The Institute of Cost and Management Accountants of Bangladesh

Assignment
On
Financial Management EF-232

Intermediate Level-II

Submitted By Name:Samsun Nahar

Registration No :2023100069
Session :July-December,2024

Answered to the Question Number-1

Requirement–(a)

Risks Of An LBO

Three key types of risks associated with LBOs are often interest rate risk, depending on
the type of financing structure, as well as operational risks and the possibility of an
industry shock.

Interest Rate Risk: Interest rates are often high on this type of financing agreement amid
rising rate environment with variable debt would compound the challenges. Finding fair
credit terms and interest rates are key to a successful leveraged buyout to help prevent
catastrophe.
Operational Risk: The intended business efficiencies may not be realized, and in some
cases a poorly strategized LBO could instigate operational problems (for example, with
line managers, customers etc.)
Industry Shock Risk: The industry within which the LBO is performed might be subject
to an unexpected shock, such as the airline industry after the 9/11 attacks.
Overall, LBO transactions often provide a large benefit to shareholders and the
acquiring firm due to all the value creation opportunities realized. However, in
exchange, investor capital is at risk, and exposed it to variables both within and outside
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their control.

Returns of LBO

In LBO transactions, financial buyers seek to generate high returns on the equity
investments and use financial leverage (debt) to increase these potential returns.
Financial buyers evaluate investment opportunities with by analyzing expected internal
rates of return (IRRs), which measure returns on invested equity. IRRs represent the
discount rate at which the net present value of cash flows equals zero. Historically,
financial sponsors’ hurdle rates (minimum required IRRs) have been in excess of 30%,
but may be as low as 15-20% for particular deals under adverse economic conditions.
Hurdle rates for larger deals tend to be a bit lower than hurdle rates for smaller deals.

Sponsors also measure the success of an LBO investment using a metric called "cash-
on-cash" (CoC). CoC is calculated as the final value of the equity investment at exit
divided by the initial equity investment, and is expressed as a multiple. Typical LBO
investments return 2.0x – 5.0x cash-on-cash. If an investment returns 2.0x CoC, for
example, the sponsor is said to have "doubled its money".

Thereturns in an LBO are driven by three factors,which we demonstratein our top icon
creating value in LBOs:

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De-levering(paying down debt) Operational improvement(e.g.margin
expansion,revenue growth) Multiple expansion (buying low and
selling high)

Acompany’s capital structure — essentially, its blend of equity and debt financing — is
a significant factor in valuing the business. The relative levels of equity and debt affect
riskandcash flowand,therefore,the amount an investor would be willing to payforthe
company or for an interest in it.

A question that often arises is whether the valuator should use the company’s actual
capital structure or its anticipated future capital structure. A valuator might also use a
prospective buyer’s capital structure or the company’s optimal capital structure. Which
method is best depending on several factors, including the type of interest being valued
and the valuation’s purpose.

What’s the cost of capital?

Capital structure matters because it influences the cost of capital. Generally, when
valuators use income-based valuation methods — such as discounted cash flow — they
convert projected cash flows or other economic benefits to present value by applying a
present value discount rate.

That rate, which generally reflects the return that a hypothetical investor would require,
is derived from the cost of capital, which is commonly based on the weighted average
cost of capital (WACC). WACC is a company’s average cost of equity and debt,
weighted accordingto the relative proportion of each in the company’s capital structure.

What’s the optimal capital structure?

Many business owners strive to be debt-free, but a reasonable amount of debt can
providesomefinancialbenefits.Debtisoftencheaperthanequity,andinterestpayments are
tax-deductible. So, as the level of debt increases, returns to equity owners also increase
— enhancing the company’s value.
If riskweren’tafactor,thenthemoredebtabusinesshas,thegreateritsvaluewouldbe.
Butatacertainlevelofdebt,therisksassociated withhigherleveragebegintooutweigh the
financial advantages.

When debt reaches this point, investors maydemand higher returns as compensation for
taking on greater risk, which has a negative impact on business value. So, the optimal
capital structure comprises a sufficient level of debt to maximize investor returnswithout
incurring excessive risk.

Identifyingtheoptimalstructureisa combinationofartandscience.Valuatorsmay:

• Useindustryaverages,
• Examinecapitalstructuresofguidelinecompanies,

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• Refertofinancialinstitutions’debt-to-equitylendingcriteria, or
• Applyfinancialmodelstoestimateasubject company’soptimal structure.

Whichever method is used, valuators exercise professional judgment to arrive at acapital

structure that makes sense for the subject company, with a level of debt that the
company’s cash flow can support.

Which structure should be used?

Therightcapitalstructureforvaluationpurposesdependsonseveralfactors,including:

Type of interest. If the interest being valued is a controlling interest, it’s often
appropriate to use the company’s optimal capital structure. Why? Because a controlling
owner generally has the ability to change the company’s capital structure and gravitates
toward a structure that will yield the most profitable results. If the interest being valued
is a minority or noncontrolling interest, however, it’s customary to use the company’s
actual capital structure, because the interest owner lacks that ability.

Purpose of valuation. To estimate fair market value, valuators often use the subject
company’s actual or optimal capital structure. But if the standard of value is investment
value, it may be appropriate to use the buyer’s capital structure because the buyer’s
financial attributes are considered in using this standard of value.

Managementplans.Acompany’scapitalstructurefluctuatesovertimeasthevalueofits equity
securities changes and the company services its debts. It may be appropriate to use
management’s target capital structure if the actual structure has veered off course
temporarily or if management plans to alter the company’s capital structure.

Finding the right structure

The blend of debt and equity can have a big impact on a value estimate. So, you should
expect to work closely with your valuation expert to identify the appropriate capital
structure to be used in the valuation.

All content provided in this article is for informational purposes only. Matters discussed
in this article are subject to change. For up-to-date information on this subject please
contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held
responsible for any claim, loss, damage or inconvenience caused as a result of any
information within these pages or any information accessed through this site.

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 Requirement–(b)

A business firm may choose to go with long-term, short-term, or a mix of the two to
finance its operations.

Depending on the mix of short- and long-term approaches, three types of workingcapital
policies may be found which are as follows −

Matching Approach

When the expected life of assets is matched with the expected life of the source offunds,
the approach is known as the matching approach. In this approach, short-term financing
is used for short-term assets while long-term financing is used for long-term assets.

The justification for such an approach is that since financing is meant for paying the
assets, the assets and the financing should be relinquished simultaneously.

Using long-term financing for short-term assets would lead to less utilization of funds,
whereas short-term financing for long-term assets would create a void of funds.
Therefore, the assets and financing patterns are matched in this approach to get the
maximum benefits from the working capital financing policy.

When a companyfollows the matchingapproach, long-term financingwill be utilized to

finance fixed assets or permanent current assets, whereas short-term financing will be
used for variable or temporary current assets.

Conservative Approach

In a conservative approach, a firm relies mostly on long-term funds for the firm’s
financing needs.

The justification for choosing a conservative approach is that with long-term financing,
the company would not fall in trouble even if it needs short-term funds as the long-term
fund will cover short-term needs as well. In the case when the company does not need
temporary or current assets, idle, long-term funds may be invested in securities.

As is obvious, in the case of a conservative approach, the company finances its fixed
assets and a part of its temporary assets with long-term financing. The idea is to avoid a
shortage of funds even when the business does not need temporary assets financing.

The idea of investing the funds in tradeable securities when there is no need of funding
the temporary assets arises from the fact that investing in tradeable securities wouldoffer
the return needed to fulfil the void that would arise if the funds are kept idle and tied up
in the company’s operations.

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Therefore, the conservative approach is a moderate approach that does not take any risk
of shortage of funds during the process of operations of a business. The downside of the
conservative approachisthatthereturnsobtained fromthisapproachmaynotbeashigh as
other approaches that are utilized to finance the working capital.

Aggressive Approach

Acompanyis saidto followan aggressiveworkingcapital financingpolicyifitfinances most

of its temporary assets with short-term financing in a proportion that is beyond the
matching approach. A portion of the permanent current assets is financed by short-term
financing in the case of an aggressive approach.

In some instances of an extremely aggressive approach, some companies may even

finance some portion of permanent assets with short-term financing tools. The returns
obtained via the aggressive approach are higher than all other approaches but the risk is
also higher in this case.

It is the particular requirement and nature of the business that must be considered while
selecting a particular workingcapital financingpolicy. Each approach has its upside and
downside but the companies must be careful not to choose the wrong approach which
can destabilize the business operations.

The matching approach is great for businesses that do not want to take too much or too
less risk while the conservative approach is for the companies that want to takerelatively
fewer risks. The aggressive approach, on the other hand, is for the companies that want
to seek higher returns by taking relatively higher risks than most other companies.

Requirement–C(i)

Calculation of Value of Company

Particulars Amount Explanation
Sales $17,500,0
00
VariableCosts $10,500,0 60%of
00
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 $17,500,000

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EBT $7,000,000
Taxes $2,800,000 40%ofEBT
NetIncome $4,200,000

Valueofthecompany=NetIncome/RequiredReturn

Valueofthecompany=$4,200,00
0/.13
Valueofthecompany=$32,307,6
92

Requirement–C(ii)

Calculationofrequiredreturnonthefirm’sleveredequit
y by usingMM Approach
RequiredReturn=R0+(B/S)(R0-Rb)(1-Tax)
Or,0.13+(0.35)(0.13-.07)
(1- 0.40)
Or, 0.1426
Or, 14.26%
Requirement–C(iii)

CalculationofvalueofcompanyusingW
ACC Rwacc=[B/(B+S)](1-Tax)Rb+
[S/(B+S)]Rs

Conpanydebtequityratiois 0.35
B/V=0.35/(1+.35)
Or, 0.2593
Equityvalueratio=1-.2593
Or, 0.7407
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Rwacc=0.2592(1-0.4)
(.07)+0.7408(0.1426) Or,
0.11652448

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 Or, 11.65%

Calculationofvalueofequity
ValueofEquity=Net
Income/WACC
Or,

($4,200,000/.1165) Or,
$36,043,928

Calculationofthevalueofcompany'sdebt
Valueofdebt=$36,043,928*0.2593
Or, $9,346,191

Valueofthecompany'sdebt=$36,043,928-
$9,346,191 Or, $26,697,737
Requirement–C(iv)

Calculationofvalueofcompany
Particulars Amount Explanation
Sales $17,500,000
VariableCost $10,500,000
EBT $7,000,000
Interest $654,233 9,346,191of7
%
EBT $6,345,767
Tax $2,538,307 6,345,767of40
%
NetIncome $3,807,460

Valueofthecompany=(NetIncome/
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RequiredReturn) Or,
$26,700,280

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 Answered to the Question Number-2

Requirement-(a)

OptimumCapitalStructure

The optimal capital structure of a firm is the best mix of debt and equity financing that
maximizes a company’s market value while minimizing its cost of capital. In theory,
debt financing offers the lowest cost of capital due to its tax deductibility. However, too
much debt increases the financial risk to shareholders and the return on equity that they
require. Thus, companies have to find the optimal point at which the marginal benefit of
debt equals the marginal cost.

As it can be difficult to pinpoint the optimal capital structure, managers usually attempt
to operate within a range of values. They also have to take into account the signals their
financing decisions send to the market.

A company with good prospects will tryto raise capital using debt rather than equity, to
avoid dilution and sending any negative signals to the market. Announcements made
aboutacompanytaking debtaretypicallyseen as positivenews,whichis knownasdebt
signaling. If a company raises too much capital during a given time period, the costs of
debt, preferred stock, and common equity will begin to rise, and as this occurs, the
marginal cost of capital will also rise.

To gauge how risky a company is, potential equity investors look at the debt/equityratio.
They also compare the amount of leverage other businesses in the same industry
areusing—ontheassumptionthatthesecompaniesareoperatingwithan optimalcapital
structure—to see if the company is employing an unusual amount of debt within its
capital structure.

Assumptions of M.M. Hypothesis:

TheassumptionsofM.M.Hypothesisare:

1. (i)Perfectcapital markets;

(ii) Investorsarerational;

(iii) Therearenotransactioncosts;

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(iv) Securities areinfinitelydivisible;

(v) Noinvestoris largeenough toinfluencemarket priceof securities;

(vi) Thereareno floatation costs.

2. There are no taxes. Alternatively, there are no differences in tax rates between
capital gains and dividends.

3. Afirmhasafixedinvestmentpolicywhichwillnotchangeoveraperiodoftime. Financing
of new investments will not change in the required rate of return.

InvestmentManagement:

i. There is perfect certainty by every investor as to future investments and profits of the
firm. In other words; investors are able to forecast future prices and dividends with
certainty.

According to the M.M. hypothesis, the crux of the matter is the “arbitrage process” or
the switching and balancing operation. It also refers to the simultaneous movement of
two transactions which exactly offset each other.

The two transactions involved are paying dividends and raising capital through external
funds either through the sale of new shares or raising additional funds through loans to
finance investment programs.

Proposal I:

If dividends are distributed, an amount will have to be raised through the sale of new
shares. The increased value per share through dividends will be exactly offset by the
external raising of shares. The terminal value of shares will decline. Shareholders are
indifferent between retention of dividend or payment, but they are interested in the
firm’s future earnings.

Proposal II:

If instead of raising equity shares the firm raises amount in the form of loan, there will
beno differencebetween debt and equitybecause ofleverage and thereal cost ofdebt is
thesameastherealcostofequity.Therefore,accordingtotheM.M.hypothesis,the

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dividend policyis irrelevant.

The arbitrage process also implies that the dividend pay-out ratio between two identical
firms should be the same and so also the total value of the firm. The individual
shareholder can invest his own earnings as well as the firm would, with dividend being
irrelevant. A firm’s cost of capital would be independent of the dividend.

Finally, the arbitrage processes the dividend policy would be irrelevant even under
uncertainty. Market price of the firm should also be the same for two identical firms.

Answered to the Question

Number-3 Requirement -(a)

If yousell yoursharestothebidderatTk75pershare, youwillreceive100*Tk75= Tk 7,500.

Whatwillhappenifeveryonemakesthesamesell/keepdecisionyoudo?

Requirement-(b)
If everyone decides to sell their shares to the bidder at Tk 75 per share, the outside
investorswillacquirealltheoutstandingshares,includingyours.Theywillthencontrol the
firm.

Requirement-(c)
IfeveryonedecidestoselltheirsharestothebidderatTk75pershareandthetakeover is
successful, the equityin the firm is expected to be worth Tk 1 million, as mentioned
earlier. Since the outside investors are acquiring the entire firm for Tk 1 million, they
will divide this equity among themselves. Therefore, the bid price of Tk 75 per share
alreadyreflects theexpected valueofthe firm ifthetakeoveris successful.

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 Answered to the Question Number-4

To evaluate the proposed investment in the Real Estate Business, we can calculate
theNet Present Value (NPV) using the following formula:

NPV=∑((1+r)tCFt)−InitialInvestment

Where:

CFtis thenet cash flowat timet,

ris thediscount rate(cost of capital),
t is thetime period.

Let'sbreakdownthecash flows:

Initialinvestment:−120−120millionBDT(immediatepayment). Cash
flows from operations during the 13 years:
60%60%ofmedium-sizedshoprevenue 40%40%
of large-sized shop revenue
Residualvalueattheendofthe14thyear:+45+45 millionBDT(aftertax). Annual

operating costs: −45%−45% of the annual revenue.

Let'scalculateNPVusingthesecash flowsanda discountrateof 13%13%.

NPV=((1+0.13)60%×Revenue)+((1+0.13)240%×Revenue)−0.45×Revenue
+(45millionBDT(1+0.13)14)−120millionBDT+((1+0.13)1445million BDT
)−120millionBDT

This NPV should be compared to zero: a positive NPV indicates a potentially good
investment, while a negative NPV suggests that the project may not be financiallyviable.

Non-FinancialFactors:

Diversifying into the real estate business involves non-financial considerations that are
crucial for the success of the venture:

MarketAnalysis
Evaluatethe demandforshoppingmalls inthespecificlocation.

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Understand the competitive landscape and potential challenges in attracting tenants and
customers.
ExpertiseandManagement

Assess the company's capabilities in managing a real estate project, which is

differentfrom hotel management.
Considerhiringprofessionalswith expertisein realestatedevelopment.

RegulatoryandLegalIssues

Investigateandcomplywithlocalzoninglaws,buildingcodes,andotherregulations. Be
aware of legal challenges and liabilities associated with real estate development.

BrandAlignment

ConsiderwhetherdiversifyingalignswiththeBestHotelsbrandimageandifit complements the

existing business.
Long-TermStrategy

Evaluatehowtherealestateventurealignswiththelong-termstrategicgoalsofthe company.
EconomicandMarketTrends

Considertheimpactofeconomiccycles and markettrendsontherealestatebusiness.

Stakeholder Communication

Communicate the diversification strategy transparently to shareholders, employees, and

other stakeholders.

Risks and Contingencies

Identify and mitigate potential risks such as construction delays, economic downturns,or
unexpected operating costs.

A thorough analysis of both financial and non-financial factors is crucial for making an
informed decision about diversifying into the real estate business. Best Hotels Ltdshould
carefullyweigh the potential returns against the associated risks and consider the broader
strategic implications of this investment.

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 Answered to the Question Number-5

Requirement-(i)

Thecurrent priceof Tangshan Miningstock

is: P =$4.89 / (0.1089 -0.05)=$83.02

Requirement-(ii)
The price of Tangshan Mining stock if the capital structure change is made is expected
to be:

P =$5.24 / (0.1134 -0.06)=$98.13

Requirement-(iii)
Yes.Tangshan Miningshouldmakethe changebecauseit willmaximizeshare price.

Answered to the Question Number-6

Interestondebt = $1,000×9%=$90

Netproceeds=$1,000-$20-($1,000× 2%) =
$960
Before-tax cost of debt = 9.45% (using
financialcalculator)ri=9.45%×(1-40%)
=5.67%
rp=$8 ÷ ($65-$3)=12.9%
Growth=(($5.07-$3.45)÷$3.45)×100=47%÷ 5years =9.3913%
Netproceeds =$40 - 1-1=$38

rn=($5.07 ÷ $38)

+9.3913%=22.73%

ra=(0.3) ×($5.67)+(0.05)×(12.9)+(0.65)×(22.73)= 16.20%

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 Answered to the Question Number-7

(i) $1,000,000/$40=25,000shares

(ii) $700,000/(250,000+25,000)=$2.55 EPS

(iii) $1,000,000/$1,000=1,000bonds

$1,000/$45=22.222 shares

1,000bonds×22.222shares=22,222share

250,000+22,222=272,222sharesoutstan

ding (iv)

$700,000/(250,000+22,222)=$2.57 EPS

(v) Since the convertible bond issue results in less dilution and higher EPS
(although the EPS are very close),it is therefore recommended. The risk of an
overhanging issue should be considered since the marginal increase in EPS is
slight.

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