing the weighted average cost of capital of Marzan will be as follows:
The after tax cost of debt is 10% (I- .OJ)= 7%

Gearing ratio WACC%


0 20%
20 (0.8 x 21.625)+ (0.2 x 7) 18.7%
40 (0.6 x 24.333) + (0.4 x 7) 17.4%
50 (0.5 x 26.5) + (0.5 X 7) 16.8%
60 (0.4x 29.75) + (0.6 x 7) 16.1%

(ii) Significance of the results:


The implication of part (i) is that WACC falls continuously as the gearing ratio increases. This is
consistent with M&M's 1963 proportions on gearing.
MM suggests that the optimal capital structure in a taxed world is 99.9% debt.
Whether the contention is true is a vexed issue. Both M&M's 1958 article, which argued that there was no optimal
capital structure but assumed no corporation tax, and their 1963 correction to allow for corporate taxes, are at
variance with the traditional view. The debate regarding the effects of gearing on the weighted average· cost of capital
is essentially empirical.

(iii) Possible consequences of a high gearing:


The general understanding is that with the introduction of corporation tax with debt interest is an allowable expenses
for tax purpose and the weighted average cost of capital shall continuously decline. The total value of firm is
maximized where the gearing ratio is 99.9%. This conclusion may not be acceptable to many finance managers and
they do not allow extremely high debt/equity ratio. The reasons are as follows:
(i) The numerical analysis carried out assumes a constant cost of debt and unaffected by the level of gearing. But in
practical with the increase of debt, risk will also increase and at a point of time cost of debt will be equal to cost
of equity.
(ii) The firm having low profit earning capacity may not suitable for high geared capital structure as it increases
financial risk and decreases earnings per share.
(iii) High gearing may lead unexpected influence by lenders through imposing of covenants on management/
shareholders decisions.
(iv) There is chance of bankruptcy due to high gearing. Hence, chance of financial distress increase due to high
gearing which may outweigh the tax advantages.

Ans. to the Question No. 2(d)

(i) Ex-right price:


Tk.
4 existing share 4 x 3.00 12.00
I right share Ix 2.00 2.00
14.00
Theoretical value of Kohinoor's ex-right is Tk.14.00 = Tk.2.80
5

UC
(ii) Value of right: T.2.80 - 2.00 = Tk.0.80.
One right enables a holder to buy a share at Tk.2.00 which will eventually sell for Tk.2.80. The value of right to buy one share
is, therefore, Tk.0.80. Four existing shares are needed to buy one additional share. Therefore, the theoretical value of the rights
attached to each existing share is Tk.0.20 (0.80/4)

Ans. to the Question No. 3(a)

Dividend relevance theories reveal that the underlying dividend policy influences the value of the firm as it causes the change
of share price in the market. On the other hand dividend irrelevance theory conveys that the dividend is merely a spilt of profit
and it does not increase the wealth of the shareholder as he receives cash but he loses his claim on company assets to that extent
so that it will not cause to increase the share price as well as the value of the firm. As per dividend irrelevance, the value of the
firm depends on the firm's earnings which result from its investment policy.

The relationship between the firm's rate of return (r) and its cost of capital (k) is important in determining the dividend policy
that will maximize the wealth of shareholders. If the firm has investment opportunities and 'r' is greater than 'k' then the value
of the firm increases as the retention increases and vice versa. If 'k' is greater than 'r' it is better to give dividend as much as
'possible. Dividend policy concerns the decision between payout and retention. Therefore dividend policy has the relevancy in
determining the value of the finn.

Ans. to the Question No. 3(b)

(i) Tk.
Projected income 20,00,000
Less: Projected capital investment 8,00,000
Available residuals 12,00,000
Shares outstanding 2,00,000
Dividend per share (DPS) Tk.6.00

(ii) EPS = 20,00,000 / 2,00,000 = Tk.1 O


Payout ratio DPS I EPS =6/10= 60%

D1 6 (1+0.05)
(iii) Currently Po=-------=------------ =----- = Tk.70
rs -g 0.14-0.05
Po just before the news of the retirement of founding director, DI would be based on a 20% payout on Tk.10 EPS, or Tk.2.
With rs = 14% and g = 12%,'
DI 2(1+0.12)
Po would be Po =-------= ------------ = Tk.1l2
rs-g 0.14-0.12
The share price has fallen to the extent of Tk.42 [112-70] after getting the news of retirement of founding director because of
reduction in ROE (possible loss). We calculated ROE from the above growth rates before and after retirement:
Before retirement: g = 0.12, b = 0.80 therefore ROE = 15% [0.12 = 0.80 X ROE]
After retirement: g = 0.05, b = 0.40 therefore ROE = 12.5% [0.05 = 0.40 X ROE]; moreover 12.5% is less than cost of capital
14% so that higher payout is insisted.
Hence share price is fallen due to lower ROE and higher payout (obvious as ROE<K) resulting lower growth after retirement
of founding director.

7,% 38 f94
(v) If a payout ratio ·was,continucd at a 20 percent, even aficr internal investment opportunities had declined, the price of the
stock would drop to Tk\26.5 [2(1.06)/0.14-0.06]. This is due to lower ROE (7.5%) which is less than cost of capital (14%).
"
Ans. to the Question No. 4(a)
A company faces three types of exchange rate risk exposures in its foreign operations. These arc translation exposure, transac-
tions exposure, and economic exposure. Translation exposure is the change in accounting income and balance sheet statements
caused by accounting treatment of a foreign subsidiary. Transactions exposure relates to settling a particular transaction such
as open-account credit, at one exchange rate when the obligation was originally booked at another. Economic exposure has to
do the impact of unanticipated changes in the exchange rates on expected future cash flows and, hence, on the economic value
of the firm.

There are many ways by which these risks can be managed. Natural hedges, cash management, adjusting of intra-company
accounts; as well as international financing hedges, and currency hedges, through forward contract, futures contracts, currency
options, and currency swaps, all serve this purpose.

Ans. to the Question No. 4(b)


Forward exchange contracts hedge against transactions exposure by allowing the importer or exporter to arrange for a bank to
sell or buy a quantity of foreign currency at a future date, at a rate of exchange determined when the forward contract is made.
The trade will know in advance in advance in the how much local currency he will receive or how much local currency he must
pay. Executed as:
• It is being executed between an el<.porter/lmportcr with a bank who deals foreign currency
• It is being binding contract between a bank and customer.
• For purchase or sale of a specified quantity of foreign currency.
• A rate is fixed at the time the contract is made.
• For performance at a future time which is agreed when making the contract.

Ans. to the Question No. 4(c)

(i) Amount of taka to be received by Friends Int. Ltd.


Method (i) Invoice in Taka, Cash received Tic. I 00,000
Method (ii) Convert price Dollars now at a current rate i.e. Tk. 100,000 x 1.11 =S 111,000
Receive $111,000 in three months and convert to Taka
Best outcome $111,000,+ 1.09 = Tk.101,835
Worst outcome$ 111,000 + 1.20 = Tk.92,500
Method (iii) Since Friends is to invoice in Dollar now($ 1111,000), Friends need to sell the
dollars forward three months.
Forward rate= Spot rate less premium
The appropriate premium to take is 1.15 cents, which applies to selling dollars for taka.
Thus forward rate= $(I.I I • 0.015) =$1.0985
Friends therefore enter into forward contract now which will enable them to receive with
certainty in three months $ 111,000+ 1.0985= Tk.101,047.

(bq
(ii) Report
Directors
Friends Int. Ltd.

Re: Best method of invoicing for the export of a machine

Dear Sir,
This report I have discussed the advantages and disadvantages of three methods of invoicing for your consideration.
(i) Invoicing in Taka: This has advantage of guaranteeing the sum which is receivable in three months as
Tk. 100,000. But there is chance of getting higher amount by taking risk.

(ii) This method has advantage by gain which will be made if the taka falls against the dollar. But there is chance of cost
if taka rises. It might be like a gamble.
(iii) The forward contracts eliminate the risk from currency fluctuations. In this case receive a value high than Tk. l 00,000.

Conclusion:
Since the risk of default is regarded as small, recommend that you adopt method (iii) in invoicing Fortuna Inc.

(iii) Implication for undertaking a major export sales drive.


Currency Problem: Invoicing in Taka, a customer's currency, is a complicated decision.
Trading risk: Lack of knowledge of the business environment of the foreign country and the risk is higher. The
customer also may not be known. This might be political risk as well. There is a risk of non-payment or delayed payment.
Collection period and working capital: As in the case of foreign sale, collection period might be longer and higher
amount of working capital is needed. Therefore, higher amount of bank finance is required.

2,% 40 -f94
%

! I.
I
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.FINANCIAL MANAGEMENT
Time allowed- 2 ½ hours
Total marks - 100

[N.B.-. Questions must be answered in English. Figures in the margin indicate full marks. Examiner will take
account of the quality of language and of the manner in which the answers arc presented. Different
parts, if any, of the same question must be answered in one place in order ofsequence.]

. I. (a) "Relevant cash flow differs from the normal cash flow" explain the difference . 2
(b) As a financial expert, you are reviewing an ongoing research project. The following cost and
revenue information is provided to you.
The project to date has cost of Tk. 15,00,000.

If proceeded with the project it will be completed within one year, when the results are to be sold
to a government agency for Tk. 30,00,000.
The following additional expenses are required to complete the project:
Materials: A toxic material has just been purchased at a cost of Tk. 600,000. If this material is not
used in this project, it must be disposed off at a cost of Tk. 50,000.

Labour: Skilled labour is not easily available. The workers concerned were transferred to the
project from a production department, and al a recent meeting the production manager claimed
that if these people were returned to him they could generate sales of Tk. 15,00,000 in the next
year. The prime cost of these sales would be Tk. I 0,00,000, including Tk. 4,00,000 for the labour
cost itself. The overhead absorbed into this production would amount to Tk. 2,00,000.

Research staff: It has already been decided that, when work on this project ceases, the research
department will be closed. Research wages for the year are Tk.600,000, and the redundancy and
severance pay has been estimated at Tk.150,000 now, or Tk. 350,000 in one year's time.

Equipment: The project itilitizes a special microscope which cost of Tk. 180,000 three years ago. It
has a residual value of Tk. 30,000 in another two years and a current disposal value of Tk. 80,000. If
used in the project it is estimated that the disposal value in one year's time will be Tk. 60,000.

Building services: the project is charged with Tk. 350,000 per annum to cover general building
expenses. Immediately the project is discontinued, the space occupied could be sub-let for an
annual rental ofTk. 70,000.

Requirement:
You are to work out the relevant cost and revenue and advise the management whether to proceed
with the project.
8

},% s4 (94
oo
(c) Gemini Foods Ltd, is considering investing in an ice cream plant to operate for the next four years.
After that time the\plant will be worn out, and Gemini, the owner of the company, wishes to retire
in any case. The plant will cost Tk. 5,000,000 and is expected to have no realizable value after four
years. If worthwhile the plant will be purchased at the end of an accounting period. Tax
depreciation at the rate of25% per annum will be available in respect of the expenditure.

Revenue from the plant will be Tk. 7,000,000 per annum for the first two years and Tk. 5,000,000
per annum thereafter. Incremental costs will be Tk. 4,000,000 per annum throughout. You may
assume that all cash flows occur at the end of the financial year to which they relate. Assume
Gemini Foods Ltd. pays corporate tax at 40% and has a cost of capital of 10%.

Required:
(a} Advise Gemini Foods Ltd., whether or not to proceed with this investment in the ice cream plant. 5

(b) Show what difference it would make if the plant were to be purchased and sold at the
beginning of the accounting period. Comment on the wisdom of disposing of an asset on
5
the first day of an accounting period.

(a) What is interest rate swap? How do swaps work? What are the risks of swap?
s
2
(b) Company A wishes to raise USD 10 m and to pay interest at a floating rate, as it would like to
be able to take advantage of any fall in interest rates. It can borrow for one year at a fixed rate
of IO percent or at a floating rate of I percent above LIB OR.
Company B also wishes to raise USD I0 m. They would prefer to issue fixed rate debt because
they want certainty about their future interest payments, but can only borrow for one year _at 13
percent fixed or LIBOR plus 2 percent floating, as it has a lower credit rating than company A.
Requirement: Calculate the effective swap rate for each company -assuming savings are split
equally.

(c) Marzan Ltd has recently been incorporated. Directors of Marzan Ltd. are considering five
different possible capital structures for the new company. An analysis of comparable
companies with equivalent business risk has been undertaken. The analysis shows that if
the before tax cost of debt is a constant 10% irrespective of the capital structure, then the
cost of equity capital after corporation tax will be as follows:

Gearing ratio Cost of equity capital


( debt capital/total capital)
% %
0 20.0
20 21.625
40 24.333
50 26.500
60 29.750

I
I 2ss
The above predictions for the equity cost of capital also assume that the earning of
Marzan will be taxed at a rate of 30% and that the debt interest is an allowable expense
for tax purposes.
The sponsors expect that the company will generate a constant annual earnings stream
before the payment of debt interest for the foreseeable future.
Requirements:
(i) Calculate the effective after· tax weighted average cost of capital for each of the five
possible capital structure, assuming that the before tax annual cost of debt will be a
constant 10% (irrespective of the capital structure chosen), 6
(ii) Interpret the results of your calculation in above and explain their significance in light
of the M&M hypothesis,
4
(iii) Discuss the possible consequences to a company of having a capital structure
containing a high gearing ratio. 4

(d) Kohinoor Ltd. has issued 100,000 Tk. I equity shares which are at present selling for
Tk.3 per share. The company has plans to issue rights to purchase one new equity share at
a price of Tk. 2 per share for every four shares.
(i) Calculate the theoretical ex-rights price of equity shares. 3
(ii) Calculate the theoretical value ofa right before the shares sell ex-rights. 3
3. (a) The terms relevance and irrelevance have been used to describe theories regarding the
way dividend policy affects a firm's value. Explain what these terms mean and discuss
the relevance of dividend policy.
6

(b) Unique Corporation Ltd. (UCL) has an all-common equity capital structure. It has 200,000
shares of Tk. 2 par value common stock outstanding. One of the most important and
contributing founding director of the company become sick and take sudden retirement in
late 2012. That caused problem and affected the company with lower growth expectation and
loss of business. Unfortunately there was no immediate replacement. Previously, the
company found it necessary to plough back most of its earnings to finance growth, which
averaged 12 percent per year. Future growth at a 5 percent rate is considered realistic, but that
level would call for an increase in the dividend pay out. Further, it now appears that new
investment projects with at least the 14 percent rate of return required by UCL's stockholders
would amount to only Tk. 800,000 for 2013 in comparison with a projected Tk. 2,000,000 of
net income. If the existing 20 percent dividend payout were continucd, retained earnings
would be Tk.1.6 million in 2013, but as noted, inveslmcnts thal yield the 14 pcrccnl cost of
capital would amount to only Tk. 800,000 ..

The one-encouraging factor is that the high earnings from existing assets arc expected to
continue, and net income of Tk. 2 million is still expected for 2013. Given the
dramatically changed circumstances, UCL's management is reviewing the firm's
dividend policy.

,% 86 /94
@y

(i) Assuming that the acceptable 2013 investment projects would be financed entirely by
earnings retained during the year, calculate DPS (dividend per share) in 2013 if UCL
5
follows the residual dividend policy.
3
(ii) What is the payout ratio for 2013?
(iii) If a 60 percent payout ratio is maintained for the foreseeable future, what is your
estimate of the current market price of the common stock? How does this compare
with the market price that should have prevailed under the assumptions existing just
before the news of the founding director's retirement? If the values of Po (present
6
va[ue at year zero) are different comment on why.
(iv) Whal would happen to the price of the stock if the old 20 percent payout were
continued? Assume that if this payout is maintained, the average rate of return on the
5
retained earnings will fall to 7.5 percent and the new growth rate will be 6 percent.

4. (a) "A company faces three types of exchange rate risk exposure in its foreign operation"
4
discuss how these risks can be managed?
4
(b) What is a forward exchange contract? How it is being executed?
(c) Friends International Ltd. has recently finalised a contract with a US company Fortuna
Inc. for the supply of a machine. The selling price is Tk. 100,000. As this is the first
export sale made by Friends Int. Ltd. the currency settlement details were not discussed at
the meeting when the sale of the machine was agreed. The management of Friends Int.
believes that Fortuna will agree to whatever currency settlement is suggested since
Fortuna is very anxious that the machine contract be completed quickly. Delivery of the
machine will take place in three months time when the account will be settled
immediately by Fortuna.
The management of Friends Int. is considering three possible methods of invoicing
Fortuna for the machine:
(i) Prepare the invoice in Taka (for Tk. 100,000) and request payment in Taka on the
settlement date;
a. Convert the Taka price at the current Tak a/Dollar spot rate and invoice Fortuna in
dollars. Buy Taka at the spot rate in three months' time when the Dollar
settlement is made by Fortuna.
b. Invoice Fortuna in Dollars converting the Taka price at the spot rate. Friends Int.
will then immediately cov\:r the position in the forward exchange market by
selling the dollars receivables forward at the three month forward exchange rate.
The current spot rate between Taka and Dollars in London is Tk. I=$ 1.11. The premium
for the Dollar for three month forward exchange contract is quoted as 1.20 -1.15 cents
(the buying/selling range). The management of storage believes that the Taka/Dollar spot
rate will be somewhere in the range Tk. 1=$1.20 lo n. !=$ 1.09 in three months' time.
Ignore taxation.
Requirements:
(i) Calculate the amount of Taka to bc received by Friends Int. under cuch of the three
. 6
methods.
(ii) Prepare a report to the management of Friends Int. which sets out the advantages and
disadvantages of each method, and which contains your recommendation as lo choice of
8
method.
(iii) What are the implications for financial management of undertaking a major export sales drive? 3

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