Financial Management

Pre-exam Preparation Test

Attempt all questions.

Working notes should form part of the answer. Make assumptions wherever necessary.

1. Olay is currently considering the launch of a new product. A market survey was
recently commissioned to assess the likely demand for the product and this showed
that the product has an expected life of four years. The survey cost Rs. 30,000 and
this is due for payment in four months’ time. On the basis of the survey information
as well as internal management accounting information relating to costs, the assistant
accountant prepared the following profit forecasts for the product.
Year 1 2 3 4
Rs.000 Rs.000 Rs.000 Rs.000
Sales 180 200 160 120
Cost of sales (115) (140) (110) (85)
Gross profit 65 60 50 35
Variable overheads (27) (30) (24) (18)
Fixed overheads (25) (25) (25) (25)
Market survey written off (30) – – –
Net profit/(loss) (17) 5 1 (8)
These profit forecasts were viewed with disappointment by the directors and there
was a general feeling that the new product should not be launched. The Chief
Executive pointed out that the product achieved profits in only two years of its four-
year life and that over the four-year period as a whole, a net loss was expected.
However, before a meeting that had been arranged to decide formally the future of the
product, the following additional information became available:
(i) The new product will require the use of an existing machine. This has a written
down value of Rs. 80,000 but could be sold for Rs. 70,000 immediately if the
new product is not launched. If the product is launched, it will be sold at the end
of the four-year period for Rs. 10,000.
(ii) Additional working capital of Rs. 20,000 will be required immediately and will be
needed over the four-year period. It will be released at the end of the period.
(iii) The fixed overheads include a figure of Rs. 15,000 per year for depreciation of the
machine and Rs. 5,000 per year for the re-allocation of existing overheads of the
business.
The company has a cost of capital 10%. Ignore taxation.
You are required to:
i) Calculate the net present value of the new product.
ii) Calculate the approximate internal rate of return of the product.
iii) Explain, with reasons, whether or not the product should be launched.
iv) Why can there be conflict in project choice by using NPV and IRR criterion?
(10+5+2+3=20)
2.
a) The current assets and current liabilities of XYZ Ltd. at the end of March 2022
are as follows:
Particulars Amount in (Rs.‘000)
Inventory 5,700
Trade receivables 6,575
Total current assets 12,275
Trade payables 2,137
Overdraft 4,682
Total current liabilities 6,819
Net current assets 5,456
For the year to ending March 2022, XYZ Ltd. had domestic and foreign sales of
Rs. 40 million, all on credit, while cost of sales was Rs. 26 million. Trade
payables are related to both domestic and foreign suppliers.
For the year to ending March 2023, XYZ Ltd. has forecasted that credit sales will
remain at Rs. 40 million while cost of sales will fall to 60% of sales. The
company expects current assets to consist of inventory and trade receivables, and
current liabilities to consist of trade payables and the company’s overdraft.
XYZ Ltd. also plans to achieve the following target working capital ratio for the
year to the end on March 2023:
Inventory days 60 days
Trade receivables days 75 days
Trade payables days 55 days
Current ratio 1.4 times
Assume 365 days in a year.
Required: (5+5=10)
i) Calculate the working capital cycle of XYZ Ltd. at the end of March 2022
and discuss whether a working capital cycle should be positive or
negative.
ii) Calculate the target quick ratio and the target ratio of sales to net working
capital of XYZ Ltd.at the end of March 2023.
b) United Enterprises is planning to relax its credit policy to motivate customers to
buy on new credit terms. It is expected that the variable cost will remain 75
percent of sales. The incremental sales are expected to be sold on credit. For the
perceived increase in risk of liberalizing the credit terms, the company requires
higher return. The following table shows the projected information:
Credit Policy Required Return on Collection New Sales
Type investment Period(days) (Rs.’000)
Alfa 20% 40 300,000
Beta On 25% 45 400,000
Celta 32% 55 500,000
Delta 40% 70 600,000
Required: 5
Advise as to which credit policy the company should pursue? You may assume 360
days in a year.
3.
a) Malina Ltd has balance sheet as at 31 December 2021 included the following:
NPR (million)
22 million ordinary shares (par value NPR 2.5 each) 55
9% Preference Share (par value NPR 10 each) 26
Reserve 20
Retained earnings 36
Loan stock (Base rate + 3%) 100

The loan stock interest is based on base rate of the Bank plus premium. The
current base rate of the Bank is 9%. The interest on loan stock is about to be paid.
On 31 December 2023, the loan stock will be redeemed at NPR 105. The loan
stock are currently traded at NPR 116 cum interest (per NPR100 nominal).
The Preference share is redeemable on 31st December 2024 at NPR 20 each.
Currently preference shares are traded at NPR. 18 per share ex-dividend.
The company has also just paid a dividend on its ordinary shares of NPR 2.32.
This was the total dividend for the year. The company has paid following
dividends in the past:
Year 2021 2020 2019 2018 2017
Dividend Per Share 2.32 2.05 2.10 1.95 1.91

The shares are currently quoted at NPR 37 each.

The company's corporation tax rate is 30%. Ignore capital gain tax.
Requirements: 8
Determine the company's weighted average cost of capital (WACC) considering
weight as market value of different sources of finance.

b) Garuda Ltd. requires Rs. 500,000 for construction of a new plant. It is considering
following three alternative financial plans:
i) The company may issue 50,000 ordinary shares at Rs. 10 per share;
ii) The company may issue 25,000 ordinary shares at Rs. 10 per share and 2,500
debentures of Rs. 100 face value bearing 8% rate of interest; and
iii) The company may issue 25,000 ordinary shares at Rs. 10 per share and 2,500
preference shares at Rs. 100 per share bearing 8 % rate of dividend.
The different possible level of earnings before interest and taxes (EBIT) of Garuda
Ltd. are Rs. 10,000; Rs. 20,000; Rs. 40,000; Rs. 60,000 and Rs. 100,000.
Applicable tax rate is 50%.
Required: (6+1=7)
i. Compute the earnings per share under each of the three financial plans and
different levels of EBIT.
ii. Which alternative would you recommend for the company and why?
4.
a) XYZ Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The
growth rate is likely to fall to 10% for the third year and fourth year. After that the
growth rate is expected to stabilise at 8% per annum. If the last dividend paid was
Rs. 1.50 per share and the investors' required rate of return is 16%, find out the
intrinsic value per share of Z Ltd. as of date. You may use the following table: 8
Years 0 1 2 3 4 5
 Discounting factor at 16% 1 0.86 0.74 0.64 0.55 0.48

b) Based on the credit rating of the bonds, an investor has decided to apply the
following discount rate for valuing the bonds.

Credit rating Discount rate

AAA 365-days Treasury-bill rate + 2% spread
AA AAA + 4% spread
A AAA + 5% spread

The investor is considering investing in an AA rated, Rs. 1,000 face value bond
currently selling at Rs. 1,010. The bond has five years to maturity and the coupon
rate on the bond is 15% per annum payable annually. The next interest payment is
due one year from today and the bond is redeemable at par. (Assume 365-days
Treasury bill rate to be 8%)

You are required to calculate:

i) Intrinsic value of the bond for the investor. Should the investor invest in
the bond?

ii) Current yield (CY) and the yield to maturity (YTM) of the bond. (4+3=7)

5.

a) All the potential projects of a company are equally risky and as risky as the
company’s other assets. Currently, two projects are being evaluated for the
investment: Project A has a rate of return of 13% while Project B has a rate of
return of 10%.
Company can borrow unlimited amounts at an interest rate of 10 percent as long
as it finances at its target capital structure, which calls for 45 percent debt and 55
percent common equity. Its last dividend was Rs. 2 and expected constant growth
rate of 4% and its stock sells at a price of Rs. 20 and company falls under tax rate
of 40%.
i) What is the cost of common equity, cost of debt and weighted average cost of
capital?
ii) Which project should the company select?
(4+1=5)
b) UKG Limited is a pharmaceutical company. Debt used by the company is
assumed to be risk free and market value of its total debt is Rs. 3 crores. The
company has 10 lacs equity shares of Rs. 10 each, market price of which is Rs. 40
at present. Equity beta is 1.40, market risk premium is 6% and NRB bonds are
quoted at 6%. Calculate:
i) Required return on equity shares
ii) Beta of assets
iii) Cost of capital
 iv) The company is diversifying into real estates. Average ungeared company in
that industry carries a beta of 1.5. What should be the expected return on this
new venture?
(1+2+1+1=5)
c) A local bank advertises the following deal: “Pay us Rs. 1,00,000 a year for 10 years,
then we will pay you or your beneficiaries Rs. 1,00,000 per year forever”. Is this a
good deal if the interest rate available on other deposits is 6 percent? (5)

6. Write short note on: (4×2.5 =10)

a) Problems faced in capital budgeting
b) Credit Rating
c) Gearing ratio
d) Share repurchase

7. Distinguish between: (4×2.5 =10)

a) Stock Split and Bonus Issue
b) Horizontal merger and Vertical Merger
c) Operating leverage & Financial leverage
d) Zero coupon Bond and Deep Discount Bond