CMA September 2022 Examination Solutions

Solution:

We can use the DuPont formula identity: $ROA = \text{Net Profit Margin} \times \text{Total Asset Turnover}$. We are given: ROA = 8% = 0.08, and Net Profit Margin = 5% = 0.05. We can rearrange the formula to solve for Total Asset Turnover.

Total Asset Turnover = $\frac{0.08}{0.05} = 1.60$

The correct answer is **(a) 1.60**.

Solution:

The correct answer is **(a) based on the systematic risk of the security**. CAPM is a model that links a security's expected return to its systematic risk, which is measured by beta. The premium is the market risk premium multiplied by the security's beta, which quantifies the systematic risk.

Solution:

We can use the Gordon Growth Model (or Dividend Discount Model) to find the required return ($k_e$).

Given: $P_0 = \text{Tk. } 100$, $D_1 = \text{Tk. } 4$, $g = 5\% = 0.05$. We rearrange the formula to solve for $k_e$:

$k_e = \frac{D_1}{P_0} + g = \frac{4}{100} + 0.05 = 0.04 + 0.05 = 0.09$ or $9\%$.

The market's required return is **(b) 9 percent**.

Solution:

We can use the future value formula for a lump sum to find the annual growth rate ($r$).

Given: FV = Tk. 1,000, PV = Tk. 250, n = 16 years. We rearrange to solve for $r$:

$(1+r)^{16} = \frac{1,000}{250} = 4$

$1+r = (4)^{1/16} \approx 1.08987$

$r = 1.08987 - 1 = 0.08987$ or $8.987\%$

The closest answer is **(b) 9 percent**.

Solution:

The correct answer is **(c) it is collecting credit sales more quickly than before**. The receivable turnover ratio is calculated as $\frac{\text{Credit Sales}}{\text{Average Accounts Receivable}}$. An increase in this ratio indicates that a firm is collecting its receivables more efficiently, or in fewer days. This could be due to a more stringent credit policy or a more efficient collection department.

Solution:

The correct answer is **(c) If the Pl of a project is less than 1, its NPV should be less than 0**. The Profitability Index (PI) is calculated as $\frac{\text{PV of Future Cash Flows}}{\text{Initial Investment}}$. The Net Present Value (NPV) is calculated as PV of Future Cash Flows - Initial Investment. If PI < 1, it means the PV of future cash flows is less than the initial investment, which results in a negative NPV.

Solution:

The correct answer is **(d) to issue new bonds at higher rate of interest**. Refunding bonds is the process of replacing existing bonds with new ones. A company would typically do this to lower interest costs (by issuing new bonds at a lower rate), eliminate restrictive covenants from the old bonds, or use surplus cash to redeem bonds. Issuing new bonds at a higher rate would be illogical as it would increase the company's cost of debt.

Solution:

The correct answer is **(d) underwriting**. In an underwriting arrangement, the investment banker agrees to purchase all the securities from the issuer and then resells them to the public. The banker thus bears the risk of not being able to sell the entire issue at the target price. In a "best efforts" offering, the banker simply tries their best to sell the securities but doesn't guarantee the sale.

Solution:

The correct answer is **(d) Cash management**. Float refers to the difference between the balance shown in a firm's bank account ledger and the balance shown in its books. It is caused by delays in the check-clearing process and is a key concept in managing a firm's cash position.

Solution:

The correct answer is **(e) market price per share do not change after the split**. This is the only statement that is not true. A stock split is a corporate action that increases the number of shares outstanding while reducing the par value and the market price per share proportionally. Total equity and proportional ownership remain unchanged, but the price per share is reduced to make the stock more accessible to a wider range of investors.

Solution:

False. The operating break-even point is the point at which **operating profits are zero**. This occurs when a firm's sales revenues are exactly equal to its total operating costs (fixed costs + variable costs).

Solution:

True. An aggressive working capital policy is characterized by low levels of current assets (such as cash and inventory) relative to sales, which leads to lower liquidity but frees up capital for more profitable investments. This policy inherently carries a higher risk of being unable to meet short-term obligations, but it also has a higher potential for profitability.

Solution:

False. A call provision allows the **issuer** of a security to redeem or "call" the security at a pre-specified price. It is the bondholder's counterpart, the put provision, that allows the purchaser to demand repayment of the principal.

Solution:

True. This is the definition of the law of one price, which is the foundation of the purchasing-power parity theory. It suggests that, in the absence of trade barriers, transaction costs, and other factors, the price of an identical good or service in different countries should be the same when expressed in a common currency.

Solution:

False. The Security Market Line (SML) describes the relationship between a security's expected return and its **systematic risk**, which is measured by beta ($\beta$). The relationship between a security's return and the market's return is described by the **characteristic line**.

Solution:

The correct matches are as follows:

• **(1) Measure of Solvency** matches with **(b) Interest coverage ratio**. The interest coverage ratio measures a firm's ability to meet its long-term interest obligations, which is a key measure of solvency.
• **(2) Mutual fund** matches with **(d) Capital market instrument**. Mutual funds invest in a portfolio of capital market securities like stocks and bonds.
• **(3) Treasury stock** matches with **(f) Buy-back own stock**. Treasury stock refers to shares of stock that a company repurchases from the open market.
• **(4) Net income approach** matches with **(g) Capital structure theory**. The net income approach is a theory of capital structure that suggests a firm's value is maximized at a specific debt-to-equity ratio where the cost of capital is minimized.
• **(5) Yield to maturity** matches with **(j) Cost of debt**. The yield to maturity is the market's required rate of return on a bond, and it represents the firm's cost of new debt.

Solution:

Maximizing a company's share price is the primary goal of financial management because it is a direct measure of **shareholder wealth**. Share price maximization is a more comprehensive and superior objective than sales maximization for the following reasons:

• **Considers risk:** Share price reflects the market's perception of a company's risk. A project that generates high sales but also carries high risk will likely be penalized by the market, leading to a lower share price. Sales maximization, on the other hand, ignores risk entirely.
• **Considers the time value of money:** Share price is a function of the discounted value of all future cash flows. It correctly accounts for the timing of cash flows, recognizing that a taka today is worth more than a taka tomorrow. Sales maximization disregards this crucial concept.
• **Focuses on long-term value:** Sales maximization can lead to short-term decisions that boost sales at the expense of profitability and long-term value, such as offering steep discounts or extending overly generous credit terms. Share price maximization encourages management to focus on sustainable, long-term growth and profitability.
• **Incentivizes management alignment:** A company's management is a team of agents for its shareholders (the principals). By aligning management's incentives (e.g., through stock options) with the goal of maximizing share price, the firm ensures that managers' decisions are in the best interest of the owners. Sales maximization can lead to sub-optimal decisions that benefit managers but not shareholders.

Solution:

i. Subjective comparison:

On a subjective basis, Annuity X seems more attractive. Although the annual payments are lower, it is an annuity due, which means the payments are received earlier. The time value of money suggests that receiving money sooner is better because it can be reinvested to earn more. Therefore, the earlier payments of Annuity X should be more valuable.

ii. Future value calculation:

We need to find the future value of each annuity at the end of year 6 at a 15% interest rate.

Future Value of an Ordinary Annuity ($FV_Y$) = $PMT \times \left[ \frac{(1+i)^n - 1}{i} \right]$

$FV_Y = 10,000 \times \left[ \frac{(1.15)^6 - 1}{0.15} \right] = 10,000 \times \left[ \frac{2.31306 - 1}{0.15} \right] = 10,000 \times 8.7537 \approx \text{Tk. } 87,537$

Future Value of an Annuity Due ($FV_X$) = $PMT \times \left[ \frac{(1+i)^n - 1}{i} \right] \times (1+i)$

$FV_X = 9,000 \times 8.7537 \times 1.15 \approx \text{Tk. } 90,416$

The future value of Annuity Y is approximately Tk. 87,537, and the future value of Annuity X is approximately Tk. 90,416.

iii. Conclusion and comparison:

Based on the future value calculation, **Annuity X is more attractive**. Its future value of Tk. 90,416 is higher than Annuity Y's future value of Tk. 87,537. This is because, even with a lower annual payment, the payments of Annuity X begin a year earlier, allowing them to compound for an extra period. This finding aligns with the subjective response, confirming that the early receipt of cash flows is indeed a significant advantage.

Solution:

Given: $D_0 = \text{Tk. } 1.80$, $k_e = 12\% = 0.12$.

i. 0% dividend growth:

This is a perpetuity, where the dividend remains constant.

The value of the stock is **Tk. 15.00**.

ii. 5% constant dividend growth:

We use the Gordon Growth Model.

$D_1 = D_0 \times (1+g) = 1.80 \times (1.05) = \text{Tk. } 1.89$

The value of the stock is **Tk. 27.00**.

iii. Non-constant dividend growth:

We need to find the present value of the dividends for the first three years, and then find the present value of the terminal value.

• $D_1 = D_0 \times (1.05)^1 = 1.80 \times 1.05 = \text{Tk. } 1.89$
• $D_2 = D_1 \times (1.05)^1 = 1.89 \times 1.05 = \text{Tk. } 1.9845$
• $D_3 = D_2 \times (1.05)^1 = 1.9845 \times 1.05 = \text{Tk. } 2.0837$

Now, we find the price at the end of year 3 ($P_3$) using the constant growth model with a growth rate of 4% ($g=0.04$).

$D_4 = D_3 \times (1.04) = 2.0837 \times 1.04 = \text{Tk. } 2.1670$

$P_3 = \frac{D_4}{k_e - g} = \frac{2.1670}{0.12 - 0.04} = \frac{2.1670}{0.08} = \text{Tk. } 27.0875$

Finally, we find the present value of all cash flows.

$P_0 = \frac{D_1}{1+k_e} + \frac{D_2}{(1+k_e)^2} + \frac{D_3}{(1+k_e)^3} + \frac{P_3}{(1+k_e)^3}$

$= \frac{1.89}{1.12} + \frac{1.9845}{1.12^2} + \frac{2.0837}{1.12^3} + \frac{27.0875}{1.12^3}$

$= 1.6875 + 1.5833 + 1.4851 + 19.3094 \approx \text{Tk. } 24.0653$

The value of the stock is approximately **Tk. 24.07**.

Solution:

First, we need to calculate the earnings available to common shareholders.

Profit Before Tax = Tk. 40,000

Tax (25%) = $40,000 \times 0.25 = \text{Tk. } 10,000$

Profit After Tax = $40,000 - 10,000 = \text{Tk. } 30,000$

Dividend on Preference Shares = $18,000 \text{ shares} \times \text{Tk. } 0.30/\text{share} = \text{Tk. } 5,400$

Earnings available to common shareholders = Profit After Tax - Preference Dividend

= $30,000 - 5,400 = \text{Tk. } 24,600$

Number of ordinary shares = 15,000

i. Dividend cover:

Dividend cover = $\frac{\text{Earnings available to common shareholders}}{\text{Dividends paid to common shareholders}}$

Dividends paid = $15,000 \text{ shares} \times \text{Tk. } 0.45/\text{share} = \text{Tk. } 6,750$

Dividend cover = $\frac{24,600}{6,750} \approx 3.64$ times

ii. Earnings per share (EPS):

EPS = $\frac{\text{Earnings available to common shareholders}}{\text{Number of ordinary shares}}$

EPS = $\frac{24,600}{15,000} = \text{Tk. } 1.64$

iii. Price-earnings ratio (P/E):

P/E ratio = $\frac{\text{Market price per share}}{\text{Earnings per share}}$

P/E ratio = $\frac{45}{1.64} \approx 27.44$ times

Solution:

i. Appraise Project PA205 using the NPV criteria:

We need to find the present value of the cash flows. The cash flows are given in real terms, and the discount rate is a money rate. We must first inflate the cash flows to nominal terms. Inflation rate = 15% = 0.15. Money rate = 25% = 0.25.

PV of Cash flows = $\frac{5,000(1.15)^1}{1.25^1} + \frac{10,500(1.15)^2}{1.25^2} + \frac{25,000(1.15)^3}{1.25^3} + \frac{28,000(1.15)^4}{1.25^4} + \frac{30,000(1.15)^5}{1.25^5} + \text{PV of perpetuity}$

First, we find the real rate of return ($r_{real}$) using the Fisher equation: $(1 + r_{real}) = \frac{1+r_{money}}{1+i} = \frac{1.25}{1.15} \approx 1.08696$. So, $r_{real} \approx 8.7\%$.

PV of cash flows = $\frac{5,000}{1.087} + \frac{10,500}{1.087^2} + \frac{25,000}{1.087^3} + \frac{28,000}{1.087^4} + \frac{30,000}{1.087^5} + \frac{\frac{30,000}{0.087}}{1.087^5}$

$= 4,599.8 + 8,837.2 + 19,410.5 + 20,019.2 + 19,730.2 + \frac{344,827.6}{1.5173} = 72,596.9 + 227,261.2 = \text{Tk. } 299,858$

$NPV_{PA205} = 299,858 - 150,000 = \text{Tk. } 149,858$

Since the NPV is positive, Project PA205 should be accepted. The NPV is approximately **Tk. 149,858**.

ii. Capital rationing advice:

First, we need to find the Profitability Index (PI) for each project.

To rank the projects, we assume the investments are mutually exclusive and we have a budget of Tk. 200,000.

Project	Initial Investment	NPV	PI
PA202	75,000	98,500	$\frac{75,000+98,500}{75,000} = 2.31$
PA204	85,000	95,400	$\frac{85,000+95,400}{85,000} = 2.12$
PA201	50,000	85,200	$\frac{50,000+85,200}{50,000} = 2.70$
PA203	48,000	65,950	$\frac{48,000+65,950}{48,000} = 2.37$
PA205	150,000	149,858	$\frac{150,000+149,858}{150,000} = 2.00$

Based on PI ranking, the order is PA201 > PA203 > PA202 > PA204 > PA205.

1. **Independent and divisible:**

   The company should fund projects in the order of their PI until the budget is exhausted.

   • Fund PA201 (Tk. 50,000). Remaining budget: Tk. 150,000.
   • Fund PA203 (Tk. 48,000). Remaining budget: Tk. 102,000.
   • Fund PA202 (Tk. 75,000). Remaining budget: Tk. 27,000.

   The company can then take a fraction of the next project, PA204.

   Total NPV = $85,200 + 65,950 + 98,500 + (\frac{27,000}{85,000} \times 95,400) = 249,650 + 30,344 = \text{Tk. } 279,994$

   The company should implement projects PA201, PA203, and PA202, and take a fraction of PA204.

2. **Independent and indivisible:**

   We must select a combination of projects that fits within the budget and maximizes total NPV.

   • PA201 (Tk. 50,000) + PA203 (Tk. 48,000) + PA202 (Tk. 75,000) = Tk. 173,000. Total NPV: $85,200 + 65,950 + 98,500 = \text{Tk. } 249,650$.
   • PA201 (Tk. 50,000) + PA203 (Tk. 48,000) + PA204 (Tk. 85,000) = Tk. 183,000. Total NPV: $85,200 + 65,950 + 95,400 = \text{Tk. } 246,550$.
   • PA201 (Tk. 50,000) + PA202 (Tk. 75,000) = Tk. 125,000. Total NPV: $85,200 + 98,500 = \text{Tk. } 183,700$.

   The best combination is to implement **PA201, PA203, and PA202** for a total NPV of Tk. 249,650.

iii. Dealing with capital rationing:

• **Increase the capital budget:** If profitable projects are being rejected, management should reconsider the constraints and, if possible, raise more capital through debt or equity to fund all projects with a positive NPV.
• **Lease instead of buy:** For projects requiring a large initial outlay for an asset, the company could consider leasing the asset instead of buying it. This would reduce the initial investment and free up capital for other projects.
• **Use a profitability index:** When a budget constraint exists, the profitability index (PI) should be used to rank and select projects that maximize the total NPV for a given budget. This is a more robust method than simply selecting projects with the highest NPV.
• **Postpone projects:** If a project has a positive NPV but cannot be funded due to the current budget constraint, the company could postpone the project until a future period when capital is more readily available. This is better than permanently rejecting a value-adding project.

Solution:

i. Cost of retained earnings financing ($k_{re}$):

The cost of retained earnings is the same as the cost of equity, which can be found using the Gordon Growth Model.

Given: $D_0 = \text{Tk. } 1.26$, $P_0 = \text{Tk. } 40$, $g = 6\% = 0.06$.

$D_1 = D_0 \times (1+g) = 1.26 \times 1.06 = \text{Tk. } 1.3356$

$k_{re} = \frac{1.3356}{40} + 0.06 = 0.03339 + 0.06 = 0.09339$ or $9.34\%$

The cost of retained earnings is **9.34%**.

ii. Cost of new common stock financing ($k_n$):

The cost of new common stock considers flotation costs.

Net proceeds per share ($N_p$) = $P_0 - \text{Flotation costs} = 40 - 7 = \text{Tk. } 33$

The cost of new common stock is **10.45%**.

iii. Cost of preferred stock financing ($k_p$):

The cost of preferred stock is the dividend divided by the net proceeds from the sale.

Net proceeds per share = $25 - 3 = \text{Tk. } 22$

The cost of preferred stock is **9.09%**.

iv. Cost of debt financing ($k_d$):

We are given a 10% coupon bond with a Tk. 1,000 par value, sold for Tk. 1,200, with a flotation cost of Tk. 25. The net proceeds are $1,200 - 25 = \text{Tk. } 1,175$.

Annual Coupon Payment = $1,000 \times 0.10 = \text{Tk. } 100$.

$= \frac{100 + \frac{1,000 - 1,175}{5}}{\frac{1,000 + 1,175}{2}} = \frac{100 - 35}{1,087.5} = \frac{65}{1,087.5} \approx 0.05976$ or $5.98\%$

The after-tax cost of debt = $5.98\% \times (1 - 0.40) = 3.59\%$.

The approximate after-tax cost of debt financing is **3.59%**.

Solution:

The CEO's argument is partially correct but oversimplifies the reality of capital structure decisions. It is based on the Modigliani-Miller (MM) theory with corporate taxes, which states that a firm's value increases with leverage due to the interest tax shield. However, a more complete view, incorporating the costs of financial distress, leads to a different conclusion.

My response to the CEO would be as follows:

• **MM Theory (Irrelevance):** The original MM theory (without taxes) suggests that a firm's value is independent of its capital structure. This is because investors can create "homemade leverage" to replicate any capital structure they desire, negating the need for the firm to do so. Under this assumption, increasing debt would have no effect on the company's value.
• **MM Theory (Relevance with Taxes):** The CEO's argument is rooted in the later MM theory that incorporates corporate taxes. In this framework, the tax deductibility of interest payments creates a "tax shield," which increases the value of the firm as it adds debt. The formula is $V_L = V_U + T_C D$, where $V_L$ is the value of the levered firm, $V_U$ is the value of the unlevered firm, $T_C$ is the corporate tax rate, and $D$ is the amount of debt. This model, if taken literally, suggests that a firm should finance with 100% debt to maximize its value.
• **Static Trade-off Theory:** The flaw in the CEO's argument is that it ignores the real-world costs of financial distress, such as bankruptcy and agency costs. As a firm increases its debt, the probability of financial distress rises, which in turn increases the firm's cost of debt and equity. The **static trade-off theory** suggests that the optimal capital structure is a balance between the benefits of the interest tax shield and the costs of financial distress. Beyond a certain point, the costs of adding more debt outweigh the benefits, and the firm's value begins to decline. Therefore, increasing debt may increase the firm's value up to a point, but excessive leverage is detrimental.

In conclusion, while using debt can be beneficial due to the tax shield, it is not a limitless source of value. The company should aim for an optimal capital structure that balances these trade-offs, rather than simply increasing debt to its maximum level. We should carefully analyze the costs and benefits of the proposed debt increase before making a decision.

Solution:

We will use the projected results for 2019 to analyze the leverage of the two firms.

i. Degree of Operating Leverage (DOL):

DOL measures the sensitivity of operating profit (EBIT) to changes in sales. The formula is:

Firm A:

Contribution Margin = $288.00 - 172.80 = \text{Tk. } 115.20 \text{ million}$

EBIT = Tk. 75.20 million

$DOL_A = \frac{115.20}{75.20} \approx 1.53$

Firm B:

Contribution Margin = $223.20 - 44.64 = \text{Tk. } 178.56 \text{ million}$

EBIT = Tk. 50.56 million

$DOL_B = \frac{178.56}{50.56} \approx 3.53$

Advice on Business Risk: Firm B has a significantly higher DOL (3.53) than Firm A (1.53). This indicates that a given percentage change in sales will lead to a much larger percentage change in operating profit for Firm B. This suggests that Firm B has a higher proportion of fixed costs and therefore a higher level of **business risk**. As a result, Firm B should adopt a more conservative capital structure with less debt to offset its high business risk.

ii. Degree of Financial Leverage (DFL):

DFL measures the sensitivity of earnings per share (or profit before tax) to changes in operating profit. The formula is:

Firm A:

EBIT = Tk. 75.20 million

Profit Before Tax = Tk. 40.20 million

$DFL_A = \frac{75.20}{40.20} \approx 1.87$

Firm B:

EBIT = Tk. 50.56 million

Profit Before Tax = Tk. (59.44) million

$DFL_B = \frac{50.56}{-59.44} \approx -0.85$

Advice on Financial Risk: Firm A's DFL is 1.87, which indicates that it can comfortably cover its interest expenses. Firm B's DFL is negative, which means its operating profit is not enough to cover its interest expense, resulting in a loss before tax. This indicates an extremely high level of **financial risk**. The directors should immediately advise Firm B to reduce its debt burden to a more manageable level to avoid financial distress. Firm A's capital structure appears much more stable and appropriate.

Solution:

Given: EBIT = Tk. 1 million, Debt = Tk. 3 million, Interest rate = 15%, Tax rate = 40%.

i. Income available to all security holders:

All-equity-financed:

EBIT = Tk. 1,000,000

Tax (40%) = Tk. 400,000

Net Income = Tk. 600,000

Income to all security holders (only equity) = Net Income = **Tk. 600,000**

Recapitalized:

EBIT = Tk. 1,000,000

Interest Expense = $3,000,000 \times 0.15 = \text{Tk. } 450,000$

EBT = $1,000,000 - 450,000 = \text{Tk. } 550,000$

Tax (40%) = $550,000 \times 0.40 = \text{Tk. } 220,000$

Net Income = $550,000 - 220,000 = \text{Tk. } 330,000$

Income to all security holders = Interest Expense + Net Income = $450,000 + 330,000 = \text{Tk. } 780,000$

Income available to all security holders is **Tk. 780,000**.

ii. Present value of debt tax-shield benefits:

Tax shield = Interest Expense $\times$ Tax Rate = $450,000 \times 0.40 = \text{Tk. } 180,000$

PV of tax shield = $\frac{\text{Tax Shield}}{\text{Interest Rate}} = \frac{180,000}{0.15} = \text{Tk. } 1,200,000$ or $1.2 \text{ million}$

Alternatively, PV of tax shield = $T_C \times D = 0.40 \times 3,000,000 = \text{Tk. } 1,200,000$

The present value of the debt tax-shield benefits is **Tk. 1.2 million**.

iii. Firm's value:

All-equity-financed:

Value of unlevered firm ($V_U$) = $\frac{EBIT \times (1-T)}{k_e}$

Value = $\frac{1,000,000 \times (1-0.40)}{0.20} = \frac{600,000}{0.20} = \text{Tk. } 3,000,000$

The value of the firm is **Tk. 3 million**.

Recapitalized:

Value of levered firm ($V_L$) = $V_U + PV(\text{Tax Shield})$

Value = $3,000,000 + 1,200,000 = \text{Tk. } 4,200,000$

The value of the firm is **Tk. 4.2 million**.

Solution:

BSRM Steel Company has a clientele of investors who value a stable dividend payout. Any financing alternative for the new plant should be evaluated based on its impact on this dividend policy and, consequently, the company's stock value.

• **Option 1: Finance with externally raised equity**

  This option avoids a dividend cut, which is a significant benefit for a company with a stable dividend policy. However, it can lead to a dilution of ownership and earnings per share for existing shareholders. The new project's high return of 30% is a strong point in favor of this option, as it is expected to generate significant future earnings that can offset the negative effects of dilution. Investors may view this as a positive signal, especially if they are growth-oriented.

• **Option 2: 50% internal and 50% external equity**

  This option requires a dividend cut, which would be a major negative signal to the market. For a company like BSRM, whose stock value is heavily influenced by its dividend policy, a dividend cut would likely be interpreted as a sign of financial weakness or a lack of profitable investment opportunities, leading to a significant drop in the stock price. This is likely the least favorable option.

• **Option 3: Mix of debt and equity**

  This is often the most balanced and common approach. It allows the company to maintain its dividend policy, which is crucial for its investor base. The use of debt introduces financial leverage, which can be beneficial if the new project's return of 30% is higher than the cost of debt. This can boost earnings per share and, in turn, the stock price. However, the use of debt also increases financial risk, and management must be careful not to take on an excessive amount of leverage. This option allows the company to capitalize on the tax-advantaged status of interest payments while maintaining a stable dividend.

In conclusion, **Option 3** appears to be the best choice. It allows BSRM to fund a highly profitable project while maintaining its dividend policy and leveraging the benefits of debt. Option 1 is a viable alternative but may be more costly due to flotation costs and the potential for dilution. Option 2 is the riskiest and least desirable option due to the negative signal of a dividend cut.

Solution:

i. Foreign exchange loss to the Bangladeshi buyer:

The Bangladeshi buyer agreed to pay US\$280,000. At the time of the transaction, the Taka equivalent would have been:

Initial Taka value = $280,000 \times 4.20 = \text{Tk. } 1,176,000$

When the payment was made three months later, the Taka value was:

Final Taka value = $280,000 \times 4.60 = \text{Tk. } 1,288,000$

Foreign exchange loss = Final Taka value - Initial Taka value

= $1,288,000 - 1,176,000 = \text{Tk. } 112,000$

The foreign exchange loss to the Bangladeshi buyer was **Tk. 112,000**.

ii. Currency risk in relation to the above:

The situation described is an example of **currency risk**, specifically **transaction exposure**. Transaction exposure is the risk that a company will face a loss in its local currency value due to an unexpected change in the exchange rate between the time a transaction is initiated and the time it is settled. In this case, the Bangladeshi buyer agreed to a price in US dollars. Over the three-month credit period, the US dollar strengthened against the Bangladeshi Taka (i.e., it took more Taka to buy one US dollar). As a result, the buyer had to pay more in their home currency than they had originally anticipated, leading to a financial loss of Tk. 112,000. This is a classic example of how unhedged foreign currency transactions can expose a company to risk.

Solution:

We need to perform an incremental analysis to determine if the proposed change in credit policy and sales is worthwhile. We will compare the additional profit to the additional costs incurred.

Incremental Profit from Sales:

Incremental Sales = New Sales - Old Sales = $30,000,000 - 24,000,000 = \text{Tk. } 6,000,000$

Contribution Margin = $6,000,000 \times (1 - \text{Variable Cost Ratio}) = 6,000,000 \times (1 - 0.70) = \text{Tk. } 1,800,000$

Incremental profit is **Tk. 1,800,000**.

Incremental Costs:

1. Cost of Bad Debts:

New Bad Debts = $30,000,000 \times 0.015 = \text{Tk. } 450,000$

Old Bad Debts = $24,000,000 \times 0.01 = \text{Tk. } 240,000$

Incremental Bad Debts = $450,000 - 240,000 = \text{Tk. } 210,000$

2. Cost of Additional Receivables Investment:

Old Receivables = $\frac{24,000,000 \times 0.70}{12} \times 1 \text{ month} = \text{Tk. } 1,400,000$

New Receivables = $\frac{30,000,000 \times 0.70}{12} \times 2 \text{ months} = \text{Tk. } 3,500,000$

Additional Receivables Investment = $3,500,000 - 1,400,000 = \text{Tk. } 2,100,000$

Cost of this investment = $2,100,000 \times 0.20 = \text{Tk. } 420,000$

Total Incremental Costs = Incremental Bad Debts + Cost of Additional Receivables

= $210,000 + 420,000 = \text{Tk. } 630,000$

Net Incremental Profit:

Net Incremental Profit = Incremental Profit from Sales - Total Incremental Costs

= $1,800,000 - 630,000 = \text{Tk. } 1,170,000$

Recommendation: Since the net incremental profit is a positive amount of **Tk. 1,170,000**, the company should **take on the new customers** as the change in credit policy is worthwhile.