SUGGESTED ANSWERS – SPRING 2015 EXAMINATIONS 1 of 7

STRATEGIC FINANCIAL MANAGEMENT – SEMESTER-5

Marks
Q. 1 (a) Selection of project on the basis of net present value (NPV):
Gas Project Rs. ‘000’
First 10 Years Last 20 Years
(2019 – 28) (2029 – 48)
Annual revenues 500,000 500,000 ½
Annual costs:
Gas purchase 200,000 200,000 ½
Customer relation 3,000 3,000 ½
Labour 60,000 60,000 ½
Sales and marketing 35,000 35,000 ½
Other costs 4,000 4,000 ½
Total costs 302,000 302,000 ½
Incremental taxable cash flow 198,000 198,000 ½
Tax at 35% 69,300 69,300 ½
After tax cash flows 128,700 128,700 ½
Tax credit on depreciation (300,000 x 10% x 35%) 10,500 0 1
Incremental cash flow 139,200 128,700 ½
PV factor @ 6% (W-1) 6.180 5.377
Present value 860,256 692,020 ½

Other cash flows: Rs. ‘000’

Years 2016 2017 2018 2019 2048
After tax redundancy costs 3,000 ½
Plant and machinery cost 150,000 150,000 ½
After tax demolition cost of existing power station 7,000 ½
After tax demolition cost of gas station 5,000 ½
PV factor @ 6% 0.943 0.890 0.840 0.792 0.146
Present value 141,450 133,500 5,880 2,376 730 1
Total 283,936 ½
OR 1½ + ½ + ½ + ½ + ½ = 3½
Total NPV = Rs.860,256,000 + Rs.692,019,900 – Rs.283,936,000
= Rs.1,268,339,900 1

W-1: Weighted average cost of capital (WACC):

Cost of equity (Ke) {5.6% + (15% – 5.6%) x 1.2} 16.88% ½
Cost of debt (K d) {0.09 x (1 – 0.35)} 5.85% ½
WACC {(16.88 x 0.7) + (5.85 x 0.3)} 13.57% 1
Real rate {(1 + 0.1357) ÷ (1 + 0.07) – 1} 0.0614 or 6% 1

2019 – 28 = 8.853 – 2.673 = 6.180 ½

2029 – 48 = 14.230 – 8.853 = 5.377 ½

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provided suggested answers on the basis of certain assumptions for general guidance of the students and there may be other possible answers/ solutions based on different assumptions and understanding. The ICMA Pakistan and its
Council Members, Examiners or Employees shall not be liable in respect of any damages, losses, claims and expenses arising out of using contents of these suggested answers. It is clarified that the ICMA Pakistan shall not be liable
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 SUGGESTED ANSWERS – SPRING 2015 EXAMINATIONS 2 of 7
STRATEGIC FINANCIAL MANAGEMENT – SEMESTER-5
Marks
Coal Project Rs. ‘000’
First 10 Years Last 20 Years
(2019 – 28) (2029 – 48)
Annual revenues 500,000 500,000 ½
Annual costs:
Coal purchase 10,000 10,000 ½
Customer relation 15,000 15,000 ½
Labour 25,000 25,000 ½
Sales and marketing 35,000 35,000 ½
Other costs 20,000 20,000 ½
Total costs 105,000 105,000 ½
Cash flows before tax 395,000 395,000 ½
Tax at 35% 138,250 138,250 ½
After tax cash flows 256,750 256,750 ½
Tax credit on depreciation (2,000,000 x 10% x 35%) 70,000 0 1
Incremental cash flow 326,750 256,750 ½
PV factor @ 8% (W-2) 5.327 3.610
Present value 1,740,597 926,868 ½

Other cash flows: Rs. ‘000’

Years 2016 2017 2018 2019 2048
After tax redundancy costs 30,000 ½
Plant and machinery cost 1,000,000 1,000,000 ½
After tax demolition cost of existing power station 7,000 ½
After tax demolition cost of coal station 500,000 ½
PV factor @ 8% 0.926 0.857 0.794 0.735 0.079
Present value 926,000 857,000 5,558 22,050 39,500 1
Total 1,850,108 ½
OR 1½ + ½ + ½ + ½ + ½ = 3½
Total NPV = Rs.1,740,597,250 + Rs.926,867,500 – Rs.1,850,108,000
= Rs.817,356,750 1

W-2: Weighted average cost of capital (WACC):

Cost of equity (Ke) {5.6% + (15% – 5.6%) x 1.6} 20.64% ½
Cost of debt (K d) {0.12 x (1 – 0.35)} 7.80% ½
WACC {(20.64% x 0.6) + (7.8 x 0.4)} 15.50% 1
Real rate {(1 + 0.155) ÷ (1 + 0.07) – 1} 0.0795 or 8% 1

2019 – 28 = 7.904 – 2.577 = 5.327 ½

2029 – 48 = 11.514 – 7.904 = 3.610 ½
Based on NPV, Gas project should be accepted. 1

DISCLAIMER: These suggested answers including write-ups, tables, charts, diagrams, graphs, figures etc., are uploaded for the use of ICMA Pakistan members, students and faculty members only. No part of it can be reproduced,
stored in a retrieval system or transmitted in any physical/ or electronic form or by any other means including electronic, mechanical, photocopying, recording or otherwise without prior written permission of the ICMA Pakis tan. The
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provided suggested answers on the basis of certain assumptions for general guidance of the students and there may be other possible answers/ solutions based on different assumptions and understanding. The ICMA Pakistan and its
Council Members, Examiners or Employees shall not be liable in respect of any damages, losses, claims and expenses arising out of using contents of these suggested answers. It is clarified that the ICMA Pakistan shall not be liable
to attend or receive any comments, observations or critiques related to the suggested answers.
 SUGGESTED ANSWERS – SPRING 2015 EXAMINATIONS 3 of 7
STRATEGIC FINANCIAL MANAGEMENT – SEMESTER-5
Marks
(b) Significance of the existence of real options to the capital investment decision:
Real options in capital investment decisions:
There are 3 types of real options available in investment appraisal decision:
 Option to expand
 Option to abandon
 Option to wait 1
A real option is such a choice or opportunity, which exists because of a capital investment. 1
Options associated with the project:
Options associated with the projects are in the main more valuable for the gas than for the
coal power project. They include the following:
 The option to abandon the project early. This may be needed for a variety of reasons,
for example because of falling demand or because of the emergence of new
technology. High decommissioning costs make this a problem for the coal powered
project. 2
 The option to expand if demand increases. This is easier for gas because of the lower
investment costs. 2
 The option to switch power sources in the future. This is more valuable for gas,
because the technology could be adopted for other fossil fuels such as oil. Coal power
technology has no easy power source alternatives. 2

Q. 2 (a) (i) If dividend paid:

Market capitalization rate (Ke) 10%
Outstanding share 150,000
Market price per share (Rs.) 100
Dividend consideration (DPS) (Rs.) 5
Expected net income (Rs.) 1,500,000
Proposal for investment (Rs.) 2,325,000

D1 + P1
Po =
(1+K e)

P1 = P o(1+Ke) – D1

P1 = 100(1+10%) – 5 1

P1 = 105 1

(ii) If dividend not paid:

P1 = 100(1+10%) – 0 1

P1 = 110 1

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provided suggested answers on the basis of certain assumptions for general guidance of the students and there may be other possible answers/ solutions based on different assumptions and understanding. The ICMA Pakistan and its
Council Members, Examiners or Employees shall not be liable in respect of any damages, losses, claims and expenses arising out of using contents of these suggested answers. It is clarified that the ICMA Pakistan shall not be liable
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 SUGGESTED ANSWERS – SPRING 2015 EXAMINATIONS 4 of 7
STRATEGIC FINANCIAL MANAGEMENT – SEMESTER-5
Marks
(b) (i) External funds needed for investment (EFN) = Projected Cost – (Profit – Dividend)
= 2,325,000 – [1,500,000 – (150,000 x 5)] 1
= 1,575,000
New shares to be issued = 1,575,000 ÷ 105
= 15,000 1
Market value of the firm:
{(old + New shares) x P1} - Investment + Profit
No. of Share x P 0 =
1 + Ke

{(150,000 + 15,000) x 105} – 2,325,000 + 1,500,000

No. of Share x P 0 = 1
1+ 10%

16,500,000
25,000 x 100 = 1
1.1

Market value of the firm = 15,000,000 = 15,000,000 1

(ii) External funds needed for investment (EFN) = Projected Cost – (Profit – Dividend)
= 2,325,000 – (1,500,000 – 0) 1
= 825,000
New shares to be issued = 8250,000 ÷ 110
= 7,500 1
Market value of the firm:
((150,000 + 7,500) x 110) – 2,325,000 + 1,500,000
No. of Share x P 0 = 1
1 + Ke

16,500,000
25,000 x 100 = 1
(1+ 10%)
Market value of the firm = 15,000,000 = 15,000,000 1
No change in market price due to dividend decision.

Q. 3 (a) Value of equity shares: Rupees

Net cash inflows 525,000 ½
Interest (2,500,000 x 0.18) 450,000 ½
Available for dividend 75,000 ½
Existing dividend 600,000 ½
Increased dividend 675,000 ½
Cost of equity 21.60%
Value of equity 3,125,000 ½
Current market value 3,000,000 ½
Gain to shareholders 125,000 ½

DISCLAIMER: These suggested answers including write-ups, tables, charts, diagrams, graphs, figures etc., are uploaded for the use of ICMA Pakistan members, students and faculty members only. No part of it can be reproduced,
stored in a retrieval system or transmitted in any physical/ or electronic form or by any other means including electronic, mechanical, photocopying, recording or otherwise without prior written permission of the ICMA Pakis tan. The
suggested answers provided on and made available through the ICMA Pakistan’s website may only be referred, relied upon or treated as general guidelines and NOT a substitute for professional advice. The ICMA Pakistan has
provided suggested answers on the basis of certain assumptions for general guidance of the students and there may be other possible answers/ solutions based on different assumptions and understanding. The ICMA Pakistan and its
Council Members, Examiners or Employees shall not be liable in respect of any damages, losses, claims and expenses arising out of using contents of these suggested answers. It is clarified that the ICMA Pakistan shall not be liable
to attend or receive any comments, observations or critiques related to the suggested answers.
 SUGGESTED ANSWERS – SPRING 2015 EXAMINATIONS 5 of 7
STRATEGIC FINANCIAL MANAGEMENT – SEMESTER-5
Marks
(b) Weighted average cost of capital (WACC):
Current WACC (600,000 ÷ 3,000,000) = 20%
WACC after debentures:

Amount Cost Weight WACC

(Rs.) (A) (B) (A x B)
Equity share capital 3,125,000 0.216 0.56 0.12 1+1
Debentures 2,500,000 0.180 0.44 0.08 1+1
5,625,000 20% 1+1

It is apparent that gearing does not affect overall cost of capital as WACC before and after
the issue of debenture is the same (20%).

Q. 4 (a) Systematic risk:

Systematic risk is measured through Beta. It depicts the sensitivity of the security's excess
return to that of the market portfolio i.e., higher the beta means higher the systematic risk
and vice versa. 1
This risk cannot be diversified away as it represents the overall market risk which is due to
change in unavoidable circumstances i.e., Macro Economic issues, fiscal policy etc. 1
Unsystematic risk:
An amount of stock's variance unexplained by overall market movements. This risk
element is specific and unique to a particular company unlike macro level changes which
impact securities in a systematic manner. 1
Unsystematic risk can be described through dispersion of the estimates from estimated
return. Since this is a specific risk, hence can be mitigated through diversification. 1

(b) Fair price:

Scenario 1 2
Beta 0.9 1.1
Current Price 230 230
Risk free rate 8.0% 8.0%
Market premium (13 – 8) 5.0% 5.0%
Cost of equity 12.5% 13.5% 1½ + 1½
Growth 10.0% 10.0%
Dividend-1 11 11 1

D1
Ke – g
Share price =

11
12.5% – 10%
(with Beta 0.9) = = Rs. 440 2

11
13.5% – 10%
(with Beta 1.1) = = Rs. 314 2

DISCLAIMER: These suggested answers including write-ups, tables, charts, diagrams, graphs, figures etc., are uploaded for the use of ICMA Pakistan members, students and faculty members only. No part of it can be reproduced,
stored in a retrieval system or transmitted in any physical/ or electronic form or by any other means including electronic, mechanical, photocopying, recording or otherwise without prior written permission of the ICMA Pakis tan. The
suggested answers provided on and made available through the ICMA Pakistan’s website may only be referred, relied upon or treated as general guidelines and NOT a substitute for professional advice. The ICMA Pakistan has
provided suggested answers on the basis of certain assumptions for general guidance of the students and there may be other possible answers/ solutions based on different assumptions and understanding. The ICMA Pakistan and its
Council Members, Examiners or Employees shall not be liable in respect of any damages, losses, claims and expenses arising out of using contents of these suggested answers. It is clarified that the ICMA Pakistan shall not be liable
to attend or receive any comments, observations or critiques related to the suggested answers.
 SUGGESTED ANSWERS – SPRING 2015 EXAMINATIONS 6 of 7
STRATEGIC FINANCIAL MANAGEMENT – SEMESTER-5
Marks
Q. 5 Present value of the refunding, using the after-tax rate: Rs. ‘000’
(a) Net cash outflow
Cost of calling old bonds at call price (2,450 x 37,500 ÷ 1,000) 91,875 ½
Net Proceeds of new issue (1,940 x 37,500 ÷ 1,000) 72,750 ½
Difference 19,125 ½
Expenses:
Issuing of new bonds 500 ½
Interest expense of old bonds during overlap period
{(37,500 x 2,000 x 16%) ÷ 2} 6,000 6,500 ½
Gross cash outlay 25,625 ½
Less: Tax saving
Interest expense of old bonds during overlap period 6,000 ½
Call premium {(2,450 – 2,000) x 37,500} 16,875 ½
Unamortized issuing expenses 400 ½
Unamortized discount 3,000 ½
26,275
Tax saving (35% x 26,275) 9,196 ½
Net cash outflow 16,429 ½

(b) Annual cash outflow of old bond is: Rs. ‘000’

Interest expenses 12,000 ½
Less: Tax saving
Interest expense 12,000
Amortization of bond discount (3,000,000 ÷ 15) 200 ½
Amortization of other expenses (400,000 ÷ 15) 27 ½
Total 12,227 ½
Tax saving (35% x 12,227) 4,279 ½
Annual net cash outflow of old bond 7,721 ½

(c) Annual cash outflow of new bond is: Rs. ‘000’

Interest expenses 9,750 ½
Less: Tax saving
Interest expense 9,750
Amortization of bond discount [{(2,000 – 1,940) x 37,500} ÷ 15] 150 ½
Amortization of issuing expense (500,000 ÷ 15) 33 ½
Total 9,933 ½
Tax saving (35% x 9,933) 3,477 ½
Annual net cash outflow of new bond 6,273 ½

DISCLAIMER: These suggested answers including write-ups, tables, charts, diagrams, graphs, figures etc., are uploaded for the use of ICMA Pakistan members, students and faculty members only. No part of it can be reproduced,
stored in a retrieval system or transmitted in any physical/ or electronic form or by any other means including electronic, mechanical, photocopying, recording or otherwise without prior written permission of the ICMA Pakis tan. The
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 SUGGESTED ANSWERS – SPRING 2015 EXAMINATIONS 7 of 7
STRATEGIC FINANCIAL MANAGEMENT – SEMESTER-5
Marks
(d) Difference in annual cash flow = 7,721 – 6,273 = 1,448 ½
The discount rate is = 13 (1 – 0.35) = 8.45% ½
The present value of 1,447,333 (15, 8.45%) = 1,447,333 x 8.329 1
= 12,054,836
As this amount lower the cash outflow of 16,428,750, the refunding is not
worthwhile. ½
NPV = 12,054,836 – 16,428,750 ½
NPV = (4,373,914) 1

Q. 6 (a) Net assets (liquidation) basis: Rupees

Land and building 105,400,000
Furniture 12,000,000
Plant and equipment 1,000,000
Inventory 6,000,000
Receivable 7,709,400
Bank balance 10,685,200
Payables (5,692,000)
Bank overdraft (8,957,200)
Net assets 128,145,400 1½
Nos. of shares 5,000,000
Value per share 25.63 ½

(b) Dividend yield basis:

5,623,100 x 10/9
Dividend per share = = 1.25 1½
5,000,000

Gross dividend yield 3.50%

Value per share 35.70 ½

(c) P/E ratio basis: Rupees

Net profit after taxation is 6,560,800
Nos. of shares 5,000,000
Earning per share 1.31 1½
P/E ratio 18
Value per share 23.62 ½

(d) Statement of financial position value: Rupees

Total assets 133,569,200
Total liabilities 14,649,200
Shares holder equity 118,920,000 1½
Nos. of share 5,000,000
Value per share 23.78 ½

THE END
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