CMA SEPTEMBER-2022 EXAMINATION STRATEGIC LEVEL
SUBJECT: F3. FINANCIAL STRATEGY
Time Allocated: Three hours Total Marks: 100
Instructions to Candidates
There are three sections (that is A, B & C) in this paper. You are required to answer ALL questions.
Answers should be properly structured, relevant and computations need to be shown wherever necessary.
You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or sub-questions).
ALL answers must be written in the answer book. Answers written on the question paper will not be submitted for marking.
Start answering each question from a fresh sheet. Your answers should be clearly numbered with the sub-question number then ruled off, so that the markers know which sub-question you are answering.
Section No of questions in the Section
No of sub-questions in the Section
Marks allocation
A 01 08 20%
B 01 05 40%
C 02 02 40%
TURN OVER
SECTION A – 20 MARKS
This section consists of 1 question and 8 sub-questions.
You are advised to spend no longer than 36 minutes on this section. Section will carry 20 marks and one sub-question will carry 2.5 marks each.
QUESTION 01
(a) Distinguish between operating lease and finance lease.
(2.5 Marks) (b) What is the difference between net present value (NPV) and adjusted present value
(APV)?
(2.5 Marks) (c) What are the primary objectives of the investment project post-audit review?
(2.5 Marks) (d) Mention TWO advantages and disadvantages of establishing treasury departments as
profit centers.
(2.5 Marks) (e) Stock A has an expected return of 14.05% and a beta of 2.2. Stock B has an expected
return of 7% and a beta of 1. What must be the expected return on a risk free asset?
(2.5 Marks) (f) Why is the cost of financing a project with retained earnings less than the cost of financing
it with a new issue of common stock?
(2.5 Marks) (g) What causes conflicts in the ranking of projects via net present value and internal rate of
return?
(2.5 Marks) (h) The Flag Company, a food distributor, is considering replacing a filling line at its Khulna warehouse. The existing line was purchased several years ago for Tk. 600,000. The line’s book value is Tk. 200,000, and Flag management feels it could be sold at this time for Tk.
150,000. A new, increased capacity line can be purchased for Tk. 1,200,000. Delivery and installation of the new line are expected to cost an additional Tk. 100,000. Assuming Flag’s marginal tax rate is 40 percent, calculate the net investment for the new line.
(2.5 Marks) END OF SECTION A
SECTION B Starts on page 3
SECTION B– 40 MARKS
This section consists of 1 question and 5 sub-questions.
You are advised to spend no longer than 14.4 minutes on each sub-question in this section.
Section will carry 40 marks and one sub-question will carry 8 marks each.
QUESTION 02
(a) G4 Ltd, a newly established security company, has constituted its first board of directors.
The directors are expected, among others, to take financial decisions in the areas of investment, financing, and dividend payment. A consultancy firm has been engaged to run an orientation program for the directors in the coming week.
You work with the consultancy firm that has been engaged to run the orientation program for the new directors. You have been asked by your boss to prepare briefing notes on the specific roles the directors are expected to play in the three fundamental decision areas and the constraints that government policies might impose on them.
Required:
Prepare a briefing note on the nature of the three fundamental decision areas. Specifically, the briefing notes should cover the objective of each class of decision; TWO (2) specific decisions the directors are expected to take in each class of financial decisions; and TWO (2) factors in the external environment they should consider when making financial decisions.
[Marks: 8]
(b) Luxe Foods is contemplating acquisition of Valley Canning Company for a cash price of Tk.180,000. Luxe currently has high financial leverage and therefore has a cost of capital of 14%. As a result of acquiring Valley Canning, which is financed entirely with equity, the firm expects its financial leverage to be reduced and its cost of capital drop to 11%. The acquisition of Valley Canning is expected to increase Luxe’s cash inflows by Tk.20,000 per year for the first 3 years and by 30,000 per year for the following 12 years.
Required:
(i) Determine whether the proposed cash acquisition is desirable. Explain your answer.
(ii) If the firm’s financial leverage would actually remain unchanged as a result of the proposed acquisition, would this alter your recommendation in part I? Support your answer with numerical data.
[Marks: (4+4) = 8]
(c) Omega Manufacturing Ltd. has projected sales of Tk. 145 million next year. Costs are expected to be Tk. 81 million and net investment is expected to be Tk. 15 million. Each of these values is expected to grow at 14 percent the following year, with the growth rate declining by 2 percent per year until the growth rate reaches 6 percent, where it is expected to remain indefinitely. There are 5.5 million shares of stock outstanding and investors require a return of 13 percent on the company’s stock. The corporate tax rate is 40 percent.
Required:
What is your estimate of the current stock price of Omega Manufacturing Ltd.?
[Marks: 8]
SECTION B Continues on page 4
(d) SEAFOOD Ltd has in issue 5 million shares with a market value of Tk. 3.81 per share. The equity beta of the company is 1.2. The yield on short-term government debt is 23% per year and equity risk premium is 5% per year. The debt finance of SEAFOOD Ltd consists of bonds with a total book value of Tk. 2 million. These bonds pay annual interest before tax of 25%. The par value and market value of each bond is Tk. 100. The Company pays tax at 25%.
Required:
Calculate SEAFOOD Ltd weighted average cost of capital.
[Marks: 8]
(e) Recent financial information of FCH Bank Ltd. a listed company, is as follows:
Tk. (mill) Tk. (mill)
Profit after tax (earnings) 66.6
Dividends 40.0
Statement of financial position information
Non-current assets 595
Current assets 125
Total assets 720
Current liabilities 70
Equity
Ordinary shares (Tk. 1 face value) 80
Reserves 410 490
Non-current liabilities
6% Bank loan 40
8% Bond (Par value Tk. 100) 120 160
Total liabilities and equity 720
Financial analysts have forecasted that the dividends of FCH Bank Ltd. will grow in the future at a rate of 4% per year. This is slightly less than the forecast growth rate of the profit after tax (earnings) of the company, which is 5% per year. The finance director of FCH Bank Ltd. thinks that, considering the risk associated with expected earnings growth, an earnings yield of 11% per year can be used for valuation purposes.
FCH Bank Ltd. has a cost of equity of 10% per year and a before-tax cost of debt of 7%
per year. The 8% bonds will be redeemed at par value in six years’ time. FCH Bank Ltd.
pays tax at an annual rate of 30% per year and the ex-dividend share price of the company is Tk. 8·50 per share
Required:
Calculate the value of FCH Bank Ltd. using the following methods:
(i) Net asset value method;
(ii) Dividend growth model;
(iii) Earnings yield method.
[Marks: (2+3+3) = 8]
END OF SECTION B SECTION C Starts on the page 5
Section C- 40 Marks
This section consists of 2 questions.
You are advised to spend no longer than 36 minutes on each question in this section. Section will carry 40 marks and allocation of marks for each sub-question is indicated next to the sub- question.
QUESTION 03
RST is a publicly-owned and funded health organization based in the Far East. It is reviewing a number of interesting possibilities for new development projects in the area and has narrowed down the choice to the five projects detailed below. RST is aware that government budget restrictions may be tighter in a year’s time and so does not want to commit to a capital budget of more than Tk. 30 million in year 1. In addition, any project cash inflows in year 1 may be used to fund capital expenditure in that year. There is sufficient capital budget remaining in year 0 to enable all projects to be undertaken. Under government funding rules, any unused capital in year 0 cannot be carried over to year 1 and no interest may be earned on unused capital. No borrowings are permitted.
RST assesses capital projects at a hurdle rate of 15% based on the equity beta of health-based companies in the private sector.
Cash outflows Cash inflows Year 0 Year 1
Project Tk. million Tk. million Tk. million
A 9 16 4 from year 1 in perpetuity
B 10 10 4 from year 2 in perpetuity
C 10 12 5 in years 1 to 10
D 8 5 6 in years 3 to 7
E 9 8 2
5
in years 1 to 5 in years 6 to 15 Notes:
the projects are not divisible
each project can only be undertaken once
ignore tax Required:
(a) Advise RST on the best combination of projects based on an evaluation of each project on the basis of both:
(i) NPV of cash flows;
(ii) a profitability index for use in this capital rationing analysis.
(b) As a publicly-owned entity, what other factors RST should consider and what other analysis it should undertake before making a final decision on which project(s) to accept.
[Marks: (15+5) = 20]
QUESTION 4
VCI is a venture capital investor that specializes in providing finance to small but established businesses. At present, its expected average pre-tax return on equity investment is a nominal 30% per annum over a five-year investment period.
YZ is a typical client of VCI. It is a 100% family owned transport and distribution business whose shares are unlisted. The company sustained a series of losses a few years ago, but the recruitment of some professional managers and an aggressive marketing policy returned the company to profitability. Its most recent accounts show revenue of $105 million and profit before interest and tax of $28.83 million. Other relevant information is as follows:
SECTION C Continues on page 6
For the last three years dividends have been paid at 40% of earnings and the directors have no plans to change this payout ratio;
Taxation has averaged 28% per annum over the past few years and this rate is likely to continue;
The directors are forecasting growth in earnings and dividends for the foreseeable future of 6% per annum;
YZ’s accountants estimated the entity’s cost of equity capital at 10% some years ago. The data they worked with was incomplete and now out of date. The current cost could be as high as 15%.
Extracts from its most recent balance sheet at 31 March 2017 are shown below:
$ million Assets
Non-current assets
Property, plant and equipment 35.50
Current assets 4.50
Total 40.00
Equity and Liabilities Equity
Share capital (Nominal value of 10 cents) 2.25
Retained earnings 18.00
20.25 Non-current liabilities
7% Secured bond repayable 2027 15.00
Current liabilities 4.75
19.75 40.00 Note: The entity’s vehicles are mainly financed by operating leases.
YZ has now reached a stage in its development that requires additional capital of $25 million.
The directors, and major shareholders, are considering a number of alternative forms of finance.
One of the alternatives they are considering is venture capital funding and they have approached VCI. In preliminary discussions, VCI has suggested it might be able to finance the necessary $25 million by purchasing a percentage of YZ’s equity. This will, of course, involve YZ issuing new equity.
Required:
Assume you work for VCI and have been asked to evaluate the potential investment.
(a) Using YZ’s forecast of growth and its estimates of cost of capital, calculate the number of new shares that YZ will have to issue to VCI in return for its investment and the percentage of the entity VCI will then own. Comment briefly on your result.
(b) Evaluate exit strategies that might be available to VCI in five years’ time and their likely acceptability to YZ.
[Marks: (15+5) = 20]
*END OF THE EXAM PAPER*
