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                                      Fall (Winter) 2010 Examinations
                                        Saturday, the 4th December 2010
                             STRATEGIC FINANCIAL MANAGEMENT – (S-601)

Time Allowed – 2 Hours 45 Minutes                                                            Maximum Marks – 90
(i)     Attempt all questions.
(ii)    Answers must be neat, relevant and brief.
(iii)   In marking the question paper, the examiners take into account clarity of exposition, logic of arguments,
        effective presentation, language and use of clear diagram/ chart, where appropriate.
(iv)    Read the instructions printed on the top cover of answer script CAREFULLY before attempting the paper.
(v)     Use of non-programmable scientific calculators of any model is allowed.
(vi)    DO NOT write your Name, Reg. No. or Roll No. anywhere inside the answer script.
(vii)   Question No. 1 – “Multiple Choice Question” printed separately, is an integral part of this question paper.

Q.2      Alpha Electronics Limited is a reputed name in the sale of household electronics
         appliances. The company purchases the household electronics appliances in bulk quantity,
         stock them in a centrally located warehouse and sell them to a chain of retail stores.
         Alpha’s balance sheet as of December 31, 2009 is as under:
                                                                                 Rs. ‘000’
               Assets                               Liabilities & owner’s equity
               Cash                        7,000    Accounts payable               18,000
               Accounts receivable        52,000    Notes payable                  36,000
               Inventories               116,000    Accruals                       17,000
                 Total current assets    175,000       Total current liabilities   71,000
               Net fixed assets           70,000    Long-term debt                 12,000
                                                    Ordinary shares                30,000
                                                    Retained earnings             132,000
               Total assets              245,000    Total liabilities and equity  245,000
         Sales for the year 2009 were Rs. 700 million, while net income for the year was
         Rs. 21 million. Alpha paid dividend of Rs. 8.4 million to ordinary shareholders. The firm is
         operating at 100% capacity. The sales are projected to increase by 20% during the
         year 2010. Assume that all ratios remain constant.
      (i) Construct Alpha Electronics Limited’s pro forma balance sheet for
          December 31, 2010. Assume that all additional funds needed (AFN) are met
          externally by bank loans and are reflected in notes payable. Do not consider any
          financing feedback effects.                                                                         12
         (ii)   Assume the Alpha Electronics Limited operated at 80% capacity utilization for net
                fixed assets. What would be the new AFN?                                                      03

Q.3      (a)    The Ghazi Cement Limited has recently expanded its production capacity by
                installing a new state of the art production plant due to increasing demand of cement
                in the country. Now the company is in a process of ascertaining the optimal level of
                current assets for the coming year. The management forecasts that sales would
                increase to approximately Rs.100 million as a result of an asset expansion just
                completed. The fixed assets are of Rs.50 million and the firm wishes to maintain a
                60% debt ratio. Ghazi’s interest cost is currently on average 15% on both short-term
                and long-term debts of its permanent capital structure.
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            Three alternative policies regarding the projected current assets level are available to
            the firm:
                A tight policy requiring current assets of only 45% of projected sales;
                A moderate policy of 50% of sales in current assets, and
                A relaxed policy requiring current assets of 60% of sales.
            The firm expects to generate earnings before interest and taxes at a rate of 20% on
            total sales. The tax rate is 35%.
       (i) What is the expected return on equity under each current asset level?                         12
       (ii) How would the overall riskiness of the firm vary under each policy?                          03

      (b)   Synthetics Limited maintains safety stock for its various food scents. However, due to
            lean inventory policy, sometimes customers must be turned away. In order to analyze
            the situation, company has estimated stock out cost establishing various levels of
            safety stock as under:
                          Safety Stock       Level of safety Stock     Annual Cost of
                             Level                 (in Liters)         Stock outs (Rs.)
                            Present                   1,500                   78,000
                            Level A                   2,250                   42,000
                            Level B                   3,000                   21,000
                            Level C                   3,750                    9,000
                            Level D                   4,500                    3,000
                            Level E                   5,250                         0
            Inventory carrying cost is Rs.6.5 per liter per year.
            What is the best level of safety stock for the company?                                      05

Q.4   On 1st January, 2010 the total market value of the Shah Limited was Rs.85 million. The
      company’s market value capital structure, shown below, is considered to be optimal.
      Assume that there is no short-term debt.
                            Debt                                     35,000,000
                            Common equity                            50,000,000
                            Total capital                            85,000,000
      Shah Limited is considering a project that will result in initial after-tax cash savings of
      Rs. 7 million at the end of the first year and these savings will grow at a rate of 5% per year
      indefinitely. The firm has a target debt-equity ratio of 0.70, a cost of equity of 13% and an
      after-tax cost of debt of 5.5%. The cost-saving proposal is somewhat riskier than the usual
      projects the firm undertakes; management uses the subjective approach and applies an
      adjustment factor of plus 2% to the cost of capital for such risky projects.
      (a) Should the company take on the project if the initial investment is Rs.100 million?
          What would be the outcome of the project? (show all your computations).                        10

      (b)   Shah Limited is to raise Rs. 100 million for a new project externally and its flotation
            costs for selling debt and equity are 2% and 16%, respectively. If flotation costs are
            considered, what is the true initial investment of the new project? Is the project viable
            considering the flotation cost?                                                              05

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Q.5   Sun Pharma intends to develop a new medicine ‘Cura’ for diabetic patients. Sun Pharma
      invested a sum of Rs.1,100,000 over past two (2) years. An amount of Rs.225,000 was
      spent on market research earlier in the year. Market research suggested the price of
      Rs.110 per packet and the expected product life cycle of four (4) years.
      Specialized machinery and equipment at a cost of Rs.1,500,000 must be purchased to
      produce the medicine. This machinery and equipment has an expected life of four years
      and will have no residual value at the end of this period having maximum production
      capacity of 15,000 packets per year. Advertising expenses are estimated to Rs.250,000
      per annum to sell the 15,000 packets of “Cura”.
      Based on the maximum output of 15,000 packets per year, the “Cura” has the following
      expected costs per packet (excluding the advertising costs above):
                              Materials                              32.50
                              Labour                                 27.50
                              Overheads                              42.50
      Other details:
       (i) The cost of materials includes Rs.10 for material “Zee” that is currently in stock and
           can be used for this product. The charge is based on the original cost of Rs.10 for 100
           grams material. Material “Zee” is currently used in other areas of the business and the
           cost of replacing it is Rs.15 per 100 grams. The material “Zee” could easily be sold at
           a price of Rs.12.50 per 100 grams.
       (ii) The labour cost is the payment to employees that will be directly involved in producing
            the “Cura”. These employees have no work at present and if the “Cura” is not
            produced, they will be fired immediately at a cost of Rs.1,150,000. If, however, the
            “Cura”is produced, no redundancy costs will be incurred at the end of four years.
       (iii) The overheads include depreciation for the new machinery and equipment. The
             company depreciates such assets in equal installments over their expected life with nil
             salvage value. All other overheads included in the above figure are incurred in
             production of the “Cura”.
       (iv) The business has a target capital structure of 50% equity and 50% loan capital. The
            market cost of equity is 12% and the market cost of loan capital is 8%. The “Cura”
            project has the same level of risk as that of other projects undertaken if the project is
            accepted; it will be financed entirely by equity. However, the level of investment
            required is very small compared to the size of the business.
       (v) Ignore taxation.
     (a) Calculate the net present value of the project.                                                 12

      (b)   What happens to NPV if sale of “Cura” has only achieved 12,000 packets per year?
            Is the project viable?                                                                       05

      (c)   What is NPV if only yearly            advertisement    expenses     are   increased    to
            Rs.312,500? Is the project viable?                                                           03


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Q.6   The Quality Publishing Limited has announced a rights offer to raise Rs.31.20 million for a
      new journal “Business Research”. This journal will attract the business community at large
      and the company will pay to the authors, who will contribute their articles, an honorarium of
      Rs.1,000 per page. The share of Quality Publishing Limited is currently selling for Rs.30
      per share and there are 5.2 million shares outstanding.
     (a) If the subscription price is set at Rs. 24 per share, how many shares must be sold?
          How many rights will it take to buy one share?                                                      02

      (b)    What is the theoretical ex-rights price? What is the value of a right?                           06

      (c)    The CEO of the company has been approached by one of his friend who owns 1,000
             shares. The shareholder have the opinion that he will suffer a loss in his personal
             wealth due to this rights issue, because the new shares are being offered at a price
             lower than the current market value.
             Prepare a statement for the CEO showing the effect of the rights issue on this
             particular shareholder’s wealth assuming that he:
             (i) sells all the rights.
             (ii) exercises one half the rights and sells the other half.
             (iii) does nothing at all.                                                                       10

      (d)    Are there any real circumstances which might support to the shareholder’s claim?
             Explain.                                                                                         02
                                              THE END
                                      PRESENT         VALUE         FACTORS
            Year    5%      6%      7%      8%       9%      10%      11%    12%     13%     14%     15%
             1     0.952   0.943   0.935   0.926    0.917   0.909    0.901   0.893   0.885   0.877   0.870
             2     0.907   0.890   0.873   0.857    0.842   0.826    0.812   0.797   0.783   0.769   0.756
             3     0.864   0.840   0.816   0.794    0.772   0.751    0.731   0.712   0.693   0.675   0.658
             4     0.823   0.792   0.763   0.735    0.708   0.683    0.659   0.636   0.613   0.592   0.572
             5     0.784   0.747   0.713   0.681    0.650   0.621    0.593   0.567   0.543   0.519   0.497
             6     0.746   0.705   0.666   0.630    0.596   0.564    0.535   0.507   0.480   0.456   0.432
             7     0.711   0.665   0.623   0.583    0.547   0.513    0.482   0.452   0.425   0.400   0.376
             8     0.677   0.627   0.582   0.540    0.502   0.467    0.434   0.404   0.376   0.351   0.327
             9     0.645   0.592   0.544   0.500    0.460   0.424    0.391   0.361   0.333   0.308   0.284
             10    0.614   0.558   0.508   0.463    0.422   0.386    0.352   0.322   0.295   0.270   0.247

                            CUMULATIVE             PRESENT       VALUE       FACTORS
            Year    5%      6%      7%      8%       9%     10%      11%     12%     13%     14%     15%
             1     0.952   0.943   0.935   0.926    0.917   0.909    0.901   0.893   0.885   0.877   0.870
             2     1.859   1.833   1.808   1.783    1.759   1.736    1.713   1.690   1.668   1.647   1.626
             3     2.723   2.673   2.624   2.577    2.531   2.487    2.444   2.402   2.361   2.322   2.283
             4     3.546   3.465   3.387   3.312    3.240   3.170    3.102   3.037   2.974   2.914   2.855
             5     4.329   4.212   4.100   3.993    3.890   3.791    3.696   3.605   3.517   3.433   3.352
             6     5.076   4.917   4.767   4.623    4.486   4.355    4.231   4.111   3.998   3.889   3.784
             7     5.786   5.582   5.389   5.206    5.033   4.868    4.712   4.564   4.423   4.288   4.160
             8     6.463   6.210   5.971   5.747    5.535   5.335    5.146   4.968   4.799   4.639   4.487
             9     7.11    6.80    6.52    6.25      6.00    5.76     5.54    5.33   5.13    4.95    4.77
            10     7.72    7.36    7.02    6.71      6.42    6.14     5.89    5.65   5.43    5.22    5.02

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