CMA May 2022 Examination Solutions

Solution:

The correct answer is **(a) Borrow short term to finance additional fixed assets**. The current ratio is calculated as Current Assets / Current Liabilities. Borrowing short-term debt increases current liabilities. While the fixed assets increase, they are not part of the current assets, so the denominator of the ratio increases while the numerator remains unchanged or increases by a smaller amount (if the loan proceeds are held as cash), thereby decreasing the ratio. All other options would increase the ratio by either increasing current assets or decreasing current liabilities without a corresponding increase in the other.

Solution:

The correct answer is **(b) Unsystematic risk**. Unsystematic risk, also known as diversifiable or firm-specific risk, is unique to a specific company or industry. It can be reduced or eliminated by holding a well-diversified portfolio of assets, as the specific risks of each asset cancel each other out. Systematic risk (or market risk) affects the entire market and cannot be diversified away.

Solution:

The correct answer is **(c) Yield to maturity**. The yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until its maturity date. It is the internal rate of return (IRR) of a bond's cash flows and is the best measure of a bond's expected return for an investor who holds it to maturity.

Solution:

The correct answer is **(b) Level of fixed operating costs**. Operating leverage arises from the presence of fixed costs in a firm's cost structure. The higher the proportion of fixed costs to total costs, the greater the firm's degree of operating leverage, and the more sensitive its operating income (EBIT) will be to changes in sales.

Solution:

The correct answer is **(e) Negotiable certificate of deposit**. A negotiable certificate of deposit (NCD) is a bank-issued, large-denomination, time deposit that is negotiable, meaning it can be sold in the secondary market. Commercial paper is issued by corporations, T-bills by the government, and repurchase agreements are typically between financial institutions.

Solution:

The correct answer is **(a) Method of project financing used**. The cash flows of a project are evaluated independently of how the project is financed. The method of financing (e.g., debt vs. equity) is accounted for in the discount rate (the Weighted Average Cost of Capital, or WACC), not in the project's cash flows themselves. The other options directly affect the project's incremental cash flows.

Solution:

The correct answer is **(b) Companies, financial institutions, and individuals derive different benefits from owning assets**. The primary reason for leasing is that it allows the party who can most effectively use the tax benefits of asset ownership (e.g., depreciation) to claim them, while still allowing another party to use the asset. This often results in a lower effective cost of financing for the lessee and a more efficient allocation of capital.

Solution:

The correct answer is **(c) There is more systematic risk involved for the common stock**. According to finance theory, equity holders have a lower priority claim on a firm's assets and earnings than bondholders. Therefore, common stock is riskier than debt. To compensate for this higher risk, investors require a higher expected return on equity. The risk is typically systematic, which is the risk that cannot be eliminated through diversification.

Solution:

The correct answer is **(d) There is an optimum capital structure**. The traditional approach, unlike the Modigliani-Miller (MM) theory, posits that a firm's overall cost of capital (WACC) can be minimized by a judicious use of debt, thus increasing the firm's value. This implies that there is an optimal capital structure that balances the benefits of lower-cost debt with the increasing costs of financial distress.

Solution:

The correct answer is **(e) A decrease in total assets**. When a company repurchases its own stock, it uses cash to do so. This action simultaneously decreases the company's cash (a current asset) and reduces its equity (by either retiring the shares or holding them as treasury stock). The net effect is a reduction in total assets and total equity on the balance sheet. EPS would likely increase as the same earnings are now divided by fewer shares.

Solution:

False. The goal of the firm should be to maximize **shareholder wealth**, which is reflected in the market price of the common stock. Maximizing EPS is a short-sighted goal that ignores risk, the timing of cash flows, and can be manipulated by accounting policies.

Solution:

False. Operating leverage arises because of **fixed operating costs**. Financial leverage arises because of fixed interest costs.

Solution:

False. The IRR method implicitly assumes that the intermediate cash inflows are reinvested at the **IRR itself**. This is often an unrealistic assumption, as the IRR may be very high. The NPV method is superior because it assumes cash flows are reinvested at the firm's required rate of return (cost of capital), which is a more realistic assumption.

Solution:

False. The market price of a bond moves in the **opposite direction** of market interest rates. When interest rates rise, a bond's fixed coupon payment becomes less attractive compared to new bonds with higher coupon rates, causing the price of the existing bond to fall. Conversely, when interest rates fall, the price of the bond rises.

Solution:

False. In a rights offering, a shareholder has three options: (1) exercise the rights and buy new shares, (2) sell the rights to another party, or (3) let the rights expire. If the shareholder does nothing, the rights will expire worthless, resulting in a loss. They can't "dispose" of them without taking some action (either selling or exercising).

Solution:

The correct matches are as follows:

• **(1) Crowd funding** matches with **(b) Financing decision**. Crowd funding is a method of raising capital by gathering small amounts of money from a large number of people, making it a financing decision for a firm.
• **(2) Coefficient of variation** matches with **(c) Measures of risk**. The coefficient of variation is a statistical measure of relative dispersion that quantifies the amount of risk per unit of expected return.
• **(3) Target capital structure** matches with **(e) It is the debt-equity ratio that the firm strives to achieve**. A firm's target capital structure is the desired mix of debt and equity that it aims to maintain over time.
• **(4) Dividend payout ratio** matches with **(h) Dividend per share divided by earnings per share**. The dividend payout ratio is the proportion of earnings paid out as dividends to shareholders.
• **(5) Baumol model** matches with **(i) Cash management**. The Baumol model is an economic model used in cash management to determine the optimal cash balance for a firm to hold.

Solution:

Understanding financial management is essential for anyone, regardless of their career path. While you may not become a financial manager, you will likely interact with financial concepts in your personal and professional life.

In your personal life, a grasp of financial management helps you with personal financial planning, including managing your budget, saving for retirement, and making informed investment decisions. It also helps you understand a firm's perspective, such as when you are making a decision about taking on debt (like a car or home loan).

Professionally, a basic understanding of financial management is crucial for all managers. A marketing manager needs to understand how their advertising campaigns affect sales and profit margins. An operations manager needs to be able to assess the financial viability of new equipment. Even in a non-managerial role, understanding the financial health of your company helps you understand the context of business decisions, such as a round of layoffs or a new expansion project.

Solution:

Given: $D_0 = \text{Tk. } 1$, $P_0 = \text{Tk. } 20$, $g = 6\% = 0.06$.

i. Implied yield:

The implied yield is the required rate of return, which we can find using the Gordon Growth Model formula:

First, we need to calculate $D_1$: $D_1 = D_0 \times (1+g) = 1.00 \times (1.06) = \text{Tk. } 1.06$

$k_e = \frac{1.06}{20} + 0.06 = 0.053 + 0.06 = 0.113$ or $11.3\%$

The implied yield is **11.3%**.

ii. Expected dividend yield:

The dividend yield is the next period's dividend divided by the current price.

The expected dividend yield is **5.3%**.

iii. Expected capital gains yield:

In the Gordon Growth Model, the capital gains yield is equal to the constant growth rate.

The expected capital gains yield is **6%**.

Solution:

i. Required rate of return (CAPM):

We use the Capital Asset Pricing Model formula to find the required rate of return ($k_e$).

Given: $R_f = 8\%$, $R_M = 13\%$, $\beta = 1.45$.

$k_e = 0.08 + 1.45 \times (0.13 - 0.08) = 0.08 + 1.45 \times 0.05 = 0.08 + 0.0725 = 0.1525$ or $15.25\%$

The required rate of return is **15.25%**.

ii. Present market price per share:

We use the Gordon Growth Model with the required return from part (i).

Given: $D_0 = \text{Tk. } 2$, $g = 10\%$.

$D_1 = D_0 \times (1+g) = 2 \times 1.10 = \text{Tk. } 2.20$

$P_0 = \frac{2.20}{0.1525 - 0.10} = \frac{2.20}{0.0525} \approx \text{Tk. } 41.90$

The present market price is approximately **Tk. 41.90**.

iii. Impact of beta change:

If beta changes to 0.80, the new required return is:

$k_{e\_new} = 0.08 + 0.80 \times (0.13 - 0.08) = 0.08 + 0.80 \times 0.05 = 0.08 + 0.04 = 0.12$ or $12\%$

The new market price is:

$P_{0\_new} = \frac{2.20}{0.12 - 0.10} = \frac{2.20}{0.02} = \text{Tk. } 110.00$

The required return would **decrease** to 12%, and the market price per share would **increase** to Tk. 110.00.

Solution:

The "Rule of 72" is a **useful approximation**, but it is not perfectly accurate. It is a simple and easy-to-remember rule of thumb that helps investors and financial planners quickly estimate the time it takes for an investment to double in value at a given compound interest rate. The rule is most accurate for interest rates in the range of 6% to 10%.

To check its accuracy, we can use the formula for future value: $FV = PV \times (1+r)^n$.

• For 6% interest: $2 = (1.06)^{12}$. A calculator shows $(1.06)^{12} \approx 2.0122$. The rule is very accurate here.
• For 12% interest: $2 = (1.12)^6$. A calculator shows $(1.12)^6 \approx 1.9738$. The rule is slightly less accurate here.

While the rule is not perfect, its simplicity makes it a valuable tool for quick estimations, especially in a world where mental math is becoming less common. It is a good starting point for understanding the power of compounding interest.

Solution:

We will analyze Shine Company's performance by calculating key financial ratios for each of the three years.

Liquidity Ratios:

• **Current Ratio** ($=\frac{\text{Current Assets}}{\text{Current Liabilities}}$):
  • 20X1: $\frac{30,000+200,000+400,000}{230,000+100,000+300,000} = \frac{630,000}{630,000} = 1.00$
  • 20X2: $\frac{20,000+260,000+480,000}{300,000+210,000} = \frac{760,000}{510,000} = 1.49$
  • 20X3: $\frac{5,000+290,000+600,000}{380,000+140,000+300,000} = \frac{895,000}{820,000} = 1.09$
• **Quick Ratio** ($=\frac{\text{Current Assets - Inventory}}{\text{Current Liabilities}}$):
  • 20X1: $\frac{630,000 - 400,000}{630,000} = 0.36$
  • 20X2: $\frac{760,000 - 480,000}{510,000} = 0.55$
  • 20X3: $\frac{895,000 - 600,000}{820,000} = 0.36$

Leverage Ratios:

• **Debt-to-Equity** ($=\frac{\text{Total Debt}}{\text{Total Equity}}$):
  • 20X1: $\frac{230,000+100,000+300,000+100,000}{500,000+200,000} = \frac{730,000}{700,000} = 1.04$
  • 20X2: $\frac{300,000+210,000+100,000+300,000}{550,000+100,000} = \frac{910,000}{650,000} = 1.40$
  • 20X3: $\frac{380,000+140,000+300,000+225,000}{550,000+100,000} = \frac{1,045,000}{650,000} = 1.61$

Activity Ratios:

• **Inventory Turnover** ($=\frac{\text{Cost of Goods Sold}}{\text{Inventory}}$):
  • 20X1: $\frac{3,200,000}{400,000} = 8.0$ times
  • 20X2: $\frac{3,600,000}{480,000} = 7.5$ times
  • 20X3: $\frac{3,300,000}{600,000} = 5.5$ times

Profitability Ratios:

• **Net Profit Margin** ($=\frac{\text{Net Profit}}{\text{Sales}}$):
  • 20X1: $\frac{300,000}{4,000,000} = 7.5\%$
  • 20X2: $\frac{200,000}{4,300,000} = 4.65\%$
  • 20X3: $\frac{100,000}{3,800,000} = 2.63\%$

Analysis and Problems:

The company appears to be facing significant problems. The **liquidity ratios** (Current and Quick) show a downward trend, indicating that the company's ability to meet its short-term obligations is deteriorating. The **leverage ratio** (Debt-to-Equity) has been steadily increasing, suggesting that the company is taking on more debt. This, combined with falling liquidity, is a major concern. The **inventory turnover** ratio is also declining, which could mean that inventory is becoming obsolete or that the company is holding too much stock. Most importantly, the **net profit margin** has been consistently falling, from 7.5% in 20X1 to just 2.63% in 20X3. This suggests that the company's profitability is in a severe and worsening state. Management needs to address the declining profitability and increasing leverage immediately.

Solution:

The IRR method's assumption that intermediate cash flows are reinvested at the IRR is likely to lead to a seriously biased measure of a project's economic return under two primary circumstances:

• **When the project's IRR is very high or very low.** If a project has an extremely high IRR (e.g., 50% or more), it is highly improbable that the firm can consistently reinvest the cash flows generated by the project at that same high rate. In such a case, the IRR method would overstate the true profitability of the project. Conversely, a very low or negative IRR would imply a negative reinvestment rate, which is also unrealistic.
• **When comparing mutually exclusive projects with significantly different cash flow patterns or lifespans.** The IRR reinvestment assumption can lead to a conflict between the IRR and NPV methods. The NPV method, which assumes reinvestment at the firm's cost of capital, is generally considered to be the more reliable measure for comparing mutually exclusive projects, as the firm can realistically reinvest cash flows at its cost of capital.

Solution:

Given: Loan amount = Tk. 100,000, Tax rate = 28% = 0.28.

i. After-tax cost of borrowing from the boat dealership:

The interest on this loan is not tax deductible. Therefore, the after-tax cost is the same as the before-tax cost.

Interest rate = 8%

After-tax cost = **8%**.

ii. After-tax cost of borrowing through a second mortgage:

The interest on this loan is tax deductible. The after-tax cost is the interest rate multiplied by (1 - tax rate).

Interest rate = 9.2%

After-tax cost = $9.2\% \times (1 - 0.28) = 9.2\% \times 0.72 \approx 6.624\%$

The after-tax cost is approximately **6.62%**.

iii. Less costly source of borrowing:

The after-tax cost of borrowing from the boat dealership is 8%, while the after-tax cost of the second mortgage is 6.62%. Since the after-tax cost of the second mortgage is lower, it is the less costly source of borrowing for the Stark family.

Solution:

Given:
Veblen (Unlevered): Operating Income = Tk. 580,000; Market Value of Stock = Tk. 4,500,000.
Knight (Levered): Operating Income = Tk. 580,000; Interest = Tk. 84,000; Market Value of Stock = Tk. 3,450,000; Market Value of Debt = Tk. 1,400,000.
Investor's borrowing rate = 6%.

i. Arbitrage Strategy Comparison:

We need to compare the dollar return of two investment strategies with the same initial cost.

Strategy A: Buy 5% of Knight's equity

Initial cost = $0.05 \times \text{Market Value of Knight Stock} = 0.05 \times 3,450,000 = \text{Tk. } 172,500$

Annual return = $0.05 \times (\text{EBIT} - \text{Interest}) = 0.05 \times (580,000 - 84,000) = 0.05 \times 496,000 = \text{Tk. } 24,800$

Strategy B: Create "homemade leverage" by buying 5% of Veblen's equity and borrowing.

To match the initial cost of Strategy A, the investor needs to borrow.

Initial cost of Veblen equity = $0.05 \times \text{Market Value of Veblen Stock} = 0.05 \times 4,500,000 = \text{Tk. } 225,000$

To match the initial cost of Strategy A, the investor must borrow: $225,000 - 172,500 = \text{Tk. } 52,500$

Annual interest on loan = $52,500 \times 0.06 = \text{Tk. } 3,150$

Annual return = $(0.05 \times \text{EBIT}) - \text{Interest on loan} = (0.05 \times 580,000) - 3,150 = 29,000 - 3,150 = \text{Tk. } 25,850$

The return from Strategy B (Tk. 25,850) is greater than the return from Strategy A (Tk. 24,800). Therefore, the investor **can increase his dollar return** by purchasing Veblen's equity with homemade leverage.

ii. Investor choice and when the process ceases:

Investors will choose **Strategy B** because it provides a higher return for the same initial cost. This process, known as MM arbitrage, will continue until the market values of the two firms are in equilibrium, which, according to MM's theory, implies that the values of the two firms should be equal ($V_L=V_U$). As more investors sell Knight stock and buy Veblen stock, the price of Knight's stock will fall, and the price of Veblen's stock will rise, until the arbitrage opportunity is eliminated and the total market values of both firms are the same. This happens when the cost of equity for the levered firm increases to exactly offset the lower cost of debt, keeping the WACC constant.

Solution:

We will compare the two options (Lease vs. Buy) by calculating the Net Present Value of Cost (NPVC). The discount rate is the after-tax cost of debt.

After-tax cost of debt = $9\% \times (1 - 0.35) = 5.85\% = 0.0585$.

Analysis of Buying:

The cash flows from buying include the initial cost, the depreciation tax shield, and the after-tax interest payments.

Initial Cost = Tk. 2,800,000

Annual Depreciation = $\frac{2,800,000}{4} = \text{Tk. } 700,000$

Depreciation Tax Shield = $700,000 \times 0.35 = \text{Tk. } 245,000$ per year.

After-tax interest payments:

Year	Beginning Balance	Interest (9%)	Interest Tax Shield (35%)	After-Tax Interest
1	2,800,000	252,000	88,200	163,800
2	2,100,000	189,000	66,150	122,850
3	1,400,000	126,000	44,100	81,900
4	700,000	63,000	22,050	40,950

NPVC of Buying = PV of Initial Cost - PV of Depreciation Tax Shield - PV of After-Tax Interest.

PV of Depreciation Tax Shield = $245,000 \times \left[ \frac{1 - (1.0585)^{-4}}{0.0585} \right] = 245,000 \times 3.486 \approx \text{Tk. } 854,070$

PV of After-tax Interest = $\frac{163,800}{1.0585} + \frac{122,850}{1.0585^2} + \frac{81,900}{1.0585^3} + \frac{40,950}{1.0585^4} = 154,756 + 109,566 + 69,183 + 32,586 \approx \text{Tk. } 366,091$

$NPVC_{Buy} = 2,800,000 - 854,070 - 366,091 = \text{Tk. } 1,579,839$

Analysis of Leasing:

Lease payments are Tk. 830,000 per year, paid in advance. After-tax lease payment = $830,000 \times (1-0.35) = \text{Tk. } 539,500$.

NPVC of Leasing = PV of After-tax Lease Payments (annuity due).

PV of Payments = $539,500 + 539,500 \times \left[ \frac{1 - (1.0585)^{-3}}{0.0585} \right] = 539,500 + 539,500 \times 2.673 \approx 539,500 + 1,440,943 = \text{Tk. } 1,980,443$

$NPVC_{Lease} = \text{Tk. } 1,980,443$

i. Should Wolfson lease or buy?

The NPVC of buying (Tk. 1,579,839) is less than the NPVC of leasing (Tk. 1,980,443). Therefore, Wolfson should **buy** the machine with bank financing.

ii. Annual lease payment for indifference:

To be indifferent, the PV cost of leasing must equal the PV cost of buying.

$PV \text{ of After-tax lease payments} = NPVC_{Buy} = 1,579,839$

Let PMT be the annual lease payment.

$1,579,839 = PMT \times (1-0.35) \times \left[ 1 + \frac{1 - (1.0585)^{-3}}{0.0585} \right]$

$1,579,839 = PMT \times 0.65 \times [1 + 2.673]$

$1,579,839 = PMT \times 0.65 \times 3.673$

$PMT = \frac{1,579,839}{2.387} \approx \text{Tk. } 661,868$

The annual lease payment that would make Wolfson indifferent is approximately **Tk. 661,868**.

Solution:

Duracell's proposal to open manufacturing plants in Bangladesh and India offers several advantages and also carries some risks.

Additional Advantages:

• **Lower Labor Costs:** These countries typically have a lower cost of labor compared to developed countries, which can significantly reduce the overall cost of production.
• **Proximity to Raw Materials:** Locating plants closer to raw material sources (if available) can reduce transportation costs and logistics complexity.
• **Access to New Markets:** Manufacturing locally allows Duracell to better serve the large and growing consumer markets in these countries, which were previously difficult to penetrate due to high import duties.
• **Improved Supply Chain Efficiency:** Shorter supply chains can reduce lead times and inventory costs.

Risks:

• **Political and Regulatory Risk:** The political and regulatory environment in these countries may be less stable. Changes in government policy, tax laws, or the risk of expropriation could negatively impact the investment.
• **Currency Risk:** Fluctuations in exchange rates between the local currency and the home currency can impact the value of repatriated profits.
• **Operational Risk:** Managing operations in a foreign country can be challenging due to cultural differences, local laws, and a potentially less-developed infrastructure.
• **Reputational Risk:** A company's reputation can be damaged by negative publicity related to labor practices or environmental issues in a host country.

Solution:

We need to compare the cost of subscribing to the credit agency with the potential benefits (avoiding bad debts).

Cost of subscribing to the agency:

Fixed Cost = Tk. 950

Variable Cost = Tk. 15 per report

Number of reports = 700 bicycles

Total Cost of agency = $950 + (15 \times 700) = 950 + 10,500 = \text{Tk. } 11,450$

Benefit of subscribing to the agency:

The benefit is the value of the bad debts that the company can avoid by identifying the customers who will not pay.

Number of bad debtors = $700 \times 0.04 = 28$ customers

Loss per bicycle (cost) = Tk. 650

Total bad-debt losses without agency = $28 \times 650 = \text{Tk. } 18,200$

Benefit = Tk. 18,200

Conclusion:

Since the cost of the agency (Tk. 11,450) is less than the benefit of avoiding bad debts (Tk. 18,200), the owner **should subscribe to the agency**. The net benefit is $18,200 - 11,450 = \text{Tk. } 6,750$.

Solution:

Number of checks per month = 5,450

Number of Tk. 55 checks = $5,450 \times 0.70 = 3,815$

Number of Tk. 80 checks = $5,450 \times 0.30 = 1,635$

i. Average daily collection float:

Float from Tk. 55 checks = $3,815 \times 55 \times 2 = \text{Tk. } 419,650$

Float from Tk. 80 checks = $1,635 \times 80 \times 3 = \text{Tk. } 392,400$

Total monthly float = $419,650 + 392,400 = \text{Tk. } 812,050$

Assuming 30 days in a month, average daily float = $\frac{812,050}{30} \approx \text{Tk. } 27,068$

This means that on any given day, approximately **Tk. 27,068** is tied up in the check-clearing process and is not available for the firm's use.

ii. Weighted average delay and average daily float:

Weighted average delay = $(0.70 \times 2 \text{ days}) + (0.30 \times 3 \text{ days}) = 1.4 + 0.9 = 2.3$ days

Average daily receipts = $\frac{(3,815 \times 55) + (1,635 \times 80)}{30} = \frac{209,825 + 130,800}{30} = \frac{340,625}{30} \approx \text{Tk. } 11,354$

Average daily float = Average daily receipts $\times$ Weighted average delay

= $11,354 \times 2.3 \approx \text{Tk. } 26,114.2$

The average daily float is approximately **Tk. 26,114**.

iii. Amount to pay to eliminate the float:

The firm should be willing to pay an amount up to the amount of the float it can eliminate. To eliminate the entire float, the firm should be willing to pay up to the average daily float, which is **Tk. 26,114**.

iv. Daily cost of the float:

Daily cost = Average daily float $\times$ Daily interest rate

Daily interest rate = $\frac{7\%}{365} = 0.00019178$

Daily cost = $26,114 \times 0.00019178 \approx \text{Tk. } 5.01$

The daily cost of the float is approximately **Tk. 5.01**.

v. Amount to pay to reduce float by 1.5 days:

Reduction in float = Average daily receipts $\times$ Reduction in delay

Reduction in float = $11,354 \times 1.5 = \text{Tk. } 17,031$

The firm should be willing to pay up to the amount of the float it can eliminate, which is approximately **Tk. 17,031**.