BHAVIK CHOKSHI

BENCHMARX ACADEMY

ADVANCED FINANCIAL MANAGEMENT (PAPER 2)

TEST 1
SUGGESTED ANSWERS

Q.1 (a)

Workings:
Asset turnover ratio = 2 times
Total Assets = ₹ 1200 lakh

Turnover ₹ 1200 lakhs × 2 = ₹ 2400 lakhs

Interest on Debentures = 350 lakh x 10% = 35 lakhs
Operating Margin = 10%
Hence operating cost = (1 - 0.10) 2400 lakhs = ₹ 2160 lakhs
Dividend Payout = 20%
Tax rate = 30%
(i) Income statement

Particulars (₹ Lakhs)
Sale 2,400
Operating Expenses 2,160
EBIT 240
Interest 35
EBT 205
Tax @ 30% 61.5
EAT 143.5
Dividend @ 20% 28.7
Retained Earnings 114.8

(ii) SGR = Return on Equity (1 - Dividend Payout Ratio)

= ROE (1-b)
PAT
ROE = NW
and NW = ₹ 200 lakh + ₹ 600 lakh = ₹ 800 lakh
₹ 143.5 lakhs
ROE = × 100 = 17.94%
₹ 800 lakhs
0.1794 × 0.80 0.14352
SGR = 0.1794 (1 - 0.20) = 14.35% or = = 16.76%
1−0.1794 × 0.80 0.85648

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(iii) Calculation of fair price of share using dividend discount model

D0 (1+g)
P0 =
ke −g

₹ 28.7 lakhs
Dividends = = ₹ 1.435
20 lakhs

Growth Rate = 14.35% or 16.76%

₹ 1.435(1+ 0.1435) ₹ 1.64
Hence Po= = = ₹ 44.93 or 44.96
0.18 − 0.1435 0.0365
1.435(1+ 0.1676) ₹ 1.676
or = = ₹ 135.16 or 135.12
0.18 − 0.1676 0.0124

(iv) Since the current market price of share is ₹ 28, the share is undervalued. Hence, the
investor should invest in the company.

Q.1 (b)

(a) Swap Ratio

Gross NPA 3:30 3/30 x 20% 0.02

CAR 4:12 4/12 x 24% 0.079
Market Price 10:9 10/92 x 30% 0.0326
Book Value Per Share* 12:120 12/120 x 26% 0.026
0.1576

Thus for every share of Weak Bank, 0.1396 share of Strong Bank shall be issued.

*Calculation of Book Value Per Share

Particulars Weak Bank Strong Bank

(W) (S)
Share Capital (₹ Lakhs) 150 500
Reserves & Surplus (₹ Lakhs) 80 5,500
230 6,000
Less: Preliminary Expenses (₹ Lakhs) 50 --
Net Worth or Book Value (₹ Lakhs) 180 6,000
No. of Outstanding Shares (Lakhs) 15 50
Book Value Per Share (₹) 12 120

(b) No. of equity shares to be issued:

150
× 0.1576 = 2.364 lakh shares
10

(c) Balance Sheet after Merger

Calculation of Capital Reserve

Particulars Amount
Book Value of Shares ₹ 180.00 lac

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Less: Value of Shares issued ₹ 20.64 lac

Capital Reserve ₹ 156.36 lac

Balance Sheet

Liabilities ₹ lac Assets ₹ lac

Paid up Share 523.64 Cash in Hand & 2,900.00
Capital RBI
Reserves & 5,500.00 Balance with 2,000.00
Surplus other banks
Capital Reserve 156.36 Investment 20,100.00
Deposits 48,000.00 Advances 30,500.00
Other Liabilities 3,390.00 Other Assets 2,070.00
57,570.00 57,570.00

(a) Calculation CAR & Gross NPA % of Bank ‘S’ after merger

Total Capital
CAR/CRWAR =
Risky Weighted Assets

Particulars Weak Bank Strong Bank Merged

4% 12%
Total Capital ₹ 180 lac ₹ 6,000 lac ₹ 6,180 lac
Risky Weighted ₹ 4,500 lac ₹ 50,000 lac ₹ 54,500 lac
Assets

6,180
CAR = ×100 = 11.34%
54,500

Gross NPA
GNPA Ratio = ×100
Gross Advances

Particulars Weak Bank Strong Bank Merged

GNPA 0.30 0.03
(Given)
GNPAR GNPAS
0.30 = 0.03 =
₹ 3,500 lac ₹ 27,000 lac

Gross NPA ₹ 1,050 lac ₹ 810 lac ₹ 1,860 lac

GNPA = (₹ 1,860/₹ 30,500) × 100 = 6.09%

Q.1 (c)

Generally, a big company takes over a small company. When the smaller company gains
control of a larger one then it is called “Take-over by reverse bid”. In case of reverse take-
over, a small company takes over a big company. This concept has been successfully followed
for revival of sick industries. The acquired company is said to be big if any one of the
following conditions is satisfied:

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(i) The assets of the transferor company are greater than the transferee company;
(ii) Equity capital to be issued by the transferee company pursuant to the acquisition
exceeds its original issued capital, and
(iii) The change of control in the transferee company will be through the introduction of
minority holder or group of holder
Reverse takeover takes place in the following cases:
1) When the acquired company (big company) is a financially weak company
2) When the acquirer (the small company) already holds a significant proportion of
shares of the acquired company (small company)
3) When the people holding top management positions in the acquirer company want to
be relived off of their responsibilities.
The concept of take-over by reverse bid, or of reverse merger, is thus not the usual case of
amalgamation of a sick unit which is non-viable with a healthy or prosperous unit but is a
case whereby the entire undertaking of the healthy and prosperous company is to be merged
and vested in the sick company which is non-viable.

Q.2 (a)

(i) Calculation of Minimum price per share S Ltd. should accept from R Ltd
Residual Cash Flow 54,87,000
Value of S Ltd. = = = = ₹ 4,20,45,977
Ke −g 0.1305 − 0

4,20,45,977
Value per share of S Ltd. = = ₹ 5.26
80,00,000
3,99,95,000
Book Value of per share of S Ltd. = = ₹ 4.99 or ₹ 5
80,00,000

Therefore, the minimum price per share S ltd. should accept from R Ltd. is ₹ 5
(current book value)
(ii) Calculation of Maximum price per share R Ltd. shall be willing to offer to S Ltd.

Residual Cash Flow 90,10,000

Value of R Ltd. = = = ₹ 6,55,27,273
Ke −g 0.1357 − 0

1,85,00,000
Value of Combined entity = = ₹ 14,80,00,000
0.125 − 0

Value of synergy = Value of Combined entity – Individual values of R Ltd. and S Ltd.
= ₹ 14,80,00,000 – (₹ 4,20,45,977 + ₹ 6,55,27,273)
= ₹ 4,04,26,750

Maximum price per share R Ltd. shall be willing to offer to S Ltd. shall be
computed as follows:

Value of S Ltd.as per Residual cash flows + Synergy benefits

=
No of Shares
4,20,45,977 + 4,04,26,750
= = ₹ 10.31
80,00,000

(iii) Floor value of per share of S Ltd shall be ₹ 3.20 (current market price) and it shall
not play any role in decision for the acquisition of S Ltd. as it is lower than its current
book value.

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Q.2 (b)

P.V. of dividend stream and sales proceeds

Year Dividend /Sale PVF PV (₹)

(12%)
1 ₹ 30/- 0.862 25.86
2 ₹ 30/- 0.743 22.29
3 ₹ 30/- 0.641 19.22
4 ₹ 45/- 0.552 24.85
5 ₹ 45/ 0.476 21.43
6 ₹ 45/ 0.410 18.47
7 ₹ 45/ 0.354 15.92
7 ₹ 2,106/- (₹ 1,800 x 1.5 x 0.90) 0.354 860.22
₹ 1008.27
Less : - Cost of Share (₹ 1,,000 x ₹ 1,100
1.10)
Net Loss (91.73)

Since Mr. A is losing ₹ 91.73 per share, he should sell the share.
Maximum price Mr. A should be ready to sell at ₹ 1008.27 which will include incidental
expenses. So the maximum price should be ₹ 1008.27 x 100/110 = ₹ 916.61

Q.2 (c)

Unrelated companies come together to form an entity. Such relationship is called

conglomerate merger.
Such mergers involve firms engaged in unrelated type of business operations. In other words,
the business activities of acquirer and the target are neither related to each other
horizontally (i.e., producing the same or competing products) nor vertically (having
relationship of buyer and supplier).
Features:
 In a pure conglomerate merger, there are no important common factors between the
companies in production, marketing, research and development and technology.
 There may however be some degree of overlapping in one or more of these common
factors. Such mergers are in fact, unification of different kinds of businesses under one
flagship company.
 The purpose of merger remains utilization of financial resources, enlarged debt
capacity and also synergy of managerial functions.

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Q.3 (a)

(i) Intrinsic value of Bond

PV of Interest + PV of Maturity Value of
Bond Forward rate of interests
1st Year 16%
2nd Year 15.5%
3rd Year 15.25%
₹ 60 ₹ 60 ₹ 60
PV of interest = + + = ₹ 135.36
(1+ 0.16) (1+ 0.16)(1+ 0.155) (1+ 0.12)(1+ 0.155)(1+ 0.1525)

₹ 1000
PV of Maturity Value of Bond = = ₹ 624.62
(1+ 0.16)(1+ 0.155)(1+ 0.1525)

Intrinsic value of Bond = ₹ 135.36 + ₹ 647.62 = ₹ 782.98

(ii) Expected Price = Intrinsic Value x Beta Value
= ₹ 782.98 x 1.05 = ₹ 822.129

Q.3 (b)

(i) Working Notes:

Present Value of Cash Flows (CF) upto 5 years

Year CF of Yes PVF PV of CF CF of PV of CF

End Ltd. @15% (₹ lakhs) Merged of Merged
(₹ lakhs) Entity Entity
(₹ lakhs) (₹ lakhs)
1 225 0.893 200.89 500 446.43
2 275 0.797 219.23 525 418.53

3 360 0.712 256.24 600 427.07

4 380 0.636 241.50 620 394.02

5 420 0.567 238.32 700 397.20

1,156.18 2,083.24

PV of Cash Flows of Yes Ltd. after the forecast period

CF5 (1+g) 420 (1+0.08) 453.6
TV5 = = = = ₹ 11,340 lakhs
Ke −g 0.12−0.08 0.04

PV of TV5 = ₹ 11,340 lakhs x 0.567 = ₹ 6,429.78 lakhs

PV of Cash Flows of Merged Entity after the forecast period

CF5 (1+g) 700 (1+0.10) 770
TV5 = = = = ₹ 38,500 lakhs
Ke −g 0.12−0.10 0.02

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PV of TV5 = ₹ 38,500 lakhs x 0.567 = ₹ 21,829.5 lakhs

Value of Yes Ltd.

Particulars Before merger After merger

(₹ lakhs) (₹ lakhs)
PV of CF (1-5 years) 1,156.18 2,083.24
Add: PV of TV5 6,429.78 21,829.5
7,585.96 23,912.74
(ii) Value of Acquisition
= Value of Merged Entity – Value of Yes Ltd.

= ₹ 23,912.74 lakhs – ₹ 7,585.96 lakhs = ₹ 16,326.78 lakhs

(iii) Gain to Shareholders of Yes Ltd.

Share of Yes Ltd. in merged entity = ₹ 23912.74 × 1/1.5 = ₹ 15941.83 lakhs

Gain to shareholder

= Share of Yes Ltd. in merged entity – Value of Yes Ltd. before merger

= ₹ 15,941.83 lakhs - ₹ 7,585.96 = ₹ 8,355.87 lakhs

Q.3 (c)

Equity Curve out can be defined as partial spin off in which a company creates its own new
subsidiary and subsequently bring out its IPO. It should be however noted that parent
company retains its control and only a part of new shares are issued to public.
On the other hand in Spin off parent company does not receive any cash as shares of
subsidiary company are issued to existing shareholder in the form of dividend. Thus,
shareholders in new company remain the same but not in case of Equity curve out.

Q.4 (a)

(i) Current Market Price of Bond

= ₹ 850 (PVIAF 10%, 5) + ₹ 10,000 (PVIF 10%, 5)
= ₹ 850 (3.79) + ₹ 10,000 (0.621) = ₹ 3,221.50 + ₹ 6,210 = ₹ 9,431.5
(ii) Macaulay’s Duration

Year Cash flow P.V. @ 10% Proportion Proportion of

of bond bond value x
value time (years)
1 850 0.909 772.65 0.082 0.082
2 850 0.826 702.10 0.074 0.148
3 850 0.751 638.35 0.068 0.204
4 850 0.683 580.55 0.062 0.248

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5 10,850 0.621 6,737.85 0.714 3.57

9,431.50 1.000 4.252
Duration of the Bond is 4.252 years
(iii) Volatility of Bond
Duration 4.252
Volatility of Bonds = = = 3.865
(1+YTM 1.10

(iv) Convexity of Bond

C* (Y)2  100
V+ + V− − 2V0
C* =
2V0 (∆Y)2

Year Cash flow P.V. @ 8% P.V @12%

1 850 0.926 787.10 0.892 758.20
2 850 0.857 728.45 0.797 677.45
3 850 0.794 674.90 0.712 605.20
4 850 0.735 624.75 0.636 540.60
5 10,850 0.681 7,388.85 0.567 6,151.95
10204.05 8,733.40
10,204.05 + 8,733.40 − 2 × 9,431.50
C* =
2 × 9,431.50 × (0.02)2
= 74.45/7.5452
Convexity of Bond = 9.867 x (0.02)2 x 100 = 0.395%

(v) The expected market price if decrease by YTM by 200 basis points
(a) By Macaulay’s duration-based estimate
₹ 9.431.50 2(3.865/100) = ₹ 729.05
Hence expected market price is ₹ 9431.50 + ₹ 729.05 = ₹ 10,160.55
Hence market price will increase
(b) By Intrinsic Value method
Intrinsic Value at YTM of 10% ₹ 9,431.50
Intrinsic Value at YTM of 8% ₹ 10,204.05
Price increased by ₹ 772.55

Hence, expected market price is ₹ 10,204.05

Q.4 (b)

(i) Earnings per share = Earnings after tax /No. of equity shares
ABC Ltd. = ₹ 50,00,000/10,00,000 = ₹ 5
XYZ Ltd. = ₹ 18,00,000 / 6,00,000 = ₹ 3
(ii) Number of Shares XYZ limited’s shareholders will get in ABC Ltd. based on market
value per share = ₹ 28/ 42 6,00,000 = 4,00,000 shares
Total number of equity shares of ABC Ltd. after merger = 10,00,000 + 4,00,000 =
14,00,000 shares
Earnings per share after merger = ₹ 50,00,000 + 18,00,000/14,00,000 = ₹ 4.86
(iii) Calculation of exchange ratio to ensure shareholders of XYZ Ltd. to earn the same

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as was before merger:

Shares to be exchanged based on EPS = (₹ 3/₹ 5)  6,00,000 = 3,60,000 shares
EPS after merger = (₹ 50,00,000 + 18,00,000)/13,60,000 = ₹ 5
Total earnings in ABC Ltd. available to shareholders of XYZ Ltd. = 3,60,000  ₹ 5 =
₹ 18,00,000.
Thus, to ensure that Earning to members are same as before, the ratio of exchange
should be 0.6 share for 1 share.