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SUBJECT NO 04M

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CORPORATE FINANCIAL
MANAGEMENT
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SUGGESTED ANSWER

FOR THE

DECEMBER 2008 EXAMINATION DIET

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SECTION A
(Compulsory - answer all questions)

Question 1

(a) Agency Problem - The relationship between stockholders and the management
is called the agency relationship. This occurs when the shareholders as
principals hire their agents to act on their behalf. The possibility of conflicts of
interest between them is termed as the agency problem. There are two types of
agency costs, the direct costs originating from compensation and the indirect
ones resulting from monitoring the agent’s performance. Hence, shareholders
should make efforts to affect managerial behaviour in order to minimize agency
cost by practicing a reward system known as executive compensation tied to
performance.

(b) A stockholder owns part of a company and is entitled to income in the form of
dividends. Stockholders also elect directors who run the company. Stakeholders
are groups of people who have an interest in how the firm is run. These include
stockholders, employees, management, creditors and customers among others.
Each group is interested in the firm’s operation and profitability for its own
reasons. All stockholders are stakeholders, but all stakeholders aren’t
stockholders.

(c) The common types (any two) of securities issued the primary market are:

(i) An offer for sale – a situation where a firm sells shares to the public. The
firm is advised by an issuing house (normally a merchant bank), which
endorses the sale. All work involved in managing the issue, including
advertising, publication of prospectus and receiving and dealing with
applications is done by the issuing house.

(ii) Rights issue– additional shares are offered only to existing shareholders on a
pro-rata basis. They are given the pre-emptive right to buy the new shares at
a price lower than the market price. This entitlement means that they can
avoid dilution of ownership and earnings in the future. Alternatively, they
can sell the rights in the market or wait for the issuer to do so and collect any
surplus available.

(iii) A tender offer – involves calling for tenders from prospective subscribers,
after fixing a minimum reserve price for the shares. After receiving all the

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offers, the firm determines the price at which there are sufficient tenders for
it to raise the amount required ( strike price) and issues shares at that price to
all those who offered at least the strike price.

(d) Government securities represents risk free rate of return. This is because
securities issued by a government is guaranteed by the government itself and
carries zero default rate (risk free rate).

The best rating of corporate debt securities that could match the government
securities is AAA, defined as corporate debt securities that have the best quality
and offer the highest safety for timely payment of interest and principle.

(e) Efficient Frontier represents the set of portfolios that has a maximum rate of
return for every given level of risk, or the minimum risk for every level of
return. Every portfolio that lies on the efficient frontier has either a higher rate
of return for equal risk or lower risk for an equal rate of return than some
portfolio beneath the frontier.

(f) The basic idea behind purchasing power parity (PPP) is that a commodity costs
the same regardless of what currency is used to purchase it or where it is selling.

Example: If a burger costs RM2 in Kuala Lumpur, and the exchange rate is
RM3.20 per US dollar, then a burger costs RM2/$3.20 = $0.625 in New York.
In other words, PPP says that $1 will buy you the same number of burger
anywhere in the world.

(g) The four (4) basic motives for capital expenditures are:
(i) Expand - Purchase of additional plant facilities, resulting from a rapid
growth in business operations.

(ii) Replace - When sales slow down or repair becomes more expensive.

(iii) Renew - Usually involves rebuilding permanent assets.

(iv) Others - Acquisition of intangible assets in the forms of advertising,


management consulting and development activities

(h) The basic features (any four) of a bond are:

(i) Coupon – the annual interest payment promised by the issuer, based on
the par value

(ii) Principal – the redemption which is guaranteed upon maturity

(iii) Maturity date – the expiry date, when the principal becomes due

(iv) Yield-to–maturity – the fully compounded rate of return earned by the


bondholder over the life of the bond

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(v) Current yield – a return measure that indicates the amount of current
income a bond provides relative to its market price

(vi) Callability – the possibility of early retirement of the bond by the issuer

(i) The different dividend policies (any two) available are:

(i) Fixed dividend payout ratio - It is certain percentage of the earnings per
share. When the firm makes more earnings, the dividend paid will be
higher. (Assuming number of shares outstanding is unchanged).

(ii) Fixed dividend payment: The amount of dividend is fixed even if the
firm does not do as well as the previous year, it must pay the agreed
amount.

(iii) Residual dividend - firms pay dividend if there is any "leftover" earnings
after making allocation of the next year's capital budget.

(j) The key factors (any four) distinguishing the finance management of firms
operating within a country from those operating globally. They are:

(i) Different currency denominations - Cash flows in various parts of a


MNC system will be denominated in various currencies. Hence, an
analysis of exchange rates becomes critical.

(ii) Economic and legal ramifications - Each country's unique economic and
legal system can cause significant problems when a MNC attempt to
coordinates its worldwide operations.

(iii) Cultural differences - Languages, ways of doing business and attitudes


towards work among employees may delay the process of setting in.

(iv) Role of governments - Most financials models assume that existence of a


competitive marketplace in which terms of trade are determined by the
participants. However, the power of the ruling governments to establish
ground rules affects MNCs decisions.

(v) Political risk - A nation is free to place constraints on the transfer of


corporate resources and even to expropriate without compensation asset
within its boundaries. It must be explicitly addressed in any finance
analysis.

[Total mark for Section A = 40 marks]

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SECTION B
(Answer only THREE questions from this Section)

Question 2

a)

i) EOQ = √ 2 (F) (S)


(C) (P)

F = Fixed cost per order = RM1000


S = Annual sales = RM26000
P = Price per unit = RM4.92
C = Carrying cost (in percentage) = 25% x RM4.92 = RM1.23

= √ 2 (1000) (26000)
(0.25 x RM4.92)

= 52000000 = 6500 cans per order


1.23

ii) Number of orders per year = Annual sales = RM26000 = 4 times


EOQ 6500

iii) Total Carrying Cost per year

= EOQ x (P x C)
2
= 6500 x RM1.23 = RM4000
2

iv) Total Ordering Cost per year

= Sales x F
EOQ
= 26000 x RM1000 = RM4000
6500

v) Total Inventory Cost per year (TIC)

TIC = TCC + TOC = RM4000 + RM4000 = RM8000

b) The consequence of adopting EOQ inventory policy i.e. ordering in smaller


amount means higher number of orders and the possibility of forging bulk
discounts.

c) Inventory control system (any three).

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i) Just In Time (JIT) - Approach focussed on minimizing the time an inventory is
held. In a production process, the inputs required for stage two is programmed
to arrived just in time. (Immediately after stage one is completed)

ii) Out-sourcing - The practice of purchasing components rather than making


them in-house, sometimes is found to be more cost effective.

iii) LIFO vs. FIFO - The last in first out methods follows that the cost of goods
sold is based on the last unit placed in inventory. The first in first out releases
goods in the order they entered the inventory record.

iv) Economic order quantity model (EOQ) - Is an optimization technique that


determines the optimal amount to order and minimizing the total cost. While
carrying / holding cost rises generally indirect proportion to the average
amount of inventory held, ordering costs are often fixed.

[Total 20 marks]

Question 3

a) Use IRR to determine the initial capital of both projects as IRR is the rate when
NPV = $0

Year Cash Flow (forecasted)


(RM’ million)
Project A = 12% Project B = 15%
1 50/ (1.12^1) = 44.643 60/(1.15^1) = 52.174
2 80/(1.12^2) = 63.776 40/(1.15^2) = 30.246
3 80/(1.12^3) = 56.942 40/(1.15^3) = 26.301
4 90/ (1.12^4) = 57.197 20/(1.15^4) = 11.435
PV 222.558 120.156

b) Project A
i. Payback period (Io = 222.58)
50 (Year1) + 80(Year2) + 80(Year3) = 210 + (12.558/90)
= 3.14 years

ii. Discount Payback Period


47.62(Year1) +72.56(Year2) +69.11(Year3) = 189.29 + (33.268/74.04)
= 3.45 years

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Year Cash Flow Discounted Cash
(RM) Flow
(RM)
0 -222.58
1 50 50/ (1.05^1) = 47.62
2 80 80/(1.05^2) = 72.56
3 80 80/(1.05^3) = 69.11
4 90 90/ (1.05^4) = 74.04

Project B
i. Payback period (Io = 120.156)
60 (Year1) + 40 (Year2) = 100 + (20.156/40)
= 2.504 years

ii. Discount Payback Period


57.143 (Year1) + 36.281 (Year2) = 93.424 + (26.732/34.554)
= 2.774 years

Year Cash Flow Discounted Cash


(RM) Flow
iii.
(RM)
iv.
0 -120.156
v.
vi. 1 60 60/ (1.05^1) = 57.14
vii. 2 40 40/(1.05^2) = 36.28
viii. 3 40 40/(1.05^3) = 34.55
ix. 4 20 20/ (1.05^4) = 16.45

c) NPV (Project A)
PV = 47.62 + 72.56 + 69.11 + 74.04 = RM263.33
NPV = 263.33 – 222.58 = RM40.750

NPV (Project B)
PV = 57.14 + 36.28 + 34.55 + 16.45 = RM144.42
NPV= 144.42 – 120.156 = RM24.26

BTB should chose Project A due to higher NPV, compared to project B

d) Project B (IRR = 15%) > Project A (IRR = 12%)


Project A (NPV = RM40.750) > Project B (NPV = RM24.26)

Result is consistent between IRR and NPV


The conflict is due to the different pattern of cash flows between the two
projects in which,
Project A has lower cash flows in the beginning of the period and increasing
towards the end, while
Project B has higher cash flows in the beginning of the period and decreasing
towards the end of the period
[Total 20 marks]

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Question 4

a) MM Proposition 1 (no taxes) states that the value of a levered firm is the same
as the value of unlevered firm (firm value is irrelevant to its capital structure)
while MM Proposition II (no taxes) states that a levered equity has greater
expected return than unlevered equity to compensate for its greater risk.

b) i) Long term debt (after tax cost)

Cost of debt (before tax cost) = 10%, Corporate tax = 35%


Kd = 10% x (1 – 0.35)
= 6.50%

ii) Preferred stock


K p = Dp / P p
= 3.30 / 100 = 3.30%

iii) Equity from retained earnings (Use Dividend Discount Model)


P0 = D1 / (K-g)
K = (D1/P0) + g
D1 = 2.10 (1.09) = 2.29
K = (2.29/55) + 0.09 = 13.16%

iv) Equity from retained earnings (Use CAPM)


K = RFR + B (RM – RFR)
= 6% + 1.60(12% - 6%) = 15.60%

v) Newly issued common stock (Use Dividend Discount Model)


Kee = D1 / P0 (1-F) + g
= 2.29/[55 (1-0.1)] + 0.09
= (2.29/49.50) + 0.09 = 13.63%

c) Long term debt = RM1200/4000 = 30%


Preferred stock = RM800/4000 = 20%
Common equity = RM2000/4000 = 50%

WACC = 0.30 (6.50%) + 0.20 (3.30%) + 0.50 (13.63%) = 9.43%

d) Interest rates appear to have fallen, since the market values of debt and preferred
exceed their original values (book values). Price of debt and preferred is
inversely related to interest rates.

[Total 20 marks]

Question 5

i) Number of shares outstanding = 3,600,000/0.50 par = 7,200,000 shares


EPS = Net Profit/ No. of shares
= 12,600,000/7,200,000 = RM1.75

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ii) Price earning ratio (PER)
Price/EPS = RM20/1.75 = 11.43x

iii) Dividend payout ratio (%)


Dividend paid = Net profit – Retained Earning
= 12,600,000 – 7,560,000 = RM5,040,000
Dividend payout = dividend paid/Net profit
= 5,040,000/12,600,000 = 40%

iv) dividend income loss per share


At 40% dividend payout ratio = 40% x 12,600,000 = RM5,040,000
At 20% dividend payout ratio = 20% x 12,600,000 = RM2,520,000
RM2,520,000
The stockholder’s dividend income loss per share
= RM2,520,000/7,200,000 shares = RM0.35 per share

v) Number of shares to be sold to make up loss in current dividend income


Dividend income loss per share = RM0.35 x 1000 shares = 350
= RM350/ RM20 = 17.50
Hence the stockholder would have to sell about 18 shares of MB

vi) Stock split of 3:2 (50% increase in number of shares owned)

(a) Number of shares owned after stock split = (3/2) x 1000 = 1,500 shares

(b) New stock price after 3: 2 stock split


= (2/3) x RM20 = RM13.33

[Total 20 marks]

Question 6

(a)
i) Quick Ratio = (Current Asset – Inventories)/Current Liabilities
= (1,730,112 – 600,000)/740,000
= 1.53x
ii) Debt Ratio = Long Term Debt/Total Asset
= 780,000/3,062,112
= 25.47%
iii) Time Interest Earned Ratio = EBIT / Interest Expenses
= 1,622,000/160,000
= 10.14x
iv) Inventory Turnover Ratio = Sales/Inventory
= 8,000,000/600,000
= 13.33x

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v) Net Profit Margin = Net Profit /Sales
= 1,052,640/8,000,000
= 13.16%
(b)
i) ICP Inventory/(Sales/360)
= 600,000/ (8,000,000/360) 27.00 days
ii) ARCP A/c Receivables/ (Sales/360)
= 400,000/ (8,000,000/360) 18.00 days
iii) APP A/c Payable/ (COGS/360)
= 450,000/ (5,800,000/360) 27.93 days
iv) CCC ICP+ARP-APP 17.07 days

(c) The relative valuation techniques are appropriate to consider under the
following conditions.

(i) You have a good set of comparable entities i.e. comparable companies that
are similar in terms of industry, size and risk
(ii) The aggregate market and the company’s industry are not at a valuation
extreme i.e. they are not either seriously undervalued or overvalued

[Total 20 marks]

-End-

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