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MASTERS IN ISLAMIC FINANCE

JUNE 2013 SEMESTER

FINAL EXAMINATION MODULE : CORPORATE FINANCE CODE : FN5033 DAY/DATE : MONDAY / JULY 29, 2013 TIME/HOUR : 9.00AM – 12.00PM / THREE (3) HOURS

Instructions to candidates:

1. Answer ALL Questions. 2. Answer ALL Questions in the Answer Booklet provided. 3. You are given FIFTEEN (15) minutes to go through and read the questions, but you are

NOT allowed to write during this time. 4. Write down your answers legibly. 5. During this time, INCEIF’s Academic Regulation on academic dishonesty applies. 6. Do not bring any material into the examination hall unless permission is given by the

invigilator. 7. Make sure that this examination pack consists of :

a. The Question Paper; b. Answer Booklet

This examination paper consists of SIX (6) printed pages including the cover page.

DO NOT TURN THIS PAGE UNTIL INSTRUCTED TO DO SO. THIS QUESTION PAPER MUST NOT BE REMOVED FROM THE EXAMINATION HALL

Corporate Finance (FN5033) CONFIDENTIAL June 2013 Semester Final Examination

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Answer ALL questions.

QUESTION 1 (25 marks)

Jan Smith is the capital-budgeting officer of West Coast Textiles Inc., an industrial textiles weaving company in California. Ms. Smith, who recently completed her MBA degree, is responsible for the analysis of capital projects proposals for WCT. Her responsibilities include completing an analysis of each project proposal presented to the vice president of finance and preparing a report with her own recommendations.

Ms Smith was recently invited to attend a meeting of the executive committee, comprising the president and vice presidents of the company. The topic discussed was a report by Tom Sales, vice president of marketing, who presented a proposal to bid for a new defense contract. A large defense contractor is soliciting bids for silk cloth to be used in the production of parachutes. West Coast Textiles (WCT) has produced high-quality silk material for a number of years and could be easily add parachute material to its existing product lines. Established supply contacts plus WCT’s experience in silk manufacturing are clear advantages in bidding for the contract.

The amount of silk material required in the contract is 100,000 pounds per year for 5 years. According to the Mr Sales, the new contract could be won with a bid of $2.00 per pound of finished material. An internal study of the production costs of silk indicates that variable production costs-raw material and labor-would be 50 per cent of revenue, or $ 1.00 per pound at the current prices. Because of the additional bookkeeping and warehouse expenses, WCT’s annual fixed costs would increase by $25,000 at current prices if it bids successfully for the contract.

At the present time WCT is operating at or near full capacity. Current sales and production are under long-term contract with various textile buyers. This none of the current weaving capacity can be diverted to the defense contract. New equipment must be purchased if production is to be increased.

A study of the current weaving technology has provided information on a new weaving machine that could produce the silk. The equipment costs $250,000 delivered and installed. As an incentive to WCT to purchase the new equipment, vendor technicians would train WCT operators at the vendor’s factory prior to the installation of the machine, at no additional cost to WCT.

The new equipment has a 5-year class life (20%, 32%, 19.20%, 11.52%, 11.52%, and 5.76%) and would be depreciated according to the MACRS procedure. At the end of 5 years WCT could sell the weaving machine to a smaller weaving company for $75,000.

At the meeting Ms. Smith expressed concern about the effect of inflation on the future profitability of the parachute material. Raw material costs, labor costs, and fixed costs increase annually with the general inflation in production costs. Unless there is a clause in the contract allowing WCT increase its price with inflation. WCT would experience reduced profits in each succeeding year of the contract. Mr. Sales replied that the contract provided for an annual


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increase in price equal to the rate of increase in the Producer price Index. It was agreed that the price and cost estimates above would be appropriate for the first year of production and sales. In year 2 through 5, however, prices and costs would increase at the expected rate of inflation of 5 percent per annum.

At the close of the meeting, Ms. Smith was assigned the responsibility of completing a capital-budgeting analysis of the defense contract proposal. Her report is due at the next weekly meeting of the executive committee.

In addition to the data provided by Mr. Sales, Ms Smith estimates that an immediate investment in net working capital of $50,000 would be required if the project were accepted. The net working capital would be recovered at the end of 5 years. From recent analyses of capital projects, Ms. Smith notes that the company’s marginal cost of capital is 12 percent. Since the risk of the new product line is equivalent to that of the company generally, no additional risk adjustment to the cost of capital is necessary; WCT’s marginal income tax rate is 34 percent.

a. Calculate the net investment cash outflow of the proposed project. (5 marks)

b. Calculate the expected operating cash flows over the 5-year life of the project. Adjust the sales revenue and costs for expected inflation in year 2 through 5.

(10 marks)

c. Calculate the terminal value cash flow at the end of year 5. (5 marks)

d. Calculate net present value and internal rate of return for the project. (5 marks)

(25 marks)


Maju Berhad, a public listed company on the Bursa Malaysia (KLSE), has the following capital structure:

RM

Ordinary shares of RM1 each 2,000,000

8% cumulative preference shares RM1 each 1,000,000

10% Redeemable debentures 2,000,000

The ordinary and preference shares are currently quoted at RM2.25 and RM0.95sen per share respectively, whilst the debentures are quoted at RM90 per RM100 nominal value. Ordinary


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dividend of RM0.22sen, preference dividend and annual interest for the current year have just been paid. Ordinary dividend is expected to grow at a constant rate of 10%. The debentures are due to retire in 10 years. Corporate tax is assumed to be at 40%.

Maju Berhad management believes that its long-term optimal capital structure should be in the ratio of 50:20:30 for ordinary, preference and debt respectively. If this capital structure ratio can be achieved without altering the current component costs, calculate Maju’s long-term weighted cost of capital.

(20 marks)


A consultant has collected the following information regarding Young Publishing:

Total assets $3,000 million Tax rate 40%

Operating income (EBIT) $800 million Debt ratio 0%

Interest expense $0 million WACC 10%

Net income $480 million M/B ratio 1.00×

Share price $32.00 EPS = DPS $3.20

The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. If the company makes this change, what would be the total market value of the firm? (The answers are in millions.)


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American Hardware, a national hardware chain, is considering purchasing a smaller chain, Eastern Hardware. American's analysts project that the merger will result in incremental free flows and interest tax savings with a combined present value of $72.52 million, and they have determined that the appropriate discount rate for valuing Eastern is 16 percent. Eastern has 4 million shares outstanding. Eastern's current price is $16.25. What is the maximum price per share that American should offer?


Hanan Inc.

2007 Income Statement.(in million)

Net Sales $ 3,800

Cost of goods sold 2075 Depreciation 750 EBIT 975 Interest Paid 140 Taxable Income 835 Taxes 281 Net Income $ 554 Dividends $ 138.50 Addition to retained earnings $ 415.50

Hanan Inc.

2007 Balance Sheet (in million)

Cash $ 80 Accounts payable 1000 Account rec. 750 Long-term debt 1150 Inventory 420 Common stock 2250 Net fixed assets 4600 Retained earnings 1450 Total assets 5850 Total liabilities & equity 5850 Assume that all costs and assets of Hanan Inc. increase directly with sales. Also assume that

the tax rate and the dividend payout ratio are constant. The firm is currently operating at full capacity. What is the external financing needed if sales increase by 8 percent?


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Below are some important figures from the budget of Pine Mulch Company for the second quarter of 2006:

April May June Credit Sales $ 160,000 $ 140,000 $ 192,000 Credit Purchases 68,000 64,000 80,000 Cash disbursements:

Wages, taxes, and expenses 8,000 7,000 8,400

Interest 3,000 3,000 3,000 Equipment purchases 50,000 4,000

The company predicts that 10 percent of its sales will be never collected; 50 percent of it sales will be collected in the month of the sale; and the rest of it sales will be collected in the following month. Purchases on trade accounts will be paid in the month following the purchase. In March 2006 the sales were $180,000. You are required to prepare cash budget for the second quarter 2006.


The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate tax rate of 30 percent. Kimberly uses $500,000 of 12.0 percent debt financing, and the cost of equity to an unlevered firm in the same risk class is 16.0 percent. What is the value of the firm according to MM with corporate taxes?

***End of Question***

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