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Time allowed – 3 hours
Total marks – 100
N.B. – Questions must be answered in English. Figures in the margin indicate full marks. All workings are to be
submitted. Examiner will take account of the quality of language and of the manner in which the answers are
presented. Different parts, if any of the same questions must be answered in one place in order of sequence.
1. ABC Ltd is an unlevered firm with expected annual earnings before taxes of Tk 21mn in perpetuity. The
current required return on the firm’s equity is 16%, and the firm distributes all of its earnings as
dividends at the end of each year. The company has 1.3 million shares of common stock outstanding and
is subject to a corporate tax rate of 35%. The firm is planning a recapitalization under which it will issue
Tk 30mn of perpetual 9% debt and use the proceeds to buy back shares.
(a) Calculate the value of the company before the recapitalization plan is announced. What is the
value of equity before the announcement? What is the price per share? 3
(b) Use the Adjusted Present Value (APV) method to calculate the company value after the
recapitalization plan is announced. What is the value of equity after the announcement? What is the
price per share? 3
(c) How many shares will be repurchased? What is the value of equity after the repurchase has
been completed? What is the price per share? 4
2. Suppose your company needs to raise TK 45mn and you want to issue 30 years bonds for this
purpose. Assume the required return on your bond issue will be 6%, and you are evaluating two
issue alternatives: A semiannual coupon bond with a 6% coupon rate and a zero coupon bond. Your
company’s tax rate is 35%.
(a) How many of the coupon bonds would you need to issue to raise the Tk 45mn? How many of
the zeroes would you need to issue? 3
(b) In 30 years, what will your company’s repayment be if you issue the coupon bonds? What if
you issue the zeroes? 3
(b) Based on your answers in (a) and (b), why would you ever want to issue the zeroes? To answer,
calculate the firm’s after tax cash outflows for the first year under the two different scenarios.
Assume the IRS amortization rules apply for the zero coupon bonds. 4
3. Heat Wave Limited (HWL) manufactures and fits large scale heating units for factories and
warehouses. Key information about the company’s equity capital at 31 July 2018 is shown below:
Issued ordinary shares ( BDT 1 nominal value) 55 million
Market value per ordinary share (ex div) BDT 2.20
Price earnings ratio 8.4
Dividend payout ratio 40%
Profit after tax as % of Capital Employed 10%
Equity beta 1.3
Risk free rate 7%
Market rate of return 11%
At 31 July 2018 HWL also had in issue BDT 10 million 9% convertible loan stock with a market
value of BDT 105 (ex interest), which is redeemable at BDT 104 on 31 July 2022 or it could be
converted to 40 ordinary shares at that date. You should assume that the market value of HWL’s
ordinary shares will increase at the same annual growth rate as its ordinary dividends.
The rate of corporation tax is 28% and is payable in the same year as profits are earned.
On 6 August 2018 HWL’s board met with representatives of Quality Household Ltd. (QHL), a
large retailer of household goods. QHL wishes to expand its product line via a new range of small
domestic heaters and would like HWL to manufacture and supply them. HWL would have to
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purchase new equipment to manufacture the heaters and this would cost BDT 18 million. HWL’s
board is proposing to raise the BDT 18 million via an issue of 10% debentures (redeemable in July
2026). Alternatively, it could raise the majority of the BDT 18 million via a one for ten rights issue
of ordinary shares at a 15% discount on the current market price per ordinary share. The balance
would come from retained earnings. However, Ahmed Chowdhury, one of HWL’s directors, is
concerned that a rights issue could be unsuccessful and the company could lose money as a result.
(a) Calculate HWL’s weighted average cost of capital at 31 July 2018 using the Gordon growth (or
earnings retention) model to calculate the cost of equity. 6
(b) Calculate the cost of equity using the CAPM and explain the reasoning behind the CAPM
approach to the cost of equity, comparing the CAPM approach with the earnings retention
model used in part (a). 5
(c) Explain the benefits to a company of using convertible loan stock as a means of raising capital. 3
(d) Assuming that the funds are raised by the debenture issue, discuss whether HWL should use the
cost of the newly issued debentures as the hurdle rate when appraising the Value Shopper
(e) Discuss Ahmed Chowdhury’s concerns. 2
4. Lotus Ltd today expects to earn Tk 8.50 per share for each of the future operating periods
(beginning at Time 1), if the firm makes no new investments today and returns the earnings as
dividends to the shareholders. However, Lotus Karim, President and CEO, has discovered an
opportunity to retain and invest 20% of the earnings beginning three years from today. This
opportunity to invest will continue for each period indefinitely. He expects to earn 10% on this new
equity investment, the return beginning one year after each investment is made. The firm’s equity
discount rate is 12%.
(a) What is the price per share of Lotus Ltd stock without making the new investment? 4
(b) If the new investment is expected to be made, per the preceding information, what would the
price of the stock be now? 5
(c) Suppose the company could increase the investment in the project by whatever amount it
chooses. What would the retention ratio need to be to make this project attractive? 4
5. You should assume that the current date is 1 April 2018
CJ is a logistics company which started trading in 1992. Its financial year end is 31 March. You are
a Chartered Accountant who works in CJ’s corporate treasury team. At a recent meeting with your
manager it was agreed that you will be involved with three tasks: (1) hedging the interest on a
planned loan, (2) hedging CJ’s share portfolio investment using options and (3) hedging CJ’s share
portfolio investment using futures.
You have been asked by your line manager to evaluate whether or not CJ should use interest rate
futures to hedge against interest rate movements on a loan. CJ’s board is planning to borrow BDT
11.5 million for a nine month period from 1 June 2018 to 28 February 2019 and is worried that
interest rates will increase from their current level of 8% pa. The current price of June Taka 3-
month futures is 91.50 and the standard contract size is BDT 500,000.
Demonstrate how Taka interest rate futures can be used by CJ to hedge against interest rate
movements, commenting on your results, if by 1 June 2018:
(a) Interest rates decrease to 6.5% pa and the futures price alters by 1.75%
(b) Interest rates increase to 9% pa and the futures price alters by 1%
(c) Interest rates increase to 10% pa and the futures price alters by 2.25% 12
6. (a) When is EAC (Equivalent Annual Cost) analysis appropriate for comparing two or more
projects? Why is this method used? Are there any implicit assumptions required by his method
that you find troubling? Explain. 4
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(b) Benson Enterprises is evaluating alternative uses for a three-story manufacturing and
warehousing building that it has purchased for Tk 1,450,000. The company can continue to rent
the building to the present occupants for Tk 61,000 per year. The present occupants have
indicated an interest in staying in the building for at least another 15 years. Alternatively, the
company could modify the existing structure to use for its own manufacturing and warehousing
needs. Benson’s production engineer feels the building could be adapted to handle one of two
new product lines. The cost and revenue data for the two product alternatives are as follows:
(Figures in Taka)
The building will be used for only 15 years for either Product A or Product B. After 15 years
the building will be too small for efficient production of either product line. At that time,
Benson plans to rent the building to firms similar to the current occupants. To rent the building
again, Benson will need to restore the building to its present layout. The estimated cash cost of
restoring the building if Product A has been undertaken is Tk 55,000. If Product B has been
manufactured, the cash cost will be Tk 80,000. These cash costs can be deducted for tax
purposes in the year the expenditures occur.
Benson will depreciate the original building shell (purchased for Tk 1,450,000) over a 30 year
life to zero, regardless of which alternative it chooses. The building modifications and
equipment purchases for either product are estimated to have a 15 year life. They will be
depreciated by the straight line method. The firm’s tax rate is 34%, and its required rate of
return on such investments is 12%.
For simplicity, assume all cash flow occur at the end of the year. The initial outlays for modifications
and equipment will occur today (Year 0), and the restoration outlays will occur at the end of Year 15.
Benson has other profitable ongoing operations that are sufficient to cover any losses.
Which use of the building would you recommend to management? 12
7. SJL is a transport operator. It has a financial year end of 31 December. SJL’s board is investigating
capital investment proposals for each of its Bus Division.
The bus division is bidding for a three-year contract to operate a number of bus routes in a large
tourist resort in the north east of Bangladesh. This contract covers the period from 1 January 2019
to 31 December 2021. Your colleagues in SJL’s finance team have produced estimates of the
incremental income and expenses (in 31 December 2018 prices) for the period of the contract as
Years to 31 December 2019 2020 2021
BDT BDT BDT
Fares 16,531,200 40,500,000 62,100,000
Fuel costs (7,776,000) (8,035,200) (8,812,800)
Other costs (see note) (13,590,000) (15,120,000) (16,290,000)
Profit/(Loss) before taxation (4,834,800) 17,344,800 36,997,200
SJL is considering hiring eight extra buses to operate on this new contract. The annual hire cost per
bus is BDT 810,000 (which is allowable for tax) and this has been included in the ‘other costs’
As an alternative to the plan to hire the eight new buses, SJL’s directors are considering whether it
would be preferable to purchase them instead. These would cost BDT 3,600,000 each on 31
Product A Product B
Initial cash outlay for building modifications 95,000 125,000
Initial cash outlay for equipment 195,000 230,000
Annual pretax cash revenues (generated for 15 years) 180,000 215,000
Annual pretax cash expenditures (generated for 15 years) 70,000 90,000
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December 2018 and would have a market value of BDT 900,000 each (in 31 December 2021
prices) at the end of the contract. It is company policy to write off buses using the straight-line
The buses will attract 20% (reducing balance) capital allowances in the year of expenditure and in
every subsequent year of ownership by the company, except the final year. In the final year, the
difference between the buses’ written down value for tax purposes and their disposal proceeds will
be treated by the company either:
- as a balancing allowance, if the disposal proceeds are less than the tax written down value, or
- as a balancing charge, if the disposal proceeds are more than the tax written down value.
SJL’s directors estimate that all costs (except for hiring and depreciation) will increase by 4% pa,
but they will cap fare increases at 3% pa.
Assume that the rate of corporation tax will be 30% pa for the foreseeable future and that tax flows
arise in the same year as the cash flows which gave rise to them.
Cost of capital
SJL uses a money cost of capital of 12% pa for investment appraisal purposes.
Assume that, unless otherwise instructed, all cash flows occur at the end of a financial year.
(a) Using money cash flows, calculate the net present values on 31 December 2018 of the two
proposals – bus hiring or bus purchase – and advise SJL’s board which of the two proposals it
should accept. 10
(b) Calculate how sensitive your decision in (a) above is to the market value of the buses on 31
December 2021. 4
(c) Estimate the internal rate of return of the bus purchase proposal and explain the advantages and
disadvantages of this method of investment appraisal. 5