CMA JANUARY-2024 EXAMINATION

INTERMEDIATE LEVEL II
EF232. FINANCIAL MANAGEMENT
Model Solution

Solution of the Question No. 1

(i) (e)
(ii) (d)
(iii) (c)
(iv) (c)
(v) (b)
(vi) (e)
(vii) (b)
(viii) (a)
(ix) (d)
(x) (a)

Solution of the Question No. 2

(a) True.
(b) False. The equity beta is the beta of the publicly traded stock of the firm
(c) False. Investors can expect to be compensated with higher returns for bearing systematic
risk.
(d) False. Companies with high growth rates tend to have high retention ratio/low dividend-
payout ratios.
(e) True.

Solution of the Question No. 3

1. (j)
2. (f)
3. (a)
4. (c)
5. (h)

Solution of the Question No. 4

(b)
(i) Effective annual interest rate
The effective annual interest rate is 17.2271%:
Annual interest, i = 16%
Frequency, m = 12
EAR = (1+0.16/12)12 −1= 0.172271
(ii) The equal withdrawal amount:
The investment period's withdrawal phase may be considered a 4-year ordinary annuity starting
from the fifth year to the eighth year. Therefore, the discounted value of all the withdrawals at the
beginning of the annuity (i.e., beginning of year 5, which is the same as the end of year 4) will be the
future value of the deposit of Tk. 100 million at the end of year 4.
The future value of the deposit at the end of year 4 is Tk. 188,847,737.7:
FV4 = Tk. 100,000,000×(1+0.16/12)4×12= Tk. 188,847,737.7
The value of the annuity at year 4, PVA4 = FV4 = Tk. 188,847,737.7
Annual interest, effective yield = 17.23%
Tk. 188,847,737.7 = PMT × 2.73085
Annual Amount = 69,153,464

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(c)
The PVs of the cash flows are as follows.
Discount PV of PV of PV of PV of
Year factor 8% plant cost running costs savings net cash flow
0 1.000 (7,000) (7,000)
1 0.926 (1,852) 5,556 3,704
2 0.857 (2,143) 5,999 3,856
Total (7,000) (3,995) 11,555 560
The project has a positive NPV and would appear to be worthwhile. Sensitivity of the project to
changes in the levels of expected costs and savings is as follows.
(i) Plant costs sensitivity = 560/7,000 X100 = 8%
(ii) Running costs sensitivity = 560/3,995 X100 = 14%
(iii) Savings sensitivity = 560/11,555 X100 = 4.8%

Solution of the Question No. 5

(a) 5 main difficulties associated with highly geared companies:
1. High volatility to company or equity returns.
2. High debt burden and bankruptcy.
3. Loss of market reputation and credibility.
4. Short-termism may dominate the thinking and behaviour of Management instead of long-term
shareholder value maximization.
5. Lower financial flexibility
(b)
(i) NPV calculation
Year 1 (Tk.) 2 (Tk.) 3 (Tk.) 4 (Tk.)
Average sales price 73.55 76.03 76.68 81.86
Average variable cost 51.50 53.05 49.17 50.65
Contribution per unit 22.05 23.98 27.51 31.21
Sales units 65,000 110,000 125,000 80,000
Tk. 000 Tk. 000 Tk. 000 Tk. 000
Total contribution 1,433 2,638 3,439 2,497
(-) Fixed costs 1,248 1,298 1,350 1,404
Taxable cash flow 185 1,340 2,089 1,093
(-) Tax (30%) 56 402 627 328
129 938 1,462 765
(+) Depreciation tax shield 150 113 84 63
Net cash flow 279 1,051 1,546 828
Discount factor, 10% 0.909 0.826 0.751 0.683
Present values 254 868 1,161 566
Total present values of net cash flows = 254 + 868 + 1,161 + 566 = Tk. 2,849
NPV = 2,849 – 2,000 = Tk. 849

(ii) Payback and discounted payback

Year Cash flow Cumulative cash flow Discounted Cumulative
cash flow discounted cash flow
Tk. 000 Tk. 000 Tk. 000 Tk. 000
0 (2,000) (2,000) (2,000) (2,000)
1 279 (1,721) 254 (1,746)
2 1,051 (670) 868 (878)
3 1,546 876 1,161 283
4 828 1,707 566 849
Non-discounted payback period = 2 years + [(670/1,546) × 12] = 2 years 5 months
Discounted payback period = 2 years + [(878/1,161) × 12] = 2 years 9 months

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(c)
Calculation of Star Ltd weighted average cost of capital
Cost of equity =14% + 5% = 19%. (Risk free rate + equity risk premium)
The company’s bonds are trading at par and before tax cost of debt is the same as the interest rate
on the bonds which is 18%
After tax cost of debt = 18% x (1- 0.25) = 13.5%
Market value of equity = 10 million x 5 = 50 million
Market value of debt is equal to its par value of 10 million
WACC = 50/60 x 19% + 10/60 x 13.5% = 18.08%

Solution of the Question No. 6

(a) The factors to consider when choosing a source of debt finance:
Cost: This will cover the interest rate, the issue cost, renewal fees etc. since the cost can affect the
viability and profitability of the project. Also, to be considered is the tax benefits of the debt finance.
The basis of interest rate is also important as fixed interest and variable interest rates have different
implications.
Purpose/Maturity: The purpose of the finance will determine the tenor of the debt or finance.
Capital expenditure or assets base investment should be financed with long term debt or tenor
finance while working capital finance should be financed with short tenor finance like overdraft.
Gearing level/Financial risk: The gearing level of the company will also determine whether more
debt should be raised or equity and the attitude of existing shareholders on the dilution of control if
new shareholders are brought on board. Over gearing and the associated risk of default on debt
service and principal payments can expose shareholders to a greater risk
Flexibility: The terms and conditions and covenants that go with the facility should be reviewed and
ensure that they friendly and will not squeeze the company unfavorably. Ability to restructure and
renegotiate during difficult times should be considered
Control: Will the new source lead to dilution of control of existing shareholder and will they be
happy? Will any debt put a lot of restrictions on shareholder and dividend payment and will they be
happy? All should be considered and analyzed. Will the debt providers exercise a; lot of control and
interference in the management?
Security/Collateral: Providing collateral or security for the debt is also crucial and should be
carefully considered. The bigger and longer the debt tenor the more the requirement to provide
security or Collateral.
(b)
(i) Book value gearing = Debt/Equity = 150/120 = 125%
Market value gearing = Debt/Equity = 135/400 = 33.75%
(ii) Proceeds raised = Tk. 2.5 x 50 million = Tk. 125 million
Ex-rights price = [Tk. 2.5 + (2 x Tk. 4)]/3 = Tk. 3.5
Value of equity after rights issue = Tk. 3.5 x 150 million = Tk. 525 million
Value of debt after rights issue = (Tk. 150m – Tk. 125m) x 0.90 = Tk. 22.5 million
Market value gearing = 22.5/525 = 4.29%
(c)
Working
Tax allowable depreciation
Year
Tk.
1 (25% of Tk.63,000) 15,750
2 (75% of Tk.15,750) 11,813
3 (75% of Tk.11,813) 8,859
36,422
4 (Tk.63,000 – Tk.36,422) 26,578
The financing decision will be appraised by discounting the relevant cash flows at the after-
tax cost of borrowing, which is 10% X 70% = 7%.
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(a) Purchase option
Cash Discount Present
Year Item flow factor 7% value
0 Cost of machine (63,000) 1.000 (63,000)
Tax saved from tax allowable depreciation
2 30% X Tk.15,750 4,725 0.873 4,125
3 30% X Tk.11,813 3,544 0.816 2,892
4 30% X Tk.8,859 2,658 0.763 2,028
5 30% X Tk.26,578 7,973 0.713 5,685
(48,270)
(b) Leasing option
It is assumed that the lease payments are tax-allowable in full.

Cash Discount Present

Year Item flow factor 7% value
1–4 Lease costs (20,000) 3.387 (67,740)
2–5 Tax savings on lease costs (X 30%) 6,000 3.165 18,990
(48,750)
The purchase option is cheaper, using a cost of capital based on the after-tax cost of
borrowing. On the assumption that investors would regard borrowing and leasing as equally
risky finance options, the purchase option is recommended.

Solution of the Question No. 7

(a)
Neither policy, if strictly interpreted, recognizes variations in the firm's investment opportunities or
cash flows. While a constant dollar payout gives some recognition to those investors seeking a
stable income, it ignores the wishes of those investors who would prefer 100-percent retention. This
same criticism can be made of the constant dividend-payout ratio policy only in reverse. A policy of
a constant regular dividend supplemented when funds for investments are unneeded would appear
to combine the better features of both policies. Investors would have a fairly stable minimum amount
of income, and the corporation would retain most of its investment flexibility.
(b)
(i)Computation of effective annual cost and recommended financing option.
Computation of effective annual cost:
Trade credit
Effective Cost= 0.015/(1-0.015) × 360/(45-10) = 15.66% (assuming 360 days in a year)
Commercial paper
On the assumption that the company would borrow enough to cover the cost of the inventory and
the issue cost, the effective cost of the commercial paper would be 20.3857%:
Interest = 0.18×Tk. 2,515,000×3/12= Tk. 113,175
Effective Cost= (113,175+15,000)/2,515,000 ×12/3 = 0.2038
Alternatively, a candidate may assume that the company would pay the issue cost from existing
funds. In that case, the effective cost would be 20.4%:
Interest = 0.18×Tk. 2,500,000×3/12= Tk. 112,500
Effective Cost= (112,500+15,000)/2,500,000 ×12/3 = 0.204
Bank loan
Assuming the company borrows enough to cover the cost of both inventory and loan arrangement
and processing, the effective cost of the loan will be 22.7984%:
Interest = 0.22×Tk. 2,505,000×3/12= Tk. 137,775
Effective Cost= (137,775+5,000)/2,505,000 ×12/3 = 0.2279
Assuming the company would pay the loan arrangement and processing costs from existing funds,
the effective cost would be 22.8%:
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Interest = 0.22×Tk. 2,500,000×3/12= Tk. 137,500
Effective Cost= (137,500+5,000)/2,500,000 ×12/3 = 0.228
Recommendation
Based on cost-effectiveness, the recommended financing option is the trade credit. The effective
annual cost of the trade credit (15.66%) is significantly lower than that of the commercial paper
(20.4%) and the bank loan (22.8%).
(ii) Advantages of commercial paper instead of the bank loan
Raising funds through the issue of Commercial Paper (CP) has several advantages over taking a
bank loan.
1. The first advantage is related to the interest rate on the loan. As CPs are financial securities
issued by large and reputable entities, the interest rate quoted on them are relatively lower than the
interest on comparable bank loans. With the help of transaction advisors, the company can benefit
from quoting the interest rate that it deems appropriate for its creditworthiness and investors’
required return. Although the company can negotiate the interest rate on the bank loan, borrowers
are interest takers when it comes to bank loans.
2. The second advantage relates to the amount that can be raised. Since CPs are negotiable
instruments that can be issued in multiple amounts to several investors in a single issue, it is a
better avenue for raising bigger sums of money than a bank loan.
3. A third advantage is that the company could enhance its credit reputation amongst several
institutional lenders in the financial market through the issue of the CP. If the company can
successfully raise the CPs and discharges its financial obligations to the expectation of the market,
it would be a track record that it could leverage in the future to raise larger amounts at lower interest
rates in the future.
(c) Interest rate risk:
Interest rate risk is the risk of uncertainty of a possible loss that could arise due to movements or
changes in interest rates. If interest rates rise, the value of bonds or financial assets drops and vice
versa. Borrowers at fixed interest rates tend to suffer or lose when interest rates vice versa.
Ways of managing interest rate risk:
Internal strategies for managing interest rate risks include the following:
 Interest matching
 Interest netting
 Interest smoothing
External strategies for managing interest rate risks include the following:
 Forward rate agreement
 Interest rate futures
 Option on interest rate futures
 Interest rate swap

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