Change in KIBOR was not taken into account for calculating rentals for later years
. • Initial deposit was not deducted while calculating the annual rental.
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN EXAMINERS’ COMMENTS
SUBJECT Business Finance Decisions
SESSION Final Examination - Summer 2013
General: Overall performance of the students remained quite dismal. Generally, the students were able to do well in conventional style questions, but were unable to apply the concepts to new practical situations. In professional examinations, the students should not expect all questions to follow specific trends. Rather, they should have in-depth conceptual understanding and the ability to apply their knowledge in diverse situations. Question-wise comments: Question 1 Though leasing is a very commonly tested topic yet the overall performance in this question was quite below average. A large number of students were able to get few marks by fulfilling some of the requirements but only few students were able to really understand how to proceed with the problem. According to the question, five cars with the same costs had been obtained on lease, two years ago, by a car rental company. The cost, terms of lease, estimated rental income and maintenance expenses for each car were the same. Lease rental were payable annually and depended upon KIBOR. The current and future disposal values of each car were different, but were given. The requirement was to conclude on behalf of the lessee whether to continue the lease till maturity or to terminate it immediately. The steps required to solve the question were as under: •
Calculation of amount payable in case of immediate termination by preparing a lease repayment schedule for the first two years. Since KIBOR for each of the first two years was different, the lease rental for each year was also different.
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Calculation of NPV for each car in case of immediate termination, taking into account the disposal value and tax payable on disposal.
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Calculation of annual lease rental for the next two years.
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Computing the NPV in case the leases continue till maturity by considering the inflows (Car rentals and disposable value) and the outflows (lease rentals, maintenance costs and tax).
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Comparing the NPV of each car under each of the two options. Page 1 of 5
Examiners’ Comments on Business Finance Decisions – Final Examination Summer 2013
Generally, the students were unable to plan their answers in advance and started making various computations without really understanding as to what they wanted to achieve. The other common errors were as follows: • • • •
Change in KIBOR was not taken into account for calculating rentals for later years. Initial deposit was not deducted while calculating the annual rental. Receipts from car rentals could not be computed correctly in most of the cases. Many students ignored these altogether, in the computation of future inflows. Tax on disposal of assets was considered but tax on income from rentals was ignored.
Question 2 (a) This was quite an easy question as the students were simply required to explain the factors that are considered for establishing the credit rating of a debt instrument. However, overall performance in this part was below average. Most of the students were unable to explain the relevant factors considered in the credit rating of a debt instrument despite the fact that it was an open book examination. A vast variety of irrelevant points were highlighted which mostly related to issuance of debt instead of credit rating of debt instruments. Question 2 (b) In this question the candidates were required to select the best out of three available options for issuance of debentures. The available options were issuance of debentures at discount with fixed interest of 8%; issuance of zero-based debentures and issuance of debentures at face value and market interest rate. Overall performance was below average as in this question also, most of the students were not very sure as to how the question is to be handled. The answer to the question consisted of the following key steps: •
Determine the issue price and the number of debentures to be issued under each of the three options, based on the available data.
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Determine the interest payable and the amount payable on redemption.
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In case of each option, discuss the circumstances under which the company would prefer to select that option.
The common errors were as follows: •
A significant number of students were unable to compute the issue price under the first two options.
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Majority of the students did not really appreciate the requirement of the question. They tried to select the best option using various criteria whereas the requirement was to identify the circumstances in which a particular option would be selected. The important point which most of them missed was that the timings of the cash outflows under each option were different and the company would prefer to select the option whose cash outflows would match with the timings of the cash inflows that the company expects to generate from the project. Page 2 of 5
Examiners’ Comments on Business Finance Decisions – Final Examination Summer 2013
Question 3 This question was about selecting the appropriate hedging instrument to cover a foreign currency exposure in case of an overseas investment. The available options were forward contracts and currency futures. Evaluating the forward contract was simple and most of the students correctly applied the forward selling rate to book the contract. Evaluation of futures hedge option required determining the number of future contracts to buy, working out financing cost and computing gain/loss on settling futures under each of the three possible prices. This question was generally attempted well. Those who could not do well usually made the following errors. •
Took the buying rate while evaluating the forward contract.
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Financing cost on futures’ margin was not taken into consideration.
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Profit on futures market transactions was treated as a loss, in the final calculation.
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Some students assumed that the closing future rate would be equal to spot rate. In the absence of any relevant information, it would have been a fair assumption but was not appropriate in this case because the relationship for determining the future rate was clearly provided in the question.
Question 4 This question was about feasibility of launching a new product and required understanding of concepts related to opportunity cost, relevant costs, inflation, sensitivity analysis and project appraisal using NPV. Part (a) required NPV computation. Though a good performance was witnessed in this question, yet, a number of students had difficulty in dealing with the concept of inflation. For incorporating the impact of inflation, the right approach was to compute its effect on the total (net) cash flows. Many students took the longer approach of inflating cash flows from each item separately. An alternative approach was to adjust the impact of inflation in the discount rate. This most efficient approach was seldom followed. Besides, some students took the impact of inflation on cash flows of year zero also. On the other hand, many students ignored inflation on 1st year’s cash flows. In the computation of cash flows, the following types of errors were observed: •
1000 units of a component required to be used in production was available in stock and had been purchased for Rs. 800. Most of the students included the entire cost in the outflows whereas many students ignored it altogether. The correct approach was to include the opportunity cost of Rs. 700 per component (the price at which the component could be sold in the open market) in the outflows.
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Majority of the students failed to consider the fact that if the project is not undertaken, 5000 hours of unskilled labour would remain idle in the first two years. Therefore, the amount which had to be paid to unskilled workers, in any case (i.e. even if they remained idle) should have been deducted in computing the outflows on account of wages. Page 3 of 5
Examiners’ Comments on Business Finance Decisions – Final Examination Summer 2013
•
The cost of designing, testing and market research was a sunk cost and should not have been considered. Many students treated it as a cash outflow in year zero.
Part (b) of the question required computing sensitivities of sales price and discount rate. Sales price sensitivity was to be computed by comparing the NPV of the project with the PV of gross sales revenue net of tax. For computing the sensitivity of discount rate, IRR had to be computed using interpolation. The sensitivity was to be computed by expressing the difference between the IRR and the nominal discount rate as a percentage of the nominal discount rate. Majority of the students were able to correctly compute both sensitivities. However, many students ignored the effect of tax, in the computation of sales price sensitivity. Question 5 This question contained a situation whereby a company Taxila Power Limited (TPL) was planning to acquire the entire shareholding of another company Digari Power Limited (DPL) under a share exchange arrangement. Part (a) of the question required working out maximum price that can be offered for acquisition. The steps involved were as follows: •
Computing the profit of the merged entity, by adding the latest profits earned by individual companies and the effect of synergy. All the three figures were given in the question.
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Computing the cost of capital, using either the dividend growth model or the earnings growth model.
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Computing the present value of the future earnings or the dividends, as the case may be, (depending upon the method used for calculating the cost of capital) on the basis of cost of capital which was to be taken at 2% less than the original cost of capital. The present value so computed represented the post-acquisition market value of the merged entity.
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The difference between the post-acquisition and pre-acquisition market value represented the maximum price that TPL may pay for the acquisition of DPL.
Majority of the candidates did not understand the correct procedure and tried various incorrect alternatives which mainly revolved around taking the sum of the existing market values of the two entities and adding to it the present value of the additional profit due to the effect of synergy. Part b (i) required computing number of shares to be issued to acquire DPL if the existing shareholders required a 20% premium over the existing market value of their shares. Hence, the number of shares to be issued was to be computed in such a way that market price after issuance of shares should satisfy both conditions i.e. o Market value of shares held by existing shareholders must not fall below their current market value i.e. Rs. 560 million; and o Market values of shares issued to the shareholders of DPL should not be less than Rs. 153.6 million (5m shares x market price of Rs. 25.6 x 1.2 i.e. premium of 20%).
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Examiners’ Comments on Business Finance Decisions – Final Examination Summer 2013
The computation was to be made by creating an equation involving the post acquisition market value of total existing shares and the post acquisition market value per share. Most of the students were not able to approach this correctly. Part b (ii) required identification of advantages that would accrue to shareholders of each company, because of the proposed acquisition. Some students explained the benefits that are generally associated with an acquisition, which had no relevance with the requirement of this question. Part b (iii) required discussing other factors to be considered while deciding the proposed acquisition. Generally the students performed well; however, some of them produced entirely irrelevant material such as merits and demerits of acquisition in general and how the shareholders of the target company can avoid the acquisition. Both these aspects were not relevant.
(THE END)
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