Financial Management

Final Exam (BBA 2007), Dec 15, 2009

Total Marks: 100; Time Allowed: 3 hours

 Answers without listing the variables and the formula applied shall accrue zero marks.
 Please do not ask questions from the invigilators. If in doubt, make and list assumptions and carry on.
 Cheating is morally reprehensible if not legally culpable.

Question 1 (10)

(a) How do you assess and quantify risk in a Business Proposal? Be brief and to the point.
(5)

Variance of returns, Beta value in CAPM (systematic risk), sensitivity & simulations

(b) Companies A and B deal in the same business and have exactly the same operating leverage.
However, A is financed exclusively through equity while B is financed 50% with equity and
50% with debt. Which company is riskier and why? How would you find the systematic risk of B
if that of A is known? (5)

Company B has higher systematic risk. Provide formula for adjusting unlevered beta to
leveraged beta.

Question 2 (15)

Three years back, John funded his business by borrowing Pak Rupees 2,000,000 @ 20% pa. to
be repaid over 10 years in equal, monthly installments. Calculate the loan outstanding as of today
and loan amortization schedule for the next three months.

To get full marks, must calculate monthly installment by using annuity formula, find PV of
7*12=84 installments, and prepare amortization schedule.

If installment only is calculated and all else is incorrect, U wl gt 5 marks. If installment is on an

annual basis, then converted into monthly, marks will be deducted because of ignoring
compounding effect.

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Question 3 (15)

You are helping ABC, a diversified industrial group on the costs of equity it should be using to
evaluate its various operations. Currently, it has three divisions – Ceramics, Sanitary equipment,
and Solar panels. The betas of comparable firms in each division are as follows: -

Ceramics 2.0
Sanitary equipment 1.2
Solar panels 2.5

a) Estimate the cost of equity for each division assuming a risk free rate of 15%. (7 1/2)

b) How would the capital budgeting decisions for each division be affected if instead of
using the above betas, you use ABC’s composite beta of 1.9 for all divisions? (7 1/2)

UWG 12 marks IF calculations are correct but you fail to relate it to Cap Budg decisions.

Question 4 (15)

You have been asked to estimate the fair value of a common stock with a beta value of 1.25. The
risk free rate is currently 15%, and the historical equity risk premium over government bonds is
5%. The company has recently paid its annual dividend of Rs. 2.50. You develop two scenarios:

a) The stock continues to pay a dividend of Rs. 2.5 per annum indefinitely; (5)
b) Dividends grow at the rate of 10% per annum for the next 5 years after which they
become stagnant i.e. growth in dividends falls to zero per cent to perpetuity. (7 1/2)

Estimate the fair value / price of the stock in each of the above cases and explain what effect, if
any, an anticipated decrease in equity risk premium would have on the value of the stock (2 1/2).

Self evident

Question 5 (15)

You plan to set up a fitness centre in an abandoned warehouse that rents for Rs. 600,000/year.
You would incur a cost of Rs. 10,000,000/- in renovating the place and buying fitness
equipment. Half of this amount i.e. Rs. 5,000,000/- will be borrowed @ 20% pa. for ten years
and the interest cost will be tax deductible. Tax rules also allow you to depreciate the full cost (of
Rs. 10 mn) over 10 years to zero by choosing straight line depreciation. You estimate the salvage
value as Rs. 1,000,000. Market research indicates that you can expect to get 500 members, each
paying Rs. 10,000/year. You have also five instructors ready to join for Rs. 30,000/- per month
per instructor. If you start making profits, you will be charged tax @ 35% per annum. Assuming

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a 10-year horizon and rents, salaries, and membership fees increasing @ 5% per annum to catch
up with inflation:

a) Estimate the after tax operating income each year on this project. (5)
b) Estimate after-tax free cash flows for the equity holder in this project (including
terminal cash flow). (5)
c) Advise project feasibility from the perspective of equity holder applying relevant
capital budgeting rules. (5)

Prefer using the standard (income statement) format for calculating free cashflows.

Question 6 (15)

You are the financial manager of a utility which has perfect record of paying dividends every
year. The shares are held mostly by pension funds for retired personnel. Given large amounts of
funds required to invest in new positive NPV projects at hand, your assistant, a graduate from a
respectable business school argues that the dividends be skipped this year because as per
Modigliani and Miller Hypothesis, they are irrelevant with respect to the valuation of a company.
So is, your assistant argues, capital structure. Why not then raise any additional funds required –
over and above the internal funds generated (including retained earnings) – exclusively through
debt even though it will significantly increase leverage? Would you buy this ‘irrelevance of
capital structure for valuation’ argument? Why or why not? Be brief and to the point!

Must bring M&M into discussion for complete marks.

Question 7 (15)

The following capital structure can be implied from Ibrahim and Co’s published statements:

 Debt: The only debt outstanding is Rs 2,000,000/- face value bonds carrying a coupon
rate of 10% pa paid semiannually and maturing in 5 years. The bonds are now selling to
yield 20% pa.
 Equity: 200,000 common shares are outstanding currently selling at $15 per share.

Calculate the company’s WACC (weighted average cost of capital) if the required rate of return
on equity is 30% pa (10). Find the tax shield benefits of debt per annum if the marginal tax rate
is 40% pa. (5)

Must base all calculationS on Market Value weights for full marks. Book value basis will be
given SOME marks on the basis of accuracy and consistency only.

Bonus Question 8 (2 + 2)

What is the yield on 10-year US bonds now-a-days?

What levels are the KSE-100, S&P 500, DJIA-30 trading now-a-days?
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………………………………………………………………

FORMULAS

FV of a single sum: ; PV of a single sum:

PV of standard annuity: ; FV of standard annuity:

PV of annuity due: ; FV of annuity due: PV of annuity due times (1+i)n

PV of perpetuity: A/I; PV of growing perpetuity: A(1+g)/(i-g)

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