Mid Term Exam (Take-Home) Fall – 2020

Student Name: Reg. ID:

Program: MBA
Subject: Financial strategy and policy Max. Marks: 25

Q. No. 1 2 3 4 5
Total Marks
Obtained Marks

Department of Business Administration

Please follow the instructions carefully:
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Blackboard.
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6. Follow the requirements of the word limit and the marking criteria while writing your
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ability to examine, explain, modify or develop concepts discussed in class.
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Attempt all Questions

Q No. 1 Lucky Cement is trying to establish its optimal capital structure. Its current capital
structure consists of 20% debt and 80% equity; however, the CEO believes that the firm should
use more debt. The risk-free rate, rRF, is 5%; the market risk premium, RPM, is 6%; and the
firm’s tax rate is 40%. Currently, Lucky Cement has beta of 1.5. What would be Lucky Cement’s
estimated cost of equity if it changed its capital structure to 40% debt and 60% equity? Should
the company opt new capital structure? (decide based on the cost of equity computations)? (5
Marks)

Q No. 2 Explain Why you agree or disagree with the following statements. The answer should
not be more than 3 sentences. Be specific in your answer and write only the most relevant
explanations (Total Marks 6, Each 2).
a. A firm should select the capital structure that is fully levered (2 Marks)
b. Leveraged beta represents fundamental operating risk. (2 Marks)
c. MM Proposition I with no tax supports the argument that a firm should borrow money to
the point where the tax benefit from debt is equal to the cost of the increased probability
of financial distress (2 Marks)

Q No. 3 Mubashir Ali is negotiating his employment contract. His opportunity cost is 14%. He
has been offered three possible 4-year contracts. Payments are in Pakistani rupees and are
guaranteed, and they would be made at the end of each year. Terms of each contract are as
follows:

Contract Year 1 Year 2 Year 3 Year 4

Contract 1 4 Million 4 Million 4 Million 4 Million
Contract 2 7 Million 1 Million 1 Million 1 Million
Contract 3 9 Million 0.5 Million 0.5 Million 0.5 Million

As his financial adviser, which contract would you recommend that he accept? (Total Marks 4)
Q No 4 Using the following income statement, balance sheet and additional information
complete the tasks mention below.
Income Statement
Sale 4,200
Operating costs 3,780
EBIT 420
Interest 120
EBT 300
Taxes (40%) 120
Net Income 180
Dividends 0
Addition to retrained earnings 180
   
Balance Sheet
Cash and marketable securities 42
Accounts receivable 336
Inventories 441
Current Assets 819
Net fixed assets 2,562
Total Assets 3,381
Accounts payable and accruals 168
Notes payable 250
Current liabilities 418
Long term debt 700
Common stock 400
Retained earnings 1863
Total liabilities and equity 3,381

In developing its forecast for the upcoming year, the company has assembled the following
information:
 Sales are expected to increase 8 % this upcoming year.
 Operating costs are expected to remain at 90% of sales.
 Cash and marketable securities are expected to remain at 1% of sales
 Accounts receivable are expected to remain at 8% of sales
 Due to excess capacity the company expects that its year end inventories will remain at
current levels.
 Fixed assets are expected to remain at 61% of sales
  Spontaneous liabilities (accounts payable and accruals) are expected to increase at the
same rate as sales.
 The company will continue to pay a zero dividend, and its tax rate will remain at 40%.
 The company anticipates that any additional funds needed will be raised in the following
manner: 25% notes payable, 25% long-term debt, and 50% common stock.
Task:
1. Based on the assumptions listed above, construct Pro forma income statement and
balance sheet. Assume that there are no financial feedback effects. (That is assume
interest will remain unchanged even though the company may increase its debt).
(Total Marks 2.5)
2. Based upon this forecast, describe changes from the prior year that should expect in its
return on equity, inventory turnover ratio and profit margin. (Total Marks 2.5)

Q No 5 The opening cash balance on 1st Jan was expected to be Rs. 30,000. The sales budget was
as follows:
November Rs. 80,000
December 90,000
January 75,000
February 75000
March 80000

Analysis of records shows that debtors settle according to the following pattern: 60% within the
month of sales, 25% the month following, 15% the month following.

Extracts from the purchases budget were as follows:

December Rs.60000
January 55000
February 45000
March 55000
All purchases are on credit and experience shows that 90% are settled in the month of purchases
and the balance settled the month after.
Wages are Rs.15000 per month and overheads of Rs.20,000 per month (including Rs.5000
depreciation) are settled monthly.
Taxation of Rs.8000 must be settled in February and company will receive settlement of an
insurance claim of Rs.25000 in March.

Required: Prepare cash budget for Jan, Feb, and March (Total Marks 5)