Mock Exam

Business Finance Decisions

Suggested Solution

Answer 1(a).
Increased sales = 500 x 150% = 750m Cost of sales = 750 x 70% = 525m

P&L impact (Rs in millions) Delta Cash released (Rs in millions) Delta Cost % Rank
A B A/B
(i) Discount cost (95 x 5 / 95) (5.00)
Collection costs saved (95 x 2%) 1.90
Savings in bad debts (95 x 3%) 2.85 Accounts Receivable reduction
(0.25) (95 x 40 / 360) 10.56 2.4% 1st

(ii) Credit enhancement (525 x 0.5%) (2.63) Accounts Payable increase 21.88 12.0% 3rd
(525 x 15/360)

(iii) Factoring interest (750 x 75% x 30 / 360) x 10% (4.69)

Factoring commission (750 x 5%) (37.50)
Collection costs saved (750 x 2%) 15.00 Accounts Receivable reduction
Savings in bad debts (750 x 3%) 22.50 (750 x 10 / 360) + (750 x 75% x
(4.69) 30 / 360) 67.71 6.9% 2nd

Decision: WC
Utilize Option (i) 10.56
Utilize Option (iii) for balancing working capital req. 39.44 Credit sales of Rs 437m (39.44/67.71 x 750m) would be factored
50.00
Answer 1(b).
Borrow Rs 30 million after 2 months for 4 months (2 v 6)

Interest rate futures

Position = Sell IRFs with March maturity @ 93.88 (6.12%)
No of contracts = 30M / 0.5M x 4 / 3 = 80 contracts
Since KIBOR and Future price after 2 months is not given we will use effective lock in rate.

Spot KIBOR 6.00%

Spot Future 6.12%
Basis -0.12%

Settlement Basis = -0.12% x 1/3 = -0.04%

Today future 6.12%

Settlement Basis -0.04%
6.08%
Spread 0.50%
Effective Interest % 6.58%

Options on Interest rate futures

Obtain 80 Put options at an exercise price of 94.250 with March maturity

Exercise price Interest Cost Total

93750 6.250% 0.045% 6.295%
94000 6.000% 0.168% 6.168%
94250 5.750% 0.300% 6.050% Lowest and Best

Effective Lock-in rate with future buy price of 6.12% 6.58% (As above)
Option discount as compared to Future (6.12% - 5.75%) -0.37%
Option cost 0.30%
Effective Interest % 6.51%
 Mock Exam
Business Finance Decisions
Suggested Solution

Answer 1(c).
Receiving "Euro in Million"
Paying "Euro in Million" Europe US Malaysia Singapore UK Total
$6.4 x 0.7296 Rm 8.3 x
Europe 6.33
= 4.67 0.2004 = 1.66
US 8.2 8.20
$5.4 x 0.7296 £ 2.2 / 1.0653
Malaysia 6.28
= 3.94 = 2.34
Sing 16 x $5 x 0.7296 = Rm 25 x
Singapore 16.41
0.4843 = 7.75 3.65 0.2004 = 5.01
Sing 4 x
UK 1.94
0.4843 = 1.94
Total Receipts 15.95 12.26 6.67 1.94 2.34
Total Payments (6.33) (8.20) (6.28) (16.41) (1.94)
Net Receipt / (Payment) 9.62 4.06 0.39 (14.47) 0.40

Euro Payment & Receipts without multi-lateral netting = 39.16 + 39.16 = 78.32

Euro Payment & Receipts after multi-lateral netting = 14.47 + 14.47 = 28.94

%age savings = 1 – (28.94 / 78.32) = 63%

 Mock Exam
Business Finance Decisions
Suggested Solution

Answer 2(a).

Working Rs 'm
Base case NPV W1 9.4
PV of issue costs W3 (2.4)
PV of tax shield on loan W4 4.9
Adjusted Present value 11.8

The project is viable since the APV is positive.

W1. Base case NPV 0 1 2 3 4 5

Pre-tax cashflow (250 - 50) - 200.0 200.0 200.0 200.0
Tax @ 30% - - (60.0) (60.0) (60.0) (60.0)
Tax savings @ 30% - 26.3 26.3 26.3 26.3
Capital investment (350.0) - - - - -
Working capital (50.0) - - - 50.0 -
(400.0) 200.0 166.3 166.3 216.3 (33.8)

Exchange rate (XD/PKR 1) 2.00 2.10 2.21 2.32 2.43 2.55

PKR "m" (200.0) 95.2 75.4 71.8 89.0 (13.2) Total
PV @ 20.4% (W2) (200.0) 79.1 52.0 41.1 42.3 (5.2) 9.4

W2. Discount rate

Beta asset = 1.3 x 5 / (5 + 0.7) = 1.14
Relative Sovereign yield spread = 7% - 5% = 2%
Relative Country risk premium = 2% x 6% / 3% = 4%
Cost of equity = 9% + (15% - 9% + 4%) x 1.14 = 20.4%

W3. Issue costs Amount Issue costs

Equity 120.0 2.4
2.4
W4. Tax sheild on Loan
Annual repayment of loan @ 10% interest = 80.0 = 25.2
3.170
Tax shield
Year Op. Bal. Int @ 10% Repay Closing Bal. Tax @ 30%* PV @ 9%
1 80.0 8.0 (25.2) 62.8 -
2 62.8 6.3 (25.2) 43.8 2.4 2.0
3 43.8 4.4 (25.2) 22.9 1.9 1.5
4 22.9 2.3 (25.2) 0.0 1.3 0.9
5 0.7 0.4
4.9
* Tax relief @ 30% since interest is claimed against Country X profits.
 Mock Exam
Business Finance Decisions
Suggested Solution

Answer 2(b).

• We should review whether we have the technical & human capabilities and experience to manage and
run an international investment specially in Oil refinery business.

• We should review the current competitive market in the Oil refinery business in Country X and review
whether our pricing, output, sales and commercial strategy is fit to obtain the desired market share.

• Since Country X has a higher risk as compared to Pakistan, we should review the forecasted macro-
economic indicators for Country X and check whether expected economic growth will support the growth
of our projected returns.

• We should evaluate whether the taxation laws and other regulations of Country X are favourable for Oil
refinery business.

• We should review the monetary policy of Country X and review if there are any current or expected future
restrictions on remittance of funds from Country X.

• We should review the degree of correlation of Country X risks with Pakistan and of Oil refinery business
risks with our current business. We should assess whether this diversification would reduce the overall
risk profile of SAL and hence add shareholder value.

• We should review the conditions for provision of low cost loan by Government of Country X and review
their impacts for our business e.g. commitment on employment, output, price etc.
 Mock Exam
Business Finance Decisions
Suggested Solution

Answer 3(a).

Aay Bee Cee Comments

Earnings 20,000 12,290 13,340 Current market value is over or under valued as
Dividend (Payout % x Earnings) 14,000 9,832 8,004 compared to value calculated based on DVM. Thus
Cost of equity (Using CAPM) 15.70% 16.40% 14.30% we use first calculate equity value based on DVM.

Present value of: Aay Bee Cee

D1 12,705 8,954 7,353 There is a different growth rate for first 3 years of
D2 11,530 8,154 6,755 DVM. We discount first 3 years separately and for
D3 10,464 7,425 6,205 the 4th year onwards we use constant growth
D4 onwards 84,865 57,073 56,558 DVM. The sum of all PVs is the value of equity
DVM based Value 119,565 81,605 76,870 based on DVM.

Market Value of Equity 143,478 77,525 84,557 DVM value adjusted for over / under value

Consideration paid 85,278 101,469 Consideration = MV of equity x (1 + Premium %)

PE based current value: Aay Bee Cee

PE ratio 6.00 9.00 8.00
Earnings 20,000 12,290 13,340
PE based value 120,000 110,610 106,720 Current Earnings x Current PE ratio

PE based merged value: Aay + Bee Aay + Cee

Combined Current Earnings 32,290 33,340
Synergy 5,000 6,000
Interest (consideration x 10% x 70%) (5,969) (7,103)
Revised Earnings 31,321 32,237

Combined PE 9.00 8.00

Combined Value 281,885 257,897 Earnings x PE ratio

Benefit to acquirer 161,885 137,897 Combined value less Acquirer current value

Profitability index 1.90 1.36 Benefit to acquirer / Consideration Paid

Answer 3(b).

Share prices may be considered under-valued in circumstances where:

• Stock market is suppressed due to an adverse political, economic, law & order, legal or specific industry
situation.
• Company is experiencing short-term difficulties but has better long term prospects not fully known to the
market.

Share prices may be considered over-valued in circumstances where:

• Company is entering into a potential merger / acquisition transaction or starting a new project and the
market has overly favourable expectations of the transaction/project.
• Market is engaging in emotional uptick buying based on current market trends, but is unaware of lower
than expected returns from the company.
 Mock Exam
Business Finance Decisions
Suggested Solution

Market efficiency can have the following impacts on determining business value:
• In a weak form efficient market, all recent developments (positive or negative) in the business or
profitability of the company need to be adjusted in ready market prices.
• In a semi-strong form efficient market, the ready market prices need to be adjusted for current or future
developments that are not “public information” as of the date of valuation.
• In a strong form efficient market, the ready market prices are considered to be reflection of true
underlying value of the business and generally no adjustments are needed in market prices.

Answer 4.

Year 0 1 2 3 4 5 5 (RV)
Discount rate 10% 11.0% 12% 13% 14%
Factor 1.10 1.11 1.12 1.13 1.14
Discount factor (PV) ** A 1.049 1.159 1.292 1.454 1.650 1.762
Discount factor (TV) * B 1.680 1.520 1.363 1.212 1.068 1.000

* Yr 1: 1.14 x 1.13 x 1.12 x 1.11 x (1.10^0.5) ; Yr 2: 1.14 x 1.13 x 1.12 x (1.11^0.5) ; Yr 3: 1.14 x 1.13 x (1.12 ^0.5) ;
Yr 4: 1.14 x (1.13^0.5) ; Yr 5: 1.12^0.5

** Yr 1: 1.10^0.5 ; Yr 2: 1.10 x (1.11^0.5) ; Yr 3: 1.10 x 1.11 x (1.12 ^0.5) ; Yr 4: 1.10 x 1.11 x 1.12 x (1.13^0.5) ;
Yr 5: 1.10 x 1.11 x 1.12 x 1.13 x (1.14^0.5) ; Yr 5 RV: 1.10 x 1.11 x 1.12 x 1.13 x 1.14

Project 1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Yr 5 (RV)

Cashflows C (11,120) 4,000 4,000 4,000 4,000 4,000 1,120
For NPV - PV @ WACC C/A (11,120) 3,814 3,451 3,096 2,752 2,424 636
For MIRR - TV @ WACC C/B 6,719 6,080 5,453 4,847 4,271 1,120

Project 2 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Yr 5 (RV)

Cashflows D (32,320) 10,000 10,000 10,000 10,000 10,000 6,020
For NPV - PV @ WACC D/A (32,320) 9,535 8,629 7,739 6,879 6,061 3,417
For MIRR - TV @ WACC D/B 16,797 15,201 13,633 12,118 10,677 6,020

NPV Project 1 = Rs 5053 million

NPV Project 2 = Rs 9939 million

MIRR Project 1 = 20.7%

MIRR Project 2 = 18.2%

Profitability index for Project 1 = 5053/11,120 = 0.45

Profitability index for Project 2 = 9939/32,320 = 0.31

Suggestion: Project 1 is recommended using both methods.

 Mock Exam
Business Finance Decisions
Suggested Solution

Answer 5(a)

Option 1: Lease and replace asset after every 3 years

0 1 2 3
Contribution 120.00 120.00 120.00
Fixed costs (10.00) (10.00) (10.00)
Running costs (6.00) (6.00) (6.00)
Deposit / Rentals (W1) (20.00) (49.93) (49.93) (49.93)
(20.00) 54.07 54.07 54.07
Tax @ 35% (18.92) (18.92) (18.92)
Residual value 50.00
Termination penalty (W2) (12.66)
Principal repayment (W2) (84.40)
Net loss on termination (47.06)
Tax saving @ 35% 16.47
(20.00) 35.15 35.15 4.56

PV @ 15% (20.00) 30.56 26.57 3.00

AF @ 15% for 3 years 2.283
EAC 17.58 per annum

Option 2: Lease and replace asset after every 5 years

0 1 2 3 4 5
Contribution 120.00 120.00 120.00 80.00 80.00
Fixed costs (10.00) (10.00) (10.00) (12.00) (12.00)
Running costs (6.00) (6.00) (6.00) (7.80) (7.80)
Deposit / Rentals (20.00) (49.93) (49.93) (49.93) (49.93) (49.93)
(20.00) 54.07 54.07 54.07 10.27 10.27
Tax @ 35% (18.92) (18.92) (18.92) (3.59) (3.59)
(20.00) 35.15 35.15 35.15 6.68 6.68

PV @ 15% (20.00) 30.56 26.57 23.11 3.82 3.32

AF @ 15% for 5 years 3.352
EAC 20.10 per annum
 Mock Exam
Business Finance Decisions
Suggested Solution

Option 3: Buy and replace asset after every 3 years

0 1 2 3 4 5
Contribution 120.00 120.00 120.00
Fixed costs (10.00) (10.00) (10.00)
Running costs (6.00) (6.00) (6.00)
104.00 104.00 104.00
Tax @ 35% (36.40) (36.40) (36.40)
Tax dep & RV loss savings (W3) 25.38 6.69 20.43
Residual value 50.00
Purchase price (200.00)
(200.00) 92.98 74.29 138.03

PV @ 15% (200.00) 80.85 56.18 90.76 - -

AF @ 15% for 3 years 2.283
EAC 12.17 per annum

Option 4: Buy and replace asset after every 5 years

0 1 2 3 4 5
Contribution 120.00 120.00 120.00 80.00 80.00
Fixed costs (10.00) (10.00) (10.00) (12.00) (12.00)
Running costs (6.00) (6.00) (6.00) (7.80) (7.80)
104.00 104.00 104.00 60.20 60.20
Tax @ 35% (36.40) (36.40) (36.40) (21.07) (21.07)
Tax dep & RV loss savings (W3) 25.38 6.69 5.69 4.84 27.41
Residual value -
Purchase price (200.00)
(200.00) 92.98 74.29 73.29 43.97 66.54

PV @ 15% (200.00) 80.85 56.18 48.19 25.14 33.08

AF @ 15% for 3 years 3.352
EAC 12.96 per annum

W1. Lease rental calculation

Cost 200.00
Security deposit (20.00)
180.00

AF for 5 years @ 12% 3.605

Lease rental 49.93

W2. Termination Penalty calculation

1 2 3
Opening Bal. 180.00 151.67 119.94
Interest 21.60 18.20 14.39
Rental (49.93) (49.93) (49.93)
Closing Bal. 151.67 119.94 84.40

Termination Penalty @ 15% 12.66

 Mock Exam
Business Finance Decisions
Suggested Solution

W3. Tax dep & loss calculation (3 years)

1 2 3
Initial 50.00
Normal 22.50 19.13 16.26
Tax loss on RV 42.12
72.50 19.13 58.38

Tax savings 25.38 6.69 20.43

Tax WDV at disposal 92.12

RV (50.00)
Tax loss 42.12

W4 - Tax dep & loss calculation (5 years)

1 2 3 4 5
Initial 50.00
Normal 22.50 19.13 16.26 13.82 11.75
Tax loss on RV 66.56
72.50 19.13 16.26 13.82 78.30

Tax savings 25.38 6.69 5.69 4.84 27.41

Tax WDV at disposal 66.56

RV -
Tax loss 66.56

Answer 5(b)

Benefits of leasing / Disadvantages of buying Disadvantages of leasing / Benefits of buying

• Lessors can adapt to the specific needs of lessees, • Purchasing is usually cheaper than leasing as
making leasing more convenient & flexible. there is no “lessor profit margin” involved.

• Lease payment can be structured on a monthly or • Purchasing gives more control on the asset as
varied amount basis to suit cash flow position. you can make modifications to the asset, as
required.
• Lessee can enjoy swaps and upgrades.
• More flexibility on selling the asset or exiting the
• Repairs, maintenance, insurance etc. can be project without any penalty/legal implications
provided with the lease as single package.

• Asset can be obtained on lease even if credit lines

and loan facilities are fully used.

• Leasing will generally come with less covenants /

restrictions as compared to loan financed buying.