STRATEGIC FINANCIAL MANAGEMENT [S5] @ICMA nce Extra Reading Writing Time: 03 Hours (i) (i) @ (iv) w (vi) (vii) (i) SUMMER 2019 EXAMINATIONS Pakistan Monday, the 29th April 2019 % inutes Maximum Marks: 100 ‘Attempt all questions \Write your Roll No. in the space provided above. ‘Answers must be neat, relevant and brief. It is not necessary to maintain the sequence. Use of non-programmable scientific calculators of any model is allowed. Read the instructions printed inside the top cover of answer script CAREFULLY before attempting the paper. In marking the question paper, the examiners take into account clarity of exposition, logic of arguments, effective presentation, language and use of clear diagrany chart, where appropriate DO NOT write your Name, Reg. No. or Roll No., or any irrelevant information inside the answer script Question Paper must be returned to invigilator before leaving the examination hall. DURING EXTRA READING TIME, WRITING IS STRICTLY PROHIBITED IN THE ANSWER SCRIPT EXAMINEES ARE ADVISED TO MANAGE SOLUTIONS/ ANSWERS WITHIN PROPOSED TIME Marks Question No. 1 Proposed Time : 15 Min. | Total Marks : 10 The Board of Directors of Razi Pharmaceutical Limited is serious about the forecast of expected return on equity on the basis of following available information and financial assumptions: * The company has recently expanded its production capacity by installing a new state-of-the-art production plant due to increasing demand of its products in the country. Recently, the company is in the process of ascertaining optimal level for total current assets for the upcoming year. * The management of the company forecasts that sales would increase to approximately Rs. 100 million as a result of an asset expansion just completed. The cost of fixed assets is Rs. 50 million and the company wishes to maintain a 60% debt-to-equity (D/E) ratio. The company’s interest cost is currently at an average of 15%, on short-term and long-term debt, of its permanent capital structure. * The following three altemates, regarding projected current assets level, are available for consideration to the company: Alternate-1 — A tight policy, requiring current assets of only 45% of projected sales Altemate-2 — A moderate policy, requiring current assets of only 55% of projected sales Altemate-3 — A relaxed policy, requiring current assets of only 70% of projected sales * The company expects to generate earnings before interests and taxes (EBIT) at a rate of 20% on total sales. The tax rate is 30% Required: Being a Financial Advisor, how would you arrive at the expected return on equity (ROE), under each alternate [current asset level] to advise the Board of Directors? 10 Question No. 2 Proposed Time : 15 Min. | Total Marks : 10 Now-a-days, stock market is very sensitive area and extra precautionary measures are required to protect the company and its stakeholders from losses by making most possibly right decisions. You are working as a Chief Investment Officer (CIO) in XYZ Investment Funds where Rs. 1,000 milion is invested in the following five stocks: SF Investment Stocks ERs in million] Beta Coefficient A 320 0.50 B 240 1.35 c 160 1.65 D 160 4.00 E 120 1.48 Summer 2019 10f6 PTOBeta coefficient for XYZ Investment Funds can be found as a weighted average of the invested fund. The current risk-free rate is 6%, whereas, the market retums have following estimated probability distribution for the next period: Probability Market Return 0.4 1% 0.2 9% 04 11% 0.2 13% 0.4 15% The Chairman, Audit Committee, constituted by the Board of the company, desires to know the different parameters to take substantial decisions: Required: Being the CIO of XYZ Investment Funds, how would you respond the Chairman, Audit Committee, regarding following (a) About the estimated equation for the Security Market Line (SML). (b) Also, compute XYZ Investment Funds’ required rate of return for the next period. Question No. 3 Proposed Time : 25 Min. | Total Marks : 15 (a) Novelty Limited is a renowned name for its quality range of sports products. Recently, the company has introduced its products in the European market and was able to get a good response. Last year, the company also enjoyed a considerable success due to receiving a huge order from England for its track suits. This order is not expected to be repeated and the company, in the absence of any attractive investment opportunities in hand, intends to utilize surplus funds by repurchasing its stock The company has net income of Rs. 4,000,000 and it has 2,000,000 ordinary shares (with a face value of Rs. 10 per share). Currently, the company’s share price is Rs. 32 per share. The company is also considering a plan where it will use all of its available cash to repurchase 20% company’s shares from open market. The repurchase is expected to have no effect on net income. Required ‘What would be the market price per share, if the shares are repurchased by Novelty Limited? (b) Following is the shareholders’ equity account of National Beverages: Rupees ‘Share capital (Rs. 10 per share) 4,000,000 Share premium 3,200,000 Retained earnings 16,800,000 Total shareholders’ equity The current market price of a share is Rs. 60, Required (i) What will happen to the shareholders’ equity account and to the number of shares outstanding with a 20% ‘small-percentage’ stock dividend? ‘What should be the per share market price after a 20% stock dividend in the absence of an informational or signaling effect? (i ‘SFM-Summer 2019 20f6 Marks 04 06 07 05 03Question No. 4 Proposed Time : 40 Min. | Total Marks : (a) {b) 10 Ghazi Textiles Limited has decided for a capital restructuring, which involves increasing its existing debt from Rs. 160 million to Rs. 250 million. The interest rate on existing debt is 9% and is expected to be 12% for any additional debt. The company, currently, has 12 million shares outstanding with a market price of Rs. 75 per share, Required If the restructuring is expected to increase the retum on equity (ROE), what would be the minimum level for earnings before interests and taxes (EBIT) that the management of Ghazi Textiles Limited must expect? Ignore taxes. Hint: While restructuring, additional debt raised will be used for repurchase of company's outstanding shares, In the beginning of current year, the total market value of Shah Limited was Rs. 170 million. It is, also assumed that the company has no short-term debt. The capital structure of the company is as follows: Rupees Debt 70,000,000 Equity 100,000,000 Total capital 170,000,000 The company is considering a new project that will result in an initial after-tax cash savings of Rs. 14 million at the end of the first year and these savings will grow at a rate of 5% per year indefinitely. Following details (on the basis of face value) are also available for considering the project: Target debt-equity ratio 0.70 Cost of equity 13% Cost of debt - after-tax 5.5% The cost-saving proposal is somewhat riskier than the usual projects the company undertakes. ‘The management of the company uses subjective approach and applies an adjustment factor of plus 2% to the cost of capital for such risky projects. Required Advise whether Shah Limited should accept the new project, if the initial investment is Rs. 200 million and what would be the outcome of the project? Question No. 5 Proposed Time : 45 Min. | Total Marks : 25 Good Health Limited, a pharmaceutical company, has invested Rs. 1,100,000 for developing a new medicine of cardiac patients in last two years. Market research, undertaken at a cost of Rs. 225,000, suggests that the price of new medicine should be Rs. 110 per packet with an expected life of 4 years. In order to produce the medicine, the business must consider the following Purchase of specialized machinery and other necessary equipment (Rupees) 1,500,000 Expected life of machinery and equipment (Years) 4 Residual value — at the end of the period (Rupees) - Maximum output (No. of packets per year) 15,000 Advertising expense (Rs. per year) 250,000 The new medicine has following expected costs per packet (excluding advertising expense): Rupees Materials 32.50 Labour 27.50 Overheads 42.50 402.50 ‘SFM-Summer 2019 3 0f6 Marks 12 08 PTOAdditional Information: + The materials cost includes a charge of Rs. 10 per packet for material ‘Zee’ that is currently in stock and can be used for this medicine. The charge is based on the original cost of Rs. 10 per packet. Material ‘Zee’ is currently used in other areas of the business and the cost of replacing material ‘Zee’ is Rs. 15 per packet, which could easily be sold at a price of Rs. 12.50 per packet. * The labour cost includes payments to the employees directly involved in the medicine production. If the medicine is not produced, these employees would be released immediately with a cost (redundancy cost saving) of Rs. 1,150,000. There will be no redundancy cost saving at the end of Year-4 * The overheads include a depreciation charge for the new machinery and equipment. The company depreciates such assets in equal installments over their expected life with 2 nil salvage value. All other overheads, included in the above figure, are incurred in production of the medicine + The business has a target capital structure of 50% equity and 50% loan capital. The market cost of equity is 12% and the market cost of loan capital is 8%. The new medicine project has the same level of risk as that of other projects undertaken. If the project is accepted, it will be financed entirely by the equity. However, the level of investment required is very small compared to the size of the business Required: ‘As a Management Accountant of Good Health Limited, the company has asked you to respond the following requirements, ignoring taxation: {a) Calculate net present value (NPV) of the project, (b) Advise whether the project will be viable and calculate NPV, if: (i) Sales of medicine achieves the level of 12,000 packets per year. (ii) Advertising expense is increased to Rs. 312,500 per year. Question No. 6 Proposed Time : 40 Min. | Total Marks : 20 (a) The Directors of Alpha Limited, a large conglomerate, are considering the acquisition of entire share capital of Beta Limited, which manufactures a range of electronic gadgets. Neither company has any long-term debt capital. The directors of Alpha Limited believe that, if Beta Limited is taken over, the business risk of Alpha Limited will not be affected. Beta Limited's statement of financial position as at June 30, 2019 is expected to be as follows: Beta Limited Forecasted Statement of Financial Pos as at June 30, 2019 Rupees Assets Equity and Liabilities Non-Current Assets (Net of Depreciation): Equity: Land and buildings 651,600 | Ordinary shares (Rs.10 each) 100,000 Furniture and fixtures 521,280 | Retained earings 808,200 Motor vehicles 130,320 | Total equity 908,200 Total non-current assets 1,303,200 Current Liabilities: Current Assets: Accounts payable 1,507,200 Inventory and work-in-progress | 1,031,800 | Running finance 1,725,800 Accounts receivable 1,490,000 | Total current liabilities 3,233,000 Cash at bank 316,200 Total current assets 2,838,000 Total assets 4,141,200 Total equity and liabilities 4,141,200 ‘SFM-Summer 2019 40f6 Marks 13 08 04Marks Beta Limited's summarized financial record for the five years upto June 30, 2019 is as follows: Rupees 2019 Year-end 2015 2016 2017 2018 (ge timated) Profit after non-recurring items 66,600 133,600 86,600 76,800 104,400 Dividends (41,000) (45,200) (50,000) (50,000) _ (50,000) Added to retained eamings 25,600 88,400 36,600 26,800 54,400 There have been no changes in the issued share capital of Beta Limited for 5 years. The estimated values of Beta Limited’s assets as at June 30, 2019 are as follows: Rupees Assets Replacement Cost__Realisable Value 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 Additional Information: + Itis expected that 2% receivable as at June 30, 2019 will be un-collectable. * The cost of capital of Alpha Limited is 9%, The shareholders of Beta Limited require a minimum retum of 12% per annum from their investment in the company. + The current price-to-eamings (P/E) ratio of Alpha Limited is 12. Other companies, having same business activities and profitability to that of Beta Limited, have P/E ratio of approximately 10, although these companies tend to be much larger than Beta Limited, Required Being the Financial Advisor/ Chief Financial Officer (CFO), you have been assigned with the duties to determine the value of total equity of Beta Limited as at June 30, 2019, using each of the following basis, ignoring taxation: (i) Replacement cost of the assets 05 Realisable value of the assets 06 (iii) Dividend valuation model 04 (b) ABC Limited desires to invest in different mega projects with a life of 10 years after making Viable decision. The following data is available for three projects: Rs. in million Project___Investment Present Value (PV) of Cash Flows x 2,000 2,100 Y 1,500 4,440 z 1,000 4,080 Required As a Financial Analyst of ABC Limited you have been tasked to maximize the wealth of the shareholders and advise which one of the three projects the company should accept (on the basis of profitability index), assuming that all the projects are mutually exclusive. 05 THE END ‘SFM-Summer 2019 5of6 PTO‘PRESEN VALUE INTEREST FACTOR PVIF(. n)= (18) Petiod Interest Rate () ) [se [mm | % | 9% | toe | 1% | 1% | 13% | 18% + | 0962 | 0035 | 0.926 | oi7 | 0909 | ovo | 0883 | oss | 0877 2 | 0907 | 07 | 0857 | 0842 | 0.626 | oi | o7e7 | 0769 | 0760 3 | 0864 | 0816 | 0704 | o77e | o7s1 | o73t | o7t2 | 060s | 0675 4 [08% | 0763 | 0735 | 0708 | 0683 | o0se | 0.698 | 0613 | 0592 S| 0784 | 0713 | 06st | oso | oz | 0809 | ose7 | 058 | 0510 6 | 0746 | 0666 | 0630 | 0508 | 0564 | 0596 | 507 | 0400 | 0488 7__[o7tt | 023 | 0683 | ose | 0513 | ose | 0462 | 0426 | 0400 8 | oa77 | 0582 | 0540 | a0 | o4e7 | 0434 | 040s | 037 | 0361 9 | 0645 | 054 | 0500 | 0460 | 0.424 | 0301 | 0261 | 0339 | 0308 10 | 0614 | 0508 | 0463 | 02a | 0.366 | 062 | 0.22 | 0206 | 0270 Tune VALUE WTEREST FacToR VIF, Period Interest Rat CO a 1 _| too [1070 [1080 | 1.000 | 1.100 | 1.110 | 4.120 | 1.190 | 1.140 2 | 103 [114s [1166 | 1.88 | 1210 | 1292 | 4250 | t2r7 | 1300 3_| te | 1205 | 1260 | 1205 | tet | 1368 | 1405 | tes | 1482 & | tae [vat | 1960 | tara | tase | tte | 1574 | 1630 | 1680 S| tare | 1403 | vase | 1500 | tert | 1.665 | 1762 | 1982 | 1925 6 7 8 8 end 340 [1501 | 1.887 | te77 | 172 | 1070 | 1974 | 2082 | 2.195 aor | 1606 | 1.714 | 1226 | 1949 | 2076 | 2211 | 2359 | 2602 var | 1718 | 1951 | 1993 | 2144 | 2905 | 2476 | 2658 | 2659 set | 1938 | 1.900 | 2172 | 2368 | 2568 | 2773 | 3004 | 3.252 10 | 1620 | 1967 | 2160 | 2367 | 2504 | 2830 | a108 | 3305 | 3707 FORMULAS, 1- Weighted average cost of capital (WACC) Wal = Tyra + Wats X Wp 2 Retum on stock (CAPM/ SML) = ree (tw —ree)B Profitability index (Pl) Initial cost 2 PV of future cash flows SFWM-Summer 2019, 6 of6