Copyright Reserved Serial No Strategic Level May 2012 Examination Examination Date : 12 th May 2012 Number of Pages : 08 Examination Time: 9.30 a:m. 12.30 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. The answers should be in the English Language. Subject Subject Code Financial Strategy and Policy (FSP / SL 3-403) PART I Answer all questions Question No. 01 (40 Marks) David Engineering Company is considering starting manufacturing of special drill bits and other equipment for oil drilling. The proposed project is currently regarded as complementary to its other lines of business, and the company has certain expertise for that by virtue of its having a large mechanical engineering staff. Because of the large outlays required to get into the business, management of the Company is concerned about earning a reasonable rate of return for the investment to be made. Further, since the new venture is considered to be sufficiently different from the company s existing businesses, management feels that the required rate of return from the project is to be higher than that of the Company s current rate of return earned. The following are some of the information extracted from the annual report published by the Company as at 31/03/2012. Rs. million Stated share capital (3.75 million shares) 37.5 Reserves 2.5 Debt Capital 20.0 Investments 20.0 Fixed assets 25.0 Net current assets 15.0 The financial manager s staff has identified several companies with capital structures similar to that of David Engineering, engaged solely in the manufacture and sale of oil-drilling equipment in the market. The Company staff believes that 18% is a reasonable estimate for the average return required on the project for the foreseeable future before taking into account the market risk involved. The prevailing 1
benchmark risk free rate will be around 12% p.a. The Company is fully aware that this kind of investment projects involves fairly high market risk and hence they have decided to fully consider the risk involved in evaluating the project. Over the last five years, the average beta factor for those companies has been 1.5. In financing new projects, David Engineering Company always uses to follow 40% debt and 60% equity ratio as its financing policy. The interest rate applicable for the existing debt capital is 16% p.a. In keeping with the total funds needed to launch the project and the project financing policy followed by the Company, the management estimates that the debt capital to be raised for financing the project will be Rs. 5,000,000/- and hopes to raise it through a term loan to be obtained from a commercial bank selected on competitive basis and finalise all the formalities before June, 2012. The two quotations obtained, to have such a loan, from two leading commercial banks are as follows. Loan period Equal monthly instalment to be paid in settling the loan. Rs. Quote I 3 years 180,760 Quote II 4 years 148,450 As it is expressed in both cases, the whole bank loan proceeds would be made available by the end of June, 2012 and if obtained, loan is required to be serviced by commencing the payment of monthly fixed instalments from July, 2012. The balance amount of funds required for financing the project up to the commencement of its commercial operations is supposed to be raised by making a right issue of shares of the Company, which is expected to be fully subscribed. The right to be offered is Rs. 3.00 per share in the context that the Company s share is currently traded at Rs. 18.00 per share.. After implementing the new project in July, 2012, it is expected to yield an incremental return. And, hence the Company is also considering a payment of 50% of the available profit as dividends which would be equal to 20% of the total stated capital including the new issue as it has been the rate of dividend declared in the recent past. The applicable tax rate for this Company is 25%. On the basis of this information you are required to: (a) Calculate the current weighed average cost of capital of the Company. (04 Marks) (b) (c) (d) (e) (f) Determine the required rate of return that David Engineering Company should apply to evaluate the new project. (05 Marks) Determine that which quote for the bank loan should be recommended to the management on the basis of cost of financing involved and justify the taking of the bank loan. (15 Marks) Calculate the total amount of funds to be raised through the right issue to be made and the number of shares to be issued in that regard. (04 Marks) Ascertain the net profit expected to be earned from this new project, before interest and tax in order to achieve the planned targets. (06 Marks) Estimate dividend yield, earning yield, price earnings and gearing ratios of the Company and comment. (06 Marks) Note: A relevant PV table is provided. (Total 40 Marks) End of Part I 2
Part II Answer any three (3) questions Question No. 02 (20 Marks) (a) ABC Plc. has recently obtained a large contract for one of its business lines. In view of that, the General Manager of the Company is considering that whether a required machine for the completion of the contract in time should be bought or leased. The machine would be used for four years and after that period it would be sold for its salvage value or returned to the lessor. The lease cost is Rs. 250,000/- a year and this includes the cost of routine maintenance and service costs. The purchase price of the machine is Rs. 850,000/- The salvage value after the four year period will be Rs. 75,000/-. If the machine is purchased the routine maintenance and service costs to be met is estimated at Rs. 35,000 a year. A loan to finance the purchase of the machine would be at an interest rate of 15% p.a. and would require a down payment of 100,000/- and the balance would be amortized over four equal instalments. (The applicable annuity factor for four years is around 2.8549). The firm uses the straight line method of deprecation. The company s cost of capital, after tax, is 14% p.a. The firm pays taxes at 20%. Make the required calculation to decide as to what method of financing is to be selected in this case. (14 Marks) (b) You are considering to purchase a three year bond with a face value of Rs.100/- and carrying a coupon rate of interest at 12% per annum, with coupons paid annually. The bond is currently selling at Rs. 95/- What is the yield to maturity of this bond? (03 Marks) If the required rate of return on this bond is 15% p.a., calculate the value of that bond. Should it be bought? (03 Marks) (Total 20 Marks) Question No. 03 (20 Marks) (a) Pump Corporation currently has 1.1 million shares of common stock outstanding and Rs. 8 million in debt bearing an interest rate of 10% on average. It is considering a Rs. 5 million expansion program financed with common stock at Rs. 20 per share being realized (option 1), or debt at an interest rate of 11% (option 2), or preferred stock with a 10% dividend rate (option 3). Earnings before interest and taxes (EBIT), after new funds are introduced, are expected to be Rs. 6 million, and the company s tax rate is 35%. You are required to: (i) (ii) Determine the likely earnings per share after financing the expansion programme under the three alternatives separately. Estimate the stock price if the company expects the same earnings per share and the respective costs of capital after financing, under the three alternatives separately. (iii) Compute the degree of financial leverage under each alternative at the expected EBIT level of Rs. 6 million. 3
(b) A Company is currently paying a dividend of Rs 2.00 per share. The dividend is expected to grow at a 15% annual rate for three years, then at 10% rate for the next three years, after which it is expected to grow at a 5% rate forever. (i) What is the present value of the share if the capitalization rate is 9%? (ii) If the share is held for three years, what shall be its present value? (Total 20 Marks) Question No. 04 (20 Marks) (a) The balance sheet of XY Company as on 31 st March 2012 is as follows: Liabilities Rs. Million Assets Rs. Million Common stock (1,000,000 shares at Rs. 20 each) 13% Debentures Retained earnings Creditors 20.0 10.0 5.0 3.0 38.0 Plant & Machinery Furniture & fittings Inventories Debtors Bank Balance 25.0 0.5 9.0 2.5 1.0 38.0 (i) (ii) (iii) The Company is to be absorbed by ABC Company on the basis of above date. The consideration for absorption is the discharge of debentures at a premium of 10%, taking over the liability in respect of sundry creditors and other current liabilities and issue of one share of Rs.10 in ABC Company, at the market value of Rs.16 per share, in exchange for one share in XY Company. The cost of dissolution of Rs.1,000,000/- is to be met by the purchasing company. Expected incremental yearly free cash flows (FCFF) from the acquisition for next 5 years would be as follows: Year-end Rs. million 1 10 2 13.5 3 17.5 4 20 5 8 The FCFF of XY Company is expected to be constant after 5 years. (iv) Cost of capital relevant for XY Company cash flows is to be 14%. Based on the information, comment on the financial soundness of ABC s decision regarding merger. 4
(b) A newly formed company has applied for a loan to a commercial bank for financing its working capital requirements. The information about the projected profit and loss account of this company is as follows: Sales Less : Cost of goods Gross profit Administrative expenses- 140,000 Selling expenses - 130,000 Rs. 2,100,000 (1,530,000) 570,000 ( 270,000) Profit before tax Provision for tax Profit after tax 300,000 100,000 200,000 Cost of goods sold has been derived as follows: Rs. Material 840,000 Wages and manufacturing expenses 625,000 Depreciation 235,000 1,700,000 Less: stock of finished goods 170,000 1,530,000 The figures given above relate only to the finished goods and not to work in progress; goods equal to 15% of the year s production (in physical terms) are in work in progress on an average, requiring full materials but only 40% of other expenses. The company wishes for keeping two months consumption requirements of material in stock; desired cash balance to be maintained is Rs.40,000/-. Average time lag in making payment of all expenses is one month; suppliers of materials extend 1.5 months credit; sales of 20% are for cash and the balance is on two months credit basis. 80% of the income tax has to be paid in advance in quarterly installments. Estimate the working capital requirement of the Company, making any other relevant assumptions as you deem necessary. (Total 20 Marks) Question No. 05 (20 Marks) (a) Alpex Company in the United Kingdom (UK) is considering an investment project in Sri Lanka. The project involves a business College offering undergraduate programme. This project requires an initial investment of Rs. 30 million and it is expected to earn cash flows after taxes as follows: Year Cash flow (Rs.) 1 7.5 2 9.5 3 13.5 4 15.5 5 8 5
Following additional information is provided: 1. The risk free rate of interest in Sri Lanka is 9% and in the United Kingdom is 7% 2. The expected inflation rate in Sri Lanka is 6% per annum. 3. The real interest rates in the two countries are expected to remain same during the project period. 4. The current spot rate is Rs.190/- per one UK pound. You are required to: (i) (ii) Calculate spot rates for each year. Calculate sterling NPV of the project. (iii) Discuss the main methods of financing the project. State any other assumptions that you made. (b) An exporter is UK based company. Invoice amount is $350,000. Credit period is three months. Exchange rates in London are: Spot rate ($/ ) 1.5865 1.5905 3-month forward rate ($/ ) 1.6100 1.6140 Rates of interest in money market: Deposit Loan $ 7% 9% 5% 8% You are required to compute and show how a money market hedge can be put in place. Compare and contrast the outcome with a forward contract. (Total 20 Marks) End of Part II 6
Month 1.50 p.m. 1.51 p.m. Annex to the Question Paper on FSP Present values at 10 different Monthly Interest Rates 1.52 1.53 1.54 1.55 1.56 1.57 p.m. p.m. p.m. p.m. p.m. p.m. 1 0.9852 0.9851 0.9850 0.9849 0.9848 0.9847 0.9846 0.9845 0.9844 0.9843 2 0.9707 0.9705 0.9703 0.9701 0.9699 0.9697 0.9695 0.9693 0.9691 0.9689 3 0.9563 0.9560 0.9558 0.9555 0.9552 0.9549 0.9546 0.9543 0.9541 0.9538 4 0.9422 0.9418 0.9414 0.9411 0.9407 0.9403 0.9400 0.9396 0.9392 0.9388 5 0.9283 0.9278 0.9273 0.9269 0.9264 0.9260 0.9255 0.9251 0.9246 0.9242 6 0.9145 0.9140 0.9135 0.9129 0.9124 0.9118 0.9113 0.9108 0.9102 0.9097 7 0.9010 0.9004 0.8998 0.8992 0.8985 0.8979 0.8973 0.8967 0.8961 0.8955 8 0.8877 0.8870 0.8863 0.8856 0.8849 0.8842 0.8835 0.8828 0.8821 0.8814 9 0.8746 0.8738 0.8730 0.8723 0.8715 0.8707 0.8700 0.8692 0.8684 0.8676 10 0.8617 0.8608 0.8600 0.8591 0.8583 0.8574 0.8566 0.8557 0.8549 0.8541 11 0.8489 0.8480 0.8471 0.8462 0.8453 0.8443 0.8434 0.8425 0.8416 0.8407 12 0.8364 0.8354 0.8344 0.8334 0.8324 0.8315 0.8305 0.8295 0.8285 0.8275 13 0.8240 0.8230 0.8219 0.8209 0.8198 0.8188 0.8177 0.8167 0.8156 0.8146 14 0.8118 0.8107 0.8096 0.8085 0.8074 0.8063 0.8052 0.8041 0.8029 0.8018 15 0.7999 0.7987 0.7975 0.7963 0.7951 0.7940 0.7928 0.7916 0.7905 0.7893 16 0.7880 0.7868 0.7856 0.7843 0.7831 0.7818 0.7806 0.7794 0.7782 0.7769 17 0.7764 0.7751 0.7738 0.7725 0.7712 0.7699 0.7686 0.7673 0.7661 0.7648 18 0.7649 0.7636 0.7622 0.7609 0.7595 0.7582 0.7568 0.7555 0.7541 0.7528 19 0.7536 0.7522 0.7508 0.7494 0.7480 0.7466 0.7452 0.7438 0.7424 0.7410 20 0.7425 0.7410 0.7396 0.7381 0.7366 0.7352 0.7337 0.7323 0.7309 0.7294 21 0.7315 0.7300 0.7285 0.7270 0.7255 0.7240 0.7225 0.7210 0.7195 0.7180 22 0.7207 0.7191 0.7176 0.7160 0.7145 0.7129 0.7114 0.7098 0.7083 0.7068 23 0.7100 0.7084 0.7068 0.7052 0.7036 0.7020 0.7005 0.6989 0.6973 0.6957 24 0.6995 0.6979 0.6962 0.6946 0.6930 0.6913 0.6897 0.6881 0.6864 0.6848 25 0.6892 0.6875 0.6858 0.6841 0.6825 0.6808 0.6791 0.6774 0.6758 0.6741 26 0.6790 0.6773 0.6756 0.6738 0.6721 0.6704 0.6687 0.6670 0.6653 0.6636 27 0.6690 0.6672 0.6654 0.6637 0.6619 0.6601 0.6584 0.6566 0.6549 0.6532 28 0.6591 0.6573 0.6555 0.6537 0.6519 0.6501 0.6483 0.6465 0.6447 0.6429 29 0.6494 0.6475 0.6457 0.6438 0.6420 0.6402 0.6383 0.6365 0.6347 0.6329 30 0.6398 0.6379 0.6360 0.6341 0.6322 0.6304 0.6285 0.6267 0.6248 0.6230 31 0.6303 0.6284 0.6265 0.6246 0.6227 0.6208 0.6189 0.6170 0.6151 0.6132 32 0.6210 0.6190 0.6171 0.6151 0.6132 0.6113 0.6094 0.6074 0.6055 0.6036 33 0.6118 0.6098 0.6079 0.6059 0.6039 0.6020 0.6000 0.5981 0.5961 0.5942 34 0.6028 0.6008 0.5987 0.5967 0.5948 0.5928 0.5908 0.5888 0.5868 0.5849 35 0.5939 0.5918 0.5898 0.5878 0.5857 0.5837 0.5817 0.5797 0.5777 0.5757 36 0.5851 0.5830 0.5810 0.5789 0.5768 0.5748 0.5728 0.5707 0.5687 0.5667 37 0.5764 0.5743 0.5723 0.5702 0.5681 0.5660 0.5640 0.5619 0.5599 0.5578 38 0.5679 0.5658 0.5637 0.5616 0.5595 0.5574 0.5553 0.5532 0.5512 0.5491 39 0.5595 0.5574 0.5552 0.5531 0.5510 0.5489 0.5468 0.5447 0.5426 0.5405 40 0.5513 0.5491 0.5469 0.5448 0.5426 0.5405 0.5384 0.5363 0.5342 0.5321 41 0.5431 0.5409 0.5387 0.5366 0.5344 0.5323 0.5301 0.5280 0.5259 0.5237 42 0.5351 0.5329 0.5307 0.5285 0.5263 0.5241 0.5220 0.5198 0.5177 0.5155 43 0.5272 0.5250 0.5227 0.5205 0.5183 0.5161 0.5140 0.5118 0.5096 0.5075 44 0.5194 0.5171 0.5149 0.5127 0.5105 0.5083 0.5061 0.5039 0.5017 0.4995 45 0.5117 0.5095 0.5072 0.5050 0.5027 0.5005 0.4983 0.4961 0.4939 0.4917 46 0.5042 0.5019 0.4996 0.4973 0.4951 0.4929 0.4906 0.4884 0.4862 0.4840 47 0.4967 0.4944 0.4921 0.4899 0.4876 0.4853 0.4831 0.4809 0.4786 0.4764 48 0.4894 0.4871 0.4848 0.4825 0.4802 0.4779 0.4757 0.4734 0.4712 0.4690 Total 34.0426 33.9700 33.8977 33.8256 33.7537 33.6820 33.6105 33.5393 33.4683 33.3975 1.58 p.m. 1.59 p.m. 7
Present value table Present value of 1.00 unit of currency, that is (1 + r) -n where r = interest rate; n = number of periods until payment or receipt. Periods (n) Interest rates (r) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 Periods (n) Interest rates (r) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065 16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026 End of Question Paper 8