FINANCIAL MANAGEMENT

Suggested Answers
July-August 2023
Answer to Question# 1 (a):

Briefing Note for Bijli Aluminum Limited's Management:

Subject: Explanation of Portfolio Theory, Systematic Risk, Unsystematic Risk, and Coefficient of
Correlation

Dear Management,

I am writing to provide you with an explanation of key financial concepts that are relevant to your
current strategy of diversification into the cement industry, as mentioned in the executive
summary received from the management consultants. Understanding these concepts will help
you make informed decisions about your investment strategy.

i) Portfolio Theory: Portfolio theory, also known as Modern Portfolio Theory (MPT), is an
investment concept developed by Harry Markowitz. It suggests that investors can optimize their
portfolio by selecting a combination of assets (stocks, bonds, etc.) that maximizes expected
returns for a given level of risk or minimizes risk for a given level of expected returns. The core
idea behind portfolio theory is that combining different assets that are not perfectly correlated
can reduce overall risk while maintaining or even improving returns.

ii) Systematic Risk and Unsystematic Risk:

 Systematic Risk (Market Risk): This is the risk that is inherent in the overall market or economy
and affects all investments. It's also known as non-diversifiable risk because it cannot be
eliminated through diversification. Factors like interest rate changes, economic recessions,
political events, and market volatility contribute to systematic risk. It's the risk that investors are
rewarded for taking on over the long term.
 Unsystematic Risk (Specific Risk): This is the risk that is unique to a specific company or industry.
It can be eliminated or significantly reduced through diversification. Examples of unsystematic
risk include company-specific events, management changes, technological advancements, and
industry-specific trends. Investors are not rewarded for taking on unsystematic risk because it can
be diversified away.

iii) Coefficient of Correlation: The coefficient of correlation measures the degree of relationship
between two sets of data. In the context of your investment strategy, it indicates the extent to
which the prices or returns of two industries (aluminum and cement) move together. The
coefficient of correlation can have values between -1 and +1:

 Positive Correlation (+1): A positive correlation indicates that the two industries tend to move in
the same direction. A coefficient of +1 suggests a perfect positive correlation, meaning that when
one industry's prices or returns go up, the other industry's prices or returns also go up.

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 Negative Correlation (-1): A negative correlation indicates that the two industries tend to move in
opposite directions. A coefficient of -1 suggests a perfect negative correlation, meaning that
when one industry's prices or returns go up, the other industry's prices or returns go down.
 Zero Correlation (0): A zero correlation means that there is no clear relationship between the two
industries' prices or returns. Changes in one industry do not predict changes in the other.

In your case, the coefficient of correlation between the aluminum and cement industries is +0.8.
This indicates a strong positive correlation, suggesting that the two industries tend to move
together. While portfolio theory advocates diversification to reduce risk, the high positive
correlation between aluminum and cement raises questions about how much risk can actually be
diversified away.

In conclusion, portfolio theory encourages diversification to manage risk, with the goal of
reducing unsystematic risk. However, the strong positive correlation between the aluminum and
cement industries may limit the extent to which risk can be diversified. It's important to carefully
evaluate the potential benefits and risks of diversifying into the cement industry considering this
correlation.

Please feel free to reach out if you need further clarification or assistance.

Sincerely,

[Your Name]

Finance Manager, Bijli Aluminum Limited

Answer to Question# 1 (b) (i):

i) 'In view of the fact that the market is efficient in the semi-strong form,
financial information released by companies is of no value to investors, because
the information is already included in share prices before it is released':

This statement refers to the semi-strong form of market efficiency and its implications
for the value of financial information to investors.

Semi-Strong Form of Market Efficiency: In the context of market efficiency, the

semi-strong form suggests that all publicly available information is already reflected in
stock prices. This includes not only past price and trading volume data (weak form),
but also all publicly available information such as financial reports, news, and
announcements (semi-strong form).

Comment: The statement is correct in its assertion that, according to the semi-strong
form of market efficiency, publicly available financial information is quickly and
accurately incorporated into share prices. Therefore, investors cannot consistently earn
abnormal returns by trading on publicly available information alone. However, it's
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important to note that private or insider information is not included in this argument,
as its utilization can lead to an advantage in the market.

ii) 'If an investor holds shares in about 20 different companies all of the risk is
eliminated and the portfolio will give a return equal to the risk-free rate':

This statement involves the concept of diversification and its impact on risk and
returns in an investment portfolio.

Diversification: Diversification is the strategy of investing in a variety of assets or

securities to reduce the overall risk of the portfolio. It's based on the idea that by
holding a mix of investments that are not perfectly correlated, the potential for large
losses due to the poor performance of a single investment is minimized.

Risk-Free Rate: The risk-free rate is the theoretical rate of return of an investment
with zero risk, usually represented by the yield on government bonds.

Comment: While diversification does reduce risk, it doesn't eliminate it entirely.

Holding shares in different companies can help mitigate company-specific risk
(unsystematic risk), but systematic risks like market fluctuations and economic changes
can still impact the overall portfolio. Additionally, the assertion that the portfolio will
give a return equal to the risk-free rate is not accurate. The return of a diversified
portfolio will generally exceed the risk-free rate because investors expect to be
compensated for taking on additional risk.

iii) 'A graph of the daily price of a share looks similar to that which would be
obtained by plotting a series of cumulative random numbers. This shows clearly
that share prices move randomly at the whim of investors, indicating that the
market is not price efficient':

This statement alludes to the idea that stock prices exhibit randomness and challenges
the concept of market efficiency.

Random Walk Hypothesis: The random walk hypothesis posits that stock prices
move in a sequence of independent random steps, with future price changes not
dependent on past price movements. This suggests that predicting stock price
movements based on historical data is difficult.

Market Efficiency: The concept of market efficiency asserts that stock prices reflect all
available information, making it difficult for investors to consistently beat the market
by using publicly available information.

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Comment: The observation of a price graph resembling cumulative random numbers
is consistent with the random walk hypothesis. However, this does not necessarily
negate market efficiency. Market efficiency doesn't imply that stock prices are
completely predictable in the short term; rather, it suggests that prices fully reflect
available information. Over the long term, market efficiency still holds, and investors
should not be able to consistently earn abnormal profits by trading on historical price
patterns alone. The notion of market efficiency does not preclude short-term price
fluctuations driven by investor sentiment or other factors that can appear random.

Answer to Question# 2 (a):

Calculation of weighted average cost of capital
Definition
k = Weighted average cost of capital
ke = Cost of equity capital
kd = Cost of debenture capital
kL = Cost of bank loan
E = Total ex-dividend market value of debt
D = Total ex-interest market value of loan
L = Total value of outstanding bank loan

i) Calculation of ke
Assuming an underlying dividend growth 'g' per anumn, the average growth rate between 2018 and
2022 is given by
(1+g)^4 = 13.6 ÷ 10
= 1.36
(1+g) = 4√1.36
= 1.0799
g 8%

Assuming that shareholders take past dividend growth as a reasonable approximation to future
growth, then using the dividend growth model,
ke = (Do (1 + g)) ÷ Po + 0.08
= (13.6 x 1.08) ÷ 135 +0.08
= 18.88%

ii) Calculation of kd
kd is the discount rate which equates the present value of future income (Tk. 8 per anumn) and
redemption (Tk. 100) to the current market price (Tk. 82.50)
Time Flow DF @ 10% PV DF @ 15% PV
1-4 8.00 3.170 25.36 2.855 22.84
4 100.00 0.683 68.30 0.572 57.20
0 (82.50) 1.000 (82.50) 1.000 (82.50)
11 (2)

By linear interpolation
kd = 10 + (11.16 ÷ (11.16+2.46)) x (15-10)
= 14%
iii) Calculation of cost of bank loan
The current cost of debt is taken as the best estimate of the future cost of debt i.e., 16.5%

iv) Calculation of weighted average cost of capital

k = (ke E + kd + kL L) ÷ (E + D + L)
= (4.05 x 18.88% + (0.66x14%) + (0.9x16.5%)) ÷ (4.05+0.66+0.9)
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 = 18%

Answer to Question# 2 (b):

Assumption underlying the use of k as a discount rate

The weighted average cost of capital should only be used as the target discount rate for appraising investment
opportunities whose acceptance will not alter the weighted average cost of capital

Since the cost of any type of capital can be regarded as a function of a risk free rate and a risk premium, this
implies that k should not be used to evaluate opportunities which have significantly different risk
characteristics from the average risk borne by the company prior to acceptance of the project.

In this context it is useful to separate the total risk of the company into business risk and financial risk. The
business risk is the risk inherent in the nature of the company's operations. The financial risk is a function of
a company's gearing. For a project to be evaluated using k, its acceptance must not alter the company's overall
business risk nor must it alter the financial risk. Therefore, it must be of a similar nature to existing projects
and it must be financed in such a way that the gearing ratio in unchanged and hence the financial risk is
unaltered. In practice k may also be used to evaluate small or marginal projects whose acceptance is unlikely
to alter overall corporate risk.

The situation outlined in the question is such that the project being considered could hardly be thought of as
marginal. The cost of the project (Tk. 2.5 million) is approximately half of the existing market value of the
company. In these circumstances k could only be used as a target discount rate if its business risk were the
same as that of existing projects and it were to be financed in the same way as existing projects. This is unlikely
to be the case, and as a generalization it is probably unwise to use the existing k to evaluate such a major
investment opportunity.

Answer to Question# 2 (c):

Practical problems in estimating k for a large Bangladeshi listed company

The problems of estimating k can be considered under four headings:

i) The validity of the model
The estimation of k and, in particular ke is based on the assumption that the value of an ordinary share is
the discounted present value of the future dividend stream. It is possible that the market is using a different
method of valuation, eg based on an earnings multiple; if this is the case, validity of the ke calculation is
undermined.

ii) The estimation of the variables in the model

Here again the major problems is in the estimation of ke. To calculate ke it is necessary to know or
estimate Do, Po, g. Of these only Do can be determined with confidence. Po is the ex-dividend value of
the share but, for the model to give an accurate estimate of ke, the market value must be in equilibrium.
In practice the market value of an ordinary share may fluctuate daily and it may be extremely difficult to
estimate its equilibrium value.

If establishing Po is a problem, then estimating g is harder still. Two approaches are frequently used, one
based on past dividend growth and one using the Gordon growth model. In using past growth rates an
average must be calculated and there is always the danger that the average is misleading. In the question
the average dividend growth of ABC Limited over the past four years has been 8%, although in the most
recent year dividends have not grown at all. To what extent is the average growth a meaningful figure?
Furthermore, it must be remembered that the growth factor in the dividend valuation model is anticipated

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 future growth. Even where the average of past growth rates is meaningful, the use of the average assumes
that past growth rates will be sustained in the future.

The earnings retention model is based on the belief that future dividend growth depends on the volume
of earnings retained in the business and the rate of return earned on retained earnings.

The estimate of g is given by

g = br
Where, b = the current retention rate
r = the current return on capital employed

Even accepting the naivety of the model and its limitation to pure equity companies, it will only give a
useful approximation to g where the retention rate and the rate of return are stable.

iii) Fluctuation in the value of the variable through time

Once the basic rationale for a discounting approach to investment appraisal has been accepted (i.e., both
the magnitude and timing of cash flows are relevant), it is incumbent upon the company to establish an
appropriate discount rate. The WACC model is a reasonable start to determining the appropriate rate,
notwithstanding the obvious difficulties in its application. In practice, a check on the calculations can be
made by comparing the result with the WACC of similar companies and with the risk-free rate (the return
on government securities)

iv) Problems associated with different sources of finance

In part (a) a calculation was made of the WACC. ABC limited is financed entirely by debt and ordinary
share capital, and the procedure for calculating the WACC is straightforward. However, in particular,
many firms use other sources of finance, which make the computation of WACC more difficult.

Specifically, a company may have unlisted preference shares which present problems of estimating their
market value; the estimation of true cost of convertible loan stock is notoriously difficult as the
calculation requires an assumption about whether or not the option to convert will be exercised; where a
company has substantial foreign currency loans, fluctuations in the exchange rate add a new dimension
to the estimate of their cost; and, finally. substantial 'off balance sheet' finance in the form of lease
agreements creates further difficulties.

Answer to Question# 3:

Calculate the effects of each of the four approaches

i) Convert at spot in three months' time

If exchange rate is Tk. 1/€1.50
€5 m /1.50 = Tk 3,333,333

If exchange rate is Tk. 1/€1.70

€5 m /1.70 = Tk 2,941,176

ii) Use the forward market

3 - month forward sell rate = 1.5625 – 0.0015 = 1,561

€5 m /1.561 = Tk 3,203,075

iii) Exchange rate in three months: Tk. 1/€1.50

In this case the company will not exercise the option but will convert at spot
€5 m /1.50 = Tk. 3,333,333
Net outcome after premium Tk 3,208,333

Exchange rate in three months: Tk. 1/€1.70

In this case the company will exercise the option and convert at the strike price of €1. 561
€5 m /1.561 = Tk. 3,203,075
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 Net outcome after premium Tk 3,078,075

iv) Money market cover

Borrow = €5 m /(1+(0.032/3))
= € 4,960,317

Convert at spot
= €4,960,317/ 1.5625
Tk. 3,174,603

Invest for three months

= Tk. 3,174,603x (1+0.015)
= Tk. 3,127,603
Summary:
Cash receipt in three months' time (in Tk.)
Spot rate in three months
Tk. 1/€1.50 Tk. 1/€1.50
(i) Conversion at spot 3,333,333 2,941,176
(ii) Using the forward market 3,203,075 3,203,075
(iii) Buying a €5 m put option 3,208,333 3,078,075

(iv) Borrowing € and investing Tk. 3,127,603 3,127,603

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Answer to Question# 4 (a):

The beta of a portfolio asset is the weighted average of the betas of the individual assets in the portfolio, with
the weight on each asset being that asset's share in the portfolio. Specifically,

𝛽𝑝 = 𝑛𝑗=1 𝑤𝑗 𝑋𝛽𝑗 𝑎𝑛𝑑𝑗=1

𝑛
𝑤𝑗 = 1 → 𝛽𝑝 = (𝑤𝐴 × 𝛽𝐴 ) + (𝑤𝐵 × 𝛽𝐵 ) (𝑤𝐶 × 𝛽𝐶 ) + (𝑤𝐷 × 𝛽𝐷 )

Asset Cost Weight (W1) Beta (𝛽 /) Wj× 𝛽 l

Asset 20,000 20% 0.80 0.1600
B 35,000 35% 0.95 0.3325
C 30,000 30% 1.50 0.4500
D 15,000 15% 1.25 0.1875
Total= 100,000 100% Sum = 𝛽 p = 1.1300

Answer to Question# 4 (b):

[(𝑒𝑛𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 − 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑣𝑎𝑙𝑢𝑒) + 𝑐𝑎𝑠ℎ 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

Return =
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
(𝑇𝑘. 20,000 − 𝑇𝑘. 20,000) + 𝑇𝑘. 1,600 𝑇𝑘. 1,600
𝑟𝐴 = = = 8%
𝑇𝑘. 20,000 𝑇𝑘. 20,000

(𝑇𝑘. 34,500 − 𝑇𝑘. 30,000) + 𝑇𝑘. 0 𝑇𝑘. 4,500

𝑟𝐶 = = = 15%
𝑇𝑘. 30,000 𝑇𝑘. 30,000

(𝑇𝑘. 36,000 − 𝑇𝑘. 35,000) + 𝑇𝑘. 1,400 𝑇𝑘. 2,400

𝑟𝐵 = = = 6.86%
𝑇𝑘. 35,000 𝑇𝑘. 35,000

(𝑇𝑘. 16,500 − 𝑇𝑘. 15,000) + 𝑇𝑘. 375 𝑇𝑘. 1,875

𝑟𝐷 = = = 12.5%
𝑇𝑘. 15,000 𝑇𝑘. 15,000

Answer to Question# 4 (c):

Total value of the portfolio today is Tk. 107,500, and total annual income from Assets A-D during the year
was Tk. 3,375, so portfolio return is given by:

(𝑇𝑘. 107,000 − 𝑇𝑘. 100,000) + 𝑇𝑘. 3,375 𝑇𝑘. 10,375

𝑟𝑃 = = = 10.375%
𝑇𝑘. 100,000 𝑇𝑘. 100,000

Answer to Question# 4 (d):

Using the CAPM equation, rj = Rf + [βj  (rm - Rf)], where rj is the required return on asset j.

RF the risk-free rate (given as 4%), βj the beta on assetj and j, rw the return on the market portfolio return (given
as 10%), solve for required return on each project:

rA = 4% + [0.80  (10% - 4%)] = 8.8%

rB = 4% + [1.50  (10% - 4%)] = 13.0%
rC = 4% + [0.95  (10% - 4%)] = 9.7%
rD = 4% + [1.25  (10% - 4%)] = 11.5%

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Answer to Question# 4 (e):

Asset Actual Return CAPM Return Over- or Underperformed CAPM

A 8.00% 8.80% Under
B 6.86% 9.70% Under
C 15.00% 13.00% Over
D 12.50% 11.50% Over

Security analysts typically use statistical techniques to estimate an asset's beta by obtaining a line of best fit
through historical asset and market returns. The slope of this line is beta. Data points-that is, actual returns on
the asset and market for a given period—will be randomly scattered around the line no matter how well it
"fits" the data. The point here is asset betas are estimates. The CAPM return is, in a sense, a forecast and even
good forecasts are subject to random error. Another possibility is beta does not fully capture all no diversifiable
or systemic factors that affect expected returns. Still another possibility is the firm behind the asset has
changed, so the beta estimated with historical data does not reflect the asset's current beta.

Answer to Question# 5 (a):

30 June
2023 2024 2025 2026 2027-43
Y0 Y1 Y2 Y3 Y4-20
BDT ’000 BDT ’000 BDT ’000 BDT ’000 BDT ’000
Construction costs -750,000 -750,000 -750,000
Land clearance -20,000
Sales 750,000 1,250,000
Rental income (W1) 60,000 144,000 144,000
Bad debts (W1) -1,800 -4,320 -4,320
New staff -4,000 -9,000 -9,000
Extra costs (W1) -2,400 -5,760 -5,760
Tax (W2) 4,500 -92,813 -166,343 -28,107 -28,107
Green machine 0 -20,000 0 2,000
Tax on machine (W3) 0 54 43 -277
Total cash flows -765,500 -112,758 385,501 98,536 96,813
9% factors (W4) 1 0.917 0.842 0.772 6.597
PV -765,500 -103,400 324,592 76,070 638,700
NPV 170,461

The project produces a positive NPV and so should be accepted as it will enhance shareholder wealth.

WORKINGS:
W1 Rental income, bad debt & Extra costs
BDT '000
Rental income (Y2) 60,000
Bad debts (Y2) 1,800
Extra costs (Y2) 2,400

Rental income (Y3) 144,000

Bad debts (Y3) 4,320
Extra costs (Y3) 5,760

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 W2 Tax allowance and Tax
2023 2024 2025 2026 2027-43
Y0 Y1 Y2 Y3 Y4-20
BDT '000 BDT '000 BDT '000 BDT '000 BDT '000
Construction cost for sold flats -337,500 -562,500
Land clearance -20,000
Sales 750,000 1,250,000
Rental income (W1) 60,000 144,000 144,000
Bad debts (W1) -1,800 -4,320 -4,320
New staff -4,000 -9,000 -9,000
Extra costs (W1) -2,400 -5,760 -5,760
Taxable (loss)/profit -20,000 412,500 739,300 124,920 124,920
Tax at 22.5% 4,500 -92,813 -166,343 -28,107 -28,107

W3: Tax savings on capital allowance 2024 2025 2026

Y1 Y2 Y3
BDT '000 BDT '000 BDT '000
Machine cost/WDV 1,200 960 768
WDA (20%)/Balancing allowance -240 -192 1,232
WDV/Sale price 100
Tax saving (22.5% x WDA) 54 43 -277

W4: Annuity factor

9% annuity factor for Y4-Y20 Y20 9.129 OR (8.544)
Y4 (2.531) x 0.772
6.597 6.597

Answer to Question# 5 (b):

Y1 Y2 Total
BDT '000 BDT '000 BDT '000
Sales 750,000 1,250,000
Tax -168,750 -281,250
Total cash flows 581,250 968,750
9% factors 0.917 0.842
PV 533,257 815,377 1,348,634

170,461
Sensitivity = 12.6%
1,348,634
Minimum selling price = (BDT 2,500,000 – 12.6%) 2,184,011

Answer to Question# 5 (c):

Y0 Y1 Y2
BDT '000 BDT '000 BDT '000
Incremental construction costs -1,350,000 750,000 750,000
Tax on costs -5,062.5 -5062.5
Total cash flows -1,350,000 744,937 744,937
9% factors 1 0.917 0.842
PV -1,350,000 683,108 627,237
-39,655
The NPV would decrease by BDT 39.65 million and so it is less likely that AHL’s board would proceed with
the development.
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Answer to Question# 6 (a):

Chairman – to use the cost of preference shares would be completely wrong. It’s only one element of the
firm’s total long-term finance and 7% is the coupon rate, not the current cost.

Finance Director and Marketing director – ordinary shares (cost of equity) should be taken into account. It
would make sense to use YBF’s current WACC figure for the investment appraisal if:

(1) the historical proportions of debt and equity are not to be changed
(2) the systematic business risk of the firm is not to be changed and
(3) the new finance is not project-specific.

Regarding the above, the bank borrowing will not change the gearing i.e. sufficient equity will be raised to
maintain the gearing at its current level. The systematic business risk of the firm is likely to change as it’s
moving into a different market. The finance is not project-specific e.g. cheap government loan.

So WACC should be used which will consider all components of debt and equity

Ethical implications:
You work for YBF and are a party to confidential information which, if made public, could influence the
market price of YBF’s shares.

An ICAB Member should assume that all unpublished information about a prospective, current or previous
client’s or employer’s affairs, however gained, is confidential.
That information should then:
- Be kept confidential
- Not disclosed, even inadvertently such as in a social environment
- Not be used to obtain personal advantage

Answer to Question# 6 (b):

Option 1
2024 2025 2026
BDT millions BDT BDT
millions millions
Sales 528 464.64 408.88
Contribution 396 348.48 306.6624
Redundancy -5
Pre-tax 396 348.48 301.6624
Tax @ 17% -89.10 -78.41 -67.87
Working capital (W1) 6 5.28 38.72
Plant and equipment 55
WDAs (W2) 2.25 1.8 5.18
Total 315.15 277.15 332.69
Factors @ 10% 0.917 0.842 0.772
Present value 288.99 233.36 256.84
Total PV 779.19

W-1
2024 2025 2026
Working Capital 6 5.28 38.72

W2 2024 2025 2026

WDA 50 40 32
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 CA 10 8 6.4
Sell value 9
Balancing charge -23
Tax 2.25 1.8 5.18

Option-2:
2023
BDT millions
Sale proceed 775

Option-3:
2023 2024 2025
BDT millions BDT millions BDT millions
CF 300 300 500
PV Factor @ 9% 1 0.997 0.842
300 275 421
After tax 772

The present values are:

Winding down operations 779 million
Selling to another company 775 million
MBO 772 million

To maximise shareholder wealth Padma plc should wind down operations since it produces the highest present
value. However the present value relies upon a number of assumptions about sales volume, the release of
working capital and the proceeds of selling plant and equipment. The present value is not sufficiently high to
choose it over the other two proposals as the figures are pretty similar.

In present value terms there is little to choose between selling to another company or an MBO. Since it might
be difficult to find a buyer for BSML, the preferred proposal would be for the current management team of
the company to buy it.

However, if BSML goes into liquidation or having financial difficulties in future, full payment would not be
received by Padma plc. So Padma plc should renegotiate with management team for higher payments in 2023
and 2024 than the previous schedule. This will increase the NPV as well as reduce the risk of default.

---The End---

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