FINANCIAL MANAGEMENT

Suggested Answers
March-April 2022

Answer to the Question # 1 (a)

Factoring services evaluation – Craft Catering

Projected annual credit sales = Tk 8,000,0000.8 = 6,400,000
Factoring service:
Fees Tk 6,400,000  1.5% = 96,000
Financing Tk 6,400,0000.75(30/365)0.09 = 35,507
Annual cost 131,507
Bank overdraft* Tk 6,400,0000.25(30/365)0.08 = 10,521
142,028
Less: Administrative savings 20,000
Net cost of factoring 122,028

Present arrangement:
Bank overdraft = (Tk =88,192
6,400,00070/365)0.08
Bad debts = Tk 6,400,0000.01 =64,000 162,192
Net benefit of factoring 40,164

*With a factoring service the business will still need to finance 25 pe cent of its credit sales for 30
days.

By entering into a factoring arrangement, the company would save Tk 40,164 per year.

With an overdraft the company would need to be able to borrow Tk 1,227,397 (Tk 6,400,000 70/365) at an
interest rate of 8 per cent. This is a very substantial amount for a small enterprise and may well be beyond the
company’s borrowing capacity. The bank would inevitably require security for a loan of this amount. This may
not be available, or if it is, John may wish to reserve it for other purposes.

With a factoring arrangement the company would seem to need access to borrowings of Tk 131,507 [Tk
6,400,0000.25(30/365)]. For a company of this size this would appear to be a more reasonable amount.

Answer to the Question # 1 (b) (i)

Evaluation of dividend policies – Energy Systems

In the scenario presented, the dividend per share (DPS) and payout ratios are calculated as follows:
Forecast DPS Payout ratio
Year EPS (Tk) %
(Tk) Policy Policy
1 2 1 2
Current 9.80 3.92 3.92 40 40
1 11.90 3.92 4.70 40 40
2 10.10 4.76 5.64 40 56
3 13.30 4.04 6.77 40 51
4 14.50 5.32 8.13 40 56
5 17.40 6.96 9.75 40 56

The dividend per share for the current year is calculated as Tk 3.92 (Tk 1.02 interim plus Tk 2.09 final). With earnings
per share (EPS) of Tk 9.80 expected in the current year, the payout ratio for the current year would be 40 per cent
(Tk3.92/Tk 9,80).

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Policy 1. If the company adopted policy number 1 and maintained a constant 40 per cent payout ratio over the five
years, the dividend is forecast to fall from Tk 4.76 in year 1 to Tk 4,04 in year 2, a reduction of 15 per cent. The
reduction in dividend per share follows directly from the projected fall in earnings per share and would conflict with
the managing director's objective of avoiding any cut in dividends. No information is given on the reason for the
forecast fall in earnings, although this should be available internally to' the board.

Policy 1 highlights one of the drawbacks of following a constant dividend payout ratio - dividend payments will
fluctuate directly in line with earnings. Payouts will increase in years of high earnings and fall in years of lower
earnings. A dividend payout which is likely to fluctuate in this way may not appeal to some of the company's
shareholders.

Policy 2. With policy number 2, maintaining a compound growth rate in dividends of 20 per cent per year might seem
ambitious and demanding in view of the company's growth aspirations.

However, based on the information provided, the policy is achievable over the planning period. In addition, should the
company adopt policy number 2, no reduction in dividend payments is forecast. This would comply with the managing
director’s objective.

It is noted that sustaining an annual growth rate of 20 per cent in dividends will significantly increase the payout ratio
(up to 56 per cent for three of the five years) and lower retentions. The dividend cover would be reduced from 2.53
times in years 1 and 2 to 1.78 times in years 4 and 5. While a cover ratio of 1.78 might still be considered adequate,
some of the directors and other investors may not be comfortable with such a reduction.

Such a policy may please some shareholders (e.g., financial institutions) and perhaps raise their expectations about
future dividend payments, but there is no information provided on the structure of share ownership.

The directors should really consider if this policy is affordable in relation to the company’s investment needs. The
company is reported to be growing rapidly and has ambitious growth plans. How are these to be financed?
Unfortunately, this cannot be determined, as there is no information given concerning the company’s investment
plants.

Based on the information provided, which is limited, it appears the directors could feasibly adopt either policy. For
policy number I they could simply adjust the payout ratio in year 2 to maintain a consistent and increasing dividend
per share payment. Adopting policy 1 could leave the company with higher internal financing than policy 2 and may
be more appropriate in relation to its strategic growth objectives.

Without further information on shareholder clienteles and company investment plans, it is not possible to arrive at a
definitive policy recommendation.

Answer to the Question # 1 (b) (ii)

The directors are implying a residual approach to dividend policy, where the amount of dividend is being determined
as a residual after the company’s investment financing requirements have been met.
Maximum
Investment Dividend DPS (Tk) Variance
EPS(Tk)
financing (Tk) Policy Policy
Year 1 2 1 2
Current 9.80 5.88 3.92 3.92 3.92 0 0
1 11.80 8.33 3.87 4.76 4.70 -1.19 -1.13
2 10.10 7.07 3.03 4.04 5.64 -1.01 -2.61
3 13.30 9.31 3.99 5.32 6.77 -1.33 -2.78
4 14.50 7.25 7.25 5.80 8.13 1.45 -0.88
5 17.40 8.70 8.70 6.96 9.75 1.74 -1.05

For the current year, the maximum dividend is the dividend actually proposed, and investment financing is the EPS of
Tk 9.80 less the proposed dividend of Tk 3.92.

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With the exception of the current year, the company’s investment needs have been calculated as a percentage of the
forecast earnings per share. For example, in year 1 the company’s investment needs are equivalent to Tk 8.33 per share
(Tk 11.90). This would leave a maximum residual dividend of Tk 3.57 per share available in year 1. Whether the
company would wish to use all of this for dividends and leave no reserves is another matter. This would have
implications for the company’s capital structure.

Adopting a purely residual approach will produce an initial decline in the pattern of dividend payments, from the
current year’s proposed dividend of Tk 3.92 through to the dividend in year 2 of Tk 3.03. The level of dividend per
share is not expected to return to current levels until year 4. After which time, there would seem to be scope for a
substantial increase in dividends.

Shareholders may not react favorably to a decline in their dividends. Although, if they are informed of the company's
plans, they may be prepared to accept an initial dividend reduction if they are persuaded this policy will produce higher
future dividends through the profitable investment of the retained earnings.

In relation to the two dividend policies originally proposed, it is evident that the directors would not be able to adopt
either policy, given the constraint on additional financing. With policy 1, financing would be needed during years 1 to
3, and policy 2 could not be achieved without significant additional financing over the five years.

Answer to the Question # 2

Costs of Capital
Cost of Equity (using CAPM) = Rf + [Ba x (Rm - Rf)]
Rf = 2%
Rm = 10%
Ba = 1.2

Cost of Equity (using CAPM) = 2% +[ 1.2 x ( 10%- 2% )]

= 2% +[ 1.2 x ( 8% )]
= 2% +[ 0.096 ]
= 11.60%

The 6% irredeemable debentures:

The yield on this can be estimated solving for Kd in the following perpetuity formula: Po = I / Kd
Kd = the after tax cost of debt
Note: tax of 12.5% must be deducted from the interest payments.

i.e. interest is BDT 3.00 per nominal BDT 100, every six months

Hence after tax payment = BDT 3.00

= (1-0.125) = 2.63 per nominal BDT 100,

Po = I / Kd where: Po = BDT 110.0and I = BDT 2.63

=> Kd = I / Po = 2.625 / 110 = 2.39% semiannual = 4.77 % annually

Cost of preference shares

Its preference shares has a BDT 10.00 nominal value
Dividend on the preference shares is 7%
Current market price of the preference shares is BDT 12.50
Cost of preference shares is = Actual Dividend / current market price
= ( 7% x BDT 10.00) / BDT 12.50
= ( 0.70 ) / 12.50
= 0.056 = 5.60%

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Market Values of the Capital Structure

The market value of Equity

Current cum div share price BDT 48.00

Current numbers of shares 500,000
Expected dividend BDT 3,000,000
Expected dividend per share BDT 6.00
Current Ex div share price BDT 42.00
Current Equity Market value BDT 21,000,000

The market value of the irredeemable Debt

= the current market price, (ex interest) per bond x # of bonds issued

The 6% irredeemable debentures

= BDT 110.00 x (BDT 12,000,000 / 100) =

BDT 110.00 x ( 120,000 ) = BDT 13,200,000

The market value of the Preference Shares

= the current market price, (ex div) per share x # of shares issued

= 12.50 x ( 10,000,000 / 10.00 )

= 12.50 x ( 1,000,000 )

BDT 12,500,000

In Summary Cost Market Value

Ordinary Shares 11.60% BDT 21,000,000
Irredeemable Debt 4.77% BDT 13,200,000
Preference Shares 5.60% BDT 12,500,000
BDT 46,700,000

Hence the WACC = Keg x {E / (E + D+PS)} + Kd x {D / (E + D+PS)}+ Kps x {PS / (E + D+PS)}

= 11.60% x ( BDT 21,000,000 / BDT 46,700,000 )
+ 4.77% x ( BDT 13,200,000 / BDT 46,700,000 )
+ 5.60% x ( BDT 12,500,000 / BDT 46,700,000 )
= 0.05216 + 0.0135 + 0.015
= 0.08063 = 8.06%

Alternatively After Tax Market Number Total %

Cost Value (BDT) Issued Value (BDT) Proportion Return
Ordinary Shares 11.60% 42.00 500,000 21,000,000 45% 5.22%
Irredeemable Debt 4.77% 110.00 120,000 13,200,000 28% 1.35%
Preference Shares 5.60% 12.50 1,000,000 12,500,000 27% 1.50%
46,700,000 100% 8.06%

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Answer to the Question # 3 (a)

(a) MEMORANDUM

To: Board of Directors

From: Finance Team Member
Date: 23 March 2022

Forward exchange contract

20 June 2022 receipt
€632,200 / (€ 1.445 - € 0.0081) = £ 439,975

Money market hedge

20 June 20X7 receipt
€632,000 / 1+ (5.2% / 4) = € 623,889 borrowed

€ 623,889 / 1.445 = £ 431,757 received now

Note: £ 431,757 (1+(4.8%/4))

= £ 436,938 in 6 months

22nd/23rd September net payment

Netting off
Payment due = (€1,347,500)
Receipt due = €560,000
Net payment due = (€787,500)
€787,500 / (1.412 - € 0.0143)
€787,500 / €1.3977
= £ 563,425

Money market hedge

22nd/23rd September net payment
€787,500 / (1 + (3.9%/2)
= €787,500/ 1.0195
= €772,437
€772,437 / 1.412
= £ 547,052 paid now

Note: £ 547,052 (1+(6.1%/2))

= £ 563,737 in 6 months

For the June receipt Attire Ltd. would be better off with a forward exchange contract, as it would receive
more Taka than with a money market hedge.

For the September net payment, a forward exchange contract produces a lower net payment in Taka.

£
In summary June receipt (forward exchange contract) 439,835
September net payment (forward exchange contract) (563,425)
Net payment (123,590)

Were Attire Ltd. to ignore hedging then the situation, using the spot rates, would be:
June receipt (€632,000/1.445) 437,370
September net payment (€787,500/1.412) (557,720)
Net payment (120,350)

Based on these figures, the hedging would cost the company £ 3,240 (£ 120,350 - £ 123,590).
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Answer to the Question # 3 (b)

(b) A futures contract is similar to a forward exchange contract (FEC) as the company would be in a no win/no loss
position. However, the future is for a standardised amount, unlike an FEC, which can be for any amount. Also the
company would not be able to buy a future at the bank (as it could with an FEC), as futures are traded on currency
exchanges.

Currency options are similar to FECs, but they would give Attire Ltd. the right to buy/sell currency in
the future, whereas FECs are a contractual obligation.

There are two types of option:

- Call option to buy currency or
- Put option – to sell currency

Because the holder of the option has the right to buy/sell, the option is more flexible. As a result of this options are
more expensive and transaction charges are high.

Answer to the Question # 4 (a)

Investment decisions will be influenced by the investor's risk propensity or the investor's attitude to risk.
Investors who have a low-risk propensity, in other words they have a preference for less risk, are said to be risk
averse. Whereas investors who have a high-risk propensity or a positive desire for risk, are referred to as risk-
taking or risk-seeking. Other individuals may be risk-indifferent, or risk-neutral, that is, for an increase in risk,
they do not necessarily require an increase in return.
Before making investment decisions the financial manager will need to evaluate the risk-return characteristics
of each potential investment and how they are likely to affect the risk-return characteristics of the firm overall.
If investments are considered to increase the firm's risk then shareholders and other investors, who are generally
considered to be risk-averse, will require a commensurate increase in return.

Answer to the Question # 4 (b) (i)

First, find the expected cash flows:

YEAR EXPECTED CASH FLOWS
0 0.2(-Tk100,000) + 0.6(-Tk100,000) + 0.2(-Tk100,000) = (Tk100,000)
1 0.2(Tk20,000) + 0.6(Tk30,000) + 0.2(Tk40,000) = Tk30,000
2 Tk30,000
3 Tk30,000
4 Tk30,000
5 Tk30,000
5* 0.2(Tk0) + 0.6(Tk20,000) + 0.2(Tk30,000) = Tk18,000
0 10%

(100,000) 30,000 30,000 30,000 30,000 48,000

Next, determine the NPV based on the expected cash flows:
$30,000 $30,000 $30,000 $30,000 $48,000
NPV = Tk100,000+ + + + + = $24,900 .
(1.10)1 (1.10)2 (1.10)3 (1.10)4 (1.10)5
Using a financial calculator, input the cash flows in the cash flow register, enter I = 10, and then press
the NPV key to obtain NPV= Tk24,900.

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Answer to the Question # 4 (b) (ii)

For the worst case, the cash flow values from the cash flow column farthest on the left are used to calculate
NPV.
0 10%

-100,000 20,000 20,000 20,000 20,000 20,000

$20,000 $20,000 $20,000
NPV = Tk100,000+ + +
(1.10)1 (1.10)2 (1.10)3
$20,000 $20
+ 4
+ = $24,184
(1.10) (1.10)5
𝑇𝑘 30,000 𝑇𝑘 30,000 𝑇𝑘 30,000 𝑇𝑘 30,000 𝑇𝑘 48,000
NPV = Tk100,000+ (1.10)1
+ (1.10)2 + (1.10)3 + (1.10)4 + (1.10)5 = Tk 24,900

Similarly, for the best case, use the values from the column farthest on the right. Here the NPV is Tk70,259.
If the cash flows are perfectly dependent, then the low cash flow in the first year will mean a low cash flow in
every year. Thus, the probability of the worst case occurring is the probability of getting the Tk20,000 net cash
flow in each year can be low, high, or average, and the probability of getting all low cash flows will be
0.2(0.2) (0.2)(0.2)(0.2) = 0.25 = 0.00032 = 0.032%.

Answer to the Question # 4 (b) (iii)

The base case NPV is found using the most likely cash flows and is equal to Tk26,142. This value differs from
the expected NPV of Tk24,900 because the Year 5 cash flows are not symmetric. Under these conditions,
the NPV distribution is as follows:
PR NPV
0.2 (Tk24,184)
0.6 26,142
0.2 70,250

Thus, the expected NPV is 0.2(-Tk24,184) + 0.6(Tk26,142) + 0.2(Tk70,259) = Tk24,900. As is generally the
case, the expected NPV is the same as the NPV of the expected cash flows found in part a. The standard deviation
is Tk29,904.

2 NPV =0.2(-Tk24,184 – Tk24,900)2 + 0.6(Tk26,142 – Tk24,900)2

+ 0.2 (Tk70,259 – Tk24,900)2
= Tk 894,261,126.
2 NPV = √𝑇𝑘 894,261,126 = 𝑇𝑘 29,904.
The coefficient of variation, CV, is Tk29,904/Tk24,900 = 1.20.

Answer to the Question # 4 (b) (iv)

Because the project’s coefficient of variation is 1.20, the project is riskier than average, and hence the project’s
risk-adjusted required rate of return is 10% + 2% = 12%. The project now should be evaluated by finding the
NPV of the expected cash flows, as in part a, but using a 12 percent discount rate. The risk adjusted NPV is
Tk18,357, and therefore the project should be accepted.

Answer to the Question # 5 (a)

Price or Range of Prices to Purchase Nice Home Ltd., based on P/E Ratios of Competitors:
Tk. '000'
Earnings After Tax of Nice Home Ltd. = 56,250
Value of Nice Home Ltd. at P/E Ratio of 14:1 = EAT x P/E Ratio
= 56,250 x 6 ÷ 1
= 337,500
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 Price per share = 337,500 ÷ 4,500
= Tk. 75 per share
Value of Nice Home Ltd. at P/E Ratio of 15:1 = EAT x P/E Ratio
= 56,250 x 7 ÷ 1
= 393,750
Price per share = 393,750 / 4,500
= Tk. 87.50 per share

The Fine Home Ltd., can offer the current market price of Tk. 65 per share to purchase Nice Home Ltd., but this price
may not be acceptable to the shareholders of Nice Home Ltd. However, based on P/E ratio of competitors, having
same business risk, the Fine Home Ltd., can offer any price between Tk. 75 per share to Tk. 87.5 per share.

Answer to the Question # 5 (b)

Cost of Equity:

Cost of equity (Ke) = Rf + (Rm – Rf)

= 5+ (11-5) 1.25
= 12.5%

Cost of Debt:
Assuming Fine Home Ltd's., cost of debt will remain unchanged on acquisition of Nice Home Ltd.:

Years Cash Flow PVF @ 5% PV PVF @ 6% PV

0 (105) (105) 1.000 (110)
1 to 3 6.75* 2.723 18.38 2.673 18.04
4 .....................................
106.75 0.823 87.86 0.792 84.54
1.000
1.24 (2.41)

IRR = 5 + ((1.24/ (1 .24 + 2.41 )) X (6 -5) = 5.34%

*After tax annual interest expense = (100 X 9%) X (1- 25% tax) = 9 X 75% = 6.75

Weighted Average Cost of Capital:

WACC at 30% gearing level = (Wd x Kd)+ (We x Ke)
= (0.3 x 5.34) + (0.70 x 12.5)
= 1.60 + 8.75
= 10.35%

WACC at 40% gearing level = (0.40 x 5.3) + (0.60 x 16.68)

= 2.14 + 7.5
= 9.64 %

Answer to the Question # 5 (c)

Future Cash Flows: Tk. '000'

2020-21 2021-22 2022-23 2023-24 2024-25
Sales 550,000 605,000 653,400 686,000 713,450
Cost of goods sold -247,500 -272,250 -294,030 -308,700 -321,053
Gross Profit 302,500 332,750 359,370 377,300 392,398
Operating expenses -77,000 -84,700 -85,000 -89,180 -90,000
Operating profit 225,500 248,050 274,370 288,120 302,398

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Capital allowances -81,250 -85,000 -87,500 -87,500 -87,500
Profit before tax 144,250 163,050 186,870 200,620 214,898
Tax @ 32% -46,160 -52,176 -59,798 -64,198 -68,767
Profit after tax 98,090 110,874 127,072 136,422 146,130
Capital allowances 81,250 85,000 87,500 87,500 87,500
Working capital -85,000 -82,000 -85,000 -90,000 -95,000
Net cash flows 94,340 113,874 129,572 133,922 138,630

Answer to the Question # 5 (d)

2020-21 2021-22 2022-23 2023-24 2024-25

Present value at 5% growth:
Net cash flows 94,340 113,874 129,572 133,922 138,630
Terminal cash flow (5% growth)W-1 2,426,025
PVF@ 11% 0.901 0.812 0.731 0.659 0.593
Present Values 85,000 92,466 94,717 88,254 1,520,841
PV 1,881,278
Present value at 7% growth:
Net cash flows 94,340 113,874 129,572 133,922 138,630
Terminal cash flow (7% growth) W-2 3,708,353
PVF@ 11% 0.901 0.812 0.731 0.659 0.593
Present Values 85,000 92,466 94,717 88,254 2,281,261
PV 2,641,698

W-1: Terminal cash flow (5% growth): (Amount in Tk. ‘000)

= 2024-25 earnings (1 + g)
(r - g)
= 138,630(1+0.05)
(0.11 - 0.05)
= 2,426,025

W-2: Terminal cash flow (7% growth):

= 2024-25 earnings (1 + g)
(r -g)
= 138,630 (1+ 0.07)
(0.11 - 0.07)
= 3,708,353

Answer to the Question # 5 (e)

Value of Shares:
At 5% growth:
Value of shares at 30% gearing = Tk. 1,881,278 x 70% = Tk. 1,316,895 (292.64 Tk. Per share)
Value of shares at 40% gearing = Tk. 1,881,278 x 60% = Tk. 1,128,767 (250.84 Tk. Per share)
Value of shares will be between Tk. 1,128,767 and Tk. 1,316,895

At 7% growth:
Value of shares at 30% gearing = Tk. 2,641,698 x 70% = Tk. 1,849,189 (410.93 Tk. Per share)
Value of shares at 40% gearing = Tk. 2,641,698 x 60% = Tk. 1,585,019 (352.23 Tk. Per share)
Value of shares will be between Tk. 1,585,019 and Tk. 1,849,189

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Answer to the Question # 6 (a)

Tk100,000,000/10 = Tk10,000,000 per year, or Tk5 million each 6 months. Because the Tk5 million
will be used to retire bonds immediately, no interest will be earned on it.

Answer to the Question # 6 (b)

The debt service requirements will decline. As the amount of bonds outstanding declines, so will the
interest requirements (amounts given in millions of Taka):

Semiannual Sinking Fund Outstanding Bonds on Interest Total bond service

Payment Period Payment which Interest is Paid Payment (2)+(4)=(5)
(1) (2) (3) (4)
1 Tk5 Tk100 Tk6.0 Tk11.0
2 5 95 5.7 10.7
3 5 90 5.4 10.4
: : : : :
20 5 5 0.3 5.3

Interest s calculated as [(0.12).2] (Column 3); for example: interest in Period 2 = (0.06) Tk95) = Tk5.7.

The company’s total cash bond service requirement will be Tk21.7 million for the first year. The
requirement will decline by 0.12 (Tk10,000,000) = Tk1,200,000 per year for the remaining years.

Answer to the Question # 6 (c)

If interest rates rose, causing the bond’s price to fall, the company would use open market purchases.
This would reduce its debt service requirements.

---The End---

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