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ICM

Pakistan

EXTRA ATTEMPT, MAY 2014 EXAMINATIONSSaturday, the 24th May 2014STRATEGIC FINANCIAL

MANAGEMENT (AF-503)SEMESTER-5

Extra Reading Time: 15 MinutesWriting Time: 03 Hours

Maximum Marks: 100 Roll No.:

(i) Attempt all questions.

(ii) Answers must be neat, relevant and brief.

(iii) In marking the question paper, the examiners take into account clarity of exposition, logic of arguments, effectivepresentation, language and use of clear diagram/ chart, where appropriate.

(iv) Read the instructions printed inside the top cover of answer script CAREFULLY before attempting the paper.

(v) Use of non-programmable scientific calculators of any model is allowed.

(vi) DO NOT write your Name, Reg. No. or Roll No., or any irrelevant information inside the answer script.

(vii) Question Paper must be returned to invigilator before leaving the examination hall.

Answer Script will be provided after lapse of 15 minutes Extra Reading Time (9:15 a.m. or 2:15 p.m. [PST] as the case may be) .

MarksQ. 1 Good Health Ltd., a pharmaceutical company, is a renowned name for its quality life saving

drugs. It is rapidly growing company and has performed quite well in the past many years.The CEO of the company has stated, during an interview that research and development ofcompany has played a pivotal role to maintain its competitive position by introducing newproducts as well as improving the quality of its existing products.

Training Courses for Research Scholars:Good Health Ltd., has employed 100 highly qualified research scholars at its five researchcentres across the country. All scholars are provided an opportunity to attend six trainingcourses per year to keep them updated on the latest development in the field of medicine.Each course lasts for several days and requires the scholars to travel to a specially selectedhotel for the training.

The current average travelling cost is Rs. 6,000 per course for each scholar and cost oflodging and meal is Rs. 20,100 per course for each scholar. However, it is expected that thecurrent travelling cost and lodging and meal cost will increase by 5% per annum from Year-2onward. The cost department of the company has compiled per course training cost asunder:

Rupees

Space hiring for training 45,000

Trainers fee 180,000

Course material 60,000

Equipment hire 45,000

Course administration 22,500

352,500

It is expected that the current course costs will increase by 2.5% per annum from Year-2onward.

You are recently employed as a management accountant of Good Health Ltd. The CFO ofthe company has shown his concern at the increasing cost of training and has emphasizedto explore other options to reduce increasing cost of training without compromising on qualityof the training.

You remembered an article about the use of the Internet for the delivery of training courses(e-learning). Your boss liked the idea and decided to hire an external consultant at a cost ofRs. 300,000 to advise the company on how to implement an e-learning solution. The costelements of implementing and running an e-learning solution, as per consultants report, areas under:

Rupees Notes

Computer hardware 45,000,000 (1)

Software licenses 1,050,000 per annum (2)

Technical Manager 900,000 per annum (3)

Camera and sound system staff 120,000 per course (4)

Trainers and course material 60,000 per course (5)

Broadband connection 9,000 per scholar per annum (6)

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Notes:

(1) Good Health Ltd., will depreciate computer hardware on straight line basis over fiveyears. The scrap value at the end of the five years is expected to be Rs. 1,500,000.

(2) A software license agreement would be signed for fixing the annual software license feefor five years. This fee is payable in advance.

(3) Mr. Khan, working in the I.T. Department, currently earning Rs. 600,000 per annum will

be promoted to Technical Manager for this project. This employee

s position will be filledby a fresh graduate at the salary of Rs. 300,000 per annum. The salary of the TechnicalManager and fresh graduate is expected to increase by 6% per annum.

(4) The camera and sound system staff fee for recording the courses for Internet deliverywould not increase for the first two years but then it will increase by 6% per annum. Allcourses will be recorded in the first quarter of the year of delivery.

(5) A fixed fee of Rs.60,000 per course would be paid to trainers for the delivery and coursematerial in the first year and it is expected to increase by 6% per annum from year twoonward. The preparation of the course material and recording the lectures of the trainerswill take place in the first quarter of the year of delivery.

(6) All of the scholars attending the training courses have to pay Rs.9,000 for broadbandcosts for accessing the courses from home. This expense will be reimbursed to the

scholars annually. Broadband costs are expected to decrease by 5% per annum afterthe first year as it becomes more widely used by Internet users.

It is expected that the number of scholars taking the e-learning courses will be the same ineach of the five years. Good Health Ltd., uses a 14% cost of capital to appraise projects ofthis nature. Ignore taxation.

New Life Saving Drug:

Good Health Ltd., is also planning to introduce a new life saving drug for heart patients. Theresearch and development department of the company was working on this project for manyyears. The director marketing is confident that this product could be launched in near future.

CFO believes that sound working capital management is necessary if a company wants tocompete in the era of information technology. He has successfully managed the working

capital issue in the past by employing use of internet to lower the costs of linking withsuppliers and dealers, turning over to an outside specialist, accelerating the pace of changespecially in employees and shedding excessive inventory and other redundant assets.

CFO seeks your help to establish a current assets policy. Fixed assets are Rs. 1,200,000,and the firm plans to maintain a 50% debt-to-assets ratio. The interest rate is 10%on all debt.Three alternative policies of current assets are under consideration: 40%, 50%, and 60% ofprojected sales. The company expects to earn 15% EBIT on sales of Rs. 6,000,000. GoodHealth Ltd., falls under the tax bracket of 40%.

Two Mutually Exclusive Equipments:

Good Health Ltd., is also required to buy state of the art equipment for launching the new lifesaving drug. Presently, two models of the equipments are available in the market and

company has to choose between these mutually exclusive models. The expected life ofModel-S is just two years whereas Model-L has four years of life. The production managerbelieves that both models provide a necessary service, so each selected model is expectedto be repeated into the foreseeable future of the company. The expected cash flows of bothmodels are as under:

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Expected Net Cash Flow Rupees

Year Model-S Model-L

0 (200,000) (200,000)

1 120,000 67,000

2 120,000 67,000

3 67,000

4 67,000

The cost of capital of each model is 10%.

Required:

(a) Prepare a financial evaluation of the options available to the company and advise thedirectors on the best course of action to reduce increasing cost of training using the netpresent value (NPV) method. 17

(b) Describe three alternative current assets financing policies. 03

(c) What is the expected return on equity under three current assets policies? 12

(d) What is each models initial NPV without replication? Determine the modelsextended

NPVs, applying the replacement chain approach. Which model should be chosen? 05(e) Which of the model should be chosen, if the cost to replicate Model-S in second year is

expected to increase to Rs. 210,000 due to inflationary pressure? 03

Q. 2 XYZ Ltd., is listed on Karachi Stock Exchange. The company facilitates the tourists for siteseeing of northern areas of Pakistan. The company has recently appointed a new FinanceDirector who is concerned about the financing of the company.

XYZ Ltd.Forecast Statement of Financial Position

as at June 30, 2014 Rs. 000

Assets Amount Liabilities and Owners Equity Amount

Current assets 390,000 Current liabilities 100,000

Non-current assets 1,110,000 Bank loans 200,000

Debentures 14% 300,000

600,000

Owners Equity:

Ordinary shares (Rs.10 per share) 400,000

Retained earnings 500,000

900,000

Total 1,500,000 Total 1,500,000

Debentures shown at nominal value are redeemable at par on June 30, 2018. Interest is paidannually.

The market value of debentures is 120% ex-interest on June 30, 2014 and the value of ashare is Rs. 30 ex-dividend on that date. Interest on the bank loan is 10% per annum and theloans are not scheduled to be repaid before June 30, 2017.

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The following earnings and closing capital employed has been forecasted for the next threeyears: Rs. 000

Year ending 2015 2016 2017

Earnings before interest and tax (EBIT) 232,000 200,000 216,000

Capital employed at year end 893,600 875,800 863,800

Two covenants relating to the debentures are as under:

(i) At no time will the gearing ratio exceed 60%, based upon book values.

(ii) The interest cover ratio shall not fall below 3.5 times.

The Finance Director is concerned that the company is reaching to breach debenturecovenants and is considering ways of restructuring the companys funding to eliminate thisrisk. Two alternatives are being considered.

One scheme is to redeem 2/3 debentures on June 30, 2014 at market value, funded by anew bank loan. The companys bank has quoted an annual interest rate of 10% for a loanmaturing on June 30, 2018.

An alternative scheme is a rights issue of 1 for 4 shares to raise Rs.200 million of funds torepay the current bank loan.

Assume that tax is recoverable at 35% on interest payments and all interest payments aremade annually in arrears. Ignore any tax implications of the redemption premium on thedebentures.

Required:

(a) Calculate gearing and interest cover ratios for the years 2015 to 2017. Would XYZ Ltd.,be likely to breach either of the two debenture covenants over the next three years?Ignore any restructuring funding proposals. 05

(b) Calculate the cost of debt for the existing debenture based on the current market valueon June 30, 2014 and state would it be cheaper to redeem the debenture with a bankloan. 10

(c) Calculate the issue price and ex-right price of proposed right issue. 05

Q. 3 Alpha Ltd., and Beta Ltd., are listed companies. The following figures have been taken fromtheir current balance sheets: Rs. 000

Alpha Ltd. Beta Ltd.

OwnersEquity:

Ordinary shares (Rs.10 each) 10,000 10,000

Retained earnings 35,000 3,000

45,000 13,000

6% Irredeemable debentures 25,000

Both companies earn an EBIT Rs. 5,000,000 which is expected to remain constant for the

infinite future. Both companies have same level of risk. It is the policy of both companies todistribute all available profits as dividends at the end of each year.

The current market value of Alpha Ltd.s ordinary shares is Rs. 30 per share cum dividendAn annual dividend is due to be paid in the very near future.

Beta Ltd., has just made annual dividend and interest payments both on its ordinary sharesand on its debentures. The current market value of the ordinary shares is Rs.14 per shareand market value of debentures is 50% of its book value.

Mr. Siddiqui owns 100,000 ordinary shares in Beta Ltd. He intends to increase his annualincome, without incurring any extra risk, by selling his shares in Beta Ltd., and buying someof the ordinary shares of Alpha Ltd. Mr. Siddiqui is able to borrow money @ 12% compoundinterest per annum.

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Required:Marks

(a) Estimate the cost of ordinary share capital and the weighted average cost of capital(WACC) of Alpha Ltd., and Beta Ltd. 08

(b) Explain briefly why both the cost of ordinary share capital and the weighted averagecost of capital (WACC) of Alpha Ltd., differ from those of Beta Ltd. 02

(c) How Mr. Siddiqui might improve his annual income as he suggested, stating clearly anyreservations you have about the scheme. 08

Q. 4 Blue Ltd., is contemplating acquiring the Green Ltd. Incremental cash flows arising from theacquisition are expected to be as under: Rs. 000

Average of Years

1 5 6 10 11 !

Cash flow after taxes 200 300 400Investment required 100 120 140Net cash flow 100 180 260

Blue Ltd., has an all equity capital structure. Its beta is 0.80, based on the past 60 months ofdata relating its excess return to that of the market. The risk-free rate is 9%, and theexpected return on the market portfolio is 14%.

Required:

(a) What is the maximum price that Blue Ltd., might pay for Green Ltd.? 06(b) What assumptions of capital asset pricing model (CAPM) must hold true for the price to

be offered to Green Ltd.? 01

Q. 5 The directors of Global Communication Ltd., a large conglomerate, are considering theacquisition of the entire share capital of Friends Engineering Ltd., which manufactures arange of engineering machinery. Neither company has any long-term debt capital. Thedirectors of Global Communication Ltd., believe that if Friends Engineering Ltd., is takenover, the business risk of Global Communication Ltd., will not be affected.

Friends Engineering Ltd.s statement of financial position as on June 30, 2014 is expected tobe as follows: Rupees

Non-current assets (net of depreciation):Free hold land and buildings 651,600Furniture and fixtures 521,280Motor vehicles 130,320 1,303,200

Current assets:

Inventory and work in progress 1,031,800Accounts receivables 1,490,000

Cash at bank 316,200 2,838,000

4,141,200

Current Liabilities:Accounts payables 1,507,200Bank overdraft 1,725,800 3,233,000

Owners equity:Ordinary shares (Rs.10 per share) 100,000Retained earnings 808,200

4,141,200

Friends Engineering Ltd., summarized financial record for the five years, is as follows:Rupees

Year Ended June 30 2010 2011 2012 20132014

(Estimated)

Earnings available to shareholders 66,600 133,600 86,600 76,800 104,400Less: dividends 41,000 45,200 50,000 50,000 50,000

Added to retained earnings 25,600 88,400 36,600 26,800 54,400

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MarksThere has been no change in the issued share capital of Friends Engineering Ltd., during thepast five years. The estimated values of Companys assets as on June 30, 2014 are asfollows:

Rupees

Replacement Cost Realisable Value

Free hold land and buildings 1,000,000 550,000

Furniture and fixtures 200,000 250,000

Motor vehicles 250,000 100,000

Inventory and work-in-progress 1,100,000 1,140,000

It is expected that 2% receivables at June 30, 2014 will be uncollectable.

The cost of capital of Global Communication Ltd., is 9%. The shareholders of FriendsEngineering Ltd., require a minimum return of 12% per annum from their investment in thecompany.

The current price earning (P/E) ratio of Global Communication Ltd., is 12. Other listedcompanies with business activities and profitability similar to those of Friends EngineeringLtd., have P/E ratios of approximately 10, although these companies tend to be 50% to100% larger than Friends Engineering Ltd. Ignore taxation.

Required:

Estimate the value of the total equity of Friends Engineering Ltd., as on June 30, 2014 using

each of the following bases:

(a) Replacement cost of the assets 04

(b) Realisable value of the assets 05

(c) The dividend valuation model 04

(d) The P/E ratio model 02

THE END

P RE S E N T V A L U E F A C T O R S

Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870

2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.756

3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 0.693 0.675 0.658

4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 0.613 0.592 0.572

5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 0.543 0.519 0.497

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 0.480 0.456 0.432

7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.376

8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404 0.376 0.351 0.327

9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361 0.333 0.308 0.284

10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322 0.295 0.270 0.247

C UMU L A T I V E P R E S E N T VA L U E F A C T O R S

Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870

2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.713 1.690 1.668 1.647 1.626

3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.444 2.402 2.361 2.322 2.283

4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.102 3.037 2.974 2.914 2.855

5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.231 4.111 3.998 3.889 3.784

7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.712 4.564 4.423 4.288 4.160

8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 5.146 4.968 4.799 4.639 4.487

9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.537 5.328 5.132 4.946 4.772

10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.889 5.650 5.426 5.216 5.019