Financial Strategy and Valuation (FSV / SL 2) Strategic Level Pilot Paper - Suggested Answer Scheme

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1 Financial Strategy and Valuation (FSV / SL 2) Strategic Level Pilot Paper - Suggested Answer Scheme PART I Question No. 01 (40 Marks) 1. Answer: Yes, I agree with the statement. Growth Business risk high Financial risk has to be kept low Funding equity Nominal dividend ratio Maturity Business risk medium Financial risk has to be kept at a medium level Funding debt High dividend payout ratio Launch Business risk very high Financial risk has to be kept very low Funding equity Nil dividend payout ratio Decline Business risk very low Financial risk can be kept at a very high level Funding debt Total dividend payout ratio (1.5 per each stage, maximum 07 Marks) 2. Debt Equity For User Interest must be paid Can choose whether to pay 1

2 For Provider Repayments must be made Lenders can possess assets A high risk source Interest is contractual Repayments is contractual Lender can possess assets A low risk investment dividends No repayment obligation A low risk source Dividends not guaranteed No guarantee of repayments A high risk investment (01 mark for each section, maximum 04 marks) 3. Revenue enhancement. eg : A mobile phone manufacturer acquiring a digital camera manufacturer can improve the revenue from mobile phone sales by improving the camera of mobile phones with the technology benefits from acquiring the camera manufacturer. (0.5 Marks) Cost Reduction (01Mark) eg : A telecommunication company acquiring a similar telecommunication company will lead to economies of scale such as sharing the marketing expenditure, sharing the management team etc. (0.5 Marks) Tax Benefits eg: If one company is having a tax loss while the other is making profits, The tax losses of the loss making company can be set off with the profits of the profit making company as a result of the acquisition ( 0.5 Marks) (Maximum of 4 marks for 3 sources and 2 valid examples) 4. Corporate charters - Golden Parachutes - Poison Pills - White Knight and White Squire other strategies such as Greenmail, Asset restructuring, recapitalization and repurchases are also accepted as answers each carrying 1 mark (Maximum 4 marks) 2

3 5. a. Calculation E 2017E 2018E 2019E 2020E Revenue Cost of Sales Depriciation and Amortization Gross profit Administration and sales expenses EBIT Interest expenses Earnings before tax Taxation - 35% Net Income after tax (+) Depreciation (+) Int (1-t) (-) Fixed Capital Investments (-) Working Capital Expenses FCFF mark each for Net Income for five years and 01 mark each for FCFF for 5 years b. Continuing Value Calculation FCFF t (2020) 4992 FCFF t+1 (FCFF t *( )) 5267 WACC % Growth rate (g) 5.50% CV -( FCCFF t+1/wacc-g) mark for FCFF t+1 02 marks for application 01 mark for answer 3

4 c. FCFF Discounting factor % PV NPV (+) continuing value Value of operations (-) non operating Assets Enterprise Value (-) Non equity claims Value of Equity mark for discount factor 01 mark for value of operations 01 mark for deducting non- operating assets 01 mark for deducting non-equity claims d. Value of Equity No of shares (millions) Intrinsic Value of a share (value of Equity/ No of shares) (02 Marks) 4

5 PART II Question No. 02 (20 Marks) 1. No, I don t agree to this statement. The price of a bond will increase when the yield goes down by a greater percentage in comparison to a decrease of the value as a result of the increase of the yield by the same amount. (03 Marks) 2. Face Value = 1000 Coupon Payment = 50 Yield = 6% k = 78/183 = Price of the Bond on 01 st April 2018 Price = 50* PVIFV 6%, *PVIF 6%14 (02 Marks) Price = Price of the Bond on the 18 th of June 2018 P = (1+0.06*0.4262) P = = (1+ ) (1+) +(1+ )(1+ ) (1+) + (1+ )(1+ )(1+ ) ( ) 1 (1+) 5

6 (04 Marks) Normalized P/E Ratio = 3.56 The asset is overpriced thus it should not be purchased 4. Stock Implied Required Rate Return of Return Pricing A 15.00% 17.50% Over Priced B 20.00% 18.10% Under Priced C 15.50% 15.50% Fairly Priced D 22.00% 17.50% Under Priced E 9.00% 17.20% Over Priced (01 mark each for two columns if the calculations are correct) (02 marks for correct identification) Question No. 03 (20 Marks) 1. WMCC = Weighted marginal cost of capital WACC = Weighted average cost of capital WMCC is the cost of next rupee of capital raised. Cost of component cost of capital can change when new capital is raised. Thus, the cost associated with the funds for new projects will take a different value than the WACC. Thus, in order to evaluate new projects the ideal rate is WMCC. (05 marks for complete answer) 2. 6

7 a) Available Retained earnings for the investment = 4.62 *60% * = 2,772, (02 Marks) amount that can be spent before new equity is required to be issued = /.80 (02 Marks) = 3,465, a) WMCC = 10.85%*15% % * 5% %*80% = 17.68% (02 Marks) The Cost of each source of capital Cost of Debentures = 12/94*.85 = 10.85% (02 Marks) Cost of Preferred Stocks = 1.10/8.50 = 12.94% (02 Marks) Cost of Equity Estimation of the growth rate of dividends: (4.62/2.10)^(1/9) 1 = (02 Marks) Cost of equity = = + = (02 Marks) =19.26% Question No. 04 (20 Marks) 1. Financial Structure shows how the assets of a business are financed. Capital Structure when the short term borrowings are excluded from the financial structure the capital structure can be determined. (02 Marks) 2. New Income Statement (000's) 7

8 Sales 84,000 Cost of Sales -30,000 Gross Profit 54,000 Operating Expenses -16,200 EBIT 37,800 Interest -10,000 Profit Before tax 27,800 Tax -4,170 Profit after tax 23,630 Degree of Operating Leverage = % Change of EBIT/ % Change of Sales = 26%/20% = 1.3 Degree of Financial Leverage = % Change of EPS / % Change of EBIT = 39%/26% = 1.5 Degree of Combined Leverage = % Change of EPS/ % Change of Sales = 39%/20% =1.95 When sales change by 1%, EBIT will change by 1.3% because of the fixed costs in the operating costs. When the EBIT changes by 1%, EPS will change by 1.5% because of the unchanged interest expenses. When the sales change by 1%, EPS changes by 1.95% because of the fixed operating expenses and the financing expenses. (02 Marks) 3. Net Income Capital Investment Residual Income Dividend per share 1,000, , , ,500, ,200, , ,000, ,200, , ,800, ,600, ,200, ,200, ,000, ,200, ,300, ,000, , (Maximum 03 marks for dividend calculations) The Net Income and the dividend payout are not related. The dividend payout depends on the residual income that is net income after financing capital investments. (02 Marks) 8

9 4. According to the bird in the hand theory, shareholders like to receive the dividend payments today rather than the capital gains tomorrow. According to the dividend signalling theory, the dividend announcements have an informational content. That is to say that the dividends give a signal to the market. Increase of dividends will give a positive signal regarding the future prospects whereas decrease of dividend gives a negative signal regarding the future prospects. (05 Marks) Question No. 05 (20 Marks) It is a fact that the MNCs face a lot of complexities in comparison to purely domestic companies, since they have to do cross border transactions. However, the MNCs have the chance to diversify their risks internationally, which is never an option for a purely domestic company. (04 Marks) a. Transactional Exposure if a company has entered in to contracts that involve foreign currency then, the change of exchange rates can change the value of the contracts. This exposure to foreign exchange risk can cause severe losses to an organization. (1.5 Marks) Translational Exposure Also known as accounting exposure. The net accounting value of a business can change because of the exchange rate movements. (1.5 Marks) b. Contractual Hedging A company can enter into financial contracts to hedge the risks arising from transactional exposure. E.g. forwards, futures, options etc. (1.5 Marks) Natural Hedging when a perfect contractual hedge is not available or when a contractual hedge does not give a solution then a company can go for a natural hedge. Eg. Lead and Lags, cross hedging, currency diversification etc. (1.5 Marks) 3. Forward 140*10,000 = Rs. 1,400, Profit in comparison to un-hedge situation = Rs (02 Marks) 9

10 Money Market Hedge Invest US $ = 10,000/1.06 = US $ 9, Local currency required to obtain US $ = Rs. 1,245, Total amount to be settled after 6 months = 1,245, * 1.05 = Rs. 1,307, Profit in comparison to un-hedge situation = Rs. 112, Option Buy a call option Profit in comparison to unhedge situation = ( )* 10,000 = Rs. 25, (02 Marks) It is obvious that the money market hedge is the most profitable option for the importer. (02 Marks) 10

Question # 1 of 15 ( Start time: 01:53:35 PM ) Total Marks: 1

MGT 201 - Financial Management (Quiz # 5) 380+ Quizzes solved by Muhammad Afaaq Afaaq_tariq@yahoo.com Date Monday 31st January and Tuesday 1st February 2011 Question # 1 of 15 ( Start time: 01:53:35 PM