The Institute of Chartered Accountants of Pakistan

                                   


 

Business Finance Decisions
 

General:

The subject covers utilization of knowledge of quantitative techniques, cost and ma nagement accounting, financial ma nagement and business environment in taking strategic decisions. The paper was mostly of computational nature, leading to precise conclusions. However, it was evident from the replies submitted by the candidates that they had emphasized on practicing various tools used in decision ma king but had paid very little attention towards developing skills relating to rationale development, analysis, reasoning and presentation.

Question-wise Comments:

   
Q 1
(a)

The candidates were required to compute 'Free Cash Flows' but most of them did not know what it meant. The candidates with conceptual lucidity faced no problem in converting conventional cash flow given in the question into free cash flow except for the following common errors:

  • Purchase of land and short term investments were incorrectly included in operating assets needed for planned production; and
  • Interest was correctly added back to operating cash flow. However, such add back should have been made after adjusting tax thereon. Most students ignored this aspect.
 
 
 
(b)

The misconception about free cash flows affected the answers to this part also. However, even those who knew the concept gave comments which lacked analytical and critical approach. They merely described what had happened during the year without critical analysis thereof. The correct approach would have been to include the following:

  • a conclusion whether or not the application of funds in areas such as acquisition of land for medium term speculative gain and short term investment was appropriate.
  • the reasons and basis of such conclusion; and
 
 
 
(c)
The retention policy from shareholders' perspective was a topic unrelated to free cash flow and those who had no idea of free cash flow also had equal opportunity to gain marks.

Many examinees totally ignored the capital appreciation of shareholders' wealth and gave only negative comments on non-declaration of dividends. Preferred approach would have been to compare the capital gain with required rate of return. Very few adopted this approach.

 
 
Q 2
(a)
Computation of current cost of capital was an easy task for the students and most of them did well.
 
 
 
(b)
(i)
 Most students were able to apply Modigliani & Miller's theory correctly. They calculated the company's ungeared value and regeared it using the revised tax rate. However, while calculating the regeared value, many of them ignored the increase of Rs. 150 million in the net present value of the company's operating cash flows.
  
 
  
(ii)
 While computing expected cost of capital, candidates used cost of equity calculated on the basis of existing tax rate. Whereas reduction in tax rate changed the effective cost of debt that changed the geared beta. Therefore, a new cost of equity emerged incorporating new debt equity ratio and beta, which should have been used in the above calculation.
   
 
(c)
Although an increase in the value of equity due to tax benefit which, produced inflows of 150 million increased the costlier part of the WACC, however it increased the ratio of equity from 75.44 % to 76.82 % only. Consequently, the increase in WACC was minimal. Most of the students who managed to do part "b" (ii) correctly were able to identify the above.
    
Q 3 In this question, the concept of residual income was tested but most of the students were not familiar with it. Those who had knowledge of the concept made certain calculation errors, which mainly include the following:
  • could not compute the increase in volume of sale by eliminating the effect of inflation, from increase in total sales.
  • assumed the increase in sales volume as 18 % i.e. (20% - 2%) instead of 17.65% i.e. {(120 102) - 1}.
  • applied the rate of increase in total sales for calculating cost of material and labour instead of applying the rate of increase in sales volume.
  • Most examinees did not have any idea about the method of computing annuity depreciation and cost of capital.
  
Q 4 A very elementary question on sensitivity analysis was examined. Existing profitability and budget forecast was given and students were required to test the sensitivity of the budget in terms of existing profitability. Following deficiencies were found in the replies given by the examinees.
  • Budgeted fixed costs were increased / decreased with the projected volume instead of treating them as constant.
  • Discontinuance of product D was suggested although it was contributing towards the recovery of fixed costs.
  • The sensitivity at break-even level was calculated instead of, on the basis of current profit.
  • Some of the students based the sensitivity on the profits of A & B only instead of the total profits.
    
Q 5
(a)
The question was quite easy. Students easily applied the probability theory to arrive at the expected return on investment at each level of risk and correctly identified that the return on medium risk investment was the highest.
 
 
 
(b)
A large number of students could not compute the return the company could earn with the help of a professional analyst. The data given in the question showed that high risk investments were expected to perform best in high market performance period, medium risk investments were expected to perform best in medium market performance period and low risk investments were expected to perform best in low market performance period. It was expected that analyst would be able to keep company's funds in best performing investments by timely shifting and earn more for the company. Most students could not work out how the analyst will react in the situation.
   
Q 6
(a)
It was an easy question for those who had studied the topic on hedging in detail. The important points that should have been considered were as follows.
  • Exchange rate for forward contract for each month should have been calculated using interest rate parity formula.
  • Hedging through futures was not feasible as the last three months' rates were not available.
  • Rate at which US dollars could be available under the Call Option should have been arrived at by adding cost of Call Option to the Strike Price of Rs.60 65 or to the spot rate, whichever was lower. The rates so arrived, should have been compared with those applicable to forward contracts, to find the better option.
  • Put option was obviously not possible as it is used in case of export i.e. when the foreign currency is required to be sold.

However, very few of the students could carry out even a part of the above analysis as it was evident that their knowledge of the topic was extremely limited

   
 
(b)
Obviously those who couldn't do part (a) were unable to do this part either.