BUSINESS FINANCE DECISIONS

Suggested Answers
Certified Finance and Accounting Professional Examination – Summer 2018

A.1 TTL / BTL

Rs. in million
Value of TTL before take over (MV of equity) (W-1) 34,800.00
Add: Expected cash flows generated from retail outlet division (W-2) 2,723.95
Add: Expected cash flows generated from disposal of BTL textile
manufacturing division (W-4) 2,853.90
Add: Synergy benefits (W-5) 810.68
Estimated value of take over 41,188.53

New number of shares – TTL ( in million) 750 + 250 × 5 ÷ 7 928.57

Expected market value of share of TTL after acquisition 41,188.53 ÷ 928.57 44.36

Synergy loss to TTL shareholders (Rs. per share)

[{(750×44.36)–34,800(W-1)}÷750] OR [44.36 – 46.40 (W-1)] (2.04)
Acquisition gain to BTL's shareholders (Rs. per share)
[{44.36×(250×5÷7)–6,000}÷250] OR [44.36×5÷7=31.68-24 (W-3.5)] 7.68

Conclusion: Sale of BTL would be beneficial for its shareholder but it would reduce the wealth of TTL's
shareholders, therefore they would not favour this merger decision.

W-1: Determination of MV of TTL before acquisition Rs. in million

MV of share of BTL (Rs.) 12 × 2,900 ÷ 750 46.40
Market value of equity (Rs. in million) 750 × 46.40 OR 2,900 × 12 34,800.00

W-2: Value from retail outlet division: Year 1 Year 2 Year 3

------------------- Rs. in million --------------------
Sales revenue (1,000 × 1.10) 1,000.00 1,100.00 1,210.00
Profit before tax (Sales revenue × 20%) 200.00 220.00 242.00
Less: Tax @ 30% 60.00 66.00 72.60
Profit after tax 140.00 154.00 169.40
Add: Depreciation 25.00 25.00 25.00
Cash inflows 165.00 179.00 194.40
Discount factor @ 11.34% (W-3) 0.8981 0.8066 0.7245
Present value of free cash flows from year 1 to 3 148.19 144.38 140.84

Rs. in million
Total present value of cash flows from year 1 to 3 433.41
Terminal value:
Cash inflows with growth [(242+25)×70%] × 2,242.62
Permanent tax shield 47.92
2,290.54
Total free cash flows from retail division 2,723.95

W-3: TTL - Weighted average cost of capital after acquisition

WACC - Post acquisition

[ ] [ ]

[ ]

[ ]

(Debt to equity ratio (MV) would be maintained at same level)

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 BUSINESS FINANCE DECISIONS
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Certified Finance and Accounting Professional Examination – Summer 2018

W-3.1: Cost of equity - Post acquisition

7% Given + 1.08 (W.5) (6% Given) 13.48%

W-3.2: Equity beta after acquisition

[ ( )]

1.08
[ ]

W-3.3: TTL - Debt to equity ratio prior to acquisition

Debt (Rs. in million) Given 17,500
Equity (Rs. in million) (W.1) 34,800
Debt to equity ratio prior to acquisition 17,500 ÷ (17,500 + 34,800) 33.00%
Equity component 34,800 ÷ (17,500 + 34,800) 67.00%

W-3.4: TTL - Asset beta after acquisition (Combined asset beta due to different business risk)

[ ] [ ]

[ ] [ ]

W-3.5: Determination of MV of BTL before acquisition

MV of share of BTL (Rs.) 500÷250×12 24.00
Market value of equity (Rs. in million) (500×12) OR (250×24) 6,000

W-3.6: Asset beta of BTL

0.77

W-3.7: Asset beta of TTL

0.81

W-4: Value from the disposal of the BTL textile manufacturing division Rs. in million
Net assets of BTL (2,500 + 520) 3,020.00
Net assets related to BTL textile manufacturing division 3,020 × 70% 2,114.00
Value from disposal 2,114 × 1.5 3,171.00
Value from disposal (net of tax) 3,171–{(3,171–2,114)×30%} 2,853.90

W-5: Synergy benefits Rs. in million

Annual administration cost savings (Post tax) (Rs. 70 mn Given × 70%)/11.34% (W-3) 432.09
One time redundancy payment (35.00)
Tax benefit on redundancy payment (35×30%) × 9.43
One time benefit of carried forward tax losses (1,500 × 30%) × (1.1134)–1 404.16
810.68

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 BUSINESS FINANCE DECISIONS
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Certified Finance and Accounting Professional Examination – Summer 2018

A.2 (a) Market Excess

Excess/ Combined Ratio
Companies Expected Market standard /(lower)
(lower) standard between risk
return % return % deviation % standard
return % deviation % and return %
(Given) deviation %
A B C=A-B X Y Z=X-Y Z÷C
A 17.71(W-1.1) 15.00 2.71 8.35 6.90 1.45 53.50
B 17.91(W-1.2) 15.00 2.91 8.23 6.90 1.33 45.70
C 18.52(W-1.3) 15.00 3.52 8.36 6.90 1.46 41.50
(Given) (Given) (Given)

Opinion: Company C should be selected as it has better trade off between risk and return.

W-1: CAPM return of Company C

6% + 1.25×(15%  6%)

W-1.1: Expected return – Company A with WPL

[ ] [ ]

W-1.2: Expected return – Company B with WPL

[ ] [ ]

W-1.3: Expected return – Company C with WPL

[ ] [ ]

W-2: Combined standard deviation

√

Company A with WPL

Company B with WPL

Company C with WPL

Note: There are other alternative methods to respond this question.

(b) The revised systematic risk of the WPL's portfolio can be measured as the weighted average of all individual
investment's beta which is computed as follows:

Revised systematic risk (New beta of WPL) [110/(110+40)×1.25] + [40/(110+40)×0.89] (W-2) 1.15
Expected return after investment in Company C 6% + 1.15 (15% – 6%) 16.35%

W-2: Beta = 0.89

After selecting the company C, overall risk profile of WPL would be improved from 1.25 to 1.15. The reduction
in expected return from 17.25% to 16.35% may be a cause of concern for WPL. However, the reduction in
expected return is compensated by reduction in risk from 8.6% to 8.36% i.e. combined standard deviation. Now it
is the decision of the management whether this trade off between risk and return is acceptable to WPL.

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 BUSINESS FINANCE DECISIONS
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Certified Finance and Accounting Professional Examination – Summer 2018

A.3 APL
Currency Futures Money market
--------- Rs. in million ---------
August installment 349.22 350.29
December installment 1,423.64 1,418.72
1,772.86 1,769.01

Opinion:
The best option is to use currency futures hedging for August installment payment and money market
hedging for December installment payments as total payments would be Rs. 1,767.94 million (Rs.
349.22mn + Rs. 1,418.72mn).

Hedge of payment to supplier using currency futures (Buy and sell futures)
August installment December installment
Future market (profit) / loss (Hedging using (Hedging using
September future) December future)
---------------------- Rupees --------------------
Today's future price (Buy) Given 116.50 118.40
Closing future prices (Sell) W-1 116.77 118.50
Difference (profit) (0.27) (0.10)
Net outcome
Spot market payments 349.80 1,422.00
(3mn×116.60) (12mn×118.50)
Future market (profit) (0.81) (1.20)
(3mn×0.27) (12mn× 0.10)
Borrowing cost on margin W-2 0.23 2.84
349.22 1,423.64

W-1: Future closing rates

Future closing rate = Expected spot rate + [(Future rate Current Spot rate) × Time remaining]
Aug future closing rate (Sep contract) 116.60 + [(116.50 - 116) × 1÷3] 116.77

W-2: Borrowing cost on margin

Aug future (Sep contract) 116.50 × 3mn × 5% × 8% × 2 ÷12 0.23
Dec future (Dec contract) 118.40 × 12mn × 5% × 8% × 6 ÷12 2.84

Hedge using Money market

Step 1: Determine the USD to be deposited in a USD deposit account for the period of payment and purchase
the required USD at spot
Payment Annualized Amount of deposit Equivalent PKR required
No. of
(USD in deposit needed at current spot rate
Installments months
million) interest (USD in million) (Rs. in million)
a b c d=a÷{1 + (c÷12×b)} d × 116.00
1 3.00 2 4.00% 2.98 345.68
2 12.00 6 4.00% 11.76 1,364.16

Step 2: Borrowed equivalent PKR amount

PKR amount to Annualized Amount of Cumulative
be borrowed Months borrowing interest repayment amount
Installments (Rs. in million) rates (Rs. in million) (Rs. in million)
h = e × (f × g ÷
e f g d+h
12)
1 345.68 2.00 8% 4.61 350.29
2 1,364.16 6.00 8% 54.56 1,418.72

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 BUSINESS FINANCE DECISIONS
Suggested Answers
Certified Finance and Accounting Professional Examination – Summer 2018

A.4 Option 1: Determination of NPV – Do not launch EDS-Adv

Year 0 Year 1 Year 2 Year 3 Year 4

------------ Rs. in million --------------------
Building (Opportunity cost) (25.00) - - - -
Plant (45.00) - - - -
Sales {25,000 Given × 1,660} × 1.12 × 1.05
(From year 2) - 41.50 48.80 57.39 67.49
Materials (25,000 Given × 210) × (1.1 × 1.05)
(From year 2) - (5.25) (6.06) (7.00) (8.09)
Labour cost {(25,000 × 2 × 145) +
(25,000 × 3 × 125)} × 1.07 × 1.05(From year 2) - (16.63) (18.68) (20.99) (23.58)
Variable overheads
(25,000 × 80) × (1.08 × 1.05) (From year 2) - (2.00) (2.27) (2.57) (2.91)
Fixed overheads (5 × 1.08) from year 2 - (5.00) (5.40) (5.83) (6.30)
Residual value of building – Given - - - - 30.00
Residual value of plant – Given - - - - 10.00
Cash (outflows) / inflows (A) (70.00) 12.62 16.39 21.00 66.61
Discount factor @ 12% (B) 1.0000 0.8929 0.7972 0.7118 0.6355
Present values (A × B) (70.00) 11.27 13.07 14.95 42.33

Modified Internal rate of return (MIRR)

( )
Present value of return phase (11.27+13.07+14.95+42.33) 81.62
= Present value of investment phase 70.00
= Cost of capital

( ) 16.38%

Option 2: Determination of NPV – Launch EDS-Adv

Year 0 Year 1 Year 2 Year 3 Year 4
------------ Rs. in million --------------------
Building (25.00) - - - -
Plant (45.00) - - - -
Additional research cost [20 + 10] - (30.00) - - -
Cash inflows of year 1 – “EDS-1” (from option–1) - 12.62 - - -
Sales of EDS-Adv
[59.34(W-3)×1.12×1.05] from 2nd year - - 59.34 69.78 82.06
Labour cost [{(32,050(W-3)× 2×145)+(32,050
(W-3) ×3×125)} ×1.07]×1.05×1.07 (from 3rd year) - (22.81) (25.63) (28.80)
Materials [32,050(W-3)×210×1.1]×1.05×1.1 (from 3rd year) - - (7.40) (8.55) (9.88)
Variable overheads
[32,050(W-3)×80×1.08]×1.05 × 1.08 (from 3rd year) - (2.77) (3.14) (3.56)
Fixed overheads (from option 1 table) - - (5.40) (5.83) (6.30)
Residual value of building – Given - - - - 30.00
Residual value of plant – Given - - - - 10.00
Cash (outflows) / inflows (A) (70.00) (17.38) 20.96 26.63 73.52
Discount factor @ 12% (B) 1.0000 0.8929 0.7972 0.7118 0.6355
Present values (A × B) (70.00) (15.52) 16.71 18.96 46.72

Modified Internal rate of return (MIRR)

( )
Present value of return phase [(12.62 × 0.8929) + 16.71 + 18.96 + 46.72)] 93.66
= Present value of investment phase [70 + (30 × 0.8929)] 96.79
= Cost of capital

( ) 11.08%

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 BUSINESS FINANCE DECISIONS
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Certified Finance and Accounting Professional Examination – Summer 2018

W-3
Overall expected sales in year 2 (Units) (33,500×80%)+ (25,000×20%×1.05) 32,050.00
Overall expected sales in year 2
(Rs. in million) (33,500×80%×1,850)+(25,000×20%×1.05×1,660×1.12) 59.34

Conclusion
Since MIRR of EDS-1 is higher than EDS-Adv’s MIRR, OJL should not launch EDS-Adv and continue with
EDS-1.

A.5 (a) IPL – Variances

(i) Sales price variance P1 P2

Actual selling price [1,825mn ÷ 250], [900mn ÷ 125] (Rs. per unit) 7,300.00 7,200.00
Standard selling price [2,250mn ÷ 300], [770mn ÷100] (Rs. per unit) 7,500.00 7,700.00
(200.00) (500.00)
Actual units sold Given 250,000.00 125,000.00
Product wise sales price variance (Rs. in million) (50.00) (62.50)

Combined sales price variance (Rs. in million) Adverse (112.50)

(ii) Sales mix variance Rs. in million

Actual sales in actual mix @ standard contribution – P1 [250,000×1,755(W-1)] 438.75
Actual sales in actual mix @ standard contribution – P2 [125,000×1,045(W-1)] 130.63
569.38
Actual sales in std. mix @ std. contribution – P1 [300,000÷400,000×375,000×1,755(W-1)] 493.59
Actual sales in std. mix @ std. contribution – P2 [100,000÷400,000×375,000×1,045(W-1)] 97.97
591.56
Sales mix variance Adverse (22.18)

(iii) Market size variance Rs. in million

Standard share of actual market in standard mix at weighted average standard
contribution margin [2.5mn × 12% × 1,577.50 (W-1)] 473.25
Standard share of original market in standard mix at weighted average standard
contribution margin [400,000 × 1,577.50 (W-1)] 631.00
Market size variance Adverse (157.75)

(iv) Market share variance Rs. in million

Actual sales in standard mix at standard contribution [375,000 × 1,577.50 (W-1)] 591.56
Standard share of actual market in standard mix at weighted average standard
contribution margin [2,500,000 × 12% × 1,577.50 (W-1)] 473.25
Market share variance Favorable 118.31

Combined sales volume variance (Sum of Sales mix, market size and market share variance) (61.62)

W-1: Standard contribution margin per unit P1 P2

------- Rs. per unit -------
Sales price (2,250mn ÷ 300,000), (770mn ÷ 100,000) 7,500.00 7,700.00
Variable cost of production (1,611mn ÷ 300,000), (627mn ÷ 100,000) (5,370.00) (6,270.00)
Sales commission (7,500 × 5%), (7,700 × 5%) (375.00) (385.00)
Contribution per unit 1,755.00 1,045.00

W-2: Standard average contribution margin per unit

{(1,755 × 300,000) + (1,045 × 100,000)}÷ (300,000 + 100,000) 1,577.50

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 BUSINESS FINANCE DECISIONS
Suggested Answers
Certified Finance and Accounting Professional Examination – Summer 2018

(b) The Board of Directors

Ikraam (Private) Limited

Subject: "Commentary on the sales variances" Date: 05 June 2018

Respected Board Members

Please find below the brief commentary on the sales variances for the quarter ended 31 March 2018.

(i) The sale mix showed an adverse variance of Rs. 22.18 million. One of the main reason of this
adverse variance is that the mixture of products sold has altered considerably from the budget, with
a noticeable movement towards P2 which has a lower margin as compare to P1. Therefore overall
profitability declined. Please see below analysis:
P1 P2
Budget mix ratio (300,000 ÷ 400,000) , (100,000 ÷ 400,000) 75% 25%
Actual mix ratio (250,000 ÷ 375,000) , (125,000 ÷ 375,000) 67% 33%
Standard margin per unit (W-1) Rs. 1,755.00 Rs. 1,045.00

(ii) Another reason of reduction in sales revenue is a result of the shrinking market. The market size has
fallen in volume by 25% {(400,000÷12%)  2,500,000)} ÷ (400,000÷12%)
i.e. (833,333 ÷ 3,333,333) and this may be considered to be outside the control of the company.
Thus the market size variance calculated may be considered to be a planning variance and should
not be used to assess the success of the company's operation.

(iii) Despite shrinking of market size as discussed in point (ii) above, it is encouraging to see that
company's market share has in fact increased from the expected 12% to 15%
(i.e. 375,000 ÷ 2,500,000). This is mainly due to increase in selling cost by Rs. 6 million (4450).

(iv) The sales prices of our products have been reduced during the quarter. Due to decrease in selling
price, P2 sales volume was increased by 25,000 units (100,000125,000) but P1 sales volume
declined by 50,000 units (300,000250,000).

I hope above would clarify the reasons of decline in sales and consequently reduction in profitability.

Kind regards
Chief Financial Officer
Ikraam (Private) Limited

(The End)

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