BUSINESS FINANCE DECISIONS

Suggested Answers
Final Examinations – Winter 2010

A.1 (a) Synergistic effects can arise from five sources:

(i) Operating economies, which result from economies of scale in management, marketing,
production, or distribution.
(ii) Financial economies, including lower interest costs etc.
(iii) Tax effects, where the combined enterprise pays less in taxes than the separate firms
would pay.
(iv) Differential efficiency, which implies that management of one firm is more efficient and
that the weaker firm’s assets will be more productive after the merger.
(v) Increased market power, due to reduced competition.

(b) (i) The number of shares in Platinum Limited offered to shareholders of Diamond Limited are:
No. of shares to be issued to DL (7/6 x 19.2) = 22.4 million shares
Existing earnings per share of PL (Rs. 231m / 90m) = Rs. 2.57
Value of shares in PL (Rs. 2.57 x 15) = Rs. 38.55
Total value of bid (22.4 million shares x Rs. 38.55) = Rs. 863.52 million

(ii) EPS of PL following a successful acquisition: Rs. in million

Earnings of PL before acquisition 231.00
Earnings of DL before acquisition 58.00
Post takeover synergy 24.00
313.00

Shares in issue following acquisition (90+22.4) (in million) 112.40

EPS after acquisition (Rs. 313m / 112.4m) = Rs. 2.78
Share price after acquisition (Rs. 2.78 x 18) 50.04

(iii) Cost of each debenture

Rupees
EPS of DL before acquisition (Rs. 58 ÷ 19.2) 3.02
Value of a share in DL (Rs. 3.02 x 19) 57.38
Value of 2 shares of DL (2 X 57.38) 114.76
Present Value of 3 redeemable debentures of Rs. 100 each (W-1) 130.17

Since the present value of debentures is greater than the current market price of DL
shares, the offer is expected to be worth considering by shareholders of DL. In case
these debentures are marketable, there will be high chance that it will satisfy those
shareholders too who are interested in equity instrument. Such shareholders will be
able to swap debentures with PL’s shares in market.

W-1
Redeemable value 8 year discounting
(Rs.) factor at 11% PV
Present Value of 3 debentures
of Rs. 100 each 300 0.4339 130.17

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 BUSINESS FINANCE DECISIONS
Suggested Answers
Final Examinations – Winter 2010

A.2 (a) Net receipt due at the end of first quarter

US $
Receipt due 1,020,000
Payment due (775,000)
245,000
(i) Net receipt under forward contract
= 245,000 x (MYR 3.03 – MYR 0.071)
= 245,000 x 2.959
= 724,955
(ii) Net receipt under money market hedge
245,000 245,000
= = 240,668
Borrowed in US $ =  7 . 2 %  1.018
1+  
 4 
Received now in MYR = 240,668 x 3.03 = MYR 729,224
Received in 3 months time = 729,224 (1+(6.6%/4) = MYR 741,256

Net payment due at the end of second quarter

US $
Receipt due 1,224,000
Payment due (1,347,000)
(123,000)
(i) Net payment under forward contract
= 123,000 x (MYR 3.11 – MYR 0.164)
= 123,000 x 2.946
= 362,358
(ii) Net payment under money market hedge
123,000 123,000
= = 119,534
Lent in US $ =  5.8%  1.02900
1+  
 2 

Paid now in MYR = 119,534 x 3.11 = 371,751

  7.9%  
Paid in 6 months time = 371,751 x 1 +    = 386,435
  2 
Conclusion:
 For the first quarter, SL would be better off with money market hedge as it would receive
more MYR than with a forward contract.
 For the second quarter, forward exchange contract produces a lower net payment in
MYR.

(b) SL wishes to lend and so will buy 5 (MYR 15,000,000 / MYR 3,000,000) interest rate
February Futures.

(i) If interest rates fall by 0.75% and March Futures price increases by 1%, the net hedging
position of the interest rate future would be as follows:
MYR
Future outcome MYR 15,000,000 x 6/12 x 1% 75,000
Receipt in spot market (MYR 15,000,000 x 5.25% x 6/12) 393,750
Net outcome 468,750
Target outcome (6% x 6/12 x MYR 15,000,000). 450,000

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 BUSINESS FINANCE DECISIONS
Suggested Answers
Final Examinations – Winter 2010

Gain on hedging through interest rate futures 18,750

(ii) If interest rates rise by 1% and March Futures price decreases by 1%, the net hedging
position of the interest rate future would be as follows:
MYR

Future outcome 15,000,000 x 6/12 x 1% (75,000)

Receipt in spot market (MYR 1,500,000 x 7% x 6/12) 525,000
Net outcome 450,000
Target outcome 450,000
No gain or loss (100% efficient) -

A.3 (a) Projects

A B C D
Required rate of return (W-1) 14.12% 13.84% 16.16% 15.84%
Expected return 16% 14% 17% 15%
Decision Invest Invest Invest Not to invest

Excess return index (Expected /Required return) 1.13 1.01 1.05

Preference 1 3 2

W-1: Required rate of return

Risk free rate of return (R f ) 10% 10% 10% 10%
Market return (R m ) 14% 14% 14% 14%
β (W-2) 1.03 0.96 1.54 1.46
Required rate of return Rf + (R m - R f )β 14.12% 13.84% 16.16% 15.84%
W-2: Computation of β
Estimated correlation of returns with market
return a 0.82 0.85 0.91 0.78
Project standard deviation of returns b 20% 18% 27% 30%
Market Standard Deviation c 16% 16% 16% 16%
β (a x b ÷ c) 1.03 0.96 1.54 1.46

(b) Combined portfolio beta

Project PV β Weighted β
A 197.20 1.03 0.34
B 202.71 0.96 0.32
C 201.60 1.54 0.52
601.51 1.18

Net annual cash flows (Rs. in millions) 85.00 87.00 90.00

*Cumulative discount factor at required rate of
return 2.32 2.33 2.24
Present value of cash flows (Rs. in millions) 197.20 202.71 201.60

1 − (1 + i) − n
*
i

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 BUSINESS FINANCE DECISIONS
Suggested Answers
Final Examinations – Winter 2010

A.4 Years 0 1 2 3 4 5
Evaluation of investment in Bangladesh
----------- BDT in million ----------
Total contribution (W-1) 490.05 718.74 790.62 869.68
Less: Fixed overhead (Expense x Inflation %) (423.50) (465.85) (512.44) (563.68)
Operating cash flows 66.55 252.89 278.18 306.00
Tax at 35% (23.29) (88.51) (97.36) (107.10)
Tax savings on depreciation (W-3) 16.73 13.38 10.71 8.56
Land (80.00)
Building (30.00) (82.50)
Plant and machinery (126.50)
Working capital (W-4) (22.00) (111.10) (13.31) (14.64) (16.11)
After tax realizable value (W-7) 322.16
Net cash flow (110.00) (231.00) (51.11) 164.45 176.89 513.48
Exchange rate BDT / PKR (W-2) 0.8400 0.8250 0.8103 0.7958 0.7816 0.7676
Net cash flow (PKR in million) (130.95) (280.00) (63.68) 206.65 226.32 668.94
Discount factor (@ 15.12%)
(PKR in million) (W-5) 1.00 0.87 0.75 0.66 0.57 0.49
Present value (PKR in million) (130.95) (243.22) (47.76) 136.39 129.00 327.78
Net present value (PKR in million) 171.24

Evaluation of investment in Sri Lanka

---------------------------------- LKR in million --------------------------------
Pre-tax cash flow
(annual increase by 8% from year 0) 29.16 40.82 44.09 47.62 51.43
Tax @ 25% (7.29) (10.21) (11.02) (11.91) (12.86)
Cost of acquisition (90.00)
Plant and machinery (18.00)
Working capital (W-4) (36.00) (2.88) (3.11) (3.36) (3.63) (3.92)
After tax net realizable value 167.9
Net cash flow (144.00) 18.99 27.50 29.71 32.08 202.55
Exchange rate LKR / PKR (W-2) 1.3250 1.2777 1.2320 1.1880 1.1456 1.1047
Net cash flow from SISL in (PKR in million) (108.68) 14.86 22.32 25.01 28.00 183.35
Additional tax @ 5% (W-6) (PKR in million) - (1.14) (1.66) (1.85) (2.07) (2.34)
Net cash flow (PKR in million) (108.68) 13.72 20.66 23.16 25.93 181.01
Discount factor (@ 15.12)(W-5)(PKR in
million) 1.00 0.87 0.75 0.66 0.57 0.49
Present value (PKR in million) (108.68) 11.94 15.49 15.29 14.78 88.70
Net present value (PKR in million) 37.52

W-1: Contribution margin – Bangladesh

Sales price 300,000

Less: Variable costs (165,000)

Contribution margin per unit (BDT) 135,000 - 163,350 179,685 197,654 217,419
Production / sales units 3,000 4,000 4,000 4,000
Total contribution (BDT in million) 490.05 718.74 790.62 869.68

W-2: Computation of exchange rates for the next 5 years

BDT / PKR 0.8400 0.8250 0.8103 0.7958 0.7816 0.7676
LKR / PKR 1.3250 1.2777 1.2320 1.1880 1.1456 1.1047

Average mid market exchange rate BDT / PKR

Year 0: 0.8300 + 0.8500 = 1.680 ÷ 2 = 0.8400
Year 1-5: Previous year x 1.10/1.12

Average mid market exchange rate LKR / PKR

Year 0: 1.3100 + 1.3400 = 2.650 ÷ 2 = 1.3250
Year 1-5: Previous year x 1.08 / 1.12

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 BUSINESS FINANCE DECISIONS
Suggested Answers
Final Examinations – Winter 2010

Years 0 1 2 3 4 5
W-3: Tax depreciation (BDT in million)
Opening balance 30.00 239.00 191.20 152.96 122.37
Machinery - 126.50
Building 30.00 82.50
30.00 239.00 239.00 191.20 152.96 122.37
Less: 20% depreciation allowance 47.80 38.24 30.59 24.47
30.00 239.00 191.20 152.96 122.37 97.90
Tax saved at the rate of 35% 16.73 13.38 10.71 8.56

W-4 : Working capital

Bangladesh ----- BDT in million -----
Working capital × inflation factor 22.00 133.10 146.41 161.05 177.16
Increase in working capital 22.00 111.10 13.31 14.64 16.11
Sri Lanka ----- LKR in million -----
Working capital × inflation factor 36.00 38.88 41.99 45.35 48.98 52.90
Increase in working capital 36 2.88 3.11 3.36 3.63 3.92

W-5: WACC as discount factor

Cost of equity 0.70 x 18% = 12.60%
Cost of debt 0.30 x 12% x 70% = 2.52%
WACC 15.12%

W-6 : Additional tax for income from Sri Lanka

Tax rate applicable in Pakistan is 5% higher than Sri Lanka. So income from Sri Lanka will be
subject to 5% additional tax.

----- LKR in million -----

Pre-tax cash flow in LKR (as above) - 29.16 40.82 44.09 47.62 51.43
Exchange rate (W-2) 1.33 1.28 1.23 1.19 1.15 1.10
Pre-tax cash flow in PKR - 22.78 33.19 37.05 41.41 46.75
Additional Tax in Pakistan @ 5% 1.14 1.66 1.85 2.07 2.34

W-7: After tax realizable value

Bangladesh Sri Lanka
(BDT) (LKR)
After tax realizable value of investment 145.00 115.00
Realization of working capital 177.16 52.90
322.16 167.90
Conclusion:
Gold Limited should invest in Bangladesh as it gives higher NPV.

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 BUSINESS FINANCE DECISIONS
Suggested Answers
Final Examinations – Winter 2010

A.5 (a) (i) Weighted average cost of capital

 Existing WACC = (Equity % (W-1) x K e (W-2)) + (Debt % (W-1) x K d (1-t))
= (60% x 17%(W-2) ) + (40% x 9% x 65%) = 12.54%

 70% equity 30% debt

WACC = (70% x 15.9% (W-2)) + (30% x 8% (W-3) x 65%) = 12.70%

 50% equity 50% debt

WACC = (50% x 18.5% (W-2)) + (50% x 11% (W-3) x 65%) = 12.83%

(ii) Value of the company

 Current value of the company (825+550) = Rs. 1.375 million

 Value of the company at 70% equity 30% debt

WACC (Computed above) = 12.70%
112.55 x 1.0403
Valuation = = 1350 million
0.1270 − 0.0403(W − 5)

 Value of the company at 50% equity 50% debt

WACC (Computed above) = 12.83%
112.55 x 1.0403
Valuation = = 1330 million
0.1283 − 0.0403( W − 5)

W-1: Existing debt equity ratio

825
Equity = = 60%
1375
550
Debt = = 40%
1375

W-2: Cost of equity

 Existing
K e = r f + (r m - r f )β
K e = 7% + (15% - 7%) x 1.25 = 17%

 At 70% equity 30% debt

K e = 7% + (15% - 7%) x 1.115 = 15.9%

E + D(1 - t) 70% + 30% x 65%

βe = βa = * 0.872 = 1.115
E 70%

 At 50% equity 50% debt

K e = 7% + (15% - 7%) x 1.439 = 18.5%

E + D(1 - t) 50% + 50% x 65%

βe = βa = * 0.872 = 1.439
E 50%

* E D(1 − t)
βa = βe + βd
E + D(1 − t) E + D(1 − t)
825
= 1.25 + 0 = 0.872
825 + 550 x 65%

Page 6 of 7
 BUSINESS FINANCE DECISIONS
Suggested Answers
Final Examinations – Winter 2010

W-3 : Cost of debt

 At 70% equity 30% debt
Since interest cover has an inverse relationship, we assume decline in debt moves the CIL
to lower category of interest rate:
30% debt in existing market value of the company (30% x 1375) = 412.5
Cost of debt = (8% x 412.5) = 33
Interest cover = (327* ÷ 33) = 9.91
∴K d = 8%
* Profit before interest and tax

 At 50% equity 50% debt

Since interest cover has an inverse relationship, we assume increase in debt moves the
CIL to upper category of interest rate:
50% debt in existing market value of the company (50% x 1375) = 687.5
Cost of debt is = (11% x 687.5) = 75.63
Interest cover = (327 ÷ 75.63) = 4.32
K d = 11%
W-4: Current Free cash flow (FCF o ) Rs. in million
Profit before tax 272.00
Add: Interest 55.00
Profit before tax and interest 327.00
Less: Income tax @ 35% 114.45
Profit after tax 212.55
Add: Depreciation 50.00
Less: Capital expenditures (150.00)
Free cash flow 112.55

W-5 Computation of growth factor

FCF1
Current valuation = 1375 =
(k - g)
FCF1 112.55(1 + g )
1375 = ⇒ 1375 =
(k - g) 0.1254 − g

1375 (0.1254 g) = 112.55 (1 + g) ⇒ 59.88 = 1488γ ⇒ γ = 4.03%

(b) Evaluation of the above options

(i) The existing debt equity structure gives the lowest WACC i.e. 12.54%.
(ii) If debt equity ratio is decreased, some of the benefits of tax shield on debt are lost.
(iii) If debt equity ratio is increased, the financial risks cause an increase in the cost of debt.

Since the existing debt equity ratio gives the lowest WACC and resultantly the highest
valuation to the company, the capital structure of the company should not be changed.

(THE END)

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