Q No. 2

Osama Co. is a listed company operating in the textile industry. Osama Co's board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the old plant and machinery and use this fund as well as borrow from market to purchase new plant and equipment. The new plant and machinery are more productive and meet the current standard quality required by the international buyers. It is also argued that new plant is more energy efficient and environment friendly that gives more advantage when facing international competitors.

The proposal stated that the funds raised from the sale of the old plant and machinery would be used to buy the new plant and machinery.

New borrowing for the balance amount will be made from local bank which offered lowest rate. Since inflation is on higher side compared to last few years so cost of borrowing is on higher side which will increase firm cost of capital.

The board of directors are of the opinion that increasing the level of debt in OSAMA Co. will increase the company's risk and therefore it can increase its cost of equity capital. It is assumed that due to change in plant and equipment current local sales of the product will not be affected.

New Plant price Rs.5.32 million

Sales of old plant Rs.1.32 million

Firm existing capital structure i.e. debt to assets ratio is 40:60.

At this level firm interest rate on all debt is 9.5%.

After borrowing firm capital structure will shift to 60:40 and at this level firm beta will shift from earlier 1.2 to 1.4. Risk free rate of return is 7% and market risk premium is 6%. New loan is negotiated with HBL bank and it is agreed that this loan will be for five years at 11% mark up.

Instructions:

1.How much borrowing required by firm?

2.Why risk factor will increase if firm is changing its capital structure?

3.What is the current weighted average cost of capital?

4.What the new cost of equity capital?

5.What would be new Weighted Average Cost of Capital?

Marks (10)

Q No. 3

The Calgary Company is attempting to establish a current assets policy. Fixed assets are

$600,000, and the firm plans to maintain a 40 percent debt-to-assets ratio. Calgary has no operating current liabilities. The interest rate is 12 percent on all debt. Three alternative current asset policies are under consideration: 40, 50, and 60 percent of projected sales. The company expects to earn 18 percent before interest and taxes on sales of $6 million. Calgary's effective tax rate is 40 percent.

1.What is the expected return on equity under each alternative?

2.Evaluate ROE from owner point of view and suggest which option is best for him?

3.Suggest which option would you like if you are managers of the company and do not have much concern about business?

4.Why current assets policy is important in this particular situation?

Marks (07)

Q No. 4

K Co. is a publicly listed company involved in the production of highly technical and sophisticated electronic components for complex machinery. It has a number of diverse and popular products, an active research and development department, significant cash reserves and a highly talented management who are very good in getting products to market quickly.

A new industry that K Co. is looking to venture into is biotechnology, which has been expanding rapidly and there are strong indications that this recent growth is set to continue. However, K Co. has limited experience in this industry. Therefore, it believes that the best and quickest way to expand would be through acquiring a company already operating in this industry sector.

Discussions taken place about the possibility of acquiring Tee Co. being acquired by K Co. Price of Tee company in stock market during last one year are as follows.

Price at the end of month

Month

Month end Price

KSE 100 INDEX

Jan

175

32600

Feb

185

33900

March

152

33500

April

190

34000

May

195

33500

June

188

33800

July

190

33700

Aug

195

33200

Sep

190

32900

Oct

185

33100

Nov

190

33900

Dec

88

34100

1.Calculate average return for both stock and market

2.Calculate Standard deviation for both

3.Calculate coefficient of variation for both

4.Calculate Beta of stock

5.Suggest what you understand from Beta

Price at the end of month Month Month end KSE 100 Price INDEX Jan 175 32600 Feb 185 33900 March 152 33500 April 190 34000 May 195 33500 June 188 33800 July 190 33700 Aug 195 33200 Sep 190 32900 Oct 185 33100 Nov 190 33900 Dec 88 34100 1. Calculate average return for both stock and market 2. Calculate Standard deviation for both 3. Calculate coefficient of variation for both 4. Calculate Beta of stock 5. Suggest what you understand from Beta Marks