SUGGESTED SOLUTIONS

SL2 – Corporate Finance and Risk

Management

June 2024
 SECTION 1
Answer 01
(a)

Relevant learning outcome/s: 3.1.2 and 3.2.2

Study text reference: Pages 145 – 158 and 163 – 168

(i)

Year 1 Year 2
Expected Expected
Units Probability demand Units Probability demand
40,000 0.25 10,000 30,000 0.20 6,000
30,000 0.15 4,500 60,000 0.40 24,000
45,000 0.50 22,500 40,000 0.30 12,000
30,000 0.10 3,000 20,000 0.10 2,000
1.00 40,000 1.00 44,000

Year 3 Year 4
Expected Expected
Units Probability demand Units Probability demand
28,000 0.30 8,400 19,000 0.10 1,900
90,000 0.20 18,000 34,000 0.55 18,700
26,400 0.25 6,600 27,500 0.20 5,500
48,000 0.25 12,000 26,000 0.15 3,900
1.00 45,000 1.00 30,000

Y0 Y1 Y2 Y3 Y4 Y5
Rs.
Investment (3,500,000)
Scrap value 350,000
Total contribution (W1) 1,392,000 1,769,856 2,085,566 1,597,440
Fixed production overheads
(W2) (108,000) (116,640) (125,971) (136,049)
Working capital (W3) (528,000) (110,880) (79,860) 191,664 527,076
Tax payment (W4) (513,600) (661,286) (783,838) (584,556)
Tax benefit from CA (W5) 420,000 294,000 205,800 340,200
Expected net cash flows (4,028,000) 1,173,120 1,479,756 1,783,973 1,760,429 (244,356)
Discount factor (16%) (W6) 1.000 0.862 0.743 0.641 0.552 0.476
Present value (4,028,000) 1,011,229 1,099,459 1,143,527 971,757 (116,314)
Expected net present value
(ENPV) 81,658

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June 2024
As the ENPV is positive, the wealth of the shareholders increases by taking on the project.
Therefore, the new machine should be purchased.

Working 1: Adjusting for inflation

Y0 Y1 Y2 Y3 Y4
Selling price (Rs.) 10% 120 132.0 145.2 159.72 175.69
Variable cost (Rs.) 8% 90 97.2 104.98 113.37 122.439
Contribution per unit (Rs.) 34.8 40.22 46.35 53.248
Number of units 40,000 44,000 45,000 30,000
Total contribution (Rs.) 1,392,000 1,769,856 2,085,566 1,597,440
Total variable cost (Rs.) 3,888,000 4,618,944 5,101,834 3,673,320

Working 2: Fixed production overheads

Y0 Y1 Y2 Y3 Y4
Fixed production overheads (Rs.) 8% 100,000 108,000 116,640 125,971 136,049

Working 3: Working capital (WC)

Y0 Y1 Y2 Y3 Y4
Rs.
Sales 5,280,000 6,388,800 7,187,400 5,270,760
10% of sales for WC 528,000 638,880 718,740 527,076
WC timing (at the start of each
year) 528,000 638,880 718,740 527,076
WC investment (528,000) (110,880) (79,860) 191,664 527,076

Working 4: Tax payment

Y1 Y2 Y3 Y4 Y5
Rs.
Contribution 1,392,000 1,769,856 2,085,566 1,597,440
Less: Fixed production overheads (108,000) (116,640) (125,971) (136,049)
Profit 1,284,000 1,653,216 1,959,595 1,461,391
Tax at 40% 513,600 661,286 783,838 584,556
Payment in arrears 513,600 661,286 783,838 584,556

Working 5: Tax benefit from capital allowances

Y1 Y2 Y3 Y4 Y5
Rs.
TWDV (opening) 3,500,000 2,450,000 1,715,000 1,200,500
Less: Capital allowances at
30% 1,050,000 735,000 514,500 850,500
TWDV (closing) 2,450,000 1,715,000 1,200,500
Tax savings on capital
allowances at 40% 420,000 294,000 205,800 340,200
Timing benefit 420,000 294,000 205,800 340,200
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June 2024
Working 6: Nominal cost of capital

Real cost of capital 7.00%

General inflation 8.41%
Money/Nominal cost of capital 16.00%

Interest charges should be ignored as the cost of capital is reflected in the discount factor.
(12 marks)

(ii)

Y0 Y1 Y2 Y3 Y4 Total
Rs.
Sales 5,280,000 6,388,800 7,187,400 5,270,760 24,126,960
Variable cost 3,888,000 4,618,944 5,101,834 3,673,320 17,282,098
Investment (already in
its PV) 3,500,000 3,500,000
PV of sales 4,551,360 4,746,878 4,607,123 2,909,460 16,814,821
PV of variable cost 3,351,456 3,431,875 3,270,275 2,027,673 12,081,279

Sensitivity: Sales value = 0.49%

If the income reduces by 0.49%, the NPV would be zero. Therefore, sales are highly sensitive.

Sensitivity: Variable cost = 0.68%

If the variable cost increases by 0.68%, the NPV would be zero. Therefore, variable cost is also
highly sensitive. However, it is less sensitive than sales.

Sensitivity: Investment = 2.33%

If the machine cost increases by 2.33%, the NPV would be zero. Therefore, the investment value
is the least sensitive compared to the other variables.
(3 marks)

(b)

Relevant learning outcome/s: 1.1.2 and 1.1.3

Study text reference: Pages 10 – 16

(i)

I disagree with the actions taken by the CFO of Dew PLC.

Despite opting for a supplier who could potentially offer materials at a lower price, Ruwan
chose this supplier (Danesh) due to personal connections rather than considering the full scope
of quality and reliability.

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June 2024
Ruwan, being the CFO of Dew PLC, is acting as an agent of the principals (i.e. the shareholders
of Dew PLC), and as such he (Ruwan) should act in the best interest of the shareholders.

Since Ruwan is using delegated power to run the day-to-day operations of the business, he is
obliged to set aside his personal interests, and act in a manner that increases the wealth of the
shareholders.

Additionally, he did not provide Pasindu adequate time to conduct a thorough analysis of the
new supplier’s quality standards.

Moreover, he accepted an unwarranted gift of Rs. 10 million, albeit with reluctance. Lastly, he
misled an employee entrusted with the task of sourcing a new supplier. Such actions
undermine ethical standards and compromise the integrity of the decision-making process.

Hence, Ruwan has failed to act in the best interest of the shareholders and has failed to fulfill
his duties as the agent of the company.
(3 marks)

(ii)

His actions are indefensible at this point due to his acceptance of a bribe in the form of a cheque
from Danesh. Had he refused the cheque and allowed Pasindu ample time to compile a
comprehensive report on the quality of the new supplier, and then made an informed decision
based on a comparison of product quality, the CFO’s choice to engage with Danesh could have
been justifiable.

If he had been confident that the new supplier’s quality fell short of Danesh’s standards and
had declined the cheque offered by Danesh, the situation might have been different.
(3 marks)
(iii)

I would promptly convene a meeting with the procurement officer/team to address the
apparent shortcomings in their duties. Subsequently, I would initiate an inquiry into the
conduct of the personnel responsible for procurement. If found culpable, appropriate
disciplinary measures would be taken, and efforts would be made to seek restitution for any
damages incurred.

Following this, I would propose to the board of directors the establishment of a procurement
committee, inclusive of board representation. This committee would be entrusted with the
responsibility of rigorously vetting and selecting suppliers based on criteria including quality
assurance and competitive pricing.

I would recommend that the internal audit committee take an active role in the monitoring of
the activities of the procurement team as an additional safety measure. Their oversight would
provide an added layer of accountability and help ensure that proper procedures are being
followed consistently.

I would initiate training programmes aimed at instilling the value of integrity among all the
employees within the organisation. These programmes would emphasise the importance of
ethical conduct in all aspects of work and encourage a culture of transparency and honesty. By
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June 2024
fostering a strong commitment to integrity, we can reinforce the ethical standards that are
fundamental to the organisation’s success and reputation.
(4 marks)

(Note: Marks were awarded for any relevant points and justifications)

(Total: 25 marks)
Answer 02

(a)

Relevant learning outcome/s: 2.3.1, 2.3.4 and 2.3.6

Study text reference: Pages 67 – 77

(i) The required yield of a similar risk bond should include adequate compensation for the
credit risk characteristics presented. The required yield can be constructed considering
the following.

• Risk-free rate: The risk-free rate is the base rate without taking into consideration
any incremental risk characteristics
• Historical premium in the bond issues: Historical premium in the bond issues would
demonstrate the risk premium (pre-default) benchmarked against the
risk-free interest rate
• Risk premium to compensate for default risk: As the present situation of the
counterparty is in default state, adequate adjustments should be incorporated to
factor in the increased risk due to defaulting the respective instruments

Required yield of the Risk premium for Risk premium for

bond = (USD risk-free rate + historical issue) x default risk
12% (6% + 4%) x 1.2
(3 marks)

(ii) Yield to maturity of proposed new bond

Year CF (USD) DCF at 4% PV Year CF (USD) DCF at 7% PV

0 (250,000,000) 1 (250,000,000) 0 (250,000,000) 1 (250,000,000)
1–5 10,800,000 4.4518223 48,079,681 1-5 10,800,000 4.1001974 44,282,132
5 270,000,000 0.8219271 221,920,319 5 270,000,000 0.7129862 192,506,268
NPV 20,000,000 NPV (13,211,599)

20,000,000
YTM = 4% + x 3%
33,211,599

YTM = 5.81%

(6 marks)

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June 2024
(iii) In order to determine the market value, the cash flow of the proposed bond should be
discounted at the required market return.

Year CF (USD) DCF at 12% PV (USD)

1–5 10,800,000 3.6047762 38,931,582.99
5 270,000,000 0.5674269 153,205,251.04
Market value of proposed new bond 192,136,834.03
(3 marks)
(b)

Relevant learning outcome/s: 5.3.3 and 5.3.6

Study text reference: Pages 529 – 535

(i)
Year 1 2 3 4 5 6 7 8 9 10
Fixed (%) 9 9 9 9 9 9 9 9 9 9
Floating (%) 8.5 9.5 10.5 11.5 7.5 7.5 7.5 7.5 7.5 7.5
Net effect (%) 0.5 -0.5 -1.5 -2.5 1.5 1.5 1.5 1.5 1.5 1.5
Net effect (%) (Total) 5.0

If SDP enters into a SWAP agreement with the term of paying SLIBOR plus 50 basis points, there
is a 5% net benefit to SDP. However, it depends on confirming the above-stated payment term
with the other party. There is a comparative advantage in entering into a SWAP agreement by
SDP as there will be a net benefit of 5%.
(4 marks)
(ii)

Floating Fixed
XYZ SLIBOR + 1.5% 10%
SDP SLIBOR + 3.5% 9%
Comparative advantage 2% 1%

SDP has a comparative advantage relative to XYZ in borrowing at a fixed interest rate, while
XYZ has a comparative advantage relative to SDP in borrowing at floating interest rates.

Since the spread between SDP and XYZ’s fixed rate cost is only 1%, while their differential is
2% in floating rate market, there is an opportunity for a 3% total gain by entering into this
swap agreement.
(3 marks)

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June 2024
(iii)

SDP XYZ
Original -9% (SLIBOR + 1.5%)
SDP pays XYZ (SLIBOR + 0.5%) SLIBOR + 0.5%
XYZ pays SDP 8.00% -8.00%
Commission -0.50% -0.50%
Net cost (SLIBOR + 2%) -9.50%
Could pay SLIBOR + 3.5% 10%
Net benefit 1.50% 0.50%

Alternatively,

SLIBOR 0.5% -0.50% SLIBOR

Financial
SDP XYZ
Institution
7.50% -0.50% 8%

9% SLIBOR 1.5%

Bank of SDP Bank of XYZ

SDP XYZ
Net payment -9% – SLIBOR – 0.5% + 7.5% -SLIBOR – 1.5% + SLIBOR – 8%
= SLIBOR + 2% = 9.5%
Net benefit 1.5% 0.5%

(6 marks)

(Total: 25 marks)

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June 2024
 SECTION 2
Answer 03
Relevant learning outcome/s: 2.2.6, 4.1.3, 4.1.4, 4.1.6, 4.1.7, 4.2.9 and 4.2.12
Study text reference: Pages 114 – 123, 242 – 249, 250 – 262 and 350 – 378

(a)

The first step is to value individual companies using the appropriate valuation technique as
given below.
Company Enterprise value (Rs. million)
Colombo Plaza Restaurants and City Hotel (CPRH) (W3) 26,576
Quick Eats PLC (QEP) (W12) 7,228

The combined entity (QEP and CPRH) can be valued at Rs. 50,661 million as calculated below.
The synergy from the business combination amounts to Rs. 16,857 million.

Rs. million
Colombo Plaza Restaurants and City Hotel (CPRH) 26,576
Quick Eats PLC (QEP) 7,228
Total 33,804
Combined entity valuation (W11) 50,661
Total synergy 16,857
25% premium for CPRH 6,644
Remaining synergy for QEP 10,213

Conclusion

QEP will end up with a positive synergistic benefit of Rs. 10,213 million after paying a premium
of 25%. Paying the full premium of Rs. 19 billion (Rs. 45 billion – Rs. 26 billion) would still
result in a negative value as the total synergy is limited to Rs. 16,857 million for QEP.

Since the enterprise value of CPRH is Rs. 26,576 million, the asking price of Rs. 45 billion seems
to be quite high. However, paying a premium of Rs. 6.6 billion (25% of synergy) to CPRH is
advisable as there will be a remaining synergy of Rs. 10.213 billion to QEP.

Working 1: Weighted average cost of capital (WACC) of CPRH

Risk-free rate 11.00%

Risk premium 5%
Levered beta 1.4
Cost of equity 18.00%

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June 2024
 Weightage Cost (%) WACC
Cost of equity 80 18% 14.4
Cost of debt 20 13% (1-0.3) 1.82
16.22
Approximately 16%

Working 2: Compound annual growth rate (CAGR)

Sales revenue growth rate: 7.586%
Approximately, CAGR is 8%

4 2,847
√
2,125

Year Cash flows (Rs. million)

1 2,125
2 2,426
3 2,735
4 2,783
5 2,847

Working 3: Free cash flow-based valuation of CPRH

2024/25 2025/26 2026/27 2027/28 2028/29
Rs. million
Free cash flows after tax 2,125 2,426 2,735 2,783 2,847
Terminal value (W4) 38,438
Total cash flows 2,125 2,426 2,735 2,783 41,285
Discount factor (16%) 0.862 0.743 0.641 0.552 0.476
Present value 1,832 1,803 1,753 1,536 19,652
Enterprise value 26,576

Working 4: Terminal value of CPRH

Cash flows in 2029/30 (Rs. million) 3,075

Ke – g 8%
Terminal value (Rs. million) 38,438

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June 2024
Working 5: Equity value of CPRH

Rs. million
CPRH enterprise value (W3) 26,576
Less: Debt (20%) (12,000/0.8) * 0.2 (3,000)
Equity value 23,576

Assumptions
1. Effective tax rate and corporate tax rate are the same
2. Income tax will be paid in the same year as earned
3. Depreciation equals capital allowances

Working 6: Unlevered beta of CPRH

Debt to equity 20:80

Beta 1.4
Unlevered beta = Levered beta * Equity/Equity + Debt (1 – Tax rate)
Unlevered beta = 1.4 * 80/(80 + 20 (1 – 0.3))
Unlevered beta 1.19

Working 7: Unlevered beta of QEP

Debt to equity 31:69

Beta 1.1
Unlevered beta = Levered beta * Equity/Equity + Debt (1 – Tax rate)
Unlevered beta = 1.1 * 69/(69 + 31 (1 – 0.3))
Unlevered beta = 0.84

Working 8: Unlevered beta of combined entity

Equity value Unlevered Unlevered beta of
(Rs. million) Weight beta combined entity
CPRH 23,576 71% 1.19 (W6) 0.84
QEP 9,600 29% 0.84 (W7) 0.24
Total 33,176 1.08

Working 9: Levered beta of combined entity

Debt to equity 31:69

Unlevered beta (W8) 1.08
Unlevered beta = Levered beta * Equity/Equity + Debt (1 – Tax rate)
1.08 = Levered beta * 69/ (69 + 31(0.7))
1.08 = 0.76 * Levered beta
Combined company levered beta 1.42

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June 2024
Working 10: WACC of combined entity

Risk-free rate 11.00%

Risk premium 5.00%
Levered beta (W9) 1.42
Cost of equity 18%
Cost of debt (1 – t) 7.7%

Weightage Cost WACC

Equity 69% 18% 12.42%
Debt 31% 7.7% 2.38%
14.8%
Approximately 15%

Working 11: Free cash flow-based valuation of combined entity

2024/25 2025/26 2026/27 2027/28 2028/29
Rs. million
Revenue 19,250 20,405 21,629 22,927 24,303
EBIT 6,160 6,530 6,921 7,337 7,777
Tax at 30% (1,848) (1,959) (2,076) (2,201) (2,333)
Additional investment (500) (185) (196) (208) (220)
Depreciation 661 651 718 763 786
Change in WC (254) (338) (124) (175) (210)
Free cash flows 4,219 4,699 5,243 5,516 5,800
Terminal value 68,311
Total cash flows 4,219 4,699 5,243 5,516 74,111
Discount factor (15%) (W10) 0.870 0.756 0.658 0.572 0.497
Present value 3,671 3,552 3,450 3,155 36,833
Enterprise value 50,661

Terminal value calculation of combined entity

2029/30 cash flows (Rs. million) 6,148

Ke – g 9%
Terminal value (Rs. million) 68,311

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June 2024
Working 12: Enterprise value of QEP
No. of Market Market
shares price per capitalisation
(million) share (Rs.) (Rs. million)
Equity value 300 32 9,600
Interest bearing loans and borrowings: Long-term 3,688
Interest bearing loans and borrowings: Short-term 1,312
Lease liability (25 + 9) 34
* Less: Other financial assets (3,050 + 4,356) (7,406)
Enterprise value 7,228

* Based on the historical numbers presented, it is assumed that Rs. 1,412 million of cash and
cash equivalents are maintained purely for working capital purposes and the excess cash is
invested in other financial assets. Therefore, these other financial assets are considered as
non-operating assets and deducted in arriving at the enterprise value of QEP as the given figure
seems to be material.
(30 marks)
(b)
Memo
From: Consultants
To: Board of directors QEP
Subject: Determination of target price

Our viewpoint

The synergy on acquisition should be attributed to both entities (QEP and CPRH). The selling
price until the synergistic benefit for QEP is zero would mean that the total benefit is given to
CPRH.

The main purpose of the acquisition is to bring value to your own shareholders. If the target
price is raised until the synergistic benefit is zero, the acquisition of CPRH will not add value to
the shareholders of QEP.

Hence, such negotiation is not acceptable from the perspective of the shareholders of QEP.

Therefore, we would agree with the top management’s decision to keep some percentage of the
synergy for QEP. We would like to suggest allocating the synergy between the companies based
on the enterprise values before the merger, as shown below.

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June 2024
 Rs. million As a %
Colombo Plaza Restaurants and City Hotel
(CPRH) 26,576 79%
Quick Eats PLC (QEP) 7,228 21%
Total 33,804 100%
Combined firm valuation 50,661
Total synergy 16,857
79% synergy for CPRH 13,317
21% synergy for QEP 3,540

In addition, the following factors make it too risky to distribute the entire synergistic benefit to
CPRH.
1. The assessment is based on many assumptions, and it may not be accurate when it comes
to the real world. For instance, the reliability of the growth rate, tax rates, cost of capital,
cost of debt, capital structure etc. used in determining the enterprise value should be
assessed. If abnormal assumptions are used the value determined based on such
assumptions will not be valid.
2. The economic condition may turn unfavourable in the long run.
3. Government laws and regulations may turn unfavourable in the long run.
Instead of giving the entire synergistic benefit to CPRH, it is advisable to retain a certain
percentage of the synergistic benefit for QEP. Therefore, QEP could consider a maximum target
price of Rs. 39.9 billion (Rs. 26.6 billion + Rs. 13.3 billion).
(8 marks)

(c)

Business acquisitions could fail for a variety of reasons such as the following.

Causes of acquisition failure Likelihood

Poor strategic fit
Sometimes, the acquiring company may not have a clear There are two types of
understanding of how the acquired business fits into its overall businesses: food delivery
strategy. This could result in a lack of synergy and difficulty in and hotel. As such, there
integrating the new business into existing operations. could be mismatches.
Overpaying
Acquiring companies may overestimate the value of the target This is a clear concern as the
company and pay too much for the acquisition. This could lead target company demands a
to financial strain and difficulty in achieving the expected return 41% premium [(Rs. 45
on investment. billion – Rs. 26.6)/Rs. 45
billion]
Financial challenges
Acquisitions can strain the financial resources of the acquiring Likely
company, especially if they take on significant debt to finance the
deal. Economic downturns or unexpected financial setbacks can Enterprise value of CPRH =
exacerbate these challenges. Rs. 26.6 billion

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June 2024
 25% premium = Rs. 6.6
Dilution of the shareholder’s stake billion
In addition, if equity is funded through external investors (to
source the acquisition), there will be an overall dilution of the Total funding = Rs. 33.2
stake from 100% to 30%. billion

Current shareholder stake = Rs. 9.6 billion (30%) Debt (31%) would be
Stake of new shareholders = Rs. 22.92 billion (70%) Rs. 10.29 billion
Total = Rs. 32.52 billion
Equity (69%) infusion would
be Rs. 22.92 billion

Having additional debt of

Rs. 10.29 billion would have
an additional pressure on
the financial statements.
Cultural differences
Mismatched corporate cultures can create tension and hinder Information not available
integration efforts. If the acquiring company fails to address
cultural differences and foster collaboration between teams, it
can impede the success of the acquisition.

Integration challenges Likely

Integrating two separate organisations can be complex and
time-consuming. Issues with integrating systems, processes, and
employees can disrupt operations and impact performance.

Lack of due diligence Likely

Inadequate due diligence can result in unforeseen problems
emerging post-acquisition, such as undisclosed liabilities,
regulatory issues, or operational inefficiencies.

Loss of key talent Likely

Key employees from the acquired company may leave due to
uncertainty or dissatisfaction with the acquisition, resulting in a
loss of critical knowledge and expertise.

Market changes Likely

Shifts in market conditions, technological advancements, or
changes in consumer behaviour can impact the viability of the
acquired business, making the original rationale for the
acquisition obsolete.

Legal or regulatory issues Likely

Legal or regulatory hurdles, such as antitrust concerns or
compliance issues, can delay or derail the acquisition process.
(12 marks)

(Total: 50 marks)
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June 2024
 Notice of Disclaimer

The answers given are entirely by the Institute of Chartered Accountants of Sri Lanka (CA Sri
Lanka) and you accept the answers on an "as is" basis.

They are not intended to be model answers, but rather suggested solutions or the best possible
answers. There can be other answers, which will need to be justified accordingly.

The answers given have two fundamental purposes, namely:

1. to provide a detailed example of a suggested solution to an examination question; and
2. to assist students with their research into the subject and to further their understanding
and appreciation of the subject.

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June 2024

SL2– Suggested Solutions June 2024