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Practice Kit
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C
Business finance decisions
Contents
Page
Question and Answers Index v
Section A Questions 1
Section B Answers 105
I
Business finance decisions
Question Answer
page page
Question Answer
page page
Question Answer
page page
Question Answer
page page
12.14 NS Technologies Limited 57 207
12.15 Copper Industries Limited 57 208
12.16 Mac Fertilizer Limited 58 211
Question Answer
page page
16.3 Foreign investment 83 252
16.4 Gold Limited 83 254
16.5 Ghazali Limited 85 257
Question Answer
page page
20.9 Definitions 102 287
20.10 Imran Limited 103 288
A
Business finance decisions
SECTION
Questions
1.3 OWNERSHIP
“Ascertaining exactly who owns a company’s shares and what, if any, are their
particular preferences and objectives” is a basic piece of information needed by
management, if it is to ensure that, as far as possible, it is acting in the shareholder’s
interest.
(a) Explain why a publicly quoted company might seek to know the detailed
composition of its shareholders and their objectives in investing in the
company.
(b) Explain any FIVE the major advantages which may accrue to the corporate
finance manager from obtaining this information.
Cost data:
2017 2018 2019 2020
Rs. m Rs. m Rs. m Rs. m
Purchases 40 50 58 62
Payables (at the year-end) 8 10 11 nil
Payments to sub-contractors, 6 9 8 8
As a direct result of introducing the new product line, employees in another department
currently earning Rs. 4 million per annum would have to be made redundant at the end
of 2017 and paid redundancy pay of Rs. 6.2 million each at the end of 2018.
Material costs
The company holds a stock of Material X which cost Rs. 6.4 million last year. There is
no other use for this material. If it is not used the company would have to dispose of it
at a cost to the company of Rs. 2 million in 2017. This would occur early in 2017.
Material Z is also in stock and will be used on the new line. It cost the company Rs. 3.5
million some years ago. The company has no other use for it, but could sell it on the
open market for Rs. 3 million early in 2017.
Further information
The year-end payables are paid in the following year.
The company’s cost of capital is a constant 10% per annum.
It can be assumed that operating cash flows occur at the year end.
Time 0 is 1st January 2017 (t1 is 31st December 2017 etc.)
Required
Calculate the net present value of the proposed new product line (work to the nearest
million).
(v) A specialised item of equipment will be needed for the project for a brief
period at the end of year 2. This equipment is currently used by the
company in another long-term project. The manager of the other project
has estimated that he will have to hire machinery at a cost of Rs. 150,000
for the period the cutting tool is on loan.
(vi) The project will require an investment of Rs. 650,000 working capital from
the end of the first year to the end of the licence period.
The company has a cost of capital of 10%. Ignore taxation.
Required
Calculate the NPV of the project.
Net present value using a nominal discount rate of 13% Rs. 82 million
Discounted payback period 3.1 years
Internal rate of return 10.5%
Modified internal rate of return 13.2% approximately
Option II : Import variety of plastic products from China
BL would buy in bulk from Chinese suppliers and sell it to the existing customers.
The projected net cash flows at current prices after acceptance of this option are as
follows:
Required
Calculate the NPV of the project and state whether or not it should be
undertaken.
The costs linked to the above indices are expected to grow at their historic
compound annual growth rate.
Required
Advise whether KL should invest in the project.
Rupees
Electricity and gas 340,000
Advertising 170,000
Repair and maintenance 85,000
Year 1 2 3 4
Alpha 60,000 110,000 100,000 30,000
Beta 75,000 137,500 125,000 37,500
The standard selling price and standard costs for each product in the first year will be
as follows.
Units
2,000 0.2
3,000 0.6
5,000 0.2
The sales demand in each year will be the same. For example, if the demand is
2,000 units in Year 1, it will be 2,000 units for every year of the project.
Taxation and fixed costs will be unaffected by any decision made.
East’s cost of capital is 6%.
Required
(a) Calculate the NPV for each of investment options, Machine A and Machine
B, for each of the possible levels of sales demand.
(b) Calculate the expected NPV for each of the investment options.
(c) Assume now that the decision is taken to buy Machine A.
(i) Calculate the probability that the NPV of the project will be negative
(ii) Calculate the minimum annual sales required for the NPV of the
project to be positive.
Company has already incurred a cost of Rs. 5 million on the preparation of technical
feasibility. The additional cost for setting up the facility for this order would be Rs. 20
million. The company qualifies for tax allowable depreciation on the cost of setting up
the facility on a straight-line basis over the life of the project.
The company has a post-tax cost of capital of 15%. The rate of tax applicable to the
company is 30%.
Required
(a) Evaluate whether the proposal is financially feasible for the company.
Assume that revenue and cost of gear box will remain the same during the
next five years.
(b) Carry out a sensitivity analysis to determine which of the following variables
is most sensitive to the feasibility of the order:
Material costs
Labour costs
Additional cost of setup
Call Rates
Subscribers in million
He foresees that the average airtime usage per subscriber would be 1800 minutes or
1600 minutes with a probability of 40% and 60% respectively. In order to cater to the
increased subscriber base, the company would need to commission new cell sites,
details of which are as follows:
It is assumed that the present customers of the company would continue to use the
existing packages.
Required
Evaluate the proposal submitted by the Marketing Director and advise the most
suitable call rates.
KL’s Budget and Planning Department anticipates that Net Cash Inflows After Tax
(NCIAT) are dependent on exchange rate of the US $ and has made the following
projections:
(B) Obtain a 5 year bank loan at an interest of 11% per annum. The loan
including interest would be repayable in 5 equal annual instalments to be
paid at the end of each year.
The company plans to depreciate the machine using straight-line method. The
insurance premium is Rs. 96,000 per annum. The corporate tax rate is 35%. For
the purpose of taxation, allowable initial and normal depreciation is 50% and 10%
respectively under the reducing balance method. The weighted average cost of capital
is 14%.
Required
Which of the two methods would you recommend to the management? Show all
relevant calculations.
The board of directors of Rotor Plc is concerned with deciding on its replacement
policy.
As the financial manager of the company, you are required to advise the board
on the optimal replacement policy of the machine assuming that the company’s
cost of capital is 10%.
Reserves
Profit for the year Rs. 600,000 (before interest and tax)
Ordinary dividend payments Rs.0.20 per share
The current market price of Rainy’s equity shares is Rs. 3.20 each. Its
debentures are priced at Rs. 90 per cent. The company’s rate of corporation tax
(income tax) is 30%.
Required
Calculate the ratios that are likely to be of interest to an investor or potential
investor in Rainy.
Comment on each.
Division Division
A B
Rs.'000 Rs.'000
Revenue 840 610
Operating profit 95 78
Interest 6 8
Taxable profit 89 70
The results for the current year have just been announced as:
Division Division
A B
Rs.'000 Rs.'000
Revenue 1,000 650
Required
Analyse the performance of the two divisions, and from the perspective of the
future strategic development of Khan Industries suggest what controls the
directors of Khan Industries might introduce to influence the future development
of the divisions.
Project 2
An investment of Rs. 450,000 in individual workstations for staff that is expected
to reduce administration costs by Rs. 140,800 per annum in money terms for the
next five years.
Project 3
An investment of Rs. 400,000 in new ticket machines. Net cash savings of Rs.
120,000 per annum are expected in current price terms and these are expected
to increase by 3.6% per annum due to inflation during the five-year life of the
machines.
Basril Company has a money cost of capital of 12% and taxation should be
ignored.
Required
(a) Determine the best way for Basril Company to invest the available funds
and calculate the resultant NPV:
(i) on the assumption that each of the three projects is divisible
(ii) on the assumption that none of the projects are divisible.
(b) Explain how the NPV investment appraisal method is applied in situations
where capital is rationed.
(c) Discuss the reasons why capital rationing may arise.
Projects A B C D E F
Initial investment required now
(Rs. in million) (300) (120) (240) (512) (800) (400)
Forecasted annual net cash
inflows (Rs. in million) 150 50 140 256 440 300
Discount rate (based on risk
involved in the project) 10% 11% 12% 11% 13% 14%
Project duration (years) 4 5 3 6 3 2
Year from which net cash
inflows would commence 1 2 1 3 1 1
Other relevant information is as follows:
(i) Project A and B are mutually dependent and are non-divisible.
(ii) Project C can be scaled down but cannot be scaled up.
(iii) Project D, E and F are mutually exclusive. They cannot be scaled down but
can be scaled up.
Total financing available with the company is Rs. 1,000 million. It may be
assumed that all cash flows would arise at the beginning of the year.
Required
Determine the most beneficial investment mix.
9.1 RIGHTS
A company wishes to increase its production capacity by purchasing additional
plant and equipment. To finance the new investment, the company will make a 1
for 4 rights issue. The shares are currently quoted on the Stock Exchange at Rs.
5.50 per share and the new shares will be offered to shareholders at Rs. 4.50 per
share.
Ignore the transaction costs of the share issue.
Required
Calculate:
(a) the theoretical ex-rights price per share.
(b) the value of the rights on each existing share.
Rs. m
Sales turnover 140.6
Profit before interest and taxation 8.4
Interest 6.8
Profit before tax 1.6
Tax 0.4
Profit after taxation 1.2
In order to finance the purchase of the new plant and equipment, the directors of
the company have decided to make a rights issue equal to the cost of the
equipment. The shares are currently quoted on the Stock Exchange at Rs. 2.70
per share and the new shares will be offered to shareholders at Rs. 1.90 per
share.
Required
(a) Calculate:
(i) the theoretical ex-rights price per share
(ii) the value of the rights on each existing share
(iii) assuming the increase in production capacity will lead to an increase
in profit after tax of Rs. 600,000 per annum and the P/E ratio of the
company will remain unchanged after the rights issue, calculate the
market value per share after the rights issue.
(b) What are the options available to a shareholder who receives a rights offer
from a company?
Rs. in million
Paid up capital (Rs. 10 each) 400
Retained earnings 150
Non-current liabilities 600
Current liabilities 100
1,250
Rs. in million
EPS 3.13
The following information has been extracted from the financial statements of PSD
for the year ended March 31, 2016:
Rs. in million
Issued ordinary shares Rs. 10 each 200
Retained earnings 390
590
10% TFCs at par, repayable in 2018 350
940
The shares of the company are currently traded at Rs. 16 per share. The profit before
interest and taxation of PSD for the year ended March 31, 2016 is Rs. 95 million.
It is expected that the right issue will not affect PSD’s current price earnings ratio.
However, the issue of TFCs would result in fall in price earnings ratio by 30%.
The tax rate applicable to the company is 35%.
Required
(a) Make appropriate calculations in each of the following independent
situations:
(i) Assuming a right issue of shares is made, calculate:
the theoretical ex-rights price of an ordinary share.
the value of the right.
(ii) Assuming the market is strong form efficient and it is expected that
new project would generate positive net present value of Rs. 96
million. Calculate the theoretical ex-right price in this case.
(iii) Assuming that the new project would increase the company’s
profit before interest and tax for the next year by 10%. Calculate the
price of an ordinary share in one year’s time under each of the two
financing options.
(b) Briefly discuss why issue of term finance certificates is expected to result in
fall in price earnings ratio.
Required
(a) Calculate the mean and standard deviation of the expected return from
Security X.
(b) Calculate the mean and standard deviation of the expected return from
Security Y.
(c) Calculate the covariance of the returns from Security X and Security Y. The
formula for a covariance is:
Cov x,y r x x y y
(d) Calculate the correlation coefficient for returns from Security X and Security
Y, for a portfolio consisting of 50% of the funds invested in Security X and
50% of the funds invested in Security Y. The formula for correlation
coefficient is:
x,y Cov x,y
x x y
where:
x = the standard deviation of returns from Security X
y = the standard deviation of returns from Security Y
Comment on the correlation coefficient.
(e) Calculate expected return, the variance and standard deviation of a
portfolio consisting of 50% of the funds invested in Security X and 50% of
the funds invested in Security Y. The formula for correlation coefficient is:
a2(Variance X)2 + (1 – a)2(Variance Y)2 + 2a(1 – a) Covx,y
where:
a = the proportion of the portfolio invested in Security X
(1 – a) = the proportion of the portfolio invested in Security Y
The expected return from investing in any of the three countries is independent of the
returns that would be obtained from the other countries.
Required
(a) Calculate the risk, return and coefficient of variation of the following three
investment portfolios:
(i) 50% in Country A, 50% in Country B
(ii) 50% in Country A, 50% in Country C
(iii) 50% in Country B, 50% in Country C
(b) Comment on the results.
X Y Z
Standard deviation (%) 5 15 14
Correlation coefficient (%) 80 40 60
Proportion of amount invested (%) 30 30 40
The expected return on shares in general and on the basis of past return and
inflationary expectation was estimated to be 20%. It is expected that the risk
premium will be about 5%. The risk of the market as measured by its standard
deviation is 8%. All the three securities lie on the Securities Market Line (SML).
Required
Prepare the following computations for a discussion with your client, as a prelude
to your advice:
(i) The expected portfolio return
(ii) The risk of the portfolio
Project A Project B
Cash flow:
Required
(a) Calculate the risk with Project 3 and Project 4.
(b) Suggest which of the four projects the divisional manager will select.
Required
(a) Use this data to calculate:
(i) the standard deviation of the monthly return from the market portfolio
and
(ii) the standard deviation of the monthly return from Security Y.
(b) Calculate the correlation coefficient for the market returns and the returns
from Security Y. This is calculated as:
m, y Cov m, y
m x y
where:
m = the standard deviation of returns from the market portfolio
Cov m, y
Var m
Alternatively
m, y x y
m
H&T F&B
Year Rs.’m Rs.’m
1 85 190
2 170 180
3 150 200
The investment in Hotel and Tourism would cost Rs. 300 million while that in
Food and Beverages would cost Rs. 400 million.
The directors have discovered that industry beta for Hotel & Tourism and Food
and Beverages sectors are 1.2 and 2.2 respectively. They believe the
investments being considered are typical of projects in the relevant industries.
Sodium Plc industries beta is 1.6, treasury bill rate is 9% and the average return
on companies quoted on the stock exchange is 14%.
Required
(a) (i) Compute the net present values of both projects using the company’s
weighted average cost of capital as a discount rate.
(ii) Compute the NPVs using a discount rate which takes account of the
risk associated with the individual projects.
(iii) Advise the directors regarding the project to accept.
(b) Enumerate the uses and limitations of the Capital Asset Pricing Model
(CAPM)
10.8 DR JAMAL
Dr Jamal has the following portfolio of shares in five listed companies:
At present the risk-free rate of return is 8% while the market return is 14%.
Required
(a) Calculate
(i) the beta factor
(ii) the required return on the portfolio.
(b) Explain the relevance of portfolio theory to Dr Jamal
He contacted a Stock Analyst to identify such stocks. After a detailed study, the
Stock Analyst recommended investments in shares of five different companies.
Based on his recommendation, Mr. Faraz invested the amount on January 1, 2016.
The relevant details are as follows:
Price per
Share on Expected Covariance
Investment Jan 1, 2016 Dividend Standard with
Company (Rs.) (Rs.) Yield Deviation KSE 100
A 15,000,000 60 3.50% 24% 2.10%
B 18,000,000 245 3.00% 22% 3.00%
C 22,000,000 225 2.50% 18% 2.60%
D 25,000,000 130 8.00% 15% 1.90%
E 20,000,000 210 5.00% 20% 2.80%
The stock analyst also informed him that the standard deviation and market return of
the KSE-100 Index is 15% and 20% respectively. The risk free rate of return is 8%.
Required
(a) Assuming that Mr. Faraz estimates his cost of equity by using the
Capital Asset Pricing Model, compute the required rate of return on each
security.
(b) As at December 31, 2016, compute the following:
Estimated value of portfolio.
Portfolio beta.
Estimated total return on portfolio.
Price
Market forecast Dividend
No of
Name of price per shares Standard after per share
share Covariance one next year
company deviation
year
Rupees in 000 Rupees Rupees
A 25 150 0.15 0.024 27 2.00
B 15 230 0.24 0.039 17 1.00
C 46 190 0.16 0.044 52 2.50
D 106 50 0.32 0.033 111 4.00
E 75 100 0.19 0.018 85 2.00
F 114 120 0.22 0.041 125 3.00
G 239 60 0.19 0.032 220 5.50
H 156 80 0.21 0.04 168 3.00
I 145 35 0.18 0.034 170 2.50
J 67 45 0.22 0.033 75 1.00
Projects
A B C D
Net annual cash flows (Rs. in millions) 85 87 90 95
Expected return 16% 14% 17% 15%
Standard deviation of returns 20% 18% 27% 30%
Estimated correlation of returns with market
0.82 0.85 0.91 0.78
returns
The current market returns are 14% with a standard deviation of 16%. Risk free rate of
return is 10%.
Required
(a) Evaluate which of the above projects may be selected for investment by
Iron Limited. Rank the selected projects in order of preference.
(b) Determine the overall systematic risk that would be associated with the
above investments if IL decides to invest in all the projects selected in (a)
above.
Mutual Funds
A B C
Funds characteristics
Front end load (Buying load) 3.00% 2.00% 1.50%
Back end load (Selling load) 1.00% 0.00% 2.00%
Sharpe ratio 0.71 0.31 0.16
Correlation with benchmark
indices 0.75 0.9 0.83
Expected performance of
benchmark indices
Benchmark index KSE 100 KSE 30 KMI 30
Total annual return % 16 17 12
Standard deviation of annual
returns 0.1 0.18 0.13
The yield on 1-year treasury bills is 9%.
Required
(a) Estimate the effective annual yield which FR would earn, from the date of
investment up to December 31, 2016.
(b) In respect of each fund, evaluate whether it would achieve the return in
accordance with its risk profile.
There are 20,000,000 ordinary shares in issue, majority of which, are owned by
private investors. There is no debt in the capital structure. Members of the Board
of Directors are considering a number of strategies for the company, some of
which, will have an impact on the company’s future dividend policy. The
company’s shareholders require a return of 15% on their investment.
The following four dividend payment options are being considered:
(i) Pay out all earnings as dividend
(ii) Pay a dividend of 50% out of earnings and retain the remaining 50% for
future investment
(iii) Pay a dividend of 25% out of earnings and retain the remaining 75% for
future investment.
(iv) Retain all earnings for an aggressive expansion programme and pay no
dividend at all.
The directors have not been able to agree on any of the four options.
Some of them prefer option (i) because they believe that doing anything else
would have an adverse impact on the share price.
Others favour either option (ii) or option (iii) because the company has identified
some good investment opportunities and they believe one of these options would
be in the best long-term interest of the shareholders.
An adventurous minority favours option (iv) and thinks that the option will allow
the company to take over a relatively small but vibrant competitor.
Required
(a) Discuss the company’s dividend policy between 2012 and 2016 and its
possible consequences on earnings.
(b) Advise the directors of Ackers Plc. on the share price which might be
expected immediately following the announcement of their decision if they
pursue each of the four options, using an appropriate valuation model
Note: (Make necessary assumptions).
Rs. in millions
Sales revenue 190.00
Cost of goods sold 110.00
Operating expense 30.00
Interest expense 15.00
Property plant and equipment 100.80
Shareholders’ equity 135.00
12.1 GEARING
The following information is available about Company A and Company B:
Company A Company B
Capital structure Rs. Rs.
Equity shares of Rs. 1 10,000 10,000
Reserves 20,000 90,000
–––––––– ––––––––
30,000 100,000
10% debt capital 70,000 0
–––––––– ––––––––
100,000 100,000
–––––––– ––––––––
Assume that annual sales now increase for both companies by 25% to Rs.
100,000.
Required
(a) Calculate the increase in earnings for each company as a result of the
increase in sales. Assume that there is no change in the variable costs as a
percentage of sales or in total annual fixed costs.
(b) For each company, calculate:
(i) the operational gearing ratio (the percentage change in earnings
before interest and tax as a ratio of the percentage increase in sales)
(ii) the financial gearing ratio (the percentage change in earnings after
tax as a ratio of the percentage increase in earnings before interest
and tax)
(iii) the combined gearing effect.
An statement of profit or loss for the year to 30th November Year 6 is as follows:
Rs. m
Sales 115.4
Profit before interest and taxation 17.9
Interest payable 1.5
Profit before taxation 16.4
Tax (25%) 4.1
Profit after taxation 12.3
The company wishes to expand its production facilities to meet an increase in
sales demand for its products. It will need Rs. 18 million of new capital to invest
in equipment. It is expected that annual profit before interest and taxation will
increase by Rs. 5 million.
Brunel is considering the following three possible methods of financing the
expansion programme:
(i) Issuing 9 million Rs.0.50 equity shares at a premium of Rs. 1.50 per share.
(ii) Issuing 12 million 12% Rs. 1 preference shares at par and Rs. 6 million
10% debentures at par.
(iii) Issuing 6 million equity shares at a premium of Rs. 1.50 per share and Rs.
6 million 10% debentures at par.
12.4 DIVERSIFY
Bustra Company is engaged in plastics manufacture. It is now considering a new
investment that would involve diversification into chemicals manufacture, where
the business risk is very different from the plastics manufacturing industry.
Research has produced the following information about three companies
currently engaged in chemicals manufacturing, in the same part of the industry
that Bustra is planning to invest.
Bustra is financed by 60% equity capital and 40% debt capital, and would intend
to maintain this same capital structure if the new capital investment is
undertaken.
The risk-free rate of return is 5% and the return on the market portfolio is 9%. Tax
is at the rate of 25%. You should assume that the debt capital of Bustra and
Companies A, B and C is risk-free.
Required
(a) Calculate a suitable cost of equity for the proposed investment by Bustra in
chemicals manufacturing.
(b) Suggest a weighted average cost of capital that should be used to carry out
an investment appraisal (NPV calculation) of the proposed project.
Issue costs, which are tax-allowable, will be 5% for the equity and 2% for the debt,
measured as a percentage of the net finance raised.
The plastics industry has an average equity beta of 1.356 and an average debt: equity
ratio of 1:5, at market values. Harvey’s current equity beta is 1.8 and 20% of its capital
(at market value) consists of long-term debt which is regarded as risk-free.
The risk-free rate is 10% per annum and the expected return on an average market
portfolio is 15%. Corporation tax is at 35%, payable one year in arrears. The machine
will attract a 70% capital allowance in the first year, and the balance will be allowable
against tax over the next three years, at an equal amount in each year.
Required
Carry out an appraisal of the investment using each of the three following methods:
(a) PV of the project, using the company’s current weighted average cost of
capital (WACC)
(b) NPV of the project, using a WACC adjusted for business risk and financial
risk
(c) the adjusted present value (APV) of the project
Required
Calculate:
(a) the NPV of the project, using the Modigliani and Miller formulas to derive a
cost of capital for the project
(b) calculate the adjusted present value (APV) of the project.
(8) Tax is payable at the rate of 25%, and is payable in the same year that the
tax liability arises.
(9) Tax-allowable depreciation will be 20% in Year 1 and will then be a
constant amount for the next five years.
(10) The average equity beta of companies in the software sector that Pobol
Company is considering is 1.39. The market return is 10% and the risk-free
interest rate is 6%.
(11) The average gearing of companies in the software sector that Pobol
Company is considering is 80% equity and 20% debt.
Required
Calculate the adjusted present value (APV) of this project.
The management has found that the following two debt equity ratios are usually
prevalent in the industry and are also acceptable to the company’s banker.
(i) 70% equity, 30% debt by market values
(ii) 50% equity, 50% debt by market values
The latest audited financial statements depict the following position:
Rs. in million
Net profit before tax 272
Depreciation 50
Interest @ 9% 55
Capital expenditure 150
Market value of existing equity and debt is Rs. 825 million and Rs. 550 million
respectively. CIL’s equity beta is 1.25 and its debt beta may be assumed to be
zero. The risk-free rate of return and market return are 7% and 15% respectively.
Applicable tax rate is 35%.
Assume that:
CIL’s cash flow growth rate would remain constant and would not be
affected by any change in capital structure.
Market value of the company at the existing weighted average cost of
capital, after the proposed expansion, would remain the same.
Required
(a) Calculate the following under the current as well as each of the above debt
equity ratios being considered by the company:
(i) Weighted average cost of capital
(ii) Value of the company
(b) Compare the three options and give recommendations in respect thereof to
the company.
The existing TFCs carry mark-up @ 11.5% per annum and are due for redemption at
par in 2020.
Currently, MFL’s shares and TFCs are traded at Rs. 80 and Rs. 102.50
respectively. Equity beta of the company is 1.3.
The proposed investment has been evaluated at a discount rate of 17% which is
based on existing cost of equity plus a premium that takes cognisance of the risks
inherent in the steel industry. However, there are divergent views among the
directors regarding the discount rate that has been used.
Director A is of the view that the premium charged to reflect the risk in the
steel industry is too low. He is of the opinion that the company’s existing
weighted average cost of capital is more appropriate discount rate for
evaluation of this investment.
Director B suggests that the discount rate should be representative of the
steel industry. He has provided the following data pertaining to a listed
company, Pepper Steel Limited (PSL).
900 million shares of Rs. 10 each are outstanding which are currently
being traded at Rs. 35.
Long term loan amounted to Rs. 8,000 million obtained from local
banks at the average rate of 13%.
Equity beta of the company is 1.5.
You have been appointed as the Lead Advisor by an Investment Bank working on
this transaction. You have obtained the following information:
13.2 VALUATION
A company has just paid an annual dividend of Rs. 38. The board of directors
has a target of increasing the share price to Rs. 800, and is considering policies
for investment and growth.
Shareholders expect a return on their investment of 10% per year.
Required
Calculate the annual expected growth rate in dividends that would be required to
raise the share price to Rs. 800. Use the dividend growth model to make your
estimate.
Notes:
An annual cost of capital of 9% is equal to a six-monthly cost of capital of
4.4%.
DCF factor at 4.4%, periods 1 – 7 = 5.914
DCF factor at 4.4%, periods 1 – 8 = 6.623
(d) A convertible bond with a coupon of 5% and interest payable annually:
these bonds are convertible after three years into equity shares at the rate
of 20 shares for every Rs. 100 nominal value of bonds. The expected share
price in three years’ time is Rs. 7.
In each of the four cases (i)–(iv), advise the holders of the convertibles and
warrants whether they should exercise their conversion and option rights.
Ignore taxation.
(b) Calculate the earnings per share for each company.
(i) In a year when all the convertibles and warrants remained
outstanding for the whole period.
(ii) For the first full year following conversion of all the convertibles in
Conver and the exercise of all the warrants in Warren.
Profits for each company are currently Rs. 1.2 million each year
before interest and taxation. The corporation tax rate is 50%.
Assume that any new cash raised by the company will be invested to
earn 10% each year before taxation.
A Plc B Plc
Rs.’000 Rs.’000
Ordinary shares of Rs. 1 each 1,000,000 500,000
Preference share capital 200,000 -
Share premium account - 20,000
Profit and loss account 380,000 40,000
10% Debentures 150,000 50,000
1,730,000 610,000
A Plc B Plc
Rs. Rs.
Maintainable annual profits after tax
attributable to equity 240,000,000 150,000,000
Current market value of ordinary shares 2.40 2.70
Current EPS 0.24 0.30
P/E ratio 10 9
Current market price of debts 125% 125%
Required
Determine the offer which the directors of A Plc would make to the shareholders
of B Plc on each of the following bases:
(a) Net Asset
(b) Earnings
(c) Market value
(d) Financial analysis
Extracts from the latest financial statements of the three companies are given below:
Statement of financial position
Additional information:
(i) All companies maintain a stable dividend payout policy.
(ii) It is estimated that earnings of PQ and RS will grow by 4% and 5%
respectively.
(iii) The risk free rate of return is 8% per annum and the market return is
13% per annum. The market applies a premium of 300 basis point on the
required returns of unlisted companies.
13.11 TAKEOVER
Flat Company intends to make a takeover bid for Slope Company, a company in the
same industry. The initial offer will be to exchange every 3 shares in Slope for 2 new
shares in Flat.
The most recent annual data for the two companies is shown below.
Flat Slope
Rs.000 Rs.000
Sales revenue 7,619 6,000
Operating costs 4,962 3,480
Tax allowable depreciation 830 700
Earnings before interest and taxation 1,827 1,820
Interest 410 860
Profit before tax 1,417 960
Tax at 30% 425 288
992 673
Dividends 500 410
Retained earnings 492 263
The weighted average cost of the combined company should be calculated as the
weighted average of the current cost of capital of the individual companies, weighted
by the current market value of their debt and equity.
Required
(a) Using free cash flow analysis, and making any assumptions you consider
necessary, calculate a value for:
(i) the current equity in Flat Company
(ii) the current equity in Slope Company
(iii) the equity in Flat Company after the takeover.
(b) Explain the limitations of your estimates in (a).
(c) Give your views as to whether the takeover bid is likely to have the support
of the shareholders in (1) Flat Company and (2) Slope Company.
13.12 MK LIMITED
MK Limited is presently considering a proposal to acquire 100 % shareholdings
of ZA Limited which is engaged in the same business. The financial data extracted
from the latest audited financial statements and other records of the two companies
is presented below:
MK ZA
Rs. in million
Sales revenue 12,000 8,460
Operating expense excluding depreciation (7,695) (4,905)
Depreciation (1,305) (990)
Profit before interest and tax 3,000 2,565
Interest (644) (1,494)
Profit after interest 2,356 1,071
Taxation (35%) (825) (375)
Profit after taxation 1,531 696
Dividend payout 50% 55%
Capital expenditure during the year (Rs. in million) 700 650
Debt ratio 40% 55%
Market rate of interest on debentures 6.5% 7.5%
Number of shares issued (in million) 100 90
Market price of share (Rs.) 20 12
Equity beta 1.1 1.3
The following further information is available:
(i) Both the companies follow the policy of maintaining stable dividend
payouts and debt ratios.
(ii) Annual growth in sales, operating expenses, depreciation and capital
expenditures are estimated as under:
Year 1 – 2 5.0%
PL DL
Rupees in
million
Turnover 3,638 901
Profit before tax 312 86
Tax 81 28
Profit after tax 231 58
13.14 EMH
Several studies show that the annual reports and financial statements are
regarded as important sources of information for making decisions on equity
investment. Other types of studies indicate that the market price of the shares in
a company does not react in the short term to the publication of its annual reports
and financial statements.
Required
(a) Explain briefly the concept of the Efficient Market Hypothesis (EMH) and
each of its forms and the degree to which existing empirical evidence
supports them.
A company’s board of directors makes a decision on 1st May to invest in a new
project that will have an NPV of + Rs. 4,000,000. The decision is announced to
the stock market on 12th May.
(b) The company has 50 million shares in issue and at close of trading on 30th
April these had a market value of Rs. 4 each.
Required
State what would happen to the share price of the company if the stock
market:
(i) has weak form efficiency
(ii) has semi-strong form efficiency
(iii) has strong-form efficiency.
14.1 ACQUISITION
Big Entity is considering a takeover bid for Little Entity, another company in the
same industry. Little is expected to have earnings next year of Rs. 86,000.
If Big acquires Little, the expected results from Little will be as follows:
Year after the acquisition
Year 1 Year 2 Year 3
Rs. Rs. Rs.
Sales 200,000 280,000 320,000
Cash costs/expenses 120,000 160,000 180,000
Capital allowances 20,000 30,000 40,000
Interest charges 10,000 10,000 10,000
Cash flows to replace assets and finance growth 25,000 30,000 35,000
From Year 4 onwards, it is expected that the annual cash flows from Little will
increase by 4% each year in perpetuity.
Tax is payable at the rate of 30%, and the tax is paid in the same year as the
profits to which the tax relates.
If Big acquires Little, it estimates that its gearing after the acquisition will be 35%
(measured as the value of its debt capital as a proportion of its total equity plus
debt). Its cost of debt is 7.4% before tax. Big has an equity beta of 1.60.
The risk-free rate of return is 6% and the return on the market portfolio is 11%.
Required
(a) Suggest what the offer price for Little should be if Big chooses to value
Little on a forward P/E multiple of 8.0 times.
(b) Calculate a cost of capital for Big.
(c) Suggest what the offer price for Little might be using a DCF-based
valuation.
Both companies retain the same proportion of profits each year and are expected
to do so in the future. Adam Plc’s return on investment is 16%, while that of Eve
Plc is 21%. After the acquisition in one year’s time, Adam Plc will retain 60% of
its earnings and expects to earn a return of 20% on new investment.
The dividends of both companies have been paid. The required rate of return of
ordinary shareholders of Adam Plc is 12% and Eve Plc 18%. After the
acquisition, this will become 16%.
Required
(a) If the acquisition is to proceed immediately, calculate the:
(i) pre-acquisition market values of the two companies.
(ii) maximum price Adam Plc will pay for Eve Plc.
(b) Briefly explain the following actions a target company might take to prevent
a hostile takeover bid:
(i) White knight
(ii) Shark repellants
(iii) Pac-man defence
(iv) Poison pill
(v) Golden parachute
14.3 D LIMITED
D Limited is a private company established about a decade ago to produce
plastic bottles. The first six years of the company witnessed strong growth,
generally facilitated by successful business operations and reduced competition.
As a result of the global economic meltdown and losses sustained in recent
years, the directors and the entire management of the company became worried
and were contemplating closing down the company for six months in the first
instance. The concomitant effect of the proposed closure would be further loss of
sales and profits. For how long will this continue? This was the question being
asked by the chairman and chief executive of the company.
In an attempt to avert the problem, the management held an emergency meeting
where various suggestions were put forward but none of them seems to proffer
solutions to the problem. The chairman and chief executive thought of outright
sale of the company to a willing competitor, F Limited, but this idea was not
acceptable to the board of directors as this could lead to the extinction of the
company.
Rs.’m Rs.’m
Profit after taxation 150 30
Dividends 60 21
Retained profit 90 9
Price per share of Clooney Plc is Rs. 5 while that of Pitt Plc is Rs. 2.
Required
(a) Calculate the price earnings ratios of Clooney Plc and Pitt Plc before the
merger.
(b) Determine what the price earnings ratio of the group will be if the value of
Clooney Plc’s shares increases by Rs.0.5 after the merger.
(c) Calculate the market capitalization of Clooney Plc after the merger
assuming that the stock market is rational and that there are no events
other than those which would influence the share price. Ignore the Rs.0.5
increase in Clooney Plc’s share price mentioned in (b) above.
(d) Calculate the net dividend income the holder of 1 share in Pitt Plc would
receive before and after the merger assuming that Clooney Plc maintains
the same dividend per share as before the merger.
The two companies retain the same proportion of profits each year and this is
expected to continue indefinitely. Nelson Plc earns a return of 21% on new
investments while Drake Plc earns 16%. After the merger, Nelson Plc is
expected to retain 60% of its earnings and earn a return of 20% on investment.
The dividends of both companies have been paid. Ordinary shareholders of
Nelson Plc require 18% rate of return and those of Drake Plc expect 12%. This
will rise to 16% after the merger.
Required
Determine the
(a) Market value of each of the TWO companies before the merger.
(b) Maximum price Nelson Plc should pay for Drake Plc
HX HY
Year 1 Year 2 Year 3 Year 1 Year 2 Year 3
Rupees in million
Profit before tax and
39 42 44 26 34 36
depreciation
Depreciation 12 11 13 9 10 11
Required
Assuming your name is XYZ and HL’s weighted average cost of capital is 18%,
prepare a brief report for the Board of Directors discussing:
(a) the feasibility of the demerger scheme for the equity shareholders of Hali
Limited, based on discounted cash flow technique. Your answer should be
supported by all necessary workings.
(b) the additional information and analysis which could assist the Board of
Directors in the process of decision making.
14.8 FF INTERNATIONAL
FF International (FFI) is considering the opportunity to acquire CS Limited (CSL).
You have been appointed as a consultant to advise the FFI’s management on the
financial aspects of the bid.
The latest summarized annual financial statements of CSL are given below:
Summarised Statement of Financial Position
Rs. in
million
Total assets 5,000
(iv) 80% of selling and administration expenses are fixed. Fixed costs include
depreciation of Rs. 25 million and salaries of Rs. 160 million. After
acquisition, FFI expects to reduce the staff in sales and administration by
making one-time payment of Rs. 100 million. It would reduce the
department’s salaries by 25% and the remaining fixed costs by 30%.
(v) Long term loan carries mark- up @ 15% per annum. The balance
amount of principal is repayable in five equal annual instalments payable
in arrears.
(vi) Mark up on short term loan is 14% per annum. CSL has failed to meet
certain debt covenants and therefore its bankers have advised CSL to
reduce the short term loan to Rs. 1,000 million.
(vii) It is the policy of the company to depreciate plant and machinery at
20% per annum using straight line method. Accounting depreciation may
be assumed to be equal to tax depreciation. (viii) Working capital would
vary at the rate of 40% of increase / decrease in sales.
(ix) Tax rate applicable to both companies is 30% and tax is payable in the
same year. CSL has unutilized carry forward tax losses of Rs. 80 million.
(x) All costs as well as sales are expected to increase by 10% per annum.
(xi) Free cash flows of CSL are expected to grow at 5% per annum after Year
5.
(xii) Based on the risk analysis of this investment, the discounting rate is
estimated at 18%.
Required
(a) Discuss any two advantages and disadvantages of growth through
acquisition.
(b) Determine the following:
Optimal sales level at which CSL’s profit would be maximised.
Amount of cash flow gap at optimal level of sales during the first five
years of acquisition.
(c) Calculate the bid price that FFI may offer for the acquisition of CSL
assuming that cash flow gap identified in (b) above would have to be filled
by FFI by way of an interest free loan.
GL’s cost of equity is 18%. It would finance the investment by borrowing at 12%
per annum in
Pakistan after which its debt equity ratio would be approximately 30:70.
The tax rate applicable to GL in Pakistan is 30%. Pakistan has double taxation
treaty agreements with both the countries.
Required
Evaluate which of the two subsidiaries (if any) should be established by GL.
(Assume that tax in all countries is payable in the same year and that all cash
flows arise at the end of the year)
Required
(a) Show how the company can create a money market hedge for its exposure
to a fall in the value of the dollar.
(b) Estimate what the exchange rate should be for a six-month forward
contract, GBP/USD.
17.3 DUNBORGEN
The treasurer of Dunborgen Company wants to hedge an exposure to currency
risk. Dunborgen is a company whose domestic currency is the euro, and the
company must make a payment of US$500,000 to a US supplier in six months’
time.
The following market rates are available:
Sterling Zants
ZIBOR is the Zantland inter-bank offered rate, which is usually set very close to
the inflation rate in Zantland.
The bank would take an annual fee of 0.5% in sterling for arranging the swap, and
Small Company would receive 75% of the net arbitrage benefit from the swap.
Required
(a) Suggest how a currency swap might be arranged between the
counterparties, and indicate whether Small Company would arrange the
swap if it decides to invest in the project.
(b) Making whatever assumptions you consider necessary and using a
discount rate of 15%, recommend whether Small Company should
undertake the project.
Thai Bhat US $
Buy Sell Buy Sell
Spot Rs. 2.33 Rs. 2.36 Rs. 65.12 Rs. 65.24
1 month forward Rs. 2.30 Rs. 2.33 Rs. 65.45 Rs. 65.57
2 months forward Rs. 2.28 Rs. 2.31 Rs. 65.77 Rs. 65.89
3 months forward Rs. 2.26 Rs. 2.29 Rs. 66.10 Rs. 66.22
Spot – July 31, 2016 Rs. 2.29 Rs. 2.32 Rs. 65.61 Rs. 65.73
1 months forward Rs. 2.27 Rs. 2.30 Rs. 65.84 Rs. 65.96
2 months forward Rs. 2.25 Rs. 2.28 Rs. 66.16 Rs. 66.28
3 months forward Rs. 2.23 Rs. 2.26 Rs. 66.38 Rs. 66.50
(c) the second shipment is cancelled on July 31, 2016. The exchange rates are
expected to be the same as in (b) above.
Due date of
Nature of transaction Amount
payment/receipt
€1
Buy Sell
Spot Rs. 124.22 Rs. 124.52
3 months forward Rs. 123.62 Rs. 123.96
6 months forward Rs. 123.21 Rs. 123.54
Rs. €
3-months / 6 months borrowing 11% 5%
3-months / 6 months lending 6.5% 3%
Required
(a) Calculate the net rupee receipts/payments that QIL should expect from
the above transactions under each of the following alternatives:
(i) Hedging through forward cover
(ii) Hedging through money market
(b) Determine which would be the better alternative for QIL.
(Ignore transaction costs)
USD 1
Exchange Rates
Buy Sell
(II) SL has sold one of its product lines for MYR 15 million. The proceeds
are expected to be received at the end of February, 2016. SL plans to
use these funds in September, 2016 for one of its major expansion project.
Consequently, the management wants to invest this amount in a fixed
deposit account for a period of six months at 6% per annum.
The management is considering to hedge the interest rate risk by using
interest rate futures. The current price of March six months’ futures is 95.50
whereas the standard contract size is MYR 3 million.
Required
(a) Determine which of the following options would be more beneficial to the
company:
(i) Hedging through forward cover
(ii) Hedging through money market
(b) Determine how beneficial would it be for SL to use interest rate futures to
hedge the interest rate risk if at the end of February, 2016 interest rates:
(i) fall by 0.75% and future price moves by 1%; or
(ii) rise by 1% and future price moves by 1%.
Ignore transaction costs.
Receiving Company
Paying Company KC (Pak) KA (USA) KB (UK)
in million
KC (Pak) - Rs. 131 £ 5.10
KA (USA) US $ 1.50 - US $ 4.50
KB (UK) £ 4.00 £ 1.80 -
Exchange Rates
US $ 1 UK £ 1
Buy Sell Buy Sell
Spot Rs. 86.56 Rs. 86.80 Rs. 134.79 Rs. 135.13
3 months forward Rs. 87.00 Rs. 87.20 Rs. 135.87 Rs. 136.18
Interest Rates
Borrowing Lending
KC (Pak) 10.50% 8.50%
KA (USA) 5.20% 4.40%
KB (UK) 5.90% 5.00%
Required
(a) Calculate the net rupee receipts/payment that KC (Pak) should expect from
the above transactions under each of the following alternatives:
Hedging through forward contract
Hedging through money market
(b) Demonstrate how multilateral netting might be of benefit to Khaldun Corporation.
18.3 BASIS
It is 1st March. The current spot exchange rate for dollars against sterling (US$/£1) is
1.8540. The exchange rate is volatile, and the June futures price for sterling/US dollar
futures is 1.8760.
Assume that the settlement date for the June futures contract is 30th June.
A company has used sterling/US dollar futures to hedge two currency exposures, one
relating to a cash payment on 1st May and the other relating to a cash payment in mid-
June.
Required
Calculate the expected futures price for June futures:
(a) at the end of the day’s trading on 30th April, if the spot sterling/dollar rate is
1.8610
(b) at the end of the day’s trading on 15th June, if the spot sterling/dollar rate is
1.8690.
Receipts €540,000
Payments €2,650,000
FX rates, €/£1
Currency futures
Currency futures for sterling/euro are each for €100,000 and are priced in sterling.
Assume that the futures contracts mature at the end of the month.
Assume for the purpose of this question that when the futures position is closed at the
end of October, the basis is 0.
Required
Calculate the net cost in sterling of hedging the currency risk:
(a) with a forward exchange contract
(b) using a money market hedge
(c) using currency futures.
(ii) DEF can obtain finances at the rate of KIBOR plus 2%. Presently, the
rate of KIBOR is 12.5%.
(iii) Transaction costs are immaterial.
Required
Based on the available information, recommend the best strategy to the management.
JPY 1
Buy Sell
Spot rate Rs. 1.9223 Rs. 1.9339
One month forward rate Rs. 1.9335 Rs. 1.9451
Three month forward rate Rs. 1.9410 Rs. 1.9493
Borrowing Investing
Japan 5% 3%
Pakistan 8% 5%
JPY 1
July 2016 Rs. 1.9365
October 2016 Rs. 1.9421
January 2017 Rs. 1.9490
The contracts can mature at the end of the above months only.
Currency options
Options have a contract size of JPY 250,000. The premiums (paisa per Rupee)
payable on various options and the corresponding strike prices are shown below:
Calls Puts
Strike 31 July 31 October 31 July 31 October
price 2016 2016 2016 2016
Rs. Paisas
1.90 2.88 3.55 0.15 0.28
1.91 1.59 2.32 1.00 1.85
1.92 0.96 1.15 2.05 2.95
20.1 FRA
A company will need to borrow $5 million for six months in three months’ time. It can
borrow at LIBOR + 0.50%. It expects interest rates to rise before it borrows the money,
and so has decided to use an FRA to hedge the risk.
The following FRA rates are available:
2v5 3.82 – 3.77
3v6 3.85 – 3.80
3v9 3.97 – 3.91
6v9 3.92 – 3.87
Required
(a) How would the company use an FRA to hedge its interest rate risk, and
what effective interest rate would be obtained by the hedge.
(b) What is the difference between an FRA and an interest rate coupon swap?
20.2 SWAP
A company has a bank loan of $8,000,000 on which it pays a floating rate of US
LIBOR plus 1.25%. The company believes that interest rates will soon increase
and remain high for the foreseeable future, and it would therefore like to switch its
debt liabilities from floating rate to fixed rate.
The loan has four years remaining to maturity. A bank has quoted the following
rates for four-year interest rate swaps in dollars:
5.20% - 5.25%
Required
Show how an interest rate swap can be used to switch from floating rate to fixed
rate liabilities, and calculate what the effective fixed rate would be.
A bank has identified an opportunity to arrange interest rate swaps with the
companies. It would expect to receive a profit margin on the arrangement of
0.10% of the notional principal amount in the swap. The remaining benefits of the
credit arbitrage should be shared equally between the two entities.
Required
Explain how the interest rate swaps might be arranged, and show the effective
interest rate that will be paid by each entity as a result of the swap.
(b) Show what will happen at the end of July if the three-month LIBOR rate is
4.25% and the interest rate exposure had been hedged as indicated in part
(a) of the answer, using:
(1) FRAs
(2) Interest rate futures
20.9 DEFINITIONS
Briefly describe each of the following financial instruments:
(a) Interest rate swaps
(b) Forwards
(c) Futures
(d) Options
(e) Caps, collars and floors
B
Business finance decisions
SECTION
Answers
CHAPTER 1 – AN INTRODUCTION TO STRATEGIC FINANCIAL MANAGEMENT
Against the traditional and ‘legal’ view that the firm is run in order to maximise
the wealth of ordinary shareholders, there is an alternative view that the firm
is a coalition of different groups: equity shareholders, preference
shareholders and lenders, employees, customers and suppliers. Each of
these groups must be paid a minimum ‘return’ to encourage them to
participate in the firm. Any excess wealth created by the firm should be and
is the subject of bargaining between these groups.
At first sight this seems an easy way out of the ‘objectives’ problem. The
directors of a company could say ‘Let’s just make the profits first, then we’ll
argue about who gets them at a later stage’. In other words, maximising
profits leads to the largest pool of benefits to be distributed among the
participants in the bargaining process. However, it does imply that all such
participants must value profits in the same way and that they are all willing
to take the same risks.
In fact the real risk position and the attitude to risk of ordinary shareholders,
loan creditors and employees are likely to be very different. For instance, a
shareholder who has a diversified portfolio is likely not to be so worried by
the bankruptcy of one of his companies as will an employee of that company,
or a supplier whose main customer is that company. The problem of risk is
one major reason why there cannot be a single simple objective which is
common to all companies.
(b) Separate from the problem of which goal a company ought to pursue are the
questions of which goals companies claim to pursue and which goals they
actually pursue. Many objectives are quoted by large companies and
sometimes are included in their annual accounts. Examples are:
to produce an adequate return for shareholders
to grow and survive autonomously
to improve liquidity
to improve productivity
to give the highest quality service to customers
to maintain a contented workforce
to be technical leaders in their field
to be market leaders
to acknowledge their social responsibilities.
Some of these stated objectives are probably a form of public relations
exercise. At any rate, it is possible to classify most of them into four
categories which are related to profitability:
(i) pure profitability goals e.g. adequate return for shareholders
(ii) ‘surrogate’ goals of profitability e.g. improving productivity, happy
workforce
(iii) constraints on profitability e.g. acknowledging social responsibilities,
no pollution, etc.
(iv) ‘dysfunctional’ goals.
The last category is goals which should not be followed because they do not
benefit in the long run. Examples here include the pursuit of market
leadership at any cost, even profitability. This may arise because
management assumes that high sales equal high profits which is not
necessarily so.
In practice, the goals which a company actually pursues are affected to a
large extent by the management. As a last resort, the directors may always
be removed by the shareholders or the shareholders could vote for a take-
over bid, but in large companies individual shareholders lack voting power
and information. These companies can, therefore, be dominated by the
management.
There are two levels of argument here. Firstly, if the management do attempt
to maximise profits, then they are in a much more powerful position to decide
how the profits are ‘carved up’ than are the shareholders.
Secondly, the management may actually be seeking ‘prestige’ goals rather
than profit maximisation. Such goals might include growth for its own sake,
including empire building or maximising turnover for its own sake, or
becoming leaders in the technical field for no reason other than general
prestige. Such goals are usually ‘dysfunctional’.
The dominance of management depends on individual shareholders having
no real voting power, and in this respect institutions have usually preferred
to sell their shares rather than interfere with the management of companies.
There is some evidence, however, that they are now taking a more active
role in major company decisions.
From all that has been said above, it appears that each company should
have its own unique decision model. For example, it is possible to construct
models where the objective is to maximise profit subject to first fulfilling the
target levels of other goals. However, it is not possible to develop the general
theory of financial management very far without making an initial simplifying
assumption about objectives. The objective of maximising the wealth of
equity shareholders seems the least objectionable.
(v) Reducing risk through diversification which may not necessarily benefit
shareholders, but may well improve the managers’ security and status.
(vi) Managers might take a more short-term view of the firm’s performance than
the shareholders would wish.
(vii) Management acting on behalf of shareholders, might also reduce the wealth
e.g. by selling off assets of the company.
viii) Since senior managers do not own the business, they may be more
concerned with their benefits rather than maximizing the wealth of
shareholders.
1.3 OWNERSHIP
(a) A publicly quoted company seeks to know the detailed composition of its
shareholders and their objectives in investing in the company for the
following reasons:
(i) To enable it take various decisions in accordance with the preferences
of such shareholders.
(ii) To prevent the occurrence of conflict of interest as related to principal
and agents.
(b) Advantages that may accrue to the corporate finance manager include the
following:
(i) Dividend Policy - The knowledge of shareholders’ preferences with
regards to dividends or capital appreciation and marginal tax rates will
assist in the determination of the company’s optimal dividend policy.
(ii) Risky Investment - Shareholders’ preferences may assist corporate
management when making decisions concerning risky capital
investments. Depending on their attitude to risk and their specific
circumstances, they may dislike, or prefer the company to undertake
risky investments with the possibility of a higher return.
(iii) Financing Decisions – With respect to the level of debt to employ, the
risk attitude of shareholders can again be useful; generally speaking,
a risky approach is to employ more and more debt, since in the event
of default, the shareholders are paid last. However, a high level of risk
is matched by a high potential return to equity holders.
(iv) Rebuffing a take-over: A company whose shares are held by a few
may find an unwanted take-over bid less easy to rebuff as the bidder
needs to convince only a few shareholders for the bid to be successful.
However, if shares are held by a few key shareholders, it may be easier
to provide these shareholders with the type of return they require with
a possible reduction in their likely acceptance of any take-over.
(v) Measurement of performance: Ascertaining how shareholders judge
performance may enable management to optimise this measure or
measures, when making decisions, although this measure may not be
in the prime interest of the company in terms of value maximisation.
(vi) Religious belief: Knowing the religious belief of the shareholders will
assist in deciding the type of business to be involved in. For example,
Islam forbids investment in businesses involved in the manufacture
and sale of alcohol. Such information will enable corporate finance
managers to tailor their performance to satisfy the expectations of the
shareholders.
3.1 BADGER
Cash Flows
01/01/17 31/12/17 31/12/18 31/12/19 31/12/20
Rs. m Rs. m Rs. m Rs. m Rs. m
0 1 2 3 4
Machine (180) 25
Existing machine 2 (1)
Operating flows
Sales W1 79 103 175 179
Purchases W2 (32) (48) (57) (73)
Payments to
subcontractors (6) (9) (8) (8)
Fixed overhead (13) (10) (9) (10)
Labour costs:
Promotion (3) (3) (3) (3)
Redundancy (6)
Material
X 2
Y (3)
Net operating flows (1) 25 27 98 109
(179) 25 27 98 109
Discount factor (10% 1.000 0.909 0.826 0.751 0.683
(179) 23 22 74 74
NPV 14
WORKINGS
(1) Sales
2016 2017 2018 2019 2020
Rs. m Rs. m Rs. m Rs. m Rs. m
Market size 1,100 1,122 1,144 1,167 1,191
Market share 0.07 0.09 0.15 0.15
Sales 79 103 175 179
(2) Purchases
2017 2018 2019 2020
Opening payables - 8 10 11
Add purchases 40 50 58 62
Less closing payables (8) (10) (11) -
Cash for purchases 32 48 57 73
Option I Option II
On financial ground, the project to be accepted should be the one with the
higher NPV, i.e. Option 2. NPV shows the absolute amount by which the
project is forecast to increase shareholders' wealth and is theoretically more
sound than the IRR and MIRR. However, In this case, both IRR and MIRR
back up the NPV.
The discounted payback period shows that Option II is more risky as it takes
longer to recover the present value.
WORKINGS
Rs. in million
PVr 1/n
MIRR = ( ) (1 − re ) − 1
PVi
where,
PVr (return phase) (Years 1 - 4) 2,359.66
PVi (investment phase) (Year 0) 2,252.25
re 13%
MIRR = 14.3%
Note: It is assumed that the company has taxable profits against which it can claim
an allowance in Year 0 (or early in Year 1).
Year 0 1 2 3 4 5 6
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Sales 250 250 300 350 400
Materials (50) (55) (58) (64) (70)
Labour (25) (25) (30) (30) (35)
–––––– –––––– –––––– –––––– ––––––
Cash profits 175 170 212 256 295
Tax at 35% (61) (60) (74) (90) (103)
Capital
equipment (600)
Cash effect of
allowances 53 39 30 22 17 50
–––––– –––––– –––––– –––––– –––––– –––––– ––––––
Net cash flow (600) 228 148 182 204 222 (53)
DCF factor at 1.000 0.870 0.756 0.658 0.572 0.497 0.432
15%
PV of cash flow (600) 198 112 120 117 110 (23)
–––––– –––––– –––––– –––––– –––––– –––––– ––––––
NPV 34
––––––
The project is just worthwhile, because the NPV is + Rs. 34,000. However, the
NPV is quite small in relation to the size of the capital investment, and in view of
the fact that it is a five-year project.
It might be appropriate to carry out some risk and uncertainty analysis on the
project, before deciding whether or not to undertake it.
The NPV is + Rs. 107,257. This indicates that the project should be undertaken.
Year CF DF @ PV
10%
Rs. Rs.
1 800,000 0.9091 727,280
2 640,000 0.8264 528,896
3 466,000 0.7513 350,106
4 836,700 0.6830 571,466
5 630,675 0.6209 391,586
2,569,334
Less: Initial outlay (3,000,000)
Net present value (430,666)
The project is not viable since the NPV shows a negative figure of Rs.
430,666.
Workings
Year 1 2 3 4 5
Sales (Rs.) 2,800,000 2,800,000 2,800,000 3,360,000 3,360,000
Less:
Materials (800,000) (840,000) (882,000) (926,100) (927,405)
Labour (1,200,000) (1,320,000) (1,452,000) (1,597,200) (1,756,920)
─────── ─────── ─────── ─────── ───────
Net MCF 800,000 640,000 466,000 836,700 630,675
═══════ ═══════ ═══════ ═══════ ═══════
(b) Features of capital budgeting decisions include the following:
(i) They involve large outlay.
(ii) The benefits will accrue over a long period of time, usually well over
one year and often much longer, so that the benefits cannot all be set
off against costs in the current year’s Statement of profit or loss.
(iii) They are very risky.
(iv) They involve irreversible decision.
(c) (i) The continued existence of any company is not predicated on its
investment on short-term basis but rather on its long-term investment
strategies.
(ii) Investment decisions facilitate the identification of viable projects in
order to maximise the wealth of the shareholders.
(iii) Companies need to undertake long-term investments which are the
pre-requisite to the concept of “on-going concern” basis.
(iv) Capital budgeting ensures that the management team does not
mortgage the future of the company for their personal individual
financial gains through short-term investments.
(v) It assists the streamlining of the projects being executed by the
organisation.
Years
Inflation
0 1 2 3 4 5
factor
Rs. in million
Investment (15,000)
Revenue (Rs.
8,000×1 million) 5% 8,000 8,400 8,820 9,261 9,724
Operating
costs(excluding
wages) (W1) 10.34% (2,000) (2,207) (2,435) (2,686) (2,965)
Wages (W2) 11.73% (1,000) (1,117) (1,248) (1,395) (1,558)
Profit before
taxation 5,000 5,076 5,137 5,180 5,201
Residual value
(Rs.
15,000×20%) 3,000
Tax @ 30 %
(W3) (600) (803) (965) (1,093) (617)
Net inflows (15,000) 4,400 4,273 4,172 4,087 7,584
Discount factor
(W4) 1 0.850 0.722 0.614 0.522 0.444
Conclusion: The projective has a negative NPV. KL should not invest in the
project.
W1: Compound annual growth rate for CPI
175
CAGR for CPI (1 i) 5
107
(1.6355)1/5 = 1 + i
1 + i = 1.1034
i = 10.34%
Year 1 2 3 4
$ $ $ $
Sales revenue 3,585,000 6,769,675 6,339,000 1,958,775
Material cost (1,395,000) (2,634,225) (2,466,750) (761,925)
Fixed costs (1,000,000) (1,050,000) (1,102,500) (1,157,625)
Advertising (500,000) (200,000) (200,000) -
–––––––– ––––––––– ––––––––– –––––––––
Taxable profit 690,000 2,885,450 2,569,750 39,225
Tax (25%) (172,500) (721,362) (642,438) (9,806)
Capital 250,000
allowance tax
benefit
Non-current 1,200,000
asset sale
Recovery of 1,000,000
working capital
–––––––– ––––––––– ––––––––– –––––––––
767,500 2,164,088 1,927,312 2,229,419
–––––––– ––––––––– ––––––––– –––––––––
Discount factors 0.885 0.783 0.693 0.613
Present values 679,237 1,694,481 1,335,626 1,366,634
$
Sum of present values 5,075,978
Initial investment 3,000,000
–––––––––
Net present value 2,075,978
–––––––––
The positive NPV indicates that the investment is financially acceptable.
Workings
Year 1 2 3 4
Alpha sales revenue
Selling price ($/unit) 31.00 31.93 32.89 33.88
Sales (units per year) 60,000 110,000 100,000 30,000
Sales revenue ($/year) 1,860,000 3,512,300 3,289,000 1,016,400
Beta sales revenue
Selling price ($/unit) 23.00 23.69 24.40 25.13
Sales (units per year) 75,000 137,500 125,000 37,500
Sales revenue ($/year) 1,725,000 3,257,375 3,050,000 942,375
Total sales revenue 3,585,000 6,769,675 6,339,000 1,958,775
Year 1 2 3 4
Alpha materials cost
Unit cost ($/unit) 12.00 12.36 12.73 13.11
Sales (units per year) 60,000 110,000 100,000 30,000
Total cost ($/year) 720,000 1,359,600 1,273,000 393,300
Beta materials cost
Unit cost ($/unit) 9.00 9.27 9.55 9.83
Sales (units per year) 75,000 137,500 125,000 37,500
Total cost ($/year) 675,000 1,274,625 1,193,750 368,625
Total materials cost 1,395,000 2,634,225 2,466,750 761,925
(b) The evaluation assumes that several key variables will remain constant, such
as the discount rate, inflation rates and the taxation rate. In practice this is
unlikely.
(1) The taxation rate is a matter of government policy and so may change
due to political or economic necessity.
(2) Specific inflation rates are difficult to predict for more than a short
distance into the future and in practice are found to be constantly
changing. The range of inflation rates used in the evaluation is
questionable, since over time one would expect the rates to converge.
Given the uncertainty of future inflation rates, using a single average
inflation rate might well be preferable to using specific inflation rates.
(3) The discount rate is likely to change as the company’s capital structure
changes. For example, issuing debentures with an interest rate of 9%
is likely to decrease the average cost of capital.
Looking at the incremental fixed production costs, it seems unusual that nominal
fixed production costs continue to increase even when sales are falling. It also
seems unusual that incremental fixed production costs remain constant in real
terms when production volumes are changing. It is possible that some of these
fixed production costs are stepped, in which case they should decrease.
The forecasts of sales volume seem to be too precise, predicting as they do the
growth, maturity and decline phases of the product life-cycle. In practice it is likely
that improvements or redesign could extend the life of the two products beyond
five years. The assumption of constant product mix seems unrealistic, as the
products are substitutes and it is possible that one will be relatively more
successful. The sales price has been raised in line with inflation, but a lower sales
price could be used in the decline stage to encourage sales.
Net working capital is to remain constant in nominal terms. In practice, the level of
working capital will depend on the working capital policies of the company, the
value of goods, the credit offered to customers, the credit taken from suppliers
and so on. It is unlikely that the constant real value will be maintained.
The net present value is heavily dependent on the terminal value derived from the
sale of non-current assets after five years. It is unlikely that this value will be
achieved in practice. It is also possible that the machinery can be used to produce
other products, rather than be used solely to produce Alpha and Beta.
(c) ARG Co currently has $50m of non-current assets and long-term debt of
$10m. The issue of $3m of 9% debentures, and investment in property and
equipment of $2m will increase non-current assets by $2m. There seems to
be ample security for the new issue.
Interest cover is currently 5.1 times (= 4,560/900) which is less than the sector
average, and this will fall to 3.9 times (= 4,560/(900 + 3m × 9%)) following the
debenture issue.
The new products will increase profit by $440,000 ($690,000 – $250,000
depreciation), increasing interest cover to 4.3 times (= 5,000/1,170). Although on
the low side and less than the sector average, this evaluation ignores any increase
in profits from current activities. Interest cover may not be a cause for concern.
Current gearing of 32% (measured as debt/equity based on book values, =
10,000/30,900) will rise to 42% (13,000/30,900) after the debenture issue. Both
values are less than the sector average and ignore any increase in reserves due
to next year’s profits.
Financial risk appears to be at an acceptable level and gearing does not appear
to be a problem.
The debentures are convertible after eight years into 20 ordinary shares per $100
of debentures. The current share price is $4.00, giving a conversion value of $80.
For conversion to be likely, a minimum average annual growth rate of only 2.83%
is needed ((5.00/4.00)0.125 – 1). This growth rate could well be exceeded, making
conversion after eight years a likely prospect. This analysis assumes that the floor
value on the conversion date is the par value of $100: the actual floor value could
well be different in eight years’ time, depending on the prevailing cost of debt.
Conversion of the debentures into ordinary shares will eliminate the need to
redeem them, as well as reducing the company’s gearing.
The current share price may be depressed by the ongoing recovery from the loss-
making magazine publication venture. Annual share price growth may therefore
be substantially in excess of 2.83%, making the conversion terms too generous
(assuming a floor value equal to par value on the conversion date). On
conversion, 600,000 new shares will be issued, representing 23% (= 0.6m/2.6m)
of share capital. The company must seek the views and approval of existing
shareholders regarding this potential dilution of ownership and control.
The maturity of the debentures (12 years) does not match the product life-cycle
(four years). This may be caution on the part of the company’s managers, but a
shorter period could be used.
It has been proposed that $1 million of the debenture issue would be used to
finance the working capital needs of the project. Financing all working capital from
a long-term source is a very conservative approach to working capital financing.
ARG Co might consider financing fluctuating current assets from a short-term
source such as an overdraft. By linking the maturity of the finance to the maturity
of the assets being financed, ARG Co would be applying the matching principle.
57,574,626
= = 16,770,937
3.433
W1: NPV of Costs
Tax Allowance on
Discount
Operating Depreciation Total Cash PV of
Year Capital Cost Operating Factor
Costs and Disposal Outflows Costs
Costs (14%)
(W2)
Rupees (Rupees)
0 (50,000,000) (50,000,000) 1.000 (50,000,000)
1 (6,000,000) 5,687,500 2,100,000 1,787,500 0.877 1,567,638
2 (6,600,000) 1,181,250 2,310,000 (3,108,750) 0.769 (2,390,629)
3 (7,260,000) 1,063,125 2,541,000 (3,655,875) 0.675 (2,467,716)
4 (7,986,000) 956,813 2,795,100 (4,234,087) 0.592 (2,506,580)
5 12,500,000 (8,784,600) 4,236,312 3,074,610 11,026,322 0.519 5,722,661
(50,074,626)
W5
Net Cash Disc
Inflows/ (Outflows) Inflows from fee NPV
Flows Factor
excluding fee Rupees Rupees
Rupees 20%
(50,000,000) (50,000,000) 1.00 (50,000,000)
1,787,500 16,770,937 18,558,437 0.83 15,403,503
(3,108,750) 16,770,937 13,662,187 0.69 9,426,909
(3,655,875) 16,770,937 13,115,062 0.58 7,606,736
(4,234,087) 16,770,937 12,536,850 0.48 6,017,688
11,026,322 16,770,937 27,797,259 0.40 11,118,903
(426,261)
Expected value of NPV = (0.2 × 1,038) + (0.6 × 9,057) + (0.2 × 25,095) = Rs.
10,661
Machine B
2,000 3,000 5,000
demand demand demand
Year Rs. Rs. Rs.
0 (20,000) (20,000) (20,000)
1 (Rs. 4 - Rs.0.5)/unit 7,000 10,500 17,500
2 7,000 10,500 17,500
3 7,000 10,500 17,500
Expected value of NPV = (0.2 × (1,289)) + (0.6 × 8,067 + (0.2 × 26,778) = Rs.
9,938
Note: A quicker way of calculating expected values is to:
calculate the EV of annual sales (which is 3,200 units)
calculate the cash flows and NPV for annual sales of 3,200 units.
However, this approach makes it more difficult to carry out risk and uncertainty
analysis.
On the basis of the figures, it would seem that Machine A should be purchased.
It has a higher expected value of NPV.
It is also a lower risk option, because the NPV will be positive even when
sales are only 2,000 units each year. With machine B, the NPV would be
negative if the annual sales are just 2,000 units.
Machine A also gives a higher NPV if sales are 3,000 units, which is the
most likely outcome.
(c) Sensitivity analysis on the Machine A investment.
(i) The NPV is + Rs. 1,038 even when sales are 2,00 units each year. The
probability of a negative NPV is 0%. (With machine B, the risk of a
negative NPV is 20%).
(ii) The project will achieve a 6% return if the NPV of annual cash profits is
Rs. 15,000.
Discount factor at 6% for years 1 – 3 = 2.673
Annual cash profits to achieve a PV of Rs. 15,000 = Rs. 15,000/2.673 =
Rs. 5,612.
The contribution per unit is Rs. 3.
Therefore minimum annual sales to achieve an NPV of Rs.0 = Rs.
5,612/Rs. 3 per unit
= 1,871 units.
If annual sales exceed 1,871 units, the NPV with Machine A will be
positive at a discount rate of 6%.
Year 0 1 2 3 4
Rs.’m Rs.’m Rs.’m Rs.’m Rs.’m
Initial Outlay (190) - - - -
Advertisement (30) (20) (10) - -
Fixed cost less depreciation - (10) (10) (10) -
Scrap value - - - - 10
Rent Forgone (9.6) (12.8) - -
Contribution (70% of sales) 106.05 249.2 66.85
Net Cash flow (220) 66.45 216.4 56.85 10
DCF (20%) 1.00 0.83 0.69 0.58 0.48
Sensitivity
NPV of project 7,486,400 7,486,400
PV of costs (see above) ÷75,084,800 ÷46,928,000
0.0997 0.1595
9.97% 15.95%
Set-up cost
Cost 20,000,000
PV of tax saving (4,022,400)
Present value 15,977,600
Sensitivity
NPV of project 7,486,400
PV of costs (see above) ÷15,977,600
0.4685
46.85%
Conclusion:
The outcome of the order is most sensitive to material costs.
incremental
incremental
incremental
subscribers in
Cost of cell
Selling Price
Expected
Expected
Expected
earnings
Probability
Probability
revenue
Costs
minutes
sites
Airtime
million
No. of
Rupees in million
AxBxCxDx ETR -
A B C D E H HxCxE
E ECOS
0.7 0.3 1,600 0.6 151 300 54 97
0.7 0.3 1,800 0.4 113 300 36 77
Rs. 280 million Rs. 330 million Rs. 360 million Rs. 340 million Rs. 380 million Rs. 400 million
(20%) (65%) (15%) (5%) (50%) (45%)
Expected NPV
Cash outflow
Probability
of Year 1 of Year 2
PV of total
inflow
Joint
Path
NPV
Discount
Discount
Amount
Amount
factor
factor
PV
PV
1 250 0.8772 219.30 *330 0.7695 253.94 473.24 500 (26.76) 0.1300 (3.48)
2 250 0.8772 219.30 *380 0.7695 292.41 511.71 500 11.71 0.4225 4.95
3 250 0.8772 219.30 *410 0.7695 315.50 534.80 500 34.80 0.0975 3.39
4 320 0.8772 280.70 *390 0.7695 300.11 580.81 500 80.81 0.0175 1.41
5 320 0.8772 280.70 *430 0.7695 330.89 611.59 500 111.59 0.1750 19.53
6 320 0.8772 280.70 *450 0.7695 346.28 626.98 500 126.98 0.1575 20.00
45.80
Cash flows
Year 0 1 2 3 4 5 6
Rs. Rs. Rs. Rs. Rs. Rs. Rs.
Equipment (30,000) 6,000
Tax relief 2,250 1,688 1,266 949 1,048
Project cash flows 10,000 10,000 10,000 10,000 10,000
Tax on these at 30% (3,000) (3,000) (3,000) (3,000) (3,000)
––––––– –––––––– ––––––– ––––––– ––––––– ––––––– ––––––––
Net cash (30,000) 10,000 9,250 8,688 8,266 13,949 (1,952)
flow
DCF factor
1.000 0.909 0.826 0.751 0.683 0.621 0.564
at 10%
Present (30,000) 9,090 7,641 6,525 5,646 8,662 (1,101)
value
NPV = + Rs. 6,463
The acquisition is worthwhile.
Tax
Security Salvage Lease Net cash PV
benefits PV
Year deposits value payment outflow Factor
35%
14%
Rupees Rs.
0 320,000 860,000 - 1,180,000 1.000 1,180,000
1 860,000 (301,000) 559,000 0.877 490,243
2 860,000 (301,000) 559,000 0.769 429,871
3 860,000 (301,000) 559,000 0.675 377,325
4 860,000 (301,000) 559,000 0.592 330,928
5 (400,000) - (301,000) (701,000) 0.519 (363,819)
2,444,548
Alternative answer
PV
Description Rupees PV factor
Rupees
Security deposit 320,000 1 320,000
Lease payments 860,000 3.913 3,365,180
Tax benefit @35% 301,000 3.432 (1,033,032)
Salvage value 400,000 0.519 (207,600)
2,444,548
Rs. 3,200,000
Installment Amount 865,825
1 (1 i ) n
R
i
Depreciation PV
Loan Interest Principal Tax Shield @ Salvage
Year Balance Insurance Outflow Factor PV
payment @ 11% Repayment Initial Normal 35% value
@14%
(Rs.)
Rupees
1 865,825 352,000 513,825 2,686,175 96,000 1,600,000 160,000 (772,800) - 189,025 0.877 165,775
2 865,825 295,479 570,346 2,115,829 96,000 - 144,000 (187,418) - 774,407 0.769 595,519
3 865,825 232,741 633,084 1,482,023 96,000 - 129,600 (160,419) - 801,406 0.675 540,949
4 865,825 163,102 702,723 780,023 96,000 - 116,640 (131,510) - 830,315 0.592 491,547
Note: Disposal value i.e. Rs. 2 million (10% of Rs. 20 million) - WDV at the
end of year 4 i.e. 9.84 = Rs. 7.84 million (Loss on disposal)
Years
0 1 2 3 4 5
Rupees in million
Total tax allowance as
computed above 6.50 1.35 1.22 8.93
Interest payment computed
above 3.20 2.40 1.60 0.80
9.70 3.75 2.82 9.73
0 1 2 3 4 5
(Opening - Loan
payment + Interest) 20.00 16.17 11.65 6.30 0.00
Interest (@18% of
opening principal) 3.60 2.91 2.08 1.13
Tax allowance as
computed above 6.50 1.35 1.22 8.93 -
Recovery of residual
value - - - (2.00) -
NPV of purchase
option 14.07
W1:
Rs. 20 million
Installment amount = 7.43
1 (1 0.18) 4
0.18
Conclusion:
Note: Insurance costs are ignored in our computation as these are the same
in both options.
Conclusion
PUS’s option is better as it gives lower overall cost in present value terms
Hence, 80 10 = 7.46 × AF
AF = 70 ÷ 7.46 = 9.383
IRR is 4% per quarter i.e. the figure corresponding to annuity factor of 9.383 and
12 periods, on the annuity table.
The optimal replacement cycle is one-year because it has the lowest cost.
ALTERNATIVE SOLUTION
Decision: Replace every 1 year.
Rs. Rs.
(818,175)
Rs. Rs.
(1,648,770)
Rs. Rs.
(2,381,265)
Cash Discount
Year flow factor at PV
10%
Rs. Rs.
(24,547)
––––––––
Cash Discount
Year flow factor at PV
10%
Rs. Rs.
0 Purchase cost (40,000) 1.000 (40,000)
1 Running costs (8,000) 0.909 (7,272)
2 Running costs (12,000)
2 Disposal value 20,000
2 Net cash flow, Year 2 8,000 0.826 6,608
––––––––
(40,664)
––––––––
Cash Discount
Year flow factor at PV
10%
Rs. Rs.
(64,694)
––––––––
Recommendation
The machine should be replaced every two years, because this replacement
policy gives the lowest equivalent annual cost.
DF
YEAR (10%) 1 2 3 4
0 1.0000 (6,000,000) (6,000,000) (6,000,000) (6,000,000)
1 0.9091 (409,095) (409,095) (409,095) (409,095)
2 0.8264 __ (396,672) (396,672) (396,672)
3 0.7513 __ __ (428,241) (428,241)
4 0.6830 __ __ __ (430,290)
PV of costs (6,409,095) (6,805,767) (7,234,008) (7,664,298)
PV of scrap
value 4,090,950 3,222,960 2,253,900 1,434,300
NPV (2,318,145) (3,582,807) (4,980,108) (6,229,998)
Annuity factor
(÷) 0.9091 1.7355 2.4868 3.1698
Annual
equivalent
cost (2,549,934) (2,064,424) (2,002,617) (1,965,423)
Option – 2: Replacement
Net Residual Net cash Discount Net present
Capital Cost
Revenue value flow rate @ value
Year
8.33%
Rupees Rs.
(W1)
0 *1(4,305,000) - (4,305,000) 1.0000 (4,305,000)
2
1 - * 3,700,000 - 3,700,000 0.9231 3,415,470
2 - 3,700,000 - 3,700,000 0.8521 3,152,770
3 3,700,000 1,312,500 5,012,500 0.7866 3,942,833
6,206,073
*1 5,250,000 – 945,000 = 4,305,000
(b) Rupees
For an investor who is not well diversified, a measure using total risk (the
standard deviation of returns) is more appropriate.
investmentreturn - risk free rate
standard deviationof returns
Based upon the available data, the company in Zedland appears to have
been the more successful during the last four years.
(b) Other useful information might include:
(i) A benchmark with which to draw comparisons, preferably data for
companies in the same industries as the two companies in Ayeland
and Zedland.
(ii) The objectives and risk aversion of the client.
(iii) Information about whether or not profits, RPI and other data are
calculated in the same way in the two countries.
(iv) Total returns from the relevant stock markets and for investors in the
companies. The data provided only shows the return from share price
movements, and excludes the dividend yield, which might be
significant.
(v) Exchange rate movements between the two countries and the UK. The
client is likely to be interested in returns in sterling, not in foreign
currencies.
(vi) Any tax implications of investing in the two countries.
(vii) Information about the future prospects of the companies. Historic
returns do not provide an accurate guide to future performance. What
are the future strategies of the two companies, what are their strengths
and weaknesses, what is their competition?
(viii) Macro economic information about the two countries and their
prospects. Ayeland is a relatively high inflation country. Is the
government likely to bring this under control? What are key economic
indicators and trends?
(ix) How stable are the governments in the two countries and would there
be significant political risk with the investments?
Division A A B B
Operating profit
11.3% 12.2% 12.8% 14.5%
Sales
Operating profit
14.4% 15.8% 15.6% 18.4%
Capital employed
Growth rates:
A B
Based upon the above financial ratios and growth rates the two divisions have both
improved their performance during the last year. There is, however, no data
allowing comparisons with similar operations to allow assessment of whether the
improved performance is of the standard that might be expected in the industry(ies)
concerned.
The only detrimental elements are the small reduction in the current ratio of division
A, and the increase in gearing of division A to 22% probably in order to finance the
purchase of fixed assets. It is unlikely that either of these factors would be of major
concern.
These results have, however, been achieved in different ways. Division A seems
to be taking a longer term perspective and has expanded its operations and
invested heavily in new fixed assets. Division B's apparent good performance, for
example in return on capital employed, has been achieved using existing assets.
Division B is more likely to have ensured that the short-term results look good
without considering the long-term implications of the lack of investment. It depends
on companies objectives as to whether it would like to increase its short term profits
or be inclined towards long term benefits.
The board of Khan Industries should be much more explicit in what is meant by 'an
improvement in performance'. Controls should be introduced to ensure that the
development of the divisions is in line with the long-term strategic plans of Khan
Industries, including the nature of products in the divisions, and the markets to be
served by the divisions.
The short termism approach of division B should be discouraged, and divisions
should be encouraged to focus on the cash flows of their activities. Investments
should be judged on their likely effect on cash flows and the value of the business
(e.g. through the expected NPV of investments) rather than accounting ratios.
Profitability
Project index Ranking Investment NPV
Rs. Rs.
3 19.4% 1st 400,000 77,791
2 12.8% 2nd 400,000 51,186 ( 57,584
× 400/
450)
800,000 128,977
One of the main reasons suggested for soft capital rationing is that managers
wish to create an internal market for investment funds. It is suggested that
requiring investment projects to compete for funds means that weaker or
marginal projects, with only a small chance of success, are avoided. This
allows a company to focus on more robust investment projects where the
chance of success is higher1. This cause of soft capital rationing can be seen
as a way of reducing the risk and uncertainty associated with investment
projects, as it leads to accepting projects with greater margins of safety.
Annuity factor for total period 3.487 4.102 2.690 4.696 2.668 1.877
Less: Annuity factor for zero cash
inflow period - (1.000) - (1.901) - -
Adjusted annuity factor 3.487 3.102 2.690 2.795 2.668 1.877
Forecasted annual net cash inflows 150.00 50.00 140.00 256.00 440.00 300.00
However, the company might be able to increase the available NPV by investing
more of its available funds.
Hence other options should be considered. While selecting other options the basic
presumption should be to select the last project (balancing amount) which can be
scaled down i.e. Project C. Considering the above, there are four more options as
shown below:
Option 2: Invest in Rank 4 ahead of Rank 2 which can be scaled down
If we consider the rank 4 project which requires lesser investment as compare to
rank 5 project, we would be able to utilize about 75% of rank 2 project, as against
option 3 in which Project C is only 28% utilized.
Investment NPV
Rs. in million
Rank 1 420.00 258.15
Rank 4 400.00 163.10 Because it cannot be scaled down.
Rank 2 (balance) 180.00 102.45
1,000.00 523.70
Investment NPV
Rs. in million
Rank 1 420.00 258.15
Rank 5 512.00 203.55 Because it cannot be scaled down.
Rank 2 (balance) 68.00 38.70
1,000.00 500.40
Investment NPV
Rs. in million
Rank 3 800.00 373.92 Because it cannot be scaled down.
Rank 2(balance) 200.00 113.83
1,000.00 487.75
Option 5: Invest in Rank 4, Rank 5 and Rank 2 which can be scaled down
Investment NPV
Rs. in million
Rank 4 400.00 163.10
Rank 5 512.00 203.55 Because it cannot be scaled down.
Rank 2(balance) 88.00 50.09
1,000.00 416.74
Conclusion:
The most beneficial mix for the company is to invest in Projects A, B, F and C
(balancing amount) which gives the highest NPV to the company.
9.1 RIGHTS
(a)
Rs.
4 shares have a current market value of ( Rs. 5.50) 22.00
1 new share - issue price 4.50
––––––
5 shares Have a theoretical value of 26.50
––––––
This is the theoretical value of the rights, for each existing share.
= Rs. 5.00
(iii) Calculation of theoretical ex-rights price
Rs.
3 shares at N6.20 18.60
1 share at N5.00 5.00
4 shares 23.60
Theoretical ex-rights price = Rs.
23.60/4
= Rs. 5.90
(iv) Calculation of right per share
Theoretical ex-rights price = Rs. 5.90
Less: Issue price 5.00
0.90
Right per share = 0.90/3
= Rs.0.30
Buy some of the shares offered to him in the rights issue and sell some
rights.
Do nothing. This is a bad choice. Shareholders will see a fall in the
value of their shares because the new shares will be issued at a
discount to the current market price. The company may try to sell any
rights that are not taken up on behalf of the shareholder, but the
shareholder should not rely on getting any money from the company.
Shares
Shares currently in issue 2,000,000
New shares on conversion of the bonds 400,000
(Rs. 1,000,000 40/Rs. 100)
2,400,000
EPS after conversion = Rs. 528,000/2,400,000 shares = Rs.0.22 per share.
There will be dilution in EPS from Rs.0.25 to Rs.0.22 per share.
Since the market value of debt on June 30, 2016 is the same as the market
value of debt on March 31, 2016, the company has to maintain the same
level of equity also.
Working 1: Market value of net equity and debt as of March 31, 2016
Rupees in
million
Net equity at book value 2,000
Right ratio - one right share will be issued for every 2.89 (40÷13.82) shares
held.
20 - 10.42
Valueof right (applicable to each existingshare)
2.89
= 3.31
Workings
d1
MV
r-g
r = Rf + (Rm-Rf) × B
= 16.9%
g=rxb
Net Profit
(1 - pay out%)
Equity
125
(1 - 70%)
550
= 6.82%
Debt 600,000
D/E ratio = 52%
Debt Equity 600,000 550,000
Rupees
in
(ii) Yield adjusted theoretical ex-right price million
Current shares market value
(20 million share of Rs. 16 each) 320
Value of right shares (8 million shares of Rs. 12.5 each) 100
NPV 96
516
Yield adjusted theoretical ex-right price
(Rs. 516 million ÷ 28 million shares) 18.43
Right Debenture
issue issue
Rupees in million
Profit before interest and taxation
(95.00 x 1.1) 104.50 104.50
Less: Debenture interest (10% × 350) (35.00) (35.00)
(9% × 100) - (9.00)
Profit before tax 69.50 60.50
Less: Taxation at 35% 24.33 21.18
45.17 39.32
Rs. Rs.
EPS
Rs. 45.17 million / 28 million shares 1.61
Rs. 39.32 million / 20 million shares 1.97
New share price
Rs. 1.61 x 8.21 13.22
Rs. 1.97 x 8.21 x 70% 11.31
(b) PSD already has a gearing level of 37% (350 ÷ 940). If it is at or near its
optimal level of gearing, shareholders may take negatively to the additional
debt which would push the gearing level up to 43% (450 ÷ 1,040).
Accordingly the cost of equity would rise and the ordinary share price would
fall.
Variance 2 15.8475
Variance 2 64.5900
This shows a high level of positive correlation between the returns from
Security X and the returns from Security Y.
(e) The EV of the return from a portfolio consisting of 50% Security X and 50%
Security Y
= (0.50 x 10.05) + (0.50 x 8.90) = 9.475%.
The variance of the returns from this portfolio would be:
[(0.50)2 × 15.8475] + [(0.50)2 × 64.5900] + [2 × 0.50 × 0.50 × 31.7550]
= 3.9619 + 16.1475 + 15.8775 = 35.9869.
The standard deviation of the portfolio returns = 35.9869 6.0%.
(f) For a portfolio consisting of 80% Security X and 20% Security Y:
The EV of the return
= (0.80 × 10.05) + (0.20 × 8.90) = 9.82%.
The variance of the returns from this portfolio would be:
[(0.80)2 × 15.8475] + [(0.20)2 × 64.5900] + [2 × 0.80 × 0.20 × 31.7550]
= 10.1424 + 2.5836 + 10.1616 = 22.8876.
The standard deviation of the portfolio returns = √22.8876 = 4.78%.
Note: In this example, since Security Y has a lower expected return than
Security X and a higher standard deviation, expected returns will be highest
and risk lowest with a ‘portfolio’ consisting of Security X only, and none of
Security Y.
Portfolio Expected
return
50% Country A, 50% Country B (0.5 × 16) + (0.5 × 22) 19.0
50% Country A, 50% Country C (0.5 × 16) + (0.5 × 30) 23.0
50% Country B, 50% Country C (0.5 × 22) + (0.5 × 30) 26.0
However, since the returns from each country are independent of each other, the
covariance of returns (ρA,B ) is 0; therefore the second half of the formula can be
ignored because its value is zero.
Standard
Portfolio deviation
of returns
50% Country A, 50% Country B [(252 × 0.52) + (362 × 0.52)]1/2 21.9
50% Country A, 50% Country C [(252 × 0.52) + (452 × 0.52)]1/2 25.7
50% Country B, 50% Country C [(362 × 0.52) + (452 × 0.52)]1/2 28.8
(Tutorial note: ‘To the power of ½’ is the same as ‘the square root’.)
Coefficient of variation
The coefficient of variation is the ratio of the risk (standard deviation of returns) to
the expected return.
Portfolio Coefficient of
variation
50% Country A, 50% Country B 21.9/19.0 = 1.15
50% Country A, 50% Country C 25.7/23.0 = 1.12
50% Country B, 50% Country C 28.8/26.0 = 1.11
The ratio of risk to expected returns is roughly the same for all three portfolios.
i.e. p = x x Wx + y x Wy + z x Wz
which is:
(0.5 x 0.3) + (0.75 x 0.3) + (1.05 x 0.4)
= 0.150 + 0.225 + 0.420
= 0.795
= 79.5% = 80%.
Determination of Rf
Rm –Rf = Premium
i.e. 0.20 – Rf = 0.05
−Rf = 0.05 – 0.20
Rf = 0.15
= 15%
15 (1.10)
= 150
+ 0.10
(b) Under the two methods, i.e. the CAPM and the DGM, Project A has a higher
Net Present Value and should therefore be selected. Assuming the two
projects are not mutually exclusive, both would have been accepted on the
basis of positive Net Present Values.
(c) The three factors are explained as follows:
(i) Life of the Asset: The life of assets can differ. For instance, bonds
have a fixed maturity life, while equity has no fixed maturity life.
(ii) The expected stream of cash flows/returns: for bond, the stream of
return can easily be determined because it is fixed, whereas those of
equity are difficult to estimate because of the discretionary nature of
the dividends.
(iii) Appropriate discount rate: This will reflect the risk attached to the
asset. The higher the risk, the higher the discount rate. The rate of
equity is subjective, but that of bond is typically determined.
σ 2.45 4.5
(b) The divisional manager will invest in projects that are more risky provided
that they offer a higher return.
The manager will not invest in Project 4 because it offers a lower expected
return than Project 3 but higher risk.
The expected return from Project 1 is (0.8 × 4) + (0.2 × 2) = + 3.6.
The expected return from Project 2 is (0.7 × 5) + (0.3 × 1.5) = + 3.95.
The highest expected return is offered by Project 3, which has a higher risk
than Project 1 and Project 2. It would seem that the divisional manager will
invest in Project 3 because he is prepared to take the higher risk for a higher
expected return. However, Project 2 might seem more attractive: its expected
return is almost as high as for Project 3 and the risk is much less.
© Emile Woolf International 171 The Institute of Chartered Accountants of Pakistan
Business finance decisions
Month x– x y– y (x – x ) (y – y )
1 + 1.5 +2 + 3.0
2 (1.5) (3) + 4.5
3 (2.5) (3) + 7.5
4 + 2.5 +4 + 10.0
+ 25.0
Alternatively
m, y x y 0.984 6.164
1.47
m 4.123
(iii) In view of the high risk inherent in the Food and Beverages project, the
Hotel and Tourism project should be selected. The positive NPV
before the incorporation of the risk factor on the F&B project should not
be taken for viability as the NPV became negative after adjusting for
risk.
(b) Uses of CAPM
(i) To evaluate projects taking risk into account.
(ii) To determine an optimal capital structure.
(iii) It is a device for understanding the risk-return relationship.
Limitations of CAPM
(i) It is based on unrealistic assumptions.
(ii) It is difficult to test its validity.
(iii) It only considers systematic risk which does not remain stable over
time.
(iv) Many times, the risk of an asset is not captured by beta alone.
(v) It only examines investments from the shareholders point of view.
(vi) It is a theoretically one-period model and should therefore be used with
caution in the appraisal of multi-period projects.
Workings
Cost of capital using CAPM:
Hotel & Tourism (HT)
Rs. = Rf + B(Rm – Rf)
= 9% + 1.2 (14% - 9%)%
= 9% + 6%
= 15%
Food and Beverages (F&B)
Rs. = Rf + B(Rm – Rf)
= 9% + 2.2 (14% - 9%)%
= 9% + 11% = 20%
Cost of capital using WACC:
𝑑(𝑙+𝑔)
Ke = √ +g
𝑀𝑉
𝐿𝑑
g = n-1√𝐸𝑑 - 1
0.25
= 5-1√ -1
0.18
1⁄
0.25 4
= (0.18) -1
= 0.085 or 8.5%
0.25(1.085 )
Ke = 0.085
3.20
= 0.169 = 16.9%
10.8 DR JAMAL
(a) (i) The Beta Factor for the portfolio can be calculated by means of a
weighted average of the Beta values of the individual shares. Market
values should be used in the weightings.
Number Market Market Beta MVx
of Shares Price Value Factor
(MV) (B)
Rs. Rs. Rs.
Black Plc. 15,000 2.50 37,500 1.32 49,500
Blue Plc. 18,000 2.20 39,600 1.20 47,520
Yellow Plc. 10,000 1.90 19,000 0.80 15,200
Purple Plc. 12,000 1.50 18,000 1.05 18,900
White Plc. 20,000 0.60 12,000 0.80 9,600
Total 126,100 140,720
At the same time, however, the portfolio manager must be aware of the
theoretical shortcomings of this form of analysis as stated below:
(i) The theory assumes that transactions costs can be ignored. In
practice, the costs of buying and selling shares, particularly in relatively
small quantities may become significant.
(ii) It further assumes that investors hold a well diversified portfolio and
they are, therefore, protected against unsystematic risk and need only
be concerned with systematic risk.
(iii) The theory is based upon a single period time horizon. This is
unrealistic in terms of the way business decisions within firms are
made.
In practice, the portfolio manager must also take other factors as well
as the risk/return profile into account. The factors include the following:
Liquidity
The manager must ensure that liquid funds are available to meet
current commitments. This may mean that the portfolio at any
one time contains a higher than predicted element of risk-free
securities which are being held in anticipation of a known
payment.
Purpose
The purpose for which the portfolio is being held will influence its
make-up. For instance, if the overall fund is small and
transaction costs are significant, and the fund is being invested
with the intention of providing a regular income, then the
manager will select high income securities in preference to
growth stocks. This may mean that the optimum portfolio from
the point of view of the theory may not be the one which should
be selected in practice.
Investment Criteria
The owners of the fund may lay down investment criteria such as
the ethical status of the companies in which to invest. This may
restrict the choice available to the portfolio manager. Again, this
may mean that the “optimum portfolio” is not chosen.
Thus, it can be seen that the theory does have relevance to a
portfolio manager in his selection of securities, but it does not
provide the complete answer to the structuring of a portfolio.
CAPM=RF+(RM-RF) x Beta
Co-
Market Required
Compan Market variance
Standard Beta RF RM-RF . Return
y Name Variance with
Deviation %
market
Price on *Price at
Co. Name
Required
Dividend
Portfolio
Return
Jan. 1, Dec 31
yield
No. of
Value on
2016 (Rs.) Shares
Dec 31 (Rs.)
(Rs.) P[1 + (x –y)]
Portfolio New
Company Weighted
Value on Investment Beta
Name Beta
Dec 31 Weightage
Rs. A B AXB
A 17,350,000 14.89% 0.93 0.14
B 21,772,538 18.65% 1.33 0.25
C 26,272,949 22.55% 1.16 0.26
D 27,519,275 23.62% 0.84 0.20
E 23,576,167 20.24% 1.25 0.25
116,490,929 1.10
Conclusion:
Since the project 1 has higher return over its cost of capital worked out under
CAPM, the company should undertake this project.
Beta of 0.9 shows that AITF substantially (90%) matches the performance
of KSE 100 Index.
(b) AITF's actual return is 11% which is less than the return which AITF should
achieve according to its risk profile i.e. 11.6% (W1) as per its current
systematic risk.
R = Rf + (Rm – Rf) × β
= 11.60%
(c)
return (W1)
after one year (Rs.)
Required
Variance
Name of company
Market
Forecasted price
Co-variance
per share
Remarks
Total
Beta
return
=Rf+β
(σ)2
(Rm-Rf)
d=(b+c- g=f ÷
a b c (e) (f) h
a)÷a e
1 No. of
Current Value Rs. Weighted
Name of shares Beta
price in ‘000’ beta
company ‘000’
(a) Projects
A B C D
Required rate of return (W1) 14.12% 13.84% 16.16% 15.84%
Expected return 16% 14% 17% 15%
Not to
Decision Invest Invest Invest
invest
Excess return index (Expected
1.13 1.01 1.05
/Required return)
Preference 1 3 2
Project PV β Weighted β
A 197.20 1.03 0.34
B 202.71 0.96 0.32
C 201.60 1.54 0.52
601.51 1.18
1 (1 i)n
*
i
Value of investment at
year end g= e x f 523,567 1,029,410 517,538
0.50 (1.0675)
Expected share price = = Rs. 23.72
(0.09 – 0.0675)
(b) Dividends are 50% of earnings and 50% of earnings are retained:
Growth rate = 0.50% × 0.09 = 0.045.
1.00 (1.045)
Expected share price = = Rs. 23.22
(0.09 – 0.045)
(c) Dividends are 70% of earnings and 30% of earnings are retained:
Growth rate = 0.30% × 0.09 = 0.027.
1.40 (1.027)
Expected share price = = Rs. 22.82
(0.09 – 0.027)
One possible implication of this policy is that insufficient earnings have been
retained to finance the investment required to at least, maintain the rate of
return on capital employed. It then means that the Company is falling behind
its competitors, which could have a serious impact on the long-term
profitability of the business. However, Rs. 1.00 dividend per share in the
current year will result in a fall in the share price.
(b) Rate of return
For the purposes of calculation, it is assumed that any new investment will
earn a rate of return equivalent to that required by the shareholders (i.e.
15%), and that this will also be the level of return that is earned on existing
investments for the foreseeable future. It is further assumed that investors
are indifferent as to whether they receive their returns in the form of dividend
or as capital appreciation.
Option 1
The amount of dividend per share is Rs. 1.00 with no growth forecast. The
rate of return required by shareholders is 15%. The theoretical share price
can be estimated using the dividend valuation model.
d1
k3
po
where d1 = do (1+g)
0.5 1.075
Po = = Rs. 7.17
0.15 0.075
or Rs. 7.17 plus 0.50 rupee = Rs. 7.67 cum-div
Option 3
In this case, 25% of the expected return is paid in form of dividend while
75% is retained.
Therefore,
g = 0.15 x 0.75 = 0.1125
0.25 1.1125
Po = = Rs. 7.416
0.15 0.1125
= Rs. 7.42 ex-div.
or
Rs. 7.42 plus 0.25 rupee dividend
= Rs. 7.67 cum-div.
Option 4
In this case, for a share price of Rs. 6.67, investors would need to believe
that retained profits will be invested in projects yielding annual growth of 15%
and that the share price will be at this rate. 100% of the expected return is
provided in the form of capital appreciation under this option.
(iv) Capacity for borrowing: A firm may not be liquid, but may be in a
strong position to borrow at short notice. This ability can be by
arranging a line of credit. The ability of a firm to borrow often largely
influences its ability to meet its short-term obligations as and when due,
including payment of cash dividends.
(v) Access to the capital market: If the company is large enough and
has good access to the corporate bond market, it needs not bother
much about its liquidity situation for the purpose of paying cash
dividends.
(vi) Existence of Restrictive Covenants: Restrictions on payment of
cash dividends may be entrenched in a loan agreement.
(vii) Dilution of Control: Payment of cash dividends, supported by
subsequent rising of external finance may dilute the controlling interest
of the existing shareholders, if they do not partake in the provision of
such finance.
(viii) Dividend policy decisions of other similar firms
(ix) Stock market reaction
(x) Taxation
(xi) Attitude of company’s board of directors
(xii) Repayment of debt
(xiii) Liquidity preference of the dominant shareholder
(b) A stable dividend policy is expected to lead to a higher market valuation of a
company’s share because this policy usually attracts a premium due to
preference for current regular income by certain investors. It gives rise to
positive signalling effects and also facilitates conformity with directives
issued by regulatory authorities to certain institutions like the Pension Fund
Administrators.
(c) (i) Determination of market value of the firm based on retention of 20% of
earnings.
Dividend payable = 80% of Rs. 2,250,000
= Rs. 1,800,000
D0 (1+ g)
∴ MV =
Ke - g
(a) YEARS
1 2 3 4 5
Rupees in million
(b) The company would have surplus cash of Rs. 79.55 million (W5) which is
less than Rs. 90 million. However, the company may pay the amount by
obtaining the balance amount from its short term running finance facility.
WORKINGS
Rs. in
W1: Existing operating profit millions
Net profit before tax and interest (190 - 110 - 30) 50.00
Add: Depreciation for current year (100.8 × 15 ÷ 85) 17.79
Operating profit 67.79
YEARS
1 2 3 4 5
Opening outstanding
balance / (Cash) 20.00 4.88 (9.92) (28.22) (51.15)
(a) Under dividend irrelevance theory, Modigliani and Miller argued that the value
of the firm depends only on the income produced by its assets, not on how
this income is split between dividends and retained earnings.
Arguments against the theory
(i) Differing rates of taxation on dividends and capital gains can create a
preference for a high dividend or one for high earnings retention.
(ii) Dividend retention should be preferred by companies in a period of
capital rationing.
(iii) Due to imperfect markets and the possible difficulties of selling shares
easily at a fair price, shareholders might need high dividends in order to
have funds to invest in opportunities outside the company.
(iv) Markets are not perfect. Because of transaction costs on the sale of
shares, investors who want some cash from their investments will prefer
to receive dividends rather than to sell some of their shares to get the
cash they want.
(v) Information available to shareholders is imperfect and they are not
aware of the future investment plans and expected profits of their
company. Even if management were to provide them with profit
forecasts, these forecasts would not necessarily be accurate or
believable.
8%
0.8 1.28
5%
12.1 GEARING
(a) Increase in earnings from increase in sales
Company A Company B
Rs. % Rs. %
increase increase
Sales 100,000 25% 100,000 25%
Variable costs 12,500 75,000
Contribution 87,500 25,000
Fixed operating costs 60,000 10,000
Earnings before interest
and tax 27,500 175% 15,000 50%
Interest costs 7,000 0
Profit before tax 20,500 15,000
Tax at 20% 4,100 3,000
Earnings after interest and
tax 16,400 583.3% 12,000 50%
Company A Company B
Operational gearing
= Increase in earnings before
interest and tax/increase in sales (175/25) 7.0 (50/25) 2.0
Financial gearing
= Increase in earnings after interest
and tax/ increase in earnings before
interest and tax (583.3/175) 3.3 (50/50) 1.0
Combined gearing effect
= Increase in earnings after interest
and tax/ increase in sales (583.3/25) 23.3 (50/25) 2.0
Financing method
i ii iii
Rs. m Rs. m Rs. m
Profit before interest and tax: 22.9 22.9 22.9
(17.9 + 5.0)
Interest payable 1.5 2.1 2.1
Profit before tax 21.4 20.8 20.8
Taxation (25%) 5.4 5.2 5.2
Profit after tax 16.0 15.6 15.6
Preference dividend 0.0 1.4 0.0
Profit available to ordinary 16.0 14.2 15.6
shareholders
Number of shares
20.0 + 9.0 29.0m
20.0m
20.0 + 6.0 26.0m
Earnings per share = Rs.0.552 Rs.0.71 Rs.0.60
12.4 DIVERSIFY
(a)
The first step is to use the equity betas of the three chemical manufacturing
companies (proxy companies) to estimate an asset beta for the business risk in
chemicals manufacturing.
It is assumed that the asset beta is a simple average of these three values:
(1.25 + 1.25 + 1.22)/3 = 1.24.
This asset beta can be used to calculate an equity beta for Bustra, for the
investment in chemicals manufacturing:
1.24 = βE 60
60 + 40 (1 – 0.25)
0.667 βE = 1.24
βE = 1.86
If an appropriate equity beta for Bustra in chemicals manufacturing is 1.86, the
cost of equity (using the CAPM) is:
5% + 1.86 (9 – 5)% = 12.44%
(b)
If the cost of equity is 12.44%, the pre-tax cost of debt is 5% (= risk-free rate) and
tax is 25%, a suitable discount rate (WACC) for evaluating the proposed
investment would be:
(60% 12.44%) + [40% 5 (1 – 0.25)%] = 8.964%, say 9%.
Rs.000 Rs.000
Sales 1,800
Minus:
Variable costs: (60,000 × Rs. 5) 300
Fixed costs: (360 + 120) 480
780
Net profit before interest and taxation 1,020
Interest payable [190 + (12.5% × Rs. 2 million)] 440
Net profit before taxation 580
Tax at 35% 203
Net profit after taxation 377
$377,000
EPS $0.4713
800,000
70 + 30 (1 - 0.30)
30% 0.90 = 1.170
70
60 + 40 (1 - 0.30)
40% 0.90 = 1.320
60
50 + 50 (1 - 0.30)
50% 0.90 = 1.530
50
40 + 60 (1 - 0.30)
60% 0.90 = 1.845
40
Step 2
Use the geared beta value and the CAPM to calculate a cost of equity at each
gearing level.
Step 3
Calculate the WACC at each level of gearing, and identify the gearing level with
the lowest WACC.
Gearing WACC
20% [20% × 5.0 (1 – 0.30)] + [80% × 7.17] = 6.44%
30% [30% × 5.4 (1 – 0.30)] + [70% × 7.51] = 6.39%
40% [40% × 5.8 (1 – 0.30)] + [60% × 7.96] = 6.40%
50% [50% × 6.5 (1 – 0.30)] + [50% × 8.59] = 6.58%
60% [60% × 7.2 (1 – 0.30)] + [40% × 9.54] = 6.84%
Conclusion
The optimal gearing level is 30%, because the WACC is lowest at this gearing
level. However, the WACC is almost as low at a gearing level of 40%.
75
βA = 1.126
75 + 25 (1 – 0.30)
βA = 0.913
(c) If the company is geared differently, its equity beta will not be 1.126 because
its financial risk will be different. A geared beta can be calculated for the new
gearing level.
60
0.913 Bgeared
60 40 1 0.30
0.913
Bgeared 1.339
0.6818
International
© Emile Woolf 197 The Institute of Chartered Accountants of Pakistan
Business finance decisions
This geared beta factor can now be used to calculate the cost of equity at
this gearing level.
Cost of equity = 5% + 1.339 (11 – 5)% = 13.03%.
WACC at this gearing level. It is assumed that the cost of debt remains risk-
free.
WACC = (60% 13.03%) + [40% 5%(1 – 0.30)] = 9.218%, say 9.2%
Year 0 1 2 3 4
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Machine (450)
Tax saved, tax
allowances 110.25 15.75 15.75 15.75
Cash profits 220.00 220.00 220.00
Tax on cash profits
(35%) (77.0) (77.0) (77.00)
Net cash flow (450) 330.25 158.75 158.75 (61.25)
Discount factor at
16.5% 1.000 0.858 0.737 0.632 0.543
Present value (450) 283.35 117.00 100.33 (33.26)
NPV = + Rs. 17,420
The company’s gearing is 60% equity and 40% debt; therefore we need to
re-gear the equity beta for the company.
60
1.20 Beta geared
60 401 0.35
Betageared = 1.72
The cost of equity for the project is therefore 10% + 1.72 (15% – 10%) =
18.6%.
WACC = (0.60 × 18.6%) + (0.40 × 10% (1 – 0.35)) = 13.76%, say 14%.
Year 0 1 2 3 4
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Net cash flows
(450.00) 330.25 158.75 158.75 (61.25)
(as in (a))
DCF factor at 14% 1.000 0.877 0.769 0.675 0.592
Present value (450.00) 289.63 122.08 107.16 (36.26)
NPV = Rs. 32,610
Year 0 1 2 3 4
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Net cash flow (450.00) 330.25 158.75 158.75 (61.25)
The PV of issue costs is calculated using the risk-free rate of 10% as the
discount rate.
Discount
Year Item Cash flow factor at 10% PV
Rs. Rs.
0 Issue costs (17,100) 1.000 (17,100)
1 Tax saved at 35% 5,985 0.909 5,440
PV of issue costs (11,660)
= 1.10
The company’s gearing is 70% equity and 30% debt; therefore we need to
re-gear the equity beta for the company.
70
1.10 Beta geared
70 301 0.25
Betageared = 1.45
The cost of equity for the project is therefore 4% + 1.45 (9% – 4%) = 11.25%.
WACC = (0.70 × 11.25%) + (0.3 × 4% (1 – 0.25))
= 7.875% + 0.9%
= 8.775%, say 8.8%
Year 0 1 2 3 4
Rs. Rs. Rs. Rs. Rs.
Capital expenditure (200,000)
Cash profits 100,000 165,000 120,000
Tax at 25% (25,000) (41,250) (30,000)
Net cash flow (200,000) 100,000 140,000 78,750 (30,000)
DCF factor at 8.8% 1.000 1/(1.088) 1/(1.088)2 1/(1.088)3 1/(1.088)4
Present value (200,000) 91,912 118,269 61,145 (21,409)
NPV = Rs. 49,917
PV of issue costs
Issue costs before tax: Rs.
Equity Rs. 1,000,000 × 4/96 41,667
Debt Rs. 1,000,000 × 3/97 30,928
Total issue costs 72,595
PV of tax shield
The amount borrowed will be Rs. 1,000,000 + Rs. 30,928 = Rs. 1,030,928.
The interest rate will be 4%.
The annual interest cost will be Rs. 1,030,928 × 4% = Rs. 41,237 each year,
years 1 – 3.
The reduction in tax due to the interest payments = Rs. 10,309 (= 25% × Rs.
41,237) each year, years 2 – 4.
Discount factor at 4%, years 1 – 4 3.630
Discount factor at 4%, year 1 0.962
Discount factor at 4%, years 2 – 4 2.668
DCF factor 11% 1.000 0.901 0.812 0.731 0.659 0.593 0.535
The base case NPV, discounting the cash flows at the ungeared cost of equity, is
(in Rs.000) + 527.
Issue costs
Issue costs will be 2%. The net borrowing after issue costs needs to be Rs.
3,400,000; therefore the gross amount borrowed will need to be Rs. 3 million/0.98
= Rs. 3,469,400. Issue costs will be (2%) Rs. 69,000. It is assumed that this is a
Year 0 cost.
There is no tax relief on issue costs
Tax shield
The annual interest cost will be Rs. 3,469,400 × 6% = Rs. 208,164.
Tax relief each year will be (25%) Rs. 52,041
Annuity factor at 6% (the risk-free cost of capital), Years 1 – 6 = 4.917.
Present value of tax shield = Rs. 255,886, say Rs. 256,000.
Rs.000
Base case NPV 527
PV of issue costs (69)
PV of tax shield 256
Adjusted present value + 714
Rs.
Amount to be raised through equity 77,000,000
Rs.
(ii) Value of equity after investment is taken up 922,000,000
51,785,820
WACC
272,538,000
= 19%
(a) APV separates project value into one component associated with the
unlevered operating cash flows and another associated with financing the
project. Each component is evaluated separately.
The disaggregation of cash flows is undertaken so that different discount rates
may be used. As operating cash flows are more risky, they are discounted at
higher rate.
Comparative advantages of APV over WACC
(i) Unbundles major components of value – drivers of value are much more
apparent under APV than WACC.
(ii) Miscalculation in WACC, sometimes, produces large errors in the
estimates of value. APV is less prone to such miscalculations.
(iii) Show better result when there are significant changes in capital
structure.
(48)
1 (1 0.1872)8 1 (1 0.06)8
*1 *2
0.1872( W 1) 0.06
Conclusion
The project is not feasible for the company as the APV of the project is
negative.
W1: Cost of equity
Ke = Rf + (Rm – Rf) x βe
Ke = 6% + (14% – 6%) x 1.59 (W2)
= 18.72%
W2: Calculating Equity Beta for Telecommunication Industry
E D (1 - t)
βa βe βd
E D(1 t) E D(1 t)
60 40(1 0.35)
1.5 βe 1.3
60 40(1 0.35) 60 40(1 0.35)
β e 1.59
* E D(1 t)
βa βe βd
E D(1 t) E D(1 t)
825
1.25 0 = 0.872
825 550 x 65%
W3 : Cost of debt
At 70% equity 30% debt
Since interest cover has an inverse relationship, we assume decline in
debt moves the CIL to lower category of interest rate:
30% debt in existing market value of the company (30% x 1375) = 412.5
Cost of debt = (8% x 412.5) = 33
Interest cover = (327* ÷ 33) = 9.91
Kd = 8%
* Profit before interest and tax
FCF1
Current valuation 1375
(k - g)
FCF1 112.55(1 g )
1375 1375
(k - g) 0.1254 g
𝑉𝑒 𝑉𝑑
𝑊𝐴𝐶𝐶 = 𝐾𝑒 × + 𝑘𝑑 ×
𝑉𝑒 + 𝑉𝑑 𝑉𝑒 + 𝑉𝑑
56,000 28,700
𝑊𝐴𝐶𝐶 = 14.5% (𝑾𝟏) × + 7.5% (𝑾𝟐) × = 12.1%
84,700 84,700
𝑉𝑒 𝑉𝑑 (1 − 𝑡)
𝐵𝑢 = 𝐵𝑔 × + 𝐵𝑑 ×
𝑉𝑒 + 𝑉𝑑 (1 − 𝑡) 𝑉𝑒 + 𝑉𝑑 (1 − 𝑡)
where,
𝑉𝑒 = 900 × 35 = 31,500,
𝑉𝑑 (1 − 𝑡) = 8,000 × 70% = 5,600
𝐵𝑔 = 1.5
31,500
𝐵𝑢 = 1.5 × + 0 = 1.274
(31,500 + 5,600)
Get the project beta on the basis of steel company un-geared beta
𝑉𝑑 (1 − 𝑡)
𝐵𝑔 = 𝐵𝑢 + (𝐵𝑢 − 𝐵𝑑 ) ×
𝑉𝑒
1,980 × 70%
𝐵𝑔 = 1.274 + 1.274 × = 2.364
1,620
13.2 VALUATION
The dividend growth model:
381 g
800
0.10 g
800 (0.10 – g) = 38 (1 + g)
80 – 800g = 38 + 38g
838g = 42
g = 0.05 or 5%.
The market value of the bonds should be 103.97 for each Rs. 100 nominal
value of bonds.
(d) Convertible bond
Cash Discount
Year Item flow factor at 9% PV
1–3 Interest 5 2.531 12.66
3 Value of shares acquired
(20 shares Rs. 7) 140 0.772 108.08
120.74
The market value of the bonds should be 120.74 for each Rs. 100 nominal
value of bonds.
1 1
PV of annuity Annuity 1
r 1 r n
1
(a) (i) Valueof zerocouponbond 100
1.05 10
= 100 ×0.6139
= 61.39.
(ii) PV of interest payments to maturity of the bond: interest = 4 every 6
months for 10 years.
1 1
PV of annuity 4 1 20
0.025 1.025
= 160 ×[0.3897]
= 62.35
Cash Discount
Period flow factor (2.5%) PV
1 – 20 Interest 4 See above 62.35
20 Redemption 100 1/(1.025)20 61.03
Value of bond 123.38
(b) When interest yields rise, bond prices fall. Edit: the below boxes needs the
‘x’ replaced
1
(i) Valueof zerocouponbond 100
1.06 10
= 100 ×0.5584
= 55.84.
1 1
(ii) PV of annuity 4 1
0.03 1.03 20
= 133.33 ×[0.4463]
= 59.51
Cash Discount factor PV
Period flow at 3%
1 – 20 Interest 4 See above 59.51
20 Redemption 100 1/(1.03)20 55.37
Value of bond 114.88
Value of equity if
Value as
Share converted per Rs. Value of
debt if not
price 100 of bonds convertibles Convert?
converted
(20 shares)
Rs. 4.40 Rs. 88 Rs. 105 Rs. 105 No
Rs. 5.20 Rs. 104 Rs. 105 Rs. 105 No
Rs. 6.00 Rs. 120 Rs. 105 Rs. 120 Yes
Rs. 6.80 Rs. 136 Rs. 105 Rs. 136 Yes
Warrants
Exercise Value of
Share price Exercise?
price warrant
Rs. 4.40 Rs. 5 Rs.0 No
Rs. 5.20 Rs. 5 Rs.0.20 Yes
Rs. 6.00 Rs. 5 Rs. 1.00 Yes
Rs. 6.80 Rs. 5 Rs. 1.80 Yes
(b) Convertibles
Before After
conversion conversion
Rs.000 Rs.000
Profit before interest 1,200 1,200
Interest (Rs. 2.5 million × 12%) 300 -
900 1,200
Tax at 50% 450 600
Earnings (profit after tax) 450 600
Number of shares 2,000,000 2,500,000
Earnings per share Rs.0.225 Rs.0.24
Warrants
Before After
exercise exercise
Rs.000 Rs.000
Profit before interest 1,200 1,200
Plus return on additional funds raised: 10% × - 250
Rs. 2,500,000
1,200 1,450
Tax at 50% 600 725
600 725
Number of shares 2,000,000 2,500,000
Company 1 9%
Company 2 11%
Total 20%
12
Average /2 = 10%
Total Dividend Rs. 2,250,000
Value of business: Dividend Yield
= *10%
= Rs. 22,500,000
Merger Merger
with PQ with RS
Rupees in million
Investment required to be made (W – 1) 848.00 1,888.75
Net profit after tax 124.80 169.00
Synergy impact (W5) 37.05 47.39
161.85 216.39
Return on investment 19.09% 11.46%
Conclusion:
By acquiring PQ (Pvt.) Ltd., the shareholders of MNO Chemicals will earn a higher
return on investment as compared to the acquisition of RS. Hence, acquisition of
PQ is financially feasible for the shareholders of MNO Chemicals.
156 (W - 3) x (1 4%)
Total Valueof PQ (Pvt.) Ltd. 1,248
17% (W - 4) - 4%
204.75(W - 3) x (1 5%)
Total Valueof RS Ltd. 2,388.75
14% (W - 4) - 5%
Ke = Rf + (Rm – Rf)
W5 Synergy Impact PQ RS
Rupees in million
Rs.
Interest (440,000)
Taxation (600,000)
Workings
(1) At the end of year 4, inventory + receivables – trade payables = 710
(in Rs. million). This amount will increase by 8% each year.
(2) Interest charges
(b) There are several definitions of free cash flow. Other definitions are
acceptable for your answer.
(c) A feature of the financial plan that might need review is the cash position of
the company. The bank overdraft is forecast to increase from Rs. 310,000 to
Rs. 943,000, although the company expects to make a profit each year. The
free cash flow each year, as measured, is not much more than the interest
payments and dividend payments.
This suggests that the company might need to reconsider its dividend policy,
and pay lower dividends. In addition, the company might possible consider
alternative sources of finance, so that it does not have to rely so much on an
overdraft facility. More long-term debt might be appropriate, if this can be
obtained at a suitable interest rate.
(d) A possible value of the company’s shares at the end of the financial planning
period can be estimated using the dividend growth model, assuming that
dividends will grow by about 8% per year (in line with sales growth) and the
cost of equity will remain at 12%.
Expected equity value in Rs. millions 179 (1.08)
(0.12 – 0.08)
= Rs. 4,833 million.
There are 9,000,000 shares of Rs.0.05 each . This gives a valuation of Rs.
537 per share.
13.11 TAKEOVER
(a) Cost of equity in Flat Company, using the CAPM = 5% + 1.20 (11 – 5)% =
12.2%
WACC in Flat Company = (12.2 × 75%) + (7 (1 – 0.30) × 25%) = 10.375%,
say 10.4%
Cost of equity in Slope Company, using the CAPM = 5% + 1.35 (11 – 5)% =
13.1%
WACC in Slope Company = (13.1 × 60%) + (8 (1 – 0.30) × 40%) = 10.1%.
Free cash flow is defined here as EBIT less tax, plus tax-allowable
depreciation minus replacement capital expenditure.
Free cash flows and valuation of Flat Company based on free cash
flows
Year 1 2 3 4
Rs.000 Rs.000 Rs.000 Rs.000
Earnings before interest and tax 1,918 2,014 2,115 2,221
Tax at 30% (575) (604) (635) (666)
1,343 1,410 1,480 1,555
Add back tax-allowable 872 915 961 1,009
depreciation
Less: Replacement capital (966) (1,014) (1,065) (1,118)
spending
Free cash flow 1,249 1,311 1,376 1,446
Discount factor at 10.4% 0.906 0.820 0.743 0.673
Present value 1,132 1,075 1,022 973
Market Cost of MV ×
value capital Cost
Rs. m
48.70 4.2277
Year 1 2 3 4
Rs.000 Rs.000 Rs.000 Rs.000
Earnings before interest and 4,100 4,305 4,520 4,746
tax
Tax at 30% (1,230) (1,292) (1,356) (1,424)
2,870 3,013 3,164 3,322
Add back tax-allowable 1,607 1,687 1,771 1,860
depreciation
Less: Replacement capital (1,860) (1,885) (1,980) (2,079)
spending
Free cash flow 2,617 2,815 2,955 3,103
Discount factor at 8.7% 0.920 0.846 0.779 0.716
Present value 2,408 2,381 2,302 2,222
33.871
On the basis of these estimates, the value of equity (as valued on a free cash
flow basis) will increase by about 72.6% as a result of the takeover.
(b) The estimates of equity value might not be reliable, for several reasons.
(1) The WACC used for the combined company, based on current market
values, is lower than the WACC used for each separate company
valuation. This lower WACC is questionable, and if a WACC of over
10% were used, the valuation of the company after the takeover would
be much lower.
(2) The estimates for the increase in the combined Year 1 EBIT might be
unrealistic, and the estimates of higher growth in sales and earnings
should also be questioned.
(3) Valuations based on a dividend growth model, rather than a free cash
flow model, would produce a lower valuation.
(c) Shareholders in Slope are being offered 2 shares in Flat (current value Rs.
6.40) for every three shares they hold (current value Rs. 4.62). On the basis
of current market values, they are being offered a price that is 38.5% above
the current share price. This is a very high premium in a takeover bid, and is
likely to be very attractive to them.
For the same reason, shareholders in Flat might oppose the takeover bid,
because ‘value’ is being given to the shareholders of Slope and a very high
premium is being offered for the shares. The shareholders in Flat will only
support the bid if they believe that it will ‘unlock value’ in the shares or result
in substantial synergy gains through higher sales, cost savings or faster
business growth.
13.12 MK LIMITED
(a) VALUE OF MK LIMITED
Years
1 2
Rupees in million
Sales 4% 12,480 12,979
Operating costs including
depreciation 75% (9,360) (9,734)
Profit before interest and tax 3,120 3,245
Taxation 35% (1,092) (1,136)
Add back depreciation 4% 1,357 1,411
Annual capital expenditure 4% (728) (757)
Free cash flow 2,657 2,763
Discount factor (W1) 9.8% 0.911 0.830
Present value 2,421 2,292
Present value 1 - 2 years 4,713
2,763(1.05)
Free cash flow after year 2 = x 0.83 = Rs. 50,166 million
0.098 0.05
Total free cash flows = (4,713 + 50,166) Rs. 54,879 million
Rupees in million
105,528
13.14 EMH
(a) Capital markets are said to be efficient when prices of securities in such
markets fully reflect all information about the company, the industry to which
it belongs and the economy as a whole. This means that any new information
about a company coming into the market is immediately reflected in the price
of the share of the company such that no investor can make above average
return on an investment.
In a supposedly efficient market, the price of a security is expected to
fluctuate randomly around its true or intrinsic value. Efficient simply means
security is price efficient. The price is right and represents the best estimate
of the security’s true value based on the available information.
Forms of efficiency:
The Weak Form: This form of efficiency implies that information about past
share price movement is already reflected in the current market price.
Therefore, the ability to forecast future prices cannot be enhanced based on
the use of past information alone.
The Semi-Strong Form: This form states that the current market price of a
security, fully and immediately reflects all publicly available information
including information from financial statements, Chairman’s report and news
items. Here, insider information is excluded.
The Strong Form: This form of efficiency implies that all pieces of
information both public and private (including insider information) are fully
and immediately reflected in the current market price of the security. Insider
information is said to be information that is known to management but
unknown to the public.
(b)
(i) Weak form efficiency
The share price will not react to the announcement by the directors.
Share prices in a market with weak-form efficiency react to historical
data, not future expectations.
(ii) Semi-strong form efficiency
If investors believe the estimate of an NPV of + Rs. 4,000,000, the
value of the company’s shares will increase by this amount (Rs.0.08
per share) and rise to Rs. 4.08 on 12th May – the date that the
announcement is made to the market.
(iii) Strong form efficiency
If investors believe the estimate of an NPV of + Rs. 4,000,000, the
value of the company’s shares will increase by this amount (Rs.0.08
per share) and rise to Rs. 4.08 on 1st May – the date that the investment
decision is taken and before it is formally announced to the market.
DAY 5
The takeover bid was announced, but no information is available yet
about the operating savings, hence, value of X Plc. shares will be (Rs.
5 x 30,000,000) = Rs. 150,000,000
Rs.
Value of Y Plc 500,000,000
Value of X Plc. acquired (Rs. 3 x 30,000,000) 150,000,000
650,000,000
Number of shares in Y Plc
80,000,000 + (5/6 30,000,000) 105,000,000
Price per share Rs. 6.29
14.1 ACQUISITION
(a) The earnings of Little next year are expected to be Rs. 86,000. A forward P/E
multiple of 8.0 could be applied to this estimate, and the valuation of the
equity shares in Little would be:
Rs. 86,000 × 8.0 = Rs. 688,000.
(b) The cost of equity of Big is expected to be:
6% + 1.60 (11 – 6)% = 14%.
The WACC of Big is expected to be:
[35% × 7.4 (1 – 0.30)] + (65% × 14)
= 10.913%.
(c) Since Little is in the same industry as Big, it is probably appropriate to use
the WACC of Big to obtain a DCF-based valuation of Little. The WACC of
10.913% will be rounded to 11%.
The cash flows from the acquisition of Little must be calculated.
$68,000 1.04
Year 3 value of cash flow s from Year 4 = Rs. 1,010,286
0.11 0.04
The expected cash flows can now be converted in to a present value:
Discount factor
Year Cash flow at 11% PV
Rs. Rs.
1 30,000 0.901 27,030
2 56,000 0.812 45,472
3 68,000 0.731 49,708
4 onwards 1,010,286 0.731 738,519
–––––––––––––––––––
14.3 D LIMITED
(a) The following are the various options available to D Limited:
(i) Merger: The term merger is normally used to describe a situation
where two businesses come together by agreement to form a single
entity. Here, the two companies go into liquidation and an entirely new
one is formed to acquire their shares. Alternatively, the life of one
company is, in law, terminated (still in physical existence as a division
or branch) and the other one remains.
(ii) Take over: This describes a situation where one business acquires
control of another business. This usually occurs when one company
buys shares in another company substantial enough to acquire a
controlling interest in the other company. The former is called the
bidding company while the latter is called the target company.
(iii) Consolidation: This is a combination of two or more companies into a
new company.
(b)
Exchange ratio = 40/80 = 1:2 (one share of D Limited exchanges for
every two shares of F Limited.)
Number of shares to be issued to shareholders of F Limited =
3,000,000/2 = 1,500,000
Combined post merger number of shares = 5,500,000 (i.e. 4,000,000
+1,500,000)
Combined post acquisition earnings = Rs. 29,000,000 (i.e. Rs.
20,000,000 + Rs. 9,000,000)
Post merger earnings per share of enlarged company –D Limited = Rs.
29,000,000/5,500,000 = Rs. 5.27
Comment:
The merger improves the Earnings Per Share (EPS) of D Limited from Rs.
5.00 to Rs. 5.27. However, the shareholders of F Limited suffer a drop in
their EPS from Rs. 3.00 to Rs. 2.64 (i.e. Rs. 5.27/2)
Total Earnings
EPS =
No of shares
No of shares = (600 + 75)m = 675 million shares.
Total earnings
Rs.’m
Clooney Plc 150.0
Pitt Plc 30.0
Increased cash flow 4.5
184.5
184,500,00 0
Therefore EPS = = Rs.0.27
675,000,00 0
If EPS = Rs.0.27 and
Share price = Rs. 5.50 (given)
Then, the Price Earning (P/E) Ratio of the group would be:
Rs. 5.50
= 20.37 times
Rs.0.27
(c) Calculation of market capitalisation of Clooney Plc (after merger)
Rs.
million
Capitalisation of Clooney Plc (pre-merger)
= 600m x Rs. 5.0 = 3,000
Capitalisation of Pitt Plc (pre-merger)
= 150m x Rs. 2.0 = 300
Value of merger benefit (given) = 45
Therefore, capitalisation of group after merger = 3,345
(d) Calculation of dividend income of the holder of 1 share in Pitt Plc before and
after merger assuming Clooney Plc maintains the same dividend per share
as before the merger.
Dividend per share (DPS) of holder of 1 share in Pitt Plc:
Before merger:
Rs. 21,000,000
DPS =
150,000,000
= Rs.0.14
After merger: assuming Clooney Plc maintains the same dividend per share
as before the merger:
60,000,000
DPS =
600,000,000
= Rs.0.10
Therefore, a holder of 1 share in Pitt Plc will now get Rs.0.1 ÷2 = Rs.0.5
since the ratio of offer is 2:1.
Comment:
The shareholders of Pitt Plc would be losing Rs.0.09, that is, (0.14 – 0.5) on
each of their shareholding since they were earning Rs.014 on each holding,
before the merger.
(b) Maximum Price Nelson Plc should pay for Drake Plc:
Earnings in the next one year:
Rs.
Nelson Plc Rs. 225,000 x 1.14 = 256,500
Drake Plc Rs. 600,000 x 1.04 = 624,000
880,500
Dear Sirs,
a) If the company opts for demerger scheme, the ordinary shareholder will
get a surplus of Rs. 28.64 million details of which are as follows:
Rupees
in million
Value of OCX 276.59 Annexure ‘A’
Value of OCY 281.05 Annexure ‘B’
Total value of both the companies 557.64
Current market value of HL
Equity (5 million shares of Rs. 90) 450.00
Debt (40+30*130/100) 79.00
Surplus 529.00
28.64
As the demerger of two separate divisions has increased the value of two
companies by approx. 5.4% as compare to current market value, it appears
that HL should float the two divisions separately.
(b) The following additional information and analysis would be relevant in the
process of decision making:
(i) Other details of items included in the profit and loss statement and
information such as expected future growth could have been useful
in determining the operating cash flows more accurately.
(ii) The model uses operating cash flows. A more reliable estimate of
value might be free cash flows, taking into account the investment
needs of both divisions.
(iii) The cash flow forecasts as they stand, appear to take no account
of uncertainty. It would have been helpful to see best-worst
estimates, simulations or other techniques that incorporate
uncertainty.
(iv) The risk profiles of the companies have not been considered.
(v) Individual divisions might be more vulnerable to takeovers because
of their smaller size.
(vi) The views of the shareholders shall be important in reaching a final
decision.
(vii) How will the decision impact on the company’s ability to negotiate
better terms with the suppliers, financial institutions, etc?
(viii) The interests of other stakeholders may have to be taken into
account – what will employees feel about the split, will there be
fewer management opportunities available, and how will creditors
view their security?
Annexure A – Value of HX
Year 1 2 3 onward Total
Rupees in million
Profit before tax and depreciation 39.00 42.00 44.00
Depreciation 12.00 11.00 13.00
Profit before tax 27.00 31.00 31.00
Tax (30%) (8.10) (9.30) (9.30)
Profit after tax 18.90 21.70 21.70
Add back depreciation 12.00 11.00 13.00
One time costs (8.50) - -
Net cash inflow 22.40 32.70 34.70
1
0.8929 0.7972 6.6432
0.12
Annexure B – Value of HY
Year 1 2 3 onward Total
Rupees in million
1
0.9091 0.8265 8.2644
0.1
In response to your advice to explore the financing options for the acquisition of
100 % shareholding in CHI Limited, we have carried out an analysis to determine
the debt equity ratio and price of our shares after the acquisition under the
following options:
Where the acquisition is financed by debt and equity in the ratio of 60:40.
The following calculations suggest that both the options are feasible to the
company as the acquisition of CHI Limited would result in increase in the
shareholders wealth as shown below.
Option 2
Option 1
Existing (acquisition
(acquisition
(Without thru 60% debt
thru 100%
acquisition) and 40%
debt)
equity)
Debt equity ratio after
acquisition W1 42 : 58 59 : 41 47 : 53
Per share price (Rs.) W3 52.50 64.00 57.75
Increase in
shareholders’ wealth
because of acquisition
(Rs. in million) W4 - 460.00 388.50
Under option 1, the shareholders’ wealth would increase by Rs. 460 million as
compared to the projected position under the existing conditions. However,
accepting option 1 would increase the debt equity ratio of the company.
If we are willing to accept the higher gearing level, option 1 should be selected.
Otherwise, we should opt for option 2 as in that case there is only a slight increase
in debt equity ratio which is more than adequately compensated by a significant
increase in the shareholders’ wealth.
Besides the increase in profitability and shareholders wealth, URD should also
consider the following aspects:
A company with stable cash flows can handle more debt because there is
constant stream of cash inflows to cover periodic interest payments. Hence, in
case the company is satisfied with the stability of future cash flows, it can opt for
option 2.
Future plans
The company may have future plans of further expansion. While comparing the
option (i) and (ii) the management should assess that if it plans to obtain further
financing in the near future, it may not be feasible to opt for 100% debt financing
at this stage.
In case the company decides to go for option 2, it should study the stock market
conditions to ensure that it would be able to generate sufficient interest in the
right issue, before making any commitments as regards investment in the new
venture.
Due Diligence
It seems that URD is relying on the audited accounts for making the above
decision. Even if the audited accounts show a true and fair view, it is not
necessary that CHI would be in a position to repeat the performance in future
years. It is therefore recommended that URD should carry out a proper due
diligence exercise before making a final decision.
Shares in
million
Existing shares in issue 40.00
Number of right shares to be issued (Rs. 1,575 (W2) × 40%
÷ 45) 14.00
Total number of shares to be outstanding after right issue 54.00
Revised EPS after right issue (Rs. 445.58 million (W4) ÷ 54m
shares) PKR 8.25
Revised market value after right issue (Rs. 8.25 x 7) PKR 57.75
14.8 FF INTERNATIONAL
Advantages of growth by acquisition
(a) (i) The company may be able to grow much faster than would be
possible through purely organic development. This is particularly true
if the company is seeking to expand into a new product or market
area when acquisition will allow the company to gain technical skills,
goodwill and customer contracts which would take it a long time to
develop by itself.
(ii) A larger company with a better spread of products, customers and
markets faces a lower level of operating risk than a small company
which may be more dependent on a small number of customers and
suppliers. Acquisition will therefore allow the company to reduce its
operating risk more quickly. This effect is enhanced if the company is
using acquisition as a mean of diversification into new product/market
areas.
(iii) Acquisition may permit the company to make operating economies
through the rationalization and elimination of duplication in areas
such as research and development, debt collection and corporate
relations.
(iv) Acquisition may allow the company to achieve a better level of asset
backing if it has a high ratio of sales to assets.
Disadvantages of growth by acquisition
(i) If the acquisition is being made for strong strategic reasons, there
may be competition between bidding companies which may force the
price to rise to a level which may not be justifiable on financial
grounds.
(ii) Acquisition may involve significant reorganizations cost which may
result in lower earnings at least in the short term.
The company can achieve the optimal sale level by reducing 10%
price.
Taxation (W3)
(17.11) (97.79) (126.38) (157.07) (190.05)
Net deficit
(414.14) (285.36) (95.81)
W3: Taxation
Year 1 Year 2 Year 3 Year 4 Year 5
Net cash flow before taxation 267.02 455.97 551.27 653.55 763.51
Less: Depreciation (75+25+30) (130.00) (130.00) (130.00) (130.00) (130.00)
Taxable income 137.02 325.97 421.27 523.55 633.51
Carry forward tax losses (80.00) - - - -
Tax profit/(loss) 57.02 325.97 421.27 523.55 633.51
Tax @ 30% 17.11 97.79 126.38 157.07 190.05
Tutorial note: You may have calculated the exchange rate to three or more
decimal places. Here, the exchange rate has been estimated to just two decimal
places.
These cash flows in sterling should be discounted at the WACC.
The NPV in sterling is positive. The project is financially viable and should be
undertaken.
Year Rs.
0 Spot = 22.00
1 22(1.02) = 22.44
2 22 (1.02)2 = 22.89
3
3 22(1.02) = 23.35
In order to determine the cost of capital in ringgit using Interest Rate Parity,
the following formula is adopted.
1+𝑅𝐹 𝑆
1+𝑅𝐷
= 𝐹
where RF= Foreign Rate, RD = Domestic Rate, S = Spot Rate and F = Future
Rate
1+𝑅𝐹 22
1+0.10
= 22.44
RF = 7.8% ≅ 8%
Computation of NPV in ringgits.
Since the NPV at the required rate of return gives a positive value, the project
is viable.
(b) Reasons why business organisations engage in cross-border investment
include the following:
(i) To take advantage of new markets e.g coca-cola, electronics etc
(ii) To seek raw material e.g. Us Oil companies establishing business in
nations where there are oil deposits.
(iii) In search of new technology.
(iv) Avoidance of political and regulatory hurdles.
(v) Diversification.
(vi) Tax avoidance.
(vii) Possible benefits from variations in exchange rates.
(viii) Protection of profit margin.
(ix) Depriving another firm of any abnormal profit
This will result in tax savings of 100,000 Francs (40% × 250,000 Francs)
each year in years 2 – 5.
Year 0 1 2 3 4 5
FR FR FR FR FR FR
Equipment (1,000,000)
Tax saved
on capital
allowances 100,000 100,000 100,000 100,000
Cash profit 500,000 500,000 500,000 500,000
Tax on
cash profit (200,000) (200,000) (200,000) (200,000)
Net cash
flow (1,000,000) 500,000 400,000 400,000 400,000 (100,000)
DCF factor
at 16% 1.000 0.862 0.743 0.641 0.552 0.476
Present
value (1,000,000) 431,000 297,200 256,400 220,800 (47,600)
NPV = + 157,800
(b) Dividend payments
Year 1 2 3 4 5
FR FR FR FR FR
Cash profit 500,000 500,000 500,000 500,000
Tax on profit (200,000) (200,000) (200,000) (200,000)
Tax saving
from capital
allowance 100,000 100,000 100,000 100,000
Profit after tax 400,000 400,000 400,000 400,000
Dividend
(50%) 200,000 200,000 200,000 200,000 800,000
Retained 200,000 200,000 200,000 200,000
(c)
Year 1 2 3 4 5
FR FR FR FR FR
Dividend in
FR 200,000 200,000 200,000 200,000 800,000
Exchange 3× 3× 3× 3× 3×
rate (1.10/1.04) (1.10/1.04)2 (1.10/1.04)3 (1.10/1.04)4 (1.10/1.04)5
= 3.1731 = 3.3561 = 3.5498 = 3.7546 = 3.9712
Dividend in
$ 63,030 59,593 56,341 53,268 201,450
The project is not worthwhile because it has a negative NPV in dollars, even
though it has a positive NPV in Francs. This is because:
the restriction on dividend payments delays returns to the parent
company
the Franc is expected to fall in value against the dollar over the next
five years
Years 0 1 2 3 4 5
Evaluation of investment in Sri Lanka
LKR in million
Pre-tax cash flow
(annual increase by 8% from
year 0) 29.16 40.82 44.09 47.62 51.43
Tax @ 25% (7.29) (10.21) (11.02) (11.91) (12.86)
Cost of acquisition (90.00)
Plant and machinery (18.00)
Working capital (W4) (36.00) (2.88) (3.11) (3.36) (3.63) (3.92)
After tax net realizable value 167.9
Net cash flow (144.00) 18.99 27.50 29.71 32.08 202.55
Exchange rate LKR / PKR (W2) 1.3250 1.2777 1.2320 1.1880 1.1456 1.1047
Net cash flow from SISL in (PKR
in million) (108.68) 14.86 22.32 25.01 28.00 183.35
Additional tax @ 5% (W6) (PKR
in million) - (1.14) (1.66) (1.85) (2.07) (2.34)
Net cash flow (PKR in million) (108.68) 13.72 20.66 23.16 25.93 181.01
Discount factor (@
15.12)(W5)(PKR in million) 1.00 0.87 0.75 0.66 0.57 0.49
Present value (PKR in million) (108.68) 11.94 15.49 15.29 14.78 88.70
Net present value (PKR in
million) 37.52
Years 0 1 2 3 4 5
W3: Tax depreciation (BDT in million)
Opening balance 30.00 239.00 191.20 152.96 122.37
Machinery - 126.50
Building 30.00 82.50
30.00 239.00 239.00 191.20 152.96 122.37
Less: 20%
depreciation
allowance 47.80 38.24 30.59 24.47
30.00 239.00 191.20 152.96 122.37 97.90
Tax saved at the rate
of 35% 16.73 13.38 10.71 8.56
W4 : Working capital
Bangladesh BDT in million
Working capital ×
inflation factor 22.00 133.10 146.41 161.05 177.16
Increase in working
capital 22.00 111.10 13.31 14.64 16.11
Sri Lanka LKR in million
Working capital ×
inflation factor 36.00 38.88 41.99 45.35 48.98 52.90
Increase in working
capital 36 2.88 3.11 3.36 3.63 3.92
The results show that the investment has an expected net present value of
approximately CX 81.252 million, which indicates that it is worthwhile and
should add to shareholder value.
Calculations
Growth Inflation YEARS
0 1 2 3
Exchange rate (PY x 1.2 /
1.07) 45.000 50.470 56.600 63.480
CX in million
Cash flows in Country X 5% 7% (7.000) (0.535) (0.601) (0.675)
Cash flows in Country Y 20% (17.778) 4.042 6.360 7.894
Total nominal cash flows (24.778) 3.507 5.759 7.219
17.3 DUNBORGEN
Forward exchange contract
Dunborgen would need to buy $500,000, and the bank would charge a rate of
$1.566.
Dunborgen could borrow euros now, convert them into dollars and put the dollars
on deposit for six months.
The six month interest rate for US dollar deposits = 2.0% 6/12 = 1.0%.
It is assumed that the euros to purchase the dollars spot would be obtained by
borrowing for six months at 4.8%. Interest for six months would be 4.8% 6/12 =
2.4%.
The cost in euros to Dunborgen of a money market hedge, for comparison with the
cost of a forward contract, would therefore be:
A money market hedge would be less expensive in this case, and is therefore
recommended as the method of hedging the currency risk exposure.
Small company would pay 1.5% less than by borrowing direct (at ZIBOR +
2%) and the Zantland counterparty would borrow at 0.5% less than by
borrowing sterling direct at 8.5%.
(b) It is assumed that 15% is the appropriate discount rate for evaluating the
project’s cash flows in sterling. (A DCF rate of 15% would be very low for
evaluating the cash flows in zants, considering the expected high rate of
inflation in Zantland.)
It is also assumed that the swap will be undertaken, and in Year 0 Small
Company will spend £333,333 (3 million zants at the spot rate of 9.00). At
the end of Year 3, it is assumed that Small Company will receive the same
amount (£333,333) on the termination of the currency swap, and a further
3,000,000 zants for the remainder of the sale price of the operations centre.
The project cash flows will therefore be as follows:
Year
0 £(333,333)
1 200,000 zants at the end of Year 1 spot rate
2 200,000 zants at the end of Year 2 spot rate
3 200,000 zants at the end of Year 3 spot rate
3 3,000,000 zants at the end of Year 3 spot rate
3 3,000,000 zants at the swap rate of 9.00, therefore £333,333.
Conclusion
On the basis of the assumptions used, the project would have a positive NPV
if inflation in Zantland exceeds inflation in the UK by 10% per year, but will
have a negative NPV if inflation in Zantland exceeds inflation in the UK by
50% per year.
There is consequently an element of risk in the project due to uncertainty
about the spot exchange rate, and this risk element should be assessed
more closely before a decision is taken about the investment.
Purchases
Per ton
Qty. Amount Conv.
Month cost Rupees
(ton) (bhat) rate
(bhat)
June (Buy
one month
forward) 50,000 4,000 200,000,000 2.33 466,000,000
1,159,000,000
Sales
Per ton
Qty. Amount Conv.
Month revenue Rupees
(ton) (US$) rate
(US $)
July (Sell two
month fwd.) 2,000 4,000 8,000,000 65.77 526,160,000
Aug. (Sell three
month fwd.) 2,000 6,000 12,000,000 66.10 793,200,000
1,319,360,000
Profit on transactions (sales minus purchases) 160,360,000
Less: Commission costs (0.01%) (247,836)
160,112,164
(b) If the shipment is delayed for a period of two month
Purchases
Per ton
Qty. Amount Conv.
Month cost rate
Rupees
(ton) (bhat)
(bhat)
June (Buy
one month
forward) 50,000 4,000 200,000,000 2.33 466,000,000
July (Buy two
month
forward) 50,000 6,000 300,000,000 2.31 693,000,000
July
(Cancelled at
spot) 50,000 (6,000) (300,000,000) 2.29 (687,000,000)
July (Buy 2
months
forward) 50,000 6,000 300,000,000 2.28 684,000,000
1,156,000,000
Sales
Per ton
Qty. Amount Conv.
Month revenue Rupees
(ton) (US$) rate
(US $)
July (Sell two
month
forward) 2,000 4,000 8,000,000 65.77 526,160,000
Aug. (Sell
three month
forward) 2,000 6,000 12,000,000 66.10 793,200,000
July (Buy 1
month
forward) 2,000 (6,000) (12,000,000) 65.96 (791,520,000)
July (Sell 3
month
forward) 2,000 6,000 12,000,000 66.38 796,560,000
1,324,400,000
Per ton
Qty. Amount Conv.
Month revenue Rupees
(ton) (US$) rate
(US $)
Profit on transactions (sales minus purchases) 168,400,000
Less: Commission costs (0.01%) (475,044)
167,924,956
(c) If shipment is cancelled on July 31, 2016
Purchases
Per ton
Qty. Amount Conv.
Month cost Rupees
(ton) (bhat) Rate
(Bhat)
June (Buy one
month
forward) 50,000 4,000 200,000,000 2.33 466,000,000
July (Buy two
month
forward) 50,000 6,000 300,000,000 2.31 693,000,000
July
(Cancelled
at spot) 50,000 (6,000) (300,000,000) 2.29 (687,000,000)
472,000,000
Sales
Per ton
Qty. Amount Conv.
Month revenue Rupees
(ton) (US$) rate
(US $)
July (Sell two
month forward) 2,000 4,000 8,000,000 65.77 526,160,000
Aug. (Sell three
month fwd.) 2,000 6,000 12,000,000 66.10 793,200,000
July (Buy 1
month
forward) 2,000 (6,000) (12,000,000) 65.96 (791,520,000)
527,840,000
Recommendation:
Feasible option for 3 month net payment -------------------------------> Money Market
Feasible option for 6 month net payment ------------------------------> Forward Cover
Conclusion:
For the first quarter, SL would be better off with money market hedge
as it would receive more MYR than with a forward contract.
For the second quarter, forward exchange contract produces a lower
net payment in MYR.
(b) SL wishes to lend and so will buy 5 (MYR 15,000,000 / MYR 3,000,000)
interest rate February Futures.
(i) If interest rates fall by 0.75% and March Futures price increases by 1%,
the net hedging position of the interest rate future would be as follows:
MYR
Future outcome MYR 15,000,000 x 6/12 x 1% 75,000
Receipt in spot (MYR 15,000,000 x 5.25% x
market 6/12) 393,750
Net outcome 468,750
Target outcome (6% x 6/12 x MYR 15,000,000). 450,000
Gain on hedging through interest rate futures 18,750
(ii) If interest rates rise by 1% and March Futures price decreases by 1%,
the net hedging position of the interest rate future would be as follows:
MYR
Future outcome 15,000,000 x 6/12 x 1% (75,000)
Receipt in spot
market (MYR 1,500,000 x 7% x 6/12) 525,000
Net outcome 450,000
Target outcome 450,000
No gain or loss (100% efficient) -
(a) USA
The full receipt i.e. US $ 1.50 will be hedged.
Hedging through Forward Contract
KC would sell US $ 1.5 million three months forward at Rs. 87.0 per US $
and receive Rs. 130.5 million.
Hedging through Money Market
To obtain US $ 1.5 million, borrow now: (1.5 million ÷
[1+(5.20%x3/12)] = $ 1.48
US $ will be converted into Rs. at spot: US $ 1.48 million x
Rs. 86.56 = Rs. 128.11
Rs. 128.11 million will be invested in Pakistan: Rs.
128.11x[1+(8.5%x3/12)] Rs. 130.83
UK
The receipts and payments can be netted off : (£ 5.10 - £ 4.0) = £1.10
Hedging through Forward Contract
KC should buy £ 1.1 million three months forward at Rs. 136.18 per £ and
pay Rs. 149.8 million.
Hedging through Money Market
To earn £ 1.1 million, invest now: £ 1.1 million ÷ [1+(5.00% x
3/12)] = £1.09
Purchase £ at spot rate : £ 1.09 x Rs. 135.13 Rs. 147.29
Borrow Rs. 147.29 million in Pak at 10.5%: Rs. 147.29m x
[1+(10.5% x 3/12) = Rs. 151.16
(b) Payments Receipts Total
KC-(Pak) KA-(USA) KB-(UK)
Rs. in million
KC-(Pak) - 131.00 688.30 819.30
KA-(USA) 130.02 - 390.06 520.08
KB-(UK) 539.84 242.93 - 782.77
Total receipts 669.86 373.93 1,078.36 2,122.15
Total
payments (819.30 ) (520.08 ) (782.77 ) (2,122.15)
Net payment
-
/ (receipts) 149.44 146.15 (295.59)
Without multilateral netting, the group companies would have required to
pay Rs. 2,122.15 million as shown in the above table. On account of
multilateral netting, the amounts payable and receivable were netted and
as a result the amount required to be paid/received was reduced to Rs.
295.59 million i.e. 13.93% of the gross amount, resulting in savings of
transaction/hedging costs.
In the answer in (b), it is assumed that the company will sell 6 March
sterling/US dollar futures.
(b) The US company will close its position in January, when the futures price is
1.8420.
The value of 1 tick for this contract is 62,500 × $0.0001 = $6.25.
$
From sale of £400,000 spot at $1.8450/£1 738,000
Profit on futures position 6,750
Total income 744,750
18.3 BASIS
(a) On 1st March: Days to settlement of the June futures contracts = 31 + 30 +
31 + 60 = 122 days.
On 1 March
Spot rate 1.8540
Futures price 1.8760
Basis 0.0220
The basis is 220 points, with the futures rate higher than the spot rate.
The basis at the end of June when the futures reach settlement will be 0.
It is assumed that basis will decrease to zero at a constant rate per day. The
basis will therefore reduce by (220 points/122 days) = 1.80328 points per
day.
At close of trading on 30th April, there are (31 + 30) 61 days remaining to the
settlement of the June futures. The expected basis at this date is therefore:
1.80328 points per day × 61 days = 110 points.
(b) At close of trading on 15th June, there are 15 days remaining to the
settlement of the June futures. The expected basis at this date is therefore:
1.80328 points per day × 15 days = 27 points.
$
At 20th April: expected value of £625,000 receivable (at
1.8050) 1,128,125
At 20th July: actual value of £625,000 received (at 1.7700) 1,106,250
Loss on underlying currency exposure 21,875
Total gain (10 contracts) = 10 contracts × 200 ticks per contract × £6.25 per
tick = $12,500.
The futures position has failed to provide a perfect hedge, resulting in a net
‘loss’ of $9,375.
Effective exchange rate $
Revenue from sale of £625,000 spot on 20th July
(at 1.7600) 1,100,000
Gain on futures position 12,500
Total dollar income 1,112,500
(b) The reason why the hedge is not perfect in this case is explained by the
existence of basis. When the futures position was opened, the basis was 250
points (1.8050 – 1.7800). When the position was closed, the basis was 100
points (1.7700 – 1.7600). The spot price has moved in value during the three
months by more than the movement in the futures price, by 150 points. The
value of this difference is $9,375 (10 contracts × 150 ticks per contract ×
£6.25 per tick).
The payments are due in October. The company should therefore buy futures
with the next settlement date following. It should buy December contracts at
0.6929.
The remaining €10,000 that is not hedged by futures can be purchased
forward at 1.4443, at a cost of £6,924.
If the basis is 0 when the futures position is closed in October, the effective
exchange rate for the €2,100,000 will be £0.6929 = €1, or £1 = €1.4432.
The net cost in sterling will be:
£
€2,100,000 at $1.4432/£1 1,455,100
€10,000 at €1.4443/£1 6,924
Total cost in sterling 1,462,024
The money market hedge is the cheapest method of hedging.
The investor could purchase 12 put options at a strike price of 1,000 (£10) or
40 put options at a strike price of 950 (£9.50).
Tutorial note:
The investor’s decision will depend on how far he expects the share price to
fall. The options with a strike price of 1,000 (£10) are currently in the money
but the investor can only buy 12 such contracts. As the share price falls, the
intrinsic value of these options rise but the intrinsic value of the options with
a strike price of 950 (£9.50) will remain at zero until the share price falls below
£9.50. For any fall below this the investor will gain more from these 40
contracts than he would from the 12 other contracts.
The share price at which the investor would be indifferent between the two
options can be found as follows:
Let x = the share price at which each course of action would yield the same
return.
The investors return would be equal when:
12(1,000 – x) = 40 (950 – x)
12,000 – 12x = 38,000 – 40x
28x = 26,000
x = 928.57 (£9.29)
If the investor expects the share price to fall below this he should invest in 40
put options with a strike price of 950.
If the investor expects the share price to fall but not below £9.29 he should
invest in 12 put options with a strike price of 1,000.
(b) If the share price is 910 at expiry and the investor still holds the options, the
options will be exercised. It is assumed that he buys the options at 950.
Traded equity options are settled by physical delivery. The investor would
need to buy shares at 910 and exercise the option to sell them at 950.
£
Buy 40 × 2,000 shares at 910 728,000
Buy 40 × 2,000 shares at 950 760,000
Profit on exercise 32,000
Cost of options 12,000
Net profit on speculative investment 20,000
(Note: This calculation of the profit ignores the time value of money. The
options are paid for when they are bought, but the profit is made only when
the options are exercised).
Traded equity options can be bought and sold on the exchange, and the
investor is likely to sell the put options before they expire, making a profit on
the sale. As the options become increasingly in-the-money, their market
value will increase.
Conclusion:
DEF should square its position in SPL shares by exercising the option and selling
the shares at the future price as it gives the highest return.
DEF should not exercise option of DESC shares as this will result in loss to the
company.
20.1 FRA
(a) The company wants to borrow in three months’ time for a period of six
months; therefore to create a hedge with an FRA, it must buy a 3v9 FRA.
The interest rate for the FRA is 3.97%.
The company will borrow in three months’ time at the current LIBOR
rate plus 0.50%.
The FRA will be settled in three months’ time.
If the six-month LIBOR rate is higher than 3.97%, the company
will receive a payment from the bank to settle the FRA. The
amount of this payment is the value of the difference between the
FRA rate of 3.97% and the LIBOR rate.
If the six-month LIBOR rate is lower than 3.97%, the company
will make a payment to the bank to settle the FRA, for the value
of the difference between the two rates.
The effect of the FRA is therefore to ‘lock in an effective interest rate of
3.97% + 0.50% = 4.47%.
Tutorial note: For example, if the LIBOR rate in three months is 5.5%,
the situation will be as follows:
%
Company borrows at LIBOR + 0.50% 6.00
Company receives from settlement of FRA (5.50 – 3.97) (1.53)
Effective interest cost 4.47
20.2 SWAP
The company should enter into a four-year interest rate coupon swap in which it
receives the floating rate and pays the fixed rate (5.25%).
The effective interest rate will change from floating rate to fixed rate, as follows:
%
Bank loan interest (LIBOR + 1.25)
Swap
Pay (5.25)
Receive LIBOR
Effective rate (6.50)
%
Entity A can borrow more cheaply at a fixed rate by (7.25 – 6.35) 0.90
Entity A can borrow more cheaply at a floating rate by (1.25 – 0.75) 0.50
Difference 0.40
Bank’s profit 0.10
Net benefit to share between the two entities 0.30
If the entities share the benefit equally, each will be able to reduce its effective cost
of borrowing by (0.30/2) 0.15%.
Entity A wants to borrow at a floating rate. It can borrow directly at LIBOR +
0.75%. By borrowing at a fixed rate and swapping into a floating rate, its
effective interest rate will be LIBOR + 0.75% – 0.15% = LIBOR + 0.60%.
Entity B wants to borrow at a fixed rate. It can borrow directly at 7.25%. By
borrowing at a floating rate and swapping into a fixed rate, its effective
interest rate will be 7.25% – 0.15% = 7.10%.
For Entity A, the arrangement could be as follows:
%
Borrow at a fixed rate (6.35)
Swap payments
Pay (LIBOR)
Receive (balancing figure) 5.75
Effective interest cost (LIBOR + 0.60)
%
Borrow at a fixed rate (LIBOR + 1.25)
Swap payments
Pay (balancing figure) (5.85)
Receive LIBOR
Effective interest cost (7.10)
The bank’s profit would come from the difference between the fixed rate received
from Entity B (5.85%) and the fixed rate paid to Entity A (5.75%).
This assumes that the two Entities each arrange their swap with the bank, and not
directly with each other.
= 15 contracts.
Conclusion
The company should sell 15 March short sterling futures.
Conclusion
The company should sell 16 March eurodollar futures at 93.70.
(b) When the futures are sold, the basis is:
It is now the end of October. The March futures will reach settlement date in
five months’ time.
If we assume that the basis will reduce from 80 points at the end of October
to 0 by the end of March at an equal amount each month, by the end of
January the basis should be:
2 months to settlement
80 points = 32 points
5 months original time to settlement
Basis 0.0032
Gain 0.0152
(Note: This differs from the rate in the futures contracts sold in October. In
October, the interest rate in the sold futures was 6.30% (100 – 93.70). The
difference is 32 points, which is the amount of the basis risk. Here, the
company has benefited from the basis to obtain a lower borrowing cost).
Receive 4.52
Profit 0.517
FRA
The company should buy a 3v5 FRA, for a notional principal amount of £21
million. The FRA rate will be 5.38%.
(Note: The FRA rate is more favourable than the futures rate of 5.39% (100
– 94.610). The company would therefore prefer to buy an FRA than sell
futures. However, it might prefer to buy put options on futures rather than buy
an FRA).
In mid-June, the company will borrow £21 million for two months. If the
LIBOR rate is 6%, it will borrow at 6.75% (LIBOR + 0.75%) for two months.
Futures
The futures price in mid-June can be estimated as follows:
The company will close its position by buying 28 June futures at 93.995.
However, after taking into account the cost of the option premiums, the net
gain is reduced.
FRA
The company’s FRA bank will make a payment equivalent to (6% - 5.38%) =
0.62% per year on £21 million for two months, to settle the FRA.
The gain on the FRA will offset the higher interest cost of borrowing.
20.9 DEFINITIONS
(a) Interest rate swaps
An interest rate swap is an agreement between two parties to exchange
interest rate payments. The objective might be to:
Switch from paying one type of interest to another
Raise less expensive loans
Securing better deposit rates
In essence, party A agrees to pay the interest on party B’s loan, whilst party
B agrees to pay the interest on party A’s loan.
(b) Forwards
A forward contract is a binding agreement to exchange a set amount of
goods at a set future date at a price agreed today.
Forward contracts are used by business to set the price of a commodity well
in advance of the payment being made. This brings stability to the company
who can budget with certainty the payment they will need to raise.
Forwards are particularly suitable in commodity markets such as gold,
agriculture and oil where prices can be highly volatile.
Forward contracts are tailor-made between the two parties and therefore
difficult to cancel (as both sides need to agree). A slightly more flexible
approach would be to use futures
(c) Futures
Futures share similar characteristics to Forward contracts i.e.:
Prices are set in advance
Futures hedges provide a fixed price
Futures are available on commodities, shares, currencies and interest
rates.
Imran Limited
Imran Limited