STRATEGIC FINANCIAL

MANAGEMENT (AF-503)

ICMA.

SEMESTER-5

SPRING (AUGUST) 2014 EXAMINATIONS

Tuesday, the 19th August 2014

Pakistan
Extra Reading Time:
Writing Time:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)

15 Minutes
03 Hours

Maximum Marks: 100

Roll No.:

Attempt all questions.

Answers must be neat, relevant and brief.
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 diagram/ 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.

Answer Script will be provided after lapse of 15 minutes Extra Reading Time

(9:15 a.m. or 2:15 p.m. [PST] as the case may be).

Marks
Q. 1

Sky Ways Ltd., a subsidiary of Best Ways Ltd., runs a high speed business train from Lahore
to Karachi and back on alternative days. The train leaves Lahore at 6:00 pm and reaches at
Karachi at 6:00 am on the next day. The train starts its journey from Karachi on the same
day at 6:00 pm and reaches at Lahore at 6:00 am on the next day. In this way, the business
train completes one single trip in a day of 24 hours. The train is fully air conditioned and also
provides different facilities i.e., TV, internet and catering services to its passengers.
The train service operates 360 days per year and a single restaurant carriage is adequate to
serve the catering needs of a train carrying up to 600 passengers. Past sales data indicates
that 50% of passengers used the catering service, spending an average of Rs. 450 per
journey. The data is expected to remain unchanged over the next five years.
Statistical forecasts per single trip from Lahore to Karachi or Karachi to Lahore for the train
service over the next five years are shown as under:
No. of Passengers
500
580
600

Probability
0.2
0.5
0.3

In-House Catering Services:

The management accountant of Sky Ways Ltd., has compiled costs data for in-house
provision of catering service as under:
Variable Costs:
Direct material
Variable overhead
Fixed Costs:
Labour (Year-1)
Purchase / storage charges
Insurance expenses
Depreciation on catering equipment
Total cost

% of Sales
55
12
10
3
2
4
86

Labour costs are expected to rise at a rate of 5% per year over the next five years. Variable
costs per rupees sales are expected to remain unchanged over the next five years. Some
catering equipment will need to be replaced at the end of Year-2 at a cost of Rs. 1,000,000.
This would increase the depreciation charge on catering equipment from Rs. 0.04 to Rs. 0.05
per rupee sale. The equipment value at the end of Year-5 is estimated to be Rs. 560,000.

SFM-Aug.2014

1 of 6

PTO

Marks
Outsource Catering Services:
In an attempt to reduce overheads, the company is considering to use services of an outside
contractor who will takeover responsibility for all on-train catering services. Sky Ways Ltd.,
invited tenders for a five-year contract. The selected contractor has agreed to purchase
immediately for cash the existing catering equipment owned by Sky Ways Ltd., at current
book value i.e., Rs. 13,000,000. The contractor would pay the company the charges at flat
rate of Rs. 5,000 per day for the provision of this catering service. The contractor will receive
daily meal charges directly from the passengers. The quality of the catering services is
expected to be unaffected by contracting out.
In case of contract out the catering, the following fixed costs will be saved every year till the
end of the contract:
Rupees
Depreciation
Purchasing/ storage costs
Insurance

2,600,000
1,600,000
500,000

Labour costs will be saved in case of contracting out the catering service. The cost of capital
for Sky Ways Ltd., is 12%. Assume that all cash flows occur at the end of each year. Ignore
taxation.
Independent Projects:
Best Spices Ltd., a multi product subsidiary of Best Ways Ltd., is now considering to
undertake three independent investment projects. Financial details of these projects are as
under:
Project
Development costs already incurred (Rs.)
Estimated cost on plant and machinery (Rs.)
Unit sales per annum (Nos.)

X
150,000
2,800,000
75,000

Y
160,000
4,800,000
80,000

Selling price and variable costs per unit for each project are estimated below:
Project
Selling price
Materials
Labour
Variable overheads

X
80
24
24
14

Y
50
9
10
5

Z
120,000
1,200,000
120,000
Rupees
Z
100
50
20
21

The useful life of plant and machinery of three projects is five years with zero salvage value.
The company charges depreciation on a straight line basis over the useful life of the plant
and machinery. Development costs of projects are written off in the year they are incurred.
The company allocates general administration costs to projects at a rate of 5% of selling
price. However, there is no impact on administration costs with the introduction of the above
projects.
Working capital, 20% of the expected annual sales, will be required immediately in each
case and will be recovered in full when the projects end in five years time. Funds available
for investment are limited to Rs. 10,400,000. However, all the three projects are divisible.
Best Spices Ltd., cost of capital is 18%. Ignore taxation.
Past due Accounts Payable:
Best Spices Ltd., is performing quite well in the last many years in terms of market share.
The companys turnover was Rs. 7 million last year earning 10% profit after tax.
Presently, the company is facing difficulties to pay its accounts payable in time. Though, the
terms of purchase are net 30 days, but its accounts payable represent 60 days purchases.
The company intends to increase bank borrowings in order to become current in meeting its
trade obligations. The statement of financial position of the company is as under:
SFM-Aug.2014
2 of 6

Marks
Best Spices Ltd.
Statement of Financial Position
as on June 30, 2014
Cash
Accounts receivable
Inventory
Current assets
Land and buildings
Equipment

200
600
2,800
3,600
1,200
1,200

Total assets

6,000

Rs. 000
Accounts payable
1,200
Bank loans
1,400
Accruals
400
Current liabilities
3,000
Long-term debt
1,400
Share capital (Rs. 10 each)
600
Retained earnings
1,000
Total liabilities and equity
6,000

Required:
(a)
(b)

number

of

passengers

per single

journey for

the
02

Which of the two alternatives i.e., in-house provision or contracting out would you
recommend?

16

Identify and critically comment upon three non financial factors which need to be taken
into account when a business is considering this type of outsourcing option.

03

(d)

How would you determine that three projects of Best Spices Ltd., are financially viable?

09

(e)

Calculate the profitability index for each project and advise the company which of the
projects are to be undertaken with total NPV.

03

How much bank financing is needed to eliminate the past due accounts payable of Best
Spices Ltd.?

02

Would you as a bank loan officer make the loan? Justify your decision based on ratio
analysis.

05

(c)

(f)
(g)

Q. 2

Calculate the expected

business train service.

Shah Ltd., a Karachi based listed company, is renowned for its quality products. The
company produces electronic products for domestic consumers. The company has 100,000
ordinary shares and the market value of its shares is Rs. 4,650,000 cum-dividend. The next
annual dividend of Rs. 900,000 is due to be paid within a few days. It is generally expected
that the companys dividends will remain indefinitely at the current level. Shah Ltd., has no
fixed interest capital.
The directors of Shah Ltd., are considering an investment project that would require the
immediate investment of Rs. 500,000 and would produce net annual receipts of Rs. 132,000
indefinitely. The first receipt would arise after one year. Details of the project have not yet
announced publicly. All receipts from the project would be distributed as dividends when
received. If the project was undertaken, it would be financed in one of the following three
ways:
(i)

A rights issue of one new share for every four held at a price of Rs. 20 per share: the
new shares would rank for dividend one year after issue.

(ii) A reduction of Rs. 500,000 in the current dividend.

(iii) A public issue of ordinary shares; the new shares would rank for dividend one year after
issue.
The Managing Director of Shah Ltd., is of the view that the proposed price of the rights issue
seems rather low and he suggests a one for five rights issue at a price of Rs. 25 per share
nearer to the current market value of ordinary shares.
You may assume that if the project were accepted, the directors expectations of future
results would be communicated to and believed by, the stock market and that the market
would perceive the risk of the company to be unaltered. Ignore issue cost of new shares and
taxation.
SFM-Aug.2014
3 of 6
PTO

Marks
Required:
(a) Estimate the new market price per ordinary share, ex-dividend If the project is accepted
and financed by:

a one for four rights issue, or

a reduction in the current dividend.

(b) Calculate the number of new shares to be issued under option (iii), and the price at
which they should be issued. If the total benefit from the project is to go to existing
shareholders.
(c) Calculate the total gain made by present shareholders under each of the three
financing options.
(d) Comment briefly on the views expressed by managing director.
Q. 3

(a)

04
01

04
04
02

Alpha Ltd., and Beta Ltd., are identical except for capital structures. Alpha Ltd., has
50% debt and 50% equity, whereas Beta Ltd., has 20% debt and 80% equity. The
percentage of debt and equity of both companies have been expressed in terms of
market value. The borrowing rate for both companies is 8% in a no-tax world, and
capital markets are assumed to be perfect.

Required:
(i)

If you own 5% of the stock of Alpha Ltd., what is your rupee return if the company
has net operating income of Rs. 720,000 and the overall capitalization rate of the
company is 18%? What is the implied required rate of return on equity of
Alpha Ltd.?
(ii) Beta Ltd., has also net operating income of Rs. 720,000. What is the implied
required equity return of Beta Ltd.? Why does it differ from that of Alpha Ltd.?
(b)

04
04

ABC Ltd., has earnings before interest and taxes (EBIT) Rs. 6,000,000 and a 40% tax
rate. Its required rate of return on equity in the absence of borrowing is 18%.

Required:
(i)

In the absence of personal taxes, what is the value of the company in an Modigliani
and Miller (MM) world with:
(1) no leverage?
(2) Rs. 8 million in debt?
(3) Rs. 14 million in debt?
(ii) You may assume that personal as well as corporate taxes now exist. The marginal
personal tax rate on common stock income and debt income is 25%, and 30%
respectively. Determine the value of the company using for each of the three debt
alternatives as mentioned above. Why do your answers differ from (i) above?
Q. 4

XYZ Ltd., is a rapidly growing company in the beverage industry. The statement of financial
position of the company is as under:
XYZ Ltd.
Statement of Financial Position
as on June 30, 2014
Rs. 000
Cash
20,000 Accounts payable
20,000
Accounts receivable
40,000 Accruals
20,000
Inventories
40,000 Short-term debt
10,000
Current assets
100,000
Current liabilities
50,000
Net fixed assets
100,000 Long-term debt
60,000
Preferred stock
10,000
Common equity:
Common stock
20,000
Retained earnings
60,000
Total common equity
80,000
Total assets
200,000 Total liabilities and equity
200,000
SFM-Aug.2014
4 of 6

02
01
01

03

Marks
The company is in process of calculating weighted average cost of capital to be used for
appraisal of the investment projects having the same risk class as the firms existing average
assets. The relevant facts are as under:

Short-term debt represents 10% bank loans with interest payable quarterly. These loans
are used to finance receivables and inventories on a seasonal basis, so in the offseason, bank loans are zero.

The long-term debt consists of 20-year, semiannual payment, Term Finance

Certificates (TFCs) of Rs. 1,000 with a coupon rate of 8%. Currently, these TFCs provide
a 12% yield to investors.

XYZ Ltd.s perpetual preferred stock has Rs. 100 par value. The company pays a
quarterly dividend of Rs. 2, and has 11% yields to investors. New perpetual preferred
stock would have to provide the same yield to investors, and the company would incur a
5% flotation cost to sell it.

The company has 2 million common shares outstanding. Current price (Po) of the stock
is Rs. 20. It has recently paid a dividend (Do) of Rs. 1 and current earning per share
(EPSo) is Rs. 2. Return on equity (ROE) based on average equity was 24% in the
year 2014.

The security analysts have calculated betas as 1.50. The risk free rate is 10%; and
estimated market return is 15%.

For the bond-yield risk premium approach, a risk premium is 5% over XYZ Limiteds
12% TFCs.

XYZ Ltd., falls under 40% tax bracket.

Required:
(a) Calculate the market value of each component of capital structure.
(b) Determine the cost of each component of capital structure. Calculate the cost of equity
using capital asset pricing model (CAPM), discounted cash flow (DCF) and bond-yield
risk premium.
(c) What is the companys weighted average cost of capital (WACC) using CAPM for cost
of equity and assuming no new equity will be issued?
Q. 5

07

06
02

Unique Ltd., is in the showbiz and provides out door shooting facilities to the various
production houses. The company has excellent record of growth in the past years and
considering to acquire Icon Ltd., a fashion show business. Both companies have the same
level of risk. The partial financial statements of each company are as under:
Partial Statement of Consolidated Income
for the year ended June 30, 2014
Rs. in million
Retained
Price/ Earnings
Earning After
Dividends Earnings for
Ratio before
Tax (EAT)
the Year
Acquiring
Unique Ltd.
50.00
12.00
38.00
10
Icon Ltd.
19.20
8.00
11.20
7.5
Summarised Statements of Financial Position
as at June 30, 2014

Rs. in million
Unique Ltd. Icon Ltd.
630.80
398.40
130.40
6.40
761.20
404.80
241.00
209.60
520.20
195.20

Non-current assets
Net current assets
Long-term debt
Owners equity
Ordinary shares (Rs. 10 each)
Retained earnings
SFM-Aug.2014

400.00
120.20
520.20
5 of 6

160.00
35.20
195.20
PTO

Marks
The Board of Directors of Unique Ltd., is considering to make an offer to the shareholders of
Icon Ltd., of five shares in Unique Ltd., for every four shares held. It is believed that a
rationalization of administrative functions arising from the merger would reap after tax
benefits of Rs. 4.8 million.
Required:
(a)

What would be the total value of the proposed offer to Icon Ltd.?

04

(b)

What would be the earnings per share of Unique Ltd., following the successful
acquisition of Icon Ltd.? Calculate the share price of Unique Ltd., following acquisition,
assuming that the benefits of the acquisition are achieved and that the price/ earnings
ratio declines by 10%.

03

Calculate the effect of the proposed takeover on the wealth of the shareholders of each
company.

08

(c)

THE END
P R E S E NT V A LU E F A C TOR S
Year

5%

6%

11%

12%

13%

14%

15%

16%

17%

18%

0.952

0.943

0.901

0.893

0.885

0.877

0.870

0.862

0.855

0.847

0.907

0.890

0.812

0.797

0.783

0.769

0.756

0.743

0.731

0.718

0.864

0.840

0.731

0.712

0.693

0.675

0.658

0.641

0.624

0.609

0.823

0.792

0.659

0.636

0.613

0.592

0.572

0.552

0.534

0.516

0.784

0.747

0.593

0.567

0.543

0.519

0.497

0.476

0.456

0.437

0.746

0.705

0.535

0.507

0.480

0.456

0.432

0.410

0.390

0.370

10

0.614

0.558

0.352

0.322

0.295

0.270

0.247

0.227

0.208

0.191

20

0.377

0.312

0.124

0.104

0.087

0.073

0.061

0.051

0.043

0.037

30

0.231

0.174

0.044

0.033

0.026

0.020

0.015

0.012

0.009

0.007

40

0.142

0.097

0.015

0.011

0.008

0.005

0.004

0.003

0.002

0.001

C U M U LA T IV E P RE S E N T V A L U E F A C TO RS

SFM-Aug.2014

Year

5%

6%

11%

12%

13%

14%

15%

16%

17%

18%

0.952

0.943

0.901

0.893

0.885

0.877

0.870

0.862

0.855

0.847

1.859

1.833

1.713

1.690

1.668

1.647

1.626

1.605

1.585

1.566

2.723

2.673

2.444

2.402

2.361

2.322

2.283

2.246

2.210

2.174

3.546

3.465

3.102

3.037

2.974

2.914

2.855

2.798

2.743

2.690

4.329

4.212

3.696

3.605

3.517

3.433

3.352

3.274

3.199

3.127

5.076

4.917

4.231

4.111

3.998

3.889

3.784

3.685

3.589

3.498

10

7.722

7.360

5.889

5.650

5.426

5.216

5.019

4.833

4.659

4.494

20

12.462

11.470

7.963

7.469

7.025

6.623

6.259

5.929

5.628

5.353

30

15.372

13.765

8.694

8.055

7.496

7.003

6.566

6.177

5.829

5.517

40

17.159

15.046

8.951

8.244

7.634

7.105

6.642

6.233

5.871

5.548

6 of 6