Suggested Answers of Financial Management CAP II Examination – June 2011
The Institute of Chartered Accountants of Nepal
Suggested Answers of Financial Management
CAP II Examination – June 2011
1. A plastic manufacturer has under consideration the proposal of production of high quality plastic glasses. The necessary equipment to manufacture the glasses would cost Rs. 80,000. Investment allowance rate on purchases of equipment is 20%. The production equipment would last 5 years with no salvage value. The glasses can be sold at Rs. 3 each. Regardless of the level of production, the manufacturer will incur cash costs of Rs. 25,000 each year, if the project is undertaken. The overhead costs allocated to this new line would be Rs. 5,000. The variable cost is estimated at Rs. 2.0 per glass. The manufacturer estimates it will sell about 75,000 glasses per year; the straight line method of depreciation will be used; the applicable tax rate is 55%.
a) Calculate the cash outflows of the project. 5
b) Determine the project’s total present value at 0, 10, 20, 30 and 40 percent discount rate. 5
c) Present the net present value profile for the proposal. 3
d) Explore the relationship between Pay Back Reciprocal and IRR? 5
e) What is the basic assumption behind terminal Value Approach? 2
You can take the help of following PV table:
Year 
10% 
20% 
30% 
40% 
1 
0.909 
0.833 
0.769 
0.714 
2 
0.826 
0.694 
0.592 
0.510 
3 
0.751 
0.579 
0.455 
0.364 
4 
0.683 
0.482 
0.350 
0.260 
5 
0.621 
0.402 
0.269 
0.186 
Answer No. 1
(i) Cash outflows:
Particulars 
Rs 
Cost of new equipment purchases 
80,000 
Less: Investment Tax Credit (Rs16,000) x 55% 
8,800 
Net cash outflow 
71,200 
Cash inflows:
Particulars 
Rs 
Sales Revenue 
225,000 
Less Costs: 

Variable Costs 
150,000 
Additional Fixed Cost 
25,000 
Additional Depreciation 
16,000 
Earning Before Taxes 
34,000 
Less Taxes 
18,700 
Earning After Taxes 
15,300 
Add Depreciation 
16,000 
Cash Flow After Tax (t = 1 – 5) 
31,300 
(Note: Costs allocated from other departments will not be considered as they do not involve any corresponding incremental cash outflows)
(ii) PV at different rates of discount:
Rate of discount (%) 
PV factor 
Time (Years) 
CFAT (Rs.) 
Total PV (Rs.) 
0 
5.000 
15 
31,300 
156,500 
10 
3.791 
15 
31,300 
118,658 
20 
2.991 
15 
31,300 
93,618 
30 
2.436 
15 
31,300 
76,247 
40 
2.035 
15 
31,300 
63,696 
(iii)
Net present value profile for the project:
Rate of discount (%) 
NPV (Rs.) 
0 
85,300 
10 
47,458 
20 
22,418 
30 
5,046 
40 
(7,505) 
(iv) The reciprocal of the pay back is a good approximation of the IRR. The pay back period reciprocal can be applied to both annuity and mixed streams of cash flows. In case of annuity, pay back period of the proposed investment project is determined and factor closest to the pay back period in the year row is looked into. In case of mixed stream cash flows, average annual cash inflow is first calculated and approximated IRR is determined with the help of ‘fake’ pay back period.
(v) Basic assumption behind the Terminal Value approach is that each cash inflow is reinvested in another asset at a certain rate of return from the moment it is received until the termination of the project.
2. Following book value capital structure is available in respect of PQR Ltd.
(Rs. in million)
_________________________________________________________________________________________
Equity Capital (in shares of Rs. 100 each, fully paidup at par) 150
11% Preference Capital (in shares of Rs. 100 each, fully paidup at par) 10
Retained Earnings 200
13.5% Debentures (of Rs. 100 each) 100
15% Term Loan 125
_________________________________________________________________________________________
The next expected dividend per share on equity shares is Rs. 36 and the dividend per share is expected to grow at the rate of 7%. The market price per share is Rs. 400.
Preference stock, redeemable after 10 years, is currently selling at Rs. 75 per share. Debentures, redeemable after 6 years, are selling at Rs. 80 per debenture. The income tax rate for the company is 25%.
You are required to: (8 +7=15)
a) Calculate the weighted average cost of capital using market value proportion., and
b) Determine the weighted marginal cost of capital for the company, if it raises Rs. 100 million next year, given the following information:
· The amount will be raised by equity and debt in equal proportions.
· the company expects to retain Rs. 15 million earnings next year.
· the additional issue of equity shares will result in the net price per share being fixed at Rs. 320.
· the debt capital raised by way of term loan will cost 15% for the first Rs. 25 million and 16% for the next Rs. 25 million.
Answer No. 2
Working Notes:
(1) Cost of Equity Capital (K_{e}) and Cost of Retained Earnings (K_{r})
K_{e }= D_{1}/P_{0} + g = 36/400 + 0.07 = 0.09 + 0.07 =0.16 or 16%
(2) Cost of Preference Share Capital (K_{p})
K_{p} = D + (Rv – Sv) / N = 11 + (100 – 75) / 10 = 11 + 2.5 = 0.1543 or 15.43%
(Rv + Sv) /2 (100 + 75) / 2 87.5
(3) Cost of Debentures (K_{d})
K_{d} = I + (Rv – Sv) / N (1 – t) = 13.5 + (100 – 80) / 6 (1 – 0.25) = (13.5 + 3.33) 0.75
(Rv + Sv) /2 (100 + 80) / 2 90
= 0.14025, say, or 14.03%
Alternatively
Cost of Debenture (K_{d})
K_{d} = I(1  t) + (Rv – Sv) / N =
(Rv + Sv) /2
K_{d} =13.5 (1 –0.25) +(10080)/6
(100 + 80) /2
= 10.125+3.333
90
= 13.458
90
= 0.1495 or 14.95%
Note: Students may also use either of one formula to calculate the cost of debenture and same can be used to calculate WACC. In the solution first alternative is used.
(4) Cost of Term Loan (K_{t})
K_{t} = I (1 – t)
0.15 (1 – 0.25) = 0.15 x 0.75 = 0.1125 or 11.25%
On first Rs. 25 million Term Loan = 0.15 (1 – 0.25) = 0.1125 or 11.25%
On the next Rs. 25 million Term Loan = 0.16 (1 – 0.25) = 0.12 or 12%
(5) Cost of Fresh Equity Shares (K_{e})
K_{e} = D1/P0 + g = 36/320 + 0.07 = 0.1825 or 18.25
(i) Calculation of Weighted Average Cost of Capital (WACC) using market value proportion:
________________________________________________________________________________________________
Source of Finance Market Value Weight Cost of Weighted cost
(Rs. Millions) Capital of Capital %
___________________________________________________________________________________________________
Equity Capital 600.00 0.739 0.1600 0.11824
(1.5 million shares x Rs. 400
11% Preference Capital
(1 lakh shares x Rs. 75) 7.50 0.009 0.1543 0,00139
13.5% Debentures 80.00 0.098 0.1403 0.01375
(1 million debentures x Rs, 80)
15% Term Loan 125.00 0.154 0.1125 0.01733
812.50 WACC: 0.15071
___________________________________________________________________________________________________
Therefore, WACC = 15.07%
Note: Retained earnings are not considered for calculating WACC since it does not have any market value separately. The market value of equity shares reflects the value of retained earnings as well.
* Alternatively 0.1495 or 14.95% can be used to calculate WACC.
(ii) Calculation of WACC of PQR Ltd. when it raises Rs. 100 million next year:
________________________________________________________________________________________________
Source of Finance Amount Weight Cost of Weighted cost
(Rs. Millions) of Capital of Capital %
___________________________________________________________________________________________________
Retained Earnings 15 0.15 0.1600 0.02400
Debt 15 0.15 0.1125 0.01688
Equity Shares 10 0.10 0.1825 0.01825
Debt 10 0.10 0.1125 0.01125
Equity Shares 25 0.25 0.1825 0.04563
Debt 25 0.25 0.1200 0.03000
100 0.14601
Therefore, WACC of raising Rs.100 million next year = 14.60%
3.
a) Progressive Manufacturers Ltd. has sales of Rs. 250 million of which 80 per cent is on credit basis. The present credit terms of the company are “2/15, net 45”. At present, the average collection period is 30 days. The proportion of sales on which customers currently take discount is 0.50.
The firm is considering relaxing its discount terms to “3/15, net 45”. Such a relaxation is expected to increase current credit sales by Rs. 10 million, reduce the average collection period to 27 days and increase the proportion of discount sales to 0.60. The average selling price of he company’s product is Rs. 1,000 per unit and variable cost per unit works out to be Rs. 800. The company is subject to a tax rate of 25 per cent and it’s, before tax rate of borrowings for working capital is 12 per cent.
Should the firm change its credit terms to “3/15, net 45”? Support your answers by calculating the expected change in net profit (assume 360 days in a year) 8
(* Note: In the question the information is found missing "by Rs. 10 million, reduce the average collection period to 27 days and increase the proportion of discount sales to 0.60.")
b) Describe the term “beta coefficient” as used in the portfolio theory. Explain what does the value of beta of 1, less than 1 and more than 1 signify. (5+2=7)
Answer No. 3
a)
Total Sales = Rs. 250 million
Credit Sales = Rs. 250 x 0.80 = Rs. 200 million
(a) Present Credit Policy:
Present credit terms are ‘2/15, net 45’
Present average collection period = 30 days
Proportion of sales on which customers currently take discount is 0.5, or 50%.
(b) Basic revenue and cost structure applicable to both the policies:
Selling price per unit: Rs. 1,000
Variable cost per unit: Rs. 800
Contribution per unit: Rs. 200
P / V Ratio = 200/1,000 x 100 = 20%
Contribution from increased sales = Rs. 1,000,000 x 20% = Rs. 200,000
(c) Relaxed Credit Policy:
Reduction in average collection period to 27 days
Increase in proportion of discount sales to 0.60, or 60%
Change in the investment of Receivables
= [Rs. 200 million x 27 – 30 ] + [Rs. 10 million x 80/100 x 27/360]
360
= () Rs. 1.667 million + Rs. 0.60 = () Rs. 1.0667 million
Therefore, the reduction in receivables investment is Rs. 1.0667 million.
Saving in cost from reduction in receivables investment
= 1.0667 x 0.12 (1 – 0.25) = 0.096 million
Increase in discount cost
= [(Rs. 200 + 10) x 60/100 x 3/100] – (200 x 50/100 x 2/100)
= 3.78 – 2 = Rs. 1.78 million
Statement showing Profitability of Relaxing Credit Policy
(Rs. in million)
Contribution from Increased Sales 2.000
Cost savings from Reduction in the Receivables Investment 0.096
2.096
Less: Incremental Discount Cost 1.780
Incremental Profit 0.316
The firm can increase its profits by Rs. 0.316 million by relaxing the credit policy. Therefore, it is suggested to change the credit terms to ‘3/15, net 45’ from the present “2/15, net 45”.
b) Under capital asset pricing model (CAPM), the risk of an individual security can be estimated. The market related risk, which is also called ‘systematic risk’ is unavoidable even by diversification of the portfolio. The systematic risk of an individual security is measured in terms of its sensitivity to market movements which is referred to as security’s beta.
Beta coefficient is a measure of the volatility of stock price in relation to movement in stock index of the market. Thus, beta is the index of systematic risk. The beta factor of the market as a whole is 1.0. A beta of 1.0 of individual security indicates the average level of risk as compared to the market.
Mathematically, the beta coefficient of a security is the security’s covariance with the market portfolio divided by the variance of the market portfolio. Symbolically,
β_{i} = Cov _{im}. = σ_{i} σ_{m} Cor _{im}, where
Var_{m } σ_{m}^{2}
β_{i }= Beta of an individual security
Cov _{im}. = Covariance of returns of individual security with the market portfolio
Var_{m }= Variance of returns of market portfolio (σ_{m}^{2})
Cor _{im }= Correlation coefficient between the return s of individual security and the market portfolio
σ_{i }= Standard deviation of returns of individual security
σ_{m }= Standard deviation of returns of market portfolio
The degree of volatility can be expressed as follows:
· If beta is 1, then it has the same level of risk profile as the market as a whole.
· If the beta is less than 1, it is not as sensitive to systematic or market risk as the average investment.
· If beta is more than 1, it is more sensitive to the market risk than the average investment.
4.
a) Based on the credit rating of the bonds, an investor has decided to apply the following discount rate for valuing the bonds.
Credit rating Discount rate
AAA 364day Treasurybill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread
The investor is considering investing in an AA rated, Rs. 1,000 face value bond currently selling at Rs. 1,010. The bond has five years to maturity and the coupon rate on the bond is 15% per annum payable annually. The next interest payment is due one year from today and the bond is redeemable at par. (Assume 364day Treasury bill rate to be 9%)
You are required to calculate: (5+3=8) (4 + 4 = 8)
i) Intrinsic value of the bond for the investor. Should the investor invest in the bond?
ii) Current yield (CY) and the yield to maturity (YTM) of the bond.
b) The capital structure of Stable Ltd. is extracted below:
(Rs. in Million)
Equity capital: 100 thousand shares of Rs.100 each 10.0
Reserve and surplus 12.0
12% preference shares: 55,000 shares of Rs. 100 each fully paid up 5.5
14% debentures of Rs. 1,000 each; 3,000 numbers 3.0
Longterm loan from financial institution at 12% per annum 2.0
32.5
The company is also availing a bank overdraft of Rs. 2 million carrying interest at 15% per annum. The company is now drawing up its profit plan for the next year. It wants to pay dividend to equity shareholders at 15% and keep the total dividend payout (equity as well as preference shareholders) at 60%.
Assuming that the tax rate applicable to the company is 25%., what level of earnings (EBIT) should the company try to achieve to meet its plan?
7
Answer No. 4
a) AA rated face value of bond = Rs. 1,000
Current selling price = Rs 1,010
Maturity period of bond = 5 years
Coupon rate of the bond = 15% per annum payable annually
Bond redeemable at par at the end of 5^{th} year.
Net interest payment is due on year from today.
Discount rate for AA rated bond = 9% + 3% + 2% = 14%
Calculation of Present Value of Cash Inflow from Bond
(Rs.
____________________________________________________________________________________________________________________________________________________________
Yearend Cash Inflow PV Factor at 14% Present Values ___________________________________________________________________________________________________________
1 150 0.8772 131.58
2 150 0.7695 115.43
3 150 0.6750 101.25
4 150 0.5921 88.82
5 1,150 0.5194 597.31
Present value of total Cash Inflow: 1,034.40
Thus, the intrinsic value of bond is Rs. 1,034.40. Since the intrinsic value of bond (Rs. 1,034.40) is more than its current market value (Rs. 1,010), it is suggested to purchase the bond.
Current yield = Annual Bond Interest x 100 = 150 x 100 = 14.85%
Market price 1,010
Yield to Maturity (YTM)
P = Rs. 150 x PVIFA @ 15% for 4 years + Rs. 1,150 x PVIF at 15% for 5^{th} year
= (150 x 2.855) + (1,150 x 0.4972 = 428 + 571.78 = 1,000.03
Present value at 14% = Rs. 1,034.40
Present value at 15% = 1,000.03
By interpolation, YTM = 14 + 1,034.40 – 1,010 x 1 = 14% + (24.40 / 34.37) = 14.71%
1,034.40 – 1,000.03
b)
Let ‘x’ be the EBIT to meet the company’s commitments.
Interest Payable Yearly (Rs. in Million)
On debentures @ 14% on Rs. 3 million 0.42
On long term loan of Rs. 2 million @ 12% 0.24
On bank overdraft of Rs. 2 million @ 15% 0.30
0.96
Profit before tax (PBT) = EBIT – 0.96 = x – 0.96
Tax at 25% = (x – 0.96) / 4
Profit after tax (PAT) = 3 (x – 0.96) / 4
Total dividend payable (Rs. in Million)
On preference capital of Rs. 5.5 million @ 12% 0.66
On equity capital of Rs. 10 million 1.50
2.16
Total dividend payout is limited to 60% of PAT and is also equal to Rs. 2.16.
Therefore, 3 (x – 0.0.96) /4 x 60 / 100 = 2.16
Or 3(X0.96)/4=216/60
Or X0.96=3.6x4/3
Or, x – 0.96 = 4.80
Or, x = 4.80 + 0.96 = 5.76
Hence, earnings before interest and tax should be Rs. 5.76 million.
5.
a) The following information pertains to a company:
Net profit (Rs. in ‘000) 60,000
12% preference shares capital (Rs. in ‘000) 20,000
Number of equity shares outstanding (in ‘000) 60
Return on investment 20%
Equity capitalization rate 16%
You are required to: (4.5+1.5=6)
i) Compute the dividend payout ratio so as to keep the share price at Rs. 412.50 by using Walter model, and
ii) Ascertain (giving reasons) the optimum payout ratio if return on investment is 16% and equity capitalization rate is 18%.
a) The beta coefficient of security X is 1.6. The risk free rate of return is 12% and the required rate of return is 18% on the market portfolio. If the dividend expected during the coming year is Rs. 25 and the growth rate of dividend and earnings is 8%, at what price should the security X can be sold based on the capital asset pricing model. 5
b) An investor saw an opportunity to invest in a new security with excellent growth potential. He wants to invest more than he had, which was only Rs. 100,000. He sold another security short with an expected rate of return of 15%. The total amount he sold was Rs. 400,000, and the total amount he invested in the growth security, which had an expected rate of return of 30%, was Rs. 500,000. Assuming no margin requirements, what is the investor’s expected rate of return? 4
Answer No. 5
a) Calculation of Earnings per Share (EPS) (Rs. in ‘000)
Net Profit 60,000
Less: Preference Dividend (20,000 X 12 / 100) 2,400
Net Profit after Preference Dividend 57,600
Earnings per Share in Rs. [Rs 57,600,000/60,000] 960
(i) Calculation of Dividend Payout Ratio:
Let dividend payout ratio be ‘x’. The formula for share price under Walter model is::
P = D + r / K_{e} (E – D), where
K_{e}
P = Market price per share (Rs. 412.50 Given)
E = Earnings per share (Rs. 960 derived above)
D = Dividend per share (Rs. 960 x Given)
r = return on investment (0.20 given)
K_{e} = Cost of equity (0.16 Given)
Substituting the values, we get:
412.50 = 960 x + 0.20/0.16 (960 – 960 x)
0.16
Or, 412.50 = 60 x + 1.25 (60 – 60 x)
0.16
Or, 412.50 = 60 x + 75  75 x
0.16
Or, 66 = 1,200 – 240x
Or, x = 4.725, or 472.5%
Thus, the required dividend payout ratio is 472.5%.
(ii) Optimum Payout Ratio when Return on Investment (16%) is less than Equity Capitalization Rate (18%)
According to Walter model, when return on investment is less than the cost of capital, the value of the share is highest when dividend payout is maximum. It is evident that when r/Ke is less than 1, higher dividend will maximize the value per share. Therefore, the dividend payout should be 100% in this case.
b) Expected rate of return is calculated as follows by applying CAPM formula:
E (R_{i}) = R_{f} + Bi (R_{m} – R_{f})
= 12% + 1.6 (18%  12%) = 12% + 9.6% = 21.6%.
Price of security X is calculated with the use of dividend growth model formula as follows:
R_{e} = D_{1} / P_{0} + g, where
D_{1} = Expected dividend during the coming year
R_{e} = Expected rate of return on security X
g = Growth rate of dividend
P0 = Price of security X
Substituting the values, we get:
0.216 = 25/ P_{0} + 0.08,
Or, 0.216 = 2.50 + 0.08 P_{0}
P_{0}
Or, 0.216 P_{0} = 25 + 0.08 P_{0}
Or, 0.216 P_{0} – 0.08 P_{0} = 25,
Or, 0.136 P_{0} = 25
Or, P_{0} = 25 / 0.136 = Rs. 183.82.
The price at which the security X should be sold as per CAPM is Rs. 183.82.
c)
Computing the portfolio weights for each security is done with the formula:
Investment in A (sold short)
Total equity investment
From the given problem, we find:
W_{A} =  Rs, 400,000/ Rs. 100,000 =  4.0
W_{B} = Rs. 500,000 / Rs. 100,000 = 5.0
R_{p} = ( 4 x 0.15) + (5 x 0.30) =  0.60 + 1.50 = 0.90, or 90%.
Thus, the expected rate of return on this portfolio is 90%.
6. Write short notes on: (4×2.5=10)
a) Factoring services
b) Commercial paper
c) Perpetuities
d) Inflation Premium
Answer No. 6
a) Factoring services  Factoring is a unique financial innovation. It is both a financial as well as a management support to a client. It is a method of converting a non productive, inactive asset like receivable into a productive asset like cash by selling receivables to a company that specializes in their collection and administration. Factoring is a business involving a continuing legal relationship between a financial institution (factor) and a business concern (client) selling goods or providing services to trade customers whereby the factor purchases the client's account receivable and in relation thereto, controls the credit, extended to customers and administers the sales ledger. Basically three kinds of services fall into this: sales ledger administration and credit management, credit collection and protection against default and bad debt losses, financial accommodation against the assigned book debts.
b) Commercial Paper  It is an important money market instrument in advanced countries like USA to raise short term funds. It is a form of unsecured promissory note issued by firms to raise short term funds. The commercial paper market in the USA is a bluechip market where financially sound and highest rated companies are able to issue commercial papers. The buyers of commercial paper include banks, insurance companies, unit trusts and firms with surplus funds to invest for a short period with minimum risk. Given this objective of the investors in the commercial paper market, there would be demand for commercial papers of highly creditworthy companies.
c) Perpetuities can be defined as a stream of equal payments expected to continue for ever. Most annuities call for payments to be made over some finite period of time, for example, Rs1000 per year for five years. However, some annuities go for indefinitely, or perpetually, and these are called perpetuities. The present value of perpetuities is found as below:
PV (Perpetuities) = Payment/ Interest Rate
Most preferred stocks entitle their owners to regular, fixed dividend payments lasting forever. These are one of the examples of ‘perpetuities’.
d) ‘Inflation Premium’ is the premium for expected inflation that investors add to the real risk free rate of return. Inflation has a major impact on interest rates because it erodes the purchasing power and lowers the real rate of return on investment. Investors are well aware of all this, so when they lend money, they build in an inflation premium equal to the average inflation rate expected over the life of the security. Therefore, if the real risk free rate is 4 percent and if inflation is expected to be 5% (and hence inflation premium=5%) during the next year, then the quoted rate of interest would be 9%.
7. Distinguish between: (4×2.5=10)
a) Asset Beta Vs. Equity Beta
b) Discrete Probability Distribution and Continuous Probability Distribution
c) Proxy fight and Takeover
d) Business Risk and Financial Risk
Answer No. 7
a) Assets of a leveraged firm are financed by debt and equity. Therefore, the assets beta should be the weighted average of the equity beta and the debt beta. For an unlevered (all equity) firm, the asset beta and the equity beta would be the same. Debt is less risky than equity. Hence the beta of debt will be lower than the equity beta. In case of the risk free debt, beta will be zero. For a levered firm, the proportion of equity will be less than 1. Therefore, the beta of asset will be less than the beta of equity.
There is also a linear relationship between the equity beta and the financial leverage. As the financial leverage increases, the equity beta also increases. The equity beta is equal to the asset beta if debt is zero.
b) Discrete Probability Distribution and Continuous Probability Distribution
In case of ‘Discrete Probability Distribution’ the number of possible outcome is limited or finite. Suppose, if we assume that there will be only three states of economy; recession, normal or boom, this will be the example of discrete probability distribution.
In other hand, if we assume that there will be unlimited or infinite number of possible outcomes that will be the case of continuous probability distribution. With continuous distribution, it is more appropriate to ask what the probability is of obtaining at least some specified rate of return than to ask what the probability is of exactly that rate.
c) Management always solicits stockholders’ proxies and usually gets them. However if earnings are poor and stockholders are dissatisfied, an outside group might solicit the proxies in an effort to overthrow management and take control of the business. This is known as proxy fight.
Takeover is an action whereby a person or group succeeds in ousting a firm’s management and taking control of the company. In recent years there are cases, where attempts have been made by one corporation to take over another by purchasing a majority of the outstanding stock.
d) Business Risk is defined as the uncertainty inherent in projections of future Return on Assets (ROA), or of Returns on Equity (ROE) if the firm uses no debt. Business risk is the single most important determinant of capital structure. Business risk varies from one industry to another and also among firms in given industry.
Financial risk is the additional risk placed on the common stockholders as a result of using financial leverage, which results when a firm uses fixed income securities (debt and preferred stock) to raise capital. Thus, it is the portion of stockholders’ risk, over and above basic business risk, resulting from the manner in which the firm is financed.