CMA January 2024 Examination Solutions

Solution:

The correct answer is **(e) may increase the firm's risk and drive the price of the shares down**. While financial leverage can magnify returns during good times, it also magnifies losses during bad times. A high degree of leverage means a firm has a large amount of debt and fixed interest payments, which increases the firm's financial risk and can potentially lead to a lower share price.

Solution:

The correct answer is **(d) slightly below the current market price**. New share issues are typically priced at a small discount to the current market price to incentivize investors to purchase the new shares, as they would otherwise simply buy the existing shares in the open market.

Solution:

This problem requires finding the interest rate of an ordinary annuity. The formula is:

Given: PV = Tk. 1,000, PMT = Tk. 263.80, n = 5 years.

$\frac{PV}{PMT} = \frac{1,000}{263.80} \approx 3.7907 = \left[ \frac{1 - (1+i)^{-5}}{i} \right]$

Using a financial calculator or trial and error, we find the interest rate that makes the present value annuity factor approximately 3.7907. Let's test the options:

• @ 8%: Factor = $\frac{1 - (1.08)^{-5}}{0.08} = 3.9927$
• @ 9%: Factor = $\frac{1 - (1.09)^{-5}}{0.09} = 3.8897$
• @ 10%: Factor = $\frac{1 - (1.10)^{-5}}{0.10} = 3.7908$

The interest rate is closest to **(c) 10 percent**.

Solution:

The correct answer is **(c) savings certificate**. Money market instruments are short-term, highly liquid debt securities with maturities of one year or less. Savings certificates, while a form of a savings account, are not typically traded in the money market. Treasury bills, commercial paper, certificates of deposit, and banker's acceptances are all common money market instruments.

Solution:

The correct answer is **(b) the dividends paid by the company grow at a constant rate**. The constant growth model, or Gordon Growth Model, is a method of valuing a stock that assumes dividends will grow at a fixed, constant rate forever. It also assumes that the cost of equity is greater than the growth rate, and that the firm's required return remains constant.

Solution:

The correct answer is **(e) they resolve uncertainty in the minds of investors**. The "bird-in-the-hand" theory suggests that investors prefer a certain dividend today to a potential, but uncertain, capital gain from retained earnings in the future. By paying a dividend, management signals its confidence in the firm's future cash flows, reducing investor uncertainty and potentially increasing the stock's value.

Solution:

The correct answer is **(b) market risk**. In a well-diversified portfolio, unsystematic (or company-specific) risks, such as business risk and financial risk, are largely eliminated. The only remaining risk is market risk (also known as systematic risk), which is the risk that affects the entire market and cannot be diversified away. Interest rate risk and inflation risk are components of market risk.

Solution:

The correct answer is **(a) temporary working capital**. Temporary working capital refers to the portion of a firm's working capital that fluctuates with seasonal or cyclical changes in a firm's business activities. In contrast, permanent working capital is the minimum level of current assets that a firm must maintain at all times to continue its operations.

Solution:

The formula for the degree of combined leverage (DCL) is the product of the degree of operating leverage (DOL) and the degree of financial leverage (DFL):

We are given DCL = 3.0. The margin of safety is not directly related to this formula, so there may be a misunderstanding of the problem. However, the question as stated only provides DCL and margin of safety. Let's assume the question meant to relate DCL to DFL and DOL. The margin of safety is related to operating leverage, specifically DOL = $\frac{1}{\text{Margin of Safety}}$. If this is the intended relationship, then DOL = $\frac{1}{0.50} = 2$.

Then we can solve for DFL:

DFL = $\frac{\text{DCL}}{\text{DOL}} = \frac{3}{2} = 1.5$

The correct answer is **(d) 1.5**, based on this assumption of the relationship between margin of safety and DOL.

Solution:

The correct answer is **(a) the yield to maturity on the firm's bond**. The cost of debt is the effective rate that a company pays on its borrowed funds. It is best measured by the yield to maturity (YTM) on the firm's outstanding debt, as YTM reflects the current market interest rate for that level of risk, whereas the coupon rate is a historical fixed value.

Solution:

True. This is the definition of the Internal Rate of Return (IRR). It is the discount rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero.

Solution:

False. The asset beta is the beta of the firm if it had **no debt**. It is a measure of the business risk of the firm's assets. The beta of the publicly traded stock is the **equity beta**, which reflects both the business risk and the financial risk of the firm.

Solution:

False. Investors can expect to be compensated only for bearing **systematic risk** (market risk), not unsystematic risk. This is because unsystematic risk can be eliminated through diversification, so a rational investor would not be paid a premium for taking on a risk they could have easily avoided.

Solution:

False. Companies with high growth rates tend to have **low dividend-payout ratios**. They need to retain a larger portion of their earnings for reinvestment in new projects to sustain their growth. Companies with low or no growth are more likely to have high payout ratios, as they have fewer profitable investment opportunities to fund with retained earnings.

Solution:

True. The formula for the degree of operating leverage is: $DOL = \frac{\text{Contribution Margin}}{\text{EBIT}}$. Since EBIT = Contribution Margin - Fixed Costs, if fixed costs are zero, then DOL = $\frac{\text{Contribution Margin}}{\text{Contribution Margin}} = 1$. A DOL of 1 means that a 1% change in sales will result in a 1% change in EBIT, with no magnifying effect from fixed costs.

Solution:

The correct matches are as follows:

• **(1) Venture capital** matches with **(j) equity financing**. Venture capital is a form of equity financing provided by investors to start-up firms and small businesses with high growth potential.
• **(2) Financial distress** matches with **(f) negative equity**. Financial distress is a state where a firm's cash flow is insufficient to cover its debt obligations. A symptom of this can be negative equity, where liabilities exceed assets.
• **(3) Discount bond** matches with **(a) zero-coupon bond**. A zero-coupon bond is a type of discount bond that does not pay periodic interest. It is sold at a discount to its face value, and the investor's return comes from the difference between the purchase price and the face value at maturity.
• **(4) Primary market** matches with **(i) Rights offering**. The primary market is where new securities are issued for the first time. A rights offering is an example of a primary market transaction where new shares are offered to existing shareholders.
• **(5) Asset turnover** matches with **(h) Efficiency ratio**. Asset turnover measures how efficiently a firm uses its assets to generate sales. It is a key measure of a firm's operational efficiency.

Solution:

i. Identification of the conflict:

This type of conflict is known as an **agency conflict**, which arises due to the separation of ownership and control in a modern corporation. The shareholders (the principals) own the company, but the managers (the agents) are responsible for its day-to-day operations. The conflict occurs when managers' personal interests diverge from the goal of maximizing shareholder wealth.

ii. Factors contributing to the conflict:

• **Different time horizons:** Shareholders, especially long-term investors, are focused on sustainable, long-term growth. Managers, however, may be motivated by short-term performance to meet annual bonuses or secure their positions, which can lead to decisions that boost short-term profits at the expense of long-term value.
• **Information asymmetry:** Managers typically have more information about the company's projects, risks, and financial health than shareholders. This information imbalance can allow managers to make decisions that benefit them personally (e.g., investing in "pet projects" that don't add value) while justifying them to shareholders with a skewed narrative.

iii. Mitigation strategies for a Management Accountant:

A management accountant can use several strategies to align management's interests with those of the shareholders:

• **Performance-based compensation:** Tying a significant portion of a manager's compensation to the firm's long-term performance, such as stock options or restricted stock awards, can align their wealth with that of the shareholders.
• **Independent board of directors:** A strong and independent board can provide effective oversight of management's decisions and ensure that they are in the best interest of the shareholders. The management accountant can provide the board with transparent and accurate financial reporting to aid in this oversight.
• **Performance measurement and control:** A management accountant can design and implement a performance measurement system that uses key metrics, such as economic value added (EVA) or return on investment (ROI), to evaluate and hold managers accountable for the value they create for the firm.

Solution:

i. Effective annual interest rate (EAR):

The formula for the EAR with monthly compounding is:

Given: $i_{nom} = 16\% = 0.16$, $m = 12$ (monthly compounding).

$EAR = (1 + \frac{0.16}{12})^{12} - 1 = (1.01333)^{12} - 1 = 1.17227 - 1 = 0.17227$ or $17.227\%$

The effective annual interest rate is approximately **17.23%**.

ii. Even annual withdrawal amount:

We need to find the future value of the initial Tk. 100 million after 4 years, which will then serve as the present value of the 4-year annuity starting at the end of year 5.

Future Value at end of Year 4 ($FV_4$):

$FV_4 = 100,000,000 \times (1.17227)^4 = 100,000,000 \times 1.8698 \approx \text{Tk. } 186,980,000$

Now, this future value acts as the present value of an ordinary annuity starting at the end of year 4. We need to find the payment (PMT) for a 4-year annuity with this PV and the EAR.

Let's find the present value annuity factor for 4 periods at 17.227%.

$PVAF = \left[ \frac{1 - (1+i)^{-n}}{i} \right] = \left[ \frac{1 - (1.17227)^{-4}}{0.17227} \right] = \left[ \frac{1 - 0.53768}{0.17227} \right] = 2.6835$

Then, the withdrawal amount is:

The even annual withdrawal amount is approximately **Tk. 69.68 million**.

Solution:

First, we need to calculate the NPV of the project using the most likely cash flows.

Net Cash Flow Year 1 = Savings - Costs = $6,000 - 2,000 = \text{Tk. } 4,000$

Net Cash Flow Year 2 = Savings - Costs = $7,000 - 2,500 = \text{Tk. } 4,500$

NPV = $-7,000 + \frac{4,000}{(1.08)^1} + \frac{4,500}{(1.08)^2}$

$NPV = -7,000 + 3,703.70 + 3,858.02 = \text{Tk. } 561.72$

Now, we measure the sensitivity of the NPV to changes in costs and savings by finding the percentage change required to make the NPV zero.

Sensitivity to Running Costs:

Let $C_1$ and $C_2$ be the new running costs. We find the increase in costs that makes NPV=0.

$0 = -7,000 + \frac{6,000 - (2,000 + \Delta C_1)}{1.08} + \frac{7,000 - (2,500 + \Delta C_2)}{1.08^2}$

Assuming a proportional increase in costs, let $\Delta C_1 = 2,000x$ and $\Delta C_2 = 2,500x$.

$0 = -7,000 + \frac{4,000 - 2,000x}{1.08} + \frac{4,500 - 2,500x}{1.08^2}$

$7,000 = \frac{4,000}{1.08} - \frac{2,000x}{1.08} + \frac{4,500}{1.08^2} - \frac{2,500x}{1.08^2}$

$7,000 = 3,703.70 - 1,851.85x + 3,858.02 - 2,130.64x$

$7,000 = 7,561.72 - 3,982.49x$

$3,982.49x = 561.72 \implies x = 0.141$ or $14.1\%$

The project is sensitive to a **14.1%** increase in running costs.

Sensitivity to Savings:

Let $S_1$ and $S_2$ be the new savings. We find the decrease in savings that makes NPV=0.

Assuming a proportional decrease in savings, let $\Delta S_1 = 6,000y$ and $\Delta S_2 = 7,000y$.

$0 = -7,000 + \frac{6,000 - 6,000y - 2,000}{1.08} + \frac{7,000 - 7,000y - 2,500}{1.08^2}$

$0 = -7,000 + \frac{4,000 - 6,000y}{1.08} + \frac{4,500 - 7,000y}{1.08^2}$

$7,000 = \frac{4,000}{1.08} - \frac{6,000y}{1.08} + \frac{4,500}{1.08^2} - \frac{7,000y}{1.08^2}$

$7,000 = 3,703.70 - 5,555.56y + 3,858.02 - 6,076.65y$

$7,000 = 7,561.72 - 11,632.21y$

$11,632.21y = 561.72 \implies y = 0.0483$ or $4.83\%$

The project is sensitive to a **4.83%** decrease in savings.

Solution:

A company is considered highly geared when it has a high proportion of debt to equity in its capital structure. While gearing can enhance shareholder returns, it also introduces several difficulties:

1. **Increased financial risk:** High gearing exposes the firm to greater financial risk. The firm has a higher amount of fixed interest payments, and if it cannot meet these obligations due to a downturn in business, it could face financial distress or even bankruptcy.
2. **Higher cost of debt:** As a firm's leverage increases, its credit risk also increases. Lenders will view the firm as a riskier borrower and will demand a higher interest rate (cost of debt) to compensate for this increased risk.
3. **Restrictive covenants:** Lenders often place restrictive covenants on highly geared firms to protect their investment. These covenants may limit the firm's ability to pay dividends, take on new debt, or sell assets, thereby restricting management's flexibility in making strategic decisions.
4. **Difficulty in raising new capital:** A highly geared firm may find it difficult to raise new capital, especially debt. Potential lenders may be unwilling to provide additional loans, and new equity may be expensive due to the increased risk for shareholders.
5. **Increased agency costs:** High gearing can exacerbate the agency conflict between shareholders and bondholders. Shareholders may be tempted to take on riskier projects, as they have more to gain and less to lose (since the debt is paid first). Bondholders will demand stricter monitoring, which increases the firm's agency costs.

Solution:

i. Net Present Value (NPV):

We need to calculate the cash flows for each year. We must adjust for inflation on variable and fixed costs.

Initial Investment (Year 0) = Tk. (2,000,000)

Year	1	2	3	4
Sales (Tk.)	4,780,750	8,363,300	9,585,000	6,548,800
Var. Cost (per unit)	51.50	53.04	47.78	49.21
Total Var. Cost	3,347,500	5,834,400	5,972,500	3,936,800
Contribution	1,433,250	2,528,900	3,612,500	2,612,000
Fixed Costs	1,248,000	1,297,920	1,349,837	1,403,831
Depreciation	500,000	375,000	281,250	210,938
**EBIT**	-314,750	855,980	1,981,413	997,231
Tax (30%)	(0)	256,794	594,424	299,169
**EAT**	-314,750	599,186	1,386,989	698,062
Add Dep.	500,000	375,000	281,250	210,938
**Cash Flow**	185,250	974,186	1,668,239	908,990

After-tax costs: Var. Cost for Year 1: $50 \times 1.03 = 51.5$. Fixed Cost for Year 1: $1,200,000 \times 1.04 = 1,248,000$. Note: Sales price data is already adjusted for inflation. Depreciation: Yr 1: $2,000,000 \times 0.25 = 500,000$. Yr 2: $1,500,000 \times 0.25 = 375,000$. Yr 3: $1,125,000 \times 0.25 = 281,250$. Yr 4: $843,750 \times 0.25 = 210,938$.

NPV = $-2,000,000 + \frac{185,250}{1.10} + \frac{974,186}{1.10^2} + \frac{1,668,239}{1.10^3} + \frac{908,990}{1.10^4}$

$NPV = -2,000,000 + 168,409 + 805,112 + 1,253,040 + 620,400 = \text{Tk. } 846,961$

The NPV of the project is approximately **Tk. 846,961**.

ii. Payback periods:

Non-discounted Payback Period:

Year 1: 185,250. Remaining: $2,000,000 - 185,250 = 1,814,750$

Year 2: 974,186. Remaining: $1,814,750 - 974,186 = 840,564$

Year 3: 1,668,239. The project pays back in Year 3.

Fraction of Year 3 = $\frac{840,564}{1,668,239} = 0.5048 \text{ years}$

Months = $0.5048 \times 12 \approx 6.06 \text{ months}$

Non-discounted payback period = **2 years and 6 months**.

Discounted Payback Period:

Year	Cash Flow	PV Factor (10%)	PV of CF	Cumulative PV
0	(2,000,000)	1.0000	(2,000,000)	(2,000,000)
1	185,250	0.9091	168,409	(1,831,591)
2	974,186	0.8264	805,112	(1,026,479)
3	1,668,239	0.7513	1,253,040	226,561

The project pays back in Year 3.

Fraction of Year 3 = $\frac{1,026,479}{1,253,040} = 0.8192 \text{ years}$

Months = $0.8192 \times 12 \approx 9.83 \text{ months}$

Discounted payback period = **2 years and 10 months**.

Solution:

The Weighted Average Cost of Capital (WACC) is calculated using the following formula:

We need to find the market values and costs of both equity and debt.

Market Value of Equity (E):

E = Number of shares $\times$ market price per share

= $10,000,000 \times 5 = \text{Tk. } 50,000,000$

Market Value of Debt (D):

The bonds' market value is given as Tk. 100 per bond, which is also their par value. The book value is Tk. 10,000,000, and since the par value is Tk. 100, the number of bonds is $\frac{10,000,000}{100} = 100,000$ bonds. Since the market value is the same as par, the market value of debt is also **Tk. 10,000,000**.

Total Firm Value (V) = $E+D = 50,000,000 + 10,000,000 = \text{Tk. } 60,000,000$

Cost of Equity ($k_e$):

Using CAPM: $k_e = R_f + \beta \times (\text{Equity Risk Premium})$

Given: $R_f = 14\%$, $\beta = 1.2$, Equity Risk Premium = $5\%$.

$k_e = 14\% + 1.2 \times 5\% = 14\% + 6\% = 20\%$

Cost of Debt ($k_d$):

The bonds have a market value equal to their par value, which means their yield to maturity is equal to their coupon rate.

After-tax cost of debt = $18\% \times (1 - 0.25) = 18\% \times 0.75 = 13.5\%$

WACC Calculation:

Weight of Equity ($\frac{E}{V}$) = $\frac{50,000,000}{60,000,000} = 0.8333$

Weight of Debt ($\frac{D}{V}$) = $\frac{10,000,000}{60,000,000} = 0.1667$

$WACC = (0.8333 \times 20\%) + (0.1667 \times 13.5\%)$

$WACC = 16.666\% + 2.25\% = 18.916\%$

Star Ltd's WACC is approximately **18.92%**.

Solution:

When choosing the type and source of debt finance, a financial manager must consider several key factors to ensure the financing is aligned with the company's needs and financial health. Four of these factors are:

• **Cost of Debt:** The primary consideration is the cost of the financing. This includes the interest rate, as well as any fees or issuance costs. The financial manager should compare the effective cost of different debt instruments, such as bank loans, commercial paper, or bonds, to find the most cost-effective option for the firm.
• **Maturity Period:** The maturity of the debt should be matched to the life of the assets being financed. Short-term debt should be used for short-term assets (working capital), while long-term debt should be used for long-term assets (plant and equipment). This is a core principle of sound financial management known as the "matching principle."
• **Restrictive Covenants:** Many debt agreements, especially bank loans or bond indentures, come with restrictive covenants. These are clauses that can limit a firm's future actions, such as paying dividends, taking on more debt, or selling assets. The financial manager must evaluate the impact of these covenants on the firm's strategic flexibility.
• **Flexibility and Speed:** The financial manager must also consider the flexibility and speed with which the funds can be raised. A bank loan, for example, can often be secured quickly but may come with more restrictions, whereas a bond issue is a more complex and time-consuming process but may offer greater flexibility once the funds are raised. The manager must choose the option that best fits the urgency and size of the funding need.

Solution:

i. Gearing at 31 March 2021 (Debt/Equity):

First, we calculate gearing using book values.

Book Value of Debt = Tk. 150 million

Book Value of Equity = Ordinary Shares + Reserves = $100 \text{ million} + 20 \text{ million} = \text{Tk. } 120 \text{ million}$

Gearing (Book Value) = $\frac{\text{Debt}}{\text{Equity}} = \frac{150}{120} = 1.25$

Next, we calculate gearing using market values.

Market Value of Debt = Nominal Value $\times \frac{\text{Market Price}}{\text{Par Value}} = 150 \text{ million} \times \frac{90}{100} = \text{Tk. } 135 \text{ million}$

Number of shares = $\frac{\text{Nominal Value of Shares}}{\text{Par Value}} = \frac{100 \text{ million}}{1} = 100 \text{ million shares}$

Market Value of Equity = Number of shares $\times$ market price per share

= $100 \text{ million} \times 4 = \text{Tk. } 400 \text{ million}$

Gearing (Market Value) = $\frac{\text{Debt}}{\text{Equity}} = \frac{135}{400} = 0.3375$

The gearing at 31 March 2021 is **1.25 (book value)** and **0.3375 (market value)**.

ii. Gearing after rights issue and redemption:

First, we calculate the number of new shares from the rights issue and the proceeds from the issue.

New shares = $100 \text{ million} \times \frac{1}{2} = 50 \text{ million shares}$

Proceeds from rights issue = New shares $\times$ issue price = $50 \text{ million} \times 2.50 = \text{Tk. } 125 \text{ million}$

Next, we calculate the new market value of equity. The original market value of equity is Tk. 400 million. The rights issue raises Tk. 125 million, so the new market value of equity is the sum of the old value and the proceeds from the new issue.

New Market Value of Equity = $400 \text{ million} + 125 \text{ million} = \text{Tk. } 525 \text{ million}$

Finally, we calculate the new market value of debt. The company uses the Tk. 125 million proceeds to redeem the debentures at their nominal value. The nominal value of the debentures is Tk. 150 million. The company redeems at nominal value, so the remaining debentures are:

Remaining Debentures = $150 \text{ million} - 125 \text{ million} = \text{Tk. } 25 \text{ million}$

New Market Value of Debt = Nominal Value of Remaining Debt $\times \frac{\text{Market Price}}{\text{Par Value}}$

= $25 \text{ million} \times \frac{90}{100} = \text{Tk. } 22.5 \text{ million}$

New Gearing (Market Value) = $\frac{\text{New Debt}}{\text{New Equity}} = \frac{22.5}{525} = 0.04286$

The gearing after the rights issue and redemption is approximately **0.0429**.

Solution:

To decide whether to lease or buy, we need to compare the present value of the cost of leasing (PV of Lease) with the present value of the cost of buying (PV of Buy). The appropriate discount rate for this analysis is the after-tax cost of debt: $10\% \times (1 - 0.30) = 7\%$.

PV of Buying (Net Cost of Owning):

PV of Buy = Initial Outlay - PV of Depreciation Tax Shield.

Initial Outlay = \$63,000.

We need to calculate the depreciation tax shield for each year.

Year	Opening NBV	Depreciation (25%)	Tax Shield (30%)	PV Factor (7%)	PV of Tax Shield
1	63,000	15,750	4,725	0.9346	4,416
2	47,250	11,813	3,544	0.8734	3,095
3	35,437	8,859	2,658	0.8163	2,169
4	26,578	6,645	1,994	0.7629	1,521

PV of Depreciation Tax Shield (total) = $4,416 + 3,095 + 2,169 + 1,521 = \text{Tk. } 11,201$

PV of Buy = Initial Outlay - PV of Tax Shield = $63,000 - 11,201 = \text{Tk. } 51,799$

PV of Leasing (Net Cost of Leasing):

The cash flows for leasing are the after-tax lease payments. The lease payments are \$20,000 at the end of each year. The tax shield on the lease payments is realized one year later.

Year	Cash Flow	Tax Shield (30%)	Net Cash Flow	PV Factor (7%)	PV of Net CF
0	-20,000		-20,000	1.0000	-20,000
1	-20,000	6,000	-14,000	0.9346	-13,084
2	-20,000	6,000	-14,000	0.8734	-12,228
3	-20,000	6,000	-14,000	0.8163	-11,428
4	0	6,000	6,000	0.7629	4,577

PV of Lease = $-20,000 - 13,084 - 12,228 - 11,428 + 4,577 = \text{Tk. } -52,163$

This calculation is for a lease payment at the end of the year. Let's re-read the problem: "payable at the end of each year." The table above is correct. The after-tax lease payment is a cash outflow. The tax shield from the lease payment is a cash inflow. The PV of leasing is the negative of the net cost of leasing, so the cost of leasing is **Tk. 52,163**.

Let's redo the calculation to simplify and clarify.

PV of Lease = PV of after-tax lease payments

After-tax lease payment = $20,000 \times (1 - 0.30) = \text{Tk. } 14,000$

PV of Lease = $14,000 \times \left[ \frac{1 - (1.07)^{-4}}{0.07} \right] = 14,000 \times 3.3872 \approx \text{Tk. } 47,421$

The calculation above is for an ordinary annuity, but the problem states the tax shield is one year in arrears. Let's stick with the original table method to be more precise.

PV of Lease payments = $\frac{20,000}{1.07} + \frac{20,000}{1.07^2} + \frac{20,000}{1.07^3} + \frac{20,000}{1.07^4} = 18,691.59 + 17,468.78 + 16,325.96 + 15,257.91 \approx \text{Tk. } 67,744$

PV of tax shield on lease payment = $\frac{20,000 \times 0.30}{1.07^2} + \frac{20,000 \times 0.30}{1.07^3} + \frac{20,000 \times 0.30}{1.07^4} + \frac{20,000 \times 0.30}{1.07^5} = 5,239.51 + 4,896.74 + 4,576.39 + 4,277 \approx \text{Tk. } 18,989.64$

Cost of Leasing = PV of Lease Payments - PV of Tax Shield = $67,744 - 18,990 = \text{Tk. } 48,754$

We need to compare the cost of buying to the cost of leasing.

Cost of Buying = Initial outlay - PV of Depreciation Tax Shield = $63,000 - 11,201 = \text{Tk. } 51,799$

Cost of Leasing = PV of after-tax lease payments = $48,754$

**Decision:** Since the cost of leasing (**Tk. 48,754**) is less than the cost of buying (**Tk. 51,799**), the company should **lease** the machine.

Solution:

As the financial manager, I would recommend adopting a **stable dividend payment per share** policy. This policy aims to pay a constant or steadily increasing dividend over time, even if earnings fluctuate. This approach is generally preferred by investors because it provides a predictable income stream, which can reduce investor uncertainty and attract a stable investor base.

Disadvantages of each policy:

• **Stable dividend payment per share:**

  The main disadvantage is that it may require the firm to retain a large portion of earnings during periods of high growth or cut into retained earnings during a downturn. This could force the firm to pass on profitable investment opportunities or to seek costly external financing during periods of low earnings.

• **Stable dividend-payout ratio:**

  The disadvantage of a stable payout ratio is that it results in a highly volatile dividend payment that mirrors the firm's earnings. This can be confusing and unsettling for investors, especially if earnings are unstable. It may be interpreted as a sign of financial instability and can lead to a lower stock price, as investors prefer a predictable stream of income.

Solution:

i. Effective annual cost of each financing option:

The invoice amount is Tk. 2.5 million.

• **Option 1: Supplier's Credit:**

  The company forgoes a 1.5% discount by not paying within 10 days and instead pays on day 45. The credit period for which the discount is foregone is $45 - 10 = 35$ days.

  Cost = $\frac{\text{Discount \%}}{100 - \text{Discount \%}} \times \frac{365}{\text{Days Credit is Taken} - \text{Discount Period}}$

  $= \frac{1.5}{100 - 1.5} \times \frac{365}{35} = \frac{1.5}{98.5} \times 10.4286 = 0.015228 \times 10.4286 = 0.15886$ or $15.89\%$

• **Option 2: Commercial Paper:**

  The total interest cost is $2,500,000 \times 0.18 \times \frac{3}{12} = \text{Tk. } 112,500$

  Issue costs = Tk. 15,000

  Net proceeds = $2,500,000 - 112,500 - 15,000 = \text{Tk. } 2,372,500$

  The cost over 3 months is $\frac{2,500,000 - 2,372,500}{2,372,500} = \frac{127,500}{2,372,500} = 0.05374$

  Effective annual cost = $(1 + 0.05374)^{12/3} - 1 = (1.05374)^4 - 1 = 1.2341 - 1 = 0.2341$ or $23.41\%$

• **Option 3: Bank Loan:**

  The total interest cost is $2,500,000 \times 0.22 \times \frac{3}{12} = \text{Tk. } 137,500$

  Processing fees = Tk. 5,000

  Net proceeds = $2,500,000 - 5,000 = \text{Tk. } 2,495,000$

  The cost over 3 months is $\frac{137,500 + 5,000}{2,495,000} = \frac{142,500}{2,495,000} = 0.057114$

  Effective annual cost = $(1 + 0.057114)^{12/3} - 1 = (1.057114)^4 - 1 = 1.2492 - 1 = 0.2492$ or $24.92\%$

The most cost-effective option is **Option 1 (supplier's credit)** with an effective annual cost of 15.89%.

ii. Advantages of commercial paper over bank loan:

• **Lower interest rates:** Commercial paper is typically issued by large, financially sound companies and is unsecured. Because of the lower risk and a more competitive market, the interest rates on commercial paper are often lower than those on bank loans.
• **Flexibility:** Commercial paper can be issued in a wide range of denominations and maturities, allowing a firm to tailor the financing to its specific needs. Bank loans often have more rigid terms and conditions.

Solution:

**Interest rate risk** is the risk that an investment's value will change due to a change in the absolute level of interest rates, the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship. For a company, this risk primarily arises from having variable-rate debt, which could become more expensive if interest rates rise, or from holding fixed-rate assets that lose value when market interest rates increase.

Three ways to manage interest rate risk:

1. **Use derivatives (e.g., interest rate swaps):** An interest rate swap is a contractual agreement between two parties to exchange future interest payments. A company with variable-rate debt could enter into a swap to exchange its variable payments for fixed-rate payments, thereby locking in a stable cost of debt and eliminating the risk of a rate increase.
2. **Matching assets and liabilities:** A firm can manage interest rate risk by matching the maturity and rate structure of its assets and liabilities. For example, a company that has long-term fixed-rate assets, such as real estate, should finance them with long-term fixed-rate debt to ensure that its cash inflows and outflows are stable.
3. **Diversification of debt portfolio:** A company can reduce its exposure to interest rate risk by diversifying its debt portfolio. This can be done by using a mix of short-term and long-term debt, as well as fixed-rate and variable-rate debt. This strategy ensures that the firm is not overly exposed to a single type of interest rate movement.