SUGGESTED SOLUTIONS Strategic Financial Management. CA Professional (Strategic Level II) Examination June 2014

Transcription

1 SUGGESTED SOLUTIONS Stategic Financial Management CA Pofessional (Stategic Level II) Examination June 2014 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF SRI LANKA All Rights Reseved

2 Answe No. 01 (a) When the management decides to etain pofits without being distibuted to shaeholde by means of dividends it should ensue that the company is in a position to einvest such funds in investment fo a etun not less than the cost of capital of the company. When thee ae no investment oppotunities offeing a etun commensuate with the equied ate of etun, management may decide to etun eanings by means of dividends to shaeholdes allowing them to look fo investment oppotunities that could geneate thei equied ate of etun. The othe altenative way of using the etained eanings is to buy back company s own shaes. This will ultimately incease the maket value pe emaining shae. The pevailing TB ates ae low. A low-yield Teasuy Bill Rate can mean businesses ae enticed to boow money, meaning that they will have moe money to spend. Howeve when thee ae no othe investment oppotunities buying back shaes athe than investing in TB s hae epuchase is moe beneficial fo the Company. Shaeholdes and management can have othe easons fo wanting to buy back shaes: A change in the elative weighting of shaeholdes between those who efuse to sell the shaes to the company fo easons of contol (i.e. in ode to incease thei pecentage of owneship) and those who agee to sell some of thei shaes, hopefully at above thei maket value. Tax easons, as it is often less costly fo shaeholdes to get cash in the fom of a shae buyback than in the fom of dividends; To send out a positive signal, i.e. that management consides the company to be undevalued. Buying back shaes and cancelling them inceases the value of the emaining shaes. Leveage fom debt, fo the elated tax benefits. This is not a vey compelling motivation, as it ovelooks the fact that debt and equity become iskie afte a shae buyback and thus moe costly. The tax benefit is often illusoy, especially as the company loses some financial flexibility. If shae buybacks educe WACC, companies would always be massively buying back thei shaes. Building up a eseve of shaes to be used late fo stock option awads o as a cuency fo an acquisition. Smoothing out shae pice fluctuations in the case of listed companies. But whateve is bought can be esold, and such buybacks, which ae often in tiny doses, ae tightly egulated by maket authoities; (b) Reasons fo Delisting (i) (ii) (iii) The company no longe satisfies the listing ules of the stock exchange. Maintaining a listing entails vaious costs which may no longe be justifiable, paticulaly fo smalle, undevalued companies. Ongoing expenditue elating to financial epoting equiements, ad hoc disclosues, investo elations. (2)

3 (iv) A delisting also eleases the company fom cetain tanspaency and disclosue obligations. (v) A delisting povides stategic and financial feedom fo the Company (vi) Long-tem stategic planning is facilitated as shot-tem consideations of yields become less impotant with delisting (vii) Restuctuings may be caied out with less public attention (viii) In the event of a takeove by a stategic investo, a planned consolidation o eoganization can be effected moe easily (ix) Possible bankuptcy situation Because a delisted stock can be had to sell, many investos will sell afte a delisting announcement, diving the pice down. Howeve, thee ae exceptions e.g. The SKF Goup of Sweden, a leade in beaings and seals, intended to delist SKF India fom the stock exchanges. Stock pices of SKF India have zoomed up since the announcement on speculation that thee may be a counte bid, but settled down afte it did not mateialise (c) The consultant has applied PAN s pe-acquisition P/E atio to the combined eanings of the new goup. The diffeence between the combined maket values pe-acquisition (Rs.8,750 MN) and the estimated maket value post-acquisition (Rs.12,500 MN) is Rs.3,750 MN. This is SMS's pe-acquisition eanings multiplied by the diffeence between the company's pe-acquisition P/E and the combined post-acquisition P/E ( = 5). EPS fo PAN appeas to have inceased fom Rs. 25 to Rs because of this effect. In the absence of any synegy o commecial benefits, o the disclosue of new infomation duing the bid, thee is no eason why the maket value of the combined goup should be any diffeent fom the total of the two individual companies maket values, i.e. Rs.8, 750 MN. This would suggest the following post-acquisition pices pe existing shae: PAN (Rs.8,750 MN x 33%) / 10 mn = Rs. 289 SMS (Rs.8,750 MN x 67%) / 30 mn = Rs. 195 Thee is a tansfe of wealth fom PANs shaeholdes to SMS's shaeholdes because the tems of the offe ae slightly moe geneous than the atio of the old shae pices. Theefoe, assuming efficient makets, PAN's shae pice will fall. The pe-acquisition pices suggest 9 fo 15, not 10 fo 15. PAN = 9 = Rs. 2,813 SMS = 15 = Rs. 2,813 PAN SMS Combined fim PRE ACQUISITION EPS (Rs.) PE Ratio MV pe shae (Rs.) Numbe of Shaes 10,000,000 30,000,000 30,000,000 Eanings (Rs.) 250,000, ,000,000 1,000,000,000 Maket Value (Rs.) 3,125,000,000 5,625,000,000 12,500,000,000 (3)

4 (d) POST ACQUISITION New shaes issues - 20,000,000 NA Owneship 10,000,000 20,000,000 30,000,000 Owneship % 33% 67% 100% Maket value 4,125,000,000 8,250,000 12,500,000,000 Cuent Maket Value 8,750,000,000 Immediate Savings 1,500,000,000 Restuctuing Expenses (250,000,000) VRS Expenses (500,000,000) Sale of assets in Y1 1,250,000,000(1,400,000,000x Incease in Net pofits 3,333,333,333 (400,000,000/.12) Inceased value afte announcements 14,083,333,333 New pice pe shae Owneship SP PAN 33% 465 SMS 67% 315 It is extemely impotant to ecognize the effect of Shae Distibution in the Mege and the table above indicates that the mege poposal would upset the contolling inteest of PAN which will not be favouable consideation by the management and shaeholdes of PAN Compaed with the cuent maket pices of both PAN and SMS, as given below, the post acquisition position has clealy impoved: Pe Pice (Rs.) Post pice (Rs.) PAN SMS (4)

5 Answe No. 02 (a) (i) Debtos US $ 20 mn x 3/12 = US $ 5 mn Inventoy US $ 20mn x 90% x 2/12 = US $ 3 mn Cost of sales Ceditos US$ 20mn x 90% x ½ = US $ (0.75)mn 12 = US $ 7.25mn Finance cost = US$ 7.25mn x 4% = US $ 290,000 (ii) Maximum cedit exposue = US $ 5mn x 0.80 x 30% = US$ 1.2mn (only fom beyond bode) Othe debtos = Zeo cedit isk due to bank guaantee. Total cedit exposue = US $ 1.2mn (iii) Impact on bottom line SLECIC pemium = US$ 1.2mn x 0.45% = US$ 5,400 Howeve, the cedit isk is eliminated bottom line = US $ 20 mn x 2.5% - US$5,400 = US $ 494,600 (b) Yes, although the pemium is aound US $ 5,400, the cedit exposue of US$ 1.2mn is nullified. Hence its fully wothwhile to obtain a SLECIC cove. Net poceeds on sales, in the event of factoing, Face amount of eceivable US$4,000,000 Non-ecouse fee (1.25%) = US$50,000 Factoing fee (0.03 x 4,000,000) = US$ 120,000 Est. Net poceeds on sale = 4,000, ,000 = US$ 3,830,000 Advantages of factoing unde a non-ecouse ageement Avoid losses due to unpaid invoices Impove cash flow - immediate cash upon pesentation of invoices Altenative means of financing without poviding additional secuities Concentate on you coe business and leave the debt collection to the facto Incease commecial competitiveness Impove Balance Sheet atios (5)

6 (c) Fowad contacts and futues (ageements made to exchange o sell foeign cuency at ascetain pice in the futue) Swaps (ageements to simultaneously exchange o sell an amount of foeign cuency now and esell o epuchase that cuency in the futue) Options (instuments that povide the option, but not the obligation, to buy o sell foeign cuency in the futue once the value of that cuency eaches a cetain, peviously ageed, pice) Back-to-back loans with back to back loans two paties, each in a diffeent county, lend money to each othe in an effot to hedge against cuency isk. They ae also called paallel loans. Lettes of cedit - An LC, also efeed to as a documentay cedit, is a contactual ageement wheeby the issuing bank (impote s bank), acting on behalf of the custome (the impote o buye), pomises to make payment to the beneficiay o expote against the eceipt of complying stipulated documents. Guaanties typically efe to financial guaantees of debt that cove the timely payment of debt sevice, i.e. guaantees cove losses in the event of a default on debt sevice. Thee ae atios types of guaantees fo mitigating foeign exchange isk. (6)

7 Answe No. 03 (a) Z = 1.2X X X X X5 = 1.2 x x x x x = = the Z Scoe is between Thus Tagico is not facing bankuptcy, but is heading towads financial difficulties. Fo a company to be financially healthy it has to have a highe scoe than (b) (i) Youth = 20mn x 40% = 8mn people Taget youth = 8 mn x 60% = 4.8mn 50% maket shae = 50% x 4.8mn = 2.4mn 1% maket shae = 1% x 2.4mn = No of sales of cameas 24,000 Aveage selling pice = Rs. 20,000 Sales = 24,000 x 20,000 = Rs. 480mn Goss pofit = 480 x 20% = Rs. 96mn Since only 50% of the maket is penetated cuently, thee is an oppotunity fo Tagico to compete (ii) Rs. million Goss Pofit = 96 Ovehead & finance = (56) Pofit befoe tax = 40 28% = (11.2) Pofit afte tax = 28.8 ====== (7)

8 (c) Befoe ights issue Rights issue 5 Post ights Pishan 1.5 mn x 51% = 765,000 1,530,000 2,295,000 Japanese 1.5 mn x 39% = 585,000 1,170,000 1,755,000 Public 1.5 mn x 10% = 150, , ,000 1,500,000 ======= 3,000,000 ======= 4,500,000 Rs. 10 Rs. 15 Rs. 5 Rs. 15 mn Rs. 30 mn New shaeholde stuctue in Rupees Rupees (mn) Pishan Rs. 10) + Rs. 5 = 15.3 Japan Rs. 10) + Rs. 5 = 11.7 Public Rs. 10) + Rs. 5 = (d) Japanese patne has infused 1,170,000 x Rs.5 = Rs mn on ights He puchased 39% stock = Rs mn Rs mn (8)

9 Answe No. 04 Statement of Financial Position Malaysian Company MYR (MN) Non Cuent Assets (NBV) 105 Cuent Assets 55 Cuent Liabilities (31) Income Statement Malaysian Company MYR (MN) Revenue Opeating Expenses Depeciation 39.0 Inteest Expense - Pofit Befoe Tax 12.3 Cost of capital Beta 0.9 Risk fee ate 7.5% Risk Pemium 5% Cost of capital 12.0% Exchange Rates F = 1 + FC x S 1 + DC Y1 = 40 x = Y2 = x = (9)

10 Disposal Value of subsidiay Malaysian Company Disposal value MYR (MN) Mn Non Cuent Assets (NBV) % Cuent Assets 55 90% Cuent Liabilities % Exchange Rate LKR Value 3,260 OPERATING CASH FLOWS INCOME STATEMENT Yea 0 Yea 1 Yea 2 MYR (MN) MYR (MN) MYR (MN) Revenue Opeating expenses Cash flow Yea Mill cost ( ) Opeating cash flows Residual Value ( ) Exchange ate Cash flows in LKR (Mn) (5,250) 2,791 9, Discounting 12% NPV IN LKR (5,250) (½) 2,492 7,749 NPV 4,991 Summay NPV ove next two yeas 4,991 Cuent Disposal value 3,260 Net NPV 1,737 Conclusion The Malaysian opeation seems pofitable unning fo futhe 2 yeas due to the fact that it can geneate a positive NPV which is geate than the cuent disposal value (4,991 MN 3,260 MN MYR). (10)

11 (b) Dividend payout decision is among the basic policy confonting copoates especially on how much to pay. A numbe of conflicting theoetical models define cuent attempt to explain copoate dividend behavio. One faction see dividend as attactive and as a positive influence on shae pice, the second goup believes that shae pices vay invesely with dividend payout level and the thid goup believes that dividend policy is ielevant on shae pices Dividend policy is concened with financial policies egading paying cash/stock dividend in the pesent o paying an inceased dividend at a late stage. Whethe to decline dividends and what amount, is detemined mainly on the basis of the company's unappopiated pofit (excess cash) and influenced by the company's long-tem eaning powe. When cash suplus exists and is not needed by the fim, then management is expected to pay out some o all of those suplus eanings in the fom of cash dividends o to epuchase the company's stock though a shae buyback pogam. If thee ae no NPV positive oppotunities, i.e. pojects whee etuns exceed the hudle ate, and excess cash suplus is not needed, then finance theoy suggests management should etun some o all of the excess cash to shaeholdes as dividends. This is the geneal case, howeve thee ae exceptions. Fo example, shaeholdes of a "gowth stock", expect that the company will, almost by definition, etain most of the excess eanings so as to fund futue gowth intenally. By withholding cuent dividend payments to shaeholdes, manages of gowth companies ae hoping that dividend payments will be inceased popotionality highe in the futue, to offset the etainment of cuent eanings and the intenal financing of pesent investment pojects. Management must also choose the fom of the dividend distibution, geneally as cash dividends o via a shae buyback. Vaious factos may be taken into consideation: whee shaeholdes must pay tax on dividends, fims may elect to etain eanings o to pefom a stock buyback, in both cases inceasing the value of shaes outstanding. Altenatively, some companies will pay "dividends" fom stock athe than in cash. Financial theoy suggests that the dividend policy should be set based upon the type of company and what management detemines is the best use of those dividend esouces fo the fim to its shaeholdes. As a geneal ule, shaeholdes of gowth companies would pefe manages to have a shae buyback pogam, wheeas shaeholdes of value o seconday stocks would pefe the management of these companies to payout suplus eanings in the fom of cash dividends Many fims choose to pay no dividends and these fims sell at positive pices. Fo example, most Intenet fims, such as Amazon.com, Google, and ebay, pay no dividends. Rational shaeholdes believe that eithe they will eceive dividends at some point o they will eceive something just as good. That is, the fim will be acquied in a mege, with the stockholdes eceiving eithe cash o shaes of stock at that time. Of couse, the actual application of the dividend discount model is difficult fo fims of this type& clealy the model fo constant gowth of dividends does not apply. Though the diffeential gowth model can wok in theoy, the difficulties of estimating the date of fist dividend, the gowth ate of dividends afte that date, and the ultimate mege pice make application of the model quite difficult in eality. As a esult one should look at the same industy othe (11)

12 entities with typical dividend payout being maintained and always make adjustments to own cost of capital figues befoe finalizing on a cost of capital figue on its own. Empiical evidence suggests that fims with high gowth ates ae likely to pay lowe dividends, a esult consistent with the analysis hee. Fo example, conside McDonald s Copoation. The company stated in the 1950s and gew apidly fo many yeas. It paid its fist dividend in 1975, though it was a billion-dolla company (in both sales and maket value of stockholdes equity) pio to that date. Why did it wait so long to pay a dividend? It waited because it had so many positive gowth oppotunities (additional locations fo new hambuge outlets) to take advantage of. In the Indian context also, thee exist a lage numbe of simila examples. The softwae giant, Infosys Limited, till a few yeas back, did not pay any dividends ensuing that all the eanings wee einvested fo its gowth oppotunities. High gowth telecom companies, such as Tata Telecom and Bhati Aitel, ae also examples of companies which have avoided paying dividends. Answe No. 05 (a) (i) The cuent cost of capital of SP in tems of the CAPM SP SP SP f ( MaketRisk P emium) SP (8.5) Requied Rate of etun fo the Bee secto Bee f Bee bee Bee ( MaketRisk Pemium) (8.5) 18.03% Requied Rate of etun fo the Diay secto Diay f Diay Diay Diay ( MaketRisk Pemium) (8.5) 11.06% Rate of etun of the maket potfolio Maket f maket Maket Maket ( MaketRisk Pemium) (8.5) 14.8% (12)

13 (ii) Retun SML 18.03% Bee IRR of the Bee Poject ( 16.25%) 14.8% maket % Cost of capital of company 11.06% Diay poducts 6.3% isk fee ate IRR of the Diay Poject (11.61%) Beta (iii) It is wong to compae newly poposed investments IRRs with the company s cost of capital. The company s cost of capital epesents the business isk of the Food Pocessing secto. Newly poposed two pojects ae into the bee and daiy poducts. Thei business isk and equied ate of etun should be diffeent fom the food pocessing business. The equied ate of etun fo the bee secto is 18.03%, while that of fo the daiy secto is 11.06%. IRR of the bee investment (16.25%) is well below the equied ate of etun of themsecto. The company should not accept this poject, though its IRR is highe than the cuent cost of capital of the Company. On the othe hand, IRR of the investment in daiy poducts (11.6%) is highe than the equied ate of etun fo the secto. So the investment in diay poducts should be accepted. (iv) Maket gowth ate Maket size Demand vaiability Industy pofitability Industy ivaly Global oppotunities Maco-envionmental factos (13)

14 (b) Real options could use in investment decisions.it povides an altenative o choice in evaluating a business investment oppotunity.e.g. to expand and abandon pojects if cetain conditions aise, amongst othe options. In the eal wold evey business decision is coupled with uncetainty about the futue that affects the pesent value of the pojects in consideation. Thus, befoe making any investment decisions,it is impotant to conside vaious appoaches to detemine whethe the investment should be undetaken o not. Taditional appoaches fo valuing investment oppotunities do not take into account management flexibility to evise its decisions in the futue, as well as the intedependence of the poject with futue investments. The Real Options Appoach attempts to evaluate pojects by consideing the value of being able to decide among seveal stategic options-especially when the value of a poject is highly dependent on the level of flexibility that it allows. The value of the abandonment option can be estimated by detemining the chaacteistics of the put option: Example: Estimated initial cost of a poject is Rs. 1,000,000 and the Cash Flows theeafte would be pepetual. The poject Discount ate is 25%. The poject pomote came up with both an optimistic (outcome: Rs. 600,000 p.a) and pessimistic (outcome: Rs.- 300,000 p.a) outlook both having a pobability of 50%. Optimistic foecast: -Rs.1,000,000 + Rs. 600,000/.25 = Rs. 1,400,000 Pessimistic foecast: -Rs.1,000,000 Rs. 300,000/.25 = -Rs. 2,200,000 Oveall NPV weighing both scenaios = Rs. 400,000 Howeve, we need to conside the option of abandonment. That is, if he expeiences the pessimist outcome it doesn't mean that he needs to continue holding a pepetuity that is losing money. He can abandon it. If we conside this then it would change the NPV of the pessimistic outlook which would in tun change the weighted NPV of both outlooks. The abandonment value is geneally a cash value, o equivalent, associated with an investment. Optimistic Outlook: emains the same Pessimist Outlook Rs. 1,000,000 - (Rs. 300,000/1.25) = -Rs. 760,000 The new weighted NPV consideing the option of abandonment: (Rs. 1,400,000 x.50) + (-Rs. 760,000 x.50) = NPV of Rs. 320,000. Abandoning the poject allows the fim to save itself fom futhe losses, this option can make a poject moe valuable. (14)

15 Notice of Disclaime The answes given ae entiely by the Institute of Chateed Accountants of Si Lanka (CA Si Lanka) and you accept the answes on an "as is" basis. They ae not intended as Model answes, but athe as suggested solutions. The answes have two fundamental puposes, namely: 1. to povide a detailed example of a suggested solution to an examination question; and 2. to assist students with thei eseach into the subject and to futhe thei undestanding and appeciation of the subject. The Institute of Chateed Accountants of Si Lanka (CA Si Lanka) makes no waanties with espect to the suggested solutions and as such thee should be no eason fo you to bing any gievance against the Institute of Chateed Accountants of Si Lanka (CA Si Lanka). Howeve, if you do bing any action, claim, suit, theat o demand against the Institute of Chateed Accountants of Si Lanka (CA Si Lanka), and you do not substantially pevail, you shall pay the Institute of Chateed Accountants of Si Lanka's (CA Si Lanka s) entie legal fees and costs attached to such action. In the same token, if the Institute of Chateed Accountants of Si Lanka (CA Si Lanka) is foced to take legal action to enfoce this ight o any of its ights descibed heein o unde the laws of Si Lanka, you will pay the Institute of Chateed Accountants of Si Lanka (CA Si Lanka) legal fees and costs by the Institute of Chateed Accountants of Si Lanka(CA Si Lanka). All ights eseved. No pat of this document may be epoduced o tansmitted in any fom o by any means, electonic, mechanical, photocopying, ecoding, o othewise, without pio witten pemission of the Institute of Chateed Accountants of Si Lanka (CA Si Lanka) Stategic Financial Management: CA Pofessional (Stategic Level II) Examination June 2014 (15)