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INSTITUTE OF CERTIFIED
MANAGEMENT ACCOUNTANTS OF SRI LANKA
Incorporated by Parliament Act No.23 of 2009

SUGGESTED SOLUTIONS
Published by CMA Sri Lanka Business School

Disclaimer Notice
The copyright of this Suggested Solutions is reserved by the Institute of Certified Management
Accountants of Sri Lanka (CMA Sri Lanka) and Suggested Solutions neither in whole nor in part may
be reproduced without the prior written approval from the Institute. The purpose of the suggested
solutions is to provide only a guidance and not to be constructed as complete answers.

402 - FSV – Financial Strategy & Valuation

Strategic Level
May 2019

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PART - I

QUESTION NO. 01

1.1. Invention is a newly established Small and Medium Enterprise (SME) to design small
scale soft wares for different requirements. With the increase demand in recent year,
they are seeking sources of finance for new equipment and computer purchases. State
the potential sources of finance for Invention.

i. The SME owner, family and friends

ii. The business angel
iii. Trade credit
iv. Factoring and invoice discounting
v. Leasing
vi. Bank finance
vii. The venture capitalist
viii. Listing
ix. Supply chain financing

1.2. How does government support to finance SMEs

i. Providing tax breaks

ii. Providing advice
iii. Guaranteeing loans
iv. Providing equity investment

1.3. Briefly explain life cycle model and indicate the stages in industry life cycle.

Life cycle models are similar in their stages in any life cycle. So Industries experience a similar
cycle of life. Just as a person is born, grows, matures, and eventually experiences decline and
ultimately death. The stages are the same for all industries, yet every industry will experience
these stages differently, they will last longer for some and pass quickly for others.
• Introduction
• Growth
• Maturity
• Decline
• Possible exit

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1.4. ‘Enterprise valuation is important for any business firms and the valuation process
involves a set of steps’. Briefly explain.

• Purpose of business valuation

• Gather the information.
• Recast the financials
• Choose the business valuation approach
• Apply the business valuation approach
• The business value conclusion

1.5. Alpha Company manufactures a toy with their own equipment, and supply to the
markets while Company Gamma, in the same industry, outsources material,
manufactures and supplies to the markets. The following information is provided for
both companies.
Company Alpha Company Gamma
Rs. million Rs. million
Revenue 100 100
Raw materials 10 35
Operating cost 40 40
Depreciation 30 5
Enterprise value 150 150

A. Estimate enterprise value to

EBITDA 150/50 = 3 times 150/25 = 6 times
B. Estimate enterprise value to
EBIT 150/20= 7.5 times 150/20= 7.5 times
C. Comment on these two Difference is the drawback of these two measures. It
measures counts the difference only in outsourcing policies

1.6. Many analysts used multiples to value young internet companies specially at the
beginning of the internet boom. Indicate three examples for non-financial multiples

i. Enterprise value/web hits

ii. Enterprise value/ No of subscribers
iii. Enterprise value/Unique visitors
iv. Enterprise value/No of employees etc.

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1.7. Alumex Company has paid the following dividends per share in recent years:
2015 2016 2017 2018
Dividend (Rs) 3.6 3.4 3.7 4.0

Alumex has a cost of equity of 12%.

Calculate the market price per shares of Alumex to the nearest cent on an ex dividend
basis.

G = (4/3.6)^(1/3)-1 =3.57%
D1= D0(1+g) =3.6(1+0.0357) =3.72
P = (D1/Ke-g) = 3.72/0.12-0.0357 =Rs. 44.13

1.8. XYZ Company recorded a net income of Rs. 1,250 million in 2018. While the company
incurred a one-time restructuring cost of Rs. 250 million during the year, non-operating
income amounted to 100 million. If the tax rate is 28%, what is the NOPLAT for 2018.

Net Income 1,250

Non-Operating Income 250
Less- Non-Core Business Income 100
1,400
Tax (28%) 392
NOPLAT 1,008

1.9. A company wants to buy back stock. How will this impact the company and its stock.

A share repurchase has an obvious effect on a company's income statement, since it reduces its
outstanding shares. On the balance sheet, a share repurchase will reduce the company's cash
holdings, and consequently its total assets base, by the amount of the cash expended in the
buyback. As buyback reduces the number of shares in a company held by the public, in the near
term, the stock price may rise because shareholders know that a buyback will immediately boost
earnings per share .

1.10. A Company is willing to merge a business enterprise with a similar competitor

saying that there is synergistic effect after merger. What is synergistic effect.

The idea that the value and performance of two companies combined will be greater than the sum
of the separate individual parts is called Synergy. This term is used mostly in the context of
mergers and acquisitions. For example, if Company A has an excellent product but lousy
distribution whereas Company B has a great distribution system but poor products, the
companies could create synergy with a merger.

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PART-II

QUESTION NO. 02

2.1 Calculate the bond’s yield to maturity:

YTM =C+((F-P)/n) = 60+ (1000-1100)/20) =5.99%
(F+P)/2) (1000+1100)/2)

Current Price= (CPx 1-((1/(1+YTM)^n)/YTM + FV/(1+YTM^n) =5.18%

Semi-annual basis

2.2 Calculate the bond’s current yield.

Current yield =(Annual coupon)/P = 120/1100 =10.91%

2.3 Calculate the bond’s capital gain or loss yield.

Capital gain or loss =(P1-P0)/P0 = (1000-1100)/1100 =-9.09%

2.4 Calculate the bond’s yield to call.

YTC= (c+(F-call price)/n) = (60+(1000-1060)/8) =5.10%
(F+call price)/2) (1000+1060)/2)

Semi-annual basis

2.5 Estimate the value per share, using the Dividend Discount Model
cost of equity=D1/MP+g
𝐷1 1.7(1.07)
=𝑀𝑃 + 𝑔 = 51
+ .07 = 10.56%

Based on DDM
𝐷1 1.70(1.07)
Value per share is: 𝐾𝑒−𝑔 = .1056−.07
= 𝑅𝑠. 51.10 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

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2.6 Estimate the value per share, using the FCFE Model.
Based on FCF
Net Earning 3.2X160 mn = 512 mn
Add: Depreciation = 315 mn
Total 827 mn
Less: Capital Expenditure (475) mn
Less Interest cost 160x6.25% (10) mn
FCF 342 mn
FCF per share 342/160 =2.1375
Value per share 2.1375x1.07/0.1056-.07 =Rs. 64.24 per share

2.7 Explain the difference between the two models and which one would you use as your
benchmark for comparison to the market price.

DDM considers the dividend capitalization while FCFE method considers FCFE capitalization
and resulting higher value per share based on FCF method. The difference depends on the
capital expenditure, non cash flows and debt obligation during the period.

QUESTION NO. 03

3.1 Estimate the average cost of capital using:

i. book value proportions, and
ii. market value proportions.

i. book value proportions,

Source Book value Book value weight cost w.cost
Equity (1,000,000) 10 10,000,000 0.27778 0.1450 0.040277778
Retained earnings 12,000,000 0.33333 0.1450 0.048333333
11% Preference (10,000) 100 1,000,000 0.02778 0.1543 0.004286111
13.5% Debentures
(50,000) 100 5,000,000 0.13889 0.1120 0.015555556
12% Term loan 8,000,000 0.22222 0.0600 0.013333333
36,000,000 1 0.121786111

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Estimations:
Ke =1.50/20+.07 = 14.5%
Kp =[Dp+(f-p)/n]/(f-p)/2 =[11+(100-75)/10]/(175/2) =15.43%
Kd =[I(1-T)+(f-p)/n]/(p+f)/2 = [13.5 (1-.5)+(100-80)/6]/(180/2) = 11.20%
Ktl =l(1-T)=12(1-.5) =6%
WACC =12.18%

ii. market value proportions

Source Mkt Price Mkt value weight Cost w.cost
Equity (1,000,000) 20 20,000,000.00 0.61069 0.145 0.08855
11% Preference (10,000) 75 750,000.00 0.0229 0.1543 0.00353
13.5% Debentures (50,000) 80 4,000,000.00 0.12214 0.112 0.01368
12% Term loan 8,000,000.00 0.24427 0.06 0.01466
32,750,000.00 1 0.12042
WACC= 12.04%

3.2 Estimate cash flows to equity and cash flow to debt (cash flows to investors) under
each plan.

Plan 1 Plan 2
EBIT 1,000,000 1,000,000
Interest 0 (400,000)
Earnings before tax=(EBIT-Kb*B) 1,000,000 600,000
Taxes (Tc=0.35) (350,000) (210,000)
Earnings after tax {EBIT-Kb*B)*(1-Tc) 650,000 390,000
Cash flows to equity + cash flow to debt 650,000 790,000

QUESTION NO. 04

4.1 What is residual dividend policy.

Dividend policy that companies use when calculating the dividends to be paid to shareholders.
Companies use funds to capital expenditures with available earnings before paying dividends to
shareholders and if there is remaining funds are distributed as dividends.

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4.2 Apple Garment is planning to purchase machineries costing Rs. 600,000/- in order to
enhance their production capacity. They have maintained their capital structure during past:
40% debt, 60% equity. Forecasted net income in the next year is Rs.600,000/-.
How much of the Rs.600,000/- should Apple pay out as dividends:
earning 600,000
60% of investment using profit 360,000 new debt issue remaining 40%
Dividends 240,000
Then payout ratio 240/600=40%

4.3 How would a decrease in net income to Rs.400,000/- affect the dividend. How would an
increase in net income to Rs.800,000/- affect dividend?

Decrease in net income to 400,000

Earnings 400,000
60% of investment using profit 360,000 new debt issue remaining 40%
dividends 40,000
then pay out 40/400=10%

increase in net income to 800,000

earnings 800,000
60% of investment using profit 360,000 new debt issue remaining 40%
Dividends 440,000
Pay out ratio 440,000/800,000 = 55%

4.4 Calculate EPS of the surviving company after the merger. If Price Earnings ratio falls to
12 after the merger:

Combined profit after tax =15+3= 18

Combined shares 2.5+0.5(8) =2.9 million
Eps =18.0/2.9=6.21
Mkt price after merger =P/E x eps
=12x 6.21=74.52

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4.5 Calculate the premium received by the shareholders of PQR (using surviving firms’s
new price):

Mkt price after merger =P/E x eps

=12x 6.21=74.52

Premium =(0.5(74.52)-33.75)/33.75
=10.4%

4.6 State whether the merger is beneficial for XYZ’s shareholders:

The merger is not beneficial to xyz’s shareholders because their price falls from 78 to 74.52- a
loss of 4.5%.

QUESTION NO. 05

5.1 Estimate the one year forward exchange rate that will make the financial manager
indifferent between investing in France or Germany:

1+rDM/1+r€ =fDM/€/SDM/€ =1.12/1.09 =1.0275

=fDM/€/3.35

fDM/€=1.0275*3.35 = 3.4421

5.2 In Sri Lanka interest rate is 14.5% and inflation is expected to be 6.5% the expected
inflation rate in Thailand is 8.5%.
Estimate the interest rate of a one year loan in Thailand?.

(1+i1)/(1+iT)(1+r1)/(1+rT) =1.065/1.085 =1.145/(1+rT)

=rT=((1.085x1.145)/1.065)-1 =0.1665 or 16.65%

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5.3 What does Modigliani-Miller theory with corporate tax explain regarding company
value

Since the value of the firm depends neither on its dividend policy nor its decision to raise capital
by issuing stock or selling debt, the Modigliani–Miller theorem is often called the capital structure
irrelevance principle. This is without corporate taxes (1958).

The key Modigliani-Miller theorem was extended (1963) with corporate taxes. Accordingly, there
are advantages for firms to be levered, since corporations can deduct interest payments.

Therefore, leverage lowers tax payments. Dividend payments are non-deductible.

VL=VUL+TcD

where
VL= is the value of a levered firm.
VUL= is the value of an unlevered firm.
TcD = is the tax rate (Tc) x the value of debt (D)
The term TcD assumes debt is perpetual

5.4 Pacific-Sri Lanka Airline is currently an unlevered firm. The company is now operating in
Sri Lanka and expects to generate Rs. 156 million in earnings before interest and taxes
(EBIT), in perpetuity. The corporate tax rate is 35%, implying after tax earnings of Rs. 100
million. All earnings after tax are paid out as dividends.
The firm is considering a capital structuring to allow Rs. 200 million of debt. Its cost of debt
capital is 10%. Unlevered international firms in the same industry have a cost of equity
capital of 20%.
Estimate new value of Pacific-Sri Lanka Airline:

VL ={EBITx((1-Tc)/ro}+TcB
= [100/0.2]+(0.35x200)
= 500 + 70 = 570
Kd =10%, Ke=20%
Tc = corporate tac rate
B =Corporate Debt

*End of the Suggested Solutions*

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