MODEL PAPER

ICMA.
Pakistan
Extra Reading Time: Writing Time: (i) (ii) (iii) (iv) (v) (vi) (vii) 15 Minutes 03 Hours Maximum Marks: 100

STRATEGIC FINANCIAL MANAGEMENT (AF-503)

SEMESTER-5 Roll No.:

Attempt all questions. Answers must be neat, relevant and brief. In marking the question paper, the examiners take into account clarity of exposition, logic of arguments, effective presentation, language and use of clear diagram/ chart, where appropriate. Read the instructions printed inside the top cover of answer script CAREFULLY before attempting the paper. Use of non-programmable scientific calculators of any model is allowed. DO NOT write your Name, Reg. No. or Roll No. anywhere inside the answer script. Question Paper must be returned to invigilator before leaving the examination hall.

Answer Script will be provided after lapse of 15 minutes Extra Reading Time (9:15 a.m. or 2:15 p.m. [PST] as the case may be).

Marks Q. 1 The Evergreen Publishing Group has two divisions; the print media division and electronic media division. The company publishes daily newspapers, weekly magazines and monthly digests in English and Urdu under its print media division. The both divisions are separate listed companies. The electronic media division runs a TV channel which telecasts the movies and dramas serials of different countries across the world after dubbing them in Urdu. In the recent past, the company was able to purchase these films and drama serials comparatively at low prices as the demand of these items was not at higher side. However, due to launching the many new TV channels, competition has increased manifold and producers of these films and drama serials have increased the sale price of their product at least 100%. The company has found it extremely difficult to maintain profitability with the present scenario. Resultantly, the Evergreen Publishing Group has decided to diversify and produce movies and drama serials in its own right. In order to gain the expertise for this venture Evergreen Publishing Group has decided to purchase a running Production House, at a cost of Rs. 800,000. The director marketing of the company has shown concern of potential success rate of in house production of Pakistani movies considering the successful release of the movies of a neighbouring country in Pakistani cinemas. He has further emphasized that other viable investment opportunities also be explored and in case we opt for production house then maximum resources should be allocated for production of drama serials which also have a large market in the Middle East. Evergreen Publishing Groups board meeting has just taken place to discuss the most viable investment decision. In this connection, two proposals for electronic media division have been discussed keeping in view available funds of Rs. 800,000 for capital investment. A third proposal has also been discussed regarding the expansion of print media division. Proposal-A: The Evergreen could invest funds of Rs. 800,000 in purchasing the production house. However, it would only produce the drama serials for the next five years and no movie would be produced as the potential success rate of independently produced films is not very promising. The CFO has produced cost and revenue forecasts of proposed investment for the next five years of operation based on data collected from the existing distribution business and discussions with industry gurus. The company aims to produce three (3) drama serials per year. Year-1 sales for the new business are uncertain, but expected to be in the range of Rs. 8 to 20 million. Probability estimates for different forecast sales revenue are as under:

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Marks Sales (Rs. in million) 8 10 14 20 Probability 0.2 0.4 0.3 0.1

Sales are expected to grow at an annual rate of 5% and anticipated costs related to new business are as under: Rs. 000 Purchase of production house for making drama serials Annual legal fee Annual lease rental (office equipment) Annual non-production staff wages Estimated costs of producing per drama serial are as follows: Studio and set hire Camera/specialist equipment hire Technical staff wages Screenplay Actors salaries Costumes and wardrobe hire Set design and painting The following additional information has also been forecasted by the CFO. Tax is payable one year in arrears, at a rate of 35% and full refund of tax can be claimed as it fall due. However, no depreciation/ capital allowance would be available. Staff wages (technical and non-production staff) and actors salaries, are expected to rise by 10% per annum Studio hire costs will be subject to an increase of 30% in Year-3. Screenplay costs per drama serial are expected to rise by 15% per annum due to a shortage of skilled writers. The new business will require a car parking space for which company is to pay rent of Rs. 40,000 per annum for the next five years. A market research survey at cost of Rs. 40,000 was conducted to ascertain the potential demand for the drama serials production business. Rs. 000 360 80 1,040 100 1,400 120 300 800 40 24 120

It was in principle agreed that the company would use weighted average cost of capital for all investment decisions. The electronic media division of Evergreen Publishing Group maintains 60% debt and 40% equity in its existing capital structure. The present cost of equity is 16% and after-tax cost of debt is 11%. The company has decided to increase the weighted average cost of capital (WACC) by 1% to incorporate the increase risk of this particular project. Proposal-B: The electronic media division of Evergreen Publishing Group could also utilize the funds of Rs. 800,000 available for capital budgeting in two other independent investment opportunities Project-X and Project-Y. In Project-X, Evergreen Publishing Group has planned to establish an advertising agency and in Project-Y, the company would arrange events for the promotion of various products of other companies.

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Marks The CFO of the company has apprised the board members that both the projects are indivisible and only one advertising agency and one outlet of event arrangement could be established. He further emphasized that due care has been exercised while forecasting the after tax cash flows of both the projects. The CFO is pretty sure that the overall risk of Project-X and Project-Y would not be more than Production House investment. The details of after tax cash flows of both projects are as under: After -Tax Cash Flows (Rs. 000) Year-0 Year-1 Year-2 Year-3 Year-4 Year-5 Year-6 Project -X (400) 400 400 300 200 200 200 Project-Y (200) 160 160 80 80 80 80 Proposal-C: Evergreen Publishing Groups board has also considered a study conducted recently by the management of print media division which concludes that if Evergreen expanded its print media division (which is less risky than its electronic media division), the firms beta would decline from 1.2 to 0.9. However, print media products have a somewhat lower profit margin, and this would cause Evergreens constant growth rate in earnings and dividends to fall from 7% to 5%. The company has just paid dividend of Rs. 2 per share and its KM is 12% and KRF is 9%. Required: Assume you are Management Accountant of the Evergreen Publishing Group and have been asked to write a report to the board of Group in which you are required to: (a) (b) Evaluate the viability of the Production House investment using the Net Present Value (NPV). (i) Calculate the profitability index of Production House project, Project-X and Project-Y. (ii) Advise the optimal investment strategy. (c) (d) Discuss the sensitivity analysis. What is the primary weakness and primary usefulness of sensitivity analysis? Drive the expected sales revenue of Production House project, can vary from its base case {as calculated at (a) above} by minus 10%. Evaluate the viability of the project under this assumption. (i) What is Evergreens current market price per share of its print media division? Should management make the change considering the new market price per share after incorporating the decrease in beta and growth rate? (ii) How low would the beta have to fall to cause the print media division expansion be a good one? Assume all the facts as given above except the change in the beta coefficient. (Hint: Set P0 under the new policy equal to P0 under the old one, and find the new beta that will produce this equality). 18 05 01 03

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(e)

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Q. 2

(a)

XYZ Ltd., sells stationery and office supplies on a wholesale basis. The most recent accounts of the company show an annual turnover of Rs. 8,000,000 and accounts receivable of Rs. 1,100,000. The company employs two people in its credit control department at an annual salary of Rs. 240,000 each. All sales are on 40 days credit with no discount for early payment. Bad debts represent 3% of turnover and XYZ Ltd., pays annual interest of 9% on its overdraft. The company is considering to offer a discount of 1% to customers paying within 14 days, which it believes will reduce bad debts to 2.4% of turnover. The company also expects that offering a discount for early payment will reduce the average credit period taken by its customers to 26 days. Resultantly one member of the credit department is to be employed. Two-third of customers are expected to take advantage of the discount.

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Required: (i) Determine whether a discount for early payment of 1% will lead to an increase in profitability for XYZ Ltd.

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(ii) Will your decision change at (i) above if both members of credit department continue their services? (b) Alpha Ltd., is a renowned name in the auto-mobile industry for its quality products. The company produces small parts for motor vehicles. In the past, the company has operated a very conservative policy in respect of the management of its working capital. You have been recently joined the company as Financial Analyst and your director has asked you to review this policy and evaluate the likely effect on the company if one or two alternative approaches to working capital management are introduced from the next year. The companys end-of-year forecast financial outcomes in six months time are as under: Rs. 000 Existing policy: Receivable 5,000 Inventory 4,000 Cash 1000 Non-current assets 2,500 Current liabilities 3,700 Forecast sales for the full year 16,000 Forecast operating profit (18% of sales) 2,880 The proposed parameters by director finance are as under: Proposed Moderate Policy: The receivable and inventory will decrease by 20%. Cash at bank will reduce to Rs. 500,000. There would be no change in the non-current assets. However, the current liabilities will increase by 10%. The forecast sale would be increased by 2% and no change would be expected in percentage profit of sales. Proposed Aggressive Policy: The receivable and inventory will decrease by 30%. Cash at bank will reduce to Rs. 200,000. There would be no change in the non-current assets. However, the current liabilities will increase by 20%. The forecast sale would be increased by 4% and no change would be expected in percentage profit of sales. Required: (i) Calculate the return on net assets and the current ratio under each of three scenarios shown below: (I) The company continues with its present policy. (II) The company adopts the moderate policy. (III) The company opts the aggressive policy. (ii) What course of action would you recommend to the company based on your conclusion drawn from scenario (I) above?

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Q. 3

(a)

Define the efficient market hypothesis. What are the three degrees or forms of efficiency? ABC Ltd., a listed company, is performing quite well in pharmaceutical industry. The company has no debt in its capital structure and it has paid an annual dividend of Rs. 4.50 per share on its 200,000 ordinary shares for a number of years. The total market value of the company is Rs. 4,650,000 cum dividend. The next annual dividend of Rs. 900,000 would be paid in a few days. The shareholders perceive that the companys dividends will remain indefinitely at the current level. 4 of 6

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(b)

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Marks The directors of ABC Ltd., are considering an immediate investment of Rs. 500,000 in a life saving drug which would produce net annual receipts of Rs. 132,000 indefinitely. The first receipt would arise after one year. The details of this particular project have not yet been communicated to the shareholders. However, all net cash flows from the project would be distributed as dividends among shareholders when received. If the project is undertaken, it would be financed in one of three ways: (A) A rights issue of one new share for every four held at a price of Rs. 10 per share. The new shares would qualify for dividend one year after issue. (B) A decrease of Rs. 500,000 in the current dividend. (C) A new issue of ordinary shares; the new shares would entitle for dividend one year after issue. The managing director of ABC Ltd., has the opinion that proposed price of the rights issue is very low and suggests one new share for every five held at a price of Rs. 12.50 per share. You may assume that directors expectations of future result would be communicated to, and believed by, the stock market in case the project is accepted. The risk of the company would remain unaltered and the issue cost of new shares and taxation may be ignored. Required: (i) Estimate the new market price per ordinary share, ex-dividend, if the project is accepted and financed by rights issue, and by a reduction in the current dividend. (ii) Calculate the share price and number of new shares to be issued under option (C), if the total benefit from the project is to go to existing shareholders. (iii) Calculate the total gain made by present shareholders under each of the three finance options. (iv) Comment briefly on the views expressed by the managing director. 05 04 04 02

Q. 4

The CEO of the Security Systems Ltd., has recently attended a seminar on leasing. He was very impressed by the views expressed by one of the speakers that leasing was the most viable option for acquiring an asset. The CEO has directed in the board meeting that the company must go for lease option for acquiring new equipment for one of its department. The CFO of company has assured the CEO that decision of acquiring the equipment would be taken in the best interest of the company and asked you to recommend the most viable course of action. The following data has been collected by the finance department of Security Systems Ltd. The equipment could be acquired on lease for a 4-year contract period. The lease payment of Rs. 400,000 per year is to pay at the beginning of each year. The lease would also include maintenance of the equipment. The equipment could also be purchased for Rs. 1600,000, financing the purchase by a bank loan for the net purchase price. Under the borrow-to-purchase arrangement, Security Systems Ltd., would have to maintain the equipment at a cost of Rs. 40,000 per year, payable at year end. The company charge depreciation on diminishing balance method for such type of equipment. The depreciation allowance is fully allowed for tax relief. The expected residual value of the machine after four years is Rs. 400,000. Security Systems Ltd., plans to replace the lathe machine after four years irrespective of whether it leases or buys. The company has a tax rate of 35% and its after tax cost of debt is 13%.

Required: (a) (b) Calculate the PV of the equipment cost under lease and purchase option. Would you support the CEOs view that lease is most viable option to purchase the equipment. 09 01

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Marks Q. 5 A summarized statement of financial position of Good Ways Ltd., is as follows: Assets less current liabilities Debt capital Ordinary share capital (4 million shares of Rs. 10) Retained earnings The companys profits in the year just ended are as follows: Earnings before interest and taxes Interest Earnings before tax Taxation 35% Earning after tax Dividends Retained earnings Rs. 000 42,000 12,000 30,000 10,500 19,500 13,000 6,500 Rs. 000 300,000 (140,000) 160,000 40,000 120,000 160,000

The company is now considering an investment of Rs. 50 million. This will add Rs. 10 million each year to the earnings before interest and taxes. The investment of Rs. 50 million could be financed by borrowing at interest of 8%. The money can also be raised by means of ordinary shares at Rs. 50 per share or 12% preference shares. The company will increase dividends per share next year from Rs. 3.25 to Rs. 3.50 whichever financing method is used. The company does not intend to allow its gearing level, measured debt finance as a proportion of equity capital plus debt finance, to exceed 55% at the end of any financial year. In addition, the company will not accept any dilution in earning per share.

Assume that the rate of taxation will remain at 35%. Required: (a) (b) (c) (d) (e) Calculate forecast earnings for next year, assuming that the new project is undertaken and is financed by debt, equity or preference shares. Calculate the earnings per share for next year, under each financing method. Calculate the projected statement of financial position at the end of the year under each financial method. Calculate the effect on gearing at the end of next year, with each financing method. Explain whether either or all methods of funding would be acceptable, if yes why? 05 03 03 03 01

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