The management accountant of Sky Ways Ltd., has compiled costs data for in-house provision of catering service as under:

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1 Extra Reading Time: Writing Time: (i) (ii) (iii) (iv) (v) (vi) (vii) ICMA. Pakistan 15 Minutes 03 Hours Maximum : 100 STRATEGIC FINANCIAL MANAGEMENT (AF-503) SEMESTER-5 SPRING (AUGUST) 2014 EXAMINATIONS Tuesday, the 19th August 2014 Roll No.: Attempt all questions. Answers must be neat, relevant and brief. Use of non-programmable scientific calculators of any model is allowed. Read the instructions printed inside the top cover of answer script CAREFULLY before attempting the paper. In marking the question paper, the examiners take into account clarity of exposition, logic of arguments, effective presentation, language and use of clear diagram/ chart, where appropriate. DO NOT write your Name, Reg. No. or Roll No., or any irrelevant information inside the answer script. Question Paper must be returned to invigilator before leaving the examination hall. Answer Script will be provided after lapse of 15 minutes Extra Reading Time (9:15 a.m. or 2:15 p.m. [PST] as the case may be). Q. 1 Sky Ways Ltd., a subsidiary of Best Ways Ltd., runs a high speed business train from Lahore to Karachi and back on alternative days. The train leaves Lahore at 6:00 pm and reaches at Karachi at 6:00 am on the next day. The train starts its journey from Karachi on the same day at 6:00 pm and reaches at Lahore at 6:00 am on the next day. In this way, the business train completes one single trip in a day of 24 hours. The train is fully air conditioned and also provides different facilities i.e., TV, internet and catering services to its passengers. The train service operates 360 days per year and a single restaurant carriage is adequate to serve the catering needs of a train carrying up to 600 passengers. Past sales data indicates that 50% of passengers used the catering service, spending an average of Rs. 450 per journey. The data is expected to remain unchanged over the next five years. Statistical forecasts per single trip from Lahore to Karachi or Karachi to Lahore for the train service over the next five years are shown as under: In-House Catering Services: No. of Passengers Probability The management accountant of Sky Ways Ltd., has compiled costs data for in-house provision of catering service as under: Variable Costs: % of Sales Direct material 55 Variable overhead 12 Fixed Costs: Labour (Year-1) 10 Purchase / storage charges 3 Insurance expenses 2 Depreciation on catering equipment 4 Total cost 86 Labour costs are expected to rise at a rate of 5% per year over the next five years. Variable costs per rupees sales are expected to remain unchanged over the next five years. Some catering equipment will need to be replaced at the end of Year-2 at a cost of Rs. 1,000,000. This would increase the depreciation charge on catering equipment from Rs to Rs per rupee sale. The equipment value at the end of Year-5 is estimated to be Rs. 560,000. SFM-Aug of 6 PTO

2 Outsource Catering Services: In an attempt to reduce overheads, the company is considering to use services of an outside contractor who will takeover responsibility for all on-train catering services. Sky Ways Ltd., invited tenders for a five-year contract. The selected contractor has agreed to purchase immediately for cash the existing catering equipment owned by Sky Ways Ltd., at current book value i.e., Rs. 13,000,000. The contractor would pay the company the charges at flat rate of Rs. 5,000 per day for the provision of this catering service. The contractor will receive daily meal charges directly from the passengers. The quality of the catering services is expected to be unaffected by contracting out. In case of contract out the catering, the following fixed costs will be saved every year till the end of the contract: Rupees Depreciation 2,600,000 Purchasing/ storage costs 1,600,000 Insurance 500,000 Labour costs will be saved in case of contracting out the catering service. The cost of capital for Sky Ways Ltd., is 12%. Assume that all cash flows occur at the end of each year. Ignore taxation. Independent Projects: Best Spices Ltd., a multi product subsidiary of Best Ways Ltd., is now considering to undertake three independent investment projects. Financial details of these projects are as under: Project X Y Z Development costs already incurred (Rs.) 150, , ,000 Estimated cost on plant and machinery (Rs.) 2,800,000 4,800,000 1,200,000 Unit sales per annum (Nos.) 75,000 80, ,000 Selling price and variable costs per unit for each project are estimated below: Project X Y Z Rupees Selling price Materials Labour Variable overheads The useful life of plant and machinery of three projects is five years with zero salvage value. The company charges depreciation on a straight line basis over the useful life of the plant and machinery. Development costs of projects are written off in the year they are incurred. The company allocates general administration costs to projects at a rate of 5% of selling price. However, there is no impact on administration costs with the introduction of the above projects. Working capital, 20% of the expected annual sales, will be required immediately in each case and will be recovered in full when the projects end in five years time. Funds available for investment are limited to Rs. 10,400,000. However, all the three projects are divisible. Best Spices Ltd., cost of capital is 18%. Ignore taxation. Past due Accounts Payable: Best Spices Ltd., is performing quite well in the last many years in terms of market share. The company s turnover was Rs. 7 million last year earning 10% profit after tax. Presently, the company is facing difficulties to pay its accounts payable in time. Though, the terms of purchase are net 30 days, but its accounts payable represent 60 days purchases. The company intends to increase bank borrowings in order to become current in meeting its trade obligations. The statement of financial position of the company is as under: SFM-Aug of 6

3 Best Spices Ltd. Statement of Financial Position as on June 30, 2014 Rs. 000 Cash 200 Accounts payable 1,200 Accounts receivable 600 Bank loans 1,400 Inventory 2,800 Accruals 400 Current assets 3,600 Current liabilities 3,000 Land and buildings 1,200 Long-term debt 1,400 Equipment 1,200 Share capital (Rs. 10 each) 600 Retained earnings 1,000 Total assets 6,000 Total liabilities and equity 6,000 (a) Calculate the expected number of passengers per single journey for the business train service. 02 (b) Which of the two alternatives i.e., in-house provision or contracting out would you recommend? 16 (c) Identify and critically comment upon three non financial factors which need to be taken into account when a business is considering this type of outsourcing option. 03 (d) How would you determine that three projects of Best Spices Ltd., are financially viable? 09 (e) Calculate the profitability index for each project and advise the company which of the projects are to be undertaken with total NPV. 03 (f) How much bank financing is needed to eliminate the past due accounts payable of Best Spices Ltd.? 02 (g) Would you as a bank loan officer make the loan? Justify your decision based on ratio analysis. 05 Q. 2 Shah Ltd., a Karachi based listed company, is renowned for its quality products. The company produces electronic products for domestic consumers. The company has 100,000 ordinary shares and the market value of its shares is Rs. 4,650,000 cum-dividend. The next annual dividend of Rs. 900,000 is due to be paid within a few days. It is generally expected that the company s dividends will remain indefinitely at the current level. Shah Ltd., has no fixed interest capital. The directors of Shah Ltd., are considering an investment project that would require the immediate investment of Rs. 500,000 and would produce net annual receipts of Rs. 132,000 indefinitely. The first receipt would arise after one year. Details of the project have not yet announced publicly. All receipts from the project would be distributed as dividends when received. If the project was undertaken, it would be financed in one of the following three ways: (i) A rights issue of one new share for every four held at a price of Rs. 20 per share: the new shares would rank for dividend one year after issue. (ii) A reduction of Rs. 500,000 in the current dividend. (iii) A public issue of ordinary shares; the new shares would rank for dividend one year after issue. The Managing Director of Shah Ltd., is of the view that the proposed price of the rights issue seems rather low and he suggests a one for five rights issue at a price of Rs. 25 per share nearer to the current market value of ordinary shares. You may assume that if the project were accepted, the director s expectations of future results would be communicated to and believed by, the stock market and that the market would perceive the risk of the company to be unaltered. Ignore issue cost of new shares and taxation. SFM-Aug of 6 PTO

4 (a) Estimate the new market price per ordinary share, ex-dividend If the project is accepted and financed by: a one for four rights issue, or 04 a reduction in the current dividend. 01 (b) Calculate the number of new shares to be issued under option (iii), and the price at which they should be issued. If the total benefit from the project is to go to existing shareholders. 04 (c) Calculate the total gain made by present shareholders under each of the three financing options. 04 (d) Comment briefly on the views expressed by managing director. 02 Q. 3 (a) Alpha Ltd., and Beta Ltd., are identical except for capital structures. Alpha Ltd., has 50% debt and 50% equity, whereas Beta Ltd., has 20% debt and 80% equity. The percentage of debt and equity of both companies have been expressed in terms of market value. The borrowing rate for both companies is 8% in a no-tax world, and capital markets are assumed to be perfect. (i) If you own 5% of the stock of Alpha Ltd., what is your rupee return if the company has net operating income of Rs. 720,000 and the overall capitalization rate of the company is 18%? What is the implied required rate of return on equity of Alpha Ltd.? 04 (ii) Beta Ltd., has also net operating income of Rs. 720,000. What is the implied required equity return of Beta Ltd.? Why does it differ from that of Alpha Ltd.? 04 (b) ABC Ltd., has earnings before interest and taxes (EBIT) Rs. 6,000,000 and a 40% tax rate. Its required rate of return on equity in the absence of borrowing is 18%. (i) In the absence of personal taxes, what is the value of the company in an Modigliani and Miller (MM) world with: (1) no leverage? 02 (2) Rs. 8 million in debt? 01 (3) Rs. 14 million in debt? 01 (ii) You may assume that personal as well as corporate taxes now exist. The marginal personal tax rate on common stock income and debt income is 25%, and 30% respectively. Determine the value of the company using for each of the three debt alternatives as mentioned above. Why do your answers differ from (i) above? 03 Q. 4 XYZ Ltd., is a rapidly growing company in the beverage industry. The statement of financial position of the company is as under: XYZ Ltd. Statement of Financial Position as on June 30, 2014 Rs. 000 Cash 20,000 Accounts payable 20,000 Accounts receivable 40,000 Accruals 20,000 Inventories 40,000 Short-term debt 10,000 Current assets 100,000 Current liabilities 50,000 Net fixed assets 100,000 Long-term debt 60,000 Preferred stock 10,000 Common equity: Common stock 20,000 Retained earnings 60,000 Total common equity 80,000 Total assets 200,000 Total liabilities and equity 200,000 SFM-Aug of 6

5 The company is in process of calculating weighted average cost of capital to be used for appraisal of the investment projects having the same risk class as the firm s existing average assets. The relevant facts are as under: Short-term debt represents 10% bank loans with interest payable quarterly. These loans are used to finance receivables and inventories on a seasonal basis, so in the offseason, bank loans are zero. The long-term debt consists of 20-year, semiannual payment, Term Finance Certificates (TFCs) of Rs. 1,000 with a coupon rate of 8%. Currently, these TFCs provide a 12% yield to investors. XYZ Ltd. s perpetual preferred stock has Rs. 100 par value. The company pays a quarterly dividend of Rs. 2, and has 11% yields to investors. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 5% flotation cost to sell it. The company has 2 million common shares outstanding. Current price (P o ) of the stock is Rs. 20. It has recently paid a dividend (D o ) of Rs. 1 and current earning per share (EPS o ) is Rs. 2. Return on equity (ROE) based on average equity was 24% in the year The security analysts have calculated betas as The risk free rate is 10%; and estimated market return is 15%. For the bond-yield risk premium approach, a risk premium is 5% over XYZ Limited s 12% TFCs. XYZ Ltd., falls under 40% tax bracket. (a) Calculate the market value of each component of capital structure. 07 (b) Determine the cost of each component of capital structure. Calculate the cost of equity using capital asset pricing model (CAPM), discounted cash flow (DCF) and bond-yield risk premium. 06 (c) What is the company s weighted average cost of capital (WACC) using CAPM for cost of equity and assuming no new equity will be issued? 02 Q. 5 Unique Ltd., is in the showbiz and provides out door shooting facilities to the various production houses. The company has excellent record of growth in the past years and considering to acquire Icon Ltd., a fashion show business. Both companies have the same level of risk. The partial financial statements of each company are as under: Partial Statement of Consolidated Income for the year ended June 30, 2014 Rs. in million Earning After Tax (EAT) Dividends Retained Earnings for the Year Price/ Earnings Ratio before Acquiring Unique Ltd Icon Ltd Summarised Statements of Financial Position as at June 30, 2014 Rs. in million Unique Ltd. Icon Ltd. Non-current assets Net current assets Long-term debt Owner s equity Ordinary shares (Rs. 10 each) Retained earnings SFM-Aug of 6 PTO

6 The Board of Directors of Unique Ltd., is considering to make an offer to the shareholders of Icon Ltd., of five shares in Unique Ltd., for every four shares held. It is believed that a rationalization of administrative functions arising from the merger would reap after tax benefits of Rs. 4.8 million. (a) What would be the total value of the proposed offer to Icon Ltd.? 04 (b) What would be the earnings per share of Unique Ltd., following the successful acquisition of Icon Ltd.? Calculate the share price of Unique Ltd., following acquisition, assuming that the benefits of the acquisition are achieved and that the price/ earnings ratio declines by 10%. 03 (c) Calculate the effect of the proposed takeover on the wealth of the shareholders of each company. 08 THE END PRESENT VALUE FACTORS Year 5% 6% 11% 12% 13% 14% 15% 16% 17% 18% C UMULATIVE PRESENT VALUE FACTORS Year 5% 6% 11% 12% 13% 14% 15% 16% 17% 18% SFM-Aug of 6