The Institute of Certified Public Accountants of Pakistan (ICPAP)

CPA Examinations
SUMMER -2017

Wednesday, July 05, 2017

Student Name:

Registration Number: Specialization

Course Code
Exam Center:
Sp-603

Advance Financial Management

NOTES:
1. Attempt any five questions.
Time allowed
2. Answers are expected to the precise, to the
Reading and planning: 15 minutes point and well written.
3. Neatness and style will be taken into account in
Writing: 3 hours
marking the papers.

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Question No:1

a) Dawlance Co has undertaken market research at a cost of Rs.200,000 in order to

forecast the future cash flows of an investment project with an expected life of four
years, as follows:

Year 1 2 3 4
Sales revenue (Rs.000) 1,250 2,570 6,890 4,530
Costs (Rs.000) 500 1,000 2,500 1,750

These forecast cash flows are before taking account of general inflation of 4·7% per year.
The capital cost of the investment project, payable at the start of the first year, will be
Rs.2,000,000. The investment project will have zero scrap value at the end of the fourth
year. The level of working capital investment at the start of each year is expected to be
10% of the sales revenue in that year.

Capital allowances would be available on the capital cost of the investment project on a
25% reducing balance basis. Dawlance Co pays tax on profits at an annual rate of 30%
per year, with tax being paid one year in arrears. Dawlance Co has a nominal (money
terms) after-tax cost of capital of 12% per year.

Required:

Calculate the net present value of the investment project in nominal terms and comment on its
financial acceptability.
Marks (10)

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b) Bata Co sells both Product P and Product Q, with sales of both products occurring
evenly throughout the year.

Product P

The annual demand for Product P is 300,000 units and an order for new inventory is placed
each month. Each order costs Rs.267 to place. The cost of holding Product P in inventory is 10
Paisas per unit per year. Buffer inventory equal to 40% of one month’s sales is maintained.

Product Q

The annual demand for Product Q is 456,000 units per year and Bata Co buys in this
product at Rs.1 per unit on 60 days credit. The supplier has offered an early settlement
discount of 1% for settlement of invoices within 30 days.

Other information

Bata Co finances working capital with short-term finance costing 5% per year. Assume that
there are 365 days in each year.

Required:

Calculate the following values for Product P:

(i) The total cost of the current ordering policy;

(ii) The total cost of an ordering policy using the economic order quantity;

(iii) The net cost or saving of introducing an ordering policy using the economic order
quantity.

Total Marks (20)

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Answer:
1 (a) Calculating the net present value of the investment project using a nominal terms approach
requires the discounting of nominal (money terms) cash flows using a nominal discount rate,
which is givenas12%.

Year 1 2 3 4 5

Rs.000 Rs.000 Rs.000 Rs.000 Rs.000

Sales revenue 1,308·75 2,817·26 7,907·87 5,443·58

Costs (523·50) (1,096·21) (2,869·33) (2,102·93)

–––––––– ––––––––– ––––––––– –––––––––
Net revenue 785·25 1,721·05 5,038·54 3,340·65

Tax payable (235·58) (516·32) (1,511·56) (1,002·20)

CA tax benefits 150·00 112·50 84·38 253·13

–––––––– ––––––––– ––––––––– ––––––––– ––––––––

After-tax cash flow 785·25 1,635·47 4,634·72 1,913·47 (749·07)

Working capital (150·86) (509·06) 246·43 544·36

–––––––– ––––––––– ––––––––– ––––––––– ––––––––
Project cash flow 634·39 1,126·41 4,881·15 2,457·83 (749·07)
Discount at 12% 0·893 0·797 0·712 0·636 0·567

–––––––– ––––––––– ––––––––– ––––––––– –––––––––

Present values 566·51 897·75 3,475·38 1,563·18 (424·72)
–––––––– ––––––– ––––––––– ––––––––– –––––––––

Rs.000
PV of future cash flows 6,078·10
Initial investment (2,000·00)
Working capital (130·88)
–––––––––
NPV 3,947·22
–––––––––
The net present value is Rs.3, 947,220 and so the investment project is financially acceptable.
Workings

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Year 1 2 3 4
Sales revenue (Rs.000) 1,250 2,570 6,890 4,530
Inflated sales revenue (Rs.000) 1, 30875 2, 81726 7, 90787 5,443·58

Year 1 2 3 4
Costs (Rs.000) 500 1,000 2,500 1,750
Inflated costs (Rs.000) 523·50 1,096·21 2,869·33
2,102·93

Year 1 2 3 4
Inflated sales revenue (Rs.000) 1,308·75 2,817·26 7,907·87 5,443·58
Working capital (Rs.000) 130·88 281·73 790·79 544·36
Incremental (Rs.000) (130·88) (150·86) (509·06) 246·43

Year 1 2 3 4
Capital allowance (Rs.000) 500·00 375·00 281·25 843.75
Tax benefit (Rs.000) 150·00 112·50 84·38 53·13

b): Limitations of the Internal Rate of Return (IRR):

One problem with the IRR is that it ignores the initial investment amount. If you’re comparing
two alternative investments and your only decision criteria is the IRR, then which is better – a
50% return on $1,000 investment, or a 10% return on a $50,000 investment? If IRR was your
only decision criteria, then you’d choose the first option, ignoring the size of your initial
investment, and therefore the actual cash you’re able receive as a result of your investment.
Another limitation of the IRR is that it doesn’t always equal the return on your initial investment
over the holding period. When periodic cash flows exist in an investment that results in capital
recovery, the IRR makes no assumptions about what you do with these interim cash flows. For
example, you might put that cash flow into a bank account with a much lower yield than the IRR,
which can be problematic when evaluating the true return for an investment.
Limitations of the Net Present Value (NPV):
One limitation of the NPV is that it doesn’t take into account the timing or variability of cash
flows. For example, which is better, a project that returns one lump sum in 10 years, or instead a
project with even cash flows every year for ten years? These are two different investments and,
depending on your needs, you might prefer one over the other, even if the NPV for both projects
is the same.
Another limitation of the NPV is that it’s often difficult to accurately estimate the discount rate.
Because of this, it might also be difficult to accurately account for the riskiness of projected cash
flows. For example, if you’re evaluating a building with short term leases, then you might
consider bumping up your discount rate to account for this rollover risk. But exactly how much
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higher should your discount rate be? This is often a subjective decision that an objective
measure, like the NPV, can’t easily account for.

Answer:

(B) (i) Cost of current ordering policy

Ordering cost = 12x267 = Rs. 3,204 per year

Monthly order = monthly demand = 300,000/12 = 25,000 units

Buffer inventory = 25,000 x 0.4 = 10,000 units

Average inventory excluding buffer inventory = 25,000/2 = 12,500 units

Average inventory including buffer inventory = 12,500 + 10,000 =22,500 units

Holding cost = 22,500 x 0.1 = Rs. 2,250 per year

Total cost = 3,204 + 2,250 = Rs. 5,454 per year

(ii) Cost of ordering policy using economic order quantity (EOQ)

EOQ = ((2x267x300, 000)/0.10)0.5 = 40,025 or 40,000 units per order

Number of orders per year = 300,000 /40,000 = 7.5 orders per year

Order cost = 7.5 x 267 = Rs. 2,003

Average inventory excluding buffer inventory = 40,000/2-20,000 units

Average inventory including buffer inventory = 20,000 + 10,000 = 30,000 units

Holding cost = 30,000 x 0.1 = Rs. 3,000 per year

Total cost = Rs. 2,003 + Rs. 3,000 = Rs. 5,003 per year

(iii) Saving from introducing EOQ ordering policy = 5,454 -5,003 = Rs. 451 per year

(b) Product Q trade payables at end of year = 456,000 x 1 x 60/365 = Rs. 74,959
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Product Q trade payables after discount = 456,000 x 1 x 0.99 x 30/365 = Rs. 37,105

Decrease in Product Q trade payables = 74,595 – 37,105 = Rs. 37,854

Increase in financing cost = 37,854 x 0.05 = Rs. 1,893

Value of discount = 456,000 x 0.01 = Rs. 4,560

Net value of offer of discount = 4,560 – 1,893 = Rs. 2,667

(c) Invoice discounting refers to the purchase of selected invoices by a financial company at a discount to
their face value. Invoice discounting can provide immediate cash to a company rather than waiting for the
invoices to be settled. It tends to be used as an occasional source of short term finance, rather than a
regular source of cash. Invoice discounting can therefore aid in the management of trade receivable by
accelerating cash inflow from trade receivables when short-term cash flow problems arise.

Factoring refers to a commercial arrangement whereby a financial company takes over the management
of a company’ trade receivables. This will include invoicing customers, accounting for sales and
collections of amounts owed. Factors will advance cash to a company against the amounts outstanding. If
the client requires, insurance against bad debts may also be provided ( non-recourse factoring).

Factoring can assist in the management of trade receivables through the expertise offered by the factoring
company. This may lead to a reduction in bad debts, a decrease in the level of trade receivables, a
decrease in the amount of managerial time devoted to chasing slow prayers, and taking advantage of early
settlement discounts from trade suppliers due to the availability of cash from trade receivables.

Question No: 2

A company is considering two capital expenditure proposals. Both proposals are for similar
products and both are expected to operate for four years. Only one proposal can be accepted.
The following information is available.

Profit/ (loss) after depreciation

Proposal A Proposal B

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$$
Initial investment 46,000 46,000
Year 1 6,500 4,500
Year 2 3,500 2,500
Year 3 13,500 4,500
Year 4 (1,500) 14,500
Estimated scrap value at the end of year 4 4,000 4,000
Depreciation is charged on the straight line basis.

Required
(a) Calculate the following for both proposals. (8 Marks)
(i) The payback period to one decimal place
(ii) The return on capital employed on initial investment, to one decimal place.

A company is trying to decide whether to buy a machine for $ 80,000 which will save costs of
$20,000 per annum for 5 Years and which will have a resale value of $ 10,000 at he end of year
5.

Required if it is the company's policy to undertake projects only if they are expected to yield a
DCF return of 10% or more ascertain using the IRR method whether this project should be
undertaken.
(12 Marks)

Q no.2 (A)

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Depreciation= initial investment- salvage value/4

46,000-4,000/4 =10,500

Project Project B
A
Year Cash flow Cumulative Annual Cash Cumulative
cash flow flow Cash flow
0 (46,000) (46,000) (46,000) (46,000)
1 (6500+10,500)= (29,000) 15,000 (31,000)
17000
2 14,000 (15,000) 13,000 (13,000)
3 24,000 9,000 15,000 (3,000)
4 9,000 18,000 25,000 22,000
5 4,000 22,000 4,000 26,000

Pay Back Period (A) = 2+ [1500/24000 *1] =26years

Pay Back Period (B) = 3+ [3800/25000 *1] =3.1 Year

Proposal A= Average Profit= (6500+3,500+13,500-1,500)/4

=22,000/4 =5,500

ROCE = 5,500/46000 *100% =12%

Proposal B = Average Profit = (4,500 + 2,500 + 4500 + 14,500)

26,000/4 = 6,500

ROCE = 6500/44000 * 100% = 14%

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Q no.2 (B)
12%

Year Cash flow PV Factor(1/i+n)^n PV of cash flows

0 (80,000) 1.00 (80,000)
1-5 20,000 3.605 72,100
5 10,000 0.567 5,670
(2,230) NPV

9%

Year Cash flow PV Factor(1/i+n)^n PV of cash flows

0 (80,000) 1.00 (80,000)
1-5 20,000 3.890 27,800
5 10,000 .650 6500
4300 NPV

Annual Depreciation

(80,000-10,000)/5=14,000

(20,000- Depreciation of 14,000)/ (1/2 of (80,000+10000)

=6000/45,400= 13.3%

IRR= 9+ [4300/4300+2230 *(12-9)] =10.98%

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Question No: 3

The Pioneer Manufacturing Company Limited (PMCL) is considering the acquisition of a new
machine so that it can increase the production capacity of the organization. The machine will
cost PKR 550,000/- with an estimated salvage value of PKR 50,000/- and useful life of five
years with 10% cost of capital. The details of operating revenues and operating expenses of that
investment option for the upcoming five years are appended below:
Description Operating revenues in PKR Operating expenses excluding
depreciation in PKR
Year 1 200,000/- 100,000/-
Year 2 250,000/- 120,000/-
Year 3 300,000/- 150,000/-
Year 4 350,000/- 180,000/-
Year 5 400,000/- 190,000/-
The Pioneer Manufacturing Company Limited (PMCL) uses straight line method of
depreciation. The company has a loan of PKR 1,000,000/- on which it will pay simple interest
@ 2.5% per annum. The loan amount will exist throughout the useful life of the new machine.
Currently, Pioneer Manufacturing Company Limited (PMCL) is in the 10% marginal tax
bracket. It expects to be in that bracket for the first three years. However, in the year four and
five it expects to be in the 20% marginal tax bracket.

REQUIRED

How you will differentiate between discounting and non-discounting techniques of capital
budgeting? (3 marks)
The discounting techniques of capital budgeting involve the use of time value of money in evaluating
the capital investment proposal. The examples of these techniques are NPV and PI etc.
The non-discounting techniques of capital budgeting techniques like payback period and ARR does not
require the use to time value of money in evaluating the capital investment project.

What will be the initial cash outflow, regular cash inflows and terminal cash inflow if the new
machine is acquired? (5 marks)
The initial cash out flow of the machine is PKR 550,000/-
The operating cash inflow of the machine are:
Description Year - 1 Year - 2 Year - 3 Year - 4 Year - 5
Operating revenue 200,000 250,000 300,000 350,000 400,000
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(-) Operating expenses 100,000 120,000 150,000 180,000 190,000

Profit before depreciation 100,000 130,000 150,000 170,000 210,000
(-) Depreciation 100,000 100,000 100,000 100,000 100,000
550,000 – 50,000 / 5 = 100,000
EBIT 0 30,000 50,000 70,000 110,000
(-) Interest 25,000 25,000 25,000 25,000 25,000
1,000,000 x 2.5/100
EBT (25,000) 5,000 25,000 45,000 85,000
Tax 10% and 20% - 500 2,500 9,000 17,000
EAIT (25,000) 4,500 22,500 36,000 68,000
(+) Depreciation 100,000 100,000 100,000 100,000 100,000
Cash flow (regular) 75,000 104,500 122,500 136,000 168,000
Cash flow terminal (salvage value) 50,000
Cash flow 75,000 104,500 122,500 136,000 218,000

What will be the Payback Period, Net Present Value (NPV), Profitability index (PI) and
Modified Internal Rate of Return (MIRR) of this investment project of buying the new
machine? (12 marks)
Cash flow 75,000 104,500 122,500 136,000 218,000
PVIF (10% 5 year) 0.909 0.826 0.751 0.683 0.621
PV of inflows 68,175 86,317 91,998 92,888 135,378
474,576

Payback period = 4 + 112,000/218,000 = 4.51 years

NPV = 474,576 – 550,000 = - 75,424

PI = 474,576 / 550,000 = 0.86

MIRR = [476,576/550,000]1/5 (1.1) – 1 = 6.89%

Question No: 4

The information relate to the capital structure of Union Corporation Limited (UCL) is given
below:
Description Amounts in PKR
Common Preferred Bonds
stock stock
Number of shares/bonds issued 2,000 1,000 1,500
Book value per share/bond 1,000/- 1,500/- 2,000/-
Market value per share/bond 1,400/- 1,700/- 2,200/-
Floating or issuing cost per share/bond 20/- 30/- 10/-

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Dividend in amount/rate and interest rate 120/- 10% 20%

Expected growth rate of dividend 20% - -
Corporate tax rate - - 40%
REQUIRED

1. What will be the amount as well as weight of the capital structure of Union Corporation
Limited (UCL) if the book values of securities and market values of securities are used?
( 8 marks)

Capital Quantity Book/Face Amount Percentage

structure Value weight
Common 2,000 1,000 2000,000 31%
stock
Preferred 1,000 1,500 1,500,000 23%
stock
Debt/Bond 1,500 2,000 3000,000 46%
Total 6,500,000

Capital Quantity Market Amount Percentage

structure Value weight
Common 2,000 1,400 2,800,000 36%
stock
Preferred 1,000 1,700 1,700,000 22%
stock
Debt/Bond 1,500 2,200 3,300,000 42%
Total 7,800,000

2. What will be cost of common stock, cost of preferred stock and cost of bonds for Union
Corporation Limited (UCL)? (6 marks)
Description Formulae Calculation
Cost of common stock ke = Do (1 + g) + g ke = 120 (1 + 0.20) + 0.20
Po - F 1,400 - 20
= 30%
Cost of preferred stock kp = Dp Dp = 1,500 x 10/100 = 150
Po - F kp = 150
1,700 - 30
= 9%
Cost of bond kp = I (1-t) I = 2,000 x 20/100 = 400

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Po - F t = 40/100 = 0.40
kp = 400 (1 – 0.40)
2,200 - 10
= 11%

3. What will be weighted average cost of capital (WACC) for Union Corporation Limited
(UCL) if the book values as well market values are used as weight?
(4 Marks)
Percentage Individual Overall cost
weight cost of of Capital
capital (ko)
31% 30% 9.30%
23% 9% 2.07%
46% 11% 5.06%
WACC 16.43%
(Book value as weight)

Percentage Individual Overall cost

weight cost of of Capital
capital (ko)
36% 30% 10.80%
22% 9% 1.98%
42% 11% 4.62%
WACC 17.40%
(Market value as weight)

4. If retained earnings are available in the capital structure of Union Corporation Limited
(UCL). How you will calculate its cost? ( 2 marks)

If the retained earnings are available in the question it calculation will be in the following way:

kr = Do (1 + g) + g

Po

Question No: 5

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National Publishers Limited (NPL) and Orient Publishers Limited (OPL) are the two famous
publishers working/operating in Urdu Bazar, Lahore - Pakistan. The balance sheet of both
companies as on December 31, 2016 are appended below:

Description Amounts in PKR

NPL OPL
Assets
Short-term assets 2,500,000/- 2,000,000/-
Long-term assets 2,500,000/- 3,000,000/-
Total assets 5,000,000/- 5,000,000/-
Debt
Sort term-debt 1,000,000/- 1,800 ,000/-
Long-term debt 2,000,000/- 1,200,000/-
Equity
Share capital 1,500,000/- 1,500,000/-
Retained earnings 500,000/- 500,000/-
Total debt and equity 5,000,000/- 5,000,000/-
Other information:

Earnings before interest and tax (EBIT) PKR 2,000,000/-

Interest on short-term debt 10% per annum
Interest on long-term debt 15% per annum
Corporate tax rate 30%

REQUIRED

1. What do you know about working capital policies? Discuss conservative, moderate and
aggressive working capital policies in the context of risk and return. (6 marks)
The policy on an organization to manage its working capital requirement is called working capital
policy. Working capital policy involves the issues relate to keeping and maintaining the current assets
and current liabilities of the business.
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In case of conservative working capital policy the company keep and maintain highest amount of
working capital to avoid any liquidity risk. In case of aggressive working capital policy the amount
of working capital is kept at the lowest to get the benefit of return by investing cash resources. The
term moderate working capital policy reflects the average amount of working capital kept by the
company.
2. What is the net working capital of National Publishers Limited (NPL) and Orient Publishers
Limited (OPL)? (2 marks)

Description NPL OPL

Current assets 2,500,000 2,000,000
Current liabilities 1,000,000 1,800,000
Net working capital 1,500,000 200,000

3. What is the Return on Equity (ROE) of National Publishers Limited (NPL) and Orient
Publishers Limited (OPL) in the current scenario? (5 marks)

Description NPL OPL

EBIT 2,000,000 2,000,000
(-) Interest
10% for short-term debt (100,000) (180,000)
20% for long-term debt (300,000) (180,000)
EBT 1,600,000 1,640,000
(-) Tax 30% 480,000 492,000
EAIT 1,120,000 1,148,000
Equity 2,000,000 2,000,000
ROE = EAIT/Equity 56% 57%

4. What will be the Return on Equity (ROE) of National Publishers Limited (NPL) and Orient
Publishers Limited (OPL) if the rate of interest on short-term debt increased to 20%?
(5 marks)

Description NPL OPL

EBIT 2,000,000 2,000,000
(-) Interest
20% for short-term debt (200,000) (360,000)
20% for long-term debt (300,000) (180,000)
EBT 1,500,000 1,460,000
(-) Tax 30% 450,000 438,000
EAIT 1,050,000 1,022,000
Equity 2,000,000 2,000,000

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ROE = EAIT/Equity 53% 51%

5. Which company is more risky with reference to working capital? (2 marks)

The OPL is more risky company with reference to working capital as the variation in ROE is more in
this company as compared to the variation of ROE of NPL due to change in interest rate for short-term
debt.

Question No: 6

1. What do you know about efficient market hypothesis? Explain weak, semi-strong and strong
forms of stock market efficiencies. (4 marks)
Efficient market hypothesis
(See the answer on the next page)

2. What do you know about derivative securities? Discuss futures, options and swaps in the
context of foreign currency transactions. (4 marks)
Derivative securities are those securities whose value depend upon the variation in the
underlying asset i.e. the asset against whom these are issued.

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3. The information relates one investment option available for Crescent Industries Limited (CIL)
in given below:

Description Security - A Security - B Probability

Possible returns:
Pessimistic 50/- 60/- 20%
Moderate 100/- 120/- 50%
Optimistic 150/- 180/- 30%
Expected return 100/- 120/-
Weight in portfolio of investment 40% 60%
REQUIRED

What will be the expected rate of return, standard deviation and coefficient of variation of the
portfolio of investment for Crescent Industries Limited (CIL)? (12 marks)
i Pi Ra Rb Rpi = WaxRa + WbxRb (RPi-ERp)2 x Pi
Pessimistic 0.20 50 60 50x.4+60x.6=56 (56-122)2 x.2=871
Moderate 0.50 100 120 100x.4+120x.6=112 (112-122)2 x.5=50
Optimistic 0.30 150 180 150x.4+180x.6=168 (168-122)2 x.3=635
Ʃ(Rpi-ERp)2 x Pi
= 1,556
Expected rate of return on portfolio
ERp = Wa x ERa + WbxERb
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ERp = .5x100+.6x120=122
Standard deviation of portfolio
SD = Square root of Ʃ(Rpi-ERp)2 x Pi
SD = Square root of 1,556
SD = 39
Coefficient of variation of portfolio
CV = SD x 100 / ERp
CV = 39 x 100 / 122 = 32%

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