Institute of Certified Management Accountants of Sri Lanka. Strategic Level November 2018 Examination

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1 Copyright Reserved Serial No Strategic Level November 2018 Examination Examination Date : 10 th November 2018 Number of Pages : 06 Examination Time: 9.30 a:m p:m. Number of Questions: 05 Instructions to Candidates 1. Time allowed is three (3) hours. 2. Total: 100 Marks. 3. Answer all questions in Part I and three (3) questions from Part II. 4. Candidates are allowed to use non-programmable calculators. 5. The answers should be in English Language. PART I Answer all questions Subject Subject Code Financial Strategy and Valuation (FSV / SL 2-402) Question No. 01 (40 Marks) a. Lalan Motors (LM) has common equity of Rs.35.5 billion and Rs billion of long term debt and Rs billion of preferred equity on its books. Required return on these funds are 12%, 8%, and 10%, respectively. Market values of the common equity and long term debt are Rs. 77 billion and Rs. 35 billion, respectively. Market value of preferred equity is the same as its book value. The effective tax rate is 30%. (i) Estimate WACC for the company. (ii) The company has an opportunity to invest Rs. 25 million and expect to receive net cash flow of Rs. 30 million in three equal installments (Rs.10 million) at the end of each year over the next three years. Comment on this investment. b. Following indicates information about MBG Company. Yield to maturity of debt 8% Market value of debt Rs. 100 million Number of common shares 10 million Market price per share Rs. 30 Cost of capital if all equity financed 10.3% Tax rate 35% Financial analyst of the company expects that an increase in MBG s financial leverage will increase its cost of debt and equity. Based on an examination of similar companies in MBG s industry, financial analyst estimates MBG s cost of debt and cost of equity at three different debt to total capital ratios as below: Strategic Level Financial Strategy and Valuation (FSV / SL 2-402) November 2018 Examination 1

2 Debt to total capital ratio (%) Cost of debt (%) Cost of equity (%) (i) Estimate company s cost of capital at different combinations of debt to total capital ratios. (ii) Determine the best debt to total capital that minimizes company s weighted average cost of capital. (iii) What would happen to cost of debt capital when an increase in tax rate while holding operating earnings constant. c. (i) Briefly explain financing strategy of a business organization. (ii) What are the main approaches for financing strategy of a business organization? Explain briefly. (06 Marks) d. Pharma operates a chain of pharmacies around the country. You have been provided with the following projections for the firm (in millions of rupees). Year (Terminal Year) EBITDA (Rs. million) Net Cap Ex (Rs. million) Total Working Capital (Rs. million) Interest charges (Rs. million) Debt to Capital Ratio 25% 25% 25% 25% The Pharma s tax rate is 40%. Currently the company has a net operating profit (before depreciation) of Rs 175 million. The firms s cost of equity and pre-tax cost of debt are 12% and 8%, respectively. The firm will grow at 5% forever, starting in year 4. The working capital currently is Rs 52 million. (i) Estimate the expected free cash flows to the firm for the next 3 years. (ii) Estimate the cost of capital for the company. (iii) Estimate the terminal value at the end of year 4. (iv) Estimate the value of the firm today. e. Apex is a limited liability company listed in the Colombo Stock Exchange. The company has new investment plan for the coming year The investment plan requires Rs. 2,700 million. The company s capital structure policy is to maintain 40% equity and 60% debt capital. The debt capital carries 10% interest. The company has Rs.1,200 million net profit for the year. The company follows residual dividend policy when compensates shareholders of the company. (i) Estimate dividend payout ratio of Apex for the current year. (05 Marks) (ii) Discuss the weaknesses of the dividend growth model as a way of valuing a company and its shares. (State any assumptions that you made.) (Total 40 Marks) End of Part I Strategic Level Financial Strategy and Valuation (FSV / SL 2-402) November 2018 Examination 2

3 Part II Answer any three (3) questions Question No. 02 (20 Marks) (a) What are the key financing strategies through business life cycle? (05 Marks) (b) Given below are the details of two companies. Company A Company B EBITA 2,000,000 2,000,000 Equity (market value) 5,000,000 10,000,000 Debt (market value) 5,000,000 0 Interest rate 6% - Tax 50% 50% (i) Calculate the Price to Earnings (P/E) multiple (ii) Calculate the Enterprise Value to Earnings Before Interest Tax and Amortization (EV/EBITA) multiple (iii) Which multiple is more appropriate for valuation (c) Justin is an analyst for an equity mutual fund that invest in Colombo Stock Exchange. At the beginning of 2018, Justin is examining domestic stocks for possible inclusion in the fund. One of the stocks that he is analysing is CML. CML has paid dividends per share of Rs. 9, Rs , and at the end of 2015, 2016,2017, respectively. The forecast by analyst is that the stock will pay a dividend per share of Rs at the end of 2018 and Rs at the end of Justin has estimated that the required rate of return on the stock is 16%. (i) Compare the compound annual growth rate in dividends from 2015 to 2017 inclusive with the predicted compound annual growth rate dividends from 2017 to 2019, inclusive. (04Marks) (ii) Estimate continuation value of dividend at the end of 2019 Question No. 03 (20 Marks) (a) The following information is provided for a company undertaking production orders and trade specific spare part of a European motor car. Particulars Case 1 Case 2 Production and sales 100,000 units 80,000 units Sales (Rs million) 10 8 Variable cost (Rs million) Fixed cost (Rs million) 4 4 Profit before tax (Rs million) Strategic Level Financial Strategy and Valuation (FSV / SL 2-402) November 2018 Examination 3

4 Additional information: 1. Capital employed of the company is Rs. 8 million. 2. Debt to equity ratio is 1:1 3. Debt carries 10% interest. (i) Estimate financial leverage of the firm under two different production capacities and comment. (ii) Estimate and comment on the operating leverage of the firm under 100,000 production capacity if the fixed cost increases to Rs. 5 million. (b) (i) What is meant by adjusted present value? How it is different from accounting profit? (ii) A project costing Rs. 50 million is expected to generate after tax cash flows of Rs. 10 million a year forever. Risk free rate is 3%, asset beta is 1.5, required return on market is 12%, cost of debt is 8%, and annual interest costs related to project are Rs.2 million and tax rate 40%. Calculate the adjusted present value of the project. (c) (i) What is meant by economic profit in business firms? (ii) Dimuthu PLC provides you following information. Year Debt and Debt equivalents Equity and equity equivalents Operating assets Nonoperating assets ROIC Historical ,300 10,000 25,500 1,000 14% Estimated ,450 10,250 31,300 1,500 15% ,900 10,700 32,800 1,575 15% You are provided following information: - Weighted average cost of capital is assumed to be unchanged at 13% per annum. - Return on invested capital and growth rate beyond 2020 are expected to be 20% and 10% respectively. You are required to calculate: (i) Invested capital over the two estimated period (ii) Economic profit over the same period Question No. 04 (20 Marks) (a) (b) Briefly discuss the term acquisition while giving the different types of acquisitions and the key drives for companies to consider acquisition. (06 Marks) Alumex dealing with aluminum products is planning to acquire a similar company, Blumex, in the same industry in a stock for stock exchange. Assume that no immediate synergistic benefits are expected. The relevant financial details of the two companies are as follows: Strategic Level Financial Strategy and Valuation (FSV / SL 2-402) November 2018 Examination 4

5 Particulars Sales Earnings after tax Stock price Dividend pay-out policy Alumex Rs. In million % Blumex Rs. In million % Number of shares outstanding for both Alumex and Blumes companies are 6 million and 2 million respectively. Earnings per share of the two companies are Rs. 5 and Rs. 6 respectively for Alumex and Blumex. Alumex is not willing to have the post-merger earnings per share below Rs. 5 per share. Alumex also feels that it will have to offer Blumex shareholders a minimum of 25% over Blumex current market price. (i) What is the relevant range of Blumex per share stock prices with which Alumex is working? (ii) Calculate Alumex post-merger earnings per share if the Alumex shareholders accept an offer by Alumex of Rs 50 a share in a stock for stock exchange (c) (d) A two-year bond is yielding 10%, while a one-year bond is yielding 8%. Estimate forward rate of bond. A big Mac in Sri Lanka costs SLR 420, while the same Big Mac in the United States is $ On the date of survey, the actual exchange rate was SLR 150/$. The price indices express in local currency for Sri Lanka and the United States are SLR 1500 and 100$ respectively. (i) Estimate implied purchasing power parity of the dollar (ii) Comment on the currency value between two countries Question No. 05 (20 Marks) (a) I. a) Briefly explain direct and indirect quotes. (01 Marks) b) Assume that Sri Lankan Rupee, recently quoted at SLR 150 per US dollar, suddenly strengthens to SLR 145 per US dollar. i. Estimate quotations express in home currency terms. ii. Quotations expressed in foreign currency terms. iii. What is the present increase/decreas in the dollar value of rupee. II. a) Briefly define cross rate in foreign currency market. (01 Marks) Strategic Level Financial Strategy and Valuation (FSV / SL 2-402) November 2018 Examination 5

6 b) On your post-graduation celebratory trip, you are leaving Colombo, for St Petersburg, Russia. You leave Colombo with Rs. 300,000 (SLR). To exchange all of these for Russian rubles (R), you obtain the following quotes: SLR 150/$ R /$ i. What is SLR/Russian ruble cross rate? ii. How many rubles will you obtain for your Rs. 300,000? III. a) Briefly explain forward quotations in percentage. b) Assume the following, where the Sri Lankan rupee is the home currency: Foreign currency/home currency Spot rate 3-months forward 150/US$ 151/US$ Estimate annual percent forward premium or discount. (b) Carlton s CFO is considering investing in marketable securities in two different countries, an index of US equity markets and an index of the German equity markets. The two equities are characterized by the following expected return and expected risk. United States equity index German equity index Expected return 14% 18% Expected risk (σ) 15% 20% Correlation coefficient between the two market returns 0.34 If the investments of the two indexes are 40% and 60% respectively for US and German indexes. Estimate portfolio return. End of Part II End of Question Paper Table Strategic Level Financial Strategy and Valuation (FSV / SL 2-402) November 2018 Examination 6

Institute of Certified Management Accountants of Sri Lanka. Strategic Level November 2012 Examination. Financial Strategy and Policy (FSP / SL 3-403)

Institute of Certified Management Accountants of Sri Lanka. Strategic Level November 2012 Examination. Financial Strategy and Policy (FSP / SL 3-403) Copyright Reserved Serial No Strategic Level November 2012 Examination Examination Date : 10 th November 2012 Number of Pages : 06 Examination Time: 9.30 a:m. 12.30 p:m. Number of Questions: 05 Instructions