Certified Finance and Accounting Professional Stage Examination

The Institute of 5 December 2017

Chartered Accountants 3 hours – 100 marks
of Pakistan Additional reading time – 15 minutes

Business Finance Decisions

Q.1 CT Limited has two divisions i.e. steel manufacturing division and investment property
division. CT's management foresees significant increase in steel demand and wants to expand
current production capacity which requires financing of Rs. 1,200 million.

Projected free cash flows specifically related to the increased steel production capacity are as
follows:
Year 1 Year 2 Year 3 Year 4 Year 5
Free cash flows (Rs. in million) 185.00 212.50 215.00 279.00 315.00

After the 5th year, free cash flows are expected to grow by 5% per annum.

CT is considering to dispose of one of its properties which represents 50% of the total value of
its investment properties to finance the expansion. The return on investment properties is 10%
of their fair values. The fair values are expected to increase by 8% each year. Management
plans to use proceeds in excess of the required amount, if any, for repayment of the long term
loan. It is estimated that every reduction of 100 basis points in the gearing results in
improvement in CT’s credit rating and a consequent reduction of 10 basis points in its cost of
debt.

Following is a summarised latest statement of financial position:

Rs. in Rs. in
Assets Equity and liabilities
million million
Property, plant and equipment 5,914 Ordinary share capital (Rs. 10 each) 3,950
Investment properties – fair value 3,500 Retained earnings 3,148
Intangibles 850 Bank loan* 2,800
Current assets 1,484 Current liabilities 1,850
11,748 11,748
* repayable after five years and carries mark-up at 1-year KIBOR + 2%

Following industry and market information is available:

Equity beta of CT 1.20

Equity beta of companies engaged in the business of steel manufacturing 1.40

Average gearing of companies engaged in the business of steel manufacturing 70%

Rate of 1-year treasury bills 6.50%

1-year KIBOR 6.75%

Average annualized return on KSE-100 Index 14%

Current market price of CT’s share Rs. 24

Applicable income tax rate 30%

Required:
Advise whether CT should initiate expansion of its steel production capacity by disposing of
its investment properties. (18)
 Business Finance Decisions Page 2 of 4

Q.2 (a) Briefly discuss any four factors which influence the dividend policy of a company. (04)

(b) GSI Company Limited (GSI) is listed on Pakistan Stock Exchange. Following is a
summarised version of GSI’s audited statement of financial position as on 30 June 2017:

Rs. in Rs. in
Equity and Liabilities Assets
million million
Share capital (Rs. 10 each) 2,500 Property, plant & equipment 2,910
Retained earnings 992 Investment in listed shares
11% debentures redeemable on (at fair value) 1,310
30 June 2022 at par (Rs. 100 each) 960
Current liabilities 675 Current assets 907
5,127 5,127

At 30 June 2017, GSI’s shares were trading at price to book value ratio (P/B ratio) of
1.20. The yield to maturity of debentures on this date was 9%. The estimated correlation
between the market value of listed securities held by GSI and KSE-100 Index is 1.1.
Profit before tax and dividend for last five years are shown below:

2013 2014 2015 2016 2017

------------------Rs. in million------------------
Profit before tax 1,075.00 1,370.63 1,398.04 1,467.94 1,752.72
Dividend 247.00 269.00 275.00 245.00 298.00

During the first five months of 2017-18, KSE-100 Index has witnessed a decline of
35% which also affected the market price of GSI's shares and at 30 November 2017 its
shares were being traded at P/B ratio of 0.7. Further, the yield to maturity of debentures
has also declined by 2%, which is expected to remain the same for the foreseeable
future. The leading stock analysts are of the view that debt and equity markets would be
range bound during the financial year ending 30 June 2018 and would remain at the
current level.

No new shares or debentures have been issued during the last 5 years. The income tax
rate applicable to GSI is 30%. It is assumed that profits occur evenly throughout the year
and it is projected that profit would grow in line with the trend prevailing during the last
five years.

Required:
Estimate the effect on GSI’s weighted average cost of capital by the end of financial year
2018 if the stock analyst viewpoint remains valid. (20)

Q.3 Moderax Company Pakistan Limited (MCL) is planning to set up a coal fired power plant in
Filansia which is a developing country whose currency is FD (Filansian Dollar). Government
of Filansia (GOF) has offered MCL to sign a five-year agreement for acquisition of entire
output of the plant. At the end of five years, GOF would take over the plant at 20% above its
carrying value and all other assets/liabilities at their carrying values.

Following information has been gathered by MCL’s team of strategic investment:

(i) Expected annual output of electricity in year 1 would be 3 billion units. Average
increase in electricity demand would be 3% per annum.
(ii) Electricity tariff would generate earnings before tax and depreciation of FD 140 per
unit which would increase in line with inflation in Filansia.
(iii) MCL would require immediate outlay of Rs. 50 billion for setting up the plant which
would be financed through equity only. An additional Rs. 2 billion would be required
initially to finance the working capital.
(iv) The plant would be depreciated at the rate of 10% under the reducing balance method.
Tax depreciation is to be calculated on the same basis.
 Business Finance Decisions Page 3 of 4

(v) Free cash flows to the extent of profit after tax would be remitted to MCL each year in
the form of dividend. Free cash flows in excess of amount of dividend would be
invested @ 9% per annum.
(vi) Asset beta applicable on this project is 1.20. Cost of capital using capital asset pricing
model for this project is estimated at 16% before adjustment of country risk premium.
For determining country risk premium, following information has been gathered:

Treasury bonds are considered risk free in Filansia and carry interest rate of 8% per
annum while the yield on similar maturity US treasury bonds is 3.5% per annum.

Average annualised return in Filansian equity market is 12% with a standard
deviation of 10%.

The annualised return and standard deviation of 10-year Euro bonds issued by
GOF is 9% and 13% respectively.
(vii) Current exchange rate is PKR 1= FD 17 which is expected to change in line with
annual inflation in both countries. The current inflation in Pakistan and Filansia is 5%
and 8% respectively which is expected to remain the same for foreseeable future.
(viii) Applicable income tax rate in Filansia on business income is 25% whereas dividend on
coal fired power plants enjoy tax exemption. Tax is paid in the same year.
(ix) Dividend remittances are taxed in Pakistan at 10%. All other remittances are exempt
from tax in Pakistan.

Required:
Advise whether MCL should proceed with the above investment. (Assume that all cash flows
arise at the end of the year except otherwise specified) (24)

Q.4 Sohrab Industries Limited (SIL) is a chemical manufacturer and is experiencing liquidity
issues due to slow recovery of trade receivables. Presently goods are sold on 30 days credit.
SIL offers 2% settlement discount to the customers if they make payment within 10 days. 30%
of the customers avail the discount. The remaining customers take an average of 65 days to
make the payment. Bad debts are currently 1% of the total sales.
The sales staff is also responsible for collection of debts. The direct cost associated with the
collection activity is Rs. 12 million per annum. The projected gross sales for coming financial
year is Rs. 1,200 million at a contribution margin of 25%.
SIL is reviewing the following options:
Option I: Engage JK Investment (factoring agency) who offers guaranteed collection
from customers within 30 days. Other terms offered by JK are as under:
Without With
recourse recourse
Commission on invoiced amounts 4.00% 3.25%
Advance payment 80% 85%
Interest on advance 21% 20%
The marketing department is confident that assignment of collection
responsibilities to the factoring agency would allow its staff to focus exclusively
on sales efforts and bring additional sales of Rs. 50 million.
Option II: Increase the settlement discount to 3%. It is estimated that 55% of the
customers would avail the discount.
Option III: Introduce cash sales at 4% below the normal selling price. 50% of the
customers who presently avail the settlement discount and 20% of the
remaining customers are estimated to shift to this option.
SIL finances its investment in debtors through a mix of running finance and own funds, in the
ratio of 40:60. Cost of debt and equity is 10% and 12% respectively.

Required:
Determine which option SIL should adopt, if any. (Ignore taxation and assume 360 days in a
year) (15)
 Business Finance Decisions Page 4 of 4

Q.5 (a) Captain (Private) Limited (CPL) manufactures a single product ‘Alpha’ and exports it to
a Chinese and a Bangladeshi company. Goods are sold to both the customers on credit
period of 90 days from the date of invoice. Bangladeshi company is invoiced in
US Dollar (USD) whereas Chinese company is invoiced in Chinese Yuan (CNY).
On 1 November 2017, CPL had negotiated the following orders:

5,000 units at the rate of CNY 700 per unit to the Chinese company

3,000 units at the rate of USD 92 per unit to the Bangladeshi company

Both customers were invoiced on 1 December 2017. CPL’s management is concerned

about the expected variations in USD and CNY and is considering to hedge the
transactions. In this regard, the following information has been provided by CPL’s bank:
(i) Exchange rates as on 1 December 2017:
CNY / USD PKR/USD
Buy Sell Buy Sell
Spot 6.67 6.77 Spot 107.40 107.70
1 month premium 0.022 0.024 1 month discount 0.134 0.136
2 month premium 0.044 0.048 2 month discount 0.268 0.271
3 month premium 0.067 0.072 3 month discount 0.403 0.407

(ii) Details of interest rates available in the money market:

Deposits Borrowing
PKR – Local bank 1 6.00% 8.00%
PKR – Local bank 2 6.50% 8.50%
USD 2.00% 2.75%
CNY 7.50% 9.00%

Required:
Advise the feasible hedging options for each of the above transactions. (11)

(b) On 30 November 2017, CPL’s Board approved an investment of Rs. 15 million in the
shares of DB Limited (DBL) and HO Limited (HOL), in the ratio of 60:40. Both
companies have significant growth prospects and are currently performing well at the
Pakistan Stock Exchange.
However, CPL does not have the required funds at present and the funds are expected
to be available in 2 months’ time. Therefore, the management is considering to hedge
the purchase through 3 months’ stock future contracts. In this regard, following
information has been provided by the stock broker:
(i) Ready market and future prices and their transaction cost per share on
1 December 2017:
Ready market price Future market price
Transaction Transaction
Shares Rate Rate
cost cost
------------------------Rupees-----------------------
DBL 16.20 0.25 16.45 0.15
HOL 112.40 1.00 113.15 0.85
(ii) 10% margin is payable on the future transaction which is adjustable at the time of
final settlement.
(iii) The share prices of DBL and HOL are expected to increase by 5% and 8%
respectively, in two months.

Required:
Devise the hedging strategy using stock future contracts and calculate the net outcome
and hedge efficiency assuming that CPL’s incremental rate of borrowing is 10% per
annum. (Assume 30 days in a month) (08)
(THE END)