BFD Revision Kit (Question Bank With Solutions - Topicwise)

Module F

Atif Abidi

www.canotes.net

November 28, 2012

Business Finance Decisions

Question Bank for Practice

Revision Kit - Summer 2008 to Summer 2012

(ICAP Past Papers with solutions With a topical index )

Topic Attempt Q # Short Description Marks Page (Q) Page (A)

Summer 2012 1 WACC + Adjusted WACC 19 1 5

Summer 2011 6 Debt Equity ratio working 17 27 33

Winter 2010 5 Interest cover + MM 23 39 45

Summer 2010 3 APV 16 48 53

Summer 2009 5 For different Capital Structures 15 73 78

Winter 2008 6 WACC + MM 13 82 88

Summer 2008 2 Market price and WACC 12 91 96

115 13%

Summer 2011 2 Involvement of sharp ratio 15 24 29

Winter 2010 3 Alpha Values 13 37 42

Winter 2009 1 Apha Values and Revised Beta 20 58 63

Winter 2008 7 Beta calculations for different projects 12 83 89

Summer 2008 1 Returns and Weighted Beta 18 91 95

78 9%

Summer 2012 3 NPV + Discounted Payback + IRR + MIRR

(Different Currencies)

17 2 7

Winter 2011 5 International + Taxation issues 20 15 21

Winter 2011 6 NPV (2 alternatives) 17 16 22

Summer 2011 3 Lease vs Buy 12 24 30

Summer 2011 4 NPV 16 25 31

Winter 2010 4 International + Tax treaty working 24 38 43

Summer 2010 4 Leasing calculations 20 49 54

Winter 2009 2 NPV 14 59 64

Winter 2009 3 NPV 13 59 65

Summer 2009 1 TFC + Other Floating rates 20 70 74

Summer 2009 2 Asset Replacement option 17 70 76

Winter 2008 4 NPV (Leasing & IRR) 18 81 86

Winter 2008 5 (a) NPV 10 82 87

Summer 2008 4 Leasing calculations 18 92 98

236 26%

Winter 2011 1 Dividend irrelevance theory 15 13 17

Summer 2010 5 Right issue and effect on price 17 50 56

Winter 2009 5 Right issue and effect on price 17 61 67

Summer 2008 3 Right shares and Capital Structure 15 92 97

64 7%

Summer 2012 5 All methods (Futures,Hedge,Options) 14 4 11

Winter 2011 4 Hedging through forward cover and money

market + multilateral netting

14 15 20


market + interest rate risk

20 37 41


market

12 61 68

Summer 2009 3 Call and Put Options 12 71 77

Summer 2008 6 Hedging through forward cover 17 94 102

89 10%

Summer 2012 2 Investment mix of Mutually exclusive &

mutually dependent projects

20 2 6

Summer 2011 1 Leverage Ratios 15 23 28

Summer 2010 1 Projected cash flow and divident payout

policy

22 47 51

Winter 2008 1 Injection of fresh equity + shareholding

calculations

13 80 84

Winter 2008 2 Forcasting and Debt/Equity Ratio 14 80 85

Winter 2008 5 (b) Sensitivity Analysis 10 82 87

94 10%

Winter 2011 2 Decision Tree + NPV 14 13 18

Summer 2009 6 Probabilities and Expected Values 15 73 79

Winter 2008 3 Interest rate swaps 10 81 85

39 4%

Summer 2012 4 Free Cash Flows + Optimum sales level +

Cash Flow Management

30 3 8

Winter 2011 3 Free cash flows + impact of acquisition 20 14 19

Summer 2011 5 Calculating purchase consideration 25 26 31

Winter 2010 1 Shares as purchase consideration EPS /

Discount Rate (+ Theory)

20 36 40

Summer 2010 2 Free cash flows + impact of SYNERGY 25 48 52

Winter 2009 4 MBO 24 60 65

Summer 2009 4 Working for mergers 21 72 77

Summer 2008 5 Surplus Value on Demerger 20 93 100

185 21%

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BFD Question Bank (Topic Wise) - Summer 2008 to Summer 2012

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Attempt Q # Topic Short Description Marks Page (Q) Page (A)

1 WACC & Capital Structures WACC + Adjusted WACC 19 1 5

2 Misc Investment mix of Mutually exclusive &

mutually dependent projects

20 2 6

3 Investment Appraisal NPV + Discounted Payback + IRR + MIRR

(Different Currencies)

17 2 7

4 Valuation Free Cash Flows + Optimum sales level +

Cash Flow Management

30 3 8

5 Foreign Excahnge All methods (Futures,Hedge,Options) 14 4 11

1 Dividends & Right Issue Dividend irrelevance theory 15 13 17

2 Risk Analysis Decision Tree + NPV 14 13 18

3 Valuation Free cash flows + impact of acquisition 20 14 19

4 Foreign Excahnge Hedging through forward cover and money

market + multilateral netting

14 15 20

5 Investment Appraisal International + Taxation issues 20 15 21

6 Investment Appraisal NPV (2 alternatives) 17 16 22

1 Misc Leverage Ratios 15 23 28

2 CAPM + Portfolio Involvement of sharp ratio 15 24 29

3 Investment Appraisal Lease vs Buy 12 24 30

4 Investment Appraisal NPV 16 25 31

5 Valuation Calculating purchase consideration 25 26 31

6 WACC & Capital Structures Debt Equity ratio working 17 27 33

1 Valuation Shares as purchase consideration EPS /

Discount Rate (+ Theory)

20 36 40


market + interest rate risk

20 37 41

3 CAPM + Portfolio Alpha Values 13 37 42

4 Investment Appraisal International + Tax treaty working 24 38 43

5 WACC & Capital Structures Interest cover + MM 23 39 45

1 Misc Projected cash flow and divident payout

policy

22 47 51

2 Valuation Free cash flows + impact of SYNERGY 25 48 52

3 WACC & Capital Structures APV 16 48 53

4 Investment Appraisal Leasing calculations 20 49 54

5 Dividends & Right Issue Right issue and effect on price 17 50 56

1 CAPM + Portfolio Apha Values and Revised Beta 20 58 63



4 Valuation MBO 24 60 65

5 Dividends & Right Issue Right issue and effect on price 17 61 67


market

12 61 68

1 Investment Appraisal TFC + Other Floating rates 20 70 74

2 Investment Appraisal Asset Replacement option 17 70 76

3 Foreign Excahnge Call and Put Options 12 71 77

4 Valuation Working for mergers 21 72 77

5 WACC & Capital Structures For different Capital Structures 15 73 78

6 Risk Analysis Probabilities and Expected Values 15 73 79

1 Misc Injection of fresh equity + shareholding

calculations

13 80 84

2 Misc Forcasting and Debt/Equity Ratio 14 80 85

3 Risk Analysis Interest rate swaps 10 81 85

4 Investment Appraisal NPV (Leasing & IRR) 18 81 86

5 (a) Investment Appraisal NPV 10 82 87

5 (b) Misc Sensitivity Analysis 10 82 87

6 WACC & Capital Structures WACC + MM 13 82 88

7 CAPM + Portfolio Beta calculations for different projects 12 83 89

1 CAPM + Portfolio Returns and Weighted Beta 18 91 95

2 WACC & Capital Structures Market price and WACC 12 91 96

3 Dividends & Right Issue Right shares and Capital Structure 15 92 97

4 Investment Appraisal Leasing calculations 18 92 98

5 Valuation Surplus Value on Demerger 20 93 100

6 Foreign Excahnge Hedging through forward cover 17 94 102

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BFD Question Bank (Attempt Wise) - Summer 2008 to Summer 2012

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The Institute of Chartered Accountants of Pakistan Business Finance Decisions

Final Examination 6 June 2012 Summer 2012 100 marks - 3 hours Module F Additional reading time - 15 minutes

Q.1 Mac Fertilizer Limited (MFL) is a listed company and is engaged in the business of manufacturing of phosphate fertilisers. MFL intends to diversify its operations by manufacturing and distributing steel products. This diversification would require an investment of Rs. 3,600 million for establishing the plant and meeting the working capital requirement. MFL plans to finance the investment as follows:

55% of the investment would be financed by issuing Term Finance Certificate (TFCs) carryinginterest at 12% per annum and repayable in 2018.

The balance amount would be generated by issuing right shares at Rs. 65 per share.

Extract of MFLs statement of financial position as at 31 December 2011 is given below:

Equity and liabilities Rs. in million Assets Rs. in million Share capital (Rs. 10 each) 7,000 Non-current assets 50,000 Retained earnings 23,000 TFCs (Rs. 100 each) 28,000 Current assets 40,000 Current liabilities 32,000

90,000 90,000

The existing TFCs carry mark up @ 11.5% per annum and are due for redemption at par in 2016.

Currently, MFLs 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 companys 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 hasprovided 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:

Interest rate for 6-months treasury bills 8% Market return 13% Applicable tax rate for all companies 30%

Debt beta of MFL and PSL is assumed to be zero.

Required: Compute the discount rate based on suggestions given by Directors A and B and discuss which suggestion is more appropriate. (19 marks)

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Business Finance Decisions Page 2 of 4

Q.2 CB Investment Limited (CBIL) has identified various projects for investments. Details of the projects are as follows:

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. (20 marks)

Q.3 Beta Limited (BL) is engaged in the business of manufacturing and marketing of high quality plastic products to the large departmental stores in Pakistan and United Arab Emirates. BL is presently experiencing a decline in sales of its products. Market research carried out by the Marketing Department suggests that sustained growth in sales and profits can be achieved by offering a wide range of products rather than a limited range of quality products. In this regard, BL is considering the following two mutually exclusive options:

Option I : Introduce low quality products in the market

Following information has been worked out by the Chief Financial Officer of the company:

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:

Year 0 Year 1 Year 2 Year 3 Year 4 Against import from China (US$ in million) (25.00) (20.00) (21.33) (22.33) (20.67) From operation in UAE (US$ in million) - 22.47 24.15 25.23 23.37 From operations in Pakistan (Rs. in million) - 333 350 414 450

The following information is also available: (i) The current spot rate is Re. 1=US$ 0.0111. (ii) BL evaluates all its investment using nominal rupee cash flows and a nominal discount rate. (iii) Inflation in Pakistan and USA is expected to be 10% and 3% per annum respectively.

Tax may be ignored.

Required: Evaluate the two options using net present value, discounted payback period, internal rate of return and modified internal rate of return. Give brief comments on each of the above methods of evaluation and their relevance in the given situation. For the purpose of evaluation, assume that BL has a four year time horizon for investment appraisal. (17 marks)

Page | 2


Q.4 FF International (FFI) is considering the opportunity to acquire CS Limited (CSL). You have been appointed as a consultant to advise the FFIs management on the financial aspects of the bid.

The latest summarized annual financial statements of CSL are given below:

Summarized Statement of Financial Position

Rs. in million

Total assets 5,000

Share capital 2,000 Accumulated profit 150 Long term loan 700 Short term loan 1,300 Other current liabilities 850

5,000

Summarized Income Statement

Rs. in million

Sales 1,000 Less: Cost of sales (430) Gross profit 570 Selling and administration expenses (250) Financial charges (280) Profit before taxation 40 Taxation (14) Profit after taxation 26

You have also gathered the following information: (i) CSL produces a single product X-201 and has a market share of 30%. A market survey

conducted to identify the impact of increase or decrease in price has revealed the following relationship between price of X-201 and market share:

Increase / (decrease) in price Market share (10%) 45%

5% 23% 10% 20%

(ii) In order to increase production, CSL would have to invest Rs. 150 million in plant and machinery which would be financed through long term loan on terms and conditions similar to those of the existing long term loan, as specified in point (v) below.

(iii) Fixed production costs amount to Rs. 100 million which include depreciation of Rs. 75 million. (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 departments 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%.

Page | 3


Required: (a) Discuss any two advantages and disadvantages of growth through acquisition. (04 marks) (b) Determine the following: Optimal sales level at which CSLs profit would be maximised. (05 marks) Amount of cash flow gap at optimal level of sales during the first five years of acquisition.

(14 marks) (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. (07 marks)

Q.5 Assume that the date today is 1 June 2012. Alpha Automobiles Limited (AAL) has imported CNG kits from Japan and has to repay an amount of JPY 175 million in three months time.

AAL intends to hedge the contract against adverse movements in foreign exchange rates and its foreign exchange exposures. The following data are available:

Exchange rates quoted on 1 June 2012

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

Interest rates available to AAL

Borrowing Investing Japan 5% 3% Pakistan 8% 5%

JPY currency futures Futures have a contract size of JPY 100,000 and the margin required is Rs. 1,000 per contract.

Contract prices (Rupee per JPY) are as follows:

JPY 1 July 2012 Rs. 1.9365 October 2012 Rs. 1.9421 January 2013 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:

Strike price

Calls Puts 31 July

2012 31 October

2012 31 July

2012 31 October

2012 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

Options are exercisable at the end of relevant month only.

Required: Illustrate four methods by which Alpha Automobiles Limited might hedge its currency exposure.

Recommend which method should be selected. (14 marks)

(THE END)

Page | 4

Business Finance DecisionsSuggested Answers

Final Examinations - Summer 2012

A.I DIRECTOR A's RECOMMENDATION: Evaluation on the basis of Existing WACC

lie = 700 X 80.00 = Rs. 56,000 millionVd = 280 x 102.50 = Rs. 28,700 million

84,700

56,000 28,700WACC = 14.5% (W - 1) x 84,700 + 7.5% (W - 2) x 84,700 = 12.1%

W-l: Cost of equityke = Rf + (Rm - Rf) x f3

= 8% + (13% - 8%)1.3 = 14.5%W-2: Cost of debt

Calculating the cost of debt using IRR6.11

kd = 6% + (6.11 + 6.19) x 3% = 7.49%

DIRECTOR B's RECOMMENDATION: Evaluation on the basis of Project Specific Cost of Capital"It: V

WACC=Kex e +kdx(l-t) dlie + Vd lie + Vd

1,620 1,980WACC = 19.82% (W - 3) x 3600 + 8.4% (W - 4) x -- = 13.54%, 3,600

W-3: Cost of equityke = 8% + (5%) x 2.364 (W - 5) = 19.82%W-4: Cost of debtkd = 12.0% x (1 - 30%) = 8.4%

W-5: Computation of project specific betaUn-geared Steel Company Beta

lie Vd(1-t)

Bu = Bg x lie + Vd(l- t) + Bd X lie + Vd(1- t)where,

lie = 900 x 35 = 31,500,Vd(l - t) = 8,000 x 70% = 5,600Bg = 1.5

31,500Bu = 1.5 x (31,500 + 5,600) + 0= 1.274

Page 1 of 7

Page | 5



Get the project beta on the basis of steel company un-geared betaVd(l-t)Bg = Bu + (Bu - Bd) x --- Ve

1,980 x 70%Bg = 1.274 + 1.274 x 1,620 = 2.364

Appropriateness of discount rate

The view expressed by the Director A is not worthwhile because: existing WACC only reflects the current business and financial risk. It does not

incorporate the additional risk of the new sector as well as additional return requiredby the company's shareholders.the proportion of debt in the investment i.e. 55% is quite high as compare to existingdebt proportion i.e. 34%. The financial risk has therefore increased and it couldtherefore be argued that current WACC is not an acceptable discount rate.rate used for evaluation of the project i.e. 17% is too high as it is based only on therelatively high cost of equity and ignores the amount of debt that will be used tofinance the project.

The suggestion given by the Director B is worthwhile as the project specific cost of capital(based on steel industry's risk) incorporates the business and financial risk of the new sector,in which MFL intends to invest and also incorporates the higher return expectation of theshareholder because of increase in financial risk.

A.2 .m ........m T ~T----T--::r:i Proiect duration ["'... 4...... ..r .... ..............f[f()~ecasted net cash i 1! Discount rate 10%

..1 .... ....,, ....1

!............. j "]............. )

:~'~~:t........i..~~ l.i;~;~li4;~ I~...}.4..!. j!

,--jf! .iA!:l.r.l.llityJi!c:t()rJ()r_t()t~I.P~.r.i()_c1 ) 3.487 ~!.._!ce:..:__A!1.!1.!oI.!tyJ'.Is:~g!.X9!.~~!.()..C



By utilizing the entire available amount the company may be in a position to increase itsNPV. Hence we should consider other options. While selecting other options the basicpresumption should be to select the last project (balancing amount) which can be scaleddown i.e. Project C. Considering the above, there can be three more options as shownbelow:

Option 2: Invest in Rank 4 ahead of Rank 2 which can be scaled downIf we consider the rank 4 project which requires lesser investment as compare to rank 5project, we would be able to utilize about 75% of rank 2 project, as against option 3 inwhich Project C is only 28% utilized.

r---- ---- - ..-..- -- - ..-..r------- ..---- ..------------0 ..-- ----- ..-..-- ..-..-----..-----..-----..---------- ..--------- ..-----------..------..-----..-------1J _ = _ , _ _ _ __.._ _ __.._ _.._ - ---- .. ------ -- ------- -..--....J

; + cc , c , .....................................................................................................................................................................................i Rank 11_ ............................. - .. ~H H HH _

; ecause it cannotbesc-~ie~fdown:-----I----.-..-----.-..---.-------.----------.----.------.-------1;--- +- ---;..._.._.._.. .. .. ..__..__.. .. .. .. .. .. .l

............................................. '-..i _---'-- __ ----'- ---'L .._.._ _ _.._._.._.._ _ _ _.._._.__.._ _ _ _ _.._.. _.._..__ .._ _.._.._...1

Option 3: Invest in Rank 5 ahead of Rank 2 which can be scaled down, _ _._ _ .._ _.__ .._ - _ .._ _._._ ..,._---------_ ..__ .._ .._._---_ _-, _ .._ .............. _ .._ ................... ,_ _ .._ .._ __ .._ ..-_ .._ ..__ _--_ .._._---_ ..__ .._ ..__ ._-----.-._".-----._---_ .._._-_ .._-_._ .._--_._-----_.,

l..!!!y~~~~!!!-~;__~V __ . . . .. . .. . . ----I"______________.._; ~~_!!!_~!!!!g-!!-----..L-----------------------------------------------------------------1~(l!!~J ~~gQ,QQj ??~.:.x.? L- .. . ...._____;

; Rank 5 ! 512.00 ! 203.55 ! Because it cannot be scaled down.i::g~~k-?:(~~!~~~-~i~~r.68.00'1 ....3s.70T:: ---:~:~~:::::::::::~::::::------------------::-~::::~lL. .._.__.... ..__.._.__._. .i 1,000.00 i 500.40 i.. !

Options 4: Invest in Rank 3 and Rank 2 which can be scaled down

Investment NPV

800.00 73. ecause it cannot be scaled down.Rs. in million

200.00 113.831,000.00 487.75

Conclusion:The most beneficial mix for the company is to invest in Projects A, B, F and C (balancingamount) which gives the highest NPV to the company.

A.3 (a) The summary of investment appraisal results are as follows:

o tion I

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 increaseshareholders' wealth and is theoretically more sound than the IRR and MIRR. However, Inthis case, both IRR and MIRR back up the NPV.

The discounted payback period shows that Option II is more risky as it takes longer torecover the present value.

Page 3 of 7

Page | 7



WORKINGS

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lower level of operating risk than a small company which may be more dependent ona small number of customers and suppliers. Acquisition will therefore allow thecompany to reduce its operating risk more quickly. This effect is enhanced if thecompany is using acquisition as a mean of diversification into new product/marketareas.

(iii) Acquisition may permit the company to make operating economies through therationalization and elimination of duplication in areas such as research anddevelopment, debt collection and corporate relations.

(iv) Acquisition may allow the company to achieve a better level of asset backing if it hasa 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 maynot be justifiable on financial grounds.

(ii) Acquisition may involve significant reorganizations cost which may result in lowerearnings at least in the short term.

(iii) The acquisition may lead to inequalities in returns between the shareholders of thebidding and the target companies. Quite often the shareholders in the target companydo disproportionately well as compared to the shareholders in the bidding company.

(b) Determination of Sales Level

Market size (Rs 1,000.:.. 30%) x Ll

PriceExistingsales

............. iT m.m.f - < jPrice increased by

decreased by5% 10% 10%

Market share 30% ! 23%! 20% ! 45%i----------- -.- -.- - - - -................. .-f -.-.-..- - - -.j .........- - .....- -.- -' ......- - - .......- ..- - - - .....-' ....... -- - .....-- ......- ..-------------------Rs. in million---------------------T667- ----3~66-fr_------j~6-67-r-------3,66i-

(82.51)

Sales M:lrl



,__Q.~_!~_~~~!~~__~f_~~~_~_Q2~__g~P' , , , ,_._..._..._._...._..._._..._.__., . ,i Cash flow i Year 1 i Year 2 i Year 3 i Year 4 i Year 5 !i G~_;;~th-~~t~------------------------------r_-----io%-r------loo/;1----1oo/:t---------lO~;:r-----lO%l

~!~~I~~~~~i~~~~~~~I~1~~~-::::r!--~~~~=~::~:::I Fin. charges - Long term loan (W-2) (127.50)Q9~:99>L-(76~5-0)-r-----(5ioo)T:::~(~~::~~g~~'Fi~~~~;~i~h~;g~;:Sh~rt~~;:;:;;I~~~(1:6oo~i4%) ( 140.00) I (140.00) 1(140:00)1(140.00)1 (140.00)-~hti~~ b~i~~~t~~~ti~~ 267.02! 455.97 i 551.27 i 653.55 I 763.51__!~~t!g~L~~~;~5.~-~=::~~~-~-_~-~:~=~-_~~~~~~~_~-_~_~~.:~=~-_i----(li.ll)T-------(97:-7-9)--r--(i26~38)r--(157:07)-r---(190.05-j--Net cash flow 249.91; 358.18 l 424.89! 496.48 j 573.46. L... . ~....... . + _.......... .. ~ .Re.~~_c:ti()~.~.~.!?:gEtterm debt (300.00) I .__:__: L..__ =J

: Reduction in long term debt (W~~L Q22.:29~_LQ_?_9.:2.~lJ ~!~q:_29>L ~_~~~_:922_L_Q72.:99>--(W-4) (194.05) i (59.40) i (65.34) i (71.88) i (79.07)

cash (414.14)! 128.78 i 189.55! 254.60 i 324.39(414.14) I (285.36) I (95.81)!

f_~:_!~__Q~_~~~!-E~~_~?!t._2K?p_~_!~!i!t.g_p.r_



(c) Determination of maximum bid price

_._ _ _._ _+ _.._ +.;-._-..(.:...76~~~)J~=i~;~~=-46s~4I~:::)~~J~I_3~~.?f~I]....................................... ..1...... . .1.. 1 1.......... . ..J

ar2 Year 3 Year 4 YearS, YearOI Net operating cash flows (fr~;;;~b~~~)r.iAdd;F~~~~i~i;;h;;;g~~---T---[~~~~(lshfu;-d~fi;;it-------T-

dd: Changes in working capital

424.89 573.46496.48165.50216.50 191.00

189.55 95.81

factor at 18%(90.78) 669.56 765.60 711.41 6,628.410.8475 i 0.7182 i 0.6086! 0.5158 i 0.4371!

Terminal value*Cash flows

*(573.46 + 165.5) x (1+5%) -;-(18% - 5%)

A.5 Hedge using forward contract

Futures Market HedgeFutures can mature at the given dates only. Since the amount is to be paid on September 30, thecontract with maturity date of September 2012 would be chosen.

L~~..2.U~~.!.~~..~2~)!.a.:~!~..!.~.~.':l..Y..n~y...!].?.!QQQ~g0Q_~J!:.!:.J._Q.Q&Q.Q2...__.__.._.. : 1,750l.~~yJLZ~Q.~~.!.c:~ ..2f.c:.P:.:?Ql?(~~:.!:2.~?L.~.J.9.Q~.QQQ..~...!~?~.91..............._.. ..~.:}}2_&~.?J.~9.Q_..li~(i~~i!lg~()~!

Page | 12

The Institute of Chartered Accountants of Pakistan

Business Finance Decisions

Final Examination 7 December 2011 Module F 100 marks 3 hours Winter 2011 Additional reading time 15 minutes

Q.1 (a) Briefly discuss the Dividend Irrelevance Theory developed by Miller and Modigliani (MM). State three arguments against the validity of this theory. (05 marks)

(b) Al-Ghazali Pakistan Limited (AGPL) is a listed company whose shares are currently traded at Rs. 80 per share. AGPLs Board has approved a proposal to invest Rs. 600 million in a project which is expected to commence on 31 December 2012. There are no internal funds available for this investment and the company would have to finance the project from the profit for the year ending 31 December 2012 and through right issue.

AGPL has a share capital consisting of 20 million shares of Rs. 10 each and its profit for the year ending 31 December 2012 is projected at Rs. 250 million.

The annual return on 1-year treasury bills, the standard deviation of returns on AGPLs shares and the estimated correlation of returns with market returns are 7.5%, 8% and 0.8 respectively. The current market return is 12.9% with a standard deviation of 5%.

Required: Using MM Theory of Dividend Irrelevance, estimate the price of AGPLs shares as at 31

December 2012, if the company declares: (i) 20% dividend (ii) Nil dividend (05 marks)

(c) Justify the MM Theory of Dividend Irrelevance, based on your computation in (b) above. (05 marks)

Q.2 The directors of Khayyam Limited (KL) are considering an investment proposal which would need an immediate cash outflow of Rs. 500 million. The investment proposal is expected to have two years economic life with salvage value of Rs. 50 million at the end of second year.

KLs 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:

Exchange Rate Rs. 84-87



NCIAT Probability NCIAT Probability NCIAT Probability

Year 1 250 65% 320 35% - -

Year 2:

If Year 1 exchange rate is Rs. 84-87 280 20% 330 65% 360 15% If Year 1 exchange rate is Rs. 88-91 340 5% 380 50% 400 45%

All NCIATs are in millions of rupees

KL uses a 14% discount rate for investments having similar risk levels.

Required: (a) Draw a decision tree to depict the above possibilities. (04 marks)

(b) Determine whether it would be advisable for Khayyam Limited to undertake this project. (10 marks)

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Q.3 Ibn-Seena Limited (ISL) is a reputable unquoted company engaged in the business of manufacturing and sale of pharmaceutical products. It is presently considering a proposal to acquire Al-Biruni Pharmaceuticals (Private) Limited (APPL) which is a wholly owned subsidiary of Al-Biruni International (ABI).

Summarised income statements of ISL and APPL for the latest financial year are given below:

ISL APPL

Rs. in million

Sales 2,500 1,800

Less: Cost of sales - Variable (1,350) (630)

- Fixed * (150) (190)

Gross profit 1,000 980

Selling expenses (375) (360)

Administration expenses (125) (90)

Profit before tax 500 530

Tax (35%) (175) (186)

Profit after tax 325 344

* includes depreciation of Rs. 70 million and 100 million respectively

Other Information (i) APPLs sales consist of Generic Medicines (40%) and Patented Products (60%). Presently,

20% of the revenue from Patented Products is contributed by a product Z-11. All patents are owned by ABI; however, no royalty or technical fee is presently claimed by it.

(ii) The variable costs of Patented Products are 30% of the sales amount. Product Z-11 will complete its patent period after three years and thereafter its price would have to be reduced. Consequently, the ratio of variable costs of production to sales would fall in line with that of Generic Medicines.

(iii) After acquisition the costs and revenues of APPL are projected as follows: Total sales and variable costs would grow at 10% per annum except in Year 4 when the

growth rate of sales would decline on account of reduction in price of product Z-11. Fixed costs other than depreciation would increase at the rate of 5% per annum. However,

depreciation would remain constant over the next five years. Selling expenses and administration expenses would be reduced by 30% and 80%

respectively. However, from Year 2 onwards, selling expenses would increase at 7% per annum whereas administration expenses would increase by 5% per annum.

ABI will charge 15% royalty on sale of Patented Products whereas 3% technical fee will be levied on the sales of all products.

(iv) Free cash flows of APPL are expected to grow at 3% per annum after Year 5.

(v) ISL intends to finance this project through debt carrying interest at the rate of 10% per annum. The principal would be re-payable at the end of Year 6.

(vi) ISL would discount this project at its existing weighted average cost of capital of 20%.

Required: (a) Calculate the bid price that ISL may offer for the acquisition of APPL. (17 marks)

(b) Assess the impact of the acquisition on the wealth of ISLs shareholders at the end of Year 5 assuming that the shares at that time would be priced at 7 times its PE ratio and ISLs profit after tax would increase at 8% per annum. (03 marks)

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Q.4 Khaldun Corporation (KC) is a Pakistan based multinational company and has number of inter-group transactions with its two foreign subsidiaries KA and KB, which are located in USA and UK respectively. Details of receipts and payments which are due after approximately three months are as follows.

Paying Company

Receiving 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 -

The current exchange rates and interest rates are as follows:

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 (08 marks)

(b) Demonstrate how multilateral netting might be of benefit to Khaldun Corporation. (06 marks)

Q.5 Ghazali Limited (GL) operates a chain of large retail stores in country X where the functional currency is CX. The company is considering to expand its business by establishing similar retail stores in country Y where functional currency is CY. As a policy, GL evaluates all investments using nominal cash flows and a nominal discount rate.

The required investments and the estimated cash flows are as follows: (i) Investment in country X CX 7 million would be required to establish warehouse facilities which would stock

inventories for supply to the retail stores in country Y at cost. At current prices, the annual expenditure on these facilities would amount to CX 0.5 million in Year 1 and would grow @ 5% per annum in perpetuity.

Investment in country Y Investment of CY 800 million would be made for establishing retail stores in country Y.

At current prices, the net cash inflows for the first three years would be CY 170 million, 250 million and 290 million respectively. After Year 3, the net cash inflows would grow at the rate of 5% per annum, in perpetuity.

(ii) Inflation in country X and Y is 7% and 20% per annum respectively and are likely to remain the same, in the foreseeable future. Presently, country Y is experiencing economic difficulties and consequently GL may face problems like increase in local taxes and imposition of exchange controls.

(iii) The current exchange rate is CX 1 = CY 45. (iv) GLs shareholders expect a return of 22% on their investments. GL uses this rate to evaluate

all its investment decisions.

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Required: Prepare a report to the Board of Directors evaluating the feasibility of the proposed investment.

Your report should include the following: (a) Computation of net present value of the project and a recommendation about the viability of

the project. (12 marks) (b) Identification of the risk and uncertainties involved. (03 marks) (c) Brief discussions on management strategies which may be adopted to counter the risks of

increase in local taxes and imposition of exchange controls. (05 marks)

Q.6 Skill Enhancement Centre (SEC) is an established institution with a mission to impart training to the youth by developing their job-related technical skills. It offers industry-specific one year diploma courses to students.

In the recent past, several other institutions have started offering a wide range of new courses with the result that the number of students enrolled in SECs Textile Designing Course (TDC) has declined to 175 students per annum. SEC is developing its 5-year plan and an important consideration is to replace TDC with Advanced Textile Graphics Course (ATGC).

The following related information is available:

(i) Several computers would need to be upgraded at a cost of Rs. 350,000. However, if ATGC is not introduced 30 such computers may be sold at Rs. 12,000 each. The current book value of each computer is Rs. 15,000.

(ii) ATGC would require new textile designing software which costs Rs. 1,200,000.

(iii) The new course would be taught and managed by the existing staff which receives total remuneration of Rs. 6,000,000 per annum. However, if the enrolment in ATGC program exceeds 225 students per annum, two new technical instructors would have to be engaged at a cost of Rs. 1,800,000 per annum which would be payable in advance.

(iv) Details relating to income from fees and other costs are as follows:

Timing of cash flows

TDC ATGC Rupees

Course fee per student In advance 42,000 43,200

Cost of training material per student In advance 6,000 7,400

Directly attributable costs (per annum) In arrears 120,000 230,000

Apportionment of overheads excluding staff costs In arrears 2,400,000 3,000,000

Preliminary costs (including training of instructors) In advance - 750,000

(v) On an average, a new student enrolled in a course brings additional revenue of Rs. 2,400 per annum on account of other activities.

(vi) Being an educational institution, SEC is exempted from income tax.

(vii) SEC assesses the viability of a course using a discount rate of 7%.

(viii) It is assumed that the number of students enrolled would remain constant throughout the five-year period.

Required: Determine the minimum annual enrolments which would make it financially viable for SEC to

introduce ATGC. (17 marks)

(THE END)

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BUSINESS FINANCE DECISIONS Suggested Answers

Final Examination Winter 2011

Page 1 of 6

A.1 (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. (vi) Perhaps the strongest argument against the MM view is that shareholders will tend to prefer a current dividend to future capital gains (or deferred dividends) because the future is more uncertain. (b) Market price per share Calculation of market price per share under MM dividend irrelevance theory 1o111o D-Ke)1(PP Ke1 DPP +=++= OR Market price if dividend Declared Not declared P Rs. 80.00 o Rs. 80.00 D Rs. 2.00 1 - Ke 14.4% (W-1) 14.4% P1 Rs. 89.52 {80x(1+0.144)-2} {80x(1+0.144)-0} Rs. 91.52 W1: Cost of equity under CAPM Ke = Rf + (Rm Rf) = 0.075 + (0.129 0.075) 1.28 (W-2) = 14.4% W2: Computation ReturnsMarket h Return wit ofn Correlatio Deviation StandardMarket ReturnMarket with Deviation Standard sAGPL' = 28.18.0%5%8 ==

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Page 2 of 6

(c) Justification of MM Dividend Irrelevance Theory No of shares to be issued Declared Not declared Rs. in million Net income 250.00 250.00 Less: Dividend paid 40.00 - Retained earnings 210.00 250.00 Less: New investments (600.00) (600.00 ) Amount to be raised through right issue A 390.00 350.00 Market price per share (as computed in (b) above B 89.52 91.52 Number of new shares to be issued (in million) C = A B 4.36 3.82 Already issued share capital D 20.00 20.00 Total number of shares to be outstanding E = C + D 24.36 23.82 Market capitalization B E 2,180 2,180 A.2 (a)

Path 1 Path 2 Path 3 Path 4 Path 5 Path 6 (b) All amount are in million rupees

Path

PV of NCIAT of Year 1 PV of NCIAT of Year 2

PV of total inflow Cash outflow

NPV Joint Probability Expected NPV Amount

Discount factor PV Amount

Discount factor 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 *including salvage value of Rs. 50 million Comment: Since the expected net present value of project is positive, it is suggested to accept investment proposal.

Cash Outflow (Rs. 500 million)

Rs. 250 million (65%)








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Page 3 of 6

A.3 (a) Growth FY00 FY01 FY02 FY03 FY04 FY05 Sales % ----- Rs. in million ----- Generic 10% 720 792.00 871.20 958.32 1,054.15 1,159.57 Patented other than Z-11 10% 864 950.40 1,045.44 1,149.98 1,264.98 1,391.48 Z-11 (Note 1) 10% 216 237.60 261.36 287.50 223.24 245.56 Less: Variable costs of production Generic 10% (336.60) (370.26) (407.29) (448.01) (492.82) Patented other than Z-11 10% (285.12) (313.63) (344.99) (379.49) (417.44) Z-11 10% (71.28) (78.41) (86.25) (94.88) (104.36) Less: Fixed costs other than depreciation 5% 90 (94.50) (99.23) (104.19) (109.40) (114.87) Less: Depreciation (100.00) (100.00) (100.00) (100.00) (100.00) Less: Selling expenses (Y1: Cost red. by 30%) 7% 360 (252.00) (269.64) (288.51) (308.71) (330.32) Less: Admin. Expenses (Y1: Cost red. by 80%) 5% 90 (18.00) (18.90) (19.85) (20.84) (21.88) Less: Royalty on patented products (W2) (Note 2) (178.20) (196.02) (215.62) (189.75) (208.72) Less: Technical fee (Total sales x 3%) (59.40) (65.34) (71.87) (76.27) (83.90) Adjusted profit before tax 584.90 666.57 757.23 815.02 922.30 Taxation (35%) (204.72) (233.30) (265.03) (285.26) (322.81) Profit after tax 380.18 433.27 492.20 529.76 599.49 Add: Depreciation 100.00 100.00 100.00 100.00 100.00 480.18 533.27 592.20 629.76 699.49 Terminal value (Note 3) 4,238.09 Total cash flows 480.18 533.27 592.20 629.76 4,937.58 Discount factor at WACC of 20% 0.833 0.694 0.578 0.482 0.402 Discount cash flows 400 370 342 304 1,985 Maximum bid price 3,401 Notes 1 Sales of Z-11 in Year 4: 94.88 42.5% [W-1] 2 Up to Year 3, 15% royalty would be charged on all patented products from year 4 onward, royalty would be charged on patented products other than Z-11. 3 {(1+FCF growth rate after year 5) x FCF in year 5} (Cost of capital FCF growth rate after year 5) = {(1+0.03) 699.49}(20% - 3%) = 4,238.09 W1: Determination of variable costs to sales % Sale Patented Generic Total Sales in Year 0 Rs. 1,080 Rs. 720 Rs. 1,800 Variable cost of production Rs. 324 Rs. 306 Rs. 630 Variable costs to sales % 30.00% 42.50% 35.00% (b) Rs. in million Value of combined entity (855.96 [W-1] x 7) 5,991.70 Value of ISL if not combined (477.53 x 7) 3,342.71 Additional value 2,648.98 W-1: Value of combined entity Year 5: Profit after tax - ISL (325 x (1+0.08)^5 477.53 Year 5: Profit after tax - APPL 599.49 Less: Additional interest on debt (3,401 10%) 65% (221.07) Combined earnings at Year 5 855.96

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Page 4 of 6

A.4 (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 .

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Page 5 of 6

A.5 To: Board of Directors Date: 7 December 2011 Subject: Evaluation of proposed investment in Country Y (a) Net present value of the investment

The financial evaluation of the Country Y Project is based on estimates of the future nominal cash flows of the investment, in both Country X and Y. All foreign cash-flows are converted to CX and total is discounted at a shareholders' required rate i.e. 22% per annum. The theory of purchasing power parity has been used to estimate future currency exchange rates. This predicts that if currencies are allowed to float freely on the market, they will adjust in the long run to compensate for differences in countries' inflation rates. 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 Y E A R S 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 Discount factor @ 30.54% [(1.22x1.07)-1] 1.000 0.766 0.587 0.450 Present value (24.778) 2.686 3.381 3.249 Net present value as computed above (15.462) Country X - NPV from Year 2 to perpetuity [(0.675 x 1.1235) (0.3054 - *0.1235)] 0.450 (1.876) Country Y - NPV from Year 4 to perpetuity [(7.894 x 1.26) (0.3054 - **0.26)] x 0.450 98.59 81.252 *Growth rate for Country X from year 4 to perpetuity [(1.07x1.05)-1]=12.35% **Growth rate for Country Y from year 4 to perpetuity [(1.20x1.05)-1]=26% (b) Risks and uncertainties (i) Large margins of potential error in the exchange rate prediction (ii) A slow payback: in present value terms the project will probably not break even until Year 8 or 4. (iii) The economic uncertainties in Country Y which may affect adversely on rate of inflation. (iv) Inappropriate projection of future cash flows specially the cash flows to be generated in Country Y and cash flows expectation to perpetuity. (c) Management Strategies To counter the increase in local taxes (i) Negotiate tax concessions in advance (ii) Use transfer price strategies including royalties and management, to minimize the impact of variation in Country Y taxable profits and dividends To counter the imposition of exchange controls (i) Make extensive use of local currency loans for financing (ii) Arranging currency swaps (iii) Back to back loans with other multinational companies and banks with complimentary cash needs

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Page 6 of 6

A.6 Timing of Cash flows Year Discount factor @ 7% Amount Students< 225 Students>225 Present value Present value ------------ Rupees ------------ Investment costs (W-1) 0 1.000 (2,660,000) (2,660,000) (2,660,000) Additional fee from existing capacity (175 (Rs. 43,200 - Rs. 42,000) Advance 0-4 4.387 210,000 921,270 921,270 Additional cost for the existing capacity (175 (Rs. 7,400 - Rs. 6,000) Advance 0-4 4.387 (245,000) (1,074,815) (1,074,815) Additional directly attributable course costs (Rs. 230,000 - Rs. 120,000) Arrears 1-5 4.100 (110,000) (451,021) (451,021.72) Additional staff costs Advance 0-4 4.387 (1,800,000) (7,896,600) (3,264,566) (11,161,166) A A Incremental benefit per student (over 175 students) (W-2) Advance 0-4 4.387 38,200.00 167,583 167,583 B B The number of additional students over 175 to cover the investment and incremental costs 19 67 C = A B C = A B No. of students required on ATGC for it to be financially viable 194 242 175 + C 175 + C Conclusion: If the enrolments are less than 225 then new course would be viable at 194 or above students. However, if the enrolments exceed 225 students then the new course would be viable at 242 or above students. WORKINGS W1: Initial investment cost Rupees Sale of computers foregone (30 x Rs. 12,000) 360,000 Upgrade of computers 350,000 Software acquisition 1,200,000 Preliminary costs 750,000 2,660,000 W2: Incremental revenues/costs per student over 175 students Fees 43,200 Additional benefit to SDS 2,400 Books and consumables (7,400) 38,200 (The End)

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The Institute of Chartered Accountants of PakistanBusiness Finance Decisions

Final Examinations Reading time 15 minutes

June 8, 2011 Module F Summer 2011 100 marks 3 hours

Q.1 (a) GER Auto Parts Limited is engaged in the manufacture of automobile spare parts. GERs summarised financial statements for the year ended December 31, 2010 are as follows:

Balance Sheet Equity and Liabilities Rupees Assets Rupees

Share capital (Rs. 10 each) 1,250,000 Fixed assets 7,500,000 Reserves 5,250,000 Inventory 750,000 Long term debt 2,500,000 Receivables 875,000 Current liabilities 625,000 Cash 500,000 9,625,000 9,625,000

Income Statement Rupees

Sales of 12,500 units 11,718,750 Variable costs (7,812,500) Fixed costs (1,750,000) Interest expense (10%) (250,000) Profit before tax 1,906,250 Tax (35%) (667,188) Net profit 1,239,062

Owing to competitive pressures, GER plans to reduce the prices of existing products by 6%. However, variable and fixed costs (excluding interest) are expected to increase by 5% and 10% respectively. Interest rate is floating and is expected to increase to 10.6% per annum.

Required: Calculate the amount of sales that GER should achieve in the following year to enable it to

maintain its existing total leverage. Show how this change would affect the operating and financial leverages. (07 marks)

(b) GERs management is also considering to launch a new product. Based on market research, it has identified the following options:

Option 1 Option 2 Product X Product Y Investment required (Rs.) 3,000,000 7,000,000 Unit price (Rs.) 15,000 5,000 Fixed cost (Rs.) 200,000 300,000 Expected sales (units) 200 1,000 Variable costs (% of sales) 78% 73%

The management plans to invest in any one of these options. The investment would be financed through long term debt which is available at 12% per annum.

Required: Calculate the impact of each of the above options on GERs operating and financial leverages

for the year ending December 31, 2011. Which option would you recommend and why? (You may assume that implementation of the above options would have no impact on the sales of existing products as computed in (a) above). (08 marks)

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BusinessFinanceDecisions Page2 of5

Q.2 The Trustees of FR Co-operative Housing Society are planning to invest its surplus funds in different open end mutual funds. Details of proposed investments along with market information gathered from a stock analyst are as follows:

Mutual Funds A B C Information on proposed investment Date of investment 1-Jul-11 1-Aug-11 1-Sep-11 Amount of investment Rs. 500,000 Rs.1,000,000 Rs. 500,000 Estimated net asset value on acquisition Rs. 10.50 Rs. 10.00 Rs. 9.70 Estimated net asset value as on December 31, 2011 Rs. 10.40 Rs. 10.00 Rs. 9.90 Expected dividends

(during the investment holding period) Cash dividend to be received Rs. 9,500 Rs. 15,000 - Bonus to be received 10% 5% 5% 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 0.92 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 0.10 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, 2011. (b) In respect of each fund, evaluate whether it would achieve the return in accordance with its

risk profile. (15 marks) Q.3 In order to reduce the cost of electricity consumption, HIN Textile Mills Limited has decided to

install a gas generator and discontinue the power supply being obtained from a utility company. The gas generator which would meet their requirements would cost Rs. 80 million. The following two proposals are being considered by HIN:

Option 1: Offer from BAL Leasing Company Limited BAL has offered a three year lease at a quarterly rent of Rs. 7.46 million payable in arrears. In

addition, HIN would be required to pay a security deposit of Rs. 10 million at the time of signing the lease agreement. Generator will be transferred to HIN at the end of the lease term, against the security deposit.

The fair value of the generator, at the end of lease period is estimated at Rs. 20 million. Operating and maintenance costs of the generator are estimated as follows: Costs Frequency Rs. in million

Staff salary Monthly 0.50 Lubricants and filters Quarterly 1.00 Parts replacement Half yearly 3.00 Overhaul At the end of 2nd year 15.00

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Option 2 : Offer from PUS Rental Services PUS has also offered to sign a three year contract according to which HIN would pay quarterly

rent of Rs. 11 million in arrears, with a 10% increase in each subsequent year. The lease rental would include the cost of maintenance and overhauling of the generator, which will be borne by PUS.

It may be assumed that HINs cost of capital is equal to the IRR offered by BAL. Required: Evaluate which of the above proposals should be accepted by HIN. (Ignore taxation) (12 marks) Q.4 The management of JAP Recreation Club is evaluating the option to launch a restaurant that

would serve complete meal to its members. Presently, it has a snack bar shop which sells snacks and drinks only.

A management consultant firm was hired at a fee of Rs. 85,000 to prepare the feasibility of the

project. JAPs Accountant has extracted the following information from the consultants report: (i) The restaurant will be launched on the first day of the next year.

(ii) The club membership has been increasing at the rate of 5% per annum. As a result of this facility, it is expected that the rate would increase to 10% per annum.

(iii) The cost of equipment for the restaurant is estimated at Rs. 7,000,000. It would have a residual value of Rs. 510,000 at the end of its estimated useful life of four years.

(iv) It is estimated that during the first year, an average of 100 customers would visit the restaurant, per day. The number would increase in line with the increase in membership. The average revenue from each customer is estimated at Rs. 400 whereas variable costs per customer would be Rs. 260.

(v) Four employees would be appointed in the first year at an average salary of Rs. 200,000 per annum. A fifth employee would be hired from the third year.

(vi) The annual fixed overheads for the current year are estimated at Rs. 4.8 million. 15% of the fixed overheads are allocated to the snack bar. As a result of the establishment of the restaurant the annual expenditure would increase as follows:

Rupees

Electricity and gas 340,000 Advertising 170,000 Repair and maintenance 85,000

After the establishment of restaurant, 20% of the overheads would be allocated to the

restaurant whereas allocation to snack bar would reduce to 10%.

(vii) The snack bar is presently serving an average of 250 customers per day and the number is increasing in proportion to the number of members. If the restaurant is launched, the number of customers would reduce by 40% in the first year but would continue to increase in subsequent years in line with the member base. The average contribution margin from snack bar is Rs. 50 per customer.

(viii) The tax rate applicable to the company is 35% and it is required to pay advance tax in four equal quarterly instalments. JAP can claim tax depreciation at 25% under the reducing balance method. Any taxable losses arising from this investment can be set off against profits of other business activities.

(ix) JAPs post tax cost of capital is 17% per annum before adjustment for inflation. The rate of inflation is 10%.

Required: Advise whether JAP should invest in the project. Assume that each year has 360 days. (16 marks)

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Q.5 ARA Venture Capital Limited specialises in acquiring loss making companies and converting them into profitable entities with the objective of disposing them subsequently.

Presently, ARA is planning to acquire 60% shareholdings in PUN Electric Supply Company. Its

Financial Analyst has obtained the following information about PUNs operations: (i) During the year ended December 31, 2010, total electricity demand and supply was Mwh 2.0

million, whereas the cumulative generation capacity of all the existing plants was Mwh 2.1 million. The demand for electricity is expected to grow at the rate of 5% per annum.

(ii) Cost of power generation per Kwh is Rs. 7 which is expected to increase by 8% per annum. (iii) PUNs line losses for the year were 30%. (iv) The Power Tariff Regulatory Authority has allowed PUN to determine the tariff so as to sell

electricity at a margin of 10% above the average cost of generation. PUN is allowed to include line losses of up to 20% in the cost of generation. The price per unit is determined by the following formula:

(Total Cost + 10%) {Number of units produced (1 Permissible line losses %)}

where, one unit = 1 Kwh and 1 Mwh = 1,000 Kwh (v) Revenue collection ratio for the year 2010 was 90% of the aggregate billing. (vi) Other expenses, excluding depreciation and financial charges for 2010 amounted to Rs. 300

million and are expected to increase by 8% per annum. (vii) Depreciation is charged on straight line method over the useful life of 20 years. Depreciation

for the year 2010 amounted to Rs. 75 million. (viii) PUN has running finance facilities of Rs. 3,000 million from various banks at an average

mark-up of 13% per annum. The facilities utilized as of December 31, 2010 amounted to Rs. 2,785 million.

(ix) In order to meet the future requirements of electricity, PUNs management has already started work on a new generation plant that will be commissioned into operation by the end of 2012 and will increase the present capacity by 15%. Total cost of the new project will be Rs. 1,500 million and PUN had issued TFCs on January 1, 2011 at 14% per annum, to finance the project.

(x) The issued share capital of PUN as at December 31, 2010 consisted of 500 million shares of Rs. 10 each.

ARA intends to invest in PUNs infrastructure facilities to reduce line losses. It also plans to

broaden the Recovery Department with the objective of improving the recovery ratio. The projected figures for the next five years are as follows:

Year ending December 31 2011 2012 2013 2014 2015 Capital expenditures (Rs. in million) 500 600 500 - - Additional staff cost in recovery

department (Rs. in million)

15

17

18

20

22 Line losses 28% 25% 22% 20% 18% Recovery ratios 92% 94% 96% 97% 97% The planned capital expenditures would be incurred at the end of the year. ARA would provide a

loan to PUN to finance the capital expenditures. The loan will be disbursed as required and carry a mark up of 10% per annum. It would be repayable on December 31, 2015.

In addition, ARA would provide guarantees to different banks to secure additional running finance facilities for PUN amounting to Rs. 8,000 million, at a mark up of 13% per annum.

ARA requires an IRR of 20% from its investment and expects to exit from this venture by selling its

shareholdings at the P/E multiple of 16. Required: Determine the purchase consideration that ARA should be willing to pay for the acquisition of 60%

shares in PUN. (Ignore taxation) (25 marks)

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Q.6 URD Pakistan Limited, a listed company, is presently considering to acquire 100% shareholdings of CHI Limited, an unlisted company, which is engaged in the same business.

The following information has been extracted from the latest audited financial statements of the

two companies:

URD CHI ----------Rs. in million---------- Non-current liabilities Term Finance Certificates 1,500 - Share capital (Rs. 10 each) 400 200 Retained earnings 100 100 Net profit after tax 300 250 Tax rate applicable to both the companies is 35%. The directors of URD believe that a cash offer for the shares of CHI would have the best chance of

success. They are considering various options to finance this acquisition. The initial negotiations suggest that interest rate on debt financing would depend upon the debt equity ratio of the company as shown below:

Debt equity ratio (up to) 40:60 50:50 60:40 70:30 Interest rate 16% 17% 18% 20% The shares of URD are currently traded at Rs. 52.50. According to the prevailing practice in the

market, price earning ratios of unlisted companies are 10% less than those of listed companies. Required: Write a report to the Board of Directors, on behalf of Mr. Shah Rukh, the Chief Financial Officer

of the company, discussing the following: (a) Which of the following financing option should the company adopt? (i) The acquisition of CHI Limited is entirely financed by debt. (ii) The acquisition is financed by issue of debt and equity in the ratio of 60:40. The equity

is to be generated by the issue of right shares at Rs. 45 per share. (b) What other matters should be considered and what impact these may have on the decision

arrived in (a) above? (17 marks)

(THE END)

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BUSINESS FINANCE DECISIONS Suggested Answers Final Examinations Summer 2011

Page 1 of 8

A.1 (a) Computation of existing operating, financial and total leverage 05.2250,906,1 500,812,7750,718,11 taxbefore Income marginon Contributi leverage Total === Determination of sales value where total leverage remains intact taxbefore Income marginon Contributi leverage Combined = Expense)Interest cost (Fixed - Sales) x margin%ion (Contribut Sales x margin%on Contributi 2.05 += 00x10.6%Rs.2,500,0000x110%(Rs.1,750,-05%)alesx625x1( - .5x94%)(salesx937

x105%)(salesx625 -937.5x94%) x (sales05.2+

=s Sales 2254,489,500 - sales 25.461 = 236.254,489,500 Sales = = 19,003 units Sales amount= 19,003x937.5x94% = 16,746,397 (rounded off) Effect on Operating and Financial Leverage Existing Revised * leverage Operating 81.1000,250250,906,1 500,812,7750,718,11 =+= 82.11)-(W 2,350,675 1)-(W 4,275,675 = ** leverage Financial 13.1250,906,1 000,250250,906,1 =+= 13.11)-(W 2,085,675 1)-(W 2,350,675 = *Operating leverage = contribution margins income before interest and tax **Financial leverage = income before interest and tax income before tax W-1: Forecasted Income Statement for the year ending December 31, 2011 Rs. % Sales 16,746,394 100 Variable costs (19,103 units x Rs. 625 x 105%) (12,470,719) 74 Contribution margin 4,275,675 26 Fixed costs (Rs. 1,750,000 x 110%) (1,925,000) Income before interest and tax 2,350,675 Interest expense (Rs. 2,500,000 x 10.6%) (265,000) Income before tax 2,085,675

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Page 2 of 8

(b) Comment on the behaviour of operating and financial leverages ratio in relation to launching of either Product X or Product Y Forecasted Income Statement Existing Operations Product X Existing operation + X Product Y Existing operation + Y A B A+B C A+C -----------------------------------Rupees----------------------------------- Sales 3,000,000 5,000,000 Variable Cost (2,340,000) (3,650,000) Contribution margin 4,275,675 660,000 *4,935,675 1,350,000 *5,675,675 Fixed Cost (200,000) (300,000) Income before interest & tax 2,350,675 460,000 *2,810,675 1,050,000 *3,450,675 Interest expense (360,000) (840,000) Income before tax 2,085,675 100,000 *2,185,675 210,000 *2,345,675 Operating leverage Existing (See (a)) 1.83 4,935,675 2,810,675 1.76 5,675,675 3,450,675 1.64 Financial Leverage Existing (See (a)) 1.13 2,810,675 2,185,675 1.29 3,450,675 2,345,675 1.47 Comment: (i) Operating leverage is declining under each of the two options, which is a favourable condition. (ii) Financial leverage would be considerably high, in case the company opts for launching product Y, although it is also accompanied by a substantial higher profit. (iii) If GER is willing to accept the higher risk as referred to in (ii) above, it would prefer to launch Product Y. Otherwise, it would opt to launch Product X. A.2 (a) Computing the effective annual yield A B C Investment a 500,000 1,000,000 500,000 Public Offer Price per unit (NAV at acquisition (1 + Buy Load) b 10.82 10.20 9.85 No of units acquired c = a b 46,210.72 98,039.22 50,761.42 Bonus units received (10%, 5%, 5%) d 4,621.07 4,901.76 2,538.07 Total units at year end e = c + d 50,831.79 102,940.98 53,299.49 Redemption value per unit (NAV at 31-Mar-2011 (1 + Sales Load)) f 10.30 10.00 9.71 Value of investment at year end g= e x f 523,567 1,029,410 517,538 Increase in NAV h = g - a 23,567 29,410 17,538 Cash dividend received i 9,500 15,000 - Total return j = h + i 33,067 44,410 17,538 No. of days k 183 152 121 Effective annual yield (j a)x365k 13.19% 10.66% 10.58%

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Page 3 of 8

(b) Evaluation of each investment A B C Required rate of return (W-1) 12.15% 11.08% 10.92% Effective annual yield (Computed in (a) above) 13.19% 10.66% 10.58% Decision Over performed Under performed Under performed Calculation of required rate of return A B C Rm 16% 17% 12% Sharpe Ratio 0.71 0.31 0.16 Rp (effective annual yield, computed above) 13.19% 10.66% 10.58% Rf 9% 9% 9% Investment SD=[(Rp - Rf)Sharpe Ratio] 0.06 0.05 0.10 Correlation with Index 0.75 0.92 0.83 Market SD 0.10 0.18 0.13 = Inv. SD Corr. with index Market SD 0.45 0.26 0.64 Required Return=Rf + (Rm - Rf) 12.15% 11.08% 10.92% A.3 Proposal of BAL Leasing Company Limited Cash flow Amount (Rs. in million) Frequency Total no. of payments (Rs. in million) Interest rate /period (W-1) Discount factor (annuity factor) PV (Rs. in million) Security deposit 10.00 1.000 10 Lease rentals 7.46 Quarterly 12 4.00% *9.385 *70 Lubricants and filters 1.00 Quarterly 12 4.00% *9.385 *9 Parts replacement 3.00 half yearly 6 8.00% *4.623 *14 Staff cost 0.50 monthly 36 1.33% *28.460 *14 Overhaul 15.00 End of 2nd year 0.731 11 Residual value (20.00) End of 3rd year 0.625 (13) Total present value 115 Proposal of PUS Rental Services Quarter 1 2 3 4 5 6 7 8 9 10 11 12 Total Quarterly rental (Rs. in m) 11.0 11.0 11.0 11.0 12.1 12.1 12.1 12.1 13.31 13.31 13.31 13.31 Discount factor (W-1) 4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 Present value (Rs. in m) 10.58 10.18 9.78 9.41 9.95 9.56 9.20 8.85 9.36 9.00 8.65 8.32 112.84 Conclusion PUSs option is better as it gives lower overall cost in present value terms W-1 : Finding the rate offered by BAL PV of inflow = Present value of outflows (annuity) = R Annuity Factor (AF) 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.

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Page 4 of 8

A.4 2011 2012 2013 2014 2015 -----------------------------------------Rupees----------------------------------------- Initial investment (7,000,000) Residual value 510,000 1 Restaurant contribution 5,040,000 5,544,000 6,098,400 6,708,240 2 Snack bar contribution in proposed structure 2,700,000 2,970,000 3,267,000 3,593,700 3 Snack bar contribution in current structure (4,725,000 ) (4,961,250) (5,209,313) (5,469,779) Salaries (800,000) (800,000) (1,000,000) (1,000,000) Additional overheads (595,000) (595,000) (595,000) (595,000) Net cash flows (7,000,000) 1,620,000 2,157,750 2,561,087 3,747,161 Tax payment (W-1) - 45,500 (295,838) (551,849) (456,413) Net cash flow after tax (7,000,000) 1,665,500 1,861,912 2,009,238 3,290,748 Discount factor (W-3) 1 0.940 0.884 0.831 0.781 Present value (7,000,000) 1,565,570 1,645,930 1,669,677 2,570,074 Net present value 451,251 1 Rs. 140 100 360 2 Rs. 50 250 60% 360 3 250 360 1.05 Rs. 50 Conclusion: The company should invest in the project as it would generate higher net cash flows as compare to existing business. W-1: Tax payments 2012 2013 2014 2015 ---------------------------------Rupees--------------------------------- Net cash flows 1,620,000 2,157,750 2,561,087 3,747,161 Less: Depreciation for the year (W-2) (1,750,000) (1,312,500) (984,375) (2,443,125) Taxable profit 4,595,000 5,806,500 6,786,025 6,773,815 Tax payments (Taxable profit x 35%) (45,500) 295,838 551,849 456,413 W-2 : Depreciation for the year Opening WDV of equipment 7,000,000 5,250,000 3,937,500 2,953,125 Less: Depreciation for the year (WDV x 25%) (1,750,000) (1,312,500) (984,375) *(2,443,125) Closing WDV of equipment 5,250,000 3,937,500 2,953,125 510,000 * Loss on disposal W-3: Adjustment of inflation in cost of capital Real discount rate = ((1+nominal discount rate)/(1+inflation rate))-1 = 6.36% A.5 Year ending Dec'11 Dec'12 Dec'13 Dec'14 Dec'15 Determination of value/bid price ---------------------Rupees in million--------------------- Loan to be given (500) (600) (500) - - Interest on loan (@10%) 50 110 160 160 Loan amount recovered 1,600 Terminal value (Rs. 653.90m (W-1) 1660%) 6,277 (500) (550) (390) 160 8,037 Discount factor (@20%) 0.833 0.694 0.578 0.482 0.402 Present value of annual cash flows (416.50) (381.70) (225.42) 77.12 3,230.87 Net present value (Purchase consideration) 2,284.37 W-1: Determination of net profit and loss for year 2015 Earnings before interest, tax and depreciation (W-2) 1,819.23 Financial charges (W-5) (1,165.10)

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Page 5 of 8

Net profit/(loss) 653.90 W-2: Earnings before interest and tax Year ending Dec'11 Dec'12 Dec'13 Dec'14 Dec'15 --------------------Rupees in million-------------------- Revenue from sale of energy (Price per unit (W-3) x Rs. 1,000 x Units Sold (W-4) 15,696.45 17,753.46 22,065.35 25,538.78 28,134.45 Cost of generation (W-3) 15,876.00 17,161.00 20,569.20 23,169.20 25,008.40 Other operating & admin exp. (LY 1.08) (324.00) (349.92) (377.91) (408.14) (440.79) Additional staff costs for recovery dept. (15.00) (17.00) (18.00) (20.00) (22.00) Prov. for non recoverability (Sales - Unrecovered %) (1,255.72) (1,065.21) (882.61) (766.16) (844.03) (Loss)/ earnings before interest (1,774.27) (839.67) 217.63 1,175.28 1,819.23 W-3: Determination of price Demand (million Mwh) (LY Demandx5%) A 2.10 2.21 2.32 2.44 2.56 Capacity (million Mwh) B 2.10 2.10 2.42 2.42 2.42 Units produced (million Mwh) (Lower of A or B) C 2.10 2.10 2.32 2.42 2.42 Existing cost of generation per Kwh (Re) (LY 8%) D 7.56 8.16 8.81 9.51 10.27 Existing cost of generation (D C 1,000) E 15,876.00 17,136.00 20,439.20 23,014.20 24,853.40 Depreciation on new plant + Infrastructure F - 25.00 130.00 155.00 155.00 Total costs 15,876.00 17,161.00 20,569.20 23,169.20 25,008.40 Price = 110% of cost #of units produced 0.8 10.40 11.24 12.19 13.16 14.21 W-4: Determination of units sold Line losses 28% 25% 22% 20% 18% Units sold (million Mwh) (C (1 line losses) 1.51 1.58 1.81 1.94 1.98 W-5: Mark up on running finance Opening balance of running finance 2,785.00 5,304.53 7,123.75 7,933.87 7,795.41 Loss / (earnings) before interest and tax (W-2) 1,774.27 839.67 (217.63 ) (1,175.28 ) (1,819.23 ) Mark up on TFCs (Rs. 1,500m x 50% x 14%) 210.00 210.00 210.00 210.00 210.00 Mark up on loan from ARA (@10%) - 50.00 110.00 160.00 160.00 Depreciation (Rs. 75 million + F) (75.00) (100.00) (205.00) (230.00) (230.00) 4,694.27 6,304.20 7,021.12 6,898.59 6,116.18 Mark up on running finance (13%) 610.26 819.55 912.75 896.82 795.10 Closing balance of running finance 5,304.53 7,123.75 7,933.87 7,795.41 6,911.28

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Page 6 of 8

A.6 To : The Management From : Chief Financial Officer Date : June 8, 2011 Subject : Report on selection of financing option 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 through debt only Where the acquisition is financed by debt and equity in the ratio of 60:40. Analysis of financing options 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. Working note

Existing (Without acquisition) Option 1 (acquisition thru 100% debt)

Option 2 (acquisition thru 60% debt and 40% equity) Debt equity ratio after acquisition W-1 42 : 58 59 : 41 47 : 53 Per share price (Rs.) W-3 52.50 64.00 57.75 Increase in shareholders wealth because of acquisition (Rs. in million) W-4 - 460.00 388.50 The relevant workings are enclosed as annexure. 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. Other factors to be considered Besides the increase in profitability and shareholders wealth, URD should also consider the following aspects: Stability of cash flows/high risk due to financial leverage 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. Stock market conditions 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

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Page 7 of 8

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. ANNEXURE TO THE REPORT W-1: Debt equity ratio after acquisition Existing (Without acquisition) Option 1 (acquisition thru 100% debt) Option 2 (acquisition thru 60% debt and 40% equity) Debt (Rs. in million) 1,500 *1 *3,075 22,445 Equity (Rs. in million) (W-2) 2,100 2,100 *32,730 Debt equity ratio 42 : 58 59 : 41 47 : 53 *1 1,500 + 1,575 (W-2) *2 1,500 + 1,575 (W-2) x 60% = 2,445 *3 2,100 + 1,575 (W-2) x 40% = 2,730 W-2: Value of URD and CHI Rs. in million URD CHI Net profit after tax 300.00 250.00 Number of shares outstanding (Rs. 400m Rs. 10) 40.00 Earnings per share (300 40) 7.50 P/E ratio (Rs. 52.5m/Rs. 7.5) 7.00 x 90% 6.30 Value of the company 2,100.00 1,575.00 W-3: Post acquisition price under each option If the acquisition is financed by debt only Rs. in million Net profit after tax-URD 300.00 Net profit after tax-CHI 250.00 Additional Interest expense (Rs. 1,575m (W-2) x 18% x 65% (184.28) Revised profit after tax 365.72 Value of URD after acquisition (Rs. 365.72 x 7 (W-2)) 2,560.04 Post acquisition value per share after (Rs. 2,560.04m 40m shares) 64.00 If the acquisition is financed by debt and equity in the ratio of 60:40. Rs. in million Net profit after tax-URD 300.00 Net profit after tax-

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