EXTRA ATTEMPT, NOVEMBER 2013 EXAMINATIONS

ICMA. Saturday, the 23rd November 2013

STRATEGIC FINANCIAL
MANAGEMENT – (AF-503)
Pakistan
SEMESTER-5
Extra Reading Time: 15 Minutes
Maximum Marks: 90 Roll No.:
Writing Time: 02 Hours 45 Minutes
(i) Attempt all questions.
(ii) Answers must be neat, relevant and brief.
(iii) 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.
(iv) Read the instructions printed inside the top cover of answer script CAREFULLY before attempting the paper.
(v) Use of non-programmable scientific calculators of any model is allowed.
(vi) DO NOT write your Name, Reg. No. or Roll No. anywhere inside the answer script.
(vii) Question No.1 – “Multiple Choice Question” printed separately, is an integral part of this question paper.
(viii) 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 (9:30 a.m. or 2:30 p.m. [PST] as the case may be).
Marks
Q. 2 Using the following information of Gamma Ltd., complete the financial statements: 12
Current ratio 1.25
Receivable turnover 20
Inventory turnover 7.50
Long-term debt to net worth 0.656
Gross profit margin 15%
Net profit margin 5%
Assets turnover 2.75
Earnings per share (EPS – Rs.) 5

Statement of Financial Position Rupees

Cash – Current liabilities –
Account receivable – Long-term loan –
Inventory – Common stock (Rs. 10 each) –
Net fixed assets 800,000 Retained earning 106,061
– –

Statement of Profit and Loss Rupees

Sales 5,000,000
Cost of goods sold –
Gross profit –
Operating expenses –
Earnings before tax (EBT) –
Tax (35%) –
Net profit –

Q. 3 (a) Define the efficient market hypothesis. What are the three degrees or forms of efficiency? 05

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(b) XYZ Ltd., a pharmaceutical company, has issued 3,000,000 ordinary shares of Rs. 10
each, which are at present selling for Rs. 20 per share. The company is performing quite
well in the industry and is in process of expanding its production capacity. To finance the
expansion, the company plans to issue rights to purchase one new equity share at a price
of Rs. 16 per share for every three shares held. Mr. Asmat Qasami, a doctor by
profession, owns 4,500 shares in XYZ Ltd. He thinks that he will suffer a loss of personal
wealth because the new shares are being offered at a price lower than the market price.
He seeks your advice for the appropriate course of action to avoid loss in his personal
wealth. You may assume that the actual market value of shares will be equal to the
theoretical ex-rights price. What would be the effect on Mr. Ahmed Qasami’s wealth, if:
Required:
(i) He sells all the rights? 05
(ii) He exercises half of the rights and sells the other half? 03
(iii) He does nothing at all? 02

Q. 4 (a) Crescent Limited manufactures filtration plants. The selling price of filtration plant is
Rs. 500,000 each. The company’s fixed costs are Rs. 10 million. The other data is as
under:
 50 filtration plants are produced and sold each year. The company is earning annual
profit of Rs. 2,500,000 and its assets (all equity financed) are Rs. 25 million.
 The company estimates that it can change its production process requiring Rs. 20
million as additional investment and Rs. 2,500,000 as additional fixed operating cost.
This change will:
(i) reduce variable cost per unit by Rs. 50,000;
(ii) increase output by 20 units;
(iii) have to lower the sales price on all units to Rs. 475,000 to ensure sales of the
additional outputs.
 The company has assessed tax loss carry-forward that cause its tax rate to be zero.
The company’s cost of equity is 15%, and it uses no debt.
Required:
(i) Should Crescent Limited make the above change? Why and why not, substantiate
your answer with reasoning. 07
(ii) Would operating leverage increase or decrease, if Crescent Ltd., made the change?
What will be the breakeven point of the company? 04
(iii) Would the new situation expose the company the more or less business risk than the
old one? 01

(b) Suppose you have been the CFO of ABC Ltd., which has surplus funds of twenty million
rupees for a year and has invested in the following portfolio of shares:
Security Amount Invested (Rs.) Expected Return (%) Beta
Stock-A 2,000,000 08 0.80
Stock-B 4,000,000 12 0.95
Stock-C 6,000,000 15 1.10
Stock-D 8,000,000 18 1.40
20,000,000

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Required:
(i) What is the expected return and beta of this portfolio? Does this portfolio have more
or less systematic risk than an average asset? 05
(ii) If ABC Ltd., invests 30% of Rs. 20 million in each of the first two securities, and 20%
in each of the last two, what would be the beta of your portfolio and the portfolio’s
expected return, and the risk-free rate is 8% and the expected return on the market
portfolio is 14%? You may assume that the expected return of each stock is not
available. 03

Q. 5 (a) A construction company recently purchased a new concrete mixing plant. The new plant
costs Rs. 450,000, and it is expected to generate net after-tax operating cash flows of
Rs. 125,000 per year. The plant has a 5-year expected life. The expected abandonment
values (salvage values after tax adjustments) for the plant are given below:
Abandonment value at the end of year
Year 0 1 2 3 4 5
Value (Rs.) 450,000 350,000 280,000 220,000 100,000 –

The company’s opportunity cost is 10%. Assume that the plant will be used indefinitely –
i.e., if the plant is sold early, it will be replaced with a new one.
Required:
Should the firm operate the plant until the end of its 5-year physical life or, if not, what is
its optimal economic life? 12

(b) The Super Engineering Ltd., manufactures the various kitchen utensils and household
items. The management of the company is presently considering to launch a new
product. The life of the product is not more than two years and capital allowance would
not be available for initial investment over the life of the product. Cash flows arise from
selling 162,500 units at Rs. 200 per unit. The estimated cash flows are as under:
Rs. ‘000’
Year Initial Investment Variable Costs Cash Inflows Net Cash Flows
0 35,000 – – –
1 – (10,000) 32,500 22,500
2 – (10,000) 32,500 22,500

The production manager is very keen to launch the product and marketing department
has also stated that subject product would capture a good percentage of market share.
However, the CFO of the company has apprised the board that we should conduct the
sensitivity analysis of the product before undertaking this project to avoid any adverse
outcome. He further explains, on CEO’s request, that sensitivity analysis is an
investigation of what happens to NPV when only one variable is changed at a time. Super
Engineering Ltd., has a cost of capital of 8%. Ignore taxation.
Required:
(i) How would you measure the sensitivity of the product to changes in each variable?
Substantiate your answer with workings. 09
(ii) Calculate internal rate of return (IRR) to compare it with cost of capital of the
company. 06

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Q. 6 Karachi Bottles Limited is considering an acquisition of Qazi Water Limited. Qazi Water
Limited currently has a cost of equity of 15%; 30% of its financing is in the form of 12% debt,
the rest is in common equity. Its tax rate is 35%. After the acquisition, Karachi Bottles Limited
expect Qazi Water Limited to have the following free cash flows and interest payments for the
next 5 years:
Rs. in million
Year-1 Year-2 Year-3 Year-4 Year-5
Free cash flow 16.00 25.00 28.00 30.00 35.00
Interest expense 35.00 39.00 42.00 45.00 48.00

After this, the free cash flows are expected to grow at the constant rate of 8% and the capital
structure will stabilize at 40% debt with an interest rate of 13%.
Required:
(a) What is Qazi Water Limited's unlevered cost of equity? What are its levered cost of equity
and cost of capital for the post-horizon period? 06
(b) Using the adjusted present value approach, what is Qazi Water Limited's value of
operations to Karachi Bottles Limited? 10

THE END

PRESENT VALUE FACTORS

Year 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 14.10% 15% 16% 17% 18% 19% 20%
1 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.876 0.870 0.862 0.855 0.847 0.840 0.833
2 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.768 0.756 0.743 0.731 0.718 0.706 0.694
3 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 0.693 0.675 0.673 0.658 0.641 0.624 0.609 0.593 0.579
4 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 0.613 0.592 0.590 0.572 0.552 0.534 0.516 0.499 0.482
5 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 0.543 0.519 0.517 0.497 0.476 0.456 0.437 0.419 0.402
6 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 0.480 0.456 0.453 0.432 0.410 0.390 0.370 0.352 0.335
7 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.397 0.376 0.354 0.333 0.314 0.296 0.279
8 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404 0.376 0.351 0.348 0.327 0.305 0.285 0.266 0.249 0.233
9 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361 0.333 0.308 0.305 0.284 0.263 0.243 0.225 0.209 0.194
10 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322 0.295 0.270 0.267 0.247 0.227 0.208 0.191 0.176 0.162

CUMULATIVE PRESENT VALUE FACTORS

Year 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 14.10% 15% 16% 17% 18% 19% 20%
1 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.876 0.870 0.862 0.855 0.847 0.840 0.833
2 1.859 1.833 1.808 1.783 1.759 1.736 1.713 1.690 1.668 1.647 1.645 1.626 1.605 1.585 1.566 1.547 1.528
3 2.723 2.673 2.624 2.577 2.531 2.487 2.444 2.402 2.361 2.322 2.318 2.283 2.246 2.210 2.174 2.140 2.106
4 3.546 3.465 3.387 3.312 3.240 3.170 3.102 3.037 2.974 2.914 2.908 2.855 2.798 2.743 2.690 2.639 2.589
5 4.329 4.212 4.100 3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.425 3.352 3.274 3.199 3.127 3.058 2.991
6 5.076 4.917 4.767 4.623 4.486 4.355 4.231 4.111 3.998 3.889 3.878 3.784 3.685 3.589 3.498 3.410 3.326
7 5.786 5.582 5.389 5.206 5.033 4.868 4.712 4.564 4.423 4.288 4.275 4.160 4.039 3.922 3.812 3.706 3.605
8 6.463 6.210 5.971 5.747 5.535 5.335 5.146 4.968 4.799 4.639 4.623 4.487 4.344 4.207 4.078 3.954 3.837
9 7.108 6.802 6.515 6.247 5.995 5.759 5.537 5.328 5.132 4.946 4.928 4.772 4.607 4.451 4.303 4.163 4.031
10 7.722 7.360 7.024 6.710 6.418 6.145 5.889 5.650 5.426 5.216 5.196 5.019 4.833 4.659 4.494 4.339 4.192

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