CWA/ICWA Final :: Valuation Management and Case Study : December 2004

*F-20(VMC)* *Revised Syllabus*
Time Allowed : 3 Hours		Full Marks : 100
Answer Question No. 1 which is compulsory carrying 20 marks and any five from the rest.
Marks

(a)

Attempt all the questions, each carrying 1 mark, by selecting the correct option

1x4=4

(i)	A strategy of anti- takeover under which the target company makes a counter bid for the rider’s company is known as (a) Green mail, (b) white space (c) Pac-man Defence (d) Bear-hug
(ii)	A call option whose exercise price is above the market value is called (a) In the money option, (b) At the money option,(c) Out of the money option, (d) Butterfly option
(iii)	A growth stock is usually indicated by (a) Very high EPS (b) Huge equity base, (c) Repaid rising Dividend (d)High market discounting
(iv)	A stock with a dividend pay-out ratio of 40%, required rate of return of 20% and a constant growth rate of 20% will have a P/E of (a) 2 times (b) 4 times (c) 7.5 times (d) None of the above

(b)

fill in the blanks by filling in the appropriate word out of the two (Increase/ Decrease)
Variables affecting call and put prices:

1x12=12

		Effect on
Factor	Call Value	Put Value
Increase in variance of underlying asset Increase in time to expiration Increase in underlying asset’s value Increase in interest rates Increase in Strike price Increase in dividend paid	Increases /Decreases Increases /Decreases Increases /Decreases Increases /Decreases Increases /Decreases Increases /Decreases	Increases /Decreases Increases /Decreases Increases /Decreases Increases /Decreases Increases /Decreases Increases /Decreases

(c)

State whether the following statements are true or false:

(i)	An option is a wasting asset. (true/false)
(ii)	Price/book value ratio is a negative function of the ROE. (true/false)
(iii)	According to dividend discount model of equity valuation, the P/E raio of the stock is negatively related to dividend pay-out ratio. (true/false)
(iv)	Immunization refers to elimination of reinvestment risk and price risk (true/false)

1x4=4

(a)

Calculate the value of equity share from the following information:

Equity share capital (Rs.20 each)
Reserve and surplus
15% Secured loans
12.5% Unsecured loans
Fixed Assets
Investments
Operating profit
Tax rate is 50%
P/E Ratio is 12.5

50,00,000
5,00,000
25,00,000
10,00,000
30,00,000
5,00,000
25,00,000

(b)

What are the possible causes of horizontal and vertical merges?

(a)

Sant Ltd wants to take over Dayal Ltd. and the financial details of both are as under:

	Sant Ltd Rs.	Dayal Ltd Rs.
Preference share capital Equity share capital of Rs.10 each Share premium Profit and loss a/c 10% Debentures Fixed Assets Current Assets Profit after tax and preference dividend Market price	20,000 1,00,000 — 38,000 15,000 1,73,000 1,22,000 51,000 1,73,000 24,000 24	— 50,000 2,000 4,000 5,000 61,000 35,000 26,000 61,000 15,000 27

What should be the share exchange ratio to be offered to the shareholders of Dayal Ltd based on
(i) Net assets value (ii) EPS and (iii) Market price?

(b)

What factors are considered for selecting a target in a business acquisition strategy?

Please turn over

( 2 )

F-20(VMC)
Revised syllabus

Marks

(a)

The Managing Director of Smartdeal Ltd. has just attended a meeting with an investment analyst who has suggested that Smartdeal’s shares are overvalued by 10%. The data used by the investment analyst is shown below:

Year	Total Dividend Rs.	Number of shares	Total Earnings Rs.
2000 2001 2002 2003	1,13,000 1,22,680 1,62,160 2,00,140	57,200 5,72,000 70,000 80,000	3,65,200 4,26,400 5,34,200 5,72,400

Smartdeal’s current share price is Rs.75 and the cost of equity is estimated to be 12%.
Prepare a brief report for the managing director, discuss whether or not Smartdeal’s shares are overvalued. Relevant calculations should form part of your report.

(b)

Explain what is meant by ‘Free cash flow’. Discuss the possible conflicts that might exist between managers and shareholders over the use of free cash flows.

(a)

As a ‘Financial Analyst’ you are analyzing the performance of two companies, a Biotechnology firm and a Mobile telephone manufacturer. You have collected the following information about the two companies:

Company	Actual ROE	Beta	ROE of Peer Group	Forecasted ROE
Biotech Firm Mobile Firm	20.5% 12.5%	1.2 1.4	16% 10%	22% 10.5%

The risk-free rate of return is 7%.
Evaluate the performance of each of these companies relative to:
(i) the required rate of return
(ii) the return on equity of the peer group, and
(iii) the forecasted return on equity.

What conclusions would you draw about the investment choices made by these firms?

(b)

Simple Ltd. is trying to estimated its debt ratio. It has 1 million equity shares outstanding, trading at Rs.50 per share. Simple Ltd. has Rs.250 million in straight debt outstanding (with a market interest rate of 9%). It has two other securities outstanding:

(i)	10,000 convertible bonds, with a coupon rate of 6% and 10 years to maturity.
(ii)	2,00,000 warrants outstanding, conferring on its holders the right to buy stock in the Simple Ltd. at Rs.65 per share.

SThese warrants are trading at Rs.12 each.
You are required to calculate the debt ration in market value terms.

(c)

Convertible bonds are often issued by small, high grown companies to raise debt. Why?

(a)

‘Great Indian Shipping’ operates cruise ships and is head-quartered in Mumbai. The firm had Rs.100 million in pre-tax operating income in the current year, of which it invested Rs. 25 million. The firm expects its operating income to grow 4% in perpetuity and maintain its existing reinvestment rate. Great Indian Shipping has a capital structure composed of 60% equity and 40% debt. Its cost of equity is12%, and it has a pre-tax cost of borrowing of 8%. The firm currently faces a tax rate of 40%.
You are required to estimate the value of the firm.

(b)

Sens Medical Ltd. is a profitable pharmaceutical firm. The business, however, is highly cyclical, and the profits of the firm have been volatile. The management of the firm is considering acquiring a food processing firm to reduce the earnings volatility and their exposure to economic cycles.
Would such an action be in the best interest of their stockholders? Would your analysis be any different if they were a private firm? Is there any condition under which you would argue for such an acquisition for a publicly traded firm?

The following are the details of two merger candidates, N Ltd and G Ltd.

	(all are Rs. In lakh)
	N Ltd	N Ltd
Revenues Cost of goods sold (excluding depreciation ) Depreciation Tax rate Working capital Market value of Equity Outstanding Debt	Rs.4,400 87.5% Rs. 200 35% 10% of Revenue Rs.2,000 Rs.160	Rs. 3,125 89.0% Rs. 74 35% 10% of Revenue Rs. 1,300 Rs.250

Both firms are expected to grow 5% per year in perpetuity. Capital spending is expected to be offset by depreciation. The beta for both the firms are rated BBB, with an interest rate on their debt of 8.5% (The risk free rate is 7%)
As a result of the merger, the combined firm is expected to have a cost of goods sold of only 86% of total revenue. The combined firm does not plan to borrow additional debt.

(a)

You are required to estimate the value of the combined firm, with no synergy.

(b)

Estimate the value of the combined firm, with synergy.

You have been asked to evaluate an investment project for a company. The project requires an initial investment of Rs.12,00,000 with a six year lifr, with no salvage value, and to be depreciated on a straight line basis. Cash earnings before depreciation and taxes are projected in each of the next 6 years as under –

Rs. 2,00,000 (20& probability of occurrence)
Rs. 4,00,000 (405 probability of occurrence)
Rs.6,00,000 (40% probability of occurrence)

The risk free interest rate is 8% and the firm has a policy if assigning certainty equivalent (CE) factors of 0.90 to the cash inflows of projects equal in risk to the firm’s risk class such as revenue expansion projects involving existing product lines. For projects which require the firm’s entry into new product areas, CE Quotient of 0.8 is used to adjust the cash inflows. Make suitable assumptions and –

(a)

Determine the annual cash inflows prior to any risk adjustment .

(b)

Calculate the risk adjusted NPV for the project if it involves expansion of (i) existing product lines, and (ii) new product areas.

(c)

Calculate the risk adjusted IRR, based on expansion in new product areas. Would you recommend the projects.

__________