Questions related to Strategic Financial Management

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Dabrue Ltd is a supplier of machinery tools. In the recent past, the company has experienced a

long-term financial planning problem. The company has more debt capital at the end of

December 2006 and the company consultant has been pressing for a reduction in debt burden,

beginning from March 2007. The company is unwilling to raise equity capital unless there is a

necessity. The balance sheet of the business as at 30 December 2006 is as follows:

Rs. 000 Rs. 000 Rs. 000

Fixed Assets

Freehold land and premises at cost 2,250

Less Accumulated depreciation 250 2,000

Fixtures and fittings at cost 1,640

Less Accumulated depreciation 480 1,160


Current Assets

Stock at cost 1,400

Debtors 1,600

Cash 800


Creditors: amounts due within the year

Trade creditors 1,250

Bank overdraft 150

Corporate Tax 200 (1,600) 2,200


Capital and Reserves

Rs.10/= ordinary shares 2,200

Profit and loss account 160


12% Redeemable debentures 3,000


Society of Certified Management Accountants of Sri Lanka 1

Professional II Stage - Strategic Financial Management (SFM)

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The following projections for the next three months ended 31March 2007are available.

1. Sales and purchases for the three months ended 31 March 2007 will be as follows:


Sales Purchases

Rs. 000 Rs. 000

January 2,400 1,920

February 2,800 2,100

March 3,000 2,460

2. 50% of sales are on credit and they are collected in the following month. All purchases

are on two weeks credit.

3. Monthly salaries are Rs. 300,000 and will increase by 10% as from March 2007. All

salaries are paid in the last week of the same month.

4. The gross profit percentage on goods sold is 25%.

5. Administration expenses are expected to be Rs. 150,000 in January and will increase by

20% from the subsequent month. This figure includes a monthly charge of Rs. 5,000 in

respect of depreciation of fixed assets. Administration expenses are paid in the month

they are incurred.

6. Selling and distribution expenses are expected to be Rs. 100,000 per month except for

March 2007 when an advertising campaign costing Rs. 120,000 will be paid for. The

advertising campaign will commence at the beginning of 2007. Selling expenses which

are approximately half of selling and distribution expenses, are paid for in the month they

are incurred and the remaining balance will be paid in the subsequent month.

7. The company intends to purchase and pay for new fixtures and fittings at the end of April

2007, costing Rs. 28,000.

The company's consultant suggests the following at the beginning of January 2007, which may

help to overcome the problem of the debt burden.

" To redeem Rs. 1.5 million debentures of Rs.100/- each carrying a interest rate of 12%


payable semi-annually, 30 September and 31 March. They have been issued in 2002

for a period of 10 years.

However, the consultant estimated that the Beta of the company's shares is 1.2 and the

required rate of return on the market portfolio is 16% while the risk free rate is 6.5%.

" To reduce credit sales to 40% and to delay payment of trade creditors by an additional

two weeks.

" To settle the OD balance in February.

You are required to:


(a) Prepare a cash flow projection for the company for each of the three months to 31

March 2007. (12 Marks)


(b) Prepare a projected profit and loss account for the three months to 31 March 2007.

(10 Marks)

(c) If the company implements the consultant's suggestions, discuss and prepare a

statement with calculations, which include the ways in which the company may

reduce the corporate debt, as required by the consultant. (12 Marks)

(d) Compute the Company's cost of debt, cost of equity and weighted average cost of capital

(WACC) before and after implementing the consultant's suggestions. State any

assumptions that you make. (6 Marks)

(Total 40 Marks)

End of Section A

Society of Certified Management Accountants of Sri Lanka 2

Professional II Stage - Strategic Financial Management (SFM)

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Answer any three (3) questions

Question No. 2 (20 Marks)

(1) De Mel and Company Ltd issued a new series of bonds on January 1, 1982. The bonds

were sold at par value of Rs 1,000 each, carrying 12% coupon, and to mature in 30 years.

Coupon payments are made semi-annually on June 30 and December 31.

You are required to answer the following:

(a) What was the Yield to Maturity (YTM) of De Mel's bonds on January 1, 1982?

(b) What was the price of the bond on January 1, 1987, 5 years later, assuming that the

level of interest rates had fallen to 10%?

(c) Find the current yield and capital gains yield on the bond on January 1, 1987, given

the price as determined in part (b).

(d) On July 1, 2000, De Mel's bonds were sold for Rs. 916.42. What was the

YTM at that date? (10 Marks)

(2) La Mel Company is experiencing a period of rapid growth. Earnings and dividends are

expected to grow at a rate of 15% during the next 2 years, at 13% in the third year, and at a

constant rate of 6% thereafter. La Mel's last dividend was Rs. 1.15 and the required rate of

return on the stock is 12%.

You are required to:


(a) Calculate the value of the stock as at 17 March 2007.

(b) Calculate the prices of the stock as a result of different dividend growth rates.

(c) Calculate the dividend yield and capital gains yield for years one, two and three.

(10 Marks)

(Total 20 Marks)

Question No: 3 (20 Marks)

(a) Harrison Company is considering purchasing a smaller company, Morrison, in the same

risk class. Morroson's Analyst projects that the merger will result in incremental net cash

flows of Rs. 1.5 million in year 1, Rs. 2 million in year 2, Rs 3 million in year 3 and Rs 5

million in year 4. Morrison's cash flows are expected to grow at a constant rate of 5% after

year 4. The acquisition would be made immediately and if it were undertaken, Morrison's

postmerger beta is estimated to be 1.5, and its postmerger tax rate would be 40%. The risk-

free rate is 6%, and the market risk premium is 4%.

You are required to estimate the value of Morrison & Harrison. (12 Marks)

(b) Rising star company plans to enlarge its capacity during the next year. The increase in

capacity will require Rs 40,000,000 in additional assets. The firm anticipates a net income

of Rs 20,000,000 and follows a 60% dividend payout policy. If rising star desires to

maintain its debt/assets ratio of 40%, how much external equity and debt financing will be

required? (8 Marks)

(Total 20 Marks)

Society of Certified Management Accountants of Sri Lanka 3

Professional II Stage - Strategic Financial Management (SFM)

Question No: 4 (20 Marks)

The Finance director of Damian Villa Company expects to expand its activities using external

funds. The expansion will cost Rs 50 million with 5 years life time.

The company's current capital structure consists of Rs 30 million floating rate loan, Rs. 50

million 12% debentures redeemable in 5 years, Rs 15 million nominal value of common shares of

Rs.5 each, and Rs. 80 million reserves. The company wishes to maintain its capital structure after

the new expansion.

The company's current share price is Rs.50, and debenture price ex-interest is Rs.150. Debentures

are to be redeemed at its par value of Rs 100 each.

Issuing costs of equity are expected to be 8% of the total raised. Unless there is a minimum

capital of Rs 20 million is received, the issuing cost will increase substantially. Issuing costs of

new debentures are estimated to be 4%.

Beta of Equity, of the company ex- dividend is Rs.12. Current dividend per share is Rs 1 and

dividends have grown by approximately 4% per year for the last four years. The market risk free

rate of return is 8% and the market return is 12% per year.

The corporate tax rate is 30%.

You are required to estimate the cost of capital of the new investment if:

(a) The internal sources of equity are used and debt finance is raised by a 7.5% floating rate

bank loan with negligible issuing cost

(b) New debentures are issued at par of Rs 100 and equity are used. New equity may be

assumed to be issued at the current market price. Comment upon your findings. State

clearly any assumptions that you make. (Total 20 Marks)

Question No: 5 (20 Marks)


(a) ABC Co Ltd's balance sheet as at 31 December 2006 is shown below.

ABC Ltd.


Balance sheet as at 31 December 2006

Rs 000 Rs 000

Common stock 19,000 Plant and equipment 40,000

Retained earnings 25,000 Inventory 5,600

Debt 3,600 Accounts receivable 10,000

Current liabilities 10,000 Cash 2,000

57,600 57,600

Directors of ABC Ltd expect to declare dividends. In this accounting period ABC Ltd had a net

income of Rs. 5,000,000. It employs Rs. 3,600,000 debt carrying 10% interest charges. The

overall capitalization rate applicable to ABC Ltd is 15%.

(i) Briefly explain, as to how much ABC Ltd's board of directors can legally pay dividends.

(ii) Estimate the probable maximum dividend ABC Ltd can pay if it seeks to maintain a

minimum cash balance of Rs 1,000,000 and other asset balances at present levels.

(iii) Assuming that ABC Ltd is a rapidly growing company that faces severe difficulty in raising

needed capital and substantial additional credit sales have been approved, is declaring

dividends likely or unlikely? (10 Marks)

Society of Certified Management Accountants of Sri Lanka 4

Professional II Stage - Strategic Financial Management (SFM)

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(b) Alex is an investor in the equity market of Sri Lanka. His current major share ownership is

900,000 shares of Magfin Company which recently announced a 3-for-1 stock split (where

the par value of a share is reduced to 1/3). At the time of the announcement, the firm's

stock price of Rs.60 per share represented a P/E ratio of 20. The firm follows a 50% payout

dividend policy.

You are required to:

(i) State what the market value of Alex's shareholding will be, when the stock split

was announced?

(ii) Assuming that the Rs.60 price has not impeded trading of the stock, what will be

the likely price per share of Alex's stock, after the split?

(iii) Compute the earnings per share before and after the stock split.

(iv) If the Rs 60 stock price has retarded trading of the stock, is Alex likely to benefit

from the split? (10 Marks)

(Total 20 Marks)

Question No: 6 (20 Marks)

(a) Bower Company currently uses a truck that was purchased two years ago. It has six years

of remaining life. It can be sold for Rs. 300,000 now, or for Rs. 40,000 six years from now.

Bower is offered a replacement truck that has a cost of Rs 800,000. Both trucks are of the

same type. The replacement truck permits an output expansion, such that sales would rise

by Rs. 25,000 per year. Further, the new truck has much greater efficiency to cause

operating expenses to decline by Rs 15,500 per year.

Bower's effective tax rate is 50%, and its cost of capital is 15%.

You are required to:

(i) Advise Bower Company whether the replacement of the truck would be beneficial.

(ii) How would your answer be changed if the six yearly incremental revenues were

Rs 20,000 annually. (15 Marks)

(b) Discuss why conflicts of interest might exist between shareholders and debt holders and

their possible influence on the objectives of the firm. (5 Marks)

(Total 20 Marks)

End of Section B

End of Question Paper