Financial Management-p Iii- Nov 08

Financial Management Time allowed – 3 hours Maximum marks – 100 [N.B. – Questions must be answered in English. The figures in the margin indicate full marks. Examiner will take account of the quality of language and of the way in which the answers are present. Different parts, if any, of the same question must be answered in one place in order of sequence.] Marks 4

1. (a) What is “4-T” approach of risk management? Discuss the four approaches. (b) A project with following cash flow is under consideration: Year 0 1 2 3 4

Cash flow (in Taka) (20,000) 8,000 12,000 4,000 2,000

Cost of capital: 8% NPV at 8%: Tk.2340 Required: Calculate the MGR and MIRR.

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(c) Black Ltd. is considering diversifying its operations away from its main area of business (food manufacturing) in to the plastics business. It wishes to evaluate an investment project, which involves the purchase of a moulding machine that costs Tk.450,000. The project is expected to produce net annual operating cash flows of Tk.220,000 for each of the three years of its life. At the end of this time its scrap value will be zero. The assets of the project will support debt finance of 40% of its initial cost (including issue cost). The loan is to be repaid in three equal annual installments. The balance of finance will be provided by a placing of new equity issue. Costs will be 5% of fund raised for the equity placing and 2% for the loan. Debt issue costs are allowable for corporate income tax. The plastics industry has an average equity beta of 1.368 and an average debt equity ratio of 1:5 at market values. Black’s current equity beta is 1.8, and 20% of its long term capital is represented by debt which is generally regarded to be risk free. The risk free is 10% pa and the expected return on an average market portfolio is 15%. Corporate income tax rate is 30%, payable one year in arrears. The machine will attract a 70% initial capital allowance and the balance is to be written off evenly over the three years and is allowable against tax. The firm is certain that it will earn sufficient profits against which to offset these allowances. Required: (i) Calculate the adjusted present value (AVP) and determine whether the project is worthwhile. (ii) Explain why the adjusted present value technique is sometimes advocated as being a more appropriate way of evaluating a project than net present value. 2. (a) Briefly explain the main features of the following: (i) Sales and leaseback (ii) Hard capital rationing (iii) Finance leases.

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3x2=6

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–2– (b) HLC Ltd. is the leasing subsidiary of a major commercial bank. It is approached by PPC Ltd., a company entirely financed by equity, which operates in the pharmaceutical industry, with a request to arrange a lease contract to acquire new computer-controlled manufacturing equipment to further automate its production line. The outlay involved is Tk.20m. The equipment will have only a four-year operating life due to the fast rate of technical change in this industry, and no residual worth. The basic project has a positive net present value when operating cash flows are discounted at the shareholders required rate of return. HLC would finance the purchase of the machinery by borrowing at the pre-tax annual rate of 14.5%. The purchase would be completed on the final day of its accounting year, when it would also require the first of the annual rental payments. HLC currently pays tax at 30%, 12 months after its financial year end. A written down allowance is available based on a 25% reducing balance. Under the terms of the lease contract, HLC would also provide maintenance services, valued by PPC at Tk.750,000 pa. These would be supplied by HLC’s computer maintenance sub-division at no incremental cost as it has spare capacity which is expected to persist for the foreseeable future. PPC has the same financial year as HLC and it also pays tax at 30% and its own bank will lend at 17.5% before tax. Required: Calculate the minimum rental which HLC would have to charge in order to just break even on the lease contract. You may assume that the rental is wholly tax-allowable as a business expense.

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(c) Assume that HLC does proceed with the contract and charge an annual rental of Tk.7m. Calculate whether, on purely financial criteria, PPC should lease the asset or borrow in order to purchase it outright: (i) Ignoring the benefit to PPC of the maintenance savings (ii) Allowing for the maintenance savings.

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(d) Discuss the non-financial factors that may influence the decision whether to lease or buy.

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3. (a) ‘Value of a firm does not depend on its method of financing operations’. Explain. (b) Shoma Ltd. has the following capital structure.

10% Debentures (Secured) Ordinary shares Tk.10 each Retained earnings • • • •

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Tk. 2,00,00,000 2,50,00,000 5,50,00,000 10,00,00,000

Debentures of similar quality are selling at 95% of face value to yield 12%. Ordinary share has been selling at Tk.140 per share. The company has paid 50% of earnings in dividends for several years and intends to continue the policy. The current dividend is 9% per share. Earnings are growing at 10% per year. The company expects to get Tk.130 net after all incidental costs in the case of new equity issue, if any. Current tax rate is 37.5%.

Required: (i) Calculate the firm’s weighted average cost of capital. (ii) Explain why such weighting system is used. (iii) How should Shoma Ltd. use the cost of capital computed in (i) above?

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–3– 4. (a) Explain the following: (i) Packing credit (ii) Zero interest fully convertible debentures (iii) Aggressive and defensive shares.

3x2=6

(b) Kushiara Ltd. has a paid-up ordinary share capital of Tk.1,500,000 represented by 6 million shares of Tk.0.25 each. It has no loan capital. Earnings after tax in the most recent year were Tk.1,200,000. The P/E ratio of the company is 12. The company is planning to make a large new investment which will cost Tk.5,040,000 and is considering raising the necessary finance through a rights issue at Tk.1.92. Required: (i) Calculate the current market price of Kushiara’s ordinary shares. (ii) Calculate the theoretical ex-rights price, and state what factors in practice might invalidate your calculation. (iii) Briefly explain what is meant by a deep-discounted rights issue, identifying the main reasons why a company might raise finance by this method.

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(c) As an alternative to a rights issue Kushiara might raise the Tk.5,040,000 required by means of an issue of convertible loan notes at par, with a coupon rate of 6%. The loan notes would be redeemable in seven years time. Prior to redemption, the loan notes may be converted at a rate of 35 ordinary shares per Tk.100 nominal. Required: (i) Explain the term conversion premium and calculate the conversion premium at the date of issue implicit in the data given. (ii) Identify the advantages of Kushiara of issuing convertible loan notes instead of rights issue to raise the necessary finance. (iii) Explain why the market value of convertible loan notes is likely to be affected by the dividend policy of the issuing company.

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5. The directors of Craze Ltd., a large conglomerate, are considering the acquisition of the entire share capital of Maize Ltd., which manufactures a range of engineering machinery. Neither company has any long-term debt capital. The directors of Craze Ltd. believe that if Maize Ltd. is taken over, the business risk of Craze Ltd. will not be affected. The accounting reference date of Maize Ltd. is 31 July. Its balance sheet as on 31 July 2008 is expected to be as follows: Tk.000 Non-current assets (net of depreciation) Current assets: inventory and work in progress Receivables Bank balances

Tk.000 651,000

515,000 745,000 159,600 1,419,600 2,070,600

Current liabilities: payable Bank overdraft Capital and reserves: issued ordinary shares of Tk.1 each Distributable reserves

753,600 862,900 1,616,500 50,000 404,100 2,070,600

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–4– Maize’s summarized financial record for the five years to 31 July 2008 is as follows: Year ended 31 July

2004 Tk.

Profit before non-recurring items Non-recurring items Profit after non-recurring items Less dividends Added to reserves

30,400 2,900 33,300 20,500 12,800

2005 Tk. 69,000 (2,200) 66,800 22,600 44,200

2006 Tk. 49,400 (6,100) 43,300 25,000 18,300

2007 2008 Tk. Tk. 48,200 (9,800) 38,400 25,000 13,400

53,200 (1,000) 52,200 25,000 27,200

The following additional information is available: (1) There have been no changes in the issued share capital of Maize Ltd. during the past five years. (2) The estimated values of Maize Ltd. non-current assets and inventory and work in progress as on 31 July 2008 are as follow:

Non-current assets Inventory and work in progress

Replacement cost Tk. 725,000 550,000

Realizable value Tk. 450,000 570,000

(3) It is expected that 2% of Maize Ltd. receivables at 31 July 2008 will be uncollectable. (4) The cost of capital of Craze Ltd. is 9%. The directors of Maize Ltd. estimate that shareholders of Maize Ltd. require a minimum return of 12% per annum from their investment in the company. (5) The current P/E ratio of Craze Ltd. is 12. Quoted companies with business activities and profitability similar to those of Maize Ltd. have P/E ratios of approximately 10, although these companies tend to be much larger than Maize Ltd. Required: (a) Estimate the value of the total equity of Maize Ltd. as on 31 July 2008 using each of the following bases: (i) Balance sheet value; (ii) Replacement cost of the assets; (iii) Realisable value of the assets; (iv) The dividend valuation model; (v) The P/E ratio model. (b) Explain the role and limitations of each of the above five valuation bases in the process by which a price might be agreed for the purchase by Craze of the total equity capital of Maize Ltd. (c) State and justify briefly the approximate range within which the purchase price is likely to be agreed. Ignore taxation.

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