THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN
Final Examinations Summer 2010
June 9, 2010
BUSINESS FINANCE DECISIONS (MARKS 100)
(3 hours)
Q.1 YB Pakistan Limited is engaged in the manufacture of pharmaceutical products. On April 1,
2010 the Board of Directors approved a plan which envisages an investment of Rs. 300
million on account of capital expenditures over the next five years. Following information
has been extracted from the management accounts of the company which have been
prepared in respect of the year ended March 31, 2010:
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
The following information is also available:
(i) Annual outlay of investment in next five years is estimated to be 13%, 16%, 22%,
22% and 27% respectively of the total amount.
(ii) The company expects that the operating profit (excluding depreciation) generated by
the existing assets will grow at the rate of 12% per annum. In addition, the new
investments would yield pre-tax cash flows of 15% per annum.
(iii) The company follows a policy of maintaining a debt equity ratio of 40:60.
(iv) Interest rates on existing and future long term debts are expected to be the same and
are not expected to change during the next five years. The current debt is repayable at
the end of five years. All future debts would be repayable on or after six years.
(v) The company has a short term financing facility of Rs. 50 million. The outstanding
balance as of March 31, 2010 was Rs. 20 million. Assume that interest @ 16% is
payable at the end of each year on the closing balances.
(vi) The company invests its surplus funds into highly secured investments which yield
8% per annum.
(vii) The additional working capital requirements are estimated at 10% of additional capital
expenditures.
(viii) Accounting depreciation is calculated at the rate of 15% of written down value. It is
equal to tax depreciation and therefore is allowable for tax purposes. The current
corporate tax rate is 40%. To promote corporate business, the Government has
announced an annual reduction of 2% in tax rate till it is reduced to 34%.
(ix) The company follows the residual dividend policy for payment of dividends.
You may assume that all cash flows are incurred at year end.
Required:
(a) Calculate the expected dividend for the next five years in accordance with the existing
payout policy of the company.
(b) Ascertain whether the company would be able to pay off its existing loan at the expiry
of five years. (22)
(2)
Q.2 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 Year 3 onward
MK 4.0% 5.0%
ZA 5.5% 5.0%
(iii) Accounting depreciation is the same as tax depreciation.
(iv) The prevailing risk-free rate of return is 8% whereas the market return is 13%.
The key aspects of the feasibility study carried out by MK are as follows:
MK would issue 7 shares in exchange for 9 shares of ZA.
A rationalization of administrative and operational functions after takeover would
reduce operating expenses including depreciation, from 75% to 70% of total sales.
The annual growth in sales, operating costs, depreciation and capital expenditures in
the merged company would be as follows:
Year 1 – 2 5.0%
Year 3 onward 5.5%
Required:
(a) Based on an analysis of Free Cash Flows, calculate the value of MK Limited, ZA
Limited and the company which would be formed after the merger.
(b) Estimate the synergy effect which is expected to accrue to MK Limited on account of
acquisition of ZA Limited. (25)
Q.3 (a) Briefly explain the Adjusted Present Value (APV) method and identify its advantages
over the Weighted Average Cost of Capital method. (04)
(3)
(b) NS Technologies Limited is in the business of developing financial software. The
directors of the company believe that the scope of future growth in the software sector is
limited and are considering to diversify into other activities. An option available with
the company is to sign an eight year distribution contract with a leading manufacturer of
telecommunication equipments.
Some of the important information related to the above proposal is as follows:
(i) Total investment is estimated at Rs. 600 million. It includes developing the
necessary infrastructure, purchase of equipment and working capital
requirements.
(ii) The investment is expected to generate pre-tax net cash flows of Rs. 180 million
per year.
(iii) Presently NS is paying interest @ 9% on its long term debt.
(iv) NS maintains a debt equity ratio of 55:45 whereas its equity beta is 0.9.
(v) Average debt ratio, overall beta and debt beta of telecommunication equipment
distribution segment is 40%, 1.5 and 1.3 respectively.
(vi) The market rate of return is 14% whereas yield on one year treasury bills is 6%.
(vii) Costs associated with the issuance of debt and equity instruments are estimated
at 1% and 3% respectively.
(viii) Tax rate applicable to the company is 35%. Tax is paid in the same year as the
income to which it relates.
(ix) In case the contract is not renewed upon expiry, after tax cash flows of Rs. 90
million would be generated from disposal of allied resources.
Required:
Evaluate the above proposal using the APV method. (12)
Q.4 DS Leasing Company Limited has been approached by BP Industries Limited, with a
request to arrange a 4-year lease contract in respect of a state of the art machine. The cost of
machine is Rs. 20 million and the expected useful life is 4 years. The residual value at the
end of lease term is estimated at 10% of cost.
DS would finance the purchase of machine by borrowing at 16% per annum. The interest
would be payable annually and the principal amount would have to be repaid in four equal
annual installments commencing from the end of first year.
DS provides free-of-cost maintenance services for all its leased assets. These services are
provided by the company’s Maintenance Department whose costs are mostly fixed. If BP
acquires this service from any other vendor, it would have to pay an annual fee of 3% of the
cost of machine. Insurance cost will be borne by BP and is estimated at 4% of the cost of
machine.
The tax rate applicable to both companies is 35% and the tax is payable in the next year.
Allowable initial and normal deprecation on the machine is 25% and 10% respectively. The
weighted average cost of capital of DS and BP are 18% and 20% respectively.
Both companies follow the same financial year. It may be assumed that the purchase would
be finalized on the last day of the financial year.
Required:
(a) Calculate the annual rental (payable in advance) which DS should charge in order to
break even on the lease contract. (08)
(b) Assume that BP has the following two options for financing the cost of machine:
(i) DS has offered to lease the machine at an annual rental of Rs. 7 million, payable
in advance.
(ii) EFT Bank has offered to finance the machine at 18% per annum. The loan
including interest would be repayable in 4 equal annual installments to be paid at
the end of each year. Insurance costs would be borne by BP.
Determine which course of action BP should follow. (12)
(4)
Q.5 The Directors of PSD Engineering Limited, a listed company, are planning to raise Rs. 100
million for a new project. They are considering two possible options of fund raising. The
first is to make a two-for-five right issue of ordinary shares priced at Rs. 12.50 per share.
The second option is to issue 9% Term Finance Certificates (TFCs) at par, redeemable in
2020.
The following information has been extracted from the financial statements of PSD for the
year ended March 31, 2010:
Rs. in million
Issued ordinary shares Rs. 10 each 200
Retained earnings 390
590
10% TFCs at par, repayable in 2012 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, 2010 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. (03)
(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. (02)
(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. (09)
(b) Briefly discuss why issue of term finance certificates is expected to result in fall in
price earnings ratio. (03)
(THE END)
