MODEL ANSWERS

STRATEGIC FINANCIAL MANAGEMENT (HNDA-4203)

4th year 2nd semester examination-2019

Question 01
i.
Definition and Rationale

The rationale behind the NPV method is its focus on the maximization of wealth for business
owners or shareholders. (2M)
Absolute Decision Criteria

The NPV method provides straightforward criteria for choosing or rejecting investment projects.
Projects with positive NPVs qualify for selection because their benefits, in terms of target rates of
returns, exceed costs. Investments yield zero NPV when they have equal benefits and costs. This
affords businesses the flexibility to accept or reject such investments. Negative NPVs, on the other
hand, are loss-making investments that must shunned completely. (2M)

TOTAL 4M

ii.
a) b)
Actual Dif. * Portfolios B & C have been better
Portfolio Expected return% return% Difference % than expected. The performance of
A 0.05+0.8(.1-.05) 9% 8% -1% B has exceeded the Expected return
B 0.05+1.1(.1-.05) 11% 15% 5% 43% by 43%, while the performance of
C has exceed the expected return by
C 0.05+1.2(.1-.05) 11% 12% 1% 9%
9%. Thus B has shown best
D 0.05+0.85(.1-.05) 9% 9% 0% performance
(1/2*4 Marks)= 2 Marks 3 Marks
(If calculations are wrong, allocate 1 mark , if (1 M for calculation of differences, 1M for
students shown his knowledge about CAPM identification of B & C as best two. 1 M for
model. , equation) identification of B as best.)
(TOTAL 5M)
iii.

a)
Particulars X Ltd (Rs. Million) Y Ltd (Rs. Million)
Sales 1250 1500
Fixed cost 375 500
Variable cost 625 375 1M
 EBIT 250 625 1M
DOL=(S-VC)/EBIT 2.5 1.8 1M
* If calculations are wrong, allocate maximum 2 marks for correct steps

X Ltd has greater risk as its DOL is higher

b) 2M
(TOTAL 5 M)

iv.
a) Optimal capital Structure: The capital Structure that minimizes a firm’s weighted
average cost of capital or maximizes the value of the firm. 1M

Target Capital Structure: The capital structure at which the firm plans to operate. May
not be optimum sometimes. 1M
(TOTAL 2M)

b) Business risk
Growth opportunities available for the firm
Industry average debt ratio
Lender/rating agency attitudes
Borrowing capacity
Effects of financing on control (ownership)
Asset structure
Expected tax rate for the firm
(Any 4* 1 M= TOTAL 4M)
*TOTAL 20 MARKS FOR Q1

Question 02
i. a)

Initial Working Net Tax

Year investment Capital Receipts expense NCF DF 15% DCF
- Since NPV is
0 -150 -10 - - -160 1 160.000 positive, we
can accept this
1 55 -5 50 0.87 43.500
project
2 75 -7 68 0.756 51.408 (1 Mark)* If
3 99 -9.4 89.6 0.658 58.957 rationale is
4 to 25 105 -10 95 4.181 397.195 correct,
allocate marks
25 25 10 - - 35 0.03 1.050
392.110
(1*2 (1 (2 (2
Marks) (1 Mark) (4 Marks)* (2 Marks)* Mark) Marks)* Marks)
(TOTAL 15 Marks)
 * Add marks for following workings if main answer is wrong

Net receipts

Contribution sales Total Net

Year per unit volume Contribution FC Receipts
0 - - - - -
1 1 100 100 45 55
2 1 120 120 45 75
3 1 144 144 45 99
4 to 25 1 150 150 45 105
Total
1M 1M 1M 1M 4M

Depreciation (150-
Per annum= 25)/25
5

Therefore
FC= 50-5
45

Tax Expense
Net Capital Taxable Tax
Year Receipts allowance profit expense
0 - - - -
1 55 5 50 5
2 75 5 70 7
3 99 5 94 9.4
4 to 25 105 5 100 10
1/2 M 1/2 M 1/2 M 1/2 M Total 2M

Cum. Discounted factor identification 15%

Cum. Discounted factor for 25 years (1) 6.464 1/2 M
cum. Discount factor for 3 years
(2) 2.283 1/2M
Cum. Discount factor for 4-23 years (1-2) 4.181 1M
Total 2 M
 • If student has got wrong answers and examiner feels that student has particular general
knowledge, allocate maximum 4 marks according to the following marking rubric.
If examiner feel student is having,
Identification of basic rationale of NPV -1M
Identification of basic rationale of Time value of money- 1M
Cash flow development basics- 1M
Basic knowledge of project evaluation- 1M

b) Technological feasibility, Environmental feasibility, Social feasibility

(Allocate 3 marks for any related answer)

ii. The net present social value (NPSV) model is based on the fact that the
total value of a project equals its economic value (NPV) plus its social value. Thus,
the present value of the future annual social values is added to the NPV to estimate
the project's total value
(2 Marks, allocate marks for any rational answer)
*TOTAL 20 MARKS FOR Q2

Question 03
i)

Stock Price Dividends

Year
(Rs) (Rs)

0 225 -
1 220 10 0.022 1M
2 240 10 0.136 1M
3 238 10 0.033 1M
4 265 10 0.155 1M
*If calculations are wrong and application is correct allocate
maximum 2 marks Total 4M

ii)

a)
 = 53%
10
= 0.053

1 Mark for final answer

1 Marks for Applications of equation
TOTAL 2 Marks

b)
284.1/10
28.41

R r-ER (R-ER)^2
8 2.7 7.29
10 4.7 22.09
11 5.7 32.49
-5 -10.3 106.09
7 1.7 2.89
-4 -9.3 86.49
8 2.7 7.29
9 3.7 13.69
3 -2.3 5.29
6 0.7 0.49
284.1

1 Mark for final answer

2 Marks for Applications of equation
TOTAL 3 Marks

iii)

a) Return%
Probability
A P*R B P*R
0.3 3 0.9 15 4.5
0.4 12 4.8 9 3.6
0.2 9 1.8 16 3.2
 0.1 -6 -0.6 30 3
6.9 14.3
1M 1M
Expected portfolio return= WA*PA+WB*PB
11.34 1M
Total 3 M

b)

The correlation coefficient, is a measure of the strength of the straight-line or linear

relationship between two variables(1M). Here, +1 indicates a perfect positive linear
relationship (1M) (Total 2Marks)

C)
A low standard deviation indicates that the values tend to be close to the mean (expected
value) of the set, while a high standard deviation indicates that the values are spread out
over a wider range. (2M) So, in case of securities low SD refers to low risk & high SD
refers to high risk. Therefore here, Asset B is riskier. (1M) (Total 3 Marks)

d)
W1 0.4 0.16
W2 0.6 0.36
Variance 1 32.49
Variance 2 36.61
SD1 5.7
SD2 6.05
Correlation 1

SD of Portfolio 5.91
Final Answer=0.5 Marks
Application= 2.5 Marks
Total 3 Marks
*TOTAL 20 MARKS FOR Q3

Question 04

i) Beta coefficient is a measure of an investment's systematic risk while the standard

deviation is a measure of an investment's total risk (2M). In a portfolio of
 investments, beta coefficient is the appropriate risk measure because it only considers
the undiversifiable risk (1M)
(TOTAL 3M)
ii) Get advice from a professional, recover outstanding debt, Reduce or rearrange
expenses, sell assets (Excess), Offer markdowns or increase prices, consolidate debt,
use new marketing techniques (Allocate Maximum 4 Marks for any rational
answer)

iii) CAPM is a model that describes the relationship between risk and expected (required)
return; in this model, a security’s expected (required) return is the risk-free rate plus a
premium based on the systematic risk of the security. (2M)

Assumptions

• Risk-averse investors.
• Maximizing the utility of terminal wealth.
• The choice on the basis of risk and return.
• Similar expectations of risk and return.
• Identical time horizon.
• Free access to all available information.
• There is a risk-free asset and there is no restriction on borrowing and lending at
the risk-free rate.
• There are no taxes and transaction costs, and.
• Total availability of assets is fixed and assets are marketable and divisible.

(1* any 3 points=3M)

(TOTAL 5M)

A B
iv) Year Rm RX Rm-ERm Rx-Erx A*B A^2
1 9.3 11.23 6.9 9.534 65.785 47.61
2 -8.5 -18.1 -10.9 -19.796 215.776 118.81
3 30 25 27.6 23.304 643.190 761.76
4 -10.3 -3.15 -12.7 -4.846 61.544 161.29
5 -8.5 -6.5 -10.9 -8.196 89.336 118.81
ER 2.4 1.696 1075.632 1208.280
1/2M 1/2M 1/2M 1/2M

Cov. (m,x) 215.1264

(1075.632/5) 1M

Variance Rm 241.656
0.890217 (Rm-Rem)^2/5 1M
2M
TOTAL 6 M
 Erx= Rf+(beta*Rm)
1.696=Rf+(0.89*2.4)
Rf=1.696-(0.89*2.4)
-0.44 1M
Therefore characteristic line,
X=(-0.44)+0.89M 1M 2 Marks

*TOTAL 20 MARKS FOR Q4

Question 05
i. Debt ratio – The ratio of debt to total capital
Debt equity ratio – The ratio of debt to equity
Interest coverage – The ratio of net operating income to interest charges
(3*1 Marks)
ii.

X Ltd Y Ltd
Sales 1400000 1400000
Less. VC 980000 980000
Less. FC 340000 340000
EBIT 80000 80000 1M
Less Interest 0 40000
EBT 80000 40000 1M
Less Tax 28000 14000
EAT 52000 26000 1M
a) DOL=(S-VC)/EBIT 5.25 5.25 1M
Yes, agree with consultant because DOL is equal in both 2M
b) DFL= EBIT/(EBIT-I) 1 2 1M
DCL= DOL*DFL 5.25 10.5 1M
DCL of X ltd is less than Y Ltd. Therefore, Z Ltd should 2M
purchase Y Ltd
If calculations are wrong, allocate maximus 5 marks Total 10M
based on the rationale on the student’s answers
 iii. Indifferent point/level is that EBIT level at which the Earnings Per Share (EPS) is the
same for two alternative financial plans. The indifferent point can be defined as "the
level of EBIT beyond which the benefits of financial leverage begin to operate with
respect to Earnings Per share (EPS)
(2 Marks)
iv. X (1-t) / N1 = {(X-i) (1-t)}/N2
Where,
T=.35, N1=300,000,I=15000, N2=200,000

X= Rs:45,000

Developing equations 02M, Substitution of values 02M, Final Answer 01M

TOTAL 5M
*TOTAL 20 MARKS FOR Q5

Question 06

i) Net operating income (NOI) approach.

Traditional approach and Net income (NI) approach.
MM hypothesis with and without corporate tax.
Miller’s hypothesis with corporate and personal taxes.
Trade-off theory: costs and benefits of leverage
(1/2 * Any 4 correct points)

ii) Motive of financial leverage is to increase the return to equity holders of the firm.
(2 Marks)

iii) According to traditional approach, the cost of capital declines and the value of the
firm increases with leverage up to a prudent debt level and after reaching the
optimum level, leverage cause the cost of capital to increase and the value of the
firm to decline. The optimum capital structure occurs when the cost of capital is
minimum or the value of firm is maximum.
(3 Marks)

iv)

a) EBIT 200,000
Interest 10,000
Net Income for equity share holders 190,000 1M
Ke 0.15
Market Value of Shares 1266667 1M
Market Value of Debt 100,000
Total Market Value of the firm 1,366,667 1M
 Total 3M
b) Ko= 20000/1366667 1M
0.146341463 1M Total 2M

v Amount borrowed Ke% Kd% Kd (1-t) WACC

0 16 7 4.2 16.0 1M
500 16.5 7.5 4.5 15.5 1M
1000 17.5 8 4.8 15.4 1M
1500 18 8 4.8 14.7 1M
2000 18.5 8.5 5.1 14.0 1M
2500 19 9 5.4 13.3 1M
3000 19.5 9.5 5.7 12.6 1M
Optimum Capital Structure
3,000,000 Debt
3,000,000 Equity 1M
TOTAL 8M