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Strategic Level
Corporate Finance & Risk Management

(Pilot Paper)

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Instructions to candidates
(1)Time allowed:

Reading and planning – 15 minutes

Writing –3 hours

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(2)Total: 100 marks
(3)Answer all questions.
(4)This paper consists of two sections

Section 1: 2 questions

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Section 2: 1 question
(Common pre-seen provided prior to the examination is in relation to this question)

(5) Answers should be in the English Language, in the answer booklet/s given
to you.
(6) Begin each answer on a separate page in the answer booklet. Submit all
workings.
(7) Answers written on the answer booklets, graph papers and any other
stationery distributed at the examination hall, only, are considered in
marking of the answer scripts. Any other attached documents are not taken
into account at the time of marking the answer scripts

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 Section 1 – Based on complex scenarios

Question 1
The following information relates to Beta Plc which operates several business segments including
assurance services.
• The Board consists of 10 directors of whom 6 are independent. The major shareholder holds
the office of both the Chairman and the Chief Executive Officer.
• Return on Assets (ROA) and Return on Equity (ROE) of Beta Plc is 16% and 30% respectively
• The Board approved to lend Rs. 200 million to one of its sister companies at an annual interest
rate of 10% per annum with the objective of solving its liquidity and debt problems. Even
though some non-independent directors were concerned about this loan, the CEO highlighted
that the company has a free cash flow of Rs. 300 million at present and therefore, the decision
would create value to the company instead of leaving such free cash flows with the company
without being utilized.
• Board approval was also given to refurbish the office space at a cost of Rs. 80 million through a
related party. One of the executive directors of Beta Plc is also a director of this related
company
• A proposal was presented to the Board highlighting the benefits of microfinance business.
Accordingly, a common and most demanded asset, a loan of Rs. 50,000 can earn the highest
return. This loan should be repaid in 12 months in monthly installments of Rs. 6,000.
• Assurance services include two unique retirement benefits plans of which particulars are
given below.

Plan 1 Plan 2
Annual Premium Rs. 1,000,000 200,000
Premium to be paid at the beginning of each year 4 years 16 years
Policy Term 10 years 16 years
Monthly Retirement benefit starting after policy
Term (Rs.) 70,000 50,000
Retirement Benefits will be paid for 15 years 10 years
Assumed interest during the benefit period 8% 8%

• Concerning the benefit plan 1 above, the premium should be paid by the policyholder only for 4
years but the retirement benefits are paid after the maturity of the policy (10 Years). Both
plans offer similar life assurance cover and other insurance benefits

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Required:
(a) What is the yield of the proposed microloan? (2 marks)

(b) Comment about the yield calculated in (a ) above by comparing it with ROA and ROE
(2 marks)

(c) Discuss whether the Board’s decisions to lend money to a sister company and to refurbish
the office premises would align with the objective of maximizing the value of Beta Plc
(5 marks)

(d) Explain the reasons as to why ROE of Beta Plc is higher compared to ROA (2 marks)

(e) Evaluate both retirement plans by comparing the present values of retirement benefits
offered with the present values of annual premiums paid. (Assuming that deposits of
annuities can also earn the assumed interest per annum for both policies and these
assumed interest rates for discounting cash flow) (10 marks)

(f) What is the time value of money in plan 1 for Beta Plc, if premiums collected can earn the
same rate as assumed interest rate during the benefit period (2 marks)

(g) What would be the reasonable value that an investor can place in life assurance and other
benefits if he or she opts to invest in plan 2 assuming that the required rate of return
during the entire period is 8% per annum (2 marks)
(Total 25 marks)

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Question 2
Alpha Plc is a company listed on the Colombo Stock Exchange. It engages mainly in manufacturing
and trading food and beverage items both in local and international markets. The following selected
information is provided.
• Stated capital, retained earnings, total equity, and bonds issued by the company as at 31st
March over the last five years is given below (earnings for the year 2016 amounted to Rs.
100,000,000).

Figures are in
Rs. 2020 2019 2018 2017 2016
Stated Capital 500,000,000 500,000,000 500,000,000 500,000,000 500,000,000
Retained 1,045,000,00
Earnings 0 869,000,000 767,000,000 689,000,000 600,000,000
1,545,000,00 1,267,000,00 1,189,000,00 1,100,000,00
Total Equity 0 1,369,000,000 0 0 0
Bonds 300,000,000 300,000,000 300,000,000 0 0

• Accounting year for Alpha Plc ends on 31st March

• Bonds had been issued at par and will mature on 31.3.2025. The coupon rate is 12% per
annum and the interest is paid semi-annually on 30th March and 30th September of every year.
These bonds were traded at 107% and 90% on 31st March 2019 and 2020 respectively.
However, the trading volumes of the company bonds were insignificant.
• Analysis of the term structure of the interest rates of the country reveals that the interest rate
applicable for 5-year maturity would be around 10% mainly due to proposed policy measures
of the government to tackle predicted economic downturn. However, it is unlikely that the
interest rate would prevail low in the future due to marketing pressure, and, experts say there
is a possibility that the interest rate may even shoot to 20%.
• Alpha Plc pays dividends in January every year and the dividend records for the last five years
are given below

2020 2019 2018 2017 2016

DPS Rs. 2.40 2.30 22.00 21.00 20.00

• Stated capital as at 31.3. 2020 comprises of 10 million ordinary shares.

• Shares of Alpha Plc were split in March 2018 in the ratio of 10 for one share. One of the main
objectives of the split was to increase the liquidity and to create value for shareholders

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• The average market price of a share for the 11 months ending 28.2.2020 was Rs. 250.
Calculation excluded the prices during the month of March as it drastically stumbled with the
announcement of the COVID-19 pandemic. The last traded price during March 2020 was Rs.
130 per share. Share prices on 31st March of the last five years are given below.

Year 2020 2019 2018 2017 2016

Market Price per
share (Rs.) 130 300 270 2,500 2,600

• Average industry PE ratio over the last five years was 23

• The beta coefficient of Alpha Plc as of 31.3.2020 was 1.2. The average treasury bill rate and the
market premium for the year ended 31.3.2020 were 5% and 9% respectively.

Required
(a) Ascertain the intrinsic value of a bond of Rs. 1000 of Alpha as of 31st March 2020 on the
assumption that analysis of the term structure of the interest rate is reliable (3 marks)
(b) Suggest an investment strategy by comparing the market price of a bond that prevailed on
31st March 2020 with your calculation made in (a) above (2 marks)
(c) Ascertain the intrinsic value of a bond of Alpha as of 31st March 2022 assuming that the
interest rate applicable for financial assets maturing within three years would be 15%
(2 marks)
(d) Explain the significance of risk and return to an investor who bought bonds of Alpha on
31.3. 2020 and intends to hold them until maturity (5 marks)

(e) Calculate the value of a share of Alpha Plc by using dividend growth model and earnings
growth models (hint; Use the simple average growth over the applicable period) (5 marks)

(f) Comment on the value a share of Alpha Plc based on your calculation made in (e) above
(2 marks)
(g) Provide your recommendation with reasons concerning an investment in shares of Alpha
Plc based on relative PE of the company (4 marks)
(h) Explain whether Alpha Plc was able to achieve the objective of the share split made in 2018
(2 marks)

(Total 25 marks)

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 Section 2

Questions based on the Common ‘pre-seen’ provided prior to the exam to familiarize
with particular business context

Gama Plc is planning to issue corporate bonds with a face value of Rs. 300 million and a coupon rate
of 16% per annum at a discounted price of 98%. Interest is paid annually.
The Board of Directors had already approved a new acquisition of an entity for a consideration of
Rs. 500 million. One of the manufacturing plants of the new acquisition is intended to be used for
manufacturing some raw materials that are imported as of now. Cash flows expected from the bond
issue will be used for this investment and an additional amount of Rs. 200 million is expected to be
raised from equity issuance. However, due to the prevailing bad market conditions, Gama Plc
intends to raise the required amount of cash through a private placement of shares instead of
issuing rights shares. New placement will be made at Rs. 50 per share.
The new acquisition is expected to generate an average profit before tax of Rs. 80 million each for
the next three years and Rs. 150 million each for the following 2 years. Annual profit before tax will
jump to Rs. 190 million in the sixth year and Gama Plc expects to maintain the profit at a constant
growth of 5% per annum from the seventh year onwards. The average annual depreciation
applicable to the new investment is Rs. 10 million. Gama Plc uses companywide WACC excluding
decimals for investment appraisals.
Financial analysis has revealed that Gama would experience the following free cash flows during
the next five years (Rs. Millions).

2020 2021 2022 2023 2024

Year
260 270 320 400 400
Net Cash flows from operations
50 40 220 160 80
Investment
75 95 110 115 90
Repayment of Debt and Interest
135 135 (10) 125 230
Free Cash flow

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Required:
(a) Explain the amount by which the cost of debt would vary after the issuance of new bonds.
(3 marks)
(b) Explain why the impact of leverage on ROE is marginal and estimate the impact of leverage
on ROE after the proposed issuance of bonds. (4 marks)
(c) Explain the amount by which the cost of equity of Gama Plc will change after the issuance of
shares through a private placement (Hint: Use CAPM to ascertain the cost of equity if it not
specified otherwise) (5 marks)
(d) Compare WACC of Gama Plc as at 31st December 2019 with WACC after issuance of both
bonds and shares as suggested (5 marks)
(e) Explain the impact of corporate tax on Gama Plc regarding the assumption made in Miller
and Modigliani’s capital structure theory (3 marks)
(f) Discuss possible risk exposures of Gama Plc prevailing as of now and after acquiring the
new investment (5 marks)
(g) Elaborate how Gama Plc could mitigate risks and adopt strategies to manage risks arising
from foreign exchange (5 marks)
(h) Discuss the consequences of private placement made on the value of existing shareholders
(3 marks)
(i) Discuss whether the new investment of acquisition is financially feasible based on the net
present value expected (5 marks)
(j) Enumerate qualitative aspects to be considered with regard to the proposed acquisition
(4 marks)
(k) Explain why interest payments in project evaluation are not considered as a cash outflow in
appraising the proposal under discounted cash flow techniques (2 marks)
(l) Explain under what circumstances Gama Plc can use a profitability index for investment
appraisals (2 marks)
(m) Suggest a suitable short-term financial plan for Gama Plc for the next five years based on the
free cash flow expectations provided (4 marks)

(Total 50 marks)