Certified Finance and Accounting Professional Stage Examinations

The Institute of 6 December 2016

Chartered Accountants 3 hours – 100 marks
of Pakistan Additional reading time – 15 minutes

Business Finance Decisions

Q.1 (a) Ramzi Corporation (RC), a listed company, has recently issued Term Finance
Certificates (TFCs) amounting to Rs. 500 million. Proceeds of the TFCs would be
utilised to acquire the assets of a textile mill. TFCs carry interest at KIBOR plus 200
basis points and are redeemable after five years. Interest is payable annually at the end
of each year.

RC is concerned that the existing KIBOR is the lowest rate prevailing during the past
several years. RC therefore considers it advisable to swap the floating rate interest with
a fixed rate.

Shawal Bank Limited (SBL) has offered RC an interest rate swap whereby RC would
have to pay to SBL a fixed annual rate of 7% in exchange for payment of one year
KIBOR rate by SBL. Payments and receipts will be made at the end of each year for
the next five years. SBL shall charge an annual fee of 20 basis points for the swap
transaction.

Currently, the annual KIBOR is 6.5% whereas annual forward rates are estimated as
follows:

Year 2 3 4 5
Rate 6.75% 7.50% 7.75% 8.00%

Required:
(i) Calculate the net amounts that RC would pay or receive each year on the swap
transaction. Also determine the net interest rate payable by RC if it chooses to
exercise the swap option. (07)
(ii) Discuss the merit(s) and demerit(s) of the swap transaction for RC. (04)

(b) In the last week of November 2016, the board of directors of RC decided to purchase
further machinery for its new textile mill under a balancing and modernisation
program. The company’s cash flow forecasts reveal that RC would need to borrow Rs.
300 million for the said program on 31 May 2017 for a period of eight months. The
directors are of the opinion that the present short-term interest rates may rise by the
end of May 2017 and are considering the use of short-term interest rate futures to
hedge against RC’s interest rate risk exposure.

On 1 December 2016, the spot rate of interest is 7% per annum and June 2017 six
month interest rate futures is traded at 92.

Required:
Assume that spot rate of interest on 31 May 2017 moves to 8.5% per annum and the
price of June interest rate futures falls to 90, demonstrate how short-term interest rate
futures can be used by RC to hedge against any rise in interest rate. Also determine the
effective rate of interest on the loan and hedge efficiency. (06)
 Business Finance Decisions Page 2 of 4

Q.2 Suffer Limited (SL) is engaged in the business of import and marketing of a range of
household cleaning products in Pakistan. All products are imported from Malaysia. One of
its most popular products is liquid dish washing detergent which is sold in the market under
the brand name of ‘Shine’. In view of Shine’s increasing demand in the market, SL is
considering to set up a plant in Pakistan for manufacture of ‘Shine’ because the
manufacturer in Malaysia is unable to increase the supply by more than 5% per annum.

Other relevant information is as under:

Information about existing business

During the latest year, sales of Shine were 10 million kg at an average selling price of Rs. 90
per kg inclusive of 17% sales tax.

Shine is imported in consignments of 1,000 kg. The cost per ton (at current prices) is as
follows:

CIF value Rs. 60,000

Import duty 10%
Sales tax 17%
Withholding income tax 5%

Information about manufacturing Shine

The estimated cost of setting up a manufacturing plant is Rs. 1,500 million. The plant would
have a manufacturing capacity of 18 million kg per annum. The life of the plant is estimated
at 5 years with a residual value of 30% of initial cost of setting up the plant. After the
establishment of manufacturing facilities, sales volume is expected to grow by 10%
annually. The raw material is locally available.

Manufacturing costs at current prices are projected as follows:

Direct material per kg (inclusive of 17% sales tax) Rs. 30

Direct labour per kg Rs. 10
Variable overheads per kg 50% of direct labour
Fixed overheads per month (excluding depreciation) Rs. 4 million

Taxation
SL is subject to taxation under the following rules:

Income tax rate applicable to SL is 25%. If the tax liability of the company is less than 1% of
the turnover (exclusive of sales tax), SL would be required to pay 1% of turnover as income
tax. Turnover tax paid in excess of the amount payable on taxable profit (if any) can be
claimed against future tax liability of the next three years. Brought forward losses can be
carried forward for the next six years.

Further, income tax paid at import stage is considered as minimum tax. The difference
between the amount of minimum tax paid and tax payable otherwise, is not allowed to be
carried forward.

Allowable initial and normal tax depreciation on the plant is 50% and 10% respectively.
Other information
(i) Sales price and all costs would increase by 10% and 5% respectively per annum.
(ii) All receipts and payments arise at the end of the year except cost of setting up of plant
which would arise at the beginning of the year. It may be assumed that the plant
would commence operations immediately (start of year 1).
(iii) SL’s cost of capital is 15%.

Required:
(a) Using the net present value method, advise SL whether it would be feasible for the
company to establish manufacturing plant. (23)
(b) Estimate the project’s sensitivity to the direct material costs. (03)
 Business Finance Decisions Page 3 of 4

Q.3 Malik Investments Limited (MIL) has identified various projects for investment of the
available funds. Details of these projects are as follows:

Present 2017 2018 2019 2020 2021 NPV

Projects
------------------------------- Rs. in million -------------------------------
A (150) 40 50 50 50 30 18
B (200) 60 70 80 90 - 34
C (250) 90 90 70 50 50 24
D (225) 100 100 100 - - 24
E (60) 25 30 15 15 - 9
F (100) 30 30 30 30 30 14

Other relevant information is as follows:

(i) Project A is a fixed five year contract and not subject to any change.
(ii) All other projects may be scaled downwards.
(iii) Only projects C, D & E can be scaled upwards up to 20%.
(iv) Budgeted funds available for investment by MIL amount to Rs. 500 million.
(v) MIL’s current cost of funds is 10%.

Required:
(a) Determine the optimum investment mix for MIL. (11)
(b) Assume that MIL wishes to invest in all the remaining available projects including
upward scaling. For this purpose, it is negotiating a financing arrangement. Advise
the maximum interest rate which MIL may offer. (09)

Q.4 Smart Limited (SL) manufactures and sells Product ‘A’ only. The standard contribution of
this product for the quarter ended 30 September 2016 is as follows:

Rupees
Sales price per unit 20,000
Less: Material (8 kg @ Rs. 800 per kg) (6,400)
Labour (9 hours @ Rs. 100 per hour) (900)
Contribution per unit 12,700

SL had budgeted production and sale during the month of September 2016 at 50,000 units.
In the last week of August 2016, the budget for the September 2016 had to be revised as
discussed below:
(i) The rival competitors had increased the price to Rs. 21,000 per unit. This increase
provided an opportunity to SL to increase its price to the same level.
(ii) Due to non-availability of material, use of an alternative material costing Rs. 850 per
kg was approved. It was also envisaged that the use of alternative material would
increase the consumption by 1 kg per unit.
(iii) Due to new labour union agreement, labour rate was increased by Rs. 10 per hour.

Actual performance for the month of September 2016 was as follows:

57,000 units were manufactured and sold.

498,750 kg of alternative material was used at Rs. 875 per kg.

494,000 hours were worked during the month. However, the production supervisors
informed the management that the handling of alternative material was difficult and
the workers were very critical about it. Consequently, it was decided to pay Rs. 115
per hour for September 2016 only.

Required:
Prepare a statement reconciling budgeted contribution for September 2016 with the actual
contribution, using planning and operational variances. (17)
 Business Finance Decisions Page 4 of 4

Q.5 Mangal Limited (ML) is a manufacturer and retailers of garments. ML is considering to

takeover Somvar Limited (SL) which is engaged in a similar business.

Extracts from the latest statements of financial position and income statements of both
companies are as follows:

Summarized Statements of Financial Position

ML SL
Rs. in million
Land and building (net) 483.0 42.3
Other non-current assets (net) 150.0 17.0
Current assets 384.0 63.0
1,017.0 122.3

Long term loan - 10% Bank loan 74.0 17.5

- 2% Term finance certificates (Rs. 100 each) 200.0 -
Current liabilities 391.0 50.1

Share capital (Rs. 10 each) 300.0 40.0

Reserves 52.0 14.7
1,017.0 122.3

Summarised Income Statements

ML SL
Rs. in million
Sales 1,130.0 181.0
Profit after tax 50.0 8.0

Dividends paid by ML and SL during the latest year amounted to Rs. 24 million and Rs. 5
million respectively. The latest market prices of their shares and debt instruments are as follows:

ML SL
Ordinary shares (ex-dividend) (Rs.) 20.5 26.5
Term finance certificates (cum interest) (Rs.) 109.0 -

ML estimates that after acquisition it would be able to achieve savings of Rs. 2.7 million per
annum (net of tax) for at least 5 years by eliminating certain administrative functions.
Further, sale of excess non-current assets would yield Rs. 6.8 million (net of tax on
disposal). However, ML would have to make ‘one time’ redundancy payment of Rs. 9
million (net of tax).

ML plans to offer four ordinary shares for every three ordinary shares of SL. A public
announcement of the proposal has not been made.

ML’s cost of equity and weighted average cost of capital are estimated at 16% and 14%
respectively whereas SL’s cost of equity is estimated at 15%.

Required:
(a) Discuss whether the proposed acquisition would be beneficial for the existing
shareholders of ML and SL if:
− the market is weak form efficient; (07)
− the market is strong form efficient. (03)
(Show working of all relevant calculations)

(b) Discuss the other factors which may influence the interests of the shareholders. (10)

(THE END)