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EF343. FSM (AL-I) Solution CMA January-2024 Exam.
EF343. FSM (AL-I) Solution CMA January-2024 Exam.
ADVANCE LEVEL-I
EF343.FSM: CORPORATE FINANCE STRATEGY & FINANCIAL MARKET
Model Solution
Solution of the Question No. 1 (a)
Investment strategy - Acquire a smaller company with promising growth potential
Financing strategy - Acquisition is made using debt capital instead using equity capital
Dividend strategy - Declare a dividend of Tk.10 per share
CFO’s Claim:
High payout ratio - shareholders would be happy.
As the current investors are elderly people, they expect dividends continuously.
If Superior Plc reduces the dividend payment, then shareholders would be unhappy, and
they will take out their investment from the company which will decrease the market price
(Clientele Effect). However, the true effect is based on the nature of the current stock holding
of the company. If more stocks are held by young-growth oriented investors, then the market
price will increase instead of going down.
Dividend signaling theory - If the company reduces dividend payments it will be an indication
of negative future prospects.
Chairman’s Claim:
Since the business is well-established and does not have profitable investment
opportunities, currently they are having excess money (as the business is not growing).
If Superior Plc takes on the profitable business financed by debt capital, the company can
settle the liabilities by the excess cash retained from Superior Plc.
On the other hand, they can strengthen the company with the synergy effect of the profitable
business.
As the investment is financed heavily by debt capital, creditors will closely monitor the
activities of the business. So, this involvement helps to improve the operational efficiency of
the business and cut down unnecessary expenditure (cut down non-value adding activities).
(b) (i)
Debt issue:
The company needs a cash infusion of Tk. 1.2 million. If the company issues debt, the annual
interest payments will be:
Interest = Tk. 1,200,000x0.08= Tk. 96,000
The cash flow to the owner will be the EBIT minus the interest payments, or:
40-hour week cash flow = Tk. 475,000 – 96,000 = Tk. 379,000
50-hour week cash flow = Tk. 560,000 – 96,000 = Tk. 464,000
Equity issue:
If the company issues equity, the company value will increase by the amount of the issue. So, the
current owner’s equity interest in the company will decrease to:
Tom’s ownership percentage = Tk. 2,900,000 / (Tk. 2,900,000 + 1,200,000) = 0.71 or 71%
So, Tom’s cash flow under an equity issue will be 71 percent of EBIT, or:
40-hour week cash flow = 0.71x Tk. 475,000 = Tk. 337,250
50-hour week cash flow = 0.71x Tk. 560,000 = Tk. 397,600
(b)(ii)
Tom will work harder under the debt issue since his cash flows will be higher. Tom will gain more
under this form of financing since the payments to bondholders are fixed. Under an equity issue,
new investors share proportionally in his hard work, which will reduce his propensity for this
additional work.
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(b)(iii)
The direct cost of both issues is the payments made to new investors. The indirect costs to the debt
issue include potential bankruptcy and financial distress costs. The indirect costs of an equity issue
include shirking and perquisites.
(c)(i)
Ke = Rf+(Rm-Rf)xbeta
=6%+(10-6)x1.5
=(6+6)%
=12%
Where Ke is the cost of equity, Rf is the risk-free return and Rm is the market return
(c)(ii)
The unleveraged beta is calculated as follows:
Unlevered beta = levered beta x[value of equity/(value of equity+ value of debt)]
Since the ratio of debt: equity is 25:75, it equates to 1:3
So,
= 1.5x[3/(3+1)]
Unleveraged beta=1.125
(c)(iii)
Since the new debt to equity ratio is 60: 40, it equates to 3:2
We shall now find the new beta as follows:
Levered beta = unleveraged beta x((value of equity+ value of debt)/ value of equity)
= 1.125x[(3+2)/2]
So,
Levered beta at this gearing level= 2.813
The new cost of equity will be,
Ke = Rf+(Rm-Rf)xbeta
=6%+(10-6)x2.813
=[6+11.252]%
=17.252%
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β= =
=1.384 =1.4
The beta of an asset β is a measure of the variability of that asset relative to the variability of the
market as whole. Beta is an index of the systematic risk of an asset.
A stock with beta greater than 1.0 has above average risk. Here, beta value of β=1.4 indicates that it
returns would be more volatile than market. The stock should earn more return the market.
(ii)
α=
Ȳ= =111.69/12= 9.31
α = 9.31-(1.384x4.15)
= 3.57
IF index move up by 7%, the return we can expect for the stock
= 3.57+1.387x7
= 13.279 %
(c)
Company Wants Floating Fixed
Would pay (no swap) (LIBOR + 0.75%) (10.5%) (LIBOR + 11.25%)
Could pay (9.0%) (LIBOR + 1.5%) (LIBOR + 10.5%)
Commission (0.15%) (0.15%) (0.30%)
Potential gain 0.45%
Split evenly 0.225% 0.225%
Expected outcome
Would pay + potential gain) (LIBOR + 0.525%) (10.275%) (LIBOR + 10.8%)
Swap terms
Could pay (9.0%) (LIBOR + 1.5%) (LIBOR + 10.5%)
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Post merger combined profit after tax= (56+21+7.5) = 84.5
Maximum number of shares after merger= Tk. 84.5/5.6= 15.089 lakh
Maximum number of shares to be exchanged = (15.089-10) = 5.089 lakh
Maximum share exchange ratio= 5.089/8.4= 0.446 = 0.6058 share for each share of Tatar.
(b)
a. Constant growth (single-stage) dividend discount model:
Value=
where:
D1= Next year’s dividend
K= Required rate of return
g= Constant growth rate
D1= (EPSo)(1 +g)/(P/O) =(4.50)(1.045)(0.55) = Tk.2.59
K = given at 11% or 0.11
g = (ROE)(1- P/O) =(0.10)(1- 0.55) =0.045
Value= + +
Here,
D1= (EPS)(1+g1) (P/O) = (4.50) (1.15) (0.55) = Tk. 2.85
D2 =(D1) (1 + g1) = (Tk.2.85) (1.15) =Tk. 3.27
D3= D2 (1+g2) = (Tk. 3.27) (1.045) = Tk. 3.42
K= given at 11% or 0.11
g2 =0.045
Value of the stock= + +
(c)
(i) Number of new shares = 1,000,000/2= 500,000
New price per share after the offering will be:
P=
= 1,000,000xTk. 32+ Tk. 2,000,000/(1,000,000+500,000)
=Tk. 22.67
The ex-right price is Tk. 22.67
Subscription Price= 2,000,000/500,000 = Tk. 4
Value of the right=
(Ex-right Price-subscription Price)/ Rights needed to buy a share of stock
= (22.67-4)/2
= 9.33
(ii) A rights offering usually cost less, it protects the proportionate interests of existing
shareholders and also protects against underpricing.
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Solution of the Question No. 4
Open Ended.
NAV =
= = Tk. 13.50
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(d)
A Depository Participant is an agent or representative of a depository. A depository can be literally
translated as a place where valuables are stored for safety purposes. However, in the financial
world, a depository can also refer to an institution that holds and also enables owners to exchange
their securities and shares. When investing or trading on the stock exchange, your broker becomes
the Depository Participant. A depository participant may be:
A financial institution
A bank
An insurance Company
Any clearing corporation
Any corporate stock dealer, stock broker merchant banker asset manager, custodian.
Functions of CDBL:
The main function of CDBL is to efficient delivery, settlement and transfer of securities through
computerized book entry system.
Dematerialization (usually known as demat) is converting physical certificates of Securities
to electronic form.
Rematerialization, known as remat, is reverse of demat, i.e. getting physical certificates from
the electronic securities
Recording and maintaining securities account and registering transferring of securities.
Changing the ownership without any physical movement or endorsement of certificates and
execution of transfer instruments.
Settlement of trades done on exchange connected to the Depository
Pledging and Unpledging of Securities for loan against shares
Corporate action benefits directly transfer to the Demat and Bank account of customer.
Method of operation of CDBL:
Investor opens a depository account with a participant or CDBL
Certificates are dematerialized by lodging them at the issuer
The issuer updates the register and moves the holding to the depository portion of the
register.
CDBL debit the seller account.
The stock exchange advises CDBL to update its records
The investors sell on a stock exchange through stock broker and another investor buys
CDBL credit the buyer accounts
Investor may rematerialize if they wish.
= THE END =
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