Notes

ACCA APPROVED
DF TCeOxtNRTEeNpTlaPcReODVEIDMEOR: Purchase from www.A-PDF.com to remove the watermark

































ACCA Approved
Practice & Revision Kit
Paper F9
Financial Management
For exams in September 2016, December 2016, March 2017 and June 2017

Validforboth paper and computer based exams


















http://accountingpdf.com/

ACCA APPROVED CONTENT PROVIDER



AsthefirstaccreditedpublisherofACCAmaterials,BPPLearningMediahassetthebenchmarkfor producingexceptionalstudymaterialsforstudentsandtutorsalike.

OurStudyTexts,Practice&RevisionKitsandi-Passes(forexamsondemand)arereviewedbytheACCA examiningteamandarewrittenbyourin-houseauthorswithindustryandteachingexperiencewho understandwhatisrequiredforexamsuccess.



EXAM SUCCESS SITE
Tohelpmaximiseyourchancesofsucceedinginyourexams,we’veputtogetherasuiteofexclusiveACCA resources.OurExamSuccesssiteprovidesyouwithaccesstoafreedigitalversionofthispublication,as wellasextraresourcesdesignedtofocusyoureffortsonexamsandstudymethods.

To accesstheExamSuccesssite,[email protected]“AccesstoExam Successsite-eBook”,includingyourorderreferencenumberandthenameofthebookyou’vebought(ie ACCAF5StudyText)foryouraccesscode.Onceyouhavereceivedyourcode,pleasefollowtheinstructions below:



















P R A C T I C
PAPERF9 E
FINANCIALMANAGEMENT &
R E V I S I O N

K I T
FOR EXAMS IN SEPTEMBER 2016, DECEMBER 2016, MARCH 2017
AND JUNE 2017




First edition 2008
Ninth edition February 2016


ISBN 9781 4727 4441 8
(previous ISBN ) 9781 4727 2691 9
e-ISBN 9781 4727 4656 6

British Library Cataloguing-in-Publication Data A catalogue record for this book
isavailablefromtheBritishLibrary Publishedby
BPPLearningMediaLtd BPPHouse,AldinePlace London W128AA

www.bpp.com/learningmedia

Printed in Beijing by
Beijing Congreat Printing Company Ltd.
Ji'an Road No. 2
Houshayu Jixiang Industrial Park Shunyi District
Beijing PRC



Allrightsreserved.Nopartofthispublicationmaybereproduced, storedinaretrievalsystemortransmittedinanyformorbyany means, electronic, mechanical, photocopying, recording or otherwise,withoutthepriorwrittenpermissionofBPPLearning Media.
The contents of this book are intended as a guide and not professionaladvice.Althougheveryefforthasbeenmadetoensure thatthecontentsofthisbookarecorrectatthetimeofgoingto press,BPPLearningMediamakesnowarrantythattheinformation inthisbookisaccurateorcompleteandacceptnoliabilityforany lossordamagesufferedbyanypersonactingorrefrainingfrom actingasaresultofthematerialinthisbook.
We are grateful to the Association of Chartered Certified Accountantsforpermissiontoreproducepastexamination questions.ThesuggestedsolutionsinthePractice&RevisionKit havebeenpreparedbyBPPLearningMediaLtd,exceptwhere otherwisestated.
©
BPP Learning Media Ltd 2016










ii

About this Practice & Revision Kit
ACCAwillstarttotransferF5–F9tocomputer-basedexamination(CBE),beginningwithapilotinlimitedmarketsin September 2016. Students will initially have the choice of CBE or paper exams and as a result, changes will be madetoBPP’slearningmaterialstoensurethatwefullysupportstudentsthroughthistransition.
This Practice & Revision Kit is valid for exams from the September 2016 sitting through to the June 2017 sitting and in this Practice & Revision Kit you will find questions in both multiple choice question (MCQ) and objective testingquestion(OTQ)format.OTQsincludeawidervarietyofquestionstypesincludingMCQaswellasnumber entry,multipleresponseanddraganddrop.MoreinformationonthesequestiontypeswillbeavailableontheACCA website.
OTQs will only appear in computer-based exams but these questions will still provide valuable practice for all studentswhicheverversionoftheexamistaken.TheseareclearlymarkedonthecontentspageaseitherCBEstyle OTQ bank or CBE style OTcase.
Inadditionpleasenotethatthespecimenpaper-basedexampaperhasbeenincludedasMockExam3inthis Practice&RevisionKit.ThequestionsinSectionsAandBareMCQonlywhereasinthecomputer-basedexam these sections will containOTQs.
More information on the exam formats and can be found on page xviii.
Atthetimeofgoingtoprint,ACCAhadnotyetannouncedtheproposeddurationofthecomputer-basedexamand so all timings given throughout this Practice & Revision Kit are based on the paper-based exam which is 3 hours and15minuteslong.Timemanagementisakeyskillforsuccessinthisexamandsowerecommendyouusethese indicative timings when attemptingquestions.
ACCAarerecommendingthatallstudentsconsulttheACCAwebsiteonaregularbasisforupdatesonthelaunchof the newCBEs.






























About this Practice &RevisionKit iii

Contents
Finding questions




Page

Questionindex v
Topicindex viii
Helpingyouwithyourrevision ix
Revising F9
Topicstorevise x
Questionpractice x
Passing theF9exam xi
Examformulae xv
Examinformation xvii
Usefulwebsites xviii
Questions and answers
Questions 3
Answers 73
Exam practice
Mock exam 1
Questions. 173
Planofattack 185
Answers 186
Mock exam 2 (CBE style)
Questions. 199
Planofattack 211
Answers 212
Mock exam 3 (Specimen exam)
Questions. 225
Answers 237
Mathematical tablesandformulae 245
Review form














iv Contents

Question index
Theheadingsinthischecklist/indexindicatethemaintopicsofquestions,butquestionsoftencoverseveral differenttopics.
Questionssetundertheoldsyllabusandexamformatareincludedbecausetheirstyleandcontentaresimilarto thosewhichappearintheF9exam.Thequestionshavebeenamendedtoreflectthecurrentexamformat.




Marks
Time
allocation Mins
Page number





Question

Answer

Part A: Financial management function



Section A Questions





1-5MCQ bank – Financial management and financial objectives
10
20
3
73

6-15CBEstyleOTQbank–Financialmanagementandfinancial objectives
20
39
4
73

Section B Questions





16-20 ABC Co
10
20
6
75



Section A Questions





21-25 MCQ bank – Financial management environment
10
20
8
75

26-30 MCQ bank – Financial management environment
10
20
9
76

31-35 MCQ bank – Financial management environment
10
20
9
76

36-40CBEstyleOTQbank–Financialmanagementenvironment
10
20
10
77



Section A Questions





41-45 MCQ bank – Working capital
10
20
12
77

46-55 CBE style OTQ bank – Managing working capital
20
39
13
78

56-60 CBE style OTQ bank – Working capital finance
10
20
14
80

Section B Questions





61-65 PKA Co (12/07, amended)
10
20
16
81

66-70 CBE style OT case Gorwa Co (12/08, amended)
10
20
17
81

71-75 CBE style OT case Cat Co
10
20
18
82

Section C Questions





76 APX Co (12/09, amended)
20
39
19
83

77 ZSE Co (6/10, amended)
20
39
20
85

78 WQZ Co (12/10, amended)
20
39
20
87

79 Bold Co (12/11, amended)
20
39
21
90



Question index v

80 Wobnig Co (6/12, amended)
20
39
22
92

81 KXP Co (12/12, amended)
20
39
23
94

82 CSZ Co (6/14, amended)
20
39
24
97

83 Flit Co (12/14, amended)
20
39
24
99

84 Widnor Co (6/15, amended)
20
39
25
102




Section A Questions





85-94 MCQ bank – Investment decisions
20
39
26
103

95-104 MCQ bank – Investment appraisal using DCF
20
39
28
105

105-114 MCQ bank – Allowing for tax and inflation
20
39
30
107

115-119 CBE style OTQ bank – Project appraisal and risk
10
20
32
109

120-129 CBE style OTQ bank – Specific investment decisions
20
39
33
110

Section B Questions





130-134 Sensitivity analysis
10
20
35
112

135-139 CBE style OT case Trecor Co (Specimen paper 2007, amended)
10
20
36
113

140-144 CBE style OT case BRT Co (6/11, amended)
10
20
37
113

Section C Questions





145 Calvic Co
20
39
39
114

146 Project E (6/14, amended)
20
39
39
116

147 AGD Co (FMC, 12/05, amended)
20
39
40
118

148 Basril Co (FMC, 12/03, amended)
20
39
40
121

149 Filtrex Co
20
39
41
122

150 Warden Co (12/11, amended)
20
39
41
124

151 BQK Co (12/12, amended)
20
39
42
126

152 Uftin Co (12/14, amended)
20
39
43
128

153 Hraxin Co (6/15, amended)
20
39
44
131



Section A Questions





154-158 MCQ bank – Sources of finance
10
20
45
133

159-163 MCQ bank – Dividend policy
10
20
46
134

164-173 MCQ bank – Gearing and capital structure
20
39
47
135

174 -183 CBE style OTQ bank – The cost of capital
20
39
49
136

184- 193 CBE style OTQ bank – Capital structure
20
39
51
138





vi Questionindex

Section B Questions





194-198 CBE style OT case IML Co
10
20
52
140

Section C Questions





199 Bar Co (12/11, amended)
20
39
53
141

200 YGV Co (6/10, amended)
20
39
54
143

201 NN Co (12/10, amended)
20
39
55
146

202 AQR Co (6/11, amended)
20
39
56
148

203 BKB Co (12/12, amended)
20
39
56
150

204 Fence Co (6/14, amended)
20
39
57
153

205 Tinep Co (12/14, amended)
20
39
57
155

206 Grenarp Co (6/15, amended)
20
39
58
157




Section A Questions





207-216 MCQ bank – Business valuations
20
39
59
160

217-221 CBE style OTQ bank – Market efficiency
10
20
61
161

Section B Questions





222-226 Phobis Co (12/07, amended)
10
20
62
162

227-231 CBE style OT case Corhig Co (6/12, amended)
10
20
63
163

232-236 CBE style OT case Close Co (12/11, amended)
10
20
64
164



Section A Questions





237-246 MCQ bank – Foreign currency risk
20
39
66
164

247-251MCQ bank – Interest rate risk
10
20
67
166

Section B Questions





252-256 Rose Co (6/15, amended)
10
20
68
166

257-261 CBE style OT case Zigto Co (6/12, amended)
10
20
69
167


Mock exam 1

Mock exam 2 (CBE style)

Mock exam 3 (Specimen exam)







Questionindex vii

Topic index
ListedbelowarethekeyPaperF9syllabustopicsandthenumbersofthequestionsinthisKitcoveringthose topics.
Ifyouneedtoconcentrateyourpracticeandrevisiononcertaintopicsorifyouwanttoattemptallavailable questions that refer to a particular subject, you will find this index useful.
Assetreplacementdecisions 165,127,128,145,149
Businessvaluation 207-216, 222-225, 227-228,232-236
Capitalrationing 123, 124, 125, 129, 145,148
Capitalstructure 184-193
Cashmanagement 56, 57, 58, 77, 81c,83
Cashoperatingcycle 41, 42, 79,82a
Costofcapital 174-183, 194, 196-198, 200,201
Dividendpolicy 159-163, 201c,205c
Environment/economics 21-23, 25, 31-40, 84c,151b
Financialintermediaries 26,76c
Financialmanagement 2, 6,15
Foreigncurrencyrisk 237-246, 252-256,257-261
Gearing 164-168, 199d,200b
Interestraterisk 247-251
Inventorymanagement 43, 47, 48, 53, 55, 62, 63, 78a,81b
IRR 98, 100, 101, 103, 132, 134, 139,150b
Leasing 102, 121, 122, 126,147
Marketefficiency 217-221,226
NPV 88-90, 94-97, 99, 101-119, 134, 137, 146, 147,150-
153
Objectives 5, 7, 9, 12, 13,20
Overtrading 44, 69,80
Payablesmanagement 54
Payback 86, 91, 131, 138,146b
Ratioanalysis 1, 3, 4, 8, 14, 16, 17, 19, 45, 66, 67, 80,82b
Receivablesmanagement 49, 50, 51, 52, 64, 65, 77b, 78b, 79c, 81a, 81d,84
ROCE 85, 87, 93, 135,136
Riskanduncertainty 115-119, 147c, 152, 153, 199c,231
Sensitivityanalysis 130, 133,150c
Sourcesoffinance 28, 29, 30, 154-158, 169-173, 199, 200c, 203c,205b,
206
Totalshareholderreturn 10, 18,195
WACC 201-205,230
Workingcapitalfinancing 59, 60, 76b, 80,82c
Workingcapitalmanagement 45, 61, 68, 70, 76, 78c,79


viii Topicindex

Helping you with your revision

BPP Learning Media – ACCA Approved ContentProvider
As an ACCA Approved Content Provider, BPP Learning Media gives you the opportunity to use revision materials reviewed by the ACCA examination team. By incorporating the ACCA examination team’s comments and suggestionsregardingthedepthandbreadthofsyllabuscoverage,theBPPLearningMediaPractice&RevisionKit provides excellent, ACCA-approved support for yourrevision.

Tackling revision and theexam
Using feedback obtained from the ACCA examination team review:
We look at the dos and don’ts of revising for, and taking, ACCAexams
WefocusonPaperF9;wediscussrevisingthesyllabus,whattodo(andwhatnottodo)intheexam,howto approach different types of question and ways of obtaining easymarks

Selectingquestions
We provide signposts to help you plan your revision.
A full questionindex
Atopicindexlistingallthequestionsthatcoverkeytopics,sothatyoucanlocatethequestionsthatprovide practice on these topics, and see the different ways in which they might beexamined

Making the most of question practice
AtBPPLearningMediawerealisethatyouneedmorethanjustquestionsandmodelanswerstogetthemostfrom your questionpractice.
Ourtoptipsincludedforcertainquestionsprovideessentialadviceontacklingquestions,presenting answers and the key points that answers need toinclude.
Weshowyouhowyoucanpickupeasymarksonsomequestions,asweknowthatpickingupallreadily available marks often can make the difference between passing andfailing.
We include marking guides to show you what the examination teamrewards.
Weincludecommentsfromtheexaminationteamtoshowyouwherestudentsstruggledorperformedwell in the actualexam.
We refer to the BPP Study Text for exams in September 2016, December 2016, March 2017 and June 2017 for detailed coverage of the topics covered inquestions.


Attempting mockexams
There are three mock exams that provide practice at coping with the pressures of the exam day. We strongly recommend that you attempt them under exam conditions. Mock exams 1 and 2 reflect the question styles and syllabuscoverageofthepaper-basedandcomputer-basedexamsrespectively;Mockexam3istheSpecimenexam paper.






Helping you withyourrevision ix

Revising F9

Topics torevise
Theexamconsistsof15objectivetestquestions,3objectivetestcasesand2longerformquestions,allofwhich arecompulsory.Noonesectioninthesyllabusismoreimportantthananothersotherearenoshort-cuts.Youwill have to be able to answer questions on the entiresyllabus.

Questionpractice
Practisingasmanyexam-stylequestionsaspossiblewillbethekeytopassingthisexam.Youmustdoquestions undertimedconditionsandensureyouwritefullanswerstothediscussionpartsaswellasdoingthecalculations.
Make sure you practise written sections as well as the calculations.











































x RevisingF9

Passing the F9 exam

Displaying the right qualities
TheaimofPaperF9istodeveloptheknowledgeandskillsexpectedofafinancemanagerinrelationtoinvestment, financing and dividenddecisions.
Youneedtobeabletocommunicateyourunderstandingclearlyinanexamcontext.Calculationsanddiscussions areequallyimportantsodonotconcentrateonthenumbersandignorethewrittenparts.
You need to be able to:
Understand the role and purpose of the financial managementfunction
Assess and understand the impact of the economic environment on financialmanagement
Discuss and apply working capital managementtechniques
Carry out effective investmentappraisal
Identify and evaluate alternative sources of businessfinance
Explainandcalculatecostofcapitalandthefactorsthataffectit
Understandandapplyriskmanagementtechniquesinbusiness

Avoiding weaknesses
Thereisnochoiceinthispaper,allquestionshavetobeanswered.Youmustthereforestudytheentire syllabus, there are noshort-cuts.
Abilitytoanswermultiplechoicequestionsandcasesimproveswithpractice.Trytogetasmuchpractice with these questions as youcan.
Thelongerquestionswillbebasedonsimplescenariosandanswersmustbefocusedandspecifictothe organisation.
Answerplansforthelongerquestionswillhelpyoutofocusontherequirementsofthequestionandenable you to manage your time effectively – but there will not be muchtime.
Answerallpartsofthelongerquestions.Evenifyoucannotdoallthecalculationelements,youwillstillbe able to gain marks in the discussionparts.
























RevisingF9 xi

Gaining the easy marks
Easy marks in this paper tend to fall into three categories.

Multiplechoicequestions
SomeMCQsareeasierthanothers.Answerthosethatyoufeelfairlyconfidentaboutasquicklyasyoucan.Come backlatertothoseyoufindmoredifficult.Thiscouldbeawayofmakinguseofthetimeintheexaminationmost efficiently andeffectively.
ManyMCQswillnotinvolvecalculations.Makesurethatyouunderstandthewordingof'written'MCQsbefore selecting youranswer.

CalculationsinSectionCquestions
Thecalculationswithinaquestionwillgetprogressivelyharderandeasymarkswillbeavailableintheeasystages. Set our your calculations clearly and show all your workings in a clear format. Use a proforma, for example in complexNPVquestionsandslotthesimplerfiguresintotheproformastraightawaybeforeyouconcentrateonthe figures that need a lot ofadjustment.

DiscussionsinSectionCquestions
ASectionCquestionmayseparatediscussionrequirementsfromcalculations,sothatyoudonotneedtodothe calculationsfirstinordertoanswerthediscussionpart.Thismeansthatyoushouldbeabletogainmarksfrom making sensible, practical comments without having to complete thecalculations.
Discussionsthatarefocusedonthespecificorganisationinthequestionwillgainmoremarksthanregurgitationof knowledge. Read the question carefully and more than once, to ensure you are actually answering the specific requirements.
Pick out key words such as 'describe', 'evaluate' and 'discuss'. These all mean something specific.
'Describe' means to communicate the key featuresof
'Evaluate' means to assess the valueof
'Discuss' means to examine in detail byargument
Clearlylabelthepointsyoumakeindiscussionssothatthemarkercanidentifythemallratherthangettinglostin thedetail.
Provide answers in the form requested. Use a report format if asked for and give recommendations if required.



















xii RevisingF9

Tackling objective test case questions
First,readthewholecasescenario.Makeanoteofanyspecificinstructionsorassumptions,suchas‘ignore inflation’ in a net present valuequestion.
Thenskimthroughtherequirementsofthefivequestions.Thequestionsareindependentofeachotherandcanbe answered in anyorder.
SomeoftheOTswillbeeasierthanothers.Forexample,youmaybeaskedtoidentifytheadvantagesoftheinternal rate of return in investment appraisal. Answer these OTsquickly.
Other OTs will be more difficult and/or complex. There are two types of OT that may take you longer to answer.
Thefirstmoretime-consumingOTwillinvolvedoingacomputation.Forexample,youmaybeaskedtocalculate thenetpresentvalueofaproject.Youwillprobablyneedtojotdownaquickproformatoansweracomputational questionlikethis.IftheOTisamultiplechoicequestion,rememberthatthewronganswerswillusuallyinvolve commonerrorssodon’tassumethatbecauseyouhavethesameanswerasoneoftheoptionsthatyouransweris necessarilycorrect!Doublechecktomakesureyouhaven’tmadeanysillymistakes.Ifyouhaven’tgotthesame answerasanyoftheoptions,reworkyourcomputation,thinkingcarefullyaboutwhaterrorsyoucouldhavemade. If you still haven’t got one of the options, choose the one which is nearest to youranswer.
Thesecondmoretime-consumingOTisonewhereyouareaskedtoconsideranumberofstatementsandidentify whichone(ormore)ofthemiscorrect.Makesurethatyoureadeachstatementatleasttwicebeforemakingyour selection. Be careful to follow the requirements of the OT exactly, for example if you are asked to identify two correctstatements.




































RevisingF9 xiii

Exam formulae
Setoutbelowaretheformulaewhichyouwillbegivenintheexam,andformulaewhichyoushouldlearn.Ifyouare notsurewhatthesymbolsmean,orhowtheformulaeareused,youshouldrefertotheappropriatechapterinthis StudyText

Examformulae Chapter in StudyText
EconomicOrderQuantity 5
=
Miller-OrrModel 6
Return point = Lower limit + (1/3 spread)

Spread =3

1
3 × transaction cost × variance of cash flows3
 

 interestrate 
⎝ 
The Capital AssetPricingModel 15
E(ri) = Rf+ ßi(E (rm) – Rf)
The AssetBetaFormula 16

ß = Ve
+ 
Vd(1T) 

a (V + V (1T))e (V + V (1T)) d
⎝e d  ⎝e d 
TheGrowthModel 17
P = D0(1+ g)
0 (re g)
Gordon'sGrowthApproximation 17
g = bre
The weighted average costofcapital 15

WACC = Ve
k + Vd
k (1–T)

V + V e V + V d
⎝e d ⎝e d
TheFisherformula 19
(1 + i) = (1 + r)(1 + h)
Purchasing Power Parity and Interest Rate Parity

S1= S0F0= S0
(1+hc) 19
(1+ hb)
(1+ic) 19
(1+ ib)





xiv RevisingF9

Formulae to learn
Profitability ratios include:
ROCE = Profitbeforeinterestandtax(PBIT)
Capital employed

ROCE = PBIT
Revenue
 Revenue Capitalemployed

ROCE = Profit margin assetturnover
Debt ratios include:

Gearing = Debt
Equity

or Debt (andeitherbookvaluesormarketvaluescanbeused) Debt +Equity

Gearing = Priorchargecapital Equity capital(includingreserves)
Interest coverage =PBIT
Interest
Liquidity ratios include:
Current ratio = Current assets : Current liabilities
Acid Test ratio = Current assets less inventory : Current liabilities
Shareholder investor ratios include:
Dividend yield =Dividend per share× 100
Market price per share
Earnings per share = Profits distributable to ordinary shareholders
Number of ordinary shares issued
Price earnings (P/E) ratio = Market price per share
EPS


Accounts receivable days=

Inventory days
Receivables (credit)sales

365days


Finished goods=
Finished goods Cost of sales

365days

WIP = AverageWIP
Cost of sales
365days

Raw material: Average raw materialinventory
Annual raw material purchases

365days

Accountspayableperiod Payables
Creditpurchases(orcostofsalesifpurchasesunavailable)

365days


IRR = a +
NPVa NPVa -NPVb

(b – a)

Equivalent annualcost = PVofcostoveronereplacementcycle
Annuity factor for the number of years in the cycle


Revising F9 xv


Cost of equity = Ke
D1 g P0


Cost of debt = Kd=
i(1 T) P0

Cost of preference shares = Kpref=
Preference Dividend = d
MarketValue(exdiv) P0


Profitability index = PV of cash flows (not including capital investment)
Capital investment















































xvi RevisingF9

Exam information

Computer based exams
ACCAhaveannouncedthattheyintendtocommencethelaunchofcomputerbasedexams(CBEs)forF5-F9.They will be piloting computer based exams in limited markets in September 2016 with the aim of rolling out into all marketsinternationallyoverafiveyearperiod.PaperbasedexaminationswillberuninparallelwhiletheCBEsare phasedinandBPPmaterialshavebeendesignedtosupportyou,whicheverexamoptionyouchoose.

Format of the exam
The exam format is the same irrespective of the mode of delivery and will comprise three exam sections.

Section
Style of question type
Description
Proportion of exam, %

A
Objective test (OT)
15 questions x 2 marks
30

B
Objective test (OT) case
3 questions x 10 marks
Each question will contain 5 subparts each worth 2 marks
30

C
Constructed Response (Long questions)
2 questions x 20 marks
40

Total


100

Section A and B questions will be selected from the entire syllabus. The paper version of these objective test questionscontainmultiplechoiceonlyandthecomputerbasedversionswillcontainavariety.Theresponsesto eachquestionorsubpartinOTcasesaremarkedautomaticallyaseithercorrectorincorrectbycomputer.
SectionCquestionswillmainlyfocusonthefollowingsyllabusareasbutaminorityofmarkscanbedrawnfrom any other area of thesyllabus
Working capital management (syllabus areaC)
Investment appraisal (syllabus areaD)
Business finance (syllabus areaE)
The responses to these questions are human marked.

Additional information
The Study Guide provides more detailed guidance on the syllabus.















RevisingF9 xvii

Useful websites
ThewebsitesbelowprovideadditionalsourcesofinformationofrelevancetoyourstudiesforFinancial Management.
www.accaglobal.com
ACCA'swebsite.Thestudents’sectionofthewebsiteisinvaluablefordetailedinformationaboutthe qualification,pastissuesofStudentAccountant(includingtechnicalarticles)andafreedownloadable Student PlannerApp.
www.bpp.com
Our website provides information about BPP products and services, with a link to the ACCA website.
www.ft.com
Thiswebsiteprovidesinformationaboutcurrentinternationalbusiness.Youcansearchforinformationand articlesonspecificindustrygroupsaswellasindividualcompanies.(Note:Subscriptionrequired)
www.economist.com
Hereyoucansearchforbusinessinformationonaweek-by-weekbasis,searcharticlesbybusinesssubject andusetheresourcesoftheEconomistIntelligenceUnittoresearchsectors,companiesorcountries.
(Note: Subscription required for some content)
www.investmentweek.co.uk
This site carries business news and articles on markets from Investment Week and International Investment.
www.pwc.com
The PricewaterhouseCoopers website includes UK Economic Outlook.
www.cfo.com
Good website for financial officers.
www.bankofengland.co.uk
This website is useful for sourcing Bank of England publications.

























xviii RevisingF9












Questions
























1

















































2



MCQ bank – Financial management and financial objectives
20 mins
Last year ABC Co made profits before tax of $2,628,000. Tax amounted to$788,000.
ABC Co's share capital was $2,000,000 (2,000,000 shares of $1) and $4,000,000 6% preference shares. What was the earnings per share (EPS) for the year?
31c
80c
92c
119c (2marks)
The following statements relate to various functions within abusiness.
The financial management function makes decisions relating tofinance
Management accounts incorporate non-monetary measures Are the statements true orfalse?
A Statement1istrueandstatement2isfalse B Both statements aretrue
Statement 1 is false and statement 2 istrue
Both statementsarefalse (2marks)
Acompanyhasrecentlydeclaredadividendof12cpershare.Thesharepriceis$3.72cumdivandearnings for the most recent year were 60c pershare.
WhatistheP/Eratio? A 0.17
B 6.00
C 6.20
D 6.60 (2marks)
ThefollowinginformationrelatestotheordinarysharesofGCo. Earningspershare 60c
Dividendcover 2.5
Publisheddividendyield 4.8%
WhatisthepriceofGCo’sordinarysharesimpliedbythedataabove? A 24c
115c
313c
500c (2marks)
Which of the following is most appropriate as an objective of a not-for-profitorganisation?

A
To achieve long term growth in earnings


B
To maximise shareholder wealth


C
To make efficient use of resources


D
To minimise input costs
(2 marks)
(Total = 10 marks)





Questions 3

CBE style OTQ bank – Financial management and financial objectives 39mins
Which of the following are the THREE key areas covered by financial managementdecisions?
Investment Cash flow Finance
Dividend (2marks)
WhichofthefollowingdoesNOTformpartoftheobjectivesofacorporategovernancebestpractice framework?
Separation of chairperson and CEO roles
Establishment of audit, nomination and remuneration committees Minimisation of risk
Employmentofnon-executivedirectors (2marks)
ThefollowinginformationrelatestoACoforthelastfinancialyear. Revenue $200million
Assetturnover 10times
Interestpayable $1.5million
Interestcoverratio 5times
What is the return on capital employed for A Co for the year?
% (2marks)
Aschooldecidestohavelargerclasses,andexaminationresultssufferasaresult.Intermsofthe'valuefor money' framework, which one of the following statements istrue?
Economy has increased but efficiency has decreased Efficiencyhasincreasedbuteffectivenesshasdecreased Economyhasincreasedbuteffectivenesshasdecreased
Economyhasincreased,butefficiencyandeffectivenesshavedecreased (2marks)
HCo'ssharepriceis$3.50attheendof20X1andthisincludesacapitalgainof$0.75sincethebeginning of the period. A dividend of $0.25 has been declared for20X1.
What is the shareholder return (to 1 dp)?

% (2marks)
Stakeholderscanbeclassifiedasinternal,connectedorexternal.Whichofthefollowingisanexternal stakeholder?
Shareholders Customers Bankers
Government (2marks)







4 Questions

Agovernmentbodyusesmeasuresbaseduponthe'threeEs'tomeasurevalueformoneygeneratedbya publicly fundedhospital.
Which of the following relates to efficiency?
Costpersuccessfullytreatedpatient Cost peroperation
Proportion of patients readmitted after unsuccessful treatment
Percentagechangeindoctors’salariescomparedwithpreviousyear (2marks)
In not-for-profit businesses and state-run entities, a value-for-money audit can be used to measure performance.Itcoversthreekeyareas:economy,efficiencyandeffectiveness.Whichofthefollowingcould be used to describe effectiveness in thiscontext?
Avoiding waste of inputs Achieving agreed targets Achieving a given level of profit
Obtainingsuitablequalityinputsatthelowestprice (2marks)
Whichofthefollowingstatementsarevalidcriticismsofreturnoncapitalemployed(ROCE)asa performancemeasure?

1
It is misleading if used to compare departments with different levels of risk


2
It is misleading if used to compare departments with assets of different ages


3
Its use may discourage investment in new or replacement assets


4
The figures needed are not easily available



2 and 3 only



2 and 4 only



1 and 3 only



1, 2 and 3
(2 marks)



Are the following statements true orfalse?

Cashflowforecastingisprimarilytheresponsibilityoffinancialreporting
Whethertoundertakeaparticularnewprojectisafinancialmanagementdecision

True False


(2 marks) (Total = 20 marks)























Questions 5

ABCCo 20mins
The following scenario relates to questions 16 – 20.

Summary financial information for ABC Co is given below, covering the last two years.
20X8 20X7
STATEMENT OF PROFIT OR LOSS (EXTRACT)
$’000

$’000


Revenue
74,521

68,000


Cost of sales
28,256

25,772


Salaries and wages
20,027

19,562


Other costs
11,489

9,160


Profit before interest and tax
14,749

13,506


Interest
1,553

1,863


Tax
4,347

3,726


Profit after interest and tax
8,849

7,917


Dividends payable
4,800

3,100



STATEMENT OF FINANCIAL POSITION (EXTRACT)
20X8
$’000

20X7
$’000


Shareholders’ funds
39,900

35,087


Long term debt
14,000

17,500



53,900

52,587


Other information





Number of shares in issue (‘000)
14,000

14,000


P/E ratio (average for year) ABC Co

14.0


13.0


Industry
15.2

15.0


Shareholders’ investment
EPS


$0.63


$0.57

Share price

$8.82

$7.41

Dividend per share

$0.34

$0.22






(2 marks)




(2 marks)




(2 marks)




6 Questions

As well as the information above, the following extra data isavailable:


20X8
20X7

Gearing (Debt/Equity)
35.1%
49.9%

Interest cover (PBIT/Interest)
9.5
7.2

Based on all of the information available, are the following statements true or false?
Employees may be unhappy with their wages in20X8
Financial risk for shareholders appears to be a problemarea
A Statement1istrueandstatement2isfalse B Both statements aretrue
Statement 1 is false and statement 2 istrue
Both statementsarefalse (2marks)
Accountingprofitsmaynotbethebestmeasureofacompany’sperformance. Which of the following statements support thistheory?
Profits are affected by accountingpolicies
Profits take no account ofrisk
Profits take no account of the level of investment made during theyear
Profits are measures of short-term historicperformance
A 2 and 4only
B 1, 2, 3 and4
2 and 3only
1only (2marks)
(Total = 10 marks)



































Questions 7



MCQ bank – Financialmanagementenvironment 20mins
Agovernmenthasadoptedacontractionaryfiscalpolicy. How would this typically affect businesses?
Higher interest rates and higherinflation
Lowertaxesandhighergovernmentsubsidies C Highertaxesandlowergovernmentsubsidies
D Lowerinflationandlowerinterestrates (2marks)
Agovernmentfollowsanexpansionarymonetarypolicy. How would this typically affectbusinesses?
A Higherdemandfromcustomers,lowerinterestratesonloansandincreasedavailabilityofcredit B Acontractionindemandfromcustomers,higherinterestratesandlessavailablecredit
Lower taxes, higher demand from customers but less government subsidies/availablecontracts
Lowerinterestrates,lowerexchangeratesandhighertaxrates (2marks)
Astheeconomyboomsandapproachesthelimitsofproductivityatapointintime,amanufacturing business would typically feel which one of the followingeffects?
Increasedinflation(highersalespricesandhighercosts),difficultyinfindingsuitablecandidatesto fill roles and higher interestrates
Highexportdemand,increasinggrowthrates,highinflationandhighinterestrates C Reducinginflation,fallingdemand,reducinginvestment,increasingunemployment
D Highergovernmentspending,lowertaxrates,highinflationandlowunemployment (2marks)
Which one of the following statements isincorrect?
Money markets are markets for long-termcapital
Money markets are operated by banks and other financialinstitutions
Money market instruments include interest-bearing instruments, discount instruments and derivatives
Moneymarketinstrumentsaretradedoverthecounterbetweeninstitutionalinvestors (2marks)

Whichofthefollowingorganisationsismostlikelytobenefitfromaperiodofhighpriceinflation? A An organisation which has a large number of long termpayables
An exporter of goods to a country with relatively lowinflation
Asupplierofgoodsinamarketwhereconsumersarehighlypricesensitiveandsubstituteimported goods areavailable
A large retailer with a high level of inventory on display and low rate of inventoryturnover
(2 marks)(Total = 10 marks)






8 Questions

MCQ bank – Financialmanagementenvironment 20mins
WhichofthefollowingisNOTafunctionthatfinancialintermediariesfulfilforcustomersandborrowers?



(2 marks)








(2 marks)


Compliancecostsarelikelytoincrease,butbetterpublicprofileandaccesstofundsbenefitthe business.
Allelsebeingequalthevalueofthebusinessislikelytobeunaffected. C It allows owners to realise theirinvestment.
D Itincreasestheliquidityofthesharesforshareholders. (2marks)
ABplc,acompanylistedinUKandAustralia,decidestoissueunsecuredUSdollarbondsinAustralia. What are these bonds referred toas?
Junkbonds
Commercialpaper
Eurobonds
Intercontinentalbills (2 marks)
Rankthefollowingfromhighestrisktolowestriskfromtheinvestor'sperspective.

1
Preference share


2
Treasury bill


3
Corporate bond


4
Ordinary share


A
1, 4, 3, 2


B
1, 4, 2, 3


C
4, 2, 1, 3


D
4, 1, 3, 2
(2 marks)



(Total = 10 marks)


MCQ bank – Financialmanagementenvironment 20mins
InterestratesinIsopiahaverecentlybeenreduced.Whichofthefollowingismostlikelytoresultfromacut in interestrates?
An increase insavings
An increase inspending C Adecreaseinborrowing
D A decreaseinconsumption (2marks)


Questions 9

Whichof the following is most likely to increase aggregate demand in theeconomy?
Increasedsaving
Increasedspendingonimports C Increased taxation
D Increasedinvestment (2marks)
Whichofthefollowingwouldbelikelytooccuriftherewasanincreaseinthemoneysupplyinthe economy?
A Ariseintherateofinflation B A rise in interestrates
A rise in exchangerates
Afallinthelevelsofinvestment (2marks)
Whichofthefollowingisanaspectoffiscalpolicymeasuresbythegovernment? A To raise short-term interest rates in the moneymarkets
B Tosupporttheexchangerateforthecountry’scurrency C To control growth in the money supply
D Toalterratesoftaxation (2marks)
ThegovernmentofBeelandisoperatinganexpansionaryfiscalpolicy.Whichofthefollowingisthismost likely toinclude?

A
A fall in interest rates


B
An increase in corporation tax


C
An increase in government spending


D
An increase in the money supply
(2 marks)



(Total = 10 marks)


CBE style OTQ bank – Financial management environment
20 mins

Thefollowingstatementsrelatetofiscalpolicyanddemandmanagement. Are the statements true orfalse?

Ifagovernmentspendsmorebyborrowingmore,itwillraisedemandintheeconomy
If demand in the economy is high then government borrowing willfall



True False


(2 marks)

If the US dollar weakens against the pound sterling, will UK exporters and importers suffer orbenefit?




UK exporters to US UK importers fromUS
Benefit Suffer




(2 marks)

GovernmentmacroeconomicobjectivestypicallyincludewhichTHREEofthefollowing? Economic growth and highemployment
Low inflation
Balance of payments stability
A guaranteed minimum income for all






(2 marks)



10 Questions

Which THREE of the following are among the main goals of macroeconomicpolicy?
Encouraging economic growth Low and stable inflation
Achievementofabalancebetweenexportsandimports Encouraging an equitable distribution ofincome
(2 marks)
Ifagovernmenthasamacro-economicpolicyobjectiveofexpandingtheoveralllevelofeconomicactivity, which of the following measures would NOT be consistent with such anobjective?
Increasing public expenditure Lowering interest rates Increasing the exchange rate
Decreasingtaxation (2 marks)
(Total = 10 marks)














































Questions 11



MCQ bank –Workingcapital 20mins
ThefollowinghasbeencalculatedforBBCo: Receivables days:58
Inventoryturnover:10timesperannum Payables days:45
Non-current asset days: 36
What is the length of the cash operating cycle?
23days
49.5days
85.5days
139.5days (2marks)
DCodecidestooffera2%earlysettlementdiscountthathalfofallcustomerstakeup.Theypayin1month instead of the usual 2. D Co pays 10% per annum for its overdraftfacility.
What impact will this have?
Cashoperatingcycle Reportedprofits

A
Reduce
Increase

B
Unaffected
Increase

C
Reduce
Reduce

D
Unaffected
Reduce

(2 marks)

WWCohasacurrentratioof2.Receivablesare$3millionandcurrentliabilitiesare$2million. What are inventory days if cost of sales is $10 million perannum?
36.5days
91.25days
14.6days
243.3days (2marks)

Which of the following best describesovertrading?
A Sellingmorethanyoucanmanufactureand/oryouholdininventory. B Havingtoomuchworkingcapitalthusreducingprofitability.
Sellingstocksandsharesoutsidethestockexchangeopeninghours.
Sufferingliquidityissuesasaresultofgrowingtooquickly. (2 marks)
MM Co sells some inventory on credit for aprofit.
All else being equal, what will happen to the quick and current ratio after this sale?
Quick Current
Increase Decrease
Nochange Increase
Increase Nochange
Increase Increase (2 marks) (Total = 10marks)





12 Questions

CBE style OTQ bank – Managing workingcapital 39mins
TS Co has daily demand for ball bearings of 40 a day for each of the 250 working days (50 weeks) of the year.Theballbearingsarepurchasedfromalocalsupplierfor$2each.Thecostofplacinganorderis$64 per order, regardless of the size of the order. The inventory holding costs, expressed as a percentage of inventory purchase price, is 25% perannum.
What is the economic order quantity?

ball bearings


EECohascalculatedthefollowinginrelationtoitsinventories. Bufferinventorylevel 50units
Reordersize 250items
Fixedordercosts $50 per order Costofholdingontooneitempa $1.25peryear Annualdemand 10,000items
Purchaseprice $2 peritem
Whatarethetotalinventoryrelatedcostsforayear(tothenearestwhole$)?

$

WhichofthefollowingisNOTgenerallyabenefitofa'justintime'approach? Lower inventorylevels
Better product customisation Ease of production scheduling
(2 marks)










(2 marks)

Higherquality (2marks)
XYZCohasannualcreditsalesof$20millionandaccountsreceivableof$4million.Workingcapitalis financed by an overdraft at 12% interest per year. Assume 365 days in ayear.
Whatistheannualfinancialeffectifmanagementreducesthecollectionperiodto60daysbyofferingan early settlement discount of 1% that all customersadopt?
$85,479 benefit
$114,521 cost
$85,479 cost
$285,479benefit (2marks)
Which of the following services may be provided by a debtfactor?
Bad debtinsurance
Advancement ofcredit
Receivables ledgermanagement
Management of debt collectionprocesses
1, 2 and 4 only
1 and 4 only
1, 2 and 3 only
1, 2, 3and4 (2marks)







Questions 13

Whichof the following is LEAST likely to be used in the management of foreign accountsreceivable?
Letters of credit Bills of exchange Invoice discounting
Commercialpaper (2marks)
LCoisconsideringwhethertofactoritssalesinvoices.AfactorhasofferedLCoanonrecoursepackageat a cost of 1.5% of sales and an admin fee of $6,000 per annum. Bad debts are currently 2% of sales per annum and sales are $1.5m perannum.
What is the cost of the package of L Co?

$
(2 marks)
WhichofthefollowingisNOTadrawbackoftheEOQmodel? Assumes certain or zero leadtimes.
Assumes certainty in demand.
Assumes a small number of close suppliers.
Ignores hidden costs such as the riskofobsolescence. (2marks)
WhichofthefollowingisNOTapotentialhiddencostofincreasingcredittakenfromsuppliers? Damage togoodwill
Early settlement discounts lost Business disruption
Increased risk ofbaddebts (2marks)
WhichofthefollowingwouldbeLEASTlikelytoarisefromtheintroductionofajust-in-timeinventory orderingsystem?
Lower inventory holding costs Less risk of inventory shortages More frequent deliveries
Increased dependenceonsuppliers (2 marks)
(Total = 20 marks)

CBE style OTQ bank – Working capitalfinance 20mins
JPCohasbudgetedthatsaleswillbe$300,100inJanuary20X2,$501,500inFebruary,$150,000inMarch and$320,500inApril.Halfofsaleswillbecreditsales.80%ofreceivablesareexpectedtopayinthemonth after sale, 15% in the second month after sale, while the remaining 5% are expected to be bad debts. Receivables who pay in the month after sale can claim a 4% early settlementdiscount.
What level of sales receipts should be shown in the cash budget for March 20X2 (to the nearest $)?

$
(2 marks)









14 Questions

WWCoisasubsidiaryofBBCo.WWCorequires$10millioninfinancetobeeasilyspreadoverthecoming year, which BB Ltd will supply. Researchshows:
There is a standing bank fee of $200 for each drawdown.
Theinterestcostofholdingcash(iefinancecostlessdepositinterest)is6%pa. HowmuchshouldWWCodrawdownatatime(tothenearest$'000)?
$
(2 marks)
ThetreasurydepartmentinTBCohascalculated,usingtheMiller-Orrmodel,thatthelowestcashbalance theyshouldhaveis$1m,andthehighestis$10m.Ifthecashbalancegoesabove$10mtheytransferthe cash into money marketsecurities.
Are the following true or false?



Whenthebalancereaches$10mtheywouldbuy$6mofsecurities
Whenthecashbalancefallsto$1mtheywillsell$3mofsecurities
Ifthevarianceofdailycashflowsincreasesthespreadbetween upper and lower limit will beincreased.

Whichstatementbestreflectsanaggressiveworkingcapitalfinancepolicy?
Moreshort-termfinanceisusedbecauseitischeaperalthoughitisrisky. Investors are forced to accept lower rates ofreturn.
More long-term finance is used as it is less risky.
True False











(2 marks)

Inventory levelsarereduced. (2marks)
WhataretheTWOkeyrisksfortheborrowerassociatedwithshort-termworkingcapitalfinance? Raterisk
Renewal risk Inflexibility
Maturitymismatch (2 marks)
(Total = 10 marks)






















Questions 15

Section B questions
PKA Co(12/07,amended) 20mins
The following scenario relates to questions 61 – 65.

PKACoisaEuropeancompanythatsellsgoodssolelywithinEurope.Therecently-appointedfinancialmanagerof PKACohasbeeninvestigatingworkingcapitalmanagementobjectivesandtheworkingcapitalmanagementofthe company,andhasgatheredthefollowinginformationabouttheinventorypolicyandaccountsreceivable.
Inventory management
Thecurrentpolicyistoorder100,000unitswhentheinventorylevelfallsto35,000units.Forecastdemandtomeet productionrequirementsduringthenextyearis625,000units.Thecostofplacingandprocessinganorderis
$250,whilethecostofholdingaunitinstoresis$0.50perunitperyear.Bothcostsareexpectedtobeconstant duringthenextyear.Ordersarereceivedtwoweeksafterbeingplacedwiththesupplier.Youshouldassumea 50-week year and that demand is constant throughout theyear.
Accounts receivable management
Customersareallowed30days’credit,butthefinancialstatementsofPKACoshowthattheaverageaccounts receivable period in the last financial year was 75 days. This is in line with the industry average. The financial manageralsonotedthatbaddebtsasapercentageofsales,whicharealloncredit,increasedinthelastfinancial year from 5% to 8%. The accounts receivables department is currently shortstaffed.
What are the objectives of working capital management atPKA?
To ensure that PKA Co has sufficient liquidresources
To increase PKA Co’sprofitability
To ensure that PKA Co’s assets give the highest possiblereturns
1only
1 and 2only
2 and 3only
1, 2and3 (2marks)
WhatisthecurrentminimuminventorylevelatPKACo? A 10,000
B 12,500
C 22,500
D 35,000 (2marks)
Whatistheeconomicorderquantity? A 250
B 3,536
C 17,678
D 25,000 (2marks)
What are the best ways for PKA Co to improve the management of accountsreceivable?
Assess the creditworthiness of newcustomers
Introduce early settlementdiscounts
Take legal action against the slow payers andnon-payers

1 and 2only
2only
1 and 3only
1, 2and3 (2marks)


16 Questions

Inordertoimprovethemanagementofreceivables,PKACoisconsideringusingafactor. Which of the following are benefits of factoring forPKA?
1
Credit customers make payments directly to the factor


2
Accounts receivable will be handled by a dedicated team


3
Optimum levels of inventory can be maintained


A B C
D
2 only
1, 2 and 3
2 and 3 only
1 and 3 only



(2 marks)



(Total = 10 marks)


CBE style OT case Gorwa Co (12/08,amended) 20mins
The following scenario relates to questions 66 – 70.

ThefinancialmanagerofGorwaCoisworriedaboutthelevelofworkingcapitalandthatthecompanymaybe overtrading.


Thefollowingextractfinancialinformationrelatestothelasttwoyears:

20X7 20X6
$'000 $'000

Sales (alloncredit) 37,400 26,720
Costofsales 34,408 23,781
Operatingprofit 2,992 2,939
20X7 20X6
$'000 $'000 $'000 $'000
Current assets
Inventory 4,600 2,400
Tradereceivables 4,600 2,200
9,200 4,600

Currentliabilities 7,975 3,600
What is the sales/net working capital ratio for 20X7 (to 2dp)?

20X7 times
(2 marks)
Bywhatpercentagehaveinventoriesincreasedbetween20X6and20X7(tothenearestwholepercentage)?

%


ArethefollowingstatementstrueorfalseforGorwaCo?


Accountsreceivableturnoverhassloweddown Inventory turnover has sloweddown
(2 marks)


True False


(2 marks)









Questions 17

GorwaCo is concerned aboutovertrading.
Which TWO of the following are symptoms of overtrading?
Rapidreductioninsalesrevenue Slowdownininventoryturnover
Shorteningofpaymentperiodtoaccountspayables A fall in the currentratio
GorwaCo’sworkingcapitalismostlikelytoincreaseinwhichofthefollowingsituations? Payments to suppliers aredelayed
Theperiodofcreditextendedtocustomersisreduced Non-current assets aresold







(2 marks)

Inventory levelsareincreased (2 marks)
(Total = 10 marks)

CBE style OT caseCatCo 20mins
The following scenario relates to questions 71 – 75.
Cat Co places monthly orders with a supplier for 10,000 components which are used in its manufacturing processes.Annualdemandis120,000components.Thecurrenttermsarepaymentinfullwithin90days,whichCat Co meets, and the cost per component is $7.50. The cost of ordering is $200 per order, while the cost of holding components in inventory is $1.00 per component peryear.
The supplier has offered a discount of 3.6% on orders of 30,000 or more components. If the bulk purchase discountistaken,thecostofholdingcomponentsininventorywouldincreaseto$2.20percomponentperyeardue to the need for a larger storagefacility.
What is the current total annual cost ofinventory?

$ (2marks)
What is the total annual inventory cost if Cat Co orders 30,000 components at atime?

$ (2marks)
CatCohasannualcreditsalesof$25millionandaccountsreceivableof$5million.Workingcapitalis financed by an overdraft at 10% interest per year. Assume 365 days in ayear.
What is the annual finance cost saving if Cat Co reduces the collection period to 60 days (to the nearest whole number)?
$ (2marks)
Cat Co is reviewing its working capitalmanagement.

Which TWO of the following statements concerning working capital management are correct?
Thetwinobjectivesofworkingcapitalmanagementareprofitabilityandliquidity Aconservativeapproachtoworkingcapitalinvestmentwillincreaseprofitability Workingcapitalmanagementisakeyfactorinacompany'slong-termsuccess
Liquidassetsgivethehighestreturnsleadingtoconflictsofobjectives (2marks)






18 Questions

Managementat Cat Co are considering an aggressive approach to financing workingcapital.
Which of the following statements relate to an aggressive approach to financing working capital management?
Allnon-currentassets,permanentcurrentassetsandpartoffluctuatingcurrentassetsarefinanced by long-termfunding
There is an increased risk of liquidity and cash flowproblems
Both statements relate to an aggressive approach Neither statement relates to an aggressive approach Statement 1 only relates to an aggressive approach
Statement2onlyrelatestoanaggressiveapproach (2marks)(Total = 10marks)

Section C questions
APX Co(12/09,amended) 39mins
APXCoachievedarevenueof$16millionintheyearthathasjustendedandexpectsrevenuegrowthof8.4%inthe nextyear.
ThefinancialstatementsofAPXCofortheyearthathasjustendedcontainthefollowingstatementoffinancial position:

















Thelong-termbankloanhasafixedannualinterestrateof8%peryear.APXCopaystaxationatanannualrateof 30% peryear.
Thefollowingaccountingratioshavebeenforecastforthenextyear: Grossprofitmargin: 30%
Operatingprofitmargin: 20%
Dividendpayoutratio: 50% Inventoryturnoverperiod: 110 days Tradereceivablesperiod: 65 days Tradepayablesperiod: 75days
Overdraftinterestinthenextyearisforecasttobe$140,000.Nochangeisexpectedinthelevelofnon-current assets and depreciation should beignored.


Questions 19

Required
Prepare the following forecast financial statements for APX Co using the informationprovided:
A statement of profit or loss for the nextyear
Astatementoffinancialpositionattheendofthenextyear (9 marks)
AnalyseanddiscusstheworkingcapitalfinancingpolicyofAPXCo. (6 marks)
Discuss the role of financial intermediaries in providing short-term finance for use by business organisations. (5 marks)
(Total = 20 marks)

ZSE Co(6/10,amended) 39mins
ZSE Co is concerned about exceeding its overdraft limit of $2 million in the next two periods. It has been experiencingconsiderablevolatilityincashflowsinrecentperiodsbecauseoftradingdifficultiesexperiencedbyits customers, who have often settled their accounts after the agreed credit period of 60 days. ZSE has also experiencesanincreaseinbaddebtsduetoasmallnumberofcustomersgoingintoliquidation.
Thecompanyhaspreparedthefollowingforecastsofnetcashflowsforthenexttwoperiods,togetherwiththeir associatedprobabilities,inanattempttoanticipateliquidityandfinancingproblems.Theseprobabilitieshavebeen producedbyacomputermodelwhichsimulatesanumberofpossiblefutureeconomicscenarios.Thecomputer model has been built with the aid of a firm of financialconsultants.

Period 1 cash flow
Probability
Period 2 cash flow
Probability

$'000

$'000


8,000
10%
7,000
30%

4,000
60%
3,000
50%

(2,000)
30%
(9,000)
20%

ZSE Co expects to be overdrawn at the start of period 1 by $500,000.
Required
Calculate thefollowing:
Theexpectedvalueoftheperiod1closingbalance;
Theexpectedvalueoftheperiod2closingbalance;
The probability of a negative cash balance at the end of period2;
Theprobabilityofexceedingtheoverdraftlimitattheendofperiod2.
Discusswhethertheaboveanalysiscanassistthecompanyinmanagingitscashflows. (12 marks)
Identifyanddiscussthefactorstobeconsideredinformulatingatradereceivablesmanagementpolicyfor ZSECo. (8 marks)
(Total = 20 marks)

WQZ Co(12/10,amended) 39mins
WQZ Co is considering making the following changes in the area of working capital management:
Inventory management
IthasbeensuggestedthattheordersizeforProductKN5shouldbedeterminedusingtheeconomicorderquantity model(EOQ).
WQZCoforecaststhatdemandforProductKN5willbe160,000unitsinthecomingyearandithastraditionally ordered10%ofannualdemandperorder.Theorderingcostisexpectedtobe$400perorderwhiletheholding costisexpectedtobe$5.12perunitperyear.Abufferinventoryof5,000unitsofProductKN5willbemaintained, whetherordersaremadebythetraditionalmethodorusingtheeconomicorderquantitymodel.



20 Questions

Receivables management
WQZCocouldintroduceanearlysettlementdiscountof1%forcustomerswhopaywithin30daysandatthesame time,throughimprovedoperationalprocedures,maintainamaximumaveragepaymentperiodof60daysforcredit customerswhodonottakethediscount.Itisexpectedthat25%ofcreditcustomerswilltakethediscountifitwere offered.
Itisexpectedthatadministrationandoperatingcostsavingsof$753,000peryearwillbemadeafterimproving operational procedures and introducing the early settlement discount.
CreditsalesofWQZCoarecurrently$87.6millionperyearandtradereceivablesarecurrently$18million.Credit salesarenotexpectedtochangeasaresultofthechangesinreceivablesmanagement.Thecompanyhasacostof short-term finance of 5.5% peryear.
Required
Calculatethecostofthecurrentorderingpolicyandthechangeinthecostsofinventorymanagementthat willariseiftheeconomicorderquantityisusedtodeterminetheoptimumordersizeforProductKN5.
(5 marks)
Calculateandcommentonwhethertheproposedchangesinreceivablesmanagementwillbeacceptable. Assuming that only 25% of customers take the early settlement discount, what is the maximum early settlementdiscountthatcouldbeoffered? (7 marks)
Discussthefactorsthatshouldbeconsideredinformulatingworkingcapitalpolicyonthemanagementof tradereceivables. (8 marks)
(Total = 20 marks)

Bold Co(12/11,amended) 39mins
Extracts from the recent financial statements of Bold Co are given below.
$'000
Revenue 21,300
Costofsales 16,400
Grossprofit 4,900

$'000 $'000
Non-currentassets 3,000
Current assets
Inventory 4,500
Tradereceivables 3,500
8,000
Totalassets 11,000


Equity
Ordinaryshares 1,000
Reserves 1,000

Non-current liabilities



2,000

Bonds 3,000


Current liabilities
Tradepayables 3,000
Overdraft 3,000



6,000

Total equityandliabilities 11,000




Questions 21

AfactorhasofferedtomanagethetradereceivablesofBoldCoinaservicingandfactor-financingagreement.The factorexpectstoreducetheaveragetradereceivablesperiodofBoldCofromitscurrentlevelto35days;toreduce baddebtsfrom0.9%ofrevenueto0.6%ofrevenue;andtosaveBoldCo$40,000peryearinadministrationcosts. The factor would also make an advance to Bold Co of 80% of the revised book value of trade receivables. The interest rate on the advance would be 2% higher than the 7% that Bold Co currently pays on its overdraft. The factor would charge a fee of 0.75% of revenue on a with-recourse basis, or a fee of 1.25% of revenue on a non- recoursebasis.Assumethatthereare365workingdaysineachyearandthatallsalesandsuppliesareoncredit.
Required
Explain the meaning of the term 'cash operating cycle' and discuss the relationship between the cash operatingcycleandthelevelofinvestmentinworkingcapital.Youranswershouldincludeadiscussionof relevantworkingcapitalpolicyandthenatureofbusinessoperations. (8marks)
Calculate the cash operating cycle of Bold Co. (Ignore the factor's offer in this part of thequestion).
(4 marks)
Calculate the value of the factor’soffer:
on a with-recoursebasis;
on anon-recoursebasis. (8 marks)
(Total = 20 marks)

Wobnig Co(6/12,amended) 39mins

ThefollowingfinancialinformationrelatestoWobnigCo.




20X1

20X0



$'000

$'000

Revenue

14,525

10,375

Cost of sales

10,458

6,640

Profit before interest and tax

4,067

3,735

Interest

355

292

Profit before tax

3,712

3,443

Taxation

1,485

1,278

Distributable profit

2,227

2,165

20X1 20X0
$'000 $'000 $'000 $'000
Non-currentassets 15,284 14,602 Currentassets
Inventory 2,149 1,092
Tradereceivables 3,200 1,734
5,349 2,826
Totalassets 20,633 17,428


Equity
Ordinaryshares 8,000 8,000
Reserves 4,268 3,541
12,268 11,541
Non-current liabilities
7%Bonds 4,000 4,000
Current liabilities
Tradepayables 2,865 1,637
Overdraft 1,500 250
4,365 1,887
Total equityandliabilities 20,633 17,428





22 Questions

Average ratios for the last two years for companies with similar business operations to Wobnig Co are as follows:
Currentratio 1.7times
Quickratio 1.1times
Inventorydays 55days
Tradereceivablesdays 60days
Tradepayablesdays 85 days Sales revenue/net working capital10 times
Required
Usingsuitableworkingcapitalratiosandanalysisofthefinancialinformationprovided,evaluatewhether WobnigCocanbedescribedasovertrading(undercapitalised). (12marks)
Critically discuss the similarities and differences between working capital policies in the followingareas:
Working capitalinvestment;
Workingcapitalfinancing. (8 marks)
(Total = 20 marks)

KXP Co(12/12,amended) 39mins
KXPCoisane-businesswhichtradessolelyovertheinternet.Inthelastyearthecompanyhadsalesof$15million. All sales were on 30 days' credit to commercialcustomers.
Extracts from the company's most recent statement of financial position relating to working capital are as follows:
$'000
Trade receivables
2,466

Trade payables
2,220

Overdraft
3,000

Inordertoencouragecustomerstopayontime,KXPCoproposesintroducinganearlysettlementdiscountof1% for payment within 30 days, while increasing its normal credit period to 45 days. It is expected that, on average, 50%ofcustomerswilltakethediscountandpaywithin30days,30%ofcustomerswillpayafter45days,and20% of customers will not change their current payingbehaviour.
KXP Co currently orders 15,000 units per month of Product Z, demand for which is constant. There is only one supplier of Product Z and the cost of Product Z purchases over the last year was $540,000. The supplier has offereda2%discountforordersofProductZof30,000unitsormore.EachordercostsKXPCo$150toplaceand theholdingcostis24centsperunitperyear.KXPCohasanoverdraftfacilitycharginginterestof6%peryear.
Required
Calculatethenetbenefitorcostoftheproposedchangesintradereceivablespolicyandcommentonyour findings. (5 marks)
Calculatewhetherthebulkpurchasediscountofferedbythesupplierisfinanciallyacceptableandcomment ontheassumptionsmadebyyourcalculation. (5 marks)
Identifyanddiscussthefactorstobeconsideredindeterminingtheoptimumlevelofcashtobeheldbya company. (5 marks)
Discussthefactorstobeconsideredinformulatingatradereceivablesmanagementpolicy. (5marks)
(Total = 20 marks)










Questions 23

82 CSZ Co (6/14, amended)
The current assets and liabilities of CSZ Co at the end of March 20X4 are as follows:

39 mins


Inventory
$'000 5,700
$'000

Trade receivables
6,575
12,275

Trade payables
2,137


Overdraft
4,682
6,819

Net current assets

5,456


FortheyeartoendofMarch20X4,CSZCohadsalesof$40million,alloncredit,whilecostofsaleswas$26 million.
FortheyeartoendofMarch20X5,CSZCohasforecastthatcreditsaleswillremainat$40millionwhilecostof saleswillfallto60%ofsales.Thecompanyexpectscurrentassetstoconsistofinventoryandtradereceivables, and current liabilities to consist of trade payables and the company'soverdraft.
CSZ Co also plans to achieve the following target working capital ratio values for the year to the end of March 20X5:
Inventorydays: 60days
Tradereceivablesdays: 75days
Tradepayablesdays: 55days
Currentratio: 1.4times
Required
Calculate the working capital cycle (cash collection cycle) of CSZ Co at the end of March 20X4 and discuss whetheraworkingcapitalcycleshouldbepositiveornegative. (6 marks)
Calculatethetargetquickratio(acidtestratio)andthetargetratioofsalestonetworkingcapitalofCSZCo attheendofMarch20X5. (5 marks)
AnalyseandcomparethecurrentassetandcurrentliabilitypositionsforMarch20X4andMarch20X5,and discusshowtheworkingcapitalfinancingpolicyofCSZCowouldhavechanged. (9 marks)
(Total = 20 marks)

83 Flit Co(12/14,amended) 39mins
FlitCoispreparingacashflowforecastforthethree-monthperiodfromJanuarytotheendofMarch.Thefollowing sales volumes have beenforecast:


December
January
February
March
April

Sales (units)
Notes:
1,200
1,250
1,300
1,400
1,500

Thesellingpriceperunitis$800andasellingpriceincreaseof5%willoccurinFebruary.Salesareallon one month'scredit.
Production of goods for sale takes place one month beforesales.
Eachunitproducedrequirestwounitsofrawmaterials,costing$200perunit.Norawmaterialsinventoryis held. Raw material purchases are on one months'credit.
Variableoverheadsandwagesequalto$100perunitareincurredduringproduction,andpaidinthemonth ofproduction.
The opening cash balance at 1 January is expected to be$40,000.
A long-term loan of $300,000 will be received at the beginning ofMarch.
A machine costing $400,000 will be purchased for cash inMarch.



24 Questions

Required
Calculatethecashbalanceattheendofeachmonthinthethree-monthperiod. (5marks)
Calculatetheforecastcurrentratioattheendofthethree-monthperiod. (2marks)
Assuming that Flit Co expects to have a short-term cash surplus during the three-month period, discuss whetherthisshouldbeinvestedinshareslistedonalargestockmarket. (3 marks)
ExplainhowtheBaumolmodelcanbeemployedtoreducethecostsofcashmanagement. (5marks)
RenpecCo,asubsidiaryofFlitCo,hassetaminimumcashaccountbalanceof$7,500.Theaveragecostto thecompanyofmakingdepositsorsellinginvestmentsis$18pertransactionandthestandarddeviationof itscashflowswas$1,000perdayduringthelastyear.Theaverageinterestrateoninvestmentsis5.11%.
Determinethespread,theupperlimitandthereturnpointforthecashaccountofRenpecCousingthe Miller-Orrmodelandexplaintherelevanceofthesevaluesforthecashmanagementofthecompany.
(5 marks)(Total = 20 marks)
Widnor Co(6/15,amended) 39mins
The finance director of Widnor Co has been looking to improve the company’s working capital management. WidnorCohasrevenuefromcreditsalesof$26,750,000peryearandalthoughitstermsoftraderequireallcredit customerstosettleoutstandinginvoiceswithin40days,onaveragecustomershavebeentakinglonger.
Approximately 1% of credit sales turn into bad debts which are not recovered.
Trade receivables currently stand at $4,458,000 and Widnor Co has a cost of short-term finance of 5% per year.
Thefinancedirectorisconsideringaproposalfromafactoringcompany,NokfeCo,whichwasinvitedtotenderto managethesalesledgerofWidnorCoonawith-recoursebasis.NokfeCobelievesthatitcanuseitsexpertiseto reduce average trade receivables days to 35 days, while cutting bad debts by 70% and reducing administration costsby$50,000peryear.AconditionofthefactoringagreementisthatthecompanywouldalsoadvanceWidnor Co80%ofthevalueofinvoicesraisedataninterestrateof7%peryear.NokfeCowouldchargeanannualfeeof 0.75% of creditsales.
Assume that there are 360 days in each year.
Required
Advisewhetherthefactor’sofferisfinanciallyacceptabletoWidnorCo. (7marks)
Brieflydiscusshowthecreditworthinessofpotentialcustomerscanbeassessed. (3marks)
Discuss how risks arising from granting credit to foreign customers can be managed andreduced.
(10 marks)(Total = 20 marks)
















Questions 25



MCQ bank –Investmentdecisions 39mins
The following information relates to questions 85 and 86.

NWCoisconsideringinvesting$46,000inanewdeliverylorrythatwilllastforfouryears,afterwhichtimeitwill be sold for $7,000. Depreciation is charged on a straight-line basis. Forecast operating profits/(losses) to be generated by the machine are asfollows.

Year
$

1
16,500

2
23,500

3
13,500

4
(1,500)

Whatisthereturnoncapitalemployed(ROCE)forthelorry(usingtheaverageinvestmentmethod)? A 70%
B 28%
C 49%
D 36% (2marks)
Assumingoperationalcashflowsariseevenlyovertheyear,whatisthepaybackperiodforthisinvestment (to the nearestmonth)?
1 year 7months
2 years 7months
1 year 5months
3 years2months (2marks)
Whichofthefollowingarebenefitsofthereturnoncapitalemployedmethodofinvestmentappraisal?
It considers the wholeproject
It is cash flowbased
Itisapercentagewhich,beingmeaningfultonon-financeprofessionals,helpscommunicatethe benefits of investmentdecisions.
1, 2 and3
1 and 3only
1, and 2only
2 and3only (2marks)
SW Co has a barrel of chemicals in its warehouse that it purchased for a project a while ago at a costof
$1,000.Itwouldcost$400foraprofessionaldisposalcompanytocollectthebarrelanddisposeofitsafely. However,thechemicalscouldbeusedinapotentialprojectwhichiscurrentlybeingassessed.
Whatistherelevantcostofusingthechemicalsinanewprojectproposal? A $1,000cost
$400benefit
$400cost
Zero (2marks)







26 Questions

A new project being considered by BLW Co would require 1,000 hours of skilled labour. The current workforceisalreadyfullyemployedbutmoreworkerscanbehiredinatacostof$20perhour.Thecurrent workersarepaid$15perhouronaprojectthatearnsacontributionof$10perhour.
What is the relevant cost of labour to be included in the project appraisal?

A $10,000
B $15,000
C $20,000
D $25,000 (2marks)
LWCohasahalfemptyfactoryonwhichitpays$5,000parent.Ifittakesonanewproject,itwillhaveto movetoanewbiggerfactorycosting$17,000paanditcouldrenttheoldfactoryoutfor$3,000pauntilthe end of the currentlease.
What is the rental cost to be included in the project appraisal?

A $14,000
B $17,000
C $9,000
D $19,000 (2marks)
Whichofthefollowingisadrawbackofthepaybackperiodmethodofinvestmentappraisal? A It is cash flowbased
It considers the time value ofmoney
It doesn't measure the potential impact on shareholderwealth
It isprofitbased (2marks)
Which stage is missing or in the wrong order from the investment decision making processbelow?
Origination ofideas
Financialanalysis
Implementation
A Project screening should follow after stage1 B Project screening should follow after stage 2 C Raising finance should be before stage1
D Implementationshouldfollowstage1 (2marks)
EECoisconsideringinvestinginanew40-yearprojectwhichwillrequireaninitialinvestmentof$50,000 (withzeroscrapvalue)andhasapaybackperiodof20years.The40yearprojecthasconsistentcashflows eachyear.
Whatisthereturnoncapitalemployed(usingtheaverageinvestmentmethod)? A 2.5%
B 10%
C 7.5%
D 5% (2marks)
Anaccountantispaid$30,000perannumandspendstwoweeksonemonthworkingonappraisingproject Alpha.
Why should the accountant NOT charge half of his month’s salary to the project?

A
Because his salary cannot be apportioned


B
Because his salary is not incremental


C
Because his salary is not a cash flow


D
Because his salary is an opportunity cost
(2 marks)
(Total = 20 marks)





Questions 27

MCQ bank – Investment appraisalusingDCF 39mins
An investor has a cost of capital of 10%. She is due to receive a 5 year annuity starting in 3 year's timeof
$7,000 per annum.
Whatlumpsumamountwouldyouneedtooffertodaytomakeherindifferentbetweentheannuityandyour offer?
A $26,537
B $19,936
C $16,667
D $21,924 (2marks)
Anewspaperreaderhaswonfirstprizeinanationalcompetitionandtheyhaveachoiceastohowtheytake theprize:
Option1 Take$90,000perannumindefinitelystartingin3years'time(andbequeaththisrighttotheir children and so on);or
Option2 Take a lump sum of $910,000 in 1 year's time Assumingacostofcapitalof10%,whichwouldyouadviseandwhy?
Option1because$90,000paindefinitelyisaninfiniteamountofmoneycomparedtoaone-off payment.
Option1becauseitisworthmoreinpresentvalueterms. C Option2becauseitisworthmoreinpresentvalueterms.
D Option2becausethelumpsumhastheflexibilitytobeinvestedandearnalargerreturnthan
$90,000pa (2marks)

The following information relates to questions 97 and 98.
JCWCoisappraisinganopportunitytoinvestinsomenewmachinerythathasthefollowingcashflows. Initialinvestment $40,000
Netcashinflowsfor5yearsinadvance $12,000perannum Decommissioning costs after5years $15,000
At a cost of capital of 10% what is the net present value of this project (to the nearest$100)?
Negative$3,800
Positive$14,800
Positive$700
Negative$11,275 (2marks)
What is the internal rate of return of the project (to the nearest whole%)?
A 12
B 10
C 14
D 9 (2marks)










28 Questions

Fourmutuallyexclusiveprojectshavebeenappraisedusingnetpresentvalue(NPV),internalrateofreturn (IRR),returnoncapitalemployed(ROCE)andpaybackperiod(PP).Thecompanyobjectiveistomaximise shareholderwealth.
Which should be chosen?


NPV
IRR
ROCE
PP

A Project A
$1m
40%
34%
4 years

B Project B
$1.1m
24%
35%
2.5 years

C Project C
$0.9m
18%
25%
3 years

D Project D
$1.5m
12%
18%
7 years

(2 marks)
WhichTWOofthefollowingareadvantagesoftheinternalrateofreturn(IRR)approachtoinvestment appraisal?
Clear decisionrule
Takes into account the time value ofmoney
Assumes funds are re-invested at theIRR
Considers the wholeproject
1, 2 and 4only
2, 3 and 4only
2 and 4only
1, 2 and3only (2marks)
A project has an initial outflow followed by years ofinflows.
Whatwouldbetheeffectonnetpresentvalueandtheinternalrateofreturnofanincreaseinthecostof capital?




(2 marks)

Aleaseagreementhasanetpresentvalueof($26,496)atarateof8%.Theleaseinvolvesanimmediate down payment of $10,000 followed by four equal annualpayments.
Whatistheamountoftheannualpayment? A $11,020
B $4,981
C $11,513
D $14,039 (2marks)
Whichofthefollowingstatementsaboutnetpresentvalue(NPV)andinternalrateofreturn(IRR)is accurate?
Two NPV calculations are needed to estimate the IRR using linearinterpolation.
ThegraphicalapproachtoIRRisonlyanestimate;linearinterpolationusingtheformulaisrequired for a preciseanswer.
The IRR isunique.
An IRR graph with NPV on the 'Y' axis and discount rate on the 'X' axis will have a negativeslope.
(2 marks)



Questions 29

Pauloplanstobuyaholidayvillainfiveyears’timeforcash.Heestimatesthecostwillbe$1.5m.Heplans tosetasidethesameamountoffundseachyearfor5years,startingimmediatelyandearningarateof10% interest per annumcompound.
To the nearest $100, how much does he need to set aside each year?

A
$223,400


B
$245,600


C
$359,800


D
$395,600
(2 marks)
(Total = 20 marks)

MCQ bank – Allowing for taxandinflation 39mins
SWCohasa31Decemberyearendandpayscorporationtaxatarateof30%,12monthsaftertheendof theyeartowhichthecashflowsrelate.Itcanclaimtaxallowabledepreciationatarateof25%reducing balance. It pays $1m for a machine on 31 December 20X4. SW Co's cost of capital is10%.
Whatisthepresentvalueon31December20X4ofthebenefitofthefirstportionoftaxallowable depreciation?
A $250,000
B $227,250
C $68,175
D $75,000 (2marks)
Acompanyreceivesaperpetuityof$20,000perannuminarrears,andpays30%corporationtax12months after the end of the year to which the cash flowsrelate.
Atacostofcapitalof10%,whatistheaftertaxpresentvalueoftheperpetuity? A $140,000
B $145,454
C $144,000
D $127,274 (2marks)

107 A projecthas
thefollowingprojectedcashinflows.

Year 1
100,000

Year 2
125,000

Year 3
105,000

Workingcapitalisrequiredtobeinplaceatthestartofeachyearequalto10%ofthecashinflowforthat year. The cost of capital is10%.
What is the present value of the working capital?

A
$ Nil


B
$(30,036)


C
$(2,735)


D
$33,000
(2 marks)

AWConeedstohave$100,000workingcapitalinplaceimmediatelyforthestartofa2yearproject.The amountwillstayconstantinrealterms.Inflationisrunningat10%perannum,andAWCo'smoneycostof capital is12%.
What is the present value of the cash flows relating to working capital?

A
$(21,260)


B
$(20,300)


C
$(108,730)


D
$(4,090)
(2 marks)





30 Questions

NCWCoisconsideringinvesting$10,000immediatelyina1yearprojectwiththefollowingcashflows. Income $100,000
Expenses $35,000
Thecashflowswillariseattheendoftheyear.Theabovearestatedincurrentterms.Incomeissubjectto 10%inflation;expenseswillnotvary.Therealcostofcapitalis8%andgeneralinflationis2%.
Using the money cost of capital to the nearest whole %, what is the net present value of the project?

A $68,175
B $60,190
C $58,175
D $78,175 (2marks)
AMCowillreceiveaperpetuitystartingin2years'timeof$10,000perannum,increasingbytherateof inflation (which is2%).
What is the present value of this perpetuity assuming a money cost of capital of 10.2%?
A $90,910
B $125,000
C $115,740
D $74,403 (2marks)
FW Co is expecting a net of tax receipt of $10,000 (in real terms) in 1 year'stime.
IfFWCoexpectsinflationtoincrease,whatimpactwillthishaveonthepresentvalueofthatreceipt? A Nil
Reduce
Increase
Cannotsay (2marks)
ShadowlineCohasamoneycostofcapitalof10%.Ifinflationis4%,whatisShadowlineCo'srealcostof capital?
A 6%
B 5.8%
C 14%
D 14.4% (2marks)
JuicyCoisconsideringinvestinginanewindustrialjuicerforuseonanewcontract.Itwillcost$150,000 andwilllast2years.JuicyCopayscorporationtaxat30%(asthecashflowsoccur)and,duetothehealth benefitsofjuicing,themachineattracts100%taxallowabledepreciationimmediately.
Givenacostofcapitalof10%,whatistheminimumvalueofthepre-taxcontractrevenuereceivablein2 years which would be required to recover the net cost of thejuicer?
A $150,000
B $105,000
C $127,050
D $181,500 (2marks)
Whichofthefollowingistrueaboutthe'inflation'figurethatisincludedinthemoneycostofcapital? A It is historic and specific to thebusiness.
B Itishistoricgeneralinflationsufferedbytheinvestors. C It is expected and specific to thebusiness.
D Itisexpectedgeneralinflationsufferedbytheinvestors. (2 marks) (Total = 20marks)





Questions 31

CBEstyleOTQbank–Projectappraisalandrisk 20 mins
WhichTWOofthefollowingaretrueinrespectofusingexpectedvaluesinnetpresentvaluecalculations? Appropriate for one-offevents
Hides risk
Probably won't actually occur Eliminates uncertainty
(2 marks)
Salesvolumesareexpectedtobeeither20,000unitswith60%probabilityortheyareexpectedtobe25,000 units.Pricewilleitherbe$10(0.3probability)orelse$15.Marginsareexpectedtobe30%or40%ofsales with an even chance ofeach.
What is the expected total cost?
$ (2marks)
SACCohasacostofcapitalof8%andisappraisingprojectGamma.Ithasthefollowingcashflows. T0 Investment 100,000
T1-5 Netcashinflow 40,000
What is the adjusted payback period for this project?
2.5 years
Just under 3 years 2 years
Just over4years (2marks)
Aprojecthasthefollowingcashflows. T0 Outflow $110,000
T1-4 Inflow $40,000
At the company's cost of capital of 10% the NPV of the project is $16,800.
Applyingsensitivityanalysistothecostofcapital,whatpercentagechangeinthecostofcapitalwouldcause the project NPV to fall tozero?
70%
17%
5%
41% (2marks)
Whatisthemainadvantageofusingsimulationstoassistininvestmentappraisal? A clear decisionrule
More than one variable can change at a time Statistically more accurate than other methods
Beingdiagrammaticitiseasiertounderstand (2marks)(Total = 10marks)










32 Questions

CBEstyleOTQbank–Specificinvestmentdecisions 39mins
PDCoisdecidingwhethertoreplaceitsdeliveryvanseveryyearoreveryotheryear.Theinitialcostofavan is $20,000. Maintenance costs would be nil in the first year, and $5,000 at the end of the second year. Second-hand value would fall from $10,000 to $8,000 if it held on to the van for two years instead of just one. PD Co's cost of capital is10%.
How often should PD Co replace their vans, and what is the annual equivalent cost ('EAC') of that option?
Replaceevery EAC($)




(2 marks)








(2 marks)
ABCoisconsideringeitherleasinganassetorborrowingtobuyit,andisattemptingtoanalysetheoptions bycalculatingthenetpresentvalueofeach.Whencomparingthetwo,ABCoisuncertainwhetheritshould includeinterestpaymentsinitsoptionto'borrowandbuy'asitisafuture,incrementalcashflowassociated withthatoption.ABCoisalsouncertainwhichdiscountratetouseinthenetpresentvaluecalculationfor the leaseoption.
How should AB Co treat the interest payments and what discount rate should it use?
IncludeInterest? Discountrate
Yes After tax cost of the loan if they borrow andbuy
Yes AB Co's weighted average cost ofcapital
No After tax cost of the loan if they borrow andbuy
No ABCo'sweightedaftercostofcapital (2marks)
Which of the following is always true about capitalrationing?



A soft constraint isflexible
Projectsbeingdivisibleisanunrealisticassumption
True False






(2 marks)














Questions 33

The following information relates to questions 124 and 125.
NBCoisfacedwithanimmediatecapitalconstraintof$100millionavailabletoinvest. It is considering investing in 4 divisibleprojects:

Initial cost
NPV


$m
$m

Project 1
40
4

Project 2
30
5

Project 3
50
6

Project 4
60
5

What is the NPV generated from the optimum investmentprogramme?
$ million (2marks)
WhatistheNPVgeneratedfromtheoptimuminvestmentprogrammeiftheprojectswereindivisible?
$11 million
$13 million
$6 million
$12million (2marks)
Whichofthefollowingispotentiallyabenefittothelesseeiftheyleaseasopposedtobuy? Avoiding taxexhaustion
Attractingleasecustomersthatmaynothavebeenotherwisepossible Exploiting a low cost ofcapital
Potential futurescrapproceeds (2marks)
Aprofessionalkitchenisattemptingtochoosebetweengasandelectricityforitsmainheatsource.Oncea choiceismade,thekitchenintendstokeeptothatsourceindefinitely.Eachgasovenhasanetpresentvalue (NPV)of$50,000overitsusefullifeof5years.EachelectricovenhasanNPVof$68,000overitsusefullife of 7 years. The cost of capital is8%.
Which should the kitchen choose and why?
GasbecauseitsaverageNPVperyearishigherthanelectric Electric because its NPV is higher thangas
Electric because its equivalent annual benefit is higher
Electricbecauseitlastslongerthangas (2marks)
WhichTWOofthefollowingaretypicallybenefitsofashorterreplacementcycle? Higher scrapvalue
Bettercompanyimageandefficiency Lower annualdepreciation
Less time to benefit from owning the asset
(2 marks)










34 Questions

Whichof the following are potential ways of attempting to deal with a capitalconstraint?
Lease
Jointventure
Delay one or more of theprojects
and 3only
and 3only
1 and 2 only
1, 2and3 (2marks)
(Total = 20 marks)

Section B questions
Sensitivityanalysis 20 mins
The following scenario relates to questions 130 – 134.

A company is considering a project with the following cash flows.

Year
Initial investment
Variable costs
Cash inflows
Net cash flows


$'000
$'000
$'000
$'000

0
(11,000)


(11,000)

1

(3,200)
10,300
7,100

2

(3,200)
10,300
7,100

Cashflowsarisefromselling1,030,000unitsat$10perunit.Thecompanyhasacostofcapitalof9%. The net present value (NPV) of the project is$1,490.

130
Whatis
the sensitivity of the project to changes in sales volume (to 1 dp)?



A
8.2%



B
8.4%



C
11.9%



D
26.5%
(2 marks)

131
Whatis
the discounted payback of the project?


1.18years
1.25years
1.55years
1.75years (2marks)
132 What is the internal rate of return (IRR) of the project (using discount rates of 15% and20%)?


A
19.2%



B
21.2%



C
24.2%



133
D
Arethe
44.3%
following statements about sensitivity analysis true or false?
(2 marks)

It provides a decision rule on whether a project should beaccepted
Its main strength is that it looks at key variables inisolation
A Statement1istrueandstatement2isfalse B Statement2istrueandstatement1isfalse C Both statements are true
D Both statementsarefalse (2marks)



Questions 35

WhichTWOofthefollowingaretrueoftheinternalrateofreturn(IRR)andthenetpresentvalue(NPV) methods ofappraisal?
IRR ignores the relative sizes ofinvestments
IRR requires a reinvestment assumption which cannot beproven
NPV is widely used inpractice
4
IRR is technically superior to NPV


A
1 and 2


B
1 and 3


C
2 and 4


D
3 and 4
(2 marks)



(Total = 10 marks)

CBE style OT case Trecor Co (Specimen paper 2007, amended) 20mins
The following scenario relates to questions 135 – 139.

TrecorCoplanstobuyamachinecosting$250,000whichwilllastforfouryearsandthenbesoldfor$5,000. Net cash flows before tax are expected to be asfollows.

T1
T2
T3
T4

Net cash flow $
122,000
143,000
187,000
78,000

Depreciation is charged on a straight-line basis over the life of an asset.

The average annual accounting profit is$71,250.
Calculatethebefore-taxreturnoncapitalemployed(accountingrateofreturn)basedontheaverage investment (to the nearest wholepercent).
% (2marks)
Are the following statements on return on capital employed (ROCE) true orfalse?


IfROCEislessthanthetargetROCEthenthepurchaseofthemachine can berecommended
ROCE can be used to compare two mutually exclusive projects
True False

(2 marks)

TrecorCocanclaimtaxallowabledepreciationona25%reducingbalancebasis.Itpaystaxatanannual rate of 30% one year inarrears.
What are the tax benefits which Trecor Co can claim in year 4 (to the nearest whole number)?
$ (2marks)
Whatisthepaybackperiodforthemachine(tothenearestwholemonth)? year(s) month(s)
(2 marks)








36 Questions

WhichTWO of the following are true of the internal rate of return(IRR)?
IRR ignores the relative sizes of investments IRR measures the increase in company value
IRR can incorporate discount rate changes during the life of the project
IRR and NPV sometimes give conflicting rankings over which project should be prioritised
(2 marks)
(Total = 10 marks)

CBE style OT case BRT Co (6/11,amended) 20mins
The following scenario relates to questions 140 – 144.
BRT Co has developed a new confectionery line that can be sold for $5.00 per box and that is expected to have continuingpopularityformanyyears.TheFinanceDirectorhasproposedthatinvestmentinthenewproductshould beevaluatedoverafour-yeartime-horizon,eventhoughsaleswouldcontinueafterthefourthyear,onthegrounds that cash flows after four years are too uncertain to beincluded.
The variable cost ( in current price terms) will depend on sales volume, as follows.
Sales volume (boxes) less than1million 1–1.9million 2–2.9million 3–3.9million
Variable cost ($perbox) 2.80 3.00 3.00 3.05
Forecast sales volumes are as follows.
Year 1 2 3 4
Demand(boxes) 0.7million 1.6million 2.1million 3.0million
Tax
Tax-allowabledepreciationona25%reducingbalancebasiscouldbeclaimedonthecostofequipment.Profittax of30%peryearwillbepayableoneyearinarrears.Abalancingallowancewouldbeclaimedinthefourthyearof operation.
Inflation
Theaveragegenerallevelofinflationisexpectedtobe3%peryearforthesellingpriceandvariablecosts.BRTCo uses a nominal after-tax cost of capital of 12% to appraise new investment projects..
AtraineeaccountantatBRTCohasstartedaspreadsheettocalculatethenetpresentvalue(NPV)ofaproposed newproject.






















Questions 37


A
B
C
D
E
F
G

1
Year
0
1
2
3
4
5

2

$’000
$’000
$’000
$’000
$’000
$’000

3
Inflated sales







4
Inflated variable
costs







5
Fixed costs

(1,030)
(1,910)
(3,060)
(4,277)


6
Net cash flow

556
1,485
1,530
2,308


7
Taxation







8
Tax benefits







9
Working capital
(750)
(23)
(23)
(24)
750


10
Investment
(2,000)






12
Project cash
flows







13
Discount factor
12%
1.000
0.893
0.797
0.712
0.636
0.567

14
Present value







What is sales figure for Year 2 (cell D3 in the spreadsheet), to the nearest$’000?
$ ’000 (2marks)
WhatarethevariablecostsforYear3(E4inthespreadsheet),tothenearest$’000?
$ ’000 (2marks)
What are the tax benefits in year 4 (cell F8), to the nearest$’000?
$ ’000 (2marks)
Which of the following statements about the project appraisal aretrue/false?



Thetraineeaccountanthasusedthewrongpercentageforthecostofcapital Ignoringsalesafterfouryearsunderestimatesthevalueoftheproject
The working capital figure in Year 4 is wrong
True False






(2 marks)

ThetraineeaccountantatBRTCohascalculatedtheinternalrateofreturn(IRR)fortheproject. Are the following statements true orfalse?
Whencashflowpatternsareconventional,theNPVandIRRmethodswillgivethesameacceptor rejectdecision.
The project is financially viable under IRR if it exceeds the cost ofcapital
Bothstatementsaretrue Bothstatementsarefalse
Statement 1 is true and statement 2 is false
Statement2istrueandstatement1isfalse (2marks)(Total = 10marks)



38 Questions

Section C questions
CalvicCo 39mins
CalvicCoservicescustomcarsandprovidesitsclientswithacourtesycarwhileservicingistakingplace.Ithasa fleetof10courtesycarswhichitplanstoreplaceinthenearfuture.Eachnewcourtesycarwillcost$15,000.The trade-in value of each new car declines over time asfollows:

Age of courtesy car (years)
1
2
3

Trade-in value ($/car)
11,250
9,000
6,200

Servicingandpartswillcost$1,000percourtesycarinthefirstyearandthiscostisexpectedtoincreaseby40% peryearaseachvehiclegrowsolder.Cleaningtheinteriorandexteriorofeachcourtesycartokeepituptothe standardrequiredbyCalvic'sclientswillcost$500percarinthefirstyearandthiscostisexpectedtoincreaseby 25% peryear.
Calvic Co has a cost of capital of 10%. Ignore taxation.
Required
Usingtheequivalentannualcostmethod,calculatewhetherCalvicCoshouldreplaceitsfleetafteroneyear, two years, orthreeyears. (12 marks)
Explainhowanorganisationcandeterminethebestwaytoinvestavailablecapitalundercapitalrationing. Youranswershouldrefertosingle-periodcapitalrationing,projectdivisibilityandtheinvestmentofsurplus funds. (8 marks)
(Total = 20 marks)

Project E (6/14, amended) 39mins
ProjectEisastrategicallyimportantprojectwhichtheBoardofOAPCohavedecidedmustbeundertakeninorder forthecompanytoremaincompetitive,regardlessofitsfinancialacceptability.Theprojecthasalifeoffouryears. Information relating to the future cash flows of this project are asfollows:

Year
1
2
3
4

Sales volume (units)
12,000
13,000
10,000
10,000

Selling price ($/unit)
450
475
500
570

Variable cost ($/unit)
260
280
295
320

Fixed costs ($'000)
750
750
750
750

Theseforecastsarebeforetakingintoaccountofsellingpriceinflationof5.0%peryear,variablecostinflationof 6.0% per year and fixed cost inflation of 3.5% per year. The fixed costs are incremental fixed costs which are associatedwithProjectE.Attheendoffouryears,machineryfromtheprojectwillbesoldforscrapwithavalueof
$400,000.TaxallowabledepreciationontheinitialinvestmentcostofProjectEisavailableona25%reducing balance basis and OAP Co pays corporation tax of 28% per year, one year in arrears. A balancing charge or allowance is available at the end of the fourth year ofoperation.
OAP Co has a nominal after-tax cost of capital of 13% per year. The initial investment for Project E is $5,000,000.
Required
Calculatethenominalafter-taxnetpresentvalueofProjectEandcommentonthefinancialacceptabilityof thisproject. (15marks)
OAP Co is considering investing $50,000 in a new machine with an expected life of five years. The machine will havenoscrapvalueattheendoffiveyears.Itisexpectedthat20,000unitswillbesoldeachyearatasellingprice of$3.00perunit.Variableproductioncostsareexpectedtobe$1.65perunit,whileincrementalfixedcosts,mainly thewagesofamaintenanceengineer,areexpectedtobe$10,000peryear.OAPCoexpectsinvestmentprojectsto recover their initial investment within twoyears.



Questions 39

Required
Calculateandcommentonthepaybackperiodofthemachine. (5 marks) (Total = 20marks)
AGD Co (FMC,12/05,amended) 39mins
AGD Co is a profitable company which is considering the purchase of a machine costing $320,000. If purchased, AGDCowouldincurannualmaintenancecostsof$25,000.Themachinewouldbeusedforthreeyearsandatthe endofthisperiodwouldbesoldfor$50,000.Alternatively,themachinecouldbeobtainedunderanoperatinglease for an annual lease rental of $120,000 per year, payable inadvance.
AGDCocanclaimtaxallowabledepreciationona25%reducingbalancebasis.Thecompanypaystaxonprofitsat anannualrateof30%andalltaxliabilitiesarepaidoneyearinarrears.AGDCohasanaccountingyearthatends on 31 December. If the machine is purchased, payment will be made in January of the first year of operation. If leased, annual lease rentals will be paid in January of each year ofoperation.
Required
Using an after-tax borrowing rate of 7%, evaluate whether AGD Co should purchase or lease the new machine. (12marks)
Explainanddiscussthekeydifferencesbetweenanoperatingleaseandafinancelease. (5marks)
Explainthedifferencebetweenriskanduncertaintyinthecontextofinvestmentappraisal. (3marks)
(Total = 20 marks)

Basril Co (FMC,12/03,amended) 39mins
BasrilCoisreviewinginvestmentproposalsthathavebeensubmittedbydivisionalmanagers.Theinvestment fundsofthecompanyarelimitedto$800,000inthecurrentyear.Detailsofthreepossibleinvestments,noneof which can be delayed, are givenbelow.
Project 1
An investment of $300,000 in work station assessments. Each assessment would be on an individual employee basis and would lead to savings in labour costs from increased efficiency and from reduced absenteeism due to work-relatedillness.Savingsinlabourcostsfromtheseassessmentsinmoneytermsareexpectedtobeasfollows:

Year
1
2
3
4
5

Cash flows ($'000)
Project 2
85
90
95
100
95

An investment of $450,000 in individual workstations for staff that is expected to reduce administration costs by
$140,800 per annum in money terms for the next five years.
Project 3
An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per annum are expected in currentpricetermsandtheseareexpectedtoincreaseby3.6%perannumduetoinflationduringthefive-yearlife of themachines.
Basril Co has a money cost of capital of 12% and taxation should be ignored.
Required
Determine the best way for Basril Co to invest the available funds and calculate the resultant NPV:
on the assumption that each of the three projects isdivisible;
ontheassumptionthatnoneoftheprojectsaredivisible. (10marks)





40 Questions

Explainhowcashshortagescanrestricttheinvestmentopportunitiesofabusiness. (5marks)
Discuss the meaning of the term ‘relevant cash flows’ in the context of investment appraisal, giving examples to illustrateyourdiscussion. (5 marks)
(Total = 20 marks)

FiltrexCo 39mins
FiltrexCoisamedium-sized,allequity-financed,unquotedcompanywhichspecialisesinthedevelopment andproductionofwater-andair-filteringdevicestoreducetheemissionofeffluents.Itssmallbutingenious R & D team has recently made a technological breakthrough which has revealed a number of attractive investmentopportunities.Ithasappliedforpatentstoprotectitsrightsinalltheseareas.However,itlacks thefinancialresourcesrequiredtoexploitalloftheseprojects,whoserequiredoutlaysandpost-taxNPVs arelistedinthetablebelow.Filtrex'smanagersconsiderthatdelayinganyoftheseprojectswouldseriously underminetheirprofitability,ascompetitorsbringforwardtheirownnewdevelopments.Allprojectsare thought to have a similar degree ofrisk.
Project Requiredoutlay NPV

$
$

A
150,000
65,000

B
120,000
50,000

C
200,000
80,000

D
80,000
30,000

E
400,000
120,000

The NPVs have been calculated using as a discount rate the 18% post-tax rate of return which Filtrex requiresforriskyR&Dventures.Themaximumamountavailableforthistypeofinvestmentis$400,000, correspondingtoFiltrex'spresentcashbalances,builtupoverseveralyears'profitabletrading.ProjectsA and C are mutually exclusive and no project can be sub-divided. Any unused capital will either remain investedinshort-termdepositsorusedtopurchasemarketablesecurities,bothofwhichofferareturnwell below 18%post-tax.
Required
AdviseFiltrexCo,usingsuitablesupportingcalculations,whichcombinationofprojectsshouldbe undertaken in the best interests of shareholders;and
Suggestwhatfurtherinformationmightbeobtainedtoassistafulleranalysis. (9 marks)
Explainhow,apartfromdelayingprojects,FiltrexCocouldmanagetoexploitmoreoftheseopportunities.
(6 marks)
Distinguishbetweenhardandsoftcapitalrationing,explainingwhyacompanymaydeliberatelychooseto restrictitscapitalexpenditure. (5 marks)
(Total = 20 marks)

Warden Co(12/11,amended) 39mins
Warden Co plans to buy a new machine. The cost of the machine, payable immediately, is $800,000 and the machinehasanexpectedlifeoffiveyears.Additionalinvestmentinworkingcapitalof$90,000willberequiredat thestartofthefirstyearofoperation.Attheendoffiveyears,themachinewillbesoldforscrap,withthescrap valueexpectedtobe5%oftheinitialpurchasecostofthemachine.Themachinewillnotbereplaced.
Production and sales from the new machine are expected to be 100,000 units per year. Each unit can be sold for
$16perunitandwillincurvariablecostsof$11perunit.Incrementalfixedcostsarisingfromtheoperationofthe machine will be $160,000 peryear.
WardenCohasanafter-taxcostofcapitalof11%whichitusesasadiscountrateininvestmentappraisal.The companypaysprofittaxoneyearinarrearsatanannualrateof30%peryear.Taxallowabledepreciationand inflation should beignored.



Questions 41

Required
Calculate the net present value of investing in the new machine and advise whether the investment is financiallyacceptable. (8 marks)
Calculatetheinternalrateofreturnofinvestinginthenewmachineandadvisewhethertheinvestmentis financiallyacceptable. (4 marks)
(i) Explainbrieflythemeaningoftheterm'sensitivityanalysis'inthecontextofinvestmentappraisal.
(2 marks)
(ii) Using the IRR you calculated in part (b), calculate the sensitivity of the investment in the new machinetoachangeinsellingpriceandtoachangeindiscountrate,andcommentonyourfindings.
(6 marks)(Total = 20 marks)
BQK Co(12/12,amended) 39mins
BQKCo,ahouse-buildingcompany,planstobuild100housesonadevelopmentsiteoverthenextfouryears.The purchasecostofthedevelopmentsiteis$4,000,000,payableatthestartofthefirstyearofconstruction.Twotypes of house will be built, with annual sales of each house expected to be asfollows:

Year
1
2
3
4

Number of small houses sold:
15
20
15
5

Number of large houses sold:
7
8
15
15

Housesarebuiltintheyearofsale.Eachcustomerfinancesthepurchaseofahomebytakingoutalong-term personalloanfromtheirbank.Financialinformationrelatingtoeachtypeofhouseisasfollows:


Small house
Large house

Selling price:
$200,000
$350,000

Variable cost of construction:
$100,000
$200,000

Sellingpricesandvariablecostofconstructionareincurrentpriceterms,beforeallowingforsellingpriceinflation of 3% per year and variable cost of construction inflation of 4.5% peryear.
Fixedinfrastructurecostsof$1,500,000peryearincurrentpricetermswouldbeincurred.Thesewouldnotrelate toanyspecifichouse,butwouldbefortheprovisionofnewroads,gardens,drainageandutilities.Infrastructure cost inflation is expected to be 2% peryear.
BQKCopaysprofittaxoneyearinarrearsatanannualrateof30%.Thecompanycanclaimtaxallowable depreciationonthepurchasecostofthedevelopmentsiteonastraight-linebasisoverthefouryearsof construction.
BQKCohasarealafter-taxcostofcapitalof9%peryearandanominalafter-taxcostofcapitalof12%peryear. Newinvestmentsarerequiredbythecompanytohaveabefore-taxreturnoncapitalemployed(accountingrateof return) on an average investment basis of 20% peryear.
Required
Calculatethenetpresentvalueoftheproposedinvestmentandcommentonitsfinancialacceptability.Work to thenearest$1,000. (13marks)
DiscusstheeffectofasubstantialriseininterestratesonthefinancingcostofBQKCoanditscustomers, andonthecapitalinvestmentappraisaldecision-makingprocessofBQKCo. (7marks)
(Total = 20 marks)









42 Questions

Uftin Co(12/14,amended) 39mins
Uftin Co is a large company which is listed on a major stock market. The company has been evaluating an investmentproposaltomanufactureProductK3J.Theinitialinvestmentof$1,800,000willbepayableatthestartof thefirstyearofoperation.Thefollowingdraftevaluationhasbeenpreparedbyajunioremployee.

Year
1
2
3
4

Sales (units/year)
95,000
100,000
150,000
150,000

Selling price ($/unit)
25
25
26
27

Variable costs ($/unit)
11
12
12
13

(Note: The above selling prices and variable costs per unit have not been inflated.)


Sales revenue
$'000 2,475
$'000 2,605
$'000 4,064
$'000 4,220

Variable costs
(1,097)
(1,260)
(1,890)
(2,048)

Fixed costs
(155)
(155)
(155)
(155)

Interest payments
(150)
(150)
(150)
(150)

Cash flow before tax
1,073
1,040
1,869
1,867

Tax allowable depreciation
(450)
(450)
(450)
(450)

Taxable profit
623
590
1,419
1,417

Taxation

(137)
(130)
(312)

Net cash flow
623
453
1,289
1,105

Discount at 12%
0.893
0.797
0.712
0.636

Present values
556
361
918
703


Present value of cash inflows
$'000 2,538




Cost of machine
(1,800)




NPV
738




The junior employee also provided the following information:
Relevant fixed costs are forecast to be $150,000 peryear.
Sales and production volumes are the same and no finished goods inventory isheld.
The corporation tax rate is 22% per year and tax liabilities are payable one year inarrears.
UftinCocanclaimtaxallowabledepreciationof25%peryearonareducingbalancebasisontheinitial investment.
A balancing charge or allowance can be claimed at the end of the fourthyear.
Itisexpectedthatsellingpriceinflationwillbe4.2%peryear,variablecostinflationwillbe5%peryearand fixed cost inflation will be 3% peryear.
The investment has no scrapvalue.
The investment will be partly financed by a $1,500,000 loan at 10% peryear.
Uftin Co has a weighted average cost of capital of 12% peryear.
Required
Prepareareviseddraftevaluationoftheinvestmentproposalandcommentonitsfinancialacceptability.
(11 marks)
ExplainanyTWOrevisionsyouhavemadetothedraftevaluationinpart(a)above. (4marks)
DiscussTWOwaysofincorporatingriskintotheinvestmentappraisalprocess. (5marks)
(Total = 20 marks)




Questions 43

Hraxin Co(6/15,amended) 39mins
HraxinCoisappraisinganinvestmentprojectwhichhasanexpectedlifeoffouryearsandwhichwillnotbe repeated.Theinitialinvestment,payableatthestartofthefirstyearofoperation,is$5million.Scrapvalueof
$500,000 is expected to arise at the end of four years.
Thereissomeuncertaintyaboutwhatpricecanbechargedfortheunitsproducedbytheinvestmentproject,asthis is expected to depend on the future state of the economy. The following forecast of selling prices and their probabilities has beenprepared:

Future economic state
Weak
Medium
Strong

Probability of future economic state
35%
50%
15%

Selling price in current price terms
$25 per unit
$30 per unit
$35 per unit

Thesesellingpricesareexpectedtobesubjecttoannualinflationof4%peryear,regardlessofwhicheconomic state prevails in thefuture.
Forecast sales and production volumes, and total nominal variable costs, have already been forecast, as follows:

Year
1
2
3
4

Sales and production (units)
150,000
250,000
400,000
300,000

Nominal variable cost ($000)
2,385
4,200
7,080
5,730

Incremental overheads of $400,000 per year in current price terms will arise as a result of undertaking the investmentproject.Alargeproportionoftheseoverheadsrelatetoenergycostswhichareexpectedtoincrease sharplyinthefuturebecauseofenergysupplyshortages,sooverheadinflationof10%peryearisexpected.
Theinitialinvestmentwillattracttax-allowabledepreciationonastraight-linebasisoverthefour-yearprojectlife. The rate of corporation tax is 30% and tax liabilities are paid in the year in which they arise. Hraxin Co has traditionallyusedanominalafter-taxdiscountrateof11%peryearforinvestmentappraisal.
Required
Calculate the expected net present value of the investment project and comment on its financial acceptability. (9 marks)
Distinguish between risk and uncertainty and briefly explain why they should be considered in the investmentappraisalprocess. (5 marks)
Critically discuss if sensitivity analysis will assist Hraxin Co in assessing the risk of the investmentproject.
(6 marks)(Total = 20 marks)






















44 Questions



MCQ bank – Sourcesoffinance 20mins
Businesses often use loans or overdrafts or both as a source offinance.
Whichofthefollowingisabenefit,totheborrower,ofaloanasopposedtoanoverdraft? A Flexible repaymentschedule
B Onlychargedfortheamountdrawndown C Easy toarrange
D Lowerinterestrates (2marks)
According to the creditor hierarchy, list the following from high risk to lowrisk:
Ordinary sharecapital
Preference sharecapital
Tradepayables
Bank loan with fixed and floatingcharges
A 1,2,3,4
B 2,1,4,3
C 1,2,4,3
D 4,1,2,3 (2marks)
Alphaisalistedcompanywithasharepriceof$2pershare.Itannouncesa1-for-4rightsissueat$1.60per share.
Whatisthetheoreticalex-rightsprice? A $2.40
B $1.80
C $1.68
D $1.92 (2marks)
Whichoneofthefollowingisissuedatadiscounttoitsredemptionvalueandpaysitsholdernointerest during itslife?
A deep discountbond
Along-termbondissuedbythegovernment C An unsecured loannote
D A zerocouponbond (2marks)
Which of the following describes asukuk?
AbondinIslamicfinancewherethelenderownstheunderlyingassetandsharesintherisksand rewards ofownership.
EquityinIslamicfinancewhereprofitsaresharedaccordingtoapreagreedcontract–dividendsare not paid assuch.
TradecreditinIslamicfinancewhereapreagreedmarkupisagreedinadvancefortheconvenience of payinglater.
AleaseinIslamicfinancewherethelessorretainsownershipandtheriskandrewardsofownership of theunderlyingasset. (2 marks)
(Total = 10 marks)







Questions 45

MCQ bank –Dividendpolicy 20mins




(2 marks)


It indicates future dividendpatterns.
Adividendthatisdifferentfrominvestorexpectationshighlightsinformationaboutthebusinessto theinvestors.
It flags reported financial results tofollow.
Itindicatespoorcashflowhealth. (2marks)
InModigliani&Miller'sdividendirrelevancetheory,theprocessof'manufacturingdividends'refersto which of thefollowing?
Dividends from manufacturingbusinesses.
Investorssellingsomesharestorealisesomecapitalgain. C Creativeaccountingtoallowdividendstobepaid.
D Investingplansdesignedtocreateregularreturnstoshareholders. (2marks)
What does an enhanced scrip dividendmean?
In addition to the scrip dividend cash is alsopaid
Bonus shares are paid in return for accepting adelay
Morethan$1worthofsharesisofferedasanalternativetoevery$1cashdividendtobepaid
Ahigherscripdividendisofferedtoalimitedshareholdergroup. (2marks)
Three companies (Sun Co, Moon Co and Nite Co) have the following dividend paymentshistory:

Company
Sun Co – Dividend
20X1
100
20X2
110
20X3
121

Sun Co – Earnings
200
200
201

Moon Co – Dividend
50
150
25

Moon Co – Earnings
100
300
50

Nite Co – Dividend
nil
300
nil

Nite Co – Earnings
400
350
500

Which best describes their apparent dividend policies?





Sun Co
Moon Co
Nite Co


A B C D
Constant growth Constant pay-out High pay-out Constant growth
Constant pay-out Constant growth Residual Residual
Residual Residual Constant pay-out Constant pay-out



(2 marks)





(Total = 10 marks)







46 Questions

MCQ bank – Gearing and capital structure
164 A summary of HM Co's recent statement of profit or loss is givenbelow:
39 mins


$'000

Revenue
10,123

Cost of sales
(7,222)

Gross profit
2,901

Expenses
(999)

Profit before interest and tax
1,902

Interest
(1,000)

Tax
(271)

Profit after interest and tax
631

70% of cost of sales and 10% of expenses are variable costs.


What is HM Co's operational gearing?


A 7.87
B 0.71
C 2.61
D 0.40 (2marks)
The following is an extract of ELW's statement of financialposition.
$m $m
Totalassets 1,000

$1 Ordinarysharecapital 100
Retainedearnings 400
Totalequity 500


Loannotes 500

1,000


Theordinarysharesarecurrentlyquotedat$5.50,andloannotesaretradingat$125per$100nominal. What is ELW’s financial gearing ratio (debt/debt+equity) using marketvalues?
A 40%
B 56%
C 57%
D 53% (2marks)
Whosuffersfinancialriskasfinancialgearingincreases,andwhy? A Lenders because they are less likely to berepaid.
B Lendersbecausetherearefewerassetstoofferassecurity. C Shareholders as their returns arelower.
D Shareholdersastheirdividendsbecomemorevariable. (2marks)
AB Co has an interest cover greater than one and gearing (debt/debt + equity) of50%.
What will be the impact on interest cover and gearing of issuing shares to repay half the debt?




(2 marks)




Questions 47

Allelsebeingequal,apoorsetofresultsandlowerdividendsthataren'tasbadasshareholderswere expecting would probably have the followingimpact:




(2 marks)
The following statements relate to small and medium sized enterprises(SMEs).
SMEs are restricted in sources of newequity
ApotentialsourceoffinancingforSMEsisventurecapital. Are the statements true orfalse?
A Statement 1 is true and statement 2 is false B Statement 2 is true and statement 1 is false C Both statements aretrue
D Both statementsarefalse (2marks)
Which of the following are handicaps that young SMEs face in accessingfunds?
Uncertainty and risk forlenders
Financial statements are not sufficientlydetailed
Shares cannot be placedprivately
1 and 3only
1 and 2only
2 and 3only
1, 2and3 (2marks)
The following statements relate to small and medium sized enterprises(SMEs).
Medium term loans are harder to obtain than longer term loans forSMEs.
SMEsarepronetofundinggaps. Are the statements true orfalse?
A Statement 1 is true and statement 2 is false B Statement 2 is true and statement 1 is false C Both statements aretrue
D Both statementsarefalse (2marks)
Privateindividualsorgroupsofindividualscaninvestdirectlyintoasmallbusiness. What is this knownas?
Reversefactoring
Supply chainfinance
Venturecapital
Businessangelfinancing (2marks)
The following statements relate to supply chain finance(SCF).
SCF is considered to be financialdebt.
SCFallowsanSMEtoraisefinanceatalowerinterestratethanwouldnormallybeavailabletoit. Are the statements true orfalse?
A
Statement 1 is true and statement 2 is false


B
Statement 2 is true and statement 1 is false


C
Both statements are true


D
Both statements are false
(2 marks)



(Total = 20 marks)




48 Questions

CBE style OTQ bank – The costofcapital 39mins
GGCohasacostofequityof25%.Ithas4millionsharesinissue,andhasdoneformanyyears. Its dividend payments in the years 20X9 to 20Y3 were asfollows.
End of year
Dividends


$'000

20X9
220

20Y0
257

20Y1
310

20Y2
356

20Y3
423

Dividends are expected to continue to grow at the same average rate into the future.
According to the dividend valuation model, what should be the share price at the start of 20Y4?
$0.96
$1.10
$1.47
$1.73 (2marks)
IPACoisabouttopaya$0.50dividendoneachordinaryshare.Itsearningspersharewas$1.50. Net assets per share is $6. Current share price is $4.50 pershare.
What is the cost of equity (to the nearest whole percent?
%
(2 marks)
Which of the following best describes systematicrisk?
Thechancethatautomatedprocessesmayfail Theriskassociatedwithinvestinginequity
The diversifiable risk associated with investing in equity
Theresidualriskassociatedwithinvestinginawell-diversifiedportfolio. (2marks)
A share in MS Co has an equity beta of 1.3. MS Co's debt beta is 0.1. It has a gearing ratio of 20% (debt:equity).Themarketpremiumis8%andtheriskfreerateis3%.MSCopays30%corporationtax.
What is the cost of equity for MS Co?

% (2marks)
HB Co has in issue 10% irredeemable loan notes, currently traded at 95%cum-interest.
If the tax rate changes from 30% to 20% for the company, what will happen to the cost of irredeemable debt?
Increases to 9.4%
Increases to 8.4%
Decreases to 9.4%
Decreasesto8.4% (2marks)









Questions 49

BRW Co has 10% redeemable loan notes in issue trading at $90. The loan notes are redeemable at a 10% premiumin5years’time,orconvertibleatthatpointinto20ordinaryshares.Thecurrentsharepriceis$2.50 andisexpectedtogrowat10%perannumfortheforeseeablefuture.BRWCopays30%corporationtax.
What is the best estimate of the cost of these loan notes?
9.8%
7.9%
11.5%
15.2% (2marks)
IDO Co has a capital structure asfollows.
$m
10m $0.50ordinaryshares 5
Reserves 20
13% Irredeemableloannotes 7
32

Theordinarysharesarecurrentlyquotedat$3.00,andtheloannotesat$90.IDOCohasacostofequityof 12% and pays corporation tax at a rate of30%.
What is IDO Co's weighted average cost of capital?
10.4%
11.1%
11.7%
11.8% (2marks)
Whichofthefollowingareassumedifacompany'scurrentweightedaveragecostofcapital(WACC)istobe used to appraise a potentialproject?

1
Capital structure will remain unchanged for the duration of the project


2
The business risk of the project is the same as the current business operations


3
The project is relatively small in size



1 and 2 only



2 and 3 only



1 and 3 only



1, 2 and 3
(2 marks)

Whichofthefollowingassumptionsisnotrequiredwhenusingthecapitalassetpricingmodeltoestimate the cost of equity for projectappraisal?
Efficient capital markets Well diversified investors
Future periods are consistent with the present
Companies arewelldiversified (2marks)
An8%irredeemable$0.50preferenceshareisbeingtradedfor$0.30cum-divcurrentlyinacompanythat pays corporation tax at a rate of30%.
What is the cost of capital for these preference shares?
10.8%
15.4%
26.7%
18.7% (2marks)
(Total = 20 marks)




50 Questions

CBE style OTQ bank –Capitalstructure 39mins
AlfCo'sgearingis1:1debt:equity.Theindustryaverageis1:5.AlfCoislookingtoraisefinancefor investmentinanewprojectanditiswonderingwhethertoraisedebtorequity.
Applying the traditional view, which of the following is true?
It should take on debt finance, as to do so will save tax.
Itshouldtakeonequityfinance,astheirgearingisprobablybeyondoptimal. Itdoesn'tmatter,asitwon'taffectthereturnstheprojectsgenerate.
Moreinformationisneededbeforeadecisioncanbemade. (2marks)
WhydoModigliani-Miller(withtax)assumeincreasedgearingwillreducetheweightedaveragecostof capital(WACC)?
Debt is cheaper than equity.
Interest payments are tax deductible.
Reduced levels of expensive equity capital will reduce the WACC.
Financialriskisnotpronouncedatmoderateborrowinglevels. (2marks)
SD Co increased its gearing and its weighted average cost of capital wasreduced.
Which TWO of the following theories might explain this?
Modigliani-Miller (with tax) The traditional view Pecking order theory Modigliani-Miller (no tax)
(2 marks)
DirectorAbelievesthereisanoptimalbalanceofdebt:equitywhereasdirectorBdoesnotbelievethatthe gearing decision affects the value of thebusiness.
Which theories are the directors subscribing to?
DirectorA DirectorB
MM(withtax) MM(notax)
Traditionalview MM(notax)
Traditionalview MM (withtax)
MM(notax) Traditionalview (2marks)
Pecking order theory suggests finance should be raised in whichorder?
Internal funds, rights issue, debt Internal funds, debt, new equity Debt, internal funds, new equity
Rights issue, internalfunds,debt (2marks)
The following information relates to questions 189 and 190.
TR Co has a gearing level of 1:3 debt : equity. TR is considering diversifying into a new market. B Co is alreadyoperatinginthenewmarket.BCohasanequitybetaof1.05andagearinglevelof1:4debt:equity. Both companies pay 30% corporationtax.
What is the asset beta relevant to TR for the new market (to 2dp)?

(2 marks)



Questions 51

Therisk free rate is 4% and the market premium is4%.
What is TR Co's cost of equity for assessing the decision to diversify into the new market?
4%
7.6%
8.4%
6.3% (2marks)
Why is an asset beta generally lower than an equitybeta?
Anequitybetaalsoincludesanelementoffinancialrisk Returns from assets are taxdeductible.
Asset betas contain less business risk
Capitalmarketsaregenerallymoreefficientthanbusinessoperations. (2marks)
When should a project-specific cost of capital be used for investmentappraisal?
Ifnewfinanceisrequiredbeforetheprojectcangoahead. If the project issmall.
If the project is different from current operations.
Iftheprojectisthesameascurrentoperations. (2marks)
What does tax exhaustionmean?
All avenues have been explored to minimise corporation tax.
Asdeductionshavereducedtaxpayabletozero,furtherdeductionswon'tsavetax. Non current assets have a zero tax written downvalue.
Taxliabilitieshavebeencompletelydischarged. (2marks)(Total = 20marks)

Section B questions
CBE style OT caseIMLCo 20mins
The following scenario relates to questions 194 – 198.

IML Co is an all equity financed listed company. Nearly all its shares are held by financial institutions.
IMLhasrecentlyappointedanewfinancedirectorwhoadvocatesusingthecapitalassetpricingmodelasameans of evaluating risk and interpreting stock market reaction to thecompany.
Thefollowinginitialinformationhasbeenputforwardbythefinancedirectorforarivalcompanyoperatinginthe sameindustry:
Equity Beta
AZTCo 0.7
Thefinancedirectornotesthattherisk-freerateis5%eachyearandtheexpectedrateofreturnonthemarket portfolio is 15% eachyear.
Calculate, using the capital asset pricing model, the required rate of return on equity of AZTCo.
(2 marks)






52 Questions

DuringtheyearIMLCopaidadividendof15cpershare.Attheyear-endsharepricewas$3.15.Shareprice was $2.50 at the start of theyear.
What is the total shareholder return over the period?

%
(2 marks)
CalculatetheequitybetaofIMLCo,assumingitsrequiredannualrateofreturnonequityis17%andthe stock market uses the capital asset pricing model to calculate the equitybeta.

(2 marks)
Which TWO of the following statements aretrue?
IfIMLCo’ssharepricemovedatthreetimesthemarketrate,itsequitybetafactorwouldbe3.0 The beta factor of IML Co indicates the level of unsystematicrisk
Thehigherthelevelofsystematicrisk,thelowertherequiredrateofreturnbyIMLCo IML Co wants a return on a project to exceed the risk-freerate


Are the following statements true orfalse?

CAPMassumesthatinvestorsinIMLCoholdafullydiversifiedportfolio If IML Co has a low price/earnings ratio, CAPM is unable to forecast returnsaccurately


Section C questions
(2 marks)

True False



(2 marks) (Total = 10 marks)


Bar Co(12/11,amended) 39mins
BarCoisastockexchangelistedcompanythatisconcernedbyitscurrentlevelofdebtfinance.Itplanstomakea rightsissueandtousethefundsraisedtopayoffsomeofitsdebt.Therightsissuewillbeata20%discounttoits current ex-dividend share price of $7.50 per share and Bar Co plans to raise $90 million. Bar Co believes that payingoffsomeofitsdebtwillnotaffectitsprice/earningsratio,whichisexpectedtoremainconstant.
Statement of profit or loss information
$m
Revenue 472
Costofsales 423
Profit before interestandtax 49
Interest 10
Profitbeforetax 39
Tax 12
Profitaftertax 27
Statement of financial position information
$m
Equity
Ordinary shares($1nominal) 60
Retainedearnings 80
140
Long-term liabilities
8% bonds($100nominal) 125
265



Questions 53

The8%bondsarecurrentlytradingat$112.50per$100bondandbondholdershaveagreedthattheywillallowBar Co to buy back the bonds at this market value. Bar Co pays tax at a rate of 30% peryear.
Required
CalculatethetheoreticalexrightspricepershareofBarCofollowingtherightsissue. (3marks)
Calculate and discuss whether using the cash raised by the rights issue to buy back bonds is likely to be financially acceptable to the shareholders of Bar Co, commenting in your answer on the belief that the currentprice/earningsratiowillremainconstant. (7marks)
CalculateanddiscusstheeffectonthefinancialriskofBarCoofusingthecashraisedbytherightsissueto buybackbonds,asmeasuredbyitsinterestcoverageratioanditsbookvaluedebttoequityratio.
(4 marks)
Discussthedangerstoacompanyofahighlevelofgearing,includinginyouransweranexplanationofthe followingterms:
Businessrisk;
Financialrisk. (6marks)
(Total = 20 marks)

YGV Co(6/10,amended) 39mins
YGV Co is a listed company selling computer software. Its profit before interest and tax has fallen from $5 million to
$1 million in the last year and its current financial position is as follows:


Non-current assets
Property, plant and equipment
$'000

3,000
$'000

Intangible assets
8,500
11,500

Current assets
Inventory

4,100


Trade receivables
11,100
15,200

Total assets

26,700

Equity
Ordinary shares

10,000


Reserves
7,000
17,000

Current liabilities Trade payables

5,200


Overdraft
4,500
9,700

Total equity and liabilities

26,700

YGVCohasbeenadvisedbyitsbankthatthecurrentoverdraftlimitof$4.5millionwillbereducedto$500,000in twomonths'time.ThefinancedirectorofYGVCohasbeenunabletofindanotherbankwillingtoofferalternative overdraft facilities and is planning to issue bonds on the stock market in order to finance the reduction of the overdraft.Thebondswouldbeissuedattheirnominalvalueof$100perbondandwouldpayinterestof9%per year,payableattheendofeachyear.Thebondswouldberedeemableata10%premiumtotheirnominalvalue after 10 years. The finance director hopes to raise $4 million from the bondissue.
TheordinarysharesofYGVCohaveanominalvalueof$1.00pershareandacurrentmarketvalueof$4.10per share.ThecostofequityofYGVCois12%peryearandthecurrentinterestrateontheoverdraftis5%peryear. Taxation is at an annual rate of30%.
Other financial information:
Averagegearingofsector(debt/equity,marketvaluebasis): 10% Averageinterestcoverageratioofsector: 8times



54 Questions

Required
Calculatetheafter–taxcostofdebtofthe9%bonds. (4marks)
Calculate the effect of using the bond issue to finance the reduction in the overdrafton:
the interest coverageratio;
gearing(debt/equity,marketvaluebasis). (4 marks)
Evaluatetheproposaltousethebondissuetofinancethereductionintheoverdraftanddiscussalternative sourcesoffinancethatcouldbeconsideredbyYGVCo,givenitscurrentfinancialposition. (12 marks)
(Total = 20 marks)

NN Co(12/10,amended) 39mins
$m $m $m
Assets
Non-currentassets 101
Current assets
Inventory 11
Tradereceivables 21
Cash 10
42
Totalassets 143


Equity and liabilities
Ordinarysharecapital 50
Preferencesharecapital 25
Retainedearnings 19
Totalequity 94
Non-current liabilities
Long-termborrowings 20
Current liabilities
Tradepayables 22
Otherpayables 7

Totalcurrentliabilities 29

Totalliabilities 49

Total equityandliabilities 143

NNCohasacostofequityof12%.Theordinarysharesofthecompanyhaveanominalvalueof50centspershare and an ex div market value of $8.30 pershare.
Thelong-termborrowingsofNNCoconsistof7%bondsthatareredeemableinsixyears’timeattheirnominal value of $100 per bond. The current ex interest market price of the bonds is$103.50.
ThepreferencesharesofNNCohaveanominalvalueof50centspershareandpayanannualdividendof8%.The ex div market value of the preference shares is 67 cents pershare.
NN Co pay profit tax at an annual rate of 25% per year.
Required
Calculatetheafter-taxcostofdebtofNNCo. (4 marks)
Calculatetheweightedaverageafter-taxcostofcapitalofNNCo. (6 marks)
Discussthefactorstobeconsideredinformulatingthedividendpolicyofastock-exchangelistedcompany.
(10 marks)(Total = 20 marks)

Questions 55

AQR Co(6/11,amended) 39mins
ThefinancedirectorofAQRCohasheardthatthemarketvalueofthecompanywillincreaseiftheweightedaverage cost of capital of the company is decreased. The company, which is listed on a stock exchange, has 100 million sharesinissueandthecurrentexdivordinarysharepriceis$2.50pershare.AQRCoalsohasinissuebondswith abookvalueof$60millionandtheircurrentexinterestmarketpriceis$104per$100bond.Thecurrentafter-tax cost of debt of AQR Co is 7% and the tax rate is30%.
The recent dividends per share of the company are as follows.

Year
20X0
20X1
20X2
20X3
20X4

Dividend per share (cents)
19.38
20.20
20.41
21.02
21.80

ThefinancedirectorproposestodecreasetheweightedaveragecostofcapitalofAQRCo,andhenceincreaseits marketvalue,byissuing$40millionofbondsattheirnominalvalueof$100perbond.Thesebondswouldpay annualinterestof8%beforetaxandwouldberedeemedata5%premiumtonominalvalueafter10years.
Required
Calculatethemarketvalueafter-taxweightedaveragecostofcapitalofAQRCointhefollowing circumstances:
before the new issue of bonds takesplace;
after the new issue of bonds takesplace.
Comment onyourfindings. (12 marks)
Discussthedirector’sviewthatissuingtradedbondswilldecreasetheweightedaveragecostofcapitalof AQRCoandtherebyincreasethemarketvalueofthecompany. (8 marks)
(Total = 20 marks)

BKB Co(12/12,amended) 39mins
The statement of financial position of BKB Co provides the following information:
$m $m
Equity finance
Ordinary shares ($1nominalvalue) 25
Reserves 15 40
Non-current liabilities
7% Convertible bonds ($100nominalvalue) 20
5% Preference shares ($1nominalvalue) 10 30
Current liabilities
Tradepayables 10
Overdraft 15 25

Totalliabilities 95

BKBCohasanequitybetaof1.2andtheex-dividendmarketvalueofthecompany'sequityis$125million.Theex- interestmarketvalueoftheconvertiblebondsis$21millionandtheex-dividendmarketvalueofthepreference shares is $6.25million.
TheconvertiblebondsofBKBCohaveaconversionratioof19ordinarysharesperbond.Theconversiondateand redemption date are both on the same date in five years' time. The current ordinary share price of BKB Co is expected to increase by 4% per year for the foreseeablefuture.
Theoverdrafthasavariableinterestratewhichiscurrently6%peryearandBKBCoexpectsthistoincreaseinthe nearfuture.Theoverdrafthasnotchangedinsizeoverthelastfinancialyear,althoughoneyearagotheoverdraft interestratewas4%peryear.Thecompany'sbankwillnotallowtheoverdrafttoincreasefromitscurrentlevel.


56 Questions

Theequityriskpremiumis5%peryearandtherisk-freerateofreturnis4%peryear.BKBCopaysprofittaxatan annual rate of 30% peryear.
Required
Calculate the market value after-tax weighted average cost of capital of BKB Co, explaining clearly any assumptionsyoumake. (12 marks)
Discusswhymarketvalueweightedaveragecostofcapitalispreferredtobookvalueweightedaveragecost ofcapitalwhenmakinginvestmentdecisions. (4 marks)
Discusstheattractionstoacompanyofconvertibledebtcomparedtoabankloanofasimilarmaturityasa sourceoffinance. (4 marks)
(Total = 20 marks)
Fence Co(6/14,amended) 39mins
TheequitybetaofFenceCois0.9andthecompanyhasissued10millionordinaryshares.Themarketvalueofeach ordinaryshareis$7.50.Thecompanyisalsofinancedby7%bondswithanominalvalueof$100perbond,which willberedeemedinsevenyears'timeatnominalvalue.Thebondshaveatotalnominalvalueof$14million.
Interest on the bonds has just been paid and the current market value of each bond is $107.14.
Fence Co plans to invest in a project which is different to its existing business operations and has identified a companyinthesamebusinessareaastheproject,HexCo.TheequitybetaofHexCois1.2andthecompanyhas anequitymarketvalueof$54million.ThemarketvalueofthedebtofHexCois$12million.
Therisk-freerateofreturnis4%peryearandtheaveragereturnonthestockmarketis11%peryear.Both companies pay corporation tax at a rate of 20% peryear.
Required
CalculatethecurrentweightedaveragecostofcapitalofFenceCo. (7marks)
Calculateacostofequitywhichcouldbeusedinappraisingthenewproject. (4marks)
Explainthedifferencebetweensystematicandunsystematicriskinrelationtoportfoliotheoryandthecapital assetpricingmodel. (4marks)
Explainthelimitationsofthecapitalassetpricingmodel. (5 marks) (Total = 20marks)
Tinep Co(12/14,amended) 39mins
TinepCoisplanningtoraisefundsforanexpansionofexistingbusinessactivitiesandinpreparationforthisthe companyhasdecidedtocalculateitsweightedaveragecostofcapital.TinepCohasthefollowingcapitalstructure:
$m $m

Equity
Ordinaryshares 200
Reserves 650
Non-current liabilities
850

Loannotes 200
1,050

TheordinarysharesofTinepCohaveanominalvalueof50centspershareandarecurrentlytradingonthestock market on an ex dividend basis at $5.85 per share. Tinep Co has an equity beta of1.15.
The loan notes have a nominal value of $100 and are currently trading on the stock market on an ex interest basis at
$103.50perloannote.Theinterestontheloannotesis6%peryearbeforetaxandtheywillberedeemedinsix years' time at a 6% premium to their nominalvalue.



Questions 57

Therisk-freerateofreturnis4%peryearandtheequityriskpremiumis6%peryear.TinepCopayscorporation tax at an annual rate of 25% peryear.
Required
Calculatethemarketvalueweightedaveragecostofcapitalandthebookvalueweightedaveragecostof capitalofTinepCo,andcommentbrieflyonanydifferencebetweenthetwovalues.


DiscussthefactorstobeconsideredbyTinepCoinchoosingtoraisefundsviaarightsissue.
(9 marks)

(6 marks)

Explainthenatureofascrip(share)dividendanddiscusstheadvantagesanddisadvantagestoacompany ofusingscripdividendstorewardshareholders. (5 marks)
(Total = 20 marks)

Grenarp Co(6/15,amended) 39mins
Grenarp Co is planning to raise $11,200,000 through a rights issue. The new shares will be offered at a 20% discounttothecurrentsharepriceofGrenarpCo,whichis$3·50pershare.Therightsissuewillbeona1for5 basisandissuecostsof$280,000willbepaidoutofthecashraised.ThecapitalstructureofGrenarpCoisas follows:
$m $m
Equity
Ordinaryshares 10
Reserves 75
85
Non-current liabilities
Loannotes 30
115

The net cash raised by the rights issue will be used to redeem part of the loan note issue. Each loan note has a nominalvalueof$100andanexinterestmarketvalueof$104.AclauseinthebondissuecontractallowsGrenarp Co to redeem the loan notes at a 5% premium to market price at any time prior to their redemption date. The price/earningsratioofGrenarpCoisnotexpectedtobeaffectedbytheredemptionoftheloannotes.
TheearningspershareofGrenarpCoiscurrently$0·42pershareandtotalearningsare$8,400,000peryear.The company pays corporation tax of 30% peryear.
Required
EvaluatetheeffectonthewealthoftheshareholdersofGrenarpCoofusingthenetrightsissuefundsto redeem theloannotes. (8marks)
Discuss whether Grenarp Co might achieve its optimal capital structure following the rightsissue.
(7 marks)
Discuss THREE sources and characteristics of long-term debt finance which may be available to GrenarpCo.
(5 marks)(Total = 20 marks)













58 Questions



MCQ bank –Businessvaluations 39mins
Which of the following best describes the replacement value of abusiness?
Value if sold offpiece-meal
Value to replace assets withnew
Cost of setting up an equivalentventure
Netpresentvalueofcurrentoperations (2marks)
The following is a summary of Monkton Co's statement of financialposition:
$m
Non-current assets
5

Net current assets
3


8

Financed by:


$1 Ordinary shares
1

Reserves
5

Loan notes
2


8

Non-currentassetsincludemachinerywhichcost$10millionwhenpurchased7yearsagoandhasauseful life of 10 years. Monkton Co uses straight-line depreciation. These assets were recently professionally valued at $1million.
What is the value per share using the realisable value basis of valuation?
$1
$2
$4
$6 (2marks)
ELWCorecentlypaidadividendof$0.50ashare.Thisis$0.10morethan3yearsago.Shareholdershavea required rate of return of10%.
Using the dividend valuation model and assuming recent dividend growth is expected to continue, what is the current value of a share?
A $23.41
B $5.00
C $38.48
D $10.48 (2marks)
Which of the following need to be assumed when using the dividend valuation formula to estimatea sharevalue?
The recent dividend, 'D0', is typical ie doesn't vary significantly from historicaltrends
Growth will beconstant
The cost of equity will remainconstant
A majority shareholding is beingpurchased
1, 2 and 3only
3 and 4only
1 and 2only
1, 2, 3and4 (2marks)





Questions 59

JoCoisacompanywhichisfinancedbyequityonly.Ithasjustpaidadividendof$60mandearnings retainedandinvestedwere60%.Returnoninvestmentsis20%andthecostofequityis22%.
What is the market value of the company (to the nearest whole million)?
A $300m
B $272m
C $305m
D $672m (2marks)

DD Co's P/E ratio is 12. Its competitor's earnings yield is10%.
When comparing DD Co to its competitor, which of the following is correct?




(2 marks)
A9%redeemableloannoteinATVCoisduetomaturein3years’timeatapremiumof15%,orconvertible into 25 ordinary shares at that point. The current share price is $4, expected to grow at 10% per annum. ATV pays corporation tax at a rate of30%.
What is the current market value of the loan note if loan note holders require a 10% return?
A $108.75
B $115.63
C $102.03
D $122.34 (2marks)
Which of the following best defines the market capitalisation for a company'sshares?
When a company is listed ie goes'public'
Whenacompanyissuesnewsharesandthusincreasesitscapital C Current shareprice
D Share price x number of sharesinissue (2marks)
HAL Co is considering purchasing SO Co and has produced the followingvaluations:
$m
1
Historical cost adjusted for general inflation
3

2
Economic value – Net present value of projects
6

3
Piecemeal net realisable value
4

4
Cost of setting up an equivalent business
5

What is the maximum HAL Co should pay based on the above?
$3million
$6million
$5million
$4million (2marks)
NCW Co is considering acquiring the ordinary share capital of CEW Co. CEW has for years generated an annualcashinflowof$10million.Foraoneoffinvestmentof$6minnewmachinery,earningsforCEWcan be increased by $2m per annum. NCW has a cost of capital of10%.
What is the value of CEW Co?

A
$114 million


B
$120 million


C
$100 million


D
$94 million
(2 marks)



(Total = 20 marks)





60 Questions

CBE style OTQ bank –Marketefficiency 20mins
WCCoannouncesthatitdecidedyesterdaytoinvestinanewprojectwithahugepositivenetpresentvalue. The share price doubledyesterday.
What does this appear to be evidence of?
Asemi-strongformefficientmarket A strong form efficient market Technicalanalysis
Aweakformefficientmarket (2marks)
Jaidoesn'tbelievethereisanyvaluetobehadinreadingthefirsteditionofthenewspapertohelpformulate an investment strategy for his shareportfolio.
How efficient does Jai believe the capital markets are?
Weak form efficient Strong form efficient Semi-strong form efficient
Semi-strong or strongformefficient (2marks)
Sarahdecidestoplotpastsharepricemovementstohelpspotpatternsandcreateaninvestmentstrategy.
What does Sarah believe the stock market is?
Completely inefficient Weak form efficient
Semi-strong form efficient
Strongformefficient (2marks)
Which of the following is evidence that stock markets are semi-strong formefficient?
Repeating patterns appear to exist.
Attemptingtotradeonconsistentlyrepeatingpatternsisunlikelytowork. Themajorityofsharepricereactiontonewsoccurswhenitisannounced. Sharepricereactionoccursbeforeannouncementsaremadepublic.


Are the following statements true orfalse?


Fundamentalanalysisvaluessharesaccordingtotheexpectedfuturecashflows and risk of abusiness
Technicalanalysisvaluesasharebasedonpastsharepricemovementsandpatterns.
(2 marks)


True False



(2 marks) (Total = 10 marks)













Questions 61

Section B questions
Phobis Co(12/07,amended) 20mins
The following scenario relates to questions 222 – 226.

Phobis Co is considering a bid for Danoca Co. Both companies are stock-market listed and are in the same businesssector.FinancialinformationonDanocaCo,whichisshortlytopayitsannualdividend,isasfollows:
Number ofordinaryshares 5million
Ordinary share price (exdivbasis) $3.30
Earningspershare 40.0c
Proposedpayoutratio 60%
Dividendpershareoneyearago 23.3c
Dividendpersharetwoyearsago 22.0c
Average sectorprice/earningsratio 10
CalculatethevalueofDanocaCousingtheprice/earningsratiomethod. A $2m
B $5m
C $16.5m
D $20m (2marks)
Are the following statements true orfalse?
IftheP/EratioofDanocaislowerthantheaveragesectorP/Eratiothenthemarketdoesnotview the growth prospects of Danoca veryfavourably
IftheP/EratioofDanocaishigherthantheaveragesectorratiothenanacquisitionbyPhobiscould result in improved financial performance ofDanoca
A Statement1istrueandstatement2isfalse B Both statements aretrue
Statement 1 is false and statement 2 istrue
Both statementsarefalse (2marks)
Usingacostofequityof13%andadividendgrowthrateof4.5%,calculatethevalueofDanocaCousing the dividend growthmodel.
A $14.75m
B $5.00m
C $2.95m
D $16.50m (2marks)
Calculate the market capitalisation of DanocaCo.
A $14.75m
B $16.50m
C $5.00m
D $20.00m (2marks)











62 Questions

WhichTWO of the following aretrue?
Underweakformhypothesisofmarketefficiency,sharepricesreflectallavailableinformationabout past changes in shareprice
If a stock market displays semi-strong efficiency then individuals can beat themarket
Behavioural finance aims to explain the implications of psychological factors on investordecisions
Randomwalktheoryisbasedontheideathatpastsharepricepatternswillberepeated A 1 and2
1 and3
2 and4
3 and4
(2 marks)(Total = 10 marks)
CBE style OT case Corhig Co(6/12,amended) 20mins
The following scenario relates to questions 227 – 231.

Corhig Co is a company that is listed on a major stock exchange. The company has struggled to maintain profitabilityinthelasttwoyearsduetopooreconomicconditionsinitshomecountryandasaconsequenceithas decidednottopayadividendinthecurrentyear.However,therearenowclearsignsofeconomicrecoveryand Corhig Co is optimistic that payment of dividends can be resumed in the future. Forecast financial information relating to the company is asfollows:

Year
1
2
3

Earnings ($'000)
3,000
3,600
4,300

Dividends ($'000)
nil
500
1,000

The current average price/earnings ratio of listed companies similar to Corhig Co is 5 times.
ThecompanyisoptimisticthatearningsanddividendswillincreaseafterYear3ataconstantannualrateof3%per year.
UsingCorhigCo’sforecastearningsforYear1andtheaverageP/Eratioofsimilarcompanies,whatisthe value of Corhig Co using the price/earnings ratiomethod?
$ m (2marks)
Are the following statements true orfalse?
True False AP/Evaluationusingaverageearningsof$3.63mwouldbemorerealisticthantheP/E
ratio method calculated above
Using the average P/E ratio of similar companies is appropriate in this situation
(2 marks)
Assuming that the cost of equity is 12%, what is the present value of Corhig Co’s year 2dividend?
$ (2marks)
Corhig Co plans to raise debt in order to modernise some of its non-current assets and to support the expected growth in earnings. This additional debt would mean that the capital structure of the company wouldchangeanditwouldbefinanced60%byequityand40%bydebtonamarketvaluebasis.Thebefore- tax cost of debt of Corhig Co would increase to 6% per year. In order to stimulate economic activity the government has reduced the profit tax rate for all large companies to 20% peryear.
Assumingthattherevisedcostofequityis14%,whatistherevisedweightedaverageaftertaxcostof capital of Corhig Co following the new debt issue? (Give your answer to 2dp.)
% (2marks)


Questions 63

Matchthedescriptionoftherisktothetypeofrisk.

Risklinkedtotheextenttowhichthecompany’sprofits depend on fixed, rather than variablecosts
Riskthatshareholdercannotmitigatebyholdingadiversified investmentportfolio
Riskthatshareholderreturnfluctuatesasaresultofthe level of debt the companyundertakes

Business Financial Systematic



(2 marks) (Total = 10 marks)


CBE style OT case Close Co(12/11,amended) 20mins
The following scenario relates to questions 232 – 236.
Recent financial information relating to Close Co, a stock market listed company, is as follows.
$m











Retainedearnings 410

Non-current liabilities
6%Bankloan 40
8% Bonds($100nominal) 120
490
160

Currentliabilities 70
Total equityandliabilities 720
FinancialanalystshaveforecastthatthedividendsofCloseCowillgrowinthefutureatarateof4%peryear.This isslightlylessthantheforecastgrowthrateoftheprofitaftertax(earnings)ofthecompany,whichis5%peryear. The finance director of Close Co thinks that, considering the risk associated with expected earnings growth, an earnings yield of 11% per year can be used for valuationpurposes.
Close Co has a cost of equity of 10% per year.
Calculate the value of Close Co using the net asset valuemethod.
$ million (2marks)
Calculate the value of Close Co using the dividend growth model(DGM).
$ million (2marks)
Calculate the value of Close Co using the earnings yield method (in millions to 1dp).
$ million (2marks)


64 Questions

The DGM has been used by financial analysts to value CloseCo.
Arethefollowingstatementsaboutthedividendgrowthmodel(DGM)trueorfalse?

It is very sensitive to changes in the growth rate
It can only be used if dividends have been paid or are expected to be paid

Close Co is considering raising finance via convertiblebonds.
Whatisthecurrentmarketvalueofaconvertiblebondwhereconversionisexpected?


True False

(2 marks)

Thesumofthepresentvaluesofthefutureinterestpayments+thepresentvalueofthebond’s conversionvalue
Thesumofthepresentvaluesofthefutureinterestpayments-thepresentvalueofthebond’s conversionvalue.
Thehigherofthesumofthepresentvaluesofthefutureinterestpaymentsandthepresentvalueof the bond’s conversionvalue.
Thelowerofthesumofthepresentvaluesofthefutureinterestpaymentsandthepresentvalueof the bond’sconversionvalue. (2 marks)
(Total = 10 marks)









































Questions 65



MCQ bank – Foreigncurrencyrisk 39mins
ExportersCoisconcernedthatthecashreceivedfromoverseassaleswillnotbeasexpecteddueto exchange ratemovements.
What type of risk is this?
Translationrisk
Economicrisk
Raterisk
Transactionrisk (2marks)
Thecurrenteuro/USdollarexchangerateis€1:$2.ABCCo,aEurozonecompany,makesa$1,000saleto aUScustomeroncredit.Bythetimethecustomerpays,theEurohasstrengthenedby20%.
What will the Euro receipt be?
A €416.67
B €2,400
C €600
D €400 (2marks)
ThecurrentspotratefortheUSdollar/eurois$/€2.0000+/-0.003.Thedollarisquotedata0.2cpremium for the forwardrate.
What will a $2,000 receipt be translated to at the forward rate?



(2 marks)


They fix the rate for a futuretransaction.
They are a bindingcontract.
They are flexible onceagreed.
They are tradedopenly.
A 1, 2 and 4only
B 1, 2, 3 and4
1 and 2only
2only (2marks)
AUScompanyowesaEuropeancompany€3.5mduetobepaidin3months'time.Thespotexchangerate is $1.96 - $2 : €1 currently. Annual interest rates in the two locations are asfollows:
Borrowing Deposit
US 8% 3%
Europe 5% 1%
What will be the equivalent US $ value of the payment using a money market hedge?
A $6,965,432
B $6,979,750
C $7,485,149
D $7,122,195 (2marks)



66 Questions

Incomparison to forward contracts, which TWO of the following are true in relation to futurescontracts?
They are moreexpensive.
They are only available in a small amount ofcurrencies.
They are lessflexible.
They may be an imprecise match for the underlyingtransaction.
1, 2 and 4only
2 and 4only
1 and 3only
1, 2, 3and4 (2marks)
AcompanybasedinFarland(withtheSplotasitscurrency)isexpectingitsUScustomertopay$1,000,000 in 3 month's time and wants to hedge this transaction using currencyoptions.
What is the option they require?
A Splot put option purchased inAmerica
A US dollar put option purchased inFarland
A Splot call option purchased inAmerica
A US dollar call option purchased inFarland.
2 or 3only
2only
1 or 4only
4only (2marks)
ThecurrentspotratefortheUS$totheEuropean€is$2:€1.Annualinterestratesinthetwocountriesare 8% in the US, and 4% inEurope.
What is the 3 months forward rate (to 4 decimal places) likely to be?
A $1.9804:€1
B $2.0198:€1
C $1.9259:€1
D $2.0769:€1 (2marks)
What does purchasing power parity refersto?
A Asituationwheretwobusinesseshaveequalavailablefundstospend. B Inflation in different locations is thesame.
Prices are the same to different customers in aneconomy.
Exchangeratemovementswillabsorbinflationdifferences. (2marks)
If a country's currency strengthens, what effect will it have on its exporters andimporters?


Exporters
Importers


A
Better off
Better off


B
Better off
Worse off


C
Worse off
Better off


D
Worse off
Worse off
(2 marks)




(Total = 20 marks)


MCQ bank – Interestraterisk 20mins
Which is the best definition of basisrisk?
A Interestratesondepositsandonloansarerevisedatdifferenttimes. B Interestratesondepositsandloansmovebydifferentamounts.
Interest ratesmove.
Thebankbaseratemightmovewithaknockoneffecttootherinterestrates. (2 marks)



Questions 67

Ifa business benefits from gap exposure what does thismean?
A Thetimingofinterestratemovementsondepositsandloansmeansithasmadeaprofit. B Thetimingofinterestratemovementsondepositsandloansmeansithasmadealoss. C Theinterestratesreducebetweendecidingaloanisneededandsigningforthatloan.
D Theinefficienciesbetweentwomarketsmeansarbitragegainsarepossible. (2marks)
Which of the following explain the shape and movement of a yieldcurve?
Expectationstheory
Liquidity preferencetheory
Market segmentationtheory
1 and 2only
2 and 3only
1 and 3only
1, 2and3 (2marks)
Interestratesarecurrently5%.ADBConeedsa$4millionsixmonthloanin3months'timeandbuysa3-9 ForwardRateAgreement(FRA)at8%.WhenADBCosignstheloantheyagreetoarateof7%.
What is the payment or receipt ADB Co will make or receive under the FRA?
A ADBpaysthebank$40,000 B ADBpaysthebank$20,000
ADB receives $40,000 from thebank
ADBreceived$20,000fromthebank (2marks)
Which of the following is true of exchange traded interest rateoptions?
They maintain access to upside risk whilst limiting the downside to thepremium.
They can be sold if notneeded.
They areexpensive.
They are tailored to an investor'sneeds.
1 and 2only
1 and 3only
2, 3 and 4only
1, 2 and3only (2marks)
(Total = 10 marks)

Rose Co(6/15,amended) 20mins
The following scenario relates to questions 252 – 256.

RoseCoexpectstoreceive€750,000fromacreditcustomerintheEuropeanUnioninsixmonths’time.Thespot exchangerateis€2.349per$1andthesixmonthforwardrateis€2.412per$1.Thefollowingcommercialinterest rates are available to RoseCo:

Depositrate Borrow rate Euros 4.0%peryear 8.0% peryear Dollars 2.0%peryear 3.5% peryear
RoseCodoesnothaveanysurpluscashtouseinhedgingthefutureeuroreceipt.Italsohasnoeuropaymentsto make.







68 Questions

WhatcouldRoseCodotoreducetheriskoftheeurovaluedroppingrelativetothedollarbeforethe
€750,000 is received?
Deposit €750,000immediately
Enter into an interest rate swap for sixmonths
Enter into a forward contract to sell €750,000 in sixmonths
Matchingpaymentsandreceiptstothevalueof€750,000 (2marks)
Whatisthedollarvalueofaforwardmarkethedge? A $310,945
B $319,285
C $1,761,750
D $1,809,000 (2marks)
IfRoseCousedamoneymarkethedge,whatwouldbethepercentageborrowingratefortheperiod? A 1.75%
B 2.00%
C 4.00%
D 8.00% (2marks)
RoseCoisalsoconsideringusingfutures,swapsandoptions,aswellasforwardexchangecontracts. Which of the following statements iscorrect?
Once purchased, currency futures have a range of close-outdates
Currencyswapscanbeusedtohedgeexchangerateriskoverlongerperiodsthantheforward market
Banks will allow forward exchange contracts to lapse if they are not used by acompany
Currencyoptionsarepaidforwhentheyareexercised (2marks)
RoseCoisworriedaboutfuturechangesininterestrates. Which of the following statements iscorrect?
Governmentscankeepinterestrateslowbybuyingshort-datedgovernmentbillsinthemoneymarket
Thenormalyieldcurveslopesupwardtoreflectincreasingcompensationtoinvestorsforbeing unable to use their cashnow
Theyieldonlong-termloannotesislowerthantheyieldonshort-termloannotesbecauselong-term debt is less risky for a company than short-termdebt
Expectations theory states that future interest rates reflect expectations of future inflation rate movements (2marks)
(Total = 10 marks)

CBE style OT case Zigto Co(6/12,amended) 20mins
The following scenario relates to questions 257 – 261.
ZigtoCoisamedium-sizedcompanywhoseordinarysharesareallownedbythemembersofonefamily.The domesticcurrencyisthedollar.IthasrecentlybegunexportingtoaEuropeancountryandexpectstoreceive
€500,000insixmonths'time.Thecompanyplanstotakeactiontohedgetheexchangerateriskarisingfromits Europeanexports.
ZigtoCocouldputcashondepositintheEuropeancountryatanannualinterestrateof3%peryear,andborrowat 5%peryear.Thecompanycouldputcashondepositinitshomecountryatanannualinterestrateof4%peryear, andborrowat6%peryear.InflationintheEuropeancountryis3%peryear,whileinflationinthehomecountryof Zigto Co is 4.5% peryear.



Questions 69

The following exchange rates are currently available to Zigto Co:
Current spotexchangerate 2.000europer$
Six-month forwardexchangerate 1.990europer$
One-yearforwardexchangerate 1.981europer$ Zigto Co wants to hedge its future euroreceipt.
What is the dollar value of a forward exchange contract (to the nearest wholenumber)?

$ (2marks)
What is the dollar value of a money market hedge (to the nearest whole number)?

$ (2marks)
Whatistheoneyearexpected(future)spotratepredictedbypurchasingpowerparitytheory(to3dp)?

$ (2marks)
ZigtoCoisconsideringtheeffectsofinterestratesandinflationrates. Are the following statements true orfalse?


Purchasingpowerparitytendstoholdtrueintheshortterm Expectedfuturespotratesarebasedonrelativeinflationrates between twocountries
Currentforwardexchangeratesarebasedonrelativeinterest rates between twocountries
True False



(2 marks)



ZigtoCoisconsideringseveraltypesofrisk. Arethefollowingstatementstrueorfalse?

Transaction risk affects cashflows
Translation risk directly affects shareholderwealth
Diversificationofsupplierandcustomerbaseacrossdifferentcountries reduces economicrisk


True False




(2 marks) (Total = 10 marks)























70 Questions












Answers
























71


























































72

MCQ bank – Financial management and financial objectives
B 80c
$
Profitbeforetax 2,628,000
Lesstax 788,000
Profitaftertax 1,840,000
Less preference dividend (6%×4,000,000) 240,000
Earnings attributable toordinaryshareholders 1,600,000

Number ofordinaryshares 2,000,000
EPS = 1,600,000 /2,000,000= 80c
Syllabus area A3(d)(i)

B Both statements aretrue.

B P/E ratio = MV ex div = $3.60 =6


Syllabus area A1(b)

EPS 60c
MVexdiv=3.72–0.12=3.60.Theexdivpriceisusedbecauseitreflectstheunderlyingvalueofthe share after the dividend has beenpaid.
Syllabus area A3(d)

4
D
500 cents
Step1Calculatethedividendamountusingdividendcover Dividend cover = EPS / Dividend pershare
Dividend per share = EPS / Dividend cover



Dividend per share = 60 / 2.5 = 24c



Step 2 Calculate the market price of share using dividend yield



Dividend yield = Dividend per share / Market price per share



Market price per share = Dividend per share / Dividend yield



Market price per share = 24 / 0.048 = 500c
Syllabus area A3(d)

5
C
Not-for-profitorganisationshaveobjectivesgenerallyconcernedwithefficientuseofresourcesinthe
lightofspecifictargets.Controllinginputcostswillbeimportant(economy)butminimisinginput costs would be likely to affectquality.

Syllabus area A4(a)

CBE style OTQ bank – Financial management and financial objectives
Investment,financeanddividend.Althoughcashflowisvitallyimportant,managingandmaximising cash flow is achieved by the other three interlinkingdecisions.
Syllabus area A2(b)
Minimisationofrisk.Corporategovernancebestpracticeaimstomanagerisktodesiredand controlledlevels,nottominimiserisk.Runningabusinessimpliestakingcalculatedrisksin anticipation of a commensuratereturn.
Syllabus area A3(e)(ii)




Answers 73

8 37.5%
ROCE = Profit before interest and tax/Capital employed
As interest cover = 5 times, and interest payable = $1.5m. Profit before interest and tax = 5 × 1.5 =
$7.5m
Asset turnover = Revenue/Capital employed. Revenue = $200m so Capital employed = 200/10 =
$20m
Therefore ROCE = 7.5 / 20 = 0.375 = 37.5%
Syllabus area A3(d)(i)
9 Efficiency has increased but effectiveness hasdecreased
Economy is the cost of inputs (for example teacher salaries). This is not mentioned in the question.
Efficiencyistheratioofinputstooutputs.Eachteacher(input)isnowteachingmorestudents,so efficiency hasincreased.
Effectivenessisthequalityofoutputs.Theoutputinthisexampleisexamresults,whichhave suffered - hence effectiveness isreduced.


10 36.4%
Shareholderreturn = (P1– P0+ D1) /P0.
shareholderreturn = (0.75 + 0.25) / (3.50 –0.75)
= 36.4%
Syllabus area A4(c)




Syllabus area A3(d)(ii)

Government
Shareholders,customersandbankersareallconnectedstakeholders.



Syllabus area A3(a)

‘Costpersuccessfullytreatedpatient’relatestoefficiency.Efficiencymeasuresrelatetheresources used to the output produced (getting as much as possible for what goesin).
‘Proportion of patients readmitted after unsuccessful treatment’ relates to effectiveness. Effectiveness means, getting done, by means of economy and efficiency, what was supposed to be done.
‘Costperoperation’relatestoeconomy(spendingmoneyfrugally).Asdoes‘Percentagechangein doctors’ salaries compared with previousyear’.
Syllabus area A4(c)
Achieving agreedtargets
Effectiveness can only be measured in terms of achieved performance. Economy consists of minimising costs, for example, by obtaining suitable inputs at the lowest price. Efficiency, in the narrowsenseusedhere,consistsofachievingthegreatestoutputperunitofinput:avoidingwasteof inputswouldcontributetothis.Achievingagivenlevelofprofitisameasureofoverallefficiency.
Syllabus area A4(b)
1,2and3.ThefiguresneededtocalculateROCEareeasilyavailablefromthefinancialaccounting records.
Syllabus area A3(d)
Statement2istrueandstatement1isfalse.Thefinancialmanagementfunctionisresponsiblefor makingdecisionsrelatingtoinvestment(statement2)butwillalsohaveprimaryresponsibilityfor cash flow forecasting (statement 1). Financial reporting control cash flow reporting but not forecasting.
Syllabus area A1(a)


74 Answers

ABC Co
B




ROCE



20X8 20X7

(PBIT/Long-termcapital) $14,749/($53,900)=27.4% $13,506/($52,587) =25.7%

Percentageincrease=27.425.7
25.7

= 6.7%

17 D 19.8%
Net profit margin = PBIT
Sales

= $14,749
$74,521


= 19.8%

D The total shareholder return is (Pl– Po+ DI)/Po= (8.82 – 7.41 + 0.34)/7.41 =23.6%.
A Statement 1 is true and statement 2 isfalse.
TheshareholdersofABCwouldprobablybereasonablypleasedwiththeperformanceoverthetwo years. (For example, share price has increased by 19% ((8.82 -7.41)/7.41 × 100%).) However, salaries and wages have only increased by 2.4% ((20,027 – 19,562)/19,562 100%) so employees maybelesspleasedwiththesituation.Sostatement1istrue.Statement2isfalse.Thefinancialrisk thattheshareholdersareexposedtodoesnotappeartobeaproblemareaasgearinghasdecreased from 49.9% to 35.1% and interest cover is more thansufficient.
B Allofthestatementssupportthetheory.Accountingprofitscanbemanipulatedtosomeextentby choices of accounting policies. Profit does not take account of risk. Shareholders will be very interested in the level of risk, and maximising profits may be achieved by increasing risk to unacceptable levels. Profits on their own take no account of the volume of investment that it has takentoearntheprofit.Profitsmustberelatedtothevolumeofinvestmenttohaveanyrealmeaning. Profits are reported every year (with half-year interim results for quoted companies). They are measuresofshort-termhistoricperformance,whereasacompany'sperformanceshouldideallybe judged over a longer term and future prospects considered as well as pastprofits.

MCQ bank – Financial management environment
C Fiscal policy is the balance of government taxation and spending. A contractionary fiscal policy impliesagovernmentbudgetsurplus–thegovernmentisreducingdemandbywithdrawinghigher amountsfromtheeconomybywayofhighertaxationand/orspendingless.'B'wouldbetheresultof an expansionary fiscal policy. 'A' may happen as a result of an expansionary policy as an economy 'booms.''D'mayhappenfollowingacontractionaryfiscalpolicy,althoughlowerinflationandinterest rates are only a secondary effect. As an economy enters recession, inflationary pressure may decrease and interest rates may be reduced to encourage borrowing. However as these are not directly due to fiscal policy, C is the more direct and immediateimpact.
Syllabus area B1(c)
A Monetarypolicymanagesdemandbyinfluencingthesupplyofmoney(includingtheavailabilityof credit)andinterestrates.Anexpansionarypolicyimplieslowinterestratestoencourageborrowing and investment, and to discourage saving. It also implies an increased availability of credit to encourage spending and the stimulation of demand in an economy. Tax rates are a tool of fiscal policy,soCandDareincorrect.Bwouldbetheresultofacontractionarymonetarypolicy.
Syllabus area B1(c)







Answers 75

A As an economy approaches its peak, inflation increases because price increases 'soak up' high demand as productivity peaks. Unemployment is low so businesses struggle to fill vacancies. B is incorrect–exportdemandisaffectedbyforeigndemandnotdomestic,andgrowthratesareunlikely tobeincreasingastheeconomyreachesitspeak-theywilldecrease.Cdescribesarecession.Dis incorrect because as an economy peaks a contractionary fiscal policy is likely to be employed implying lower government spending and highertaxation.


A Moneymarketsaremarketsforshort-termcapital,notlong-termcapital.
Syllabus area B1(c)

Syllabus area B3(c)


A Rationale:Debtslose'real'valuewithinflation:acompanythatowesalotofmoneywouldeffectively pay less (in real terms) over time. The other organisations would suffer because: inflation would makeexportsrelativelyexpensiveandimportsrelativelycheap;businessmightbelostduetoprice rises; and the cost of implementing price changes would behigh.


MCQ bank – Financial managementenvironment
Syllabus area B1(d)

C Dividend creation benefits the intermediaries' investors, not theircustomers/borrowers.
Syllabus area B2(b)
C Certificate of deposit, commercial paper and treasury bill. Money markets focus on short-term financialinstruments.Acorporatebondisalong-termsourceoffinance,henceisacapitalmarket instrument. Certificates of deposit and commercial paper are short-term private sector lending/borrowing. A treasury bill is short-term governmentborrowing.
Syllabus area B3(c)
B Increasedregulationandtransparencyreducetheactualandperceivedriskfromthepointofviewof shareholders,makingthesharesmoreattractiveandhencemorevaluable.Inadditionlistedcompany sharesarenaturallymoreliquidthananequivalentunlistedcompany,againaddingtotheirvalue.The process of listing is therefore likely to createvalue.
Syllabus area B2(c)
C Eurobonds by definition are bonds issued in a currency other than the domestic currency of the countryofissue.Theprefix'Euro'doesnotrefertothecontinentEuropeortheEuropeancurrency the'Euro'.
Syllabus area B2(d)
D Ordinary shares are riskiest as all other investors are preferential to ordinary shareholders. Preferencesharesareriskierthancorporatebondsaspreferencesharesarepaidaftercorporate bonds–bondsimplyacontractualrighttoreceiveapre-definedlevelofreturn.Treasurybillsare short-term government borrowing hence are the lowest risk ofall.


MCQ bank – Financial managementenvironment
Syllabus area B2(d)

B Lowerinterestratesarelikelytoleadtoanincreaseinspending.Thecostofborrowingwilldecrease, sopeoplecanborrowmore,andusetheirborrowingstospendmore.Conversely,peoplewillsave less, because they will earn less interest on theirsavings.
D Investmentisaninjectionofincomeintotheeconomy.Saving,importsandtaxationareall withdrawals.
A This is the central argument of monetaristtheory.




76 Answers

D Fiscalpolicyisconcernedwiththegovernment'staxincome,expenditureandborrowing(tomakeup the difference between income andexpenditure).
C Fiscal policy looks at the way government spending and taxation are balanced. An increase in governmentspendingwillactasaninjectiontoboostaggregatedemandintheeconomy,soCisthe correct answer. An increase in corporation tax (B) would reduce aggregate demand rather than increaseit.Althoughloweringinterestratescouldboostaggregatedemandinaneconomy(andis thereforeexpansionary)itisamonetarypolicyratherthanafiscalpolicy.Similarly,increasingthe moneysupply,althoughexpansionary,isamonetarypolicyratherthanafiscalpolicy.

CBE style OTQ bank – Financial management environment
Both statements are true. If a government spends more, for example, on public services such as hospitals,withoutraisingmoremoneyintaxation,itwillincreaseexpenditureintheeconomyand raisedemand.Althoughthesecondstatementappearstocontradictthefirst,itisalsotrue.Afterthe government has kick-started demand (as in statement 1) then it should be able to repay the borrowing it has taken on as tax receipts rise due to higher economicactivity.
Syllabus area B1(c)
UK exporters to US will suffer. UK importers from US willbenefit.
Aweakeningdollarimplies,forexample,anexchangeratethatmovesfrom,say,$1:£1to$2:£1.A UK exporter will therefore receive less £ sterling for their $ revenue. However a UK company importingfromtheUSwillbenefitbywayofalower£costforanygiven$pricetheyneedtopayfor theirimports.
Syllabus area B1(b)
Options1,2and3only.Option4ismorelikelytobeasocialpolicyobjectiveasopposedtoa macroeconomicobjective.
Syllabus area B1(a)
Encouragingeconomicgrowth Low and stableinflation
Achievement of a balance between exports and imports.

Thefourmainobjectivesofmacroeconomicpolicyrelatetoeconomicgrowth,stableinflation, unemployment and the balance of payments (balance between exports and imports). Equitable income distribution of income is a social / politicalissue.
Syllabus area B1(a)
Increasing the exchange rate. Rationale: Increasing the exchange rate will increase the price of exported goods and lower the price of imported goods, this is likely to lead to a fall in domestic economic activity. Increasing public expenditure should increase the level of consumer demand. Decreasingtaxationhastheoppositeeffect.Loweringinterestratesshouldstimulateinvestment(by companies) and consumer expenditure, even if only after a timelag.
Syllabus area B1(b)

MCQ bank – Working capital
B 49.5days
Thelengthofthecashoperatingcycleisreceivablesdaysplusinventorydayslesspayablesdays. Inventory days = 365 days/10 = 36.5days.
Therefore the length of the cash operating cycle is: 58 days + 36.5 days – 45 days = 49.5 days
Non-current assets are not relevant as they are not part of working capital.
Syllabus area C3(a)



Answers 77

C Both the cash operating cycle and reported profits willreduce.
Receivables paying sooner will reduce receivables days and hence reduce the length of the cash operatingcycle.Thecostofthediscount(approximately2%permonthastheypayamonthearlier thanusual)outweighstheinterestsavedontheoverdraft(at10%perannumthisislessthan1%per month) hence the net effect will be reducedprofit.


A 36.5days
Currentratio=currentassets/currentliabilities=2 Here = ($3m + inventory) / $2m =2
So inventory = $1m
Ifcostofsalesis$10mtheninventorydays=(1/10)×365=36.5days
Syllabus area C2(d)






Syllabus area C3(a)

D Overtradingoftenoccurswithyoung,successful,fastgrowingbusinesses.Cashbeingreceivedfrom salesmadeawhileago(whichwererelativelylowifthebusinessisgrowingquickly)isinsufficientto finance current production levels if growth is excessive. The result is a strain on cash flows, even if the business is technically profitable. Option B describesover-capitalisation.
Syllabus area C3(a)
D Both willincrease.
The quick ratio = Current assets (less inventories)/Current liabilities.
Ifsomeinventoryissoldoncredit,allelsebeingequalreceivables(currentassets)willincrease,so the quick ratio willincrease.
The current ratio = Current assets/Current liabilities. Inventory and receivables are both current assets.Howeverastheinventoryissoldataprofit,theincreaseinreceivableswillbemorethanthe decreaseininventory,theneteffectbeinganincreaseincurrentassets,hencethecurrentratiowill increase.
Syllabus area C2(b)(i)

CBE style OTQ bank – Managing workingcapital
46 1,600
Annual demand = 40 250 = 10,000 ball bearings = D Order cost = $64 = Co
Holdingcostperyearperunit=25%of$2=$0.50=ChEOQ =
= 26410,000
0.5

= 1,600 ball bearings

47 $22,219
Totalcost=Annualpurchasecosts+annualorderingcost+annualholdingcost. Annual purchase cost = 10,000 units × $2 =$20,000

Syllabus area C2(c)

Annualorderingcost=numberoforders×costperorder=(10,000/250)×$50=$2,000 Annualholdingcost=Averageinventorylevel×costtoholdperunitperannum


78 Answers

= [(250/2) + 50] × $1.25 = $218.75
Totalcost=$20,000+$2,000+$218.75=$22,218.75=$22,219(tonearest$).

48 Ease of productionscheduling


Syllabus area C2(c)

Manufacturingtoordermakesproductionschedulinginherentlydifficultasproductionlevelsare more difficult to planfor.


49 $114,521cost
The current collection period is 4/20 × 365 = 73 days
Thereforeareductionto60dayswouldbeareductionof13days Hence13/365×$20m=$712,329reductioninreceivables.
Finance cost saving = $712,329 × 12% = $85,479
Cost of discount = 1% × $20 million = $200,000 per annum Net cost = $200,000 – $85,479 = $114,521
Syllabus area C2(c)









Syllabus area C2(d)

1,2,3and4.Baddebtinsuranceisprovidedbyanon-recoursefactoringarrangement.Factorsalso provide administrative services such as managing the receivables ledger and the collection procedures.Factorscanalsolendmoneyusingthereceivablesledgerassecuritysotheyarealsoa potential source offinance.
Syllabus area C2(d)
Commercialpaper.
Commercialpaperisasourceoffinanceandnotdirectlyapplicabletothemanagementofforeign debts.


52 $28,500
The cost is (total sales × 1.5%) + $6,000 = ($1.5m × 1.5%) + $6,000 = $28,500 Non recourse means that the factor carries the risk of the bad debts.
Syllabus area C2(d)




Syllabus area C2(d)

‘Assumes a small number of close suppliers’ relates to just-in-time. It is not a drawback ofEOQ.
Syllabus area C2(c)
‘Increased risk of bad debts’ relates to receivables, notpayables.
Syllabus area C2(e)
Lessriskofinventoryshortages.InventoryshortagesarethemostlikelyproblemwithaJITinventory orderingsystem.
Syllabus area C2(c)











Answers 79

CBE style OTQ bank – Working capitalfinance
56 $290,084
Receipts for March:
$
50% March sales for cash (50%×$150,000) 75,000
80%×Februarycreditsalesless4%discount(50%×80%×$501,500×96%) 192,576
15% × January credit sales (50% × 15%×$300,100) 22,508
290,084
Syllabus area C2(b)
57 $258,000
TheBaumolmodelapplieshere.Thisiseffectivelyeconomicorderquantityappliedtocashdraw- downs asfollows:


=


=$258,199=$258,000tothenearest$'000

They are alltrue.

Syllabus area C2(f)

MillerOrrdefinesthedifferencebetweentheupperlimitandlowerlimitasthe'spread'. TB Co's spread is $10m – $1m =$9m.
MillerOrralsodefinesthereturnpointasthelowerlimitplusathirdofthespread.Inthiscase: 1 + [(1/3) × 9] =$4m
Whentheupperlimitisreached,sufficientsecuritiesarepurchasedtoreducethecashbalanceback tothereturnpoint.Inthiscase$10m–$4m=$6m.Thereforestatement1iscorrect.
Whenthelowerlimitisreached,sufficientsecuritiesaresoldtoincreasethecashbalancebackupto the return point. In this case $4m – $1 = $3m. Therefore statement 2 iscorrect.
The spread is calculated as:

1
3 transaction cost variance of cash flows 3
34 
 interestrate 
⎝ 
An increase in variance will therefore increase the spread. Therefore statement 3 is correct.
Syllabus area C2(f)
Moreshort-termfinanceisusedbecauseitischeaperalthoughitisrisky.Aggressiveworkingcapital finance means using more short-term finance (and less long-term). Short-term finance is cheaper butitisrisky–itmaynotberenewedwhenrequiredandfinanceratesmaychangewhentheyare renewed. C describes a conservative financing policy. D is describing a more aggressive working capital investment policy (notfinance).
Syllabus area C3(b)





80 Answers

Raterisk and renewalrisk.
Rateriskreferstothefactthatwhenshort-termfinanceisrenewed,theratesmayvarywhen comparedtothepreviousrate.Thisriskislesswithlong-termfinanceasitisrenewedless frequently.
Renewalriskreferstothefactthatfinanceprovidersmaynotrenewthesourceoffinancewhenit matures.Thisriskwillbemoreacutewithshort-termfinanceasitneedsrenewingmoreoften.
Short-termfinancetendstobemoreflexiblethanlong-termfinance(egoverdraft,orsuppliercredit) so‘inflexibility’isincorrect.Maturitymismatchisnotariskspecificallyrelatedtoshort-termfinance so isincorrect.


PKA Co
Syllabus area C3(b)

B 1and2only.Thetwomainobjectivesofworkingcapitalmanagementaretoensurethebusiness hassufficientliquidresourcestocontinuethebusinessandtoincreaseitsprofitability.Thesetwo objectiveswilloftenconflictbecauseliquidassetsgivethelowestreturns.Statement3istherefore notcorrect.
A 10,000units
Minimuminventorylevel=re-orderlevel–(averageusageaverageleadtime) Average usage per week = 625,000 units/ 50 weeks = 12,500units
Average lead time = 2 weeks Re-order level = 35,000 units
Minimum inventory level = 35,000 – (12,500 × 2) = 10,000 units
D 25,000units
Economic order quantity

EOQ= = = 25,000units.

A 1 and 2 only. The key to reducing the percentage of bad debts is to assess the credit worthiness of customers.Sincetheindustryaverageaccountsreceivableperiodis75days,PKAneedstobecareful not to lose business as a result of over-stringent credit control action (such as legal action). A good approachwouldbetoencourageearlypayment,forexample,throughearlysettlementdiscounts.
C 2 and 3 only. Statement 2 is true. Factors have expertise in managing receivables. Statement 3 is true.Optimumlevelsofinventorycanbemaintainedbecausethebusinesswillhaveenoughcashto payfortheinventoriesthatitneedsStatement1isnottrue.Thisisadisadvantageaspayingdirectly toafactorislikelytopresentanegativepictureofthefirm’sattitudetocustomerrelations.

Gorwa Co

66
20X7 30.53 times




Sales/net working capital
20X7
37,400/(9,200 – 7,975) = 30.53 times

67
92%



68
Increase in inventory Both statements are true.
(4,600 – 2,400)/2,400 × 100% = 92%


20X7
20X6

Inventorydays 4,600/34,408 × 365 =49days 2,400/23,781 × 365 = 37days Receivablesdays 4,600/37,400 × 365 =45days 2,200/26,720 × 365 = 30days


Answers 81

Thecorrectanswersare:Inventoryturnoverslowsdownandthecurrentratiofalls.Anothersymptom of overtrading is a rapid growth in sales revenue (not a rapid reduction). The payment period to accounts payables lengthens as the business takes longer to pay amountsdue.
Non-current assets aresold.
The other events may have limited or no effect on working capital.

Cat Co
71 $907,400
Current cost = purchase cost + order cost + holding cost Purchase cost = 120,000 units × $7.50 = $900,000 per year
Ordercosts=numberoforders×fixedordercost=(120,000/10,000)×$200=$2,400peryear Holdingcost=averageinventorylevel×costperunitperyear=(10,000/2)×$1=$5,000.
Total current cost = $900,000 + $2,400 + $5,000 = $907,400.
Syllabus area C2c
72 $901,400
The cost = purchase cost + order cost + holding cost
Purchase cost = 120,000 units × $7.50 × (1 – 3.6%) = $867,600 per year
Ordercosts=numberoforders×fixedordercost=(120,000/30,000)×$200=$800peryear Holdingcost=averageinventorylevel×costperunitperyear=(30,000/2)×$2.20=$33,000. Total cost = $867,600 + $800 + $33,000 =$901,400.
Syllabus area C2c
73 $89,041
If the credit period is reduced to 60 days, receivables will become (60/365) × $25 million =
$4,109,589.
This is ($5 million – $4,109,589=) $890,411 lower than before, saving interest of 10% × $890,411 =
$89,041 per year.
This interest is saved as lower receivables implies more money (lower overdraft) in the bank.
Syllabus area C2d
Statements 1 and 3 arecorrect.
Statement1iscorrect.Sufficientworkingcapitalshouldbemaintainedtoensurebillscanbepaidon time, however working capital (receivables, inventory, payables) do not earn a return as such, so excessive working capital is undesirable – spare cash for example should be temporarily placed to earn a return (provided risk islow).
Statement2isincorrect.Aconservativeapproachtoworkingcapitalinvestmentimpliesaimingto keeprelativelyhighlevelsofworkingcapital.Thereasonforthisisgenerallytoreducerisk(lessrisk ofinventoryshortages,givecustomersplentyoftimetopay,paysuppliercash)butitisexpensive– itismoneytiedupnotdirectlyearningareturn–hencewilldecreaseprofitability,notincreaseit.
Statement3iscorrect.Toomuchortoolittleworkingcapitalleadstopoorbusinessperformance. Too much reduces profitability, too little is risky. Hence managing it to an appropriate level is important for a business if it is to besuccessful.
Statement 4 is incorrect. The two objectives of working capital management are to ensure the businesshassufficientliquidresourcesandincreaseprofitability.Theseobjectiveswilloftenconflict as liquid assets give the lowestreturns.
Syllabus area C1b
Statement 2 only relates to an aggressiveapproach.
Statement1relatestoaconservativeapproachtofinancingworkingcapital.Statement2relates to an aggressiveapproach.
Syllabus area C3b

82 Answers

APXCo

Marks
Grossprofit 1
Netprofit 1
Profitbeforetax 1
Retainedprofit 1
Inventory 1
Tradereceivables 1
Tradepayables 1
Reserves 1
Overdraft 1
Layoutandformat 1
Maximum 9
Working capitalfinancingpolicies 2-3
Financialanalysis 1-2
Working capital financing policyofcompany 2-3
Maximum 6
Relevant discussion onfinancialintermediaries 5
20


(a) (i) Forecast statement of profit orloss

$m

Revenue (16.00m × 1.084)
17.344

Cost of sales (17.344m – 5.203m)
12.141

Gross profit (17.344m × 30%)
5.203

Other expenses (5.203m – 3.469m)
1.734

Net profit (17.344m × 20%)
3.469

Interest (10m × 0.08) + 0.140m
0.940

Profit before tax
2.529



Answers 83





(ii)


















Working capital financingpolicy
Working capital financing policies can be described as conservative, moderate or aggressive, depending on the extent to which fluctuating current assets and permanent current assets are financed by short-term sources of finance.
Permanentcurrentassetsaretheamountrequiredtomeetlong-termminimumneedsandsustainnormal tradingactivity,forexampleinventoryandtheaveragelevelofaccountsreceivable.
Fluctuating current assets are the current assets which vary according to normal business activity, for example due to seasonal variations.
A conservative working capital financing policy uses long-term funds to finance non-current assets and permanent current assets, as well as a proportion of fluctuating current assets.
An aggressive working capital financing policy uses short-term funds to finance fluctuating current assets and a proportion of permanent current assets as well. This is riskier but potentially more profitable.
A balance between risk and return might be best achieved by a moderate policy, which uses long-term fundstofinancelong-termassets(non-currentassetsandpermanentcurrentassets)andshort-termfunds to finance short-term assets (fluctuating currentassets).
The current statement of financial position shows that APX Co uses trade payables and an overdraft as sourcesofshort-termfinance.89%(100×4.1/4.6)ofcurrentassetsarefinancedfromshort-termsources and only 11% are financed from long-term sources. This appears to be a very aggressive working capital financingpolicywhichcarriessignificantrisk.Forexample,ifthebankcalledintheoverdraft,APXComight have to resort to more expensive short-termfinancing.
Theforecaststatementoffinancialpositionshowsareducedrelianceonshort-termfinance.79%(100× 5.36/6.75)ofcurrentassetsarenowfinancedfromshort-termsourcesand21%arefinancedfromlong- term sources. This reduces the risk of the working financing capitalpolicy.
Further moves away from an aggressive policy would be hampered by a lack of ability to pay interest on morelong-termdebt.Theforecastinterestcoverageratioisonly3.7times(3.469/0.94).Alternatively,APX Co could consider an increase in equity funding to decrease reliance on short-termfinance.



84 Answers

Roleof financialintermediaries
Financialintermediariesprovidealinkbetweeninvestorswhohavesurpluscashandborrowerswhohavea need forfinance.
Financialintermediariesaggregateinvestedfunds.Thismeansthattheygrouptogetherthesmallamounts of cash provided by individual investors, so that borrowers who need large amounts of cash have a convenient and readily accessible route to obtain necessaryfunds.
Financial intermediaries reduce the risk for individual lenders by pooling. They will assume the risk of loss onshort-termfundsborrowedbybusinessorganisations.Suchlossesaresharedamonglendersingeneral.
Financialintermediariesalsooffermaturitytransformation,inthattheybridgethegapbetweenthewishof most lenders for liquidity and the desire of most borrowers for loans over longerperiods.

ZSECo




Expected value of period 1closingbalance 2
Expected value of period 2closingbalance 4
Probability of negativecashbalance 1
Probability of exceedingoverdraftlimit 2
Discussion of expectedvalueanalysis 3
Creditanalysis 2-3
Creditcontrol 2-3
Collectionprocedures 2-3
Marks





12

Maximum 8
20






Answers 85

(i)
Opening
balance
Period 1 cash
flow
Closing balance
for period 1

Probability

Expected value

$'000
$'000
$'000

$'000

(500)
8,000
7,500
0.1
750

(500)
4,000
3,500
0.6
2,100

(500)
(2,000)
(2,500)
0.3
(750)





2,100

The expected value of the cash balance at the end of period 1 is $2,100,000.
(ii)
Period 1
closing balance

Probability

Period 2 cash flow

Probability
Period 2
closing balance

Joint probability

Expected value

$'000

$'000

$'000

$'000

(a)
(b)
(c)
(d)
(a) + (c)
(b) (d)


7,500
0.1
7,000
0.3
14,500
0.03
435

7,500
0.1
3,000
0.5
10,500
0.05
525

7,500
0.1
(9,000)
0.2
(1,500)
0.02
(30)

3,500
0.6
7,000
0.3
10,500
0.18
1,890

3,500
0.6
3,000
0.5
6,500
0.30
1,950

3,500
0.6
(9,000)
0.2
(5,500)
0.12
(660)

(2,500)
0.3
7,000
0.3
4,500
0.09
405

(2,500)
0.3
3,000
0.5
500
0.15
75

(2,500)
0.3
(9,000)
0.2
(11,500)
0.06
(690)







3,900

The expected value of the cash balance at the end of period 2 is $3,900,000.
Thereisa0.20(0.02+0.12+0.06)or20%chanceofanegativecashbalanceattheendofperiod2. (These are the joint probabilities of the negative period two closingbalances.)
Thereisa0.18(0.12+0.06)or18%chancethattheoverdraftlimitwillbeexceededattheendof period 2. (These are the joint probabilities of the period two closing balances in excess of the overdraft limit of$2m.)
Discussion
Expectedvaluesdonotworkwellforone-offactivitiesastheyarebasedonaverages.Assuchtheexpected value may not be a possible outcome. For example in period one the expected value of $2.1m is not a possible outcome and nor is the period two expected balance of $3.9m. Expected values work best for repeatdecisionsastheygivetheaverageoutcomefromanactivityrepeatedmanytimes.
ZSEisatriskofexceedingitsoverdraftlimitinbothperiods.Thereisa30%chanceofthisinperiod1and an18%chanceinperiod2.However,extrafinancingof$500,000willonlybeneededtoguardagainstthis in period 1, but $9.5m may be required in period2.
Extending the overdraft facility may be appropriate for period 1, but not for period 2.
ThemodelisusefulinhighlightingtheriskfacedbyZSE,butassigningprobabilitiesissubjective,evenwhen externalexpertsareused.Whethertheseprobabilitiesrepresentrealisticoutcomesisquestionable.
ThefactorsthatZSEshouldconsiderareananalysisofcredit,thecreditcontrolpolicyandcollectionof amountsowing.
Analysis of credit
Findingalevelofcreditthatcanbeofferedinvolvesfindingabalancebetweenenticingcreditcustomers, which comes at a cost to the business, and refusing opportunities to makesales.
Creditworthinessisanimportantareatoconsider.Theriskofthecustomerdefaultingmustbebalanced against the profitability of sales to thatcustomer.



86 Answers

ZSE should use the following information when assessing creditworthiness of its customers. New customersshouldprovidetworeferences,onefromabankandonetradereference.Publiclyavailable information from published accounts and other sources such as credit reference agencies may be considered.Previousexperienceoftheindividualcustomershouldalsobetakenintoaccount.
ZSEcoulddeviseitsowncreditratingsystembasedonthecustomer’scharacteristics.Thisprocess depends on having good quality information to base creditworthiness decisionson.
Credit control policy
Customers’paymentrecordsandtheagedreceivablesanalysisshouldbereviewedonaregularbasistosee if customers are acting within the agreed creditterms.
Regularcontactshouldbemadewithcustomerseitherthroughstatements,emails,lettersortelephonecalls to ensure that they are aware of the debt and to find out when payment is likely to be received. For ZSE regular contact with customers who are in financial difficulty is necessary to assess going concern issues and to work out whether extended credit terms will bebeneficial.
Collecting amounts owing
Theoveralldebtcollectionpolicyshouldbethatthecostsofcollectingthedebtdonotexceedthebenefitsof thecollection.
Proceduresforpursuingoverduedebtmustbeestablishedandfollowedbycreditcontrolstaff.Initiating legalproceedingortheuseofadebtcollectionagencyshouldonlybeconsideredasalastresort,asthisis likely to antagonise customers and may end important traderelationships.

WQZCo

















Answers 87

Marking scheme




Marks


(a) Currentpolicy:
Annual ordering cost

0.5



Annual holding cost
0.5



Total annual cost EOQ policy: Annual order size
1

1



Annual ordering cost and holding cost
1



Change in inventory management cost
1

5


(b) Reduction in tradereceivables
2



Financing cost saving
1



Cost of early settlement discount
1



Comment on net benefit
2



Maximum early settlement discount
1

7


(c) Relevantdiscussion

8




20








(a) Currentpolicy


Order size = 10% × 160,000 = 16,000 units per order


Number of orders = 160,000/16,000 = 10 orders per year


Annual ordering cost = 10 × 400 = $4,000


Average inventory = 5,000 + 16,000/2 = 13,000 units


Holding cost of average inventory = 13,000 × 5.12 = $66,560 per year


Total annual cost = $4,000 + $66,560 = $70,560


EOQ model


Order size = 2×400×160,000 = 5,000 units per order



Numberoforders=160,000/5,000=32ordersperyear Annual ordering cost = 32 × 400 =$12,800
Average inventory = 5,000 + 5,000/2 = 7,500 units
Holdingcostofaverageinventory=7,500×5.12=$38,400peryear Total annual cost = $12,800 + $38,400 =$51,200
Cost savings from EOQ method
70,560 – 51,200 = $19,360 per year
Note:
Sincetheholdingcostofbufferstockisacommoncosttobothmodels,thiscouldhavebeenomittedfrom the calculations. Full marks could still be gained from thisapproach.
Change of receivablespolicy
Receivables payment period is currently (18/87.6) × 365 = 75 days
Under the new policy only 25% will pay in 30 days, so the revised payment period would be


88 Answers

(0.25 × 30) + (0.75 × 60) = 52.5 days
Current trade receivables = $18 m
Revisedlevelusingtherevisedpaymentperiod=87.6×(52.5/365)=$12.6m Reduction in receivables = 18 – 12.6 = $5.4m
Short-term finance cost is 5.5%
Finance cost savings = 5.4m × 0.055 = $297,000 Administration savings = $753,000
Total savings = 297,000 + 753,000 = $1,050,000
Cost of the discount = credit sales × % customers taking discount × discount % Cost of the discount = 87.6m × 0.25 × 0.01 = $219,000
Benefit of the discount = 1,050,000 – 219,000 = $831,000
Theproposedchangeinreceivablesmanagementshouldbeaccepted,althoughthisdoesdependonthe forecast cost savings beingachieved.
Maximum discount
25%ofthecustomerswilltakethediscount.Thereforethetotalsalesvalueaffectedbythediscountwillbe 25% of $87.6milion, which is$21.9million
Themaximumdiscountwillbewherethecostsequalthebenefitsof$1,050,000.Thiswouldoccurat 1.05/21.9 = 0.048 =4.8%
The policy on the management of trade receivables will depend on a number offactors.
The level of trade receivables
Ifthereisasubstantialamountofcapitaltiedupintradereceivables,thenthepolicymaybeaimedat reducingthelevelofinvestmentbynotgrantingcreditasfreelyasbeforeorshorteningthecreditterms.
The cost of trade credit
Wherethecostoftradecredit(includingopportunitycosts)ishigh,acompanywillwanttoreducethelevel of investment in tradereceivables.
Competitor trade terms
Unlessacompanycandifferentiateitselffromitscompetitors,itwillneedto,atleast,matchthecreditterms offered by its competitors to avoid a loss ofcustomers.
Liquidity needs
Whereacompanyneedstoimproveitsliquiditytheymaywanttoreducecredittermsorconsiderdebt factoring or invoicediscounting.
Risk appetite
Acompanymaybepreparedtoriskhigherlevelsofbaddebtsbyofferingcredittermsthatarerelatively relaxed as this will increase salesvolume.
Expertise in credit management
Ifacompanylacksexpertiseincreditmanagement,particularlyinmonitoringthelevelofreceivablesthen they may choose to factor theirdebts.









Answers 89

BoldCo




Marks

(a)
Explanation of cash operating cycle
1-2



Cash operating cycle and working capital policy
2-3



Cash operating cycle and business operation
2-3



Other relevant discussion
1-2




Maximum
8

(b)
Inventory days
1



Receivables days
1



Payables days
1



Cash operating cycle
1





4

(c)
Revised trade receivables
1



Reduction in trade receivables
1



Reduction in finance cost
1



Administration costs
0.5



Saving in bad debts
0.5



Interest on advance
1



With-recourse factor fee
0.5



Net benefit of with-recourse offer
0.5



Without-recourse factor fee
0.5



Elimination of bad debts
1



Net benefit of non-recourse offer
0.5





8




20


(a) Thecashoperatingcycleistheperiodoftimewhichelapsesbetweenthepointatwhichcashbeginstobe expendedontheproductionofaproductandthecollectionofcashfromacustomer.Thecashoperating cycleinamanufacturingbusinessequalstheaveragetimethatrawmaterialsremainininventorylessthe averageperiodofcredittakenfromsuppliersplustheaveragetimetakentoproducethegoodsplusthe average time taken by customers to pay for thegoods.
Thereisarelationshipbetweenthecashoperatingcycleandthelevelofinvestmentinworkingcapital.Ifthe turnover periods for inventories and accounts receivable lengthen, or the payment period to accounts payableshortens,thentheoperatingcyclewilllengthenandtheinvestmentinworkingcapitalwillincrease. Thelengthofthecashoperatingcycledependsontheworkingcapitalpolicywhichwilldeterminethelevel of investment in working capital and also of the nature of the businessoperations.
Working capital policy
Thelevelofinvestmentinworkingcapitaldependsonthecompany'sworkingcapitalpolicy.Twocompanies withsimilarbusinessoperationsmayhavesignificantlydifferentlevelsofinvestmentdependingonwhether they adopt a conservative or an aggressive approach. An aggressive policy involves having lower levels of inventory and trade receivables and will therefore mean there is a shorter cash operating cycle. A conservativepolicyinvolveshavinghigherlevelsofinventoryandtradereceivablesandwillgiverisetoa


90 Answers

longercashoperatingcycle.Thelongercashoperatingcyclewillmeanprofitabilityislessthanunderthe aggressive approach, but it reduces risk such as the risk of astock-out.
Nature of business operations
Businessoperationswillhaveasignificanteffectonthecashoperatingcycle.Abusinesssupplyingservices may have very low levels of inventory whereas a manufacturer may have very high levels of inventory. A retailerwhooperatesmainlyusingcashsaleswillhaveasignificantlylowerleveloftradereceivablesthana company who conducts most of its sales by offering creditterms.
(b) Inventory days = 4,500 / 16,400 × 365 = 100days
Trade receivables days = 3,500 / 21,300 × 365 = 60 days
Trade payables days = 3,000 / 16,400 × 365 = 67 days
Cash operating cycle = 100 + 60 – 67 = 93 days
(c) With-recourse offer
Sincethefactorwillreducetradereceivablesdaysto35thetradereceivablesfigurewillchange. Revised trade receivables / $21,300,000 × 365 days = 35days
Revised trade receivables = 35 / 365 × $21,300,000 Revisedtradereceivablesunderfactoring=$2,042,466
Reduction in trade receivables = $3,500,000 – $2,042,466 = $1,457,534

$
Finance cost saving ($1,457,534 × 7%)
102,027

Administration cost saving
40,000

Bad debt saving ($21,300,000 × (0.09 – 0.06) )
63,900


205,927

Additional interest on advance ( 2,042,466 × 0.8 × 0.02)
(32,679)

Net benefit
173,248

Factor fee (21,300,000 × 0.0075)
(159,750)


13,498


Non-recourse offer
Astheofferiswithoutrecourse,baddebtsarereducedtozeroasthefactorwillbearthese.ThereforeBold will gain a benefit of a further 0.6% ofrevenue.
$
Net benefit of with recourse offer
173,248

Non-recourse factor fee (21,300,000 × 0.0125)
(266,250)

Net cost before adjusting for bad debts
(93,002)

Elimination of bad debts ($21,300,000 × 0.006)
127,800

Net benefit
34,798

















Answers 91

WobnigCo




Marks

(a)
Rapid increase in revenue
1-2



Increase in trade receivables days
1-2



Decrease in profitability
1-2



Rapid increase in current assets
1-2



Increased dependence on short-term finance
2-3



Decrease in liquidity
2-3



Conclusion as regards overtrading
1




Maximum
12

(b)
Working capital investment policy
3-4



Working capital financing policy
5-6




Maximum
8




20


Signs ofovertrading:
Rapid increase in sales revenue: Wobnig's sales revenue has increased by 40% from $10,375k in 20X0 to
$14,525kin20X1.Thisrapidgrowthinrevenueisnotsupportedbyasimilarincreaseinlong-term financing,whichhasonlyincreasedby4.7%($16,268kin20X1comparedto$15,541kin20X0).
Rapid increase in current assets: Wobnig's current assets have also nearly doubled, increasing from
$2,826k in 20X0 to $5,349k in 20X1 (89%). This is striking, given that long-term financing has only increased by 4.7%. Trade receivables have increased by 85% ($1,734k in 20X0 and $3,200k in 20X1), and inventory levels have increased by 97% ($2,149k from $1,092k in 20X0).
Increaseininventorydays:Linkedtotheabove,inventoryturnoverhasslowednoticeably,from60daysin 20X0 to 75 days in 20X1, well above the industry average of 55 days. This may indicate that Wobnig is expecting further increases in sales volumes in thefuture.
Increaseinreceivabledays:Perhapsamatterofgreaterconcernisthefactthattradereceivablesarebeing paid much more slowly. Receivable days have increased from 61 days in 20X0 to 80 days in 20X1, again significantlyabovetheindustryaverage.Itcouldbethatinordertoencouragesales,Wobnighasoffered morefavourablecredittermstoitscustomers.However,theincreaseinreceivabledaysmayalsoindicate thatWobnigislackingsufficientresourcestoeffectivelymanageitsreceivables,and/orthatitscustomers may be unable to settle their debts on time, as they are strugglingfinancially.



92 Answers

Reduction in profitability: Although Wobnig's sales revenue has increased by 40% over the past year, its PBIT has only increased by 8.9%. The net profit margin has actually decreased, from 36% in 20X0 to 28% in 20X1. This may be due partly to the company selling at lower margins to increase sales volumes, but most likely points to increased costs of sales and operating costs.
Withtheadditionalcostsassociatedwithholdinglargerinventories,andincreasingfinancingcostsfrom overdrafts(seebelow),thecompany'sprofitabilityislikelytosufferevenmoreinthefuture.
Increase in current liabilities: Wobnig is increasingly financed through current liabilities, which has increasedby131%(from$1,887kin20X0to$4,365kin20X1)whilelong-termfinancinghasincreasedonly marginallyby4.7%.Thesalesrevenue/networkingcapitalratiohasincreasedfrom11timesto15timesin 20X1. In particular, overdraft has increased by 500% from 20X0 to 20X1. Payables days have lengthened from90daysto100days,indicatingthatWobnigisfindingitmoredifficulttosettletradedebts.
Allofthiswillputfurtherstrainonfinancingcosts,erodingthedistributableprofits.Thecompany'sinterest expense has increased from $292k to$355k.
Reduced liquidity: The cause of Wobnig's increasing dependence on overdrafts and lengthening payables daysliesinitsreducedliquidity.Wobnig'scurrentratiohasreducedfrom1.5timesto1.2times,compared totheindustryaverageof1.7times.Themoresensitivequickratiohasreducedfrom0.9timesto0.7times, againsttheaverageof1.1times.Wobnigdoesnotyethavealiquiddeficitthough,asitscurrentassetsstill exceed its currentliabilities.
Conclusion
From the trends discussed above, we can conclude that Wobnig is overtrading.
Workings

Ratio
Formula
20X1
20X0

Net profit margin
PBIT/Revenue × 100%
28%
36%

Current ratio
Current assets/current liabilities
1.2 times
1.5 times

Quick ratio
(Current assets – inventory)/current liabilities
0.7 times
0.9 times

Inventory days
Inventory/cost of sales 365
75 days
60 days

Receivables days
Trade receivables/revenue 365
80 days
61 days

Payables days
Trade payables/cost of sales 365
100 days
90 days

Net working capital
Current assets – current liabilities
$984,000
$949,000

Revenue/net working capital
Revenue/net working capital
15 times
11 times

Workingcapitalinvestmentpolicydictateshowmuchacompanychoosestoinvestincurrentassets. Workingcapitalfinancingpolicy,ontheotherhand,determineshowacompanyfundsitsdaytoday operations:withshort-termorlong-termsources.Theworkingcapitalinvestmentpolicyisthereforean investment decision, while the working capital financing policy is a financingdecision.
Bothworkingcapitalinvestmentpolicyandworkingcapitalfinancingpolicyaredescribedintermsof conservative,moderateandaggressive.However,thesetermsmeandifferentthingsinthecontextsof investment andfinancing.
In the context of working capital investment, a conservative policy aims to reduce the risk of system breakdown by holding high levels of working capital: generous credit terms for customers, high levels of inventory and quick payment of suppliers. This approach can result in a high financing cost and may give rise to cash flow problems. By contrast, an aggressive approach reduces financing cost and increases profitabilitybycuttinginventories,collectingdebtsearlyfromcustomersanddelayingpaymenttosuppliers.
In the context of working capital financing, current assets are divided into permanent current assets (the levelofcurrentassetsthatsupportsastandardlevelofbusinessactivity)andfluctuatingassets(thelevelof current assets that rise and fall due to unexpected business demands). A conservative policy is one that useslong-termfundingtofinancemostoftheassetsofthecompany,callinguponshort-termfinancingonly whenfluctuationsincurrentassetspushtotalassetsaboveacertainlevel.Anaggressivepolicy,bycontrast, is one that finances all fluctuating current assets and some permanent current assets out of short-term sources.Thisapproachpresentsagreaterriskofliquidityissues,butallowsforlowerfinancingcosts.Thisisbecause short-term finance is cheaper than long-termfinance.
Workingcapitalinvestmentandworkingcapitalfinancingthereforedescribetwodifferentaspectsofworking capitalmanagement.Infact,itispossibleforacompanytoadoptanaggressiveworkingcapitalinvestment policy and a conservative working capital financing policy, or viceversa.

Answers 93

KXPCo



Marks

(a)
Revised trade receivables
0.5



Reduction in trade receivables
0.5



Reduction in financing cost
1



Cost of early settlement discount
1



Net cost of change in receivables policy
1



Comment on findings
1





5

(b)
Current annual ordering cost
0.5



Current holding cost
0.5



Total cost of current inventory policy
0.5



Revised cost of materials
0.5



Revised number of orders
0.5



Revised ordering cost
0.5



Revised holding cost
0.5



Net benefit of bulk purchase discount
0.5


Commentonassumptions 1
5

Transactions needforcash 1-2
Precautionary needforcash 1-2
Speculative needforcash 1-2
Otherrelevantdiscussion 1-2
Maximum 5
Creditanalysis 1-2
Creditcontrol 1-2
Receivablescollection 1-2
Cost and benefits of tradereceivablespolicy 1-2
Maximum 5
20






94 Answers

Cost/benefit of changing trade receivablespolicy
Receivables paying within 30 days = 50% × $15m × 30/365 = $616,438 Receivables paying after 45 days = 30% × $15m × 45/365 = $554,795
Totalreceivableschangingtheirpaymentpatterns=$616,438+$554,795=$1,171,233 Original value of these receivables = 80% × $2,466k =$1,972,800
Reduction in receivables = $801,567
Cost of early payment discount = 50% × $15m × 1% = $75,000 Reduction in financing cost = $801,567 × 6% = $48,094
Net cost of changing trade receivables policy = $75,000 – $48,094 = $26,906 Alternative calculation for the reduction in receivables
Current receivable days = $2,466k/ $15,000k × 365 = 60 days
Receivable days under new trade receivables policy = 50% × 30 + 30% × 45 + 20% × 60 = 40.5 days Decrease in receivable days = 60 – 40.5 = 19.5 days
Reduction in receivables = $15m × 19.5/365 = $801,370 (difference due to rounding)
Conclusion
Thebenefitofthenewtradereceivablespolicyisoutweighedbytheassociatedcosts.KXPCoshouldnot adopttheproposedpolicy.However,theanalysiscurrentlyexcludesbaddebtsandassumesconstantsales throughouttheyear–thecompanymayneedtotaketheseintoaccount.Giventhatreceivablesonaverage arefailingtomeetthecreditperiod,KXPComaystillwanttoconsiderhowthetradereceivablespolicymay be changed in order to encourage earlierpayment.
Total annual cost of inventory policy = cost of materials + ordering cost + holdingcost
Current policy
Annual ordering cost = 12 × $150 = $1,800
Annual holding cost = $0.24 × (15,000/2) = $1,800
Total annual cost = $540,000 + $1,800 + $1,800 = $543,600
Proposed policy
Annual cost of materials = $540,000 × 98% = $529,200
KXP Co currently requires 180,000 units of Product Z per year (12 × 15,000).
Tobenefitfromthebulkdiscount,KXPConeedstoorder30,000unitseachtime.ThismeansKXPCowill make 6 orders per year (180,000 /30,000).
Revised annual ordering cost = 6 × $150 = $900
Revisedannualholdingcost=$0.24×(30,000/2)=$3,600 Total annual cost = $529,200 + $900 + $3,600 = $533,700 Netbenefit
Net benefit of taking bulk purchase discount = $543,600 – $533,700 = $9,900

Conclusion
Theanalysisshowsthatthebulkdiscountshouldbeaccepted.However,KXPComaywishtoevaluatethe appropriateness of a number of key assumptionsfirst:
Demand for Product Z is constant throughout the year, and does not change from year toyear
Ordering costs and holding costs are both constant throughout theyear




Answers 95

The optimum level of cash to be held by a company depends on the followingfactors:
The level of cash required for the company's operations
This includes holding enough cash to:
Payforthetransactionsexpectedtooccurduringtheperiod(includingthepaymentofsuppliers,and finance costs). This can be achieved by drawing up a cashbudget.
Coverunexpectedexpenditureandaccountforuncertaintyinthecashbudget.Inadditiontothecash needs forecasted in the cash budget, the company needs to have a precautionary 'buffer' for unexpected events. This can be estimated based on previousexperience.
The availability of finance
Notallsourcesoffinancemaybeavailabletoacompany.Asmallandmediumcompany,forexample,may not be able to obtain or extend bank loans as easily. An unlisted company will find it very difficult, and expensive, to raise funds through issuing securities. Where it is difficult and / or expensive to raise new finance, a company will need to hold morecash.
The availability and attractiveness of other uses for the cash
Theamountofcashthatacompanyholdswillalsodependonwhetherthereareother,moreattractiveways tousethecash.Insteadofholdingcashfornoreturn,acompanyusuallyhastheoptionofputtingthecash inadepositaccountwithabank,investingitinshortorlongtermdebtinstruments,orinvestinginequity sharesoflistedcompanies.Theextenttowhichthecompanywillconsiderthesealternativeusesdepends ontheamountofinvestmentrequired,theexpectedlevelofreturn(interest,dividendsorcapitalgrowth),the term to maturity, the ease of realising theinvestment.
Acompanymayalsowishtoholdcashinordertobeabletakeadvantageofanunexpectedspeculative opportunity when itarises.
Factors to consider in formulating a trade receivables managementpolicy
The total credit
Eachcompanymustdeterminetheleveloftotalcredititiswillingtooffer.Thisinvolvesfindingabalance betweenmaximisingrevenuefromcustomers,andminimisingthefinancecostsassociatedwithfundingthe period of credit and also minimising baddebts.
Allowing a long period of credit may attract more sales, but the company may suffer from high finance costs.Ashortperiodofcreditwillreducetheneedforadditionalfinance,butthecompanymayloseouton salesopportunities.
The cost of the additional finance – be it bank overdraft interest, loans or equity – must be considered.
Credit control
Companiesneedtohaveapolicyinplaceforassessingthecreditworthinessofcustomers.Verifyingthat newcustomersarecreditworthybeforeconcludingthesalereducestheriskofcustomerdefault.
Thismayinvolverequiringreferencesfornewcustomers,checkingcreditratingsthroughacreditrating agency,andofferingalowerlevelofcreditfornewcustomers.Acredit-ratingsystemmaybedevisedto determinetheappropriatelevelofcredittooffertonewcustomersbasedontheircharacteristics(suchas age andoccupation).
Collection
A credit policy can only be maintained if it is policed effectively and the amounts owing collected. The companywillneedtomonitorcustomers'paymentrecordstoensurethatthecreditlimitsaremaintained. Anagedreceivablesanalysisshouldbeperformedonaregularbasis.Anybreachesofcreditlimitsshould be brought to the attention of the creditcontroller.
Factors which would influence how tightly a company polices its credit policy include the number of customersrequiringmorecredit,andtheextenttowhichthecompanyisexposedtoaccountsreceivable.



96 Answers

Theassociatedcostsofcollection,eitherinternalorexternal,alsoneedtobeconsidered.Thecostsof collection should not be greater than the amountcollected.
Changes to the credit policy
Thecreditpolicyneedstobereviewedregularlyandrevisedaseconomicconditionsandcustomerpayment patterns change. The company may wish to assess whether it is beneficial to offer an early payment discounttoencouragecustomerstopayearlier,orextendthecreditperiodtoencouragecustom.
Theassociatedcostsandimpactonthecompany'sworkingcapitalmustbeconsidered.Onlywhenthe financialbenefitofthechangeinpolicyoutweighstheadditionalcosts,shouldthechangegoahead.

CSZCo

Marking scheme




Marks

(a) Inventorydays
0.5


Trade receivables days
0.5


Trade payables days
0.5


Working capital cycle
0.5


Discussion of working capital cycle

(b) Cost ofsales
4

0.5

6

Inventory
0.5


Trade receivables
0.5


Current assets
0.5


Current liabilities
0.5


Target quick ratio
1


Net working capital cycle
0.5


Target sales/net working capital ratio
1

5

(c) Tradepayables
1


Overdraft
1


Analysis of current asset and liability positions
1-3


Comparison of current asset and liability positions
1-3


Discussion of change in financing policy
1-3
Maximum

9



20




Answers 97




Average inventory × 365 Cost of sales
Trade receivables × 365 Credit sales revenue
Trade payables × 365 Cost of sales

5,700 × 365
26,000
6,575 × 365
40,000
2,137 × 365
26,000
Days
= 80

= 60

= (30)

Workingcapitalcycle: 110
Theworkingcapitalcycleistheperiodoftimewhichelapsesbetweenthepointatwhichcashbeginstobe expended on the production of a product and the collection of cash from a customer. Therefore CSZ Co starts spending 110 days (on average) before cash is collected from the customer.
A negative working capital cycle would mean that CSZ was paid by customers before it started to spend cashontheproduction.Thiscansometimesoccur.Forexample,supermarketsoftenreceivepaymentfor goods before they have paid forthem.
A business does not normally have a choice on whether its working capital cycle is positive or negative becauseitdependsontheinventory,receivablesandpayablesdaysandtheseusuallydependonthenature of the business. The length of the working capital cycle is usually similar between businesses in the same sector.

Quickratio=Currentassetslessinventories=

8,219

= 0.95 times


Currentliabilities 5,073 +3,616
Inventorydays= Inventory × 365 Inventory × 365 = 60 Inventory =$3,945

Costofsales 24,000
Receivables days = Receivables × 365 Receivables × 365 = 75 Receivables = $8,219

Sales 40,000
Payables days = Payables × 365 Payables × 365 = 55 Payables =$3,616

Costofsales 24,000

Currentratio= 3,945 + 8,219 = 1.4 overdraft = $5,073 3,616 +overdraft
NetcurrentassetsattheendofMarch20X5 = $3,945k + $8,219k – $3,616k –$5,073k
= $3,475,000
Target sales = $40 million
Target ratio of sales to net working capital = 40,000 / 3,475 = 11.5 times
ThecurrentliabilitiesattheendofMarch20X5,calculatedinpart(b),canbedividedintotradepayablesand the forecast overdraftbalance.
Tradepayablesusingtargettradepayablesdays=24,000,00055/365=$3,616,438. The overdraft (balancing figure) = 8,688,846 – 3,616,438 =$5,072,408
Comparing current assets and current liabilities:
March20X4 March20X5
$’000 $’000 $’000 $’000
Inventory 5,700 3,945
Tradereceivables 6,575 12,275 8,219 12,164
Overdraft 2,137 3,616
4,682 6,819 5,072 8,688
Netcurrentassets 5,456 3,476



98 Answers

Theoverdraftasapercentageofcurrentliabilitieswillfallfrom69%(4,682/6/819)to58%(5,702/8,688). Eventhoughtheoverdraftisexpectedtoincreaseby8.3%,currentliabilitiesareexpectedtoincreaseby 27.4%(8,688/6,819).Mostofthisincreaseisexpectedtobecarriedbytradepayables,whichwillriseby 69.2% (3,616/2,317), with trade payables days increasing from 30 days to 55days.
AttheendofMarch20X4,currentliabilitieswere56%ofcurrentassets(1006,819/12,275),suggesting that 44% of current assets were financed from a long-term source. At the end of March 20X5, current liabilitiesareexpectedtobe71%ofcurrentassets(1008,688/12,164),suggestingthat29%ofcurrent assets are finance from a long-term source. This increasing reliance on short-term finance implies an aggressive change in the working capital financing policy of CSZCo.

FlitCo

Marking scheme




Marks


(a) Monthlyreceivables
1



Loan
0.5



Raw materials
1



Variable costs
1



Machine
0.5



Closing balances

(b) Closing finished goodsinventory
1

0.5

5


Revised holding and ordering costs
0.5



Inventory cost if discount is taken
0.5



Benefit if bulk purchase discount taken

(c) Temporary nature of short-term cashsurplus
0.5

1

2


Investment should have no risk of capital loss
1



Shares are not suitable for investment
1

3


(d) Discussion of Baumol model 2-3 marks per validpoint
Maximum
5


(e) Calculation ofspread
1



Calculation of upper limit
1



Calculation of return point
1



Explanation of findings
2

5




20







Answers 99

(a)



Jan
Feb
Mar





$'000
$'000
$'000


Sales revenue (W1)


960
1,000
1,092


Loan income




300


Total cash receipts


960
1,000
1,392


Production costs (W2)


500
520
560


Variable overheads (W3)


130
140
150


Machine purchase




400


Total cash payments


630
660
1,110


Net surplus


330
340
282


Opening balance


40
370
710


Closing balance


370
710
992


Workings







1 Sales







Month of sale



Cash received



Dec
1,200 units × $800
=
$960,000
Jan



Jan
1,250 units × $800
=
$1,000,000
Feb



Feb
1,300 units × $800 × 1.05
=
$1,092,000
Mar



2 Productioncosts







Month of



Cash paid


production





Dec
1,250 units × 2 units × $200
=
$500,000
Jan

Jan
1,300 units × 2 units × $200
=
$520,000
Feb

Feb
1,400 units × 2 units × $200
=
$560,000
Mar



3 Variableoverheads
Month of production

Cash paid

Jan
1,300 units × $100
=
$130,000
Jan

Feb
1,400 units × $100
=
$140,000
Feb

Mar
1,500 units × $100
=
$150,000
Mar

Current ratio = currentassets
current liabilities
Current assets
Inventory = finished goods for April sales of 1,500 units
Costofproduction=materials+variablecosts=$400+$100=$500perunit 1,500 units × $500 =$750,000
Cash = $992,000
Trade receivables = March 1,400 units × $800 × 1.05 = $1,176,000
Current liabilities
Trade payables = cash owed for March raw materials = 1,500 units × 2 units × $200 = $600,000
$750,000 + $992,000 + $1,176,000

currentratio=

$600,000 = 4.9times



100 Answers

Wheninvestingasurplusthecompanyshouldconsiderthefollowing. Liquidity.Sharesarenotquicklyandeasilyconvertedintocash.
Profitability.Thecompanyshouldseektoobtainagoodreturnfortheriskincurred.Agoodreturnonshares usually means a long-term investment. However, the surplus is onlytemporary.
Safety. Share values can go down as well as up which could lead to capital losses.
Thequestionstatesthatthesurplusisashort-termsurplus.Investinginsharesisthereforeinappropriate.A deposit account with a bank would be moreappropriate.
The Baumol model and cashmanagement
A number of different cash management models indicate the optimum amount of cash that a company shouldhold.Onesuchmodelisbasedontheideathatdecidingonoptimumcashbalancesislikedeciding on optimum inventory levels, and suggests the optimum amount to be transferred regularly from investments to currentaccount.
We can distinguish two types of cost which are involved in obtaining cash:
Thefixedcostrepresented,forexample,bytheissuecostofequityfinanceorthecostofnegotiating anoverdraft
Thevariablecost(opportunitycost)ofkeepingthemoneyintheformofcash TheBaumolapproachhasthefollowingdrawbacksforcompaniessuchasFlitCo.
Inreality,itisunlikelytobepossibletopredictamountsrequiredoverfutureperiodswithmuch certainty.
No buffer inventory of cash is allowed for. There may be costs associated with running out ofcash.
There may be other normal costs of holding cash, which increase with the average amountheld.
It assumes constant transaction costs and interestrates.
Determination ofspread
Daily interest rate = 5.11/365 = 0.014% per day
Variance = SD2 so variance of cash flows = 1,000 1,000 = $1,000,000 per day Transaction cost = $18 per transaction
Spread = 3 ((0.75 transaction cost variance)/interest rate)1/3
= 3 ((0.75 18 1,000,000)/0.00014)1/3 = 3 4,585.7 = $13,757
Lower limit = $7,500
Upper limit = $(7,500 + 13,757) = $21,257 Return point = $7,500 + ($13,757/3) = $12,086 Relevance of the values
TheMiller-Orrmodeltakesaccountofuncertaintyinrelationtocashflows.ThecashbalanceofRenpecCo is allowed to vary between the lower and upper limits calculated by themodel.
Ifthecashbalancereachesanupperlimitthefirmbuyssufficientsecuritiestoreturnthecashbalancetoa normallevel(calledthe'returnpoint').Whenthecashbalancereachesalowerlimit,thefirmsellssecurities to bring the balance back to the returnpoint.
TheMiller-OrrmodelthereforehelpsRenpecCotodecreasetheriskofrunningoutofcash,whileavoiding the loss of profit caused by having unnecessarily high cashbalances.






Answers 101

WidnorCo


Marking scheme




Marks


(a) Reduction in tradereceivables
1



Reduction in financing cost
1



Reduction in administration costs
1



Saving in bad debts
1



Increase in financing cost
1



Factor’s annual fee
1



Advice on acceptance of factor’s offer

(b) Bank and otherreferences
1

1

7


Credit rating
1



Other relevant discussion
1

3


(c) Relevant discussion 2-3 marks per validpoint
Maximum
10




20



Thefactor'sofferwillbefinanciallyacceptabletoWidnorCoifitresultsinanetbenefitratherthananet cost.
$














The factor’s offer is therefore financially acceptable.





102 Answers

Thecreditworthiness of potential customers can be assessed from a range of different sources of information.Referencesareusefulinthisrespect,andpotentialcustomersshouldsupplyabankreference andatradeorotherreferencewhenseekingcreditonpurchases.Anothersourceofinformationisthecredit ratingofthepotentialcustomer,whichcanbecheckedbyacreditratingagencyorcreditreferenceagency. Forlargerpotentialcustomers,afilecanbeopenedwhereadditionalinformationcanbelocated,evaluated andstored,suchastheannualreportandaccountsofthepotentialcustomer,pressreleasesandsoon.
Risks arising from granting credit to foreigncustomers
Foreign debts raise the following special problems. When goods are sold abroad, the customer might ask forcredit.Exportstaketimetoarrange,andtheremightbecomplexpaperwork.Transportingthegoodscan be slow, if they are sent by sea. These delays in foreign trade mean that exporters often build up large investmentsininventoriesandaccountsreceivable.Theseworkingcapitalinvestmentshavetobefinanced somehow.
The risk of bad debts can be greater with foreign trade than with domestic trade. If a foreign customer refusestopayadebt,theexportermustpursuethedebtinthecustomer'sowncountry,whereprocedures will be subject to the laws of thatcountry.
How risks can be managed and reduced
Acompanycanreduceitsinvestmentinforeignaccountsreceivablebyinsistingonearlierpaymentfor goods.Anotherapproachisforanexportertoarrangeforabanktogivecashforaforeigndebt,sooner thantheexporterwouldreceivepaymentinthenormalcourseofevents.Thereareseveralwaysinwhich this might bedone.
Wheretheexporteraskstheirbanktohandlethecollectionofpayment(ofabillofexchangeoracheque)on their behalf, the bank may be prepared to make an advance to the exporter against the collection. The amount of the advance might be 80% to 90% of the value of thecollection.
Negotiation of bills or cheques is similar to an advance against collection, but would be used where the bill or cheque is payable outside the exporter's country (for example in the foreign buyer's country).
Discountingbillsofexchangeiswhereabankbuysthebillbeforeitisdueandcreditsthevalueofthebill after a discount charge to the company'saccount.
Exportfactoringcouldbeconsideredwheretheexporterpaysforthespecialistexpertiseofthefactorin ordertoreducebaddebtsandtheamountofinvestmentinforeignaccountsreceivable.
Documentarycreditsprovideamethodofpaymentininternationaltrade,whichgivestheexporterasecure risk-freemethodofobtainingpayment.Thebuyer(aforeignbuyer,oradomesticimporter)andtheseller(a domesticexporteroraforeignsupplier)firstofallagreeacontractforthesaleofthegoods,whichprovides forpaymentthroughadocumentarycredit.Thebuyerthenrequestsabankintheircountrytoissuealetter ofcreditinfavouroftheexporter.Theissuingbank,byissuingitsletterofcredit,guaranteespaymenttothe beneficiary.
Countertrade is a means of financing trade in which goods are exchanged for other goods.
Exportcreditinsuranceisinsuranceagainsttheriskofnon-paymentbyforeigncustomersforexportdebts. Ifacreditcustomerdefaultsonpayment,thetaskofpursuingthecasethroughthecourtswillbelengthy, and it might be a long time before payment is eventuallyobtained.
Premiumsforexportcreditinsurancearehowever,veryhighandthepotentialbenefitsmightnotjustifythe cost.

MCQ bank – Investment decisions
85 C 49%
Return on capital employed = Average annual accounting profits / Average investment Averageannualaccountingprofits=(16,500+23,500+13,500–1,500)/4=$13,000pa. Noteaccountingprofitsareafterdepreciationsonoadjustmentisrequired.

Answers 103

Averageinvestment=(initialinvestment+scrap)/2=($46,000+$7,000)/2=$26,500 ROCE = 13,000/26,500 =49%


A Paybackperiodistheamountoftimetakentorepaytheinitialinvestment.
Syllabus area D1(d)

Cumulative

Time

Profit
Depreciation*
Cash flow
cash flow



$
$
$
$

0
Investment


(46,000)
(46,000)

1
Cash inflow
16,500
9,750
26,250
(19,750)

2
Cash inflow
23,500
9,750
33,250
13,500

* Depreciation = ($46,000 – $7,000) / 4
Payback period = 1 + (19,750/33,250) = 1.59 years or 1 year 7 months to the nearest month.
Syllabus area D1(b)
B 1iscorrectasthereisno'cutoff'point(unlikethepaybackperiodcalculation). 2 is incorrect. ROCE is profitbased.
3 is correct, and may well help explain ROCE's use in the real world.
Syllabus area D1(d)
B The$1,000issunk.IfthechemicalisusedinanewprojectitwouldsaveSWCo$400thatitwould otherwisehavetospendtodisposeofthechemical.Thisequatestoaneffectivenetcashinflow(or, more precisely, the avoidance of an outflow) of $400. Thus the project appraisal should show an inflow of $400 in relation to using thischemical.
Syllabus area D1(a)
89 C $20,000
WeassumeBLWwouldchoosethecheapestsourceoflabour. Cost to buy in = $20 × 1,000 hours =$20,000
Cost to divert existing labour = lost contribution + labour cost ie ($10 + $15) × 1,000 hours =
$25,000
The cheapest alternative is therefore to buy in at a cost of $20,000.
To calculate how the existing BLW project would suffer as a result of diverting labour, the current labourcostisaddedbacktothelostcontributiontogivethefullimpactofdivertinglabourawayfrom its currentrole.
Syllabus area D1(a)
A $14,000. The current rental cost is $5,000. The net new rental cost, should the project proceed, wouldbe($17,000+$5,000–$3,000)=$19,000,soanincrementof$19,000–$5,000=$14,000.
Syllabus area D1(a)
C OptionAisabenefitnotadrawback.OptionBisincorrect.Paybackperioddoesnottakeaccountof thetimevalueofmoney.Disincorrect.Thecalculationisnotbasedonprofit.Ontheassumptionthat thebasicreasonforapprovingaprojectisthatitwillincreaseshareholderwealth,amajordrawback ofpaybackperiodisthatitdoesnotattempttomeasuretheimpactonshareholderwealthshouldthe project goahead.
Syllabus area D1(b)
A Projectscreeningshouldbeundertakenafterstage1tosiftoutunsuitableideasbeforefurthertime and money is spent investigating further. Raising finance is impractical before knowing what the fundingrequirementis.Implementationcanonlyoccuronceasuitableprojecthasbeenselected.
Syllabus area D1(a)


104 Answers

D 5%. A payback of 20 years suggests net annual inflow of 50,000/20 = $2,500 per annum. Returnoncapitalemployed(ROCE)=Averageannualaccountingprofit/Averageinvestment. Average annual accounting profit = $2,500 cash inflows lessdepreciation.
Depreciation = 50,000/40 = $1,250 per year
So average annual accounting profit = $2,500 – $1,250 = $1,250. Average investment = ($50,000 + 0)/2 = $25,000
Therefore ROCE = $1,250/$25,000 = 0.05 or 5% per annum
Syllabus area D1(d)
B Thecostshouldnotfeatureintheprojectappraisalastheaccountantispaidanywayiehissalaryis notincremental.


MCQ bank – Investment appraisal usingDCF
D The present value of the annuity = $7,000 ×AF3-7
whereAF3-7isthe10%Annuityfactorfromyears3-7inclusive. AF3-7 = AF1-7–AF1-2
= 4.868 – 1.736 (from tables)
= 3.132
Therefore the present value = $7,000 × 3.132 = $21,924
Syllabus area D1(a)










Syllabus area D1(e)


96
C
Option 1
Step 1 Calculate the future value of the perpetuity using the cost of capital


$90,000 / 0.1 = $900,000


Step2Discountitbacktotodayusingadiscountfactorof10%attheendofyear2


PV = $900,000 × 0.826 = $743,400


Option 2


The present value of the lump sum = $910,000 × DF1
WhereDF1isthe1year10%discountfactorfromtables=0.909 So present value of lump sum = $910,000 × 0.909 =$827,180


The lump sum should be chosen because it has a higher net present value.

Syllabus area D1(e)
97 C Rememberthatacashoutlayorreceiptwhichoccursatthebeginningofatimeperiodistakento occurattheendofthepreviousyear.Thereforeaninflowof$12,000inadvancefor5years
(ie starting now) is taken to occur in years 0, 1, 2, 3 and 4.
NPV at 10%:
Time $ DF10% PV$
0
Investment
(40,000)
1
(40,000)

0-4
Net cash inflows
12,000
1+3.17 = 4.17
50,040

5
Decommissioning
(15,000)
0.621
(9,315)


Net present value


725


= $700 to the nearest $100
Syllabus area D1(e)


Answers 105

98 A 12%

IR R a 


NP Va

b – a %

NPVa–NPV 
⎝ b 
where a = lower % discount rate b = higher % discountrate NPVA= NPV ata%
NPVB= NPV at b%

NPV at 10% = NPV at 15%:
Time
$725 (see question above)


$


DF 15%


PV $

0
Investment
(40,000)
1
(40,000)

0-4
Net cash inflows
12,000
1+2.855 =3.855
46,260

5
Decommissioning
(15,000)
0.497
(7,455)


Net present value


(1,195)

Therefore IRR = 10%+ [(725/(725+1,195)) × (15% – 10%)] = 11.9% (12% to the nearest whole %)
Syllabus area D1(f)
D TheprojectwiththehighestNPVwillmaximiseshareholderwealthasNPVdirectlymeasuresthe impact on shareholderwealth.
Syllabus area D1(g)
C It takes into account the time value of money and it considers the wholeproject.
Statement1isnotanadvantage.ThedecisionruledependsontheshapeoftheIRRcurve.There couldbeseveralIRRsandwhethertheIRRneedstobehigherorlowerthanthecostofcapital depends on the project cashflows.
Statement2isanadvantage.IRRisadiscountingtechniquehencetakesintoaccountthetimevalue ofmoney.
Statement3isadisadvantage.The'reinvestmentassumption'isaflawinIRR.Thereisnoreasonto supposethatfundsgeneratedearlyoninaprojectwillbereinvestedattheIRRafterthatpoint.The funds may well be distributedelsewhere.
Statement4isanadvantage.Unlikepaybackperiod,theIRRconsidersallofthefutureincremental cash flows associated with a decision in itscalculation.
Syllabus area D1(f)
C The NPV will decrease and there will be no change to theIRR.
A higher cost of capital will discount future inflows more heavily, reducing the NPV of the project. ThecostofcapitaldoesnotfeatureinthecalculationoftheIRR,onlyinthedecisionrulethatfollows thecalculation.
Syllabus area D1(e)(f)
B The net present value of the agreement is $26,496,hence:

$26,496
= ($a × AF1-4)+10,000
WhereAF1-4isthe4year8%annuityfactor

$16,496
$a
= $a × 3.312
= $16,496/3.312
= $4,981
(from tables)

Syllabus area D1(e)




106 Answers

A TheIRRformularequirestwoNPVcalculationsatdifferentratestoestimatetheIRR. Bisinaccurate.Linearinterpolationisstillanestimate.Itisnot100%precise.
Cisinaccurate.TheremaybemorethanoneIRR.Itdependsonwhetherthecashflowsare conventional ornot.
Disnotnecessarilytrue.Forexample,anunusualprojectwithaninitiallargeinflowfollowedby years of outflows will have a positiveslope.
Syllabus area D1(h)
A Thepresentvalueoftheholidayhome=$1.5m×(DF510%)=$1.5m×0.621=$931,500 Therefore the present value of the annuity =$931,500.
$931,500 = $a × AF0-4
WhereAF0-4istheannuityfactorfromtime0totime4 AF0-4= 1+AF1-4 = 1 + 3.170 =4.170
So$931,500 = $a ×4.170
$a =$931,500/4.170
= $223,381 or $223,400 to the nearest $100


MCQ bank – Allowing for tax and inflation
Syllabus area D1(e)

C Theassetispurchasedon31December20X4(T0)sothefirstportionoftaxallowabledepreciationis accountedforonthatdate(asthisistheendoftheyear).Theamountofthedepreciationwouldbe
$1m × 25% = $250,000.
Claimingthisallowancewillsave($250,000×30%=)$75,000taxwhenitispaidatT1(oneyear delay) hence the present value = $75,000 × DF1= $75,000 × 0.909 =$68,175
Syllabus area D2(b)
B Astaxispaidoneyearinarrears,the$20,000andassociatedtaxaretreatedseparately: PVofperpetuity:$20,000×1/0.1 = $200,000
Less PV of tax: ($20,000 × 30%) × (AF 2-∞) AF 2-∞= (1/0.1) – DF1= 10 – 0.909 = 9.091
PV of tax = $20,000 × 30%×9.091 = $(54,546)
Aftertax = $145,454


C


Working capital required (10% ×



Increments=



Discount
Syllabus area D2(b)

$ sales)
cashflow
factor10% Presentvalue

To
10,000
(10,000)
1
(10,000.00)

T1
12,500
(2,500)
0.909
(2,272.50)

T2
10,500
2,000
0.826
1,652.00

T3
0
10,500
0.751
7,885.50





(2,735.00)


Syllabus area D1(e)






Answers 107

A Theworkingcapitalrequiredwillinflateyearonyear,thentheinflatedamountwillbe'returned'atthe end of theproject:

Working
capital required (with
$ 10%inflation)

Increments=cashflow

Discount factor
12% Presentvalue

To
100,000
(100,000)
1
(100,000)

T1
110,000
(10,000)
0.893
(8,930)

T2
0
110,000
0.797
87,670





(21,260)


Syllabus area D2(a)
C $58,175.Asnotallcashflowswillinflateatthesamerate,cashflowswillbeinflatedwhere necessary and discounted using the moneyrate.
(1 + money rate) = (1.08) × (1.02) = 1.1016 so m = 10% to the nearest whole % Nominal income = $100,000 × (1 + income inflation) = $100,000 × 1.1 = $110,000 Nominal expenses = $35,000 (zero inflation)
Therefore NPV = [(110,000 – 35,000) × DF1]–10,000 where DF1= the 1 year 10%discount
factor (tables)
= (75,000 × 0.909) – 10,000 = $58,175
Syllabus area D2(a)
C Inordertousetheperpetuityfactor(1/r)theannualamountmustbeconstant,sothecalculation needs to be done in realterms.
Themoneycostofcapitalisgiveninthequestion,sotherealrateneedstobecalculatedusing: (1 + r) × (1 + h) = (1 +i) wherer=realrate,h=inflation,i=moneyrate,so
(1 + r) × (1.02) = (1.102)
(1 + r) = 1.102 / 1.02 = 1.08 or 8%.
TheperpetuityfactorfromT2-∞=(1/r)–DF1=(1/0.08)–0.926=11.574 Therefore the present value = 10,000 × 11.574 =$115,740


A Increasedexpectationofinflationwillhavetwoeffects.
Higher expected nominal cashflow
Higher nominal discount rate Thesewillcanceleachotheroutexactly.
Syllabus area D2(a)





Syllabus area D2(a)

B (1 + r) × (1 + h) = (1 +i) wherer=realrate,h=inflation,i=moneyrate,so (1 + r) × (1.04) =(1.10)
(1 + r) = 1.10/1.04 = 1.058 or 5.8%.
Syllabus area D2(a)
D Thevalueofthetaxallowabledepreciationis150,000×100%×30%=$45,000receivable immediately so the net initial outlay = 150,000 – 45,000 =$105,000
The future value of 105,000 in 2 years time (note….'receivable in 2 years….')
= 105,000 × 1.12 = $127,050.
The revenue is taxable, so the pre tax contract revenue needs to be 127,050/(1 – 0.3) = $181,500
Syllabus area D2(b)


108 Answers

D Theinflationincludedinthemoneycostofcapitalisrequiredbytheinvestorstocompensatethem forthelossofgeneralpurchasingpowertheirmoneywillsufferinthefutureasaresultofinvesting in thebusiness.
Syllabus area D2(a)

CBE style OTQ bank – Project appraisal and risk
Hides risk and probably won’t actuallyoccur.
Statement1isfalse.Asanaveragetheexpectedvalueprobablywon'tactuallyoccurinanysingle eventsoitdoesnotrepresentaprobableoutcome.Itismoreappropriateforrepeatedevents(for exampleexpectedsaleseachyearformanyyears).Bythesamelogicstatement3istrue.
Statement2istrue.Expectedvaluesfailtoshowthespreadofpossiblevalues,thereforehidingthe best/worst outcomes from the decision makingprocess.
Statement4isfalse.Riskiscalculable(knownorestimatedprobabilitiesand/oroutcomes), uncertainty is not (either probabilities or some outcomes areunknown).
Syllabus area D3(c)
116 $193,050
Expected sales = (20,000 × 0.6) + (25,000 × 0.4) = 22,000 units Expected sales price = ($10 × 0.3) + ($15 × 0.7) = $13.50
Soexpectedrevenue=22,000units×$13.50 =$297,000
Expected margin = (30% × 0.5) + (40% × 0.5) = 35% therefore costs will be 1 – 35% = 65% So expected cost = 65% × $297,000 = $193,050


Just under 3years
Adjustedpaybackperiodispaybackperiodbasedondiscountedcashflows:
Syllabus area D3(c)


Cumulative


Cash flow

Discounted cash
discounted cash

Time
($)
DF 8%
flow ($)
flow

0
(100,000)

(100,000)
(100,000)

1
40,000
0.926
37,040
(62,960)

2
40,000
0.857
34,280
(28,680)

3
40,000
0.794
31,760
3,080



70%To force an NPV = 0, the 4 year annuity factor, AF1-4= 110,000/40,000 = 2.75 Proof: the NPV calculation would be (2.75 × 40,000) – 110,000 =0
Syllabus area D3(d)

Fromtables,the4-yearannuityfactorclosestto2.75is2.743,correspondingtoadiscountrateof 17%.
In terms of sensitivity: (17 – 10)/10 = 70% sensitivity
The cost of capital can therefore increase by 70% before the NPV becomes negative.

Note:alternativelyIRRcouldbeestimatedtofindthe17%insteadoftables. NPV when cost of capital is 18% = -110,000 + (40,000 × 2.69) =(2,400)
IRR =0.1+ 16,800 × (0.18 – 0.1) =17%
16,800 + 2,400
Syllabus area D3(b)



Answers 109

Morethan one variable can change at atime
‘Acleardecisionrule’isincorrect.Thereisnodecisionrulewithsimulations–itisnotan'optimising' technique
‘Morethanonevariablecanchangeatatime’isaclearadvantagethatsimulationshaveover sensitivityanalysis
‘Statisticallymoreaccuratethanothermethods’isincorrect.Theinputvariablesanddistributions areestimates
‘Beingdiagrammaticitiseasiertounderstand’hassomevaliditypotentially,butisnotnecessarily thecase.
Syllabus area D3(d)

CBE style OTQ bank – Specific investment decisions
The2-yearcycleshouldbechosenwithanequivalentannualcostof$10,093 Netpresentcostof1yearcycle=20,000–(10,000×0.909)=$10,910cost
Net present cost of 2 year cycle = 20,000 – [(8,000 – 5,000) × 0.826] = $17,522 cost EAC 1 year cycle = $10,910 / 0.909 = 12,002
EAC 2 year cycle = $17,522 / 1.736 = 10,093
The 2-year cycle should be chosen with an equivalent annual cost of $10,093
Syllabus area D4(b)
2only
Statement 1 is incorrect: Lessees acquire the risk and responsibility of ownership with finance leases.
Statement2iscorrect:Financeleasesareaccountedforasanassetandapayableonthestatement of financial position of thelessee.
Statement3isincorrect:Financeleaseshaveaprimaryperiodcoveringallormostoftheuseful economic life of theasset.
Syllabus area D4(a)
‘No After tax cost of the loan if they borrow andbuy’
Interest should not be included as a cash flow as it is part of the discount rate.
Asafinancingdecisionthealternativesshouldbeassessedattheaftertaxcostofborrowing–the riskassociatedwitheachistheriskofborrowing(ornot),andnotrelatedtowhatisdonewiththe asset.
Syllabus area D4(a)
Botharefalse.Aconstraintbeingtermed'soft'meansitisinternallyimposed.Itmayormaynotbe flexible so is not alwaystrue.
Whetheraprojectmaybeconsidereddivisibleornotdependsontheproject–forexampleinvesting in a machine is unlikely to be divisible (half a machine will not generate half the return), however buyingachainofshopscouldbedivisible;itmightbepossibletobuyhalfthechainforhalfthecost and expect half the net presentvalue.
Syllabus area D4(c)
$13million

Project
Initial cost
NPV ($m)
Profitability
Ranking


($m)

index*


1
40
4
1.10
3

2
30
5
1.167
1

3
50
6
1.12
2

4
60
5
1.08
4





110 Answers

Investment plan:

Investment
($m)
NPV ($m)

100% of Project 2
30
5

100% of Project 3
50
6

50% of Project 1
20
2


100
13




$11million
Projects2and3givethehighestNPVwithoutbreakingthe$100millionconstraint.

'Avoiding tax exhaustion'
Syllabus area D4c



Syllabus area D4c

'Avoidingtaxexhaustion'ispotentiallyabenefit.Taxexhaustioniswhenabusinesshasnegative taxableincomesoitcannotbenefitfromtaxreliefsuchastaxallowabledepreciation.Inthiscase,it may be beneficial to lease the asset from a business that can benefit from the tax allowable depreciation and share in that benefit via lower leasepayments.
‘Attractingleasecustomersthatmaynothavebeenotherwisepossible’isapotentialbenefittoa lessor, not alessee.
‘Exploiting a low cost of capital’ is a potential benefit for the purchaser, not the lessee.
‘Potentialfuturescrapproceeds’isapotentialbenefitforthepurchaser,notthelesseeasthelessee is not entitled to scrapproceeds.
Syllabus area D4a
‘Electricbecauseitsequivalentannualbenefitishigher‘
TheNPVscannotbedirectlycomparedastheyrelatetodifferenttimeperiods.Equivalentannual benefits(EAB)shouldbecompared.Thisissimilarinprincipletoequivalentannualcost.
EAB Gas = $50,000 / AF1-5= 50,000 / 3.993 = $12,522 pa EAB Electric = $68,000 / AF1-7= 68,000 / 5.206 = $13,062pa
Therefore electric should be chosen as its equivalent annual benefit is higher.
Syllabus area D4b
Higher scrapvalue
Better company image and efficiency
Statement 1 is a benefit. Scrapped assets will be newer hence worth more.
Statement 2 is a benefit. Newer assets look better, motivate employees and are more efficient.
Statement3isnottruehencenotabenefit.Typicallydepreciationishigherinearlieryears,meaning annual depreciation charges will be higher with a shorter replacementcycle.
Statement4isinaccuratehencenotabenefit.Althoughownedforashorterperiod,theassetwillbe replaced so ownership of that type of asset will beindefinite.
Syllabus area D4b
1,2and3.Leasingmaybepossible.Ajointventurepartnermayprovideadditionalfunding.Although delayingprojectswillprobablyreducetheirNPV(timevalueofmoney,andcompetitorresponse),this may be better than not investing atall.
Syllabus area D4a





Answers 111

Sensitivity analysis

130
C
11.9%

Year

Variable cost

Discount factor 9%


PV

Cash inflows


PV




$'000

$'000
$'000
$'000



1
3,200
0.917
2,934
10,300
9,445



2
3,200
0.842
2,694
NPV =5,628
10,300
8,673
NPV =18,118

Sensitivity of project to sales volume =

1,490

18,118 - 5,628

100% = 11.9%


131
D
1.75 years
Netcash Discount
Year flow factor9% PV

Cumulative PV




$'000 $'000
$'000




0 (11,000) 1 (11,000.00)
(11,000.00)




1 7,100 0.917 6,510.70
(4,489.30)




2 7,100 0.842 5,978.20






4,489.30 / 5,978.20 = 0.75





Therefore the discounted payback = 1.75 years



132
A
19.2%





Usingdiscountratesof15%and20%perthequestionwehave:





Netcash Discount
Discount




Year flow factor15% PV
factor 20%
PV



$'000 $'000

$'000



0 (11,000) 1 (11,000)
1
(11,000)



1 7,100 0.870 6,177
0.833
5,914



2 7,100 0.756 5,638
0.694
4,927



IRR = 15+ 815 (20 - 15)=19.2%
NPV=815 NPV =(159)

815159 
D Bothstatementsarefalse.Sensitivityanalysisdoesnotprovideadecisionrule.Parametersdefining acceptability must be laid down by managers. Another weakness of sensitivity analysis is that it requiresthatchangesinvariablesareisolated.However,lookingatfactorsinisolationisunrealistic as they are ofteninterdependent.
A 1 and2
Thefirsttwostatementsaretrue.TheIRRignorestherelativesizesofinvestments.Itthereforedoes notmeasuretheabsoluteincreaseincompanyvalue,andthereforeshareholderwealth,whichcanbe created by aninvestment.
TheIRRmethodassumesthatcashflowscanbereinvestedtoearnareturnequaltotheIRRofthe originalproject.
IRR (not NPV) is widely used in practice. NPV is technically superior to IRR.


112 Answers

Trecor Co
135 56%
Average investment = (250,000 + 5,000)/2 = $127,500 ROCE = 71,250/127,500 100 = 56%
136 Thefirststatementisfalse.ROCEneedstobehigherthanthetargetROCEforthemachinepurchase toberecommended.Thesecondstatementistrue.Two(ormore)mutuallyexclusiveprojectscanbe compared using ROCE. The project with the highest ROCE should beselected.
137 $10,547
Taxallowabledepreciation Taxbenefits

$

$

1
250,000 0.25 =
62,500
2 62,500 0.3 =
18,750

2
62,500 0.75 =
46,875
3 46,875 0.3 =
14,063

3
46,875 0.75 =
35,156
4 35,156 0.3 =
10,547

1 year 11months
Year 1 cumulative balance = -250,000 + 122,000 = -128,000
(128,000 / 143,000) × 12 months = 11 months payback is 1 year 11 months
IRR ignores the relative sizes ofinvestments
IRR and NPV sometimes give conflicting rankings over which project should be prioritised
Statement1istrue.TheIRRignorestherelativesizesofinvestments.Itthereforedoesnotmeasurethe absolute increase in company value, and therefore shareholder wealth, which can be created by an investment.
Statement2isthereforefalse.Whendiscountratesareexpectedtodifferoverthelifeoftheproject,such variations can be incorporated easily into NPV calculations, but not into IRR calculations. Therefore statement 3 is alsofalse.
Statement4istrue.NPVandIRRmethodscangiveconflictingrankingsastowhichprojectshouldbegiven priority.

BRT Co
140 $8,487 (or$8,488)
1,600,000 × $5 × 1.032 = $8,487,200 or
1,600,000×5.305=$8,488,000(ifyouhaveroundedtheinflatedprice) 141 $6,884
2,100,000 × $3 × 1.033 = $6,884,180
142 $84


Tax allowable depreciation

Tax benefits

Year

Year


1
2,000,000 × 0.25 = $500,000
2
$500,000 × 0.3 = $150,000

2
500,000 × 0.75 = $375,000
3
$375,000 × 0.3 = $112,500

3
$375,000 × 0.75 = $281,250
4
$281,250 × 0.3 = 84,375






Answers 113

Thetrainee accountant has used the wrong percentage for the cost of capital -false
Asinflatedsalesandcostshavebeenused,thecostofcapitalshouldbethenominalcostofcapital(at 12%).

Ignoring sales after four years underestimates the value of the project - true
Cuttingoffcashflowsafter4yearswillunderestimatethevalueoftheprojectasfuturecashinflowswillbe ignored.
The working capital figure in Year 4 is wrong - true
The final year should recover the total working capital and so should be $750k + $23k + $23k + $24k =
$820k.
Both statements aretrue.
WhenthereareunconventionalcashflowpatternstheremaybemultipleIRRsandsotheNPVandIRR decisions may not be thesame.
AprojectisfinanciallyviableundertheIRRcriteriaiftheIRRisgreaterthanthecostofcapital(12%inthis case).

CalvicCo




Servicingcosts 1
Cleaningcosts 1
Present values oftotalcosts 1
Present values oftrade-invalues 2
Net present values of costs ofeachcycle 3
Annuityfactors 1
Equivalentannualcosts 2
Recommendation 1
Single-periodcapitalrationing 2-3
Projectdivisibility 3-4
Investment ofsurplusfunds 3 -4
Marks







12

Maximum Maximum 8
20





114 Answers

(a)
Replace every year
Year

0

1



Initial cost
Trade-in value
(15,000)

11,250



Service cost

(1,000)



Cleaning cost

(500)



Net cost
(15,000)
9,750



Discount factor @ 10%
1
0.909



Present value
(15,000)
8,863



NPV
(6,137)




Annuity factor
Equivalent annual cost
0.909
(6,751) pa




Replace every 2 years
Year

0

1

2


Initial cost
Trade-in value
(15,000)


9,000


Service cost

(1,000)
(1,400)


Cleaning

(500)
(625)


Net cost
(15,000)
(1,500)
6,975


Discount factor 10%
1
0.909
0.826


Present value
(15,000)
(1,364)
5,761


NPV
Annuity factor
Equivalent annual cost
(10,603)
1.736 for 2 years
(6,108) pa




Replace every 3 years





Year
0
1
2
3

Initial cost
Trade-in value
(15,000)



6,200

Service cost

(1,000)
(1,400)
(1,960)

Cleaning cost

(500)
(625)
(781)

Net cost
(15,000)
(1,500)
(2,025)
3,459

Discount factor @ 10%
1
0.909
0.826
0.751

Present value
(15,000)
(1,364)
(1,673)
2,598

NPV
Annuity factor
Equivalent annual cost
(15,439)
2.487 for 3 years
(6,208) pa




As the lowest cost option, the decision should be made to replace every two years.
(b) The net present value decision rule is to invest in all projects that have a positive net present value. By following this decision rule, managers will maximise the value of a company and therefore maximise the wealthofordinaryshareholders,whichisaprimaryobjectiveoffinancialmanagement.Evenwhencapital is rationed, it is still essential to be able to offer advice on which capital investment projects should be selected in order to secure the maximum return for the investing company, ie the maximum overall net presentvalue.
Single-period capital rationing
Theapproachtosolvingsingle-periodcapitalrationingproblemsdependsonwhetherprojectsaredivisible or not. A divisible project is one where a partial investment can be made in order to gain a pro rata net presentvalue.Forexample,investinginaforestisadivisibleproject,sincetheamountoflandpurchased canbevariedaccordingtothefundsavailableforinvestment(providingtheselleragreestoapartialsale,of course).Anon-divisibleprojectisonewhereitisnotpossibletoinvestlessthanthefullamountofcapital. Whenbuildinganoilrefinery,forexample,itisnotpossibletobuildonlyonepartoftheoverallfacility.



Answers 115

Whereprojectsaredivisible,theobjectiveofmaximisingthenetpresentvaluearisingfrominvestedfunds canbeachievedbyrankingprojectsaccordingtotheirprofitabilityindexandinvestingsequentiallyinorder ofdecreasingprofitabilityindex,beginningwiththehighest,assumingthateachprojectcanbeinvestedin only once, ie isnon-repeatable.
Theprofitabilityindexcanbedefinedasnetpresentvaluedividedbyinitialinvestment.Rankingprojectsby profitability index is an example of limiting factor analysis. Because projects are divisible, there will be no investmentfundsleftover:wheninvestmentfundsareinsufficienttoforthenextrankedproject,partofthe project can be taken on because it isdivisible.
Whenprojectsarenon-divisible,theobjectiveofmaximisingthenetpresentvaluearisingfrominvested fundscanbeachievedbycalculatingthenetpresentvaluearisingfromdifferentcombinationsofprojects. Withthisapproach,therewillusuallybesomesurplusfundsremainingfromthefundsinitiallyavailable.
The investment of surplus funds
Wheninvestigatingcombinationsofnon-divisibleprojectsinordertofindthecombinationgivingrisetothe highest net present value, any return from investing surplus funds is ignored. The net present value analysishasbeenbasedonthecompany'saveragecostofcapitalanditisunlikelythatsurplusfundscanbe invested in order to earn a return as high asthis.
Investmentofsurplusfundsin,forexample,themoneymarketswouldthereforebeaninvestmentproject that would be rejected as having a negative net present value, or an internal rate of return less than the company'saveragecostofcapitalifusingIRRtoassessinvestmentsprojects.However,itisgoodworking capitalmanagementtoensurethatliquidfundsareinvestedtoearnthehighestavailablereturn,subjectto any risk constraints, in order to increase overallprofitability.

ProjectE


Marks
Salesincome 1
Inflation ofsalesincome 1
Variablecost 1
Inflation ofvariablecost 1
Inflatedfixedcosts 1
Taxliability 1
Timing oftaxliability 1
Tax allowable depreciation years 1–3 1
Balancingallowance 1
Tax allowable depreciationtaxbenefits 1
116 Answers

Scrapvalue 1
Calculation ofpresentvalues 1
CalculationofNPV 1
Comment on financial acceptability & that E mustbeundertaken 2
Calculation ofpaybackperiod 2
Discussion ofpaybackperiod 3



15


5
20





Asinflationratesdifferforrevenueandcost,nominalcashflows(ieincludinginflation)needtobecalculatedand discounted at the nominal rate (also includinginflation).













Net present value = -5,000 + 1,405 + 1,426 + 810 + 1,361 – 48 = (46)
Thenetpresentvalueisnegativeandtheinvestmentisnotfinanciallyworthwhile.However,theboardhavedecided that it is strategically important to undertake thisproject.
Workings
Sales
Volume Price Inflation Revenue
$ $

Year 1
12,000 ×
450 ×
1.05
5,670,000


Year 2
13,000 ×
475 ×
1.052
6,807,938


Year 3
10,000 ×
500 ×
1.053
5,788,125


Year 4
10,000 ×
570 ×
1.054
6,928,386

(2)
Variable costs







Volume
Price
Inflation
Revenue




$

$

Year 1
12,000 ×
260 ×
1.06
3,307,200

Year 2
13,000 ×
280 ×
1.062
4,089,904

Year 3
10,000 ×
295 ×
1.063
3,513,497

Year 4
10,000 ×
320 ×
1.064
4,039,926


Fixedcosts
Fixed costs $750,000 per year inflating at 3.5%










Taxallowable depreciation taxbenefits

Year

Taxallowabledepn
($)


Tax benefit @ 28% ($)

1
5,000,000 × 25%
1,250,000
350,000

2
1,250,000 × 75%
937,500
262,500

3
937,500 × 75%
703,125
196,875

4
Balancing charge
1,709,375
478,625

Scrap value

400,000




5,000,000



Tax benefits and tax charges affect the following period since tax is paid in arrears.
(b) Assumingthatcashflowsoccurevenlythroughouttheyear: Contribution per unit = $3.00 – $1.65 =$1.35
Totalcontribution=20,000units$1.35=$27,000peryear Annual cash flow = $27,000 – $10,000 =$17,000
Payback = $50,000/$17,000 = 2.9 years
This exceeds the company's hurdle payback period of two years. Payback is often used as a first screening method. By this, we mean that the first question to ask is: 'How long will it take to pay back its cost?' Umunathasatargetpayback,andsoitmightbetemptedtorejectthisproject.However,aprojectshould notbeevaluatedonthebasisofpaybackalone.Ifaprojectgetsthroughthepaybacktest,itoughtthentobe evaluated with a more sophisticated investment appraisal technique, such as NPV. Payback ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and thereforethetotalprojectreturn.Italsoignoresthetimevalueofmoney(aconceptincorporatedintomore sophisticated appraisalmethods).

AGDCo

Marks
Purchaseprice 1
Saleproceeds 1
Tax allowable depreciation andbalancing allowance 2
Tax allowable depreciationtaxbenefits 1
Maintenance costsaftertax 2
PV of borrowingtobuy 1
Leaserentals 1
118 Answers

Lease rentaltaxbenefits 1
PVofleasing 1
Selection ofcheapestoption 1
12
Explanation anddiscussion
Financelease 2-3
Operatinglease 2-3
Maximum 5
Riskanduncertainty 3
20


(a) (i) Present value of purchasecosts





Cash inflows










NPV ofcashflow ($259k)
Working
Tax allowable depreciation



Tax
Allowable Tax Yearof
depn benefit cashflow
$'000 $'000 $'000

Initialinvestment 320
Allowances at 25% pa on a reducing balance basis over 3 years
Year1 (80) (80) 24 Y2
240
Year 2 (60) (60) 18 Y3
180
Year 3
Proceedsonsale (50)
Balancingallowance 130 39 Y4












Answers 119

(ii)
Present value of leasing costs

Cash outflows

Year 0
$'000

Year 1
$'000

Year 2
$'000

Year 3
$'000

Year 4
$'000


Annual lease rentals
(120)
(120)
(120)





Cash inflows
(120)
(120)
(120)




Taxation (at 30% in
following year) – tax deduction for lease rentals








36


36


36


Net cash flows
(120)
(120)
(84)
36
36


Discount at 7%
1.000
0.935
0.873
0.816
0. 763


PV of cash flow
(120)
(112)
(73)
29
27



NPV of cash flow

($249k)





Therefore the machine should be leased rather than purchased as the NPV of the cost is lower.
Key differences between operating and financeleases Financelease
Afinanceleaseisanagreementbetweentheuseroftheleasedassetandaprovideroffinancethatcovers the majority of the asset's usefullife.
Key features of a finance lease
Theprovideroffinanceisusuallyathirdpartyfinancehouseandnottheoriginalproviderofthe equipment.
The lessee is responsible for the upkeep, servicing and maintenance of theasset.
Theleasehasaprimaryperiod,whichcoversallormostoftheusefuleconomiclifeoftheasset.At theendoftheprimaryperiodthelessorwouldnotbeabletoleasetheequipmenttosomeoneelse because it would be wornout.
Itiscommonattheendoftheprimaryperiodtoallowthelesseetocontinuetoleasetheassetforan indefinite secondary period, in return for a very low nominal rent, sometimes known as a 'peppercorn'rent.
Thelesseebearsmostoftherisksandrewardsandsotheassetisshownonthelessee'sstatement of financialposition.
Operating leases are rental agreements between a lessor and a lessee
Key features of an operating lease
The lessor supplies the equipment to thelessee.
The lessor is responsible for the upkeep, servicing and maintenance of theasset.
Theleaseperiodisfairlyshort,lessthantheexpectedeconomiclifeoftheasset.Attheendofone leaseagreementthelessorcaneitherleasethesameequipmenttosomeoneelseandobtainarent for it or sell itsecond-hand.
The asset is not shown on the lessee's statement of financialposition.
Risk anduncertainty
Risk can be applied to a situation where there are several possible outcomes and, on the basis of past relevantexperience,probabilitiescanbeassignedtothevariousoutcomesthatcouldprevail.Theriskofa project increases as the variability of returnsincreases.
Uncertaintycanbeappliedtoasituationwherethereareseveralpossibleoutcomesbutthereislittlepast relevantexperiencetoenabletheprobabilityofthepossibleoutcomestobepredicted.Uncertaintyincreases as the project lifeincreases.



120 Answers

BasrilCo

(a)




Project 1
12% discount




$
factor
$


Initial investment
(300,000)
1
(300,000)


Year 1
85,000
0.893
75,905


Year 2
90,000
0.797
71,730


Year 3
95,000
0.712
67,640


Year 4
100,000
0.636
63,600


Year 5
95,000
0.567
53,865





32,740


Profitability index
332,740/300,000

1.11



Project 2
$
12% discount factor

$


Initial investment
(450,000)
1
(450,000)


Year 1
140,800
0.893
125,734


Year 2
140,800
0.797
112,218


Year 3
140,800
0.712
100,250


Year 4
140,800
0.636
89,549


Year 5
140,800
0.567
79,834





57,585


Profitability index
507,585/450,000

1.13



Project 3
$
12% discount factor

$


Initial investment
(400,000)
1
(400,000)


Year 1 (120,000 × 1.036)
124,320
0.893
111,018


Year 2 (120,000 × 1.0362)
128,796
0.797
102,650


Year 3
133,432
0.712
95,004


Year 4
138,236
0.636
87,918


Year 5
143,212
0.567
81,201





77,791


Profitability index
477,791/400,000

1.19


The most profitable projects are Projects 3 and 2, so if they are divisible it is suggested that Basril invests
$400k in Project 3 for an NPV of $77,791, and the remaining $400k in Project 2 for an NPV of 400/450 
$57,585 = $51,187.



Answers 121

Iftheprojectsareindivisible,thenBasrilcaneitherinvestinProject1+Project2atacostof$750,000,or Project1+Project3atacostof$700,000(Project2+Project3wouldcosttoomuch).TheNPVof1+2=
$32,740 + $57,584 = $90,324. The NPV of 1 + 3 = $32,740 + $77,791 = $110,531. Therefore the best combination is Projects 1 and 3.
Cashshortages
Aperiodofcapitalrationingisoftenassociatedwithmoregeneralproblemsofcashshortage.Possible reasons for this include thefollowing.
The business has become loss making and is unable to cover the depreciation charge. Since one purpose of the depreciation charge is to allow for the cost of the assets used in the statement of profitorloss,theimplicationisthattherewillbeinsufficientcashwithwhichtoreplacetheseassets whennecessary.
Highinflationmaymeanthateventhoughthebusinessisprofitableinhistoricalcostterms,itisstill failing to generate sufficient funds to replaceassets.
Ifthebusinessisgrowingitmayfaceashortageofworkingcapitalwithwhichtofinanceexpansion, and this may result in a period of capitalrationing.
If the business is seasonal or cyclical it may face times of cash shortage despite being fundamentallysound.Inthissituation,theremaybeaperiodicneedforcapitalrationing.
A large one-off item of expendituresuch as a property purchase may mean that the company faces a temporary shortage of cash for furtherinvestment.
Investment opportunities
A further reason for capital rationing arises in the situation where the company has more investment opportunitiesavailablethanthefundsallocatedtothecapitalbudgetpermit.Thismeansthatprojectsmust be ranked for investment, taking into account both financial and strategicfactors.
Whenappraisinganinvestmentproject,itisessentialthatonlythosecashflowsrelevanttotheprojectbe takenintoaccount,otherwiseanincorrectinvestmentdecisioncouldbemade.A'relevantcashflow'isan incremental cash flow that arises or changes as a direct result of the investment being made. Some costs will be sunk before an investment decision is made. An example would be research and development or marketresearchcostsintotheviabilityofanewproduct.Onceincurred,suchcostsbecomeirrelevanttothe decision as to whether or not to proceed, and so should be excluded from the analysis. Cash flows that would be relevant include an increase in production overheads or labour costs, new purchases that are necessary,andanyincrementaltaxeffects.Itisimportanttonotethatanyinterestpaymentsonthefinance foranewprojectarerelevanttotheprojectdecision,butarenottakenintoaccountinanyNPVcalculation. Theinterestpaymentswillalreadybe'builtin'tothecalculationinthediscountfactorthatisbeingapplied.

FiltrexCo







122 Answers

(i) Profitabilityindex
Whenresourcesarelimited,theaimmustbetomaximisetheproductivityofthescarceresource,in this case capital. It is therefore helpful to calculate the profitability index (PI) for each project to determine which delivers the most NPV per dollar of investment.

Project Outlay NPV PI(NPV/Outlay)

$
$


A
150,000
65,000
0.43

B
120,000
50,000
0.42

C
200,000
80,000
0.40

D
80,000
30,000
0.38

E
400,000
120,000
0.30

Onthisbasis,projectAisthemostattractivesinceitshowsthehighestPI,andprojectEistheleast attractive. Since the projects are not divisible and projects A and C are mutually exclusive it is not possiblesimplytoworkdowntherankingstodeterminetheoptimumcombination.Insteadthismust bedonealgebraicallyorbytrialanderror.Variouscombinationsofprojectscanbeevaluatedusing the latterapproach.


Outlay
$
NPV
$

A, B, D
350,000
145,000

B, C, D
400,000
160,000

E
400,000
120,000

It appears that the optimum combination of projects is B, C and D. As well as delivering the highest NPV it also has the benefit that all the funds available for investment are used and Filtrex does not face the choice between investments showing a poorer return or returning excess funds to its shareholders.
Useful furtherinformation
The possibility of raising additional finance and at whatcost.
If rationing is to continue, then the effect on the NPV of postponing projects becomes relevant.IfalltheprojectsareequallypostponablethenFiltrexshouldselectthosewhich providethefastestflowoffundsinordertofinancethosewhichhavebeenpostponedas quickly aspossible.
Ithasbeenassumedthatalltheprojectscarryasimilardegreeofrisk.Ifthisisnotthecase then Filtrex should allow for this, for example by the use of sensitivity analysis in its evaluations.
Itmaybethatsomeoftheprojectscarryagreaterstrategicsignificancethanothers. Informationonthisareashouldalsobetakenintoaccountintheinvestmentdecision.
Furtheropportunity
Filtrex might consider some of the following options as a means of exploiting more of these opportunities.
Sale of patentrights
Itcouldacceptthatitwillbeunabletomanageallthelaterstagesofdevelopmentitselfandcould decide to sell some of the patent rights once they have beenobtained.
Jointventures
It could seek joint venture partners to share in the development.
Licensing orfranchising
Some of the areas may be appropriate for licensing or franchising with a royalty being payable to Filtrex.Thisinturncouldhelptofinancethedevelopmentofthoseprojectswhichareretainedforin- housepromotion.

Answers 123

Additionalfinance
It could seek additional finance in the following forms.
Furtherequitybywayofarightsissueor,byagreementwithexistingshareholders,viaa publicissue.
Debt finance secured on the assets. This should be possible since the company iscurrently ungeared.
Debt finance secured against the working capital ie factoring or invoicediscounting.
Itmaybepossibletoarrangeasaleandleasebackofsomeofthecompany'spropertyor equipment.
Dependingonitslocationandbusinesstheremaybethepossibilityofapplyingforgrantaid, for example from one of the EU regional development funds.
Hardcapitalrationingdescribesthesituationwhenafirmispreventedfromundertakingattractive investments for reasons external to thefirm.
Softcapitalrationingdescribesthepositionwhenmanagementplacesalimitontheamountofcapital investment that may be undertaken: it is due to factors internal to thefirm.
Reasons for the deliberate restriction of capital expenditure include the following.
Managementmaydecidetolimitthefundsavailabletothosewhichcanbegeneratedfromretained earnings, for the followingreasons.
Theydonotwishtoissuefurtherequitytopreventoutsidersfromgainingcontrolofthe business.
They do not wish to raise further equity to avoid earningsdilution.
Theydonotwishtocommitthecompanytomeetinglargefixedinterestpaymentson additional debtcapital.
A capital budgeting procedure may be used to ensure that only the best projects areundertaken.
Thenumberofprojectsundertakenmayberestrictedinordertoensurethatthereareadequate management resources available for them to realise their fullpotential.

WardenCo















124 Answers

Marking scheme




Marks

(a) Salesrevenue
0.5


Variable costs
0.5


Fixed costs
0.5


Tax liabilities
1


Working capital recovered
1


Scrap value
0.5


Initial working capital
1


Initial investment
0.5


Discount factors
0.5


NPV calculation
1


Decision as to financial acceptability
1

8

(b) Calculation of revisedNPV
1


Calculation of IRR
2


Comment on financial acceptability
1

4

(c) (i) Explanation ofsensitivityanalysis 2
(ii) After-tax present value ofsalesrevenue 2
Sellingpricesensitivity 2
Discountratesensitivity 1
Commentonfindings 1
6
20



Calculation ofNPV
Year 0 1 2 3 4 5 6

$'000
$'000
$'000
$'000
$'000
$'000
$'000

Sales revenue

1,600
1,600
1,600
1,600
1,600


Variable costs

(1,100)
(1,100)
(1,100)
(1,100)
(1,100)


Fixed costs

(160)
(160)
(160)
(160)
(160)


Before-tax cash flows

340
340
340
340
340


Taxation at 30%


(102)
(102)
(102)
(102)
(102)

Capital investment
(800)




40


Working capital
(90)




90


Project cash flows
(890)
340
238
238
238
368
(102)

Discount factor 11%
1.000
0.901
0.812
0.731
0.659
0.593
0.535

Present value
(890)
306
193
174
157
218
(55)

NPV
103







The net present value is positive and therefore the project is financially acceptable.

Calculation ofIRR
Year
0
1
2
3
4
5

6


$’000
$’000
$’000
$’000
$’000
$’000

$’000

Project cash flows
(890)
340
238
238
238
368

(102)

Discount factor 17%
1.000
0.855
0.731
0.624
0.534
0.456

0.390

Present value
(890)
291
174
149
127
168

(40)

NPV
(21)











Answers 125

 NPVa  

IRR a+ (b a)%
NPVaNPVb 
IRR 11 + 103 17 11
103 21 
15.98%, say 16%
Astheinternalrateofreturnisgreaterthanthecostofcapital,theprojectisfinanciallyacceptabletoWarden Co.
Note: Other discount rates may give a slightly different IRR, but it should still be around 16%.
(i) Thesensitivityofaninvestmentprojecttoachangeinavariablecanbecalculatedastheratioofthe NPV to the present value (PV) of the variable. This shows the relative change in the variable which willmaketheNPVoftheprojectzero.Sensitivityanalysiscanbeusedtocalculatethekeyvariablefor a project and show the area on which management should focus in order to make the project successful.
(ii) Selling pricesensitivity
Assalesrevenueisafive-yearannuitythepresentvaluecanbecalculatedasfollows: 100,000 units × $16 × Five year annuity factor at11%
100,000 × $16 × 3.696 = $5,913,600
ThetaxliabilityfromthisrevenuealsoneedstobeconsideredastheNPVincludesthetaxpaid. Tax liability (before taking account of paying in arrears) = $5,913,600 × 30% = $1,774,080 Discounting by one year to give PV of tax liability = $1,774,080 × 0.901 =$1,598,446
Total PV relating to sales revenue = $5,913,600 – $1,598,446 = $4,315,154 Sensitivity of project to sales revenue = (103,000 / 4,315,154) × 100% = 2.4% Discount rate sensitivity
ChangeindiscountraterequiredforNPVtobezero=16–11=5% Sensitivityofprojecttothediscountrate=(5/11)×100%=45.5%
Ascanbeseenfromtheanalysisabovethecriticalvariableisthesellingpriceastheinvestmentis significantly more sensitive to changes in the sales price than the discountrate.

BQKCo





126 Answers

Marking scheme




Marks


(a) Sales income withoutinflation
1



Inflation of sales income
1



Variable costs without inflation
1



Inflation of variable costs
1



Inflated fixed costs
1



Calculation of tax allowable depreciation
1



Correct use of tax allowable depreciation
1



Calculation of tax liabilities
1



Correct timing of tax liabilities
1



Selection of correct discount rate
1



Selection of discount factors
1



Calculation of net present value
1



Comment on financial acceptability

(b) Customer financingcosts
1

2-3

13


Company financing costs
2-3



Effect on investment appraisal process
2-3
Maximum

7




20








(a) Present value of cashflows




Year 0 1 2 3 4 5
$'000 $'000 $'000 $'000 $'000 $'000
Capital cost
(4,000)


Sales revenue (W1)

5,614
7,214
9,015
7,034


Variable costs (W2)

(3,031)
(3,931)
(5,135)
(4,174)


Fixed costs*

(1,530)
(1,561)
(1,592)
(1,624)


Taxable cash flow

1,053
1,722
2,288
1,236


Tax liabilities


(316)
(517)
(686)
(371)

TAD tax benefits**


300
300
300
300

After-tax cash flow

1,053
1,706
2,071
850
(71)

Discount at 12%
1
0.893
0.797
0.712
0.636
0.567

Present values
(4,000)
940
1,360
1,475
541
(40)

NPV
276






This project has a positive NPV which indicates it should be undertaken.
*Fixed costs are inflated by 2% year on year.
**TAD tax benefits = Purchase cost $4,000k / 4 years × 30%
Workings

1
Sales revenue



Year
1
2
3
4


Small houses selling price ($'000/house)
200
200
200
200


Small houses sales quantity
15
20
15
5


Large houses selling price ($'000/house)
350
350
350
350


Large houses sales quantity
7
8
15
15


Total sales revenue (nearest $'000)
5,450
6,800
8,250
6,250


Inflated sales revenue ($'000/year) – sales
5,614
7,214
9,015
7,034


revenue × 1.03n







Answers 127

2
Variable costs



Year
1
2
3
4


Small houses selling price ($'000/house)
100
100
100
100


Small houses sales quantity
15
20
15
5


Large houses selling price ($'000/house)
200
200
200
200


Large houses sales quantity
7
8
15
15


Total sales revenue (nearest $'000)
2,900
3,600
4,500
3,500


Inflated sales revenue ($'000/year) – sales
revenue × 1.045n
3,031
3,931
5,135
4,174

Impact of a substantial rise in interest rates on BQK’s financingcosts
AsubstantialincreaseininterestrateswillcauseBQK’sborrowingcoststorise.Thecompany’scostofdebt will increase as loans require higher interest payments. This will in turn cause the company’s weighted averagecostofcapital(WACC)toincrease–themorethecompany’scapitalstructureconsistsofdebt,the more the WACC will beaffected.
Ultimately,theincreaseininterestrateswillalsocausethecostofequitytorise.ThisisshownintheCAPM formula:thecostofequityislinkedtotherisk-freerateofreturnatanygiventime,andtherisk-freerateof return(therateofreturnongovernmentsecurities,forexample),variesinaccordancewiththeprevailing interestrate.Thisshouldhaveanevengreaterimpactonthecompanythantheincreaseinthecostofdebt.
Impact of a substantial rise in interest rates on customers’ financing costs
BQK’scustomerswouldbefinancingthepurchaseoftheirhousesthroughlong-termmortgages.Astherate ofinterestrises,existingandpotentialcustomers’borrowingcostswillincrease,makingthehousepurchase moreexpensive.
Impact on the capital investment appraisal process
BQKislikelytousetheWACCasthediscountratetobeappliedinevaluatinginvestmentdecisions. As the WACC increases in response to the rise in interest rates, the present value of investment projectswilldecrease.Asaresult,BQKislikelytoinvestinlessprojects–projectswhich,attimesof lowerinterestrates,wouldhavebeenattractivemaynowbedeemedunsuitable.
BQKwillfinditmoredifficulttosellhouses,asthehighermortgagecostsputoffpotentialhouse- buyers.
Tomakecertaininvestmentprojectsattractive,BQKmayraisehouseprices.However,thisislikelyto further reduce its volume of potentialsales.
Constructionandinfrastructurecostsmayalsoincrease,assupplierslooktopassontheirhigher borrowingcosts.
Insummary,asubstantialriseininterestratesislikelytoreduceBQK’sannualprofits.BQKwillneedto consider a longer time period when appraisinginvestments.

UftinCo







128 Answers




Marks

(a)
Sales revenue
1



Inflated sales revenue
1



Inflated variable costs
1



Inflated fixed costs
1



Excluding interest payments
1



Tax allowable depreciation
1



Balancing allowance
1



Tax liabilities
1



Timing of tax liabilities
1



Net present value
1



Comment on financial acceptability
1





11

(b)
Explanation of first revision
1-3



Explanation of second revision
1-3




Maximum
4

(c)
Discussion of two methods, 2-3 marks per method
Maximum
5




20


Asinflationratesdifferforrevenueandcost,nominalcashflows(ieincludinginflation)needtobecalculated and discounted at the nominal rate (also includinginflation).


0
1
2
3
4
5



$'000
$'000
$'000
$'000
$'000

Revenue
W1

2,475
2,714
4,413
4,775


Variable Cost
W2

(1,097)
(1,323)
(2,084)
(2,370)


Fixed cost
W3

(155)
(159)
(164)
(169)


Before-tax cash


1,223
1,232
2,165
2,236


flows








Taxation at 22%



(269)
(271)
(476)
(492)

Investment

(1,800)





TAD
W4


99
74
56 167

Net cash flow

(1,800)
1,223
1,062
1,968
1,816 (325)

12% discount

1
0.893
0.797
0.712
0.636 0.567

factor (tables)







Present value

(1,800)
1,092
846
1,401
1,154 (184)


Net present value = total of the present value line = $2,509k. As this is positive, the proposal is financially acceptable and should go ahead.
Workings

1
Revenue




1
2
3
4


Price (Current terms) ($)
25
25
26
27


Inflation factor
× (1.042)
× (1.042)2
× (1.042)3
× (1.042)4


Inflated price ($)
= 26.05
= 27.14
= 29.42
= 31.83


× Volume (units)
95,000
100,000
150,000
150,000


= Nominal sales ($)
2,474,750
2,714,000
4,413,000
4,774,500







Answers 129

2
Variable cost



1
2
3
4


Unit cost (currentterms)($) 11
12
12
13


Inflationfactor ×(1.05)
× (1.05)2
× (1.05)3
× (1.05)4


Inflatedprice =11.55
= 13.23
= 13.89
= 15.80


×Volume(units) 95,000
100,000
150,000
150,000


= Nominal variablecost($) 1,097,250
1,323,000
2,083,500
2,370,000

3
Fixed cost





1
2
3
4


Fixed cost (currentterms)($) 150,000
150,000
150,000
150,000


×Inflationfactor ×(1.03)
× (1.03)2
× (1.03)3
× (1.03)4


= Nominal fixedcost($) 154,500
159,135
163,909
168,826

4

Tax allowable depreciation

Taxbenefits


Year


$

$



1 1,800,000 0.25= 450,000
450,000 0.22 =
99,000
2


2 450,000 0.75= 337,500
337,500 0.22 =
74,250
3


3 337,500 0.75= 253,125
253,125 0.22 =
55,688
4


4 Bydifference 759,375
759,375 0.22 =
167,063
5


1,800,000

396,001



You could have chosen any TWO of the followingrevisions.
Inflation
Realcashflows(cashflowsincurrentprices)shouldbediscountedatarealdiscountrateandnominalcash flowsshouldbediscountedatanominaldiscountrate.Thejuniorhascorrectlyappliedoneyearofinflation inyear1,butincorrectlyappliedoneyearofinflationineachofyears2to4.Theinflationinyear2shouldbe
× (1+h)2 and in year 3 should be (1+h)3 and so on.
Interest payments
Interest repayments on the loan should not be included as these are dealt with via the cost of capital.
Tax allowable depreciation
Taxallowabledepreciationiscalculatedonareducingbalancebasisandnotastraightlinebasisasthe junior employee has done. There is also a balancing allowance in the finalyear.
The dates should correspond with the tax payments, so should be received a year in arrears.
Tax timing
ThetaxliabilitydueinYear5wasomitted.Thisisacashflowwhichisrelevanttotheproposalandshould therefore beincluded.
NOTE:Onlytwomethodsarerequiredtobediscussed. Risk anduncertainty
A distinction should be made between the terms risk and uncertainty. Risk can be applied to a situation wherethereareseveralpossibleoutcomesand,onthebasisofpastrelevantexperience,probabilitiescanbe assignedtothevariousoutcomesthatcouldprevail.Uncertaintycanbeappliedtoasituationwherethere are several possible outcomes but there is little past relevant experience to enable the probability of the possible outcomes to bepredicted.
There are a wide range of techniques for incorporating risk into project appraisal.
Sensitivity analysis
Thebasicapproachofsensitivityanalysisistocalculatetheproject'sNPVunderalternativeassumptionsto determinehowsensitiveitistochangingconditions.Onevariableisconsideredatatime.Anindicationis thusprovidedofthosevariablestowhichtheNPVismostsensitive(criticalvariables)andtheextentto


130 Answers

whichthosevariablesmaychangebeforetheinvestmentresultsinanegativeNPV.Sensitivityanalysis therefore provides an indication of why a project mightfail.
Managementshouldreviewcriticalvariablestoassesswhetherornotthereisastrongpossibilityofevents occurring which will lead to a negative NPV. As sensitivity analysis does not incorporate probabilities it shouldnotbedescribedasawayofincorporatingriskintoinvestmentappraisal,althoughitoftenis.
Probability analysis
Probability analysis involves assigning probabilities to either the outcome of an investment project or to differentvaluesofvariablesinaproject.TherangeofNPVsandtheirassociatedjointprobabilitiescanbe usedtocalculateanexpectednetpresentvaluewhichwouldariseiftheprojectwasrepeatedanumberof times.Thisanalysiscanalsoshowworstandbestcasescenarioresultsandtheirassociatedprobabilities.It canalsoshowthemostandleastlikelyoutcomes.Thiswouldallowmanagerstoconsidertheriskprofileof the project before making adecision.
Risk-adjusted discount rate
In investment appraisal, a risk-adjusted discount rate can be used for particular types or risk classes of investment projects to reflect their relative risks. For example, a high discount rate can be used so that a cashflowwhichoccursquitesometimeinthefuturewillhavelesseffectonthedecision.Alternatively,with thelaunchofanewproduct,ahigherinitialriskpremiummaybeusedwithadecreaseinthediscountrate as the product becomesestablished.
Adjusted payback
Onewayofdealingwithriskistoshortenthepaybackperiodrequired.Amaximumpaybackperiodcanbe set to reflect the fact that risk increases the longer the time period under consideration and a shorter paybackperiodwillfocusoncashflowsthataremorecertainbecausetheyarenearerintimetothepresent day.
HraxinCo


Marks
Mean selling priceperunit 0.5
Inflated selling priceperunit 1
Inflatedrevenue 1
Inflatedoverhead 1
Taxliabilities 1
Timing oftaxliabilities 1
Tax-allowabledepreciationbenefits 1
Answers 131


Scrap value

0.5





Present values of future cash flows

1





Comment on financial acceptability

1









9


(b)
Discussion of risk and uncertainty distinction

3





Value of considering risk and uncertainty

2









5


(c)
Explanation of sensitivity analysis

1-3





Explanation of risk in investment appraisal

1-2





Discussion of sensitivity analysis and risk

1-3







Maximum

6







20











(a)

Calculation of expected net present value Year







Year 1
2
3
4




$000
$000
$000
$000




Revenue 4,524
7,843
13,048
10,179




Variablecost (2,385)
(4,200)
(7,080)
(5,730)




Contribution 2,139
3,643
5,968
4,449




Overhead (440)
(484)
(532)
(586)




Cash flowbeforetax 1,699
3,159
5,436
3,863




Tax (510)
(948)
(1,631)
(1,159)




Depreciationbenefits 338
338
338
338




Cash flowaftertax 1,527
2,549
4,143
3,042




Scrap value


500




Projectcashflow 1,527
Discountat11% 0.901
2,549
0.812
4,143
0.731
3,542
0.659



Present values
1,376
2,070
3,029
2,334



$000



PV of future cash flows

8,809



Initial investment

(5,000)



Expected net present value (ENPV)

3,809



TheinvestmentprojecthasapositiveENPVof$3,809,000.ThisisameanoraverageNPVwhichwillresult fromtheprojectbeingrepeatedmanytimes.However,astheprojectisnotbeingrepeated,theNPVsassociated witheachfutureeconomicstatemustbecalculatedasitisoneoftheseNPVswhichisexpectedtooccur.Thedecision bymanagementonthefinancialacceptabilityoftheprojectwillbebasedontheseNPVsandtheriskassociatedwith eachone.
Workings
Mean or average selling price = (25 0.35) + (30 0.5) + (35 0.15) = $29 per unit

Year
1
2
3
4

Inflated selling price ($ per unit)
30.16
31.37
32.62
33.93

Sales volume (units/year)
150,000
250,000
400,000
300,000

Sales revenue ($000/year)
4,524
7,843
13,048
10,179

Year
1
2
3
4

Inflated overhead ($000/year)
440
484
532
586

Totaltax-allowabledepreciation=5,000,000–500,000=$4,500,000 Annualtax-allowabledepreciation=4,500,000/4=$1,125,000peryear
Annual cash flow from tax-allowable depreciation = 1,125,000 0.3 = $337,500 per year





132 Answers

Theterms risk and uncertainty are often used interchangeably but a distinction should be made between them.Withrisk,thereareseveralpossibleoutcomes,whichuponthebasisofpastrelevantexperience,can be quantified. In areas of uncertainty, again there are several possible outcomes, but with little past experience, it will be difficult to quantify its likelyeffects.
Ariskysituationisonewherewecansaythatthereisa70%probabilitythatreturnsfromaprojectwillbein excess of $100,000 but a 30% probability that returns will be less than $100,000. If, however, no informationcanbeprovidedonthereturnsfromtheproject,wearefacedwithanuncertainsituation.
Managersneedtoexercisecautionwhenassessingfuturecashflowstoensurethattheymakeappropriate decisions.Ifaprojectistoorisky,itmightneedtoberejected,dependingupontheprevailingattitudeto risk.
Ingeneral,riskyprojectsarethosewhosefuturecashflows,andhencetheprojectreturns,arelikelytobe variable.Thegreaterthevariabilityis,thegreatertherisk.Theproblemofriskismoreacutewithcapital investment decisions than other decisions because estimates of cash flows might be for several years ahead,suchasformajorconstructionprojects.Actualcostsandrevenuesmayvarywellaboveorbelow budget as the workprogresses.
Sensitivity analysis assesses the extent to which the net present value (NPV) of an investment project responds to changes in project variables. Two methods are commonly used: one method determines the percentagechangeinaprojectvariablewhichresultsinanegativeNPV,whiletheothermethoddetermines the percentage change in NPV which result from a fixed percentage change (for example, 5%) in each projectvariableinturn.Whichevermethodisused,thekeyorcriticalprojectvariablesareidentifiedasthose to which the NPV is most sensitive, for example. Those where the smallest percentage change result in a negative NPV. Sensitivity analysis is therefore concerned with calculating relative changes in project variables.
Whendiscussingriskinthecontextofinvestmentappraisal,itisimportanttonotethat,unlikeuncertainty, riskcanbequantifiedandmeasured.Theprobabilitiesoftheoccurrenceofparticularfutureoutcomescan beassessed,forexample,andusedtoevaluatethevolatilityoffuturecashflows,forexample,bycalculating theirstandarddeviation.Theprobabilitiesofthefutureeconomicstatesintheassessmentoftheinvestment projectofHraxinCoareanexampleofprobabilityanalysisandtheseprobabilitiescanleadtoanassessment of projectrisk.
Sensitivity analysis is usually studied in investment appraisal in relation to understanding how risk can be incorporatedintheinvestmentappraisalprocess.Whilesensitivityanalysiscanindicatethecriticalvariables ofaninvestmentproject,however,sensitivityanalysisdoesnotgiveanyindicationoftheprobabilityofa changeinanycriticalvariable.Sellingpricemaybeacriticalvariable,forexample,butsensitivityanalysisis notabletosaywhetherachangeinsellingpriceislikelytooccur.Intheappraisaloftheinvestmentproject ofHraxinCo,theprobabilitiesofdifferentsellingpricesarisingtherelatedeconomicstateshavecomefrom probability analysis, not from sensitivityanalysis.
SensitivityanalysiswillnotthereforedirectlyassistHraxinCoinassessingtheriskoftheinvestmentproject. However, it does provide useful information which helps management to gain a deeper understanding projectandwhichfocusesmanagementattentiononaspectsoftheinvestmentprojectwhereproblemsmay arise.

MCQ bank – Sources of finance
D Short-termloansaresubjecttoaloanagreementgivingthebanksecurityandadefiniterepayment schedule.Thislowerstheriskfromtheirperspective,hencetheinterestratechargedislower.
Syllabus area E1a
A Ordinarysharesaremostriskyfromthedebtholder'sperspective–thecompanycandecidewhether and how much of a dividend topay.
Preferencesharesarenextmostrisky–dividendsareonlypayableifprofitisavailabletopay dividendsfrom.



Answers 133

Tradepayablesarenextbecausetheyhavetobepaidbeforeshareholdersbutaretypically unsecured.
Finally, banks with fixed and floating charges face least risk.


156 D $1.92

$2 ×
4
=
$8.00

$1.60 ×
1
=
$1.60


5

$9.60


Theoreticalexrightsprice=$9.60/5=$1.92
Syllabus area E1b





Syllabus area E1c

D Zerocouponbondsareissuedatadiscounttotheirredemptionvalueanddonotpayanyinterest.
Syllabus area E1b
A Bismudaraba.Cismurabaha.Disijara.Akeyprincipleisthatcharginginterest,andmakingmoney frommoneylendingaloneisforbiddenunderSharia'alaw,soprovidersoffinancearemoredirectly involved with the risks and rewards of the businesses theyfinance.


MCQ bank – Dividend policy
Syllabus area E1d

A ModiglianiandMiller(M&M)assumeperfectcapitalmarketssothereisnoinformationcontentin dividendpolicy.Theyassumenotaxesortaxpreferencessoinvestorswillbeindifferentbetween income and capital gains. They also assume no transaction costs so investors can switch between income and capital gains without cost – eg if a company withholds a dividend when the investor wouldprefercash,theinvestorcansellsomeoftheirshares(knownas'manufacturingadividend'). M&M's theory is not contingent upon the existence or otherwise ofinflation.
Syllabus area E1e
B Thesignallingeffectalludestotheinformationcontentinthedividendannouncement.Insemi-strong formcapitalmarketswithimperfectinformation,investorswill'interpret'dividendannouncements andbycomparingthemtoexpectationstheywilladjusttheirperceptionsofpast,currentandfuture performance.
Syllabus area E1e
B M&Mstatedthatincomepreferenceisirrelevantindecidingdividendpolicy,becauseifyou'assume away' taxation and transaction costs, it is costless for investors to switch from capital gain to dividends by selling someshares.
Syllabus area E1e
C Toincentiviseinvestorstochoosethesharesalternativefortheirdividend,companiescanofferan 'enhanced scrip' ie offer more value in shares than the cashalternative.
Syllabus area E1e
A CompanySunCo=Constantgrowth.CompanyMoonCo=Constantpay-out.CompanyNiteCo= Residual/random
CompanySunCodividendsaregrowingat10%perannumeventhoughearningsarenot. Company Moon Co is paying 50% of its earnings out as a dividendconsistently.
CompanyNiteCo'sdividendsarenotobviouslyconnectedwithreportedearnings,sotheirpolicyis eitherresidual(ieonlypayingdividendsonceinvestmentplansarebudgetedfor)orrandom.
Syllabus area E1e




134 Answers

MCQ bank – Gearing and capital structure
C Operational gearing = Contribution / Profit before interest andtax.
Contribution = Revenue – variable cost = 10,123 – (70% × 7,222) – (10% × 999) = 4,967.70
Operational gearing = 4,967.70 / 1,902 = 2.61


165 D 53%
Market value of equity = $5.50 × $100m = $550m
Marketvalueoflongtermdebt=$500m×(125/100)=$625m Therefore financial gearing = 625 / (625 + 550) = 53%
Syllabus area E3d





Syllabus area E3d

D Statements A and B are incorrect. They may be true but are not definitions of financialrisk.
Statement C is incorrect. Overall, dividends may be lower as gearing increases compared to an equivalent ungeared firm, but there are fewer shareholders/shares in the geared equivalent, meaning dividend per share could be higher, lower or the same as the ungeared firm.
Statement D is correct. As interest payments do not vary with profits, interest is effectively a fixed costtothebusiness.Highfinancialgearingmeansthatacompanyismorevulnerabletopoortrading conditions. For example, reductions in revenue result in relatively large reductions in profits and dividends, as there are less variable costs to cushion the reduction in revenue. The opposite is the case with increases in revenue, thus shareholders in a geared firm face higher variability in their returns.
Syllabus area E3a
B Interestcoverwillrise.Gearingwillfall.Allelsebeingequallessinteresttopaywillmeanahigher interestcover.
(Interestcover=ProfitBeforeInterestandTax/Interest) Reducing debt will reduce the gearingratio.
Syllabus area E3d
B P/E ratio will increase. Dividend yield willdecrease.
Inrelationtoexpectations,resultsbeingbetterthanexpectedwouldboostshareprice.Thiswould increase the price / earningsratio.
Bythesamelogic,dividendyieldwouldreduce.Dividendyieldiscalculatedasdividend/shareprice; hence a higher share price would reduce theratio.
Syllabus area E3d
C Both statements aretrue.
SMEsareprivatecompanieswithalimitednumberofshareholders.Unlesstheshareholdersare wealthy,thereisalimittotheamountofextracapitaltheymaybeabletoinvest.
Venturecapitalisapotentialsourceoffinancing.However,itisnotnecessarilyeasyforSMEsto attractventurecapital.Theymustbeabletodemonstratestrongopportunitiesforprofitgrowth.
Syllabus area E5
B Statement 1 and Statement 2 aretrue
Statement1.ThemainhandicapthatSMEsfaceinaccessingfundsistheproblemofuncertaintyand riskforlenders.Thisisbecausetheyhaveneitherthebusinesshistorynorthelongtraderecordthat larger organisationspossess.
Statement 2. Larger enterprises are subject by law to more public scrutiny and their financial statementshavetocontainmoredetailandbeaudited,givinggreaterclaritytoinvestorsthanless detailed financial statements of smallercompanies.

Answers 135

Statement3.Oncesmallfirmshavebecomeestablishedtheydonotnecessarilyneedtoseeka market listing to obtain equity finance. Shares can be placedprivately.
Syllabus area E5
C Both statements aretrue
Statement 1 is true. For long-term loans, security can be provided in the form of property (eg mortgages)butSMEsmaynothavesuitablesecurityforamedium-termloanduetomismatchingof the maturity of assets and liabilities. This problem is known as the maturitygap.
Statement2istrue.Afundinggapisashortfallincapitalneededtofundtheongoingoperationsand this is a common problem forSMEs.
Syllabus area E5
D Thisisknownasbusinessangelfinancing.Businessangelsarepreparedtotakehighrisksinthe hope of highreturns.
Syllabus area E5
B Statement1isfalse.SCFallowsabuyertoextendthetimeinwhichitsettlesitsaccountspayable. For the supplier, it is a sale of theirreceivables.
Statement2istrue.Thebuyerisusuallyalargecompanywithagoodcreditrating.Thismeansthat lowinterestratesarechargedtothesupplierbytheintermediaryfundprovider,forprovidingthe supplier with finance, ie, in the form of purchasing itsinvoices.


CBE style OTQ bank – The cost of capital
174 $1.73
20X9 to 20Y3 covers 4 years of growth,
Syllabus area E5

sotheaverageannualgrowthrate= Ke = d0(1+ g) +g

P0
Ke –g= d0 (1g)
P0
P0 = d0 (1g)
Ke – g
– 1 = 0.178 = 17.8%

= (423,000 × 1.178) / (0.25 – 0.178) = $6,920,750 for 4 million shares = $1.73 per share
Syllabus area F2c
31% Using Gordon's growth approximation,g=br
g=proportionofprofitsretained×rateofreturnoninvestment. Proportionofearningsretained=($1.50–$0.5)/$1.50=66.7%
Rateofreturnoninvestment=EPS/netassetspershare=$1.5/$6=0.25so25% g = 66.7% × 25% =16.7%
Ke = d0 (1g) + g P0

=($0.50×1.167)+0.167
($4.50 – $0.50)
= 31%

Note: Share price given is cum div


Syllabus area E2a


136 Answers

The residual risk associated with investing in a well-diversifiedportfolio
‘Thechancethatautomatedprocessesmayfail’isincorrect.Systematicriskreferstoreturnvolatility, not automatedprocesses.
‘Theriskassociatedwithinvestinginequity’isincorrect.Thisdescribestotalrisk,whichhasboth systematic and unsystematicelements
‘Thediversifiableriskassociatedwithinvestinginequity’isincorrect.Systematicriskcannotbe diversifiedaway
‘Theresidualriskassociatedwithinvestinginawell-diversifiedportfolio’iscorrect.Itistherisk generated by undiversifiable systemic economic riskfactors.
Syllabus area E2a
177 13.4%
Theequitybetarelatestothecostofequity,hencegearingandthedebtbetaarenotrelevant. E(ri)=Rf+β (E(Rm)–Rf)=3%+(1.3×8%)=13.4%
Syllabus area E2a
178 Increases to 9.4% Kd= i(1–T) /Po
The loan note pays interest of $100 nominal × 10% = 10%. Ex-interest market price is $95 – $10 =
$85.
Before the tax cut Kd= 10(1 – 0.3) / 85 = 8.2%
After the tax cut Kd= 10(1 – 0.2) / 85 = 9.4%
Decreasing tax reduces tax saved therefore increases the cost of debt.
Syllabus area E2b
179 11.5%
Conversionvalue:Futureshareprice=currentsharepriceincludinggrowth=$2.50×(1.1)5=$4.03. So conversion value = 20 × $4.03 = $80.60. The cash alternative = 100 × 1.1 = $110 therefore investors would not convert and redemption value =$110.
Kd = IRR of the after tax cash flows as follows:

Time
DF 10%
Present value
DF 15%
Present value



10%

15%


$
($)

($)

0
(90) 1
(90)
1
(90)

1-5
10(1 – 0.3)=7 3.791
26.54
3.352
23.46

5
110 0.621
68.31
0.497
54.67



4.85

( 11.87)




IRR = a+
NPVa NPVa – NPVb

(b – a)

=10%+ 4.85
(4.85 + 11.87)
(15% – 10%)




180 11.7%
= 11.5%


Syllabus area E2b

Kd= i(1 – T) / P0= 13(1 – 0.3) / 90 = 10.11% Vd= $7m × (90/100) = $6.3m
Ke= 12% (given)
Ve= $3 × 10m shares= $30m Note: reserves are included as part of shareprice

Answers 137

Ve+Vd= $6.3m + $30m = $36.3m

WACC= Ve
  V 
k  k



V V e V V d
⎝e d ⎝e d

= [30/36.3]12% + [6.3/36.3]10.11% =11.7%


181 1, 2 and3


Syllabus area E2c

ChangesincapitalstructurewillaffecttheWACCsoneedtostayconstant.ThecurrentWACCreflects ariskpremiumrelatingtocurrentoperations,hencethenewprojectshouldbeofasimilarriskprofile to current operations. The project should be small in size; large projects are both riskier (commandingariskpremium)andlikelytoaffectthevalueofequity,inturnaffectingtheWACC.
Syllabus area E3e
182 Companies are welldiversified
‘Efficientcapitalmarkets’isanecessaryassumption.Sharepricecanbeusedtoaccuratelycalculate betafactors.
‘Welldiversifiedinvestors’isanecessaryassumption.Shareholdersonlyrequirecompensationfor systematic risk ie the risk that cannot be diversifiedaway.
‘Futureperiodsareconsistentwiththepresent’isanecessaryassumption.Betafactorsareestimated usinghistoricaldata,butthecostofequityistobeusedtoappraiseafutureproject,henceweneed to assume the historical beta willcontinue.
‘Companies are well diversified’ is not a necessary assumption. So long as investors are well diversified,anyindividualcompanyneednotbe.Investorsareassumedtoinvestinadiversified portfolioofprojects.Itdoesn'tmatterhowfeworhowmanyresideinanyonecompany.
Syllabus area E2a
183 15.4%
Ex-div share price = $0.30 – (8% × $0.50) = $0.26 Kp= $0.50 × 8% / $0.26 = 15.4%
Note: dividends are not tax deductible hence no adjustment for corporation tax is required.
Syllabus area E2b
CBE style OTQ bank – Capitalstructure
It should take on equity finance, as their gearing is probably beyondoptimal.
‘Itshouldtakeondebtfinance,astodosowillsavetax’referstoModigliani-Miller(MM)withtax: raisingdebtfinancewillincreaseinterestpaymentsandhencesavetax,addingtothetotalreturnsa businessgenerates.
‘It should take on equity finance, as their gearing is probably beyond optimal’ is correct: the traditional view implies that once gearing has gone beyond optimal the weighted average cost of capital(WACC)willincreaseifmoredebtistakenon.AsACoissignificantlymorehighlygearedthan theindustrystandard,itisprobablyreasonabletoassumeitsgearingisbeyondoptimal.
‘It doesn't matter, as it won't affect the returns the projects generate’ refers to MM with no tax: payinginterestorpayingdividendsdoesnotaffecttheoverallreturnsgeneratedbyanon-taxpaying business.
‘More information is needed before a decision can be made’ is incorrect: see 'B' above.
Syllabus area E4a&b
Interest payments are taxdeductible
‘Debtischeaperthanequity’:Althoughtrue,highergearingincreasesthecostofequity(financial risk) therefore this doesn't in itself explain a reducingWACC.


138 Answers

‘Interestpaymentsaretaxdeductible’iscorrect:TheonlydifferencebetweenMM(notax)andMM (withtax)isthetaxdeductibilityofinterestpayments.MMdemonstratedthatwhenabusinessdoes notpaytax,returnsarenotaffectedbycapitalstructure.However,asinterestistaxdeductible(and dividendsarenot)payingrelativelymoreinterestwillreducetaxpayableandincreasetotalreturnsto investors.
‘Reduced levels of expensive equity capital will reduce the WACC’ is similar to Statement A.
‘Financialriskisnotpronouncedatmoderateborrowinglevels’referstothetraditionalview.MM assume financial risk is consistently proportionate to gearing across alllevels.
Syllabus area E4b

Modigliani-Miller (with tax) and the traditionalview
Option1.MM(withtax)assumesincreasedgearingwillalwaysreducetheweightedaveragecostof capital(WACC).
Option2.Atlowlevelsofgearing,thetraditionalviewstatesfinancialriskislow,hencemore inexpensive debt will reduce theWACC.
Option3isnotrelevant:peckingordertheoryrelatestoalogicalorderforchoosingfinancebasedon convenience and issuecost.
Option 4. MM (no tax) concludes that the gearing level will not affect the WACC.
Syllabus area E4a&b
Traditionalview MM (notax)
Thetraditionalviewhasa'u'shapedweightedaveragecostofcapital(WACC)curvehencethereisan optimal point where WACC isminimised.
MM (with tax) assumes 100% gearing is optimal, so there is no balance with equity.
MM(notax)assumestheWACCisunaffectedbythelevelofgearing.AstheWACCisthediscount ratefortheprojectsofthebusinessitfollowsthatthevalueofthebusinessisunaffectedbythe gearingdecision.
Syllabus area E4a&b

Internal funds, debt, newequity
Peckingordertheorysuggeststhatasinternalfundsarefreetoraiseandimmediatetheyshouldbe usedfirst.Afterthat,debtisrelativelyquickandinexpensivetoraise,interestistaxdeductibleand the cost of debt is lower than the cost of equity. New equity is relatively expensive hence is consideredlast.
Syllabus area E4d

189 0.89.
BCoisbeingusedasaproxycompanyandhasadifferentlevelofgearingtoTRCo. Ungear B Co's equitybeta:

ßa = ße ×
Ve

Ve + Vd 1– T

= 1.05 ×

= 0.89

190 8.4%
4


4+ 11– 0.3



Syllabus area E3e

Regear ßa using TR assumption of a gearing level of 1:3 debt : equity



Answers 139

ße = ßa ×
Ve Vd(1T) Ve

ß = 0.89 × 3 1(10.3)
3
ße= 1.10
Put into CAPM:

Ke
=
Rf+ ß(E(rm) – Rf)
Rf= 4%, E(Rm) – Rf= 4% (market premium)

Ke
=
4 + 1.10(4)



=
8.4%

Syllabus area E3e

An equity beta also includes an element of financialrisk
An equity beta reflects both business risk and financial risk. An asset beta only reflects the former.
Syllabus area E3e
If the project is different from currentoperations
A project-specific cost of capital is relevant to appraise a project with a different risk profile from current operations. In these circumstances the current weighted average cost of capital is not relevant–soproxyinformationisusedtocalculateaprojectspecificcostofcapitalforthatparticular appraisal.
Syllabus area E3e
As deductions have reduced tax payable to zero, further deductions won't savetax
Taxexhaustiontypicallyreferstoasituationwherealthoughinterestpaymentsaretaxdeductible,tax expenseshavealreadybeeneliminatedcompletelyandsoanyfurtherinterestpaymentscannotsave more tax. The cost of additional debt is the gross cost (moreexpensive).
Syllabus area E3c

IML Co
194 12%
Therequiredrateofreturnonequitycanbefoundusingthecapitalassetpricingmodel: E(ri) = Rf+ i(E(rm) –Rf)
AZT Co
E(ri) = 5% + 0.7(15% –5%)
= 12%
195 32%
Total shareholder return = P1 P0 D
P0
= (315 – 250) + 15
250
= 0.32 = 32%








140 Answers

196 1.2
TheequitybetaforIMLcanbefoundusingthesameexpression: 17% = 5% + (15% –5%)
= (17% – 5%)
(15% – 5%)
The equity beta factor = 1.2
Statements 1 and 4 aretrue.
Theequitybetafactorisameasureofthevolatilityofthereturnonasharerelativetothestockmarket.Iffor exampleasharepricemovedatthreetimesthemarketrate,itsequitybetafactorwouldbe3.0.
Thebetafactorindicatesthelevelofsystematicrisk,whichistheriskofmakinganinvestmentthatcannot be diversifiedaway.
Itisusedinthecapitalassetpricingmodeltodeterminethelevelofreturnrequiredbyinvestors;thehigher the level of systematic risk, the higher the required level ofreturn.
It is true that companies want a return on a project to exceed the risk-free rate.
Both statements aretrue.
UndertheCAPM,thereturnrequiredfromasecurityisrelatedtoitssystematicriskratherthanitstotalrisk. Onlytherisksthatcannotbeeliminatedbydiversificationarerelevant.Theassumptionisthatinvestorswill holdafullydiversifiedportfolioandthereforedealwiththeunsystematicriskthemselves.
The CAPM is unable to forecast accurately returns for companies with low price/earnings ratios.

BarCo




Rightsissueprice 1
Theoreticalex-rightsprice 2
Nominal value ofbondsredeemed 1
Interest saved onredeemedbonds 1
Earningsafterredemption 1
Currentprice/earningsratio 1
Revisedshareprice 1
Comment on acceptabilitytoshareholders 1-2
Comment on constantprice/earningsratio 1-2
Marks
3

Maximum 7






Answers 141

Currentinterestcoverage 0.5
Revisedinterestcoverage 1
Currentdebt/equityratio 0.5
Reviseddebt/equityratio 1
Comment onfinancialrisk 1
Explanation ofbusinessrisk 1
Explanation offinancialrisk 1
Up to 2 marks for each danger ofhighgearing 4




4


6
20





The rights issue price is at a 20%discount
$7.5 × 0.8 = $6 per share
Number of shares to be issued = $90m / $6 = 15 million shares Current number of shares in issue = 60 million
Therefore the rights issue will be a 1 for 4 issue
Theoretical ex-rights price
$
4 shares@$7.50 30.00
1 share@$6.00 6.00
36.00

Theoretical ex-rights price (TERP) = 36/5 = $7.20
Theproposaltobuybackthebondswillonlybeacceptabletoshareholdersifitincreasesshareholder wealth.
Thebondswouldbeboughtbackatmarketprice($112.50),whichishigherthanthenominalvalue($100). Thenominalvalueofbondsthatwillbeboughtbackis$90million/$112.50×$100=$80million.
Interestsavedonthesebonds=$80m×0.08=$6.4mperyear New annual interest charge = $10m – $6.4m =$3.6m
Revised profit before tax = $49m – $3.6m = $45.4m
Revised profit after tax (earnings) = $45.4m × 0.7 = $31.78m Revisedearningspershare=$31.78m/75m=42.37centspershare
Currentearningspershare=$27m/60m=45centspershare Current price/earnings ratio = 750/45 = 16.7times
Assumingtheprice/earningsratioremainsconstant,therevisedsharepricewillbe Share price = 16.7 × 42.37 = 708 cents or $7.08 pershare.
Thisrevisedsharepriceislessthanthetheoreticalex-rightspriceandthereforeusingtheissueproceedsto buybackdebtwillnotbeacceptabletotheshareholdersastheirwealthwillhavedecreased.
This conclusion has been reached based on the assumption that the price/earnings ratio remains unchanged. However, the share price will be determined by the stock market and this will determine the price/earningsratio,ratherthantheprice/earningsratiodeterminingtheshareprice.Buyingbackdebtwould decreasethefinancialriskofBarCoandthiscouldcausethecostofequitytofallsinceshareholderswillbe takingonlessrisk.Thismeansthesharepriceislikelytoriseandthereforetheprice/earningsratiowillalso increase. If the share price were to increase above the theoretical ex-rights price, which would mean the price/earnings ratio would be at least 17 times, the shareholders would find the debt buy back to be an acceptable use of funds as they would experience a capitalgain.



142 Answers

Currentinterest coverage ratio = 49m / 10m = 4.9 times Revisedinterestcoverageratio=49m/3.6m=13.6times
Current debt/equity ratio = 125m/140m = 89.3% Revised book value of debt = 125m – 80m = $45m
Revised book value of equity = 140m + 90m – 10m = $220m
$10millionhasbeendeductedbecause$90millionwasspenttoredeembondswithanominalvalueof$80 million.
Revised debt/equity ratio = 45m/220m = 20.5%
Note:Fullcreditwouldalsobegivenforacalculationthatomittedthe$10millionloss.Therevised debt/equity ratio would be 45m/230m =19.6%.
Redeemingthebondswithabookvalueof$80millionwouldsignificantlyreducethefinancialriskofBarCo. This is shown by the reduction in gearing from 89.3% to 20.5% and the increase in the interest coverage from 4.9 times to 13.6times.
(i) Businessrisk,theinherentriskofdoingbusinessforacompany,referstotheriskofmakingonly lowprofits,orevenlosses,duetothenatureofthebusinessthatthecompanyisinvolvedin.One way of measuring business risk is by calculating a company's operating gearing or 'operational gearing'.
Operatinggearing= Contribution
Profit before int erest and tax (PBIT)
The significance of operating gearing is as follows.
If contribution is high but PBIT is low, fixed costs will be high, and only just covered by contribution. Business risk, as measured by operating gearing, will behigh.
If contribution is not much bigger than PBIT, fixed costs will be low, and fairly easily covered. Business risk, as measured by operating gearing, will below.
Ahighlevelofdebtcreatesfinancialrisk.Thisistheriskofacompanynotbeingabletomeetother obligationsasaresultoftheneedtomakeinterestpayments.Theproportionofdebtfinancecarried by a company is therefore as significant as the level business risk. Financial risk can be seen from different points ofview.
Thecompanyasawhole.Ifacompanybuildsupdebtsthatitcannotpaywhentheyfalldue, it will be forced intoliquidation.
Payables.Ifacompanycannotpayitsdebts,thecompanywillgointoliquidationowing payables money that they are unlikely to recover infull.
Ordinaryshareholders.Acompanywillnotmakeanydistributableprofitsunlessitisableto earnenoughprofitbeforeinterestandtaxtopayallitsinterestcharges,andthentax.The lower the profits or the higher the interest-bearing debts, the less there will be, if there is anything at all, forshareholders.
YGVCo


Answers 143





Calculation of after-taxinterestpayment 1
Calculation of after-tax costofdebt 3
Currentinterestcoverage 1
Revisedinterestcoverage 1
Currentgearing 1
Revisedgearing 1
Comment on interestcoverageratio 1-2
Commentongearing 1-2
Comment on needforsecurity 2-3
Comment on advisability ofbondissue 1-2
Discussion of alternative sourcesoffinance 4-5
Otherrelevantdiscussion 1-2
Marks


4



4

Maximum 12
20


(a)
The after tax interest charge per bond is $9 × 0.7 = $6.30
Two discounts should be chosen, 6% and 8%



Year 0
$
Cashflow (100)
1-10
$ 6.30
10
$ 110


Discount factor@8% 1.000
6.710
0.463


Presentvalue (100.00)
42.27
50.93


Net present value = (6.80)




Year 0
$
Cashflow (100)
1-10
$ 6.30
10
$ 110


Discount factor@6% 1.000
7.360
0.558


Presentvalue (100.00)
(46.37)
61.38


Net present value = 7.75




Cost of debt = 6 + [(8 – 6) × 7.75 / (7.75 + 6.8)] = 6 + 1.1 = 7.1%



(b)
(i) Thecurrentlevelofinterestchargeperyearis$4.5m×5%=$225,000




Current interest coverage ratio = PBIT/Interest




1m / 0.225m = 4.4 times




Interest on bonds after issue = $4m × 9% = $360,000




Interest on overdraft = $0.5m × 5% = $25,000




Total interest per year = $385,000




Interest coverage ratio with bond issue = 1m / 0.385m = 2.6 times




144 Answers

(ii) Thecurrentmarketcapitalisationis$4.10×10millionshares=$41million Current gearing = zero (as no long-termdebt)
Gearingfollowingbondissue(debt/equity)=4m/41m=9.8% Alternatively if the overdraft is included in the calculations Current gearing = 4.5m / 41m =11.0%
Gearing following bond issue (debt/equity) = 4.5m / 41m = 11.0%
(c) Interest coverageratio
Thecurrentinterestcoverageratioisalmosthalfofthesectoraverageof8.Althoughwiththeprioryear profitbeforetaxitwas22times.Followingthebondissuethiswoulddropto2.6timeswhichisalowlevel of cover compared to the sector average and may create operational issues forYGV.
Gearing
Whethertheoverdraftisincludedinthegearingcalculationornot,therevisedgearinglevelofeither9.8%or 11% is not significantly different from the sector average of 10%. As a result, there are no concerns about the level of gearing resulting from the bondissue.
Security
Thereductioninprofitabilitywillincreasethelikelihoodofthebondissueneedingtobesecuredagainstthe non-current assets of YGV. This may create issues as the tangible non-current assets of YGV have a net bookvalueof$3million,whichdoesnotcoverthevalueofthebondissueof$4million.Itisunlikelythat the intangible assets could be used as security, but their nature has not beendisclosed
Using the bond to reduce the overdraft
Consideringtheissuesraisedabove,particularlythefallintheinterestcoverageandthelackofassetstouse assecurity,thebondissueisnotrecommendedasitisunlikelytosucceed.Asaresult,alternativesources of finance should be considered in order to reduce theoverdraft.
Alternative sources of finance
Thereisalackofavailabilityofadditionaloverdraftfinance,sothisisnotaviableoption.Theissuewiththe lack of interest coverage will also rule out any other form of debtfinance.
Anyprovideroffinancewillfirstneedtobereassuredthatthefallinprofitabilityisduetoshort-termreasons and that YGV will continue to be a going concern in the longterm.
Theamountoffinancerequiredisthe$4millionrequiredtoreducetheoverdraft,butthisamountcouldbe reducedthroughworkingcapitalmanagement,particularlygiventheamountofworkingcapitaltiedupin accountsreceivable.
Noinformationisgivenaboutdividends,butifthesearepaidtheycouldbeeitherreducedtoincreasethe amount of retained earningsavailable.
Equity finance is the most likely source of finance to consider. YGV may consider a rights issue. The offer price will be lower than the market price and given the situation a fairly large discount may need to be applied. A discount of 25% would give a price for the rights issue of $3.08. A 1 for 7 rights issue at this pricewouldraise$4.4millionwhichcouldreducetheoverdraftto$100,000wheretheinterestchargewould only be $5,000 peryear.
Anewissueofsharesisapossibilityas$4millionisonly9%ofthetotalsharesinissueatthatpoint($45 million).Thismeansthatdilutionofexistingholdingswillnotbeasignificantissue.Newshareholdersmay notbeattractedtoinvestiftherearenodividendsonofferthough.Anewissueofshareswouldalsobe more expensive forYGV.
Saleandleasebackisnotlikelytoraisesignificantlevelsoffinance,giventhetangiblenon-currentasset level of $3 million, but could be used alongside another source offinance.
Convertible bonds could also be considered as an alternative.





Answers 145

NNCo




(a)

Correct use of taxation

1
Marks


Calculation of after-tax cost of debt
3





4

(b)
Cost of preference shares
1



Market value of equity
1



Market value of preference shares
1



Market value of debt
1



Weighted average cost of capital
2





6

(c)
Profitability
1-2



Liquidity
1-2



Legal and other restrictions
1-2



The need for finance
1-2



The level of financial risk
1-2



The signalling effect of dividends
1-2




Maximum
10

20


ThecostofredeemabledebtisfoundbyanIRRstylecalculationusinglinearinterpolation. The annual after tax interest payment is 7 × (1 – 0.25) =$5.25







The approximate cost of redeemable debt capital is, therefore:

(4 +
3.02

(3.022.25)
1) = 4.6%



146 Answers

Note:Thecostofdebtwillvarydependingonthediscountsratesused.Othervaluescalculatedforthecost of debt would also beacceptable.
Preferencedividend=8%×50cents=4cpershare Cost of preferenceshares

kp=
d = 4/67 = 0.06 = 6%
P0

Number of ordinary shares = $50m / 0.5 = 100m Market value of equity Ve= 100m × 8.30 = $830m Numberofpreferenceshares=$25m/0.5=50mshares
Market value of preference shares Vp= 50m × 0.67= $33.5m
Marketvalueoflong-termborrowings=Vd=20m×103.50/100=$20.7m Marketvalueofcompany=Ve+Vd+Vp=830+33.5+20.7=$884.2m

 V
WACC= e
k+ Vd
  V 
k (1 –T)+ p k



 e
⎝VeVdVp
 d
⎝VeVdVp
 p
⎝VeVdVp

WACC = (830/884.2) × 0.12 + (33.5/884.2) × 0.06 + (20.7/884.2) × 4.6 = 11.6%
Dividend policy will depend on a number offactors
Profits and retained earnings
Thecompanyneedstoremainprofitable.Dividendsarepaidoutofprofits,andanunprofitablecompany cannot for ever go on paying dividends out of retained profits made in thepast.
Law
Companylegislationmaymakecompaniesboundtopaydividendssolelyoutofaccumulatednetrealised profits, as in theUK.
Other restrictions
There may be other dividend restraints that might be imposed, such as covenants in loan agreements.
Liquidity
Sincedividendsareacashpayment,andacompanymusthaveenoughcashtopaythedividendsitdeclares without compromising its day-to-dayoperations.
If the company has to repay any debt in the near future, then this will also need to be considered.
Gearing
Ifgearingishigh,thenlowdividendpaymentscanhelptokeepretainedearningshighwhichwillthen reduce the level of gearing as the level of reserves will behigher.
The signalling effect
Although the market would like to value shares on the basis of underlying cash flows on the company's projects,suchinformationisnotreadilyavailabletoinvestorsinasemi-strongformefficientmarket.Butthe directors do have this information so information asymmetry exists. The dividend declared can be interpretedasasignalfromdirectorstoshareholdersaboutthestrengthofunderlyingprojectcashflows.
Investorsusuallyexpectaconsistentdividendpolicyfromthecompany,withstabledividendseachyearor, even better, steady dividendgrowth.
The need for finance
Another factor is the ease with which the company could raise extra finance from sources other than retainedearnings.Smallcompanieswhichfindithardtoraisefinancemighthavetorelymoreheavilyon retained earnings than largecompanies.
Inflation
Theeffectofinflationmeansthatthereisaneedtoretainsomeadditionalprofitwithinthebusinessjustto keep its operating capabilityunchanged.

Answers 147

AQRCo



Calculation of historic dividendgrowthrate 1
Calculation of cost of equityusingDGM 2
Calculation ofmarketweights 1
Calculation ofpre-issueWACC 2
Correct use of tax as regardsnewdebt 1
Setting up linearinterpolationcalculation 1
Calculating after-tax cost of debt ofnewdebt 1
Calculation of postissueWACC 2
Comment 1
Marginal and average costofdebt 1-2
Traditional view ofcapitalstructure 1-2
Miller and Modigliani 1and2 1-3
Marketimperfectionsview 1-2
Peckingordertheory 1-2
Otherrelevantdiscussion 1-2
Marks








12

Maximum 8
20



Cost ofequity

Geometric average growth rate =


– 1 = 0.0298 = 2.98% or 3%

Puttingthisintothedividendgrowthmodelgives ke= ((21.8 × 1.03) / 250) +0.03
= 0.09 + 0.03 = 0.12 = 12%
Market values of equity and debt
Marketvalueofequity=Ve=100m×$2.50=$250millionMarketvalue of bonds = Vd = 60m × (104/100) = $62.4 million Total market value = $250 million + $62.4 million = $312.4 million WACCcalculation
The current after tax cost of debt is 7%



148 Answers

WACC = ((ke× Ve) + (kd(1 – T) × Vd) / (Ve+Vd))
= ((12 × 250m) + (7 × 62.4m)) / 312.4m
= 11%
Cost of debt
After-tax interest payment = 100 × 8% × (1 – 30%) = 5.6%



Year


Cash flow
5%
discount
factors


PV
6%
discount
factors


PV


$

$

$

0 Market value
(100.00)
1.000
(100.00)
1.000
(100.00)

1-10 Interest
5.60
7.722
43.24
7.360
41.22

10 Capitalrepayment
105.00
0.614
64.47
0.558
58.59




7.71

(0.19)


Calculate the cost of debt using an IRR calculation.



IRR =

a%+
NPVa

× (b – a)%

⎝NPVa–NPVb 


=5%+ 7.71
7.71+ 0.19
= 5.98% or 6%

(6% 5%)

Note: Other discount factors and therefore costs of debt are acceptable.
Revised WACC calculation
Marketvalueofthenewissueofbondsis$40million Newtotalmarketvalue=$312.4m+$40m=$352.4m Cost of debt of bonds is 6% (fromabove)
WACC = ((12 × 250m) + (7 × 62.4m) + (6 × 40m)) /352.4m
= 10.4%
ThedebtissuehasreducedtheWACC.Thisisbecauseoftheadditionofrelativelycheapdebt.Gearingupin thismannerwouldusuallybeassumedtoincreasefinancialrisk.However,thishasn'tbeenincludedinthe abovecalculations.
Thereisarelationshipbetweentheweightedaveragecostofcapital(WACC)andthevalueofacompanyas thevaluecanbeexpressedasthepresentvalueofthefuturecashflowswiththeWACCasthediscountrate.
Marginal and average cost of debt
If the marginal cost of capital for the issue of the new capital, in this case the bond issue, is less than the currentWACCthenitmaybeexpectedthattheWACCwillincrease.Howeverasnewdebtincreasesgearing it will also increase financial risk. This increased risk may lead to an increase in the cost of equity which could offset the effect of the cheaperdebt.
Traditional view
Under the traditional view there is an optimal capital mix at which the average cost of capital, weighted accordingtothedifferentformsofcapitalemployed,isminimised.Thetraditionalviewisthattheweighted averagecostofcapital,whenplottedagainstthelevelofgearing,issaucershaped.Theoptimumcapital structure is where the weighted average cost of capital islowest.
As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing. Beyondthislevel,thecostofdebtwillincrease.Thecostofequityrisesasthelevelofgearingincreasesand financialriskincreases.Thereisanon-linearrelationshipbetweenthecostofequityandgearing.


Answers 149

Theweightedaveragecostofcapitaldoesnotremainconstant,butratherfallsinitiallyastheproportionof debt capital increases, and then begins to increase as the rising cost of equity (and possibly of debt) becomesmoresignificant.Theoptimumlevelofgearingiswherethecompany'sweightedaveragecostof capitalisminimised.Underthistheorythefinancedirectormaybecorrectinhisviewthatissuingdebtwill decreaseWACCdependingonthepositionofAQRrelativetotheoptimumcapitalstructure.
Modigliani and Miller
Intheir1958theory,ModiglianiandMiller(MM)proposedthatthetotalmarketvalueofacompany,inthe absenceoftax,willbedeterminedonlybytwofactors:thetotalearningsofthecompanyandthelevelof operating (business) risk attached to those earnings. The total market value would be computed by discountingthetotalearningsataratethatisappropriatetothelevelofoperatingrisk.Thisratewould representtheWACCofthecompany.ThusModiglianiandMillerconcludedthatthecapitalstructureofa company would have no effect on its overall value orWACC.
In1963ModiglianiandMillermodifiedtheirtheorytoadmitthattaxreliefoninterestpaymentsdoeslower theweightedaveragecostofcapital.Thesavingsarisingfromtaxreliefondebtinterestarethetaxshield. Theyclaimedthattheweightedaveragecostofcapitalwillcontinuetofall,uptogearingof100%.Under thistheorythefinancedirectorofAQRiscorrectinhisbeliefthatissuingbondswilldecreasetheWACC.
Market imperfections
MM’stheoryassumesperfectcapitalmarketssoacompanywouldalwaysbeabletoraisefinanceandavoid bankruptcy.Inreality,however,athigherlevelsofgearingthereisanincreasingriskofthecompanybeing unable to meet its interest payments and being declared bankrupt. At these higher levels of gearing, the bankruptcyriskmeansthatshareholderswillrequireahigherrateofreturnascompensation.
Ascompaniesincreasetheirgearingtheymayreachapointwheretherearenotenoughprofitsfromwhich toobtainallavailabletaxbenefits.Theywillstillbesubjecttoincreasedbankruptcyandagencycostsbutwill not be able to benefit from the increased taxshield.
Pecking order theory
Peckingordertheoryhasbeendevelopedasanalternativetotraditionaltheory.Itstatesthatfirmswillprefer retainedearningstoanyothersourceoffinance,andthenwillchoosedebt,andlastofallequity.Theorder ofpreferenceis:retainedearnings,straightdebt,convertibledebt,preferencesharesandequityshares.

BKBCo


150 Answers

Marking scheme




Marks


(a) Calculation of cost of equity usingCAPM
2



Calculation of bond market price
0.5



Calculation of current share price
0.5



Calculation of future share price
1



Calculation of conversion value
1



After-tax interest payment
1



Setting up interpolation calculation
1



Calculation of after-tax cost of debt
1



Calculation of cost of preference shares
1



Calculation of after-tax WACC
2



Explanation of any assumptions made
1

12


(b) Market values reflect current marketconditions
1-2



Market values and optimal investment decisions
1-2



Other relevant discussion or illustration

(c) Self-liquidating
1-2
Maximum
1

4


Lower interest rate
1



Increase in debt capacity on conversion
1



Other relevant advantages of convertible debt
1-3
Maximum

4




20



Equity
TheMVofequityisgivenas$125m. CAPM:EriRfβiErmRf
Rf = Risk-free rate = 4%
i = Equity beta = 1.2
Erm Rf = Equity risk premium = 5% Therefore the cost of equity = 4% + 1.2 × 5% = 10%
Convertible bonds
AssumethatbondholderswillconvertiftheMVof19sharesinfiveyears'timeisgreaterthan$100. MV per bond = $100 × $21m/$20m =$105
MV per share today = $125m/25m = $5
MVpershareinfiveyears'time=$5×1.045=$6.08pershare Conversion value = $6.08 × 19 =$115.52
Theafter-taxcostoftheconvertiblebondscanbecalculatedbylinearinterpolation,assumingthe bondholders willconvert.




Answers 151

Time Cashflow$ Discount factor (7%)
Presentvalue$ Discountfactor
(5%)
Present value $






** after-tax interest payment = 7 × (1 – 0.3) = $4.90 per bond
Cost of convertible bonds = 5 + [(7 – 5) × 6.78/6.78 + 2.54)] = 5 + 1.45 = 6.45%
Preference shares
After-tax cost of preference shares = 5% × $10m/$6.25m = 8%
WACC
Total value = $125m + $21m + $6.25m = $152.25m
After-tax WACC = [($125m × 10%) + ($21m × 6.45%) + ($6.25m × 8%) / $152.25m]
After-tax WACC = 9.4% per year
Note:Asoverdraftrepresentsashort-termsourceoffinance,ithasbeenassumednottoformpartofthe company's capital and has therefore been excluded from the WACC calculation. The overdraft is large, however,andseemstorepresentafairlyconstantamount.Thecompanyshouldevaluatewhetheritshould be taken intoaccount.
MarketvaluesarepreferabletobookvalueswhencalculatingWACC,becausetheyreflectthecurrentvalue of the company'scapital.
Ifbookvaluesareusedinsteadofmarketvalues,thiswillseriouslyunderstatetheproportionthatequity representsinthecompany'scapitalstructure.Thisisbecausethemarketvalueofordinarysharesisusually significantly higher than its nominal bookvalue.
Understating the impact of the cost of equity on the WACC will most likely cause the WACC to be understated,since,aswecanseeintheanswerabove,thecostofequityisgreaterthanthecostofdebt. Under-estimatingtheWACCwillskewthecompany'sinvestmentappraisalprocessasalowerdiscountrate is used, and cause the company to make sub-optimal investmentdecisions.
Using book values instead of market values will also change the value of debt in the company's capital structure.Theimpactofunderstatingoroverstatingthevalueofdebtwouldbelesssignificantthanisthe caseforequity,becausedebtinstrumentsareoftentradedatclosetotheirnominalvalue.
Convertible bonds are attractive for companies for the followingreasons:
Lowerratesofinterest:Investorsarenormallywillingtoacceptalowercouponrateofintereston convertiblebonds,becauseoftheadditionalvalueofferedbytheconversionrights.Thishelpsto ease the burden on cashflows.
The possibility of not redeeming the debt at maturity: Companies issue convertible bonds with the expectation that they will be converted. If the bonds are converted, this frees the company from a cashrepaymentatredemption.Thecashadvantageisfurtheraugmentedbythegreaterflexibilitythat equity shares allow in terms ofreturns.
Availabilityoffinance:Issuingconvertiblebondsmayallowgreateraccesstofinance,aslenders whowouldotherwisenotprovideordinaryloanfinancemaybeattractedbytheconversionrights.
Impactongearing:Onconversion,thecompany’sgearingwillbereducednotonlybecauseofthe removalofdebt,butalsobecauseequityreplacesthedebt.Thiscansendpositivesignalsaboutthe company’s financialposition.
Delayedequity:Thefactthatconvertiblebondsallowtheissueofsharesatapre-determinedpointin thefuturepermitsthecompanytoplantheimpactonitsearningspershareuponconversion.




152 Answers

FenceCo



Calculation of equityriskpremium 1
Calculation of costofequity 1
After-taxinterestpayment 1
Setting upIRRcalculation 1
Calculating after-tax costofdebt 1
Market valueofequity 0.5
Market valueofdebt 0.5
CalculatingWACC 1
Ungearing proxy companyequitybeta 2
Regearingequitybeta 1
Calculation of costofequity 1
Riskdiversification 1
Systematicrisk 1
Unsystematicrisk 1
Portfolio theory andtheCAPM 1
1-2 marks per pointmade
Marks








7


4



4

Maximum 5
20



(a) After-tax cost of debt (Kd) can be calculated by linearinterpolation.

Year

Cash flow
Discount factor4%
PV Discount PV factor5%

$ $ $
0
Market value
(107.14)
1.000
(107.14)
1.000
(107.14)

1 – 7
Interest (7 ×(1 – 0.2))
5.60
6.002
33.61
5.786
32.40

7
Redemption
100.00
0.760
76.00
0.711
71.10





2.47

(3.64)


Aftertaxcostofdebt=4%+
2.47

2.473.64
(5% – 4%) = 4.4%

Cost of equity (Ke) can be found using CAPM. E(ri) = Rf+ i(E(rm) – Rf)
= 4 + 0.9 (11 – 4)
= 10.3%

Answers 153

Market value of equity (Ve) = $10m × $7.50 = $75m

Market value of debt (V ) = $14m × 107.14


= $15m


 V
WACC =
d


k + Vd
100

k

 e
⎝VeVd
 d
⎝VeVd



=  75
10.3+ 15
4.4

75 15 
= 9.3%
75 15 

Ungear to remove the financialrisk
= Ve
a e Ve Vd(1T)

a= 1.2 ×
54m

54m (12m0.8)

= 1.019
Convert back to a geared beta


= 
Ve Vd(1T)


e a
e
=1.019 × 75 + 15(10.2)
e 75
=1.182
Use CAPM to estimate cost of equity.
Equity or market risk premium = 11 – 4 = 7% Cost of equity = 4 + (1.182 × 7) = 4 + 8.3 = 12.3%
Unsystematicriskcanbediversifiedawaybutevenwelldiversifiedportfolioswillbeexposedtosystematic risk. This is the risk inherent in the market as a whole, which the shareholder cannot mitigate by holding a diversified investmentportfolio.
Portfolio theory is concerned with total risk (systematic and unsystematic). The capital asset pricing modelassumesthatinvestorswillholdafullydiversifiedportfolioandthereforeignoresunsystematicrisk.
Diversification
Under the CAPM, the return required from a security is related to its systematic risk rather than its total risk. Only the risks that cannot be eliminated by diversification are relevant. The assumption is that investors will hold a fully diversified portfolio and therefore deal with the unsystematic risk themselves. However, in practice, markets are not totally efficient and investors do not all hold fully diversified portfolios.Thismeansthattotalriskisrelevanttoinvestmentdecisions,andthatthereforetherelevanceof the CAPM may belimited.
Excess return
In practice, it is difficult to determine the excess return (Rm– Rf). Expected rather than historical returns
should be used, although historical returns are used in practice.
Risk-free rate
It is similarly difficult to determine the risk-free rate. A risk-free investment might be a government security; however, interest rates vary with the term of the debt.
Risk aversion
Shareholdersareriskaverse,andthereforedemandhigherreturnsincompensationforincreasedlevelsof risk.

154 Answers

Beta factors
Betafactorsbasedonhistoricaldatamaybeapoorbasisforfuturedecisionmaking,sinceevidence suggests that beta values fluctuate overtime.
Unusual circumstances
TheCAPMisunabletoforecastaccuratelyreturnsforcompanieswithlowprice/earningsratios,andtotake account of seasonal 'month-of-the-year' effects and 'day-of-the-week' effects that appear to influence returns onshares.

TinepCo




Costofequity 1
After-taxinterestpayment 1
Setting upIRRcalculation 1
After-tax cost of debt ofloannotes 1
Marketvalues 1
MarketvalueWACC 1
BookvalueWACC 1
Commentondifference 2
Marks








9


Issueprice 1-2
Relativecost 1-2
Ownershipandcontrol 1-2
Gearing andfinancialrisk 1-2
Maximum 6
Explanation ofscripdividend 1-2
Advantages of scrip dividendtocompany 2-3
Disadvantages of scrip dividendtocompany 2-3
Maximum 5
20



Cost of equity usingCAPM
Ke=Rf+ ß(E(rm)–Rf) Rf=4%,E(Rm)–Rf=6%(marketpremium) Ke= 4 + (1.15 × 6) =10.9%




Answers 155

After-tax cost of debt Kd
Time

Cash flow

Discount

Present value

Discount

Present value


($)
factor 4%
($)
factor 5%
($)

0 Marketvalue
(103.50)
1
(103.50)
1
(103.50)

1-6 Interest
(6% × 100) ×
5.242
23.59
5.076
22.84


75% = 4.5





6
Redemption
106
0.790
83.74
0.746
79.08





3.83

(1.58)



Kd = 4 +
3.83

3.83+1.58

× 1 = 4.7%

Market value of equity
Numberofshares=$200m/0.5=400m Marketvalue=400m×$5.85=$2,340m Market value ofdebt

200m loan notes × 103.50
100.00
= $207m

Total market value = $2,340 + $207 = $2,547 Using the formula from the formula sheet:

WACC= Ve
k + Vd k



V + V e V + V d
e d e d
WACC using market values
WACC = (2,340/2,547)10.9% + (207/2,547)4.7% = 10.40%
WACC using book values
WACC = (850/1,050)10.9% + (200/1,050)4.7% = 9.72%
The WACC using book values is lower than the WACC using market values. This is because the market valuesofsharesarenearlyalwayshigherthanthenominalvalues.Bookvaluesarebasedonhistoricalcosts andtheirusewillunderstatetheimpactofthecostofequityfinanceontheaveragecostofcapital.Market valuesshouldalwaysbeusedifdataisavailable.IftheWACCisunderstatedthenunprofitableprojectswill beaccepted.
Considerationsofrightsissue Issueprice
Tinepmustsetapricewhichislowenoughtosecuretheacceptanceofshareholdersbutnottoolowsoas to dilute earnings per share. This balance can be difficult toestimate.
Relative cost
Rights issues are cheaper than, say, IPOs to the general public. This is partly because no prospectus is normallyrequired,partlybecausetheadminissimplerandpartlybecausethecostofunderwritingwillbe less.
Ownership and control
Relative voting rights are unaffected if shareholders take up their rights.
Gearing and financial risk
Thefinanceraisedmaybeusedtoreducegearingbyincreasingsharecapital.Theshareholdersmayseethis as a positive move depending on their riskpreference.





156 Answers

Ascripdividendisadividendpaidbytheissueofadditionalcompanyshares,ratherthanbycash.Itis offered pro rata to existingshareholdings.
Fromacompanypointofviewthereareacoupleofmainadvantagesofscripdividends.Theycanpreservea company'scashpositionifasubstantialnumberofshareholderstakeuptheshareoptionandashareissue willdecreasethecompany'sgearing,andmaythereforeenhanceitsborrowingcapacity.
Therearetwomaindisadvantagesofscripdividends.Assumingthatdividendpershareismaintainedor increased,thetotalcashpaidasadividendwillincrease.Scripdividendsmaybeseenasanegativesignal by the market ie the company is experiencing cash flowissues.

GrenarpCo




Rightsissueprice 0.5
Newsharesissued 0.5
Net cash raised byrightsissue 0.5
TERPpershare 1
Buy-back price ofloannotes 0.5
Nominal value of loannotesredeemed 1
Before-taxinterestsaving 0.5
After-taxinterestsaving 0.5
Revisedearnings 0.5
Revised earningspershare 0.5
Revised share price using P/Eratiomethod 1
Comment on effect of redemption onshareholders’wealth 1
Marks











8


Traditional view ofcapitalstructure 1-3
M&M views ofcapitalstructure 1-3
Otherrelevantdiscussion 1-3
Maximum 7

1-2markspersourceoffinance
Maximum 5
20










Answers 157

Rights issue price = 3·50 x 0·8 = $2·80 pershare
Grenarp Co currently has 20 million shares in issue ($10m/0·5) The number of new shares issued = 20m/5 = 4 million shares
Cash raised by the rights issue before issue costs = 4m x 2·80 = $11,200,000
Net cash raised by the rights issue after issue costs = 11,200,000 – 280,000 = $10,920,000 Revised number of shares = 20m + 4m = 24 million shares
Market value of Grenarp Co before the rights issue = 20,000,000 x 3·50 = $70,000,000 MarketvalueofGrenarpCoaftertherightsissue=70,000,000+10,920,000=$80,920,000 Theoretical ex rights price per share = 80,920,000/24,000,000 = $3·37 pershare
(Alternatively, issue costs are $0·07 per share (280,000/4m) and this is a 1 for 5 rights issue, so the theoretical ex rights price = (5 3.50 + (2.80 – 0·07))/6 = 20.23/6 = $3.37 per share)
Redemption price of loan notes = 104 1.05 = $109.20 per loan note
Nominal value of loan notes redeemed = 10,920,000/(109·20/100) = $10,000,000
Before-taxinterestsaving=10,000,0000.08=$800,000peryear After-taxinterestsaving=800,000(1–0.3)=$560,000peryear
Earnings after redeeming loan notes = 8,400,000 + 560,000 = $8,960,000 per year
Revised earnings per share = 100 (8,960,000/24,000,000) = $0.373 per share
Price/earnings ratio of Grenarp Co before the rights issue = 3.50/0·42 = 8.33 times Thisprice/earningsratioisnotexpectedtobeaffectedbytheredemptionofloannotes SharepriceofGrenarpCoafterredeemingloannotes=8.330·373=$3.11pershare
ThewealthofshareholdersofGrenarpCohasdecreasedastheyhaveexperiencedacapitallossof$0·26per share ($3.37 –$3.11) compared to the theoretical ex rights price pershare.
Thecapitalstructureisconsideredtobeoptimalwhentheweightedaveragecostofcapital(WACC)isata minimumandthemarketvalueofacompanyisatamaximum.Thegoalofmaximisingshareholderwealth might be achieved if the capital structure isoptimal.
ThequestionofwhetherGrenarpComightachieveitsoptimalcapitalstructurefollowingtherightsissuecan bediscussedfromatheoreticalperspectivebylookingatthetraditionalviewofcapitalstructure,theviews ofMillerandModiglianioncapitalstructure,andotherviewssuchasthemarketimperfectionsapproach.It is assumed that a company pays out all of its earnings as dividends, and that these earnings and the business risk of the company are constant. It is further assumed that companies can change their capital structure by replacing equity with debt, and vice versa, so that the amount of finance invested remains constant,irrespectiveofcapitalstructure.Theterm‘gearingup’thereforereferstoreplacingequitywithdebt in the context of theoretical discussions of capitalstructure.
Traditional view
Thetraditionalviewofcapitalstructure,whichignorestaxation,heldthatanoptimalcapitalstructuredid exist. It reached this conclusion by assuming that shareholders of a company financed entirely by equity would not be very concerned about the company gearing up to a small extent. As expensive equity was replacedbycheaperdebt,therefore,theWACCwouldinitiallydecrease.Asthecompanycontinuedtogear up,shareholderswoulddemandanincreasingreturnasfinancialriskcontinuedtoincrease,andtheWACC wouldreachaminimumandstarttoincrease.Athigherlevelsofgearingstill,thecostofdebtwouldstartto increase, for example, because of bankruptcy risk, further increasing theWACC.
Views of Miller and Modigliani
MillerandModiglianiassumedaperfectcapitalmarket,wherebankruptcyriskdoesnotexistandthecostof debt is constant. In a perfect capital market, there is a linear relationship between the cost of equity and financial risk, as measured by gearing. Ignoring taxation, the increase in the cost of equity as gearing increases exactly offsets the decrease in the WACC caused by the replacement of expensive equity by cheaperdebt,sothattheWACCisconstant.Thevalueofacompanyisthereforenotaffectedbyitscapital structure.


158 Answers

WhenMillerandModiglianiincludedtheeffectofcorporatetaxation,sothattheafter-taxcostofdebtwas used instead of the before-tax cost of debt, the decrease in the WACC caused by the replacement of expensiveequitybycheaperdebtwasgreaterthantheincreaseinthecostofequity,sothattheWACC decreased as a company geared up. The implication in terms of optimal capital structure was that a companyshouldgearupasmuchaspossibleinordertodecreaseitsWACCasmuchasitcould.
Market imperfections view
Whenothermarketimperfectionsareconsideredinadditiontotheexistenceofcorporatetaxation,theview ofMillerandModiglianithatacompanyshouldgearupasmuchaspossibleisnolongertrue.Theseother marketimperfectionsrelatetohighlevelsofgearing,bankruptcyriskandthecostsoffinancialdistress,and theycausethecostofdebtandthecostofequitytoincrease,sothattheWACCincreasesathighlevelsof gearing.
Grenarp Co
ThequestionofwhetherGrenarpComightachieveitsoptimalcapitalstructurefollowingtherightsissuecan also be discussed from a practical perspective, by considering if increasing the gearing of the company woulddecreaseitsWACC.Thiswouldhappenifthemarginalcostofcapitalofthecompanywerelessthan its WACC. Unfortunately, there is no information provided on the marginal cost of capital of Grenarp Co, although its gearing is not high. Before the rights issue ,the debt/equity ratio of Grenarp Co was 35% on a bookvaluebasisand45%onamarketvaluebasis,whileaftertheredemptionofloannotesthedebt/equity ratio would fall to 21% on a book value basis and 28% on a market valuebasis.
Remember that the question only asked for three sources of long-termfinance.
Bonds
Bondsarelong-termdebtcapitalraisedbyacompanyforwhichinterestispaid,usuallyhalfyearlyandata fixed rate. Holders of bonds are therefore long-term payables for the company. Bonds issued by large companies are marketable, but bond markets are small. They can be issued in a variety of foreign currencies.
Deep discount bonds
Deepdiscountbondsarebondsorloannotesissuedatapricewhichisatalargediscounttothenominal value of the notes, and which will be redeemable at nominal value (or above nominal value) when they eventuallymature.Thecouponrateofinterestwillbeverylowcomparedwithyieldsonconventionalbonds withthesamematurity.Foracompanywithspecificcashflowrequirements,thelowservicingcostsduring thecurrencyofthebondmaybeanattraction,coupledwithahighcostofredemptionatmaturity.Themain benefit of deep discount bonds for a company is that the interest yield on the bonds is lower than on conventionalbonds.However,itwillhavetopayamuchlargeramountatmaturitythanitborrowedwhen the bonds were issued. Deep discount bonds defer much of the cost of thedebt.
Convertible bonds
Convertiblebondsarebondsthatgivetheholdertherighttoconverttoothersecurities,normallyordinary shares,atapre-determinedprice/rateandtime.Thecouponrateofinterestisnormallylowerthanonsimilar conventionalbonds.Theygivethebondholderstheright(butnotanobligation)toconverttheirbondsata specifiedfuturedateintonewequitysharesofthecompany,ataconversionratethatisalsospecifiedwhen the bonds are issued. If the bonds are converted there can be a reduction in the gearing of the issuing company.
Long-term bank loan
A bank loan can be obtained with interest paid annually, bi-annually or quarterly at either a fixed rate or floating rate of interest. Bank loans are often secured and a bank may charge higher interest for an unsecuredloancomparedwithasimilarsecuredloan.Repaymentsusuallyincludeacapitalelementandan interestelement,withtheproportionofinterestdecreasingovertimeandtheproportionofcapitalincreasing overtime.





Answers 159

MCQ bank – Business valuations
C Thereplacementvalueofthebusinessattemptstocalculatethecostofsettingupanequivalent venture. This is more than simply tangible assets, it includes intangibles such as brand value, customerandsupplynetworks,andintellectualproperty.Itisverydifficulttocalculateinpractice.
Syllabus area F2a
208 C $4
Statementoffinancialpositionvalueofequity=ordinaryshares+reserves=(1+5=)$6million. Net book value of revalued assets = $10m × 3/10 =$3m.
Professionalvaluationofrevaluedassets=$1m;(3–1=)$2mlowerthannetbookvalue. Number of shares = $1m / $1 per share = 1 millionshares.
Realisable value per share = ($6m – $2m) / 1 million shares = $4 per share.



A P0

= D0 1+ g
re - g


Givenontheformulasheet
Syllabus area F2a

Growth 'g' – Dividends grew from ($0.50–$0.10) = $0.40 to $0.50 in 3 years. This is an average annual growth rate of:
$0.40 (1+g)3 = $0.50 (1+g) = 3√(0.5/0.4)
g = 0.077 = 7.7%

P = $0.50 1+ 0.077
0 0.10 – 0.077

= $23.41


Syllabus area F2c


A Statement1needstobeassumed:IfD0isnottypical,abettervaluationwouldincludethedividend that would have been paid if D0were in line with historicaltrends.
Statement 2 needs to be assumed: Only one rate for growth is included in the formula. Statement 3 needs to be assumed: Only one cost of equity is included in the formula.
Statement4doesnotneedtobeassumed:Minorityshareholdersareentitledtodividendsonly, hencethisvaluationtechniqueisinfactbestsuitedtoaminorityshareholding.


211 D $672m
g = br.
g = 0.2 × 0.6 = 0.12
MV = D0(1+ g) = 60m × 1.12 = $672m
keg 0.22 -0.12

C Earnings yield is lower. P/E ratio ishigher.
ForDDCo,P/E=12,Earningsyield(=1/(P/Eratio)=0.0833=8.3%. Forcompetitor,P/E(=1/earningsyield)=10,Earningsyield=10%.
Syllabus area F2c







Syllabus area F2b




Syllabus area F2b




160 Answers

D Corporationtaxisnotrelevantasinvestorspaymarketpriceandtheyreceivethegrossdividend. Redemption value = ($100 × 1.15) = $115cash
Conversion value = P0(1+g)R = (4 × 1.13 × 25) = $133.10 worth of shares.
Investors would opt to convert, hence the redemption value built into market price will be $133.10.
Time Discount Presentvalue
$ factor10% $
1-3
Interest
9
2.487
22.383

3
Redemption
133.10
0.751
99.9581





122.3411


So current market value = $122.34
Syllabus area F3a
D Marketcapitalisationreferstothetotalvalueofacompany'ssharecapitalasvaluedbythecapital markets / stockexchange.
Syllabus area F4b
C Options1and3donotconsiderintangibleassetssuchasbrandvalue,intellectualpropertyand supplynetworks.
Asthecostofsettingupanequivalentventureislessthanthenetpresentvalueofthecurrent business, the former is the maximum HAL Co should pay for SOCo.
Syllabus area F2a
A Should NCW Co purchase CEW Co it will acquire a cash flow of ($10 + 2) = $12m per annum, assumingthatCEWinveststhe$6minnewmachinery.(Note:itshoulddothisasitsnetpresent value = $2m/0.1 – $6m =$14m.)
Therefore the value would be: $12m/0.1 – $6m = $114 million. Note the $12m is a perpetuity.
Syllabus area F2c

CBE style OTQ bank – Marketefficiency
A strong form efficientmarket
Assharepricereactionappearstohaveoccurredbeforetheinformationconcerningthenewproject wasmadepublic,thissuggestsastrong-formefficientmarket(andquitepossiblyinsiderdealing) becauseinastrongformefficientmarketthesharepricereflectsevenprivatelyheldinformation.
Syllabus area E4a
Semi-strong or strong formefficient
Aweakformefficientmarketwillnotreacttonew,publiclyannouncedinformationhenceastrategy based around using publicly available information couldwork.
Inasemistrongformmarket,allpubliclyavailableinformationisalreadyassumedtobereflectedin theshareprice,hencereadingthenewspapertohelpformulateastrategyisunlikelytowork.
Inastrongformefficientmarket,allpubliclyavailableinformationisalreadyreflectedintheshare price.Again,readingthenewspaperisthereforeunlikelytoaddanyvaluetoanyinvestmentstrategy.
Syllabus area E4a
Completelyinefficient
Inaweakformefficientmarket,allinvestorsknowprevioussharepricemovements,whichwillstop patternsconsistentlyandpredictablyrepeating.Sarahmustthereforebelievethemarketsarenot even weak formefficient.
Syllabus area E4a


Answers 161

The majority of share price reaction to news occurs when it isannounced
‘Repeating patterns appear to exist’ supports the view that markets are completely inefficient.
‘Attemptingtotradeonconsistentlyrepeatingpatternsisunlikelytowork’supportstheviewthat markets are weak formefficient.
‘Themajorityofsharepricereactiontonewsoccurswhenitisannounced’supportstheviewthat markets are semi-strong form efficient because in such a market share prices reflect publicly available information, but not privately held information. Share price will therefore not reflect information before it isannounced.
‘Sharepricereactionoccursbeforeannouncementsaremadepublic’supportstheviewthatmarkets arestrongformefficient:theyreflectallavailableinformationincludingthatwhichisprivatelyheld.
Syllabus area E4a
Statement 1 is true and statement 2 isfalse.
Fundamentalanalysisvaluessharesaccordingtothefutureincrementalcashflowsassociatedwith owningthatshare,discountedbytheinvestor'srequiredrateofreturnwhichreflectstheperceived risk associated with thatinvestment.
Technicalanalysis(orcharting)attemptstopredictsharepricemovementsbyanticipatingrepeating patterns following detailed analysis of past share pricemovements.


Phobis Co
Syllabus area E4a


222
D
$20 million

Price/earnings ratio method of valuation
Market value = P/E ratio × EPS



EPS = 40.0c
Average sector P/E ratio = 10
Value of shares = 40.0 × 10 = $4.00 per share Number of shares = 5 million
Value of Danoca Co = $20 million

223
A
Statement 1 is true and statement 2 is false.



ThecurrentsharepriceofDanocais$3.30whichequatestoaP/Eratioof8.25(3.30/0.4).Thisis lowerthantheaveragesectorP/Eratioof10whichsuggeststhatthemarketdoesnotviewthe growthprospectsofDanocaasfavourablyasanaveragecompanyinthatbusinesssector.



AlowerthanaverageP/EratioimpliesthatanacquisitionbyPhobiscouldresultinimprovedfinancial performanceofDanoca,assumingthatPhobishasthecompetencesandskillstotransfertoDanoca.

224
A
$14.75 million



Dividend growth model method of valuation

P = Do(1 g) .

Ke g
Note:TheformulasheetinthisexamusesreinsteadofkeD0canbefoundusingtheproposedpayoutratioof60%. D0= 60% × 40c =24c
Value of shares = 0.24 (10.045)
0.13 0.045
= $2.95
Value of Danoca Co = $2.95 × 5 million shares = $14.75 million


162 Answers

225 B $16.5m
Market capitalisation of Danoca is $3.30 × 5m = $16.5m

226 B 1 and3
‘Underweakformhypothesisofmarketefficiency,sharepricesreflectallavailableinformationabout past changes in share price’ istrue.
‘Ifastockmarketdisplayssemi-strongefficiencythenindividualscanbeatthemarket’isnottrue. Individualscannotbeatthemarketbecauseallinformationpubliclyavailablewillalreadybereflected in the shareprice.
‘Behaviouralfinanceaimstoexplaintheimplicationsofpsychologicalfactorsoninvestordecisions’ istrue.
‘Randomwalktheoryisbasedontheideathatpastsharepricepatternswillberepeated’isnottrue. Chartists believe that past share price patterns will berepeated.

Corhig Co
227 $15m
The value of the company can be calculated using the P/E ratio valuation as:
Expected future earnings P/E ratio
UsingtheCorhigCo'sforecastearningsforYear1,andtakingtheaverageP/Eratioofsimilarlisted companies, Corhig Co can be valued at $3m x 5 =$15m.
Statement 1 is true and statement 2 isfalse.
Thevaluationabovedoesnottakeintoconsiderationthefactthatearningsareexpectedtoriseby 43%overthenextthreeyears.InsteadofusingYear1earnings,wecoulduseaverageexpected earningsoverthenextthreeyearsof$3.63m.Thiswouldgiveusamoreappropriatevaluationof
$18.15m.
TheP/Eratioof5istakenfromtheaverageofsimilarlistedcompanies.However,P/Eratiosvary fromcompanytocompanydependingoneachcompany'sbusinessoperations,capitalstructures, gearing,andmarkets.Theratiousedhereisthereforesubjecttoahighdegreeofuncertainty.An inaccurateP/Eratiowouldcallthevaluationintoquestion,asitissocrucialtothecalculation.
CorhigCoislisted,soitwouldbemuchmoreappropriatetousethecompany'sowncurrentP/E ratioinstead.
PV of Year 2 dividend = 500,000 x 0.797 = $398,500 (using cost of capital of12%) 230 10.32%
After-tax cost of debt = 6 × (1 – 0.2) = 4.8%
Revised after-tax WACC = 14 × 60% + 4.8 × 40% = 10.32%
Risklinkedtotheextenttowhichthecompany’sprofitsdependonfixed,ratherthanvariablecostsis businessrisk.
Risk that shareholder cannot mitigate by holding a diversified investment portfolio is systematic risk.
Riskthatshareholderreturnfluctuatesasaresultofthelevelofdebtthecompanyundertakesis financialrisk.








Answers 163

Close Co
$490million
Net assets
Asnoadditionalinformationisavailable,thisisbasedonbookvalues. Net assets = 720 – 70 – 160 = $490million
$693million
Dividend growth model
Dividends are expected to grow at 4% per year and the cost of equity is 10%.

P0 =
40 1.04

0.10 0.04

= 41.6/0.06
= $693 million
$605.5million
Earnings yield
Earningsaretheprofitaftertaxfigureof$66.6millionandtheearningsyieldthatcanbeusedforthe valuation is11%.
ie 66.6/0.11 = $605.5 million.
Both statements aretrue.
TheDGMisverysensitivetochangesinthegrowthrate.A1%changeinthegrowthratecangivea significantly differentvaluation.
Ifdividendsareexpectedtobepaidatsomepointinthefuture,theDGMcanbeappliedatthatpoint tocreateavaluefortheshareswhichcanthenbediscountedtogivethecurrentexdividendshare price.
In a situation where dividends are not paid and are not expected to be paid the DGM has no use.
A Thesumofthepresentvaluesofthefutureinterestpayments+thepresentvalueofthebond’s conversionvalue

MCQ bank – Foreign currency risk
D Aisafinancialreportingimplicationofretranslatingforeignassets/liabilitiesandnotimmediately related tocash.
B is the impact on business value of long-term exchange rate trends.
Discorrect:transactionriskreferstothefactthatthespotratemaymovebetweenpointofsale (denominatedinforeignexchange)andwhenthecustomerpays,suchthatthenetdomesticreceipt differs fromexpected.
Syllabus area G1a
A AstrengtheningEuromeansEurosaregettingmoreexpensive:theywillcostmoredollars. The exchange rate becomes €1 : $2.40 ($2 ×1.2)
The Euro receipt will be $1,000 / 2.4 = €416.67
Syllabus area G1a
B The spot rate for translating $ to € is 2.0000 + 0.003 = $2.003 / € – the worst rate for someone sellingdollars.Thedollarisatapremiumsosubtractthepremiumbecausetheexchangerateisto theEurosoifthe$isstrengtheningthentheEuroisweakeningontheforwardmarket.
$2.003 / € – $0.002 = $2.001 / €


164 Answers

The Euro receipt will be $2,000 / 2.001 = €999.50.
Syllabus area G3a
C Statements1and2aretrue:Astheyarebindingcontracts,forwardcontractsfixtheratetothatrate notedinthecontract.Bythesametokenthereforetheyarenotflexible(statement3isfalse.)The contractcontainsnamedpartiessothecontractscannotbesoldontosomeoneelse(statement4is false).
Syllabus area G3a
D TheUScompanyshouldborrowUS$immediatelyandsendittoEurope.Itshouldbeleftondeposit in € for 3 months then used to pay thesupplier.
The amount to put on deposit today = €3.5m × 1/(1+ (0.01/4)) = €3,491,272.
This will cost €3,491,272 × $2 = $6,982,544 today (note $2 is the worst rate for buying €) Assuming this to be borrowed in US$, the liability in 3 months will be:
$6,982,544 × [1+(0.08/4)] = $7,122,195.
Syllabus area G3a
B Theyareonlyavailableinasmallamountofcurrencies.Theyareprobablyanimprecisematchforthe underlyingtransaction.
Statement1:False:Futurescontractsaresubjecttoabrokeragefeeonly(forexamplethereisno spread on the rate) so are relativelycheap.
Statement2:True:Itisnotpossibletopurchasefuturescontractsfromeverycurrencytoeveryother currency – there are only limited combinationsavailable.
Statement3:False.Futurescontractscanbe'closedout'soif,forexample,customerspayearlyor late, the timing of the futures hedge can accommodatethis.
Statement4:True.Futurescontractsareforstandardisedamountssomaynotmatchthesizeofthe transaction being hedgedprecisely.
Syllabus area G3a

A TheFarlandbusinesswillwanttoselltheUS$whentheyreceivethemwhichimplieseitheraUS$ put (sell) option purchased in Farland, or a Splot call (buy) option purchased in America. In this secondalternativepaymentwouldbeinUS$,effectivelygivingupUS$inreturnforSplot.
Syllabus area G3c
B Using Interest RateParity:
Fo = So × (1+ ic)
(1+ ib)
The quarterly rates are: US: 8%/4 = 2%; Europe 4%/4 = 1% Forward rate = 2 × 1.02/1.01 = $2.0198 : €1
Syllabus area G2b

D Purchasingpowerparitymeansthatthecostofidenticalgoodsindifferenteconomiesshouldbethe same.Iftheyaren'tthesame,businesseswillbuyfromonelocationandselltotheothertomakea profit,withtheinteractionofsupplyanddemandbringingthepricesbackintoline.Anydifferencesin inflationbetweencountriesthereforecreatessupplyanddemandforcurrenciesthatevensoutthe price differences inflationcauses.
Syllabus area G2b

C Exporters are worse off. Importers are betteroff.
Ifacurrencystrengthensitgetsmoreexpensive(egIftheEurostrengthensitmaymovefrom$1:€1to$2:€1)meaningexporterswillreceivefewer€fortheirgiven$sales,andimporterswillpayfewer
€ to satisfy their given $ debts with suppliers.
Syllabus area G1a


Answers 165

MCQ bank – Interest rate risk
B 'A' describes gap exposure. C and D is interest rate risk but not specifically basisrisk.
Syllabus area G1b
A Gapexposureoccurswheninterestratesondepositsandonloansmoveatdifferenttimes.Thefact thatthecompanyhasbenefitedinthisinstancemeanstherateshavemovedfavourably.
Syllabus area G1b
D Expectations theory: The shape of the curve reflects market expectations about future interest rate movements.
Liquiditypreferencetheoryexplainswhythecurveisgenerallyupwardsloping–implyingahigher periodicrateofreturnisrequiredtocompensateformoneybeingtiedupforlongerwithlongerterm debt.
Marketsegmentationtheoryexplainswhythecurvemaybekinkedorevendiscontinuousasdifferent investors(withdifferentriskappetites)investindifferenttypesofdebt.Forexample,manybankswill invest in short dated bonds, but pension funds are more likely to invest in long dated ones. The differences in the investor risk/return preferences are reflected through changes in the shape and steepness of the curve inplaces.
Syllabus area G2c
B The FRA guarantees a net interest payment of8%.
As the loan has been signed for 7%, ADB Co will need to pay the bank 1% × $4million × (6/12) =
$20,000.
Syllabus area G4a

D Statement1:Optionsdon'thavetobeexercisedsoifanoptionwouldotherwiseyieldaloss,itcanbe abandoned.
Statement2:Asthequestionreferstoexchangetradedoptionsthisistrue.Over-the-counteroptions however cannot betraded.
Statement3:Sizeablepremiumsarepayablefortheabilitytoabandonoptionsthataren'tinthe investor'sfavour.
Statement 4: Exchange traded options are standardised contracts so are for standard sized loans/deposits.Theyaren'ttailoredtoaninvestor'sparticularamountsordates.Incomparison, over-the-counter options aretailored.


Rose Co
Syllabus area G4b

C Rose Co should enter into a forward contract to sell €750,000 in six months. Statement 1 is incorrect.RoseCocoulduseamoneymarkethedgebut€750,000wouldhavetobeborrowed,then convertedintodollarsandthenplacedondeposit.Statement2isincorrect.Aninterestrateswap swaps one type of interest payment (such as fixed interest) for another (such as floating rate interest).Thereforeitwouldnotbesuitable.Statement4isnotsuitableasRoseCodoesnothave any euro payments tomake.
253 A $310,945
Future value = €750,000 / 2.412 = $310,945.
254 C 4%
RoseCoisexpectingaeuroreceiptinsixmonths’timeanditcanhedgethisreceiptinthemoney marketsbyborrowingeurostocreateaeuroliability.Euroborrowingrateforsixmonths=8.0%/2
= 4%.



166 Answers

B StatementAisincorrect.Currencyfutureshaveasettlementdate. Statement B iscorrect.
Statement C is incorrect. The bank will make the customer fulfil the contract.
StatementDisincorrect.Buyingacurrencyoptioninvolvespayingapremiumtotheoptionseller. This is a non-refundable fee which is paid when the option isacquired.
Syllabus area G3c
B Statement A isincorrect.
Statement B is correct. The longer the term to maturity, the higher the rate of interest.
StatementCisincorrect.Longer-termisconsideredlesscertainandmorerisky.Itthereforerequires a higheryield.
StatementDisincorrect.Expectationstheorystatesthatfutureinterestratesreflectexpectationsof future interest rate (not inflation rate)movements.
Syllabus area G2c

Zigto Co
257 $251,256
Forward exchange contract
500,000/1.990 = $251,256
Using the six-month forward rate under the forward exchange contract, Zigto Co will receive $251,256.
258 $248,781
Money market hedge
Expected receipt after 6 months = Euro 500,000 Euro interest rate over six months = 5%/2 = 2.5%
EurostoborrownowinordertohaveEuro500,000liabilityaftersixmonths=Euro500,000/1.025=Euro 487,805
Spot rate for selling euros today = 2 euro/$
Dollardepositfromborrowedeurosatspotrate=487,805/2=$243,903 Dollar deposit rate over six months = 4%/2 =2%
Valueofthedollardepositinsixmonthstime=$243,903×1.02=$248,781 259 Euro1.971/$
Using purchasing power parity:
F0= S0× (1+ic)/(1+ib)
Where:
F0= expected spot rate S0= current spot rate
ic=expectedinflationincountryc ib=expectedinflationincountryb
F0= 2.00 × 1.03/1.045 = Euro 1.971/$
Statement 1 is false. Statements 2 and 3 aretrue.
Theexpectedfuturespotrateiscalculatedbasedontherelativeinflationratesbetweentwocountries.The currentforwardexchangeratesaresetbasedontherelativeinterestratesbetweenthem.
Expectations theory states that there is an equilibrium between relative inflation rates and relative interest rates,sotheexpectedspotrateandthecurrentforwardratewouldbethesame.Realistically,purchasing

Answers 167

powerparitytendstoholdtrueinthelongerterm,soisusedtoforecastexchangeratesanumberofyears into the future. Short-term differences are notunusual.
Statement1istrue.Transactionriskaffectscashflows.Statement2isfalse.Translationriskdoesnotaffect cash flows so does not directly affect shareholder wealth. However, investors may be influenced by the changing values of assets and liabilities so a company may choose to hedge translation risk through, for example matching the currency of assets and liabilities. Statement 3 is true. Economic exposure can be difficult to avoid, although diversification of the supplier and customer base across different countries will reduce this kind of exposure torisk.



















































168 Answers












Mock Exams
























169


























































170

ACCA
Paper F9
Financial Management

Mock Examination1



Question Paper

Time allowed: 3 hours 15 minutes

ALL questions are compulsory and MUST be attempted









DONOTOPENTHISPAPERUNTILYOUAREREADYTOSTARTUNDER EXAMINATIONCONDITIONS











171


























































172

Section A – ALL 15 questions are compulsory and MUST be attempted
1 TKQCohasjustpaidadividendof21centspershareanditssharepriceoneyearagowas$3.10pershare. The total shareholder return for the year was19.7%.
What is the current share price?



(2 marks)


Securitisation is the conversion of illiquid assets into marketablesecurities
The reverse yield gap refers to equity yields being higher than debtyields
Disintermediation arises where borrowers deal directly with lending individuals
2only
1 and 3only
2 and 3only
1, 2and3 (2marks)
3 Which of the following statements arecorrect?
Maximising market share is an example of a financialobjective
Shareholderwealthmaximisationistheprimaryfinancialobjectiveforacompanylistedonastock exchange
Financial objectives should be quantitative so that their achievement can bemeasured
1 and 2only
1 and 3only
2 and 3only
1, 2and3 (2marks)
Acompanywhosehomecurrencyisthedollar($)expectstoreceive500,000pesosinsixmonths'time fromacustomerinaforeigncountry.Thefollowinginterestratesandexchangeratesareavailabletothe company:

Spot rate
Six-month forward rate
15.00 peso per $
15.30 peso per $



Home country
Foreign country

Borrowing interest rate
4% per year
8% per year

Deposit interest rate
3% per year
6% per year

Working to the nearest $100, what is the six-month dollar value of the expected receipt using a money- market hedge?
A $32,500
B $33,700
C $31,800
D $31,900 (2marks)








Mock exam1:questions 173

Which of the following statements iscorrect?
A bonus issue can be used to raise new equityfinance
A share repurchase scheme can increase both earnings per share andgearing
MillerandModiglianiarguedthatthefinancingdecisionismoreimportantthanthedividenddecision
Shareholdersusuallyhavethepowertoincreasedividendsatannualgeneralmeetingsofacompany
(2 marks)
Which of the following statements iscorrect?
Taxallowabledepreciationisarelevantcashflowwhenevaluatingborrowingtobuycomparedto leasing as a financingchoice
Assetreplacementdecisionsrequirerelevantcashflowstobediscountedbytheafter-taxcostofdebt
Ifcapitalisrationed,divisibleinvestmentprojectscanberankedbytheprofitabilityindexwhen determining the optimum investmentschedule
Governmentrestrictionsonbanklendingareassociatedwithsoftcapitalrationing (2marks)
Aninvestmentprojecthasacostof$12,000,payableatthestartofthefirstyearofoperation.Thepossible future cash flows arising from the investment project have the following present values and associated probabilities:
PV of Year 1cashflow PV of Year 2 cashflow
($)
Probability
($)
Probability

16,000
0.15
20,000
0.75

12,000
0.60
(2,000)
0.25

(4,000)
0.25



Whatistheexpectedvalueofthenetpresentvalueoftheinvestmentproject? A $11,850
B $28,700
C $11,100
D $76,300 (2marks)
Acompanyhas7%loannotesinissuewhichareredeemableinsevenyears'timeata5%premiumtotheir nominalvalueof$100perloannote.Thebefore-taxcostofdebtofthecompanyis9%andtheafter-taxcost of debt of the company is6%.
What is the current market value of each loan note?



(2 marks)








(2 marks)





(2 marks)


174 Mock exam 1:questions

Whichofthefollowingstatementsconcerningprofitarecorrect?
Accountingprofitisnotthesameaseconomicprofit
Profit takes account ofrisk
Accounting profit can be manipulated bymanagers
1 and 3only
1 and 2only
2 and 3only
1, 2and3 (2marks)
Acompanyhasannualcreditsalesof$27millionandrelatedcostofsalesof$15million.Thecompanyhas the following targets for the nextyear:
Tradereceivablesdays 50days
Inventorydays 60days
Tradepayables 45days
Assume there are 360 days in the year.
What is the net investment in working capital required for the next year?



(2 marks)


An increase in the cost of equity leads to a fall in shareprice
Investors faced with increased risk will expect increased return ascompensation
The cost of debt is usually lower than the cost of preferenceshares
2only
1 and 3only
2 and 3only
1, 2and3 (2marks)
Governments have a number of economic targets as part of their fiscalpolicy.
Which of the following government actions relate predominantly to fiscal policy?
Decreasing interest rates in order to stimulate consumerspending
Reducing taxation while maintaining publicspending
Using official foreign currency reserves to buy the domesticcurrency
Borrowing money from the capital markets and spending it on publicworks
1only
1 and3
2 and 4only
2, 3and4 (2marks)















Mock exam1:questions 175

The following are extracts from the statement of financial position of acompany:
$'000 $'000
Equity
Ordinary shares
8,000


Reserves
20,000




28,000

Non-current liabilities



Bonds
4,000


Bank loans
6,200


Preference shares
2,000




12,200

Current liabilities



Overdraft
1,000


Trade payables
1,500




2,500

Total equity and liabilities

42,700


The ordinary shares have a nominal value of 50 cents per share and are trading at $5.00 per share. The preferenceshareshaveanominalvalueof$1.00pershareandaretradingat80centspershare.Thebonds have a nominal value of $100 and are trading at $105 perbond.
What is the market value based gearing of the company, defined as prior charge capital/equity?

A
15.0%


B
13.0%


C
11.8%


D
7.3%
(2 marks)

(Total = 30 marks)




























176 Mock exam 1:questions

Section B – ALL 15 questions are compulsory and MUST be attempted
The following scenario relates to questions 16 – 20.

Plot Co sells Product P with sales occurring evenly throughout the year. Product P
TheannualdemandforProductPis300,000unitsandanorderfornewinventoryisplacedeachmonth. Eachordercosts$267toplace.ThecostofholdingProductPininventoryis10centsperunitperyear. Buffer inventory equal to 40% of one month's sales ismaintained.
Other information
PlotCofinancesworkingcapitalwithshort-termfinancecosting5%peryear.Assumethatthereare365 days in eachyear.
What is the total cost of the current ordering policy (to the nearest wholenumber)?

A $2,250
B $2,517
C $3,204
D $5,454 (2marks)
Whatisthetotalcostofanorderingpolicyusingtheeconomicorderquantity(EOQ)(tothenearest whole number)?

A $3,001
B $5,004
C $28,302
D $40,025 (2marks)
Plot Co is considering offering a 2% early settlement discount to its customers. Currently sales are $10 millionandcustomerstake60daystopay.PlotCoestimateshalfthecustomerswilltakeupthediscount andpaycash.Plotiscurrentlyfinancingworkingcapitalusinganoverdraftonwhichitpaysa10%charge. Assume 365 days in ayear.

What will be the effect of implementing the policy?
Benefit of$17,808
Cost of$17,808
Benefit of$82,192
Benefitof$182,192 (2marks)
Plot Co managers are considering the cost of working capitalmanagement.
Are the following statements about working capital management true or false?
A conservative working capital finance approach is low risk butexpensive
Good working capital management adds to the wealth ofshareholders
A Statement 1 is true and statement 2 is false B Statement 2 is true and statement 1 isfalse C Both statements aretrue
D Both statementsarefalse (2marks)








Mock exam1:questions 177

If Plot Co were overtrading, which TWO of the following could besymptoms?

1
Decreasing levels of trade receivables


2
Increasing levels of inventory


3
Increasing levels of long term borrowings


4
Increasing levels of current liabilities


A B C D
1 and 3
and4
and3
2 and 4



(2 marks)



(Total = 10 marks)

The following scenario relates to questions 21 – 25.

GWWCoisalistedcompanywhichisseenasapotentialtargetforacquisitionbyfinancialanalysts.The valueofthecompanyhasthereforebeenamatterofpublicdebateinrecentweeksandthefollowing financial information isavailable:

Year
20Y2
20Y1
20Y0
20X9

Profit after tax ($m)
10.1
9.7
8.9
8.5

Total dividends ($m)
6.0
5.6
5.2
5.0


Statement of financial position information for 20Y2
$m $m
Non-currentassets 91.0
Current assets
Inventory 3.8
Trade receivables
4.5
8.3

Total assets

99.3

Equity finance



Ordinary shares
20.0


Reserves
47.2
67.2

Non-current liabilities



8% bonds

25.0

Current liabilities

7.1

Total liabilities

99.3

ThesharesofGWWCohaveanominal(par)valueof50cpershareandamarketvalueof$4.00pershare. The business sector of GWW Co has an average price/earnings ratio of 17times.
Theexpectednetrealisablevaluesofthenon-currentassetsandtheinventoryare$86.0mand$4.2m, respectively.Intheeventofliquidation,only80%ofthetradereceivablesareexpectedtobecollectible.
What is the value of GWW Co using market capitalisation (equity marketvalue)?

$20m
$40m
$80m
$160m (2marks)
What is the value of GWW Co using the net asset value (liquidationbasis)?
A $58.9m
B $61.7m
C $62.6m
D $99.3m (2marks)





178 Mock exam 1:questions

WhatisthevalueofGWWCousingtheprice/earningsratiomethod(businesssectoraverage price/earningsratio)?

A $1.7m
B $61.7m
C $160m
D $171.7m (2marks)
An investor believes that they can make abnormal returns by studying past share pricemovements.
In terms of capital market efficiency, to which of the following does the investor's belief relate?
Fundamentalanalysis
Operationalefficiency
Technicalanalysis
Semi-strongformefficiency (2marks)
Assume that GWW Co's P/E ratio is 15. Its competitor's earnings yield is6.25%.
When comparing GWW Co to its competitor, which of the following is correct?


Earnings yield of GWW
P/EratioofGWW

A
Higher
Higher

B
Higher
Lower

C
Lower
Higher

D
Lower
Lower

(2 marks)
The following scenario relates to questions 26 – 30.
EdwenCoisaUK-basedcompanywhichhasthefollowingexpectedtransactions. Onemonth: Expected receipt of$240,000
Onemonth: Expectedpaymentof$140,000 Threemonths: Expectedreceiptsof$300,000
A one month forward rate of $1.7832 per £1 has been offered by the company's bank and the spot rate is
$1.7822 per £1.
Other relevant financial information is as follows: Short-term dollarborrowingrate 5.4% per year Short-term sterlingdepositrate 4.6% per year Assume that it is now 1April.
What are the expected sterling receipts in one month using a forward hedge (to the nearestwhole number)?
A £56,079
B £56,110
C £178,220
D £178,330 (2marks)
What are the expected sterling receipts in three months using a money market hedge (to thenearest whole number)?
A £167,999
B £296,004
C £166,089
D £164,201 (2marks)






Mock exam1:questions 179

EdwenCo is expecting a fall in the UK/$ exchangerate.
What is the impact of a fall in a country's exchange rate?
Exports will be given astimulus
The rate of domestic inflation willrise
1only
2only
Both 1 and2
Neither 1nor2 (2marks)

Edwen Co is considering a currency futurescontract.
Which of the following statements about currency futures contracts are true?
The contracts can be tailored to the user’s exactrequirements
Theexactdateofreceiptorpaymentofthecurrencydoesnothavetobeknown 3 Transaction costs are generally higher than other hedgingmethods
1 and 2only
1 and 3only
2only
3only (2marks)

Do the following features apply to forward contracts or currencyfutures?
1Contractpriceisinanycurrencyofferedbythebank 2 Traded over thecounter
A Both features relate to forward contracts B Bothfeaturesrelatetocurrencyfutures
Feature 1 relates to forward contracts and feature 2 relates to currencyfutures
Feature2relatestoforwardcontractsandfeature1relatestocurrencyfutures (2marks)

Section C – BOTH questions are compulsory and MUST be attempted
DarnCohasundertakenmarketresearchatacostof$200,000inordertoforecastthefuturecashflowsof an investment project with an expected life of four years, asfollows:

Year
1
2
3
4


$'000
$'000
$'000
$'000

Sales revenue
1,250
2,570
6,890
4,530

Costs
500
1,000
2,500
1,750

Theseforecastcashflowsarebeforetakingaccountofgeneralinflationof4.7%peryear.Thecapitalcostof theinvestmentproject,payableatthestartofthefirstyear,willbe$2,000,000.Theinvestmentprojectwill havezeroscrapvalueattheendofthefourthyear.Thelevelofworkingcapitalinvestmentatthestartof each year is expected to be 10% of the sales revenue in thatyear.
Tax allowable depreciation would be available on the capital cost of the investment project on a 25% reducingbalancebasis.DarnCopaystaxonprofitsatanannualrateof30%peryear,withtaxbeingpaid oneyearinarrears.DarnCohasanominal(moneyterms)after-taxcostofcapitalof12%peryear.
Required
Calculate the net present value of the investment project in nominal terms and comment on its financialacceptability. (10marks)



180 Mock exam 1:questions

Discusstheproblemsfacedwhenundertakinginvestmentappraisalinthefollowingareasand comment on how these problems can beovercome:
assets with replacement cycles of differentlengths;
aninvestmentprojecthasseveralinternalratesofreturn; (5marks)
'Despitethetheoreticallimitationsofthepaybackmethodofinvestmentappraisal,itisthemethod most used inpractice.'
Discuss thisstatementbriefly. (5 marks)
(Total = 20 marks)
BurseCowishestocalculateitsweightedaveragecostofcapitalandthefollowinginformationrelatestothe company at the currenttime:
Number ofordinaryshares 20million
Bookvalueof7%convertibledebt $29million
Book value of 8%bankloan $2million
Marketpriceofordinaryshares $5.50 pershare
Marketvalueofconvertibledebt $107.11 per $100bond
Equity beta ofBurseCo 1.2
Risk-free rateofreturn 4.7%
Equityriskpremium 6.5%
Rateoftaxation 30%
BurseCoexpectssharepricestoriseinthefutureatanaveragerateof6%peryear.Theconvertibledebt canberedeemedatparineightyears’time,orconvertedinsixyears’timeinto15sharesofBurseCoper
$100 bond.
Required
Calculate the market value weighted average cost of capital of Burse Co. State clearly any assumptions thatyoumake. (13 marks)
Discuss whether the dividend growth model or the capital asset pricing model offers the better estimateofthecostofequityofacompany. (7 marks)
(Total = 20 marks)



























Mock exam1:questions 181


























































182 Mock exam 1:questions























Answers




DONOTTURNTHISPAGEUNTILYOUHAVECOMPLETEDTHEMOCKEXAM










183


























































184

A PLAN OF ATTACK
Managing your nerves
As you turn the pages to start this mock exam a number of thoughts are likely to cross your mind. At best, examinationscauseanxietysoitisimportanttostayfocusedonyourtaskforthenextthreehours!Developingan awareness of what is going on emotionally within you may help you manage your nerves. Remember, you are unlikelytobanishtheflowofadrenaline,butthekeyistoharnessittohelpyouworksteadilyandquicklythrough youranswers.
Workingthroughthismockexamwillhelpyoudeveloptheexamstaminayouwillneedtokeepgoingforthree hours and 15minutes.
Managing your time
Planningandtimemanagementaretwoofthekeyskillswhichcomplementthetechnicalknowledgeyouneedto succeed.Tokeepyourselfontime,donotbeafraidtojotdownyourtargetcompletiontimesforeachquestion, perhapsnexttothetitleofthequestiononthepaper.Asallthequestionsarecompulsory,youdonothaveto spend time wondering which question toanswer!
Doing the exam
Actuallydoingtheexamisapersonalexperience.Thereisnotasinglerightway.Aslongasyousubmitcomplete answers to all questions after the three hours are up, then your approach obviouslyworks.
Looking through the paper
SectionAhas15MCQs.Thisisthesectionofthepaperwheretheexaminercantestknowledgeacrossthebreadth ofthesyllabus.Makesureyoureadthesequestionscarefully.Thedistractersaredesignedtopresentplausible,but incorrect,answers.Don’tletthemmisleadyou.Ifyoureallyhavenoidea–guess.Youmayevenberight.
SectionBhasthreequestions,eachwithascenarioandfiveobjectivetestquestions. Section C has two longerquestions:
Question31requiresyoutocalculateNPV,withinflation.Don'tgetswampedbyinflation–showclear workings and lay your thinking on the page like a road map for themarker.
Question 32 looks at the cost of debt of a convertible bond as part of the calculation of WACC. Part (b) requiresadiscussiononwhetherthedividendgrowthmodelortheCAPMoffersthebetterestimateofcost ofequity.
Allocating your time
BPP's advice is to always allocate your time according to the marks for the question. However, use common sense.Ifyou'redoingaquestionbuthaven'tacluehowtodopart(b),youmightbebetteroffre-allocatingyour timeandgettingmoremarksonanotherquestion,whereyoucanaddsomethingyoudidn'thavetimeforearlier on. Make sure you leave time to recheck the MCQs and make sure you have answered themall.
















Mock exam1:answers 185

Section A
1 A Shareholder return = P1 P0 +D1
P0
0.197 = P1 3.10+ 0.21
3.10
0.6107 = P1– 3.10 + 0.21
P1=3.5007

B Statement 1 istrue.









Syllabus area A3d

Statement2isfalse.Thereverseyieldgapreferstoyieldsonsharesbeinglowerthanonlow-risk debt.Areverseyieldgapcanoccurbecauseshareholdersmaybewillingtoacceptlowerreturnson theirinvestmentsintheshort-term,inanticipationthattheywillmakecapitalgainsinthefuture.
Statement3istrue.Disintermediationmeansborrowersdealingwithlendersdirectlyandhasledtoa reduction in the role of financialintermediaries.
Syllabus area B2b
C Statement 1 is false. Maximising market share is not a financialobjective.
Statement2istrue.Theprimaryfinancialobjectiveofanyprofit-makingcompanyistomaximise shareholderwealth.
Statement3istrue.Financialobjectivesshouldbequantifiable.Theseinclude,forexample,target valuesforearningspershare,dividendpershareandgearingwhichareallquantifiablemeasures.
Syllabus area A2b
A The borrowing interest rate for 6 months is 8% / 2 =4%.
Thecompanyshouldborrow500,000pesos/1.04=480,769today.Aftersixmonths,500,000pesos will be repayable, includinginterest.
Thesepesoswillbeconvertedto$at480,769/15=$32,051.Thecompanymustdepositthis amount for 6 months, when it will have increased in value withinterest.
$32,051 × (1 + (0.03/2)) = $32,532 or $32,500 to the nearest $100.
Syllabus area G3a
B StatementAisfalse.Abonusissueiswhenacompanyoffersfreeadditionalsharestoexisting shareholders. Therefore, it does not raise new equityfinance.
StatementBistrue.Byreducingthenumberofsharesinissue,thecompanycanincreasetheEPS. This allows debt to be substituted for equity so gearing israised.
StatementCisfalse.M&Mproposedthatinaperfectcapitalmarket,shareholdersareindifferent betweendividendsandcapitalgainsandthevalueofacompanyisdeterminedsolelybytheearning powerofitsassetsandinvestments.Thisisknownastheirrelevancytheoryofdividendpolicy
StatementDisfalse.Shareholdersareentitledtoreceiveashareofanyagreeddividendsbut directorsdecideontheamountandfrequencyofdividendpayments(ifany).
Syllabus area E1e
C StatementAisincorrect.Withbuyinganasset,thecompanyreceivestaxallowances(tax-allowable deprecation) which results in cash savings on tax. With leasing, the lessor does not receive these allowances.However,theleaserentalisallowablefortaxpurposeswhichresultsincashsavingson tax.
StatementBisincorrect.Theyneedtobediscountedatthecostofcapital,notjustthecostofdebt. StatementCiscorrect.Rankingusingtheprofitabilityindexcanbeusedifprojectsaredivisible.


186 Mock exam 1:answers

StatementDisincorrect.Softcapitalrationingisbroughtaboutbyinternalfactorsanddecisionsby management, not external governmentdecisions.



7
C
Total cashflow
Joint
probability
EV of
cash flow



$

$



36,000
0.1125
4,050



14,000
0.0375
525



32,000
0.4500
14,400



10,000
0.15000
1,500



16,000
0.1875
3,000



(6,000)
0.0625
(375)





23,100

Less initial investment (12,000)EV oftheNPV 11,100

Syllabus area D4c




A ThecostofdebtistheIRRandthereforegivesanNPVofzero.
current MV + [ 7 × AF1-79% ] + [ 105 × DF79% ] = 0
current MV + [ 7 × 5.033 ] + [ 105 × 0.547 ] = 0
current MV = $92.67
Syllabus area D3c





Syllabus area E2b

D Statement1iscorrect.Ifabusinessisprofitablethenanincreaseinsalesshouldtranslatetomore workingcapital.
Statement 2 is correct. The greater the cash operating cycle, the greater the working capital investmentneedis.Greaterworkingcapitalmeansmorecashtiedupandthereforenotearning profit.
Statement3iscorrect.Overtrading(orundercapitalisation)iswhereabusinessisoverrelianton short-termfinancetosupportitsoperations.Itistryingtodotoomuchtooquicklywithlittlelong- termcapital.
Syllabus area C1b/c
D Financialmanagementdecisionscoverinvestmentdecisions,financingdecisions(optionsBandC) and dividend decisions (optionA).
Syllabus area A1a
A Statement1istrue.Theeconomistsconceptofprofitsisbroadlyintermsofcash,whereas accounting profits may not equate to cashflows.
Statement 2 is false. Profit does not take account of risk.
Statement3istrue.Accountingprofitcanbemanipulatedtosomeextentbychoicesofaccounting policies.


12 B Inventory = 15,000,000 ×60
360


= $2,500,000
Syllabus area A2b

Trade receivables = 27,000,000 × 50
360

= $3,750,000

Trade payables = 15,000,000 × 45
360

= $1,875,000

Net investment required = 2,500,000 + 3,750,000 - 1,875,000 = $4,375,000
Syllabus area C3a


Mock exam1:answers 187

D Statement1iscorrect.Anincreaseinthecostofequitywillleadtoafallinshareprice.Thinkabout thedividendvaluationmodelandhowP0willbeaffectedifKeincreases.
Statement 2 is correct. This is known as the risk-return trade off.
Statement3iscorrect.Preferencesharesareriskierthandebtandthereforeamoreexpensiveform offinance.
Syllabus area E3a/b
C Fiscalpolicyisactionbythegovernmenttospendmoney,ortocollectmoneyintaxeswiththe purpose of influencing the condition of the nationaleconomy.
Statement1isincorrect.Decreasinginterestratesrelatestomonetarypolicy. Statement 2 is correct. Reducing taxation relates to fiscalpolicy.
Statement3isincorrect.Thisisgovernmentpolicyoninterventiontoinfluencetheexchangerate. Statement4iscorrect.Spendingmoneyonpublicworksisanexampleoffiscalpolicy.
Syllabus area B1b/c
A Gearing = Prior chargecapital
Equity
Marketvalueofpreferenceshares=2,000shares×80c=$1,600. Priorchargecapital =preferenceshares+bonds+loan.
Prior chargecapital = $1,600 + ($4,000 × 1.05) +$6,200
= $12,000
Market value of equity:
Number of shares = $8,000 ÷ 50c = 16,000 shares 16,000 shares × $5 = $80,000
Gearing = $12,000 × 100% = 15.0%
$80,000
Syllabus area E3d
























188 Mock exam 1:answers

Section B
D $5,454 peryear
Cost of current ordering policy
Total cost = order costs + holding costs
Ordering cost = 12 $267 = $3,204 peryear Note: One order permonth Monthly order = monthly demand = 300,000/12 = 25,000units
Buffer inventory = 25,000 0.4 = 10,000 units
Average inventory excluding buffer inventory = 25,000/2 = 12,500 units Averageinventoryincludingbufferinventory=12,500+10,000=22,500units Holding cost = 22,500 0.1 = $2,250 peryear
Total cost = $3,204 + $2,250 = $5,454 per year
B $5,004 peryear
Cost of ordering policy using economic order quantity (EOQ)
EOQ = √ (2 CoD)/Ch
EOQ = √ (2 267 300,000)/0·10) = 40,025 per order
Numberofordersperyear=300,000/40,025=7.5ordersperyear Order cost = 7.5 267 =$2,003
Average inventory excluding buffer inventory = 40,025/2 = 20,013 units Averageinventoryincludingbufferinventory=20,013+10,000=30,013units Holding cost = 30,013 0.1 = $3,001 peryear
Total cost = $2,003 + $3,001 = $5,004 per year
B Current receivables = $10 million × (60 / 365) =$1,643,835.
Overdraft interest charge per annum relating to current receivables = $1,643,835 × 10% =
$164,383.50 pa
Interestsavedwhenhalfcustomerspaycash=0.5×$164,383.50=$82,191.75peryear Annual cost of the discount = 0.5 × $10 million × 2% =$100,000.
Netcostofofferingtheearlysettlementdiscount=$100,000–$82,191.75=$17,808.25costper year
C Both statements aretrue.
Intermsofworkingcapitalfinance,organisationscanhaveaconservative(mainlylong-termfinance) or aggressive (mainly short-term finance) approach. The former is likely to be low risk but expensive, the latter more risky but cheaper (as short-term finance is low risk from an investor's perspective.)
Poorfinancialmanagementofworkingcapitalcanleadtocashflowdifficultiesoreventhefailureofa business. Good working capital management can also create profits and minimise costs, and this ultimatelyaddstothewealthofshareholders–akeyobjectiveinthevastmajorityofbusinesses.
D Thetwosymptomsofovertradingareincreasinglevelsofinventoryandcurrentliabilities.Trade receivablesincreaseduringovertradingsostatement1isnotasymptom.Mostoftheincreasein assetsisfinancedbycreditratherthanlongtermborrowingssostatement3isnotasymptom.
21 D $160m

Market capitalisation = number of shares × market value.
= ($20m / $0.5) × $4.00 = $160m



Mock exam1:answers 189

22 B Thenetrealisablevalueofassetsatliquidation=non-currentassets+inventory+tradereceivables– current liabilities –bonds
= $86m + $4.2m + ($4.5m × 80%) - $7.1m - $25m
= $61.7m
23 D $171.7m

Historicearningsbasedon20X2profitaftertax=$10.1m Average P/E ratio in industry = 17times
AssumingnoadjustmentrequiredtoP/Eratio(GWWisalistedcompanysononeedtoadjustfor transferability) and using historicearnings:
P/E ratio value = 17 × $10.1m = $171.7m
C Technicalanalysis.Technicalanalystsworkonthebasisthatpastpricepatternswillberepeated,so that future price movements can be predicted from historicalpatterns.
B For GWW Co, P/E = 15, Earnings yield (=1/(P/E ratio) =6.7%.
For competitor, P/E (= 1/earnings yield) = 16, Earnings yield = 6.25%.
26 A £56,079
Forward market
Net receipt in one month = $(240,000 – 140,000) = $100,000 EdwenConeedstosell$satanexchangerateof$1.7832=£1 Sterlingvalueofnetreceipt=$100,000/1.7832=£56,079
27 A £167,999
Money market hedge
Expected receipt after three months = $300,000
$ interest rate over three months = 5.4/4 = 1.35%
$s to borrow now in order to have $300,000 liability after three months = $300,000/1.0135 =
$296,004
Spot rate for selling $s = $1.7822 per £1
Sterlingdepositfromborrowed$satspot=$296,004/1.7822=£166,089 Sterling interest rate over three months = 4.6/4 =1.15%
Value in three months of sterling deposit = £166,089 1.0115 = £167,999
C Withafallinacountry'sexchangerate(forexampleifthe£/$exchangeratefallsfrom£0.7:$1to
£0.8:$1)Edwen’sUKexportswillbecheaper(andsobemorecompetitive)andimportswillbecome moreexpensive.Givenimportsmayincluderawmaterials,thispusheslocalpricesup–inflation.
C ‘Thecontractscanbetailoredtotheuser’sexactrequirements’isfalse.Futurescontractsare standardcontracts.
‘Theexactdateofreceiptorpaymentofthecurrencydoesnothavetobeknown’istrue.Thefutures contractdoesnothavetobeclosedoutuntiltheactualcashreceiptorpaymentismade.
‘Transactioncostsaregenerallyhigherthanotherhedgingmethods’isfalse.Transactionscostsare usually lower than other hedgingmethods.
A ‘Contractpriceisinanycurrencyofferedbythebank’relatestoforwardcontracts.‘Tradedoverthe counter’ also relates to forwardcontracts.





190 Mock exam 1:answers

Section C Question 31










Inflatedsalesrevenue 1
Inflatedcosts 1
Taxliability 1
Tax allowable depreciation, years 1to3 1
Balancing allowance,year4 0.5
Tax allowable depreciationtaxbenefits 1
Timing of tax liabilitiesandbenefits 1
Incremental workingcapitalinvestment 1
Recovery ofworkingcapital 0.5
Market research omitted assunkcost 0.5
Calculation of nominaltermsNPV 1
Comment onfinancialacceptability 0.5
Marks











10


Discussion of assetreplacementdecisions 2-3
Discussion of projects withseveralIRRs 2-3
5
1-2 marksperpoint Maximum 5
20



Astherequirementstatescalculationsaretobeperformedinnominalterms,cashflowsneedtobestatedin theirfutureamounts(ieinflatedifnecessary)anddiscountedatthenominalrate–thenominalratealso
includes inflation.


$'000
0
1
2
3
4
5

Net cash inflow before

785.25
1,721.05
5,038.54
3,340.65


corporation tax (working 1)







Tax in net cash inflow @ 30%


(235.58)
(516.32)
(1,511.56)
(1,002.20)

1 year in arrears







Benefit of tax allowable depn (working 2)


150
112.5
84.38
253.13

Investment
(2,000)






Working capital (working 3)
(130.88)
(150.85)*
(509.06)
246.43
544.36


Net cash flow
(2,130.88)
634.40
1,126.41
4,881.15
2,457.83
(749.07)

12% Discount factor
1
0.893
0.797
0.712
0.636
0.567

Present value
(2,130.88)
566.52
897.75
3,475.38
1,563.18
(424.72)


Net present value = ∑ Present values = 3,947.23



Mock exam1:answers 191

A positive NPV of $3,947,230 makes the project financially acceptable, as accepting it should increase shareholder wealth.
Workings
Inflated net cashinflows
1 2 3 4
Salesrevenue 1,250 2,570 6,890 4,530
Less Costs
(500)
(1,000)
(2,500)
(1,750)

Net cash inflow in real terms
750
1,570
4,390
2,780

Inflation factor
× 1.047
× (1.047)2
× (1.047)3
× (1.047)4

Net cash flow in nominal terms
785.25
1,721.05
5,038.54
3,340.65



Tax allowabledepreciation

Initialcost 2,000

Tax saved @30% Timing

1st yearTAD25% (500)
TWDV endyear1 1,500
150
T1


2nd yearTAD25% (375)
TWDV endyear2 1,125
112.5
T2


3rd yearTAD25% (281.25)
TWDV endyear3 843.75
84.38
T3


Disposal (0)




Balancingallowance 843.75
253.13
T4


3 Workingcapital




0
1
2
3
4

Sales revenue (real terms)
1,250
2,570
6,890
4,530

Inflation factor
1.047
(1.047)2
(1.047)3
(1.047)4

Sales revenue (nominal terms)
1,308.75
2,817.26
7,907.87
5,443.58

Working capital (10%)
130.88
281.73
790.79
544.36

Increments(=cashflow)inplaceatstart (130.88) ofyear
(150.85)*
(509.06)
246.43
544.36

*for example, 281.73 – 130.88 = 150.85





(i) TheNPVmethoddoesnotassesswhenorhowfrequentlyanassetshouldbereplaced.Theannual equivalentcostmethodaddressesthisissue.Theannualequivalentcostisthepresentvalueofcost overonereplacementcycledividedbythecumulativepresentvaluefactorforthenumberofyearsin thecycle.Theoptimumreplacementperiodistheperiodwiththelowestequivalentannualcost.
(ii) Investmentprojectswithnon-conventionalcashflowscanhavemorethanoneinternalrateofreturn. Decision makers need to be aware of this to avoid making the wrong decision. The use of NPV can removethisissueastheNPVmethoddealswithnon-conventionalcashflows.Thisisareasonwhy NPV is considered to be superior to the IRRmethod.
Payback
Thepaybackmethodofprojectappraisalinvolvescalculatingtheperiodoftimethatitislikelytotaketo recoup the initial outlay on a project, and then comparing this with what the company defines as an acceptableperiod.Ifthepaymentperiodiswithinthatdefinedasacceptable,andprovidedthatthereareno other constraints (for example, capital rationing), the project will beaccepted.
Limitations of payback
Itignoresthetimingofcashflowswithinthepaybackperiod,thecashflowsatthepaybackperiod and therefore the total projectreturn.
It ignores the time value ofmoney.
It is unable to distinguish between projects with the same paybackperiod.
It tends to favour short term (often smaller) projects over longer termprojects.
It takes account of the risk of the timing of cash flows but not the variability of those cashflows.


192 Mock exam 1:answers

Popularity of payback
It is simple to calculate and simple to understand, and this may be important whenmanagement resources are limited. It is similarly helpful in communicating information about minimum requirements to managers responsible for submittingprojects.
Itcanbeusedasascreeningdeviceasafirststageineliminatingobviouslyinappropriateprojects prior to more detailedevaluation.
Thefactthatittendstobiasinfavourofshorttermprojectsmeansthatittendstominimiseboth financial and businessrisk.
Itcanbeusedwhenthereisacapitalrationingsituationtoidentifythoseprojectswhichgenerate additional cash for investmentquickly.

Question 32
Text references. Cost of capital is covered in Chapter 15.
Top tips. This question looks at the cost of debt of a convertible bond as part of the calculation of WACC. In part (a),thecostofequityhastobecalculatedusingthecapitalassetpricingmodel(CAPM)asthereisinsufficientdata inthequestiontousethedividendgrowthmodel.Therisk-freerateofreturn,theequitybetaandtheequityrisk premium(thisisthedifferencebetweenthemarketreturnandtherisk-freereturn)aregiven,andsothecostof equity can be calculated from the CAPM formula. For the convertible debt calculation you need to assume that conversion is likely to occur, and then calculate the cost of debt using the current market value, the after-tax interest rate, the conversion value after six years and use the IRRmethod.
Ifyouunderstandtheformulaforthedividendgrowthmodel,part(b)shouldbeastraightforwardexplanationof theuncertaintiesbehindeachvariableintheformula.Youcantakeasimilarapproachwiththecapitalassetpricing model.
Easymarks.Eachpartofthecalculationsinpart(a)willgainmarksso,ifyougetstuck,makeanassumptionand moveon.Don’tspendtoolongonthispartofthequestionasthereareeasiermarksavailableinpart(b).
Examiner’s comments. Answers to part (a) of the question were of variable quality. A common error was to confusetheequityriskpremiumwiththereturnonthemarket,resultinginacostofequitylessthanthecostof debt. Such a result is inconsistent with the risk-returnhierarchy.
Many candidates ignored the bank loan, or assumed that it was not relevant, and lost credit as a result.
Findingthecostofdebtoftheconvertiblebondsprovedtobeachallengeformanycandidates.Somecandidates statedsimplythattheyassumedthebondsweretoberedeemedratherthanconvertedandlostmarksasaresult, eveniftheycalculatedcorrectlythecostofdebtofthebondwithredemptionaftereightyears.Studentsgained credit for any parts of this evaluation that were carried outcorrectly.
Manycandidateswereabletocalculatemarketweightscorrectly,althoughsomechosetoignorethecurrentbond marketpriceandcalculateamarketpricebasedonthepresentvalueoftheconversionvalue.Creditwasgiven where method was correct but calculation errors weremade.
Inpart(b)weakeranswerssimplyoutlinedthetwomodelsandtheirconstituentvariables.Betteranswers comparedandcontrastedthetwomodels,andarguedforthesuperiorityoftheCAPM.













Mock exam1:answers 193




Calculation of costofequity 2
Calculation of cost ofconvertibledebt 5
Calculation of cost ofbankloan 2
Calculation ofmarketvalues 2
CalculationofWACC 2
Discussion of dividendgrowthmodel 2-3
Discussion of capital assetpricingmodel 2-3
Conclusion 1-2
Marks





13

Maximum Maximum 7
20



Cost ofequity
Therequiredrateofreturnonequitycanbefoundusingthecapitalassetpricingmodel: E(ri) = Rf+ i(E(rm) –Rf)
E(ri) = 4.7% + (1.2 x6.5%)
= 12.5%
Cost of convertible debt
Conversionvalue = P0(1 + g)nR WherePo isthecurrentshareprice
g istheexpectedannualgrowthoftheshareprice n is the number of years toconversion
R isthenumberofsharesreceivedonconversion Conversion value = $5.50 x (1 + 0.06)6 x15
= $117.03 per bond
Wecanthereforeassumethatconversionwilltakeplaceastheconversionvalueismuchgreaterthanparvalue. The annual interest cost net of tax will be 7% (1 – 0.3) = $4.90 perbond
The cash flows will be as follows:

Year

Cash flow
10%
discount factors

PV
5%
discount factors

PV


$m

$m

$m

0 Marketvalue
(107.11)
1.000
(107.11)
1.000
(107.11)

1-6 Interest
4.90
4.355
21.34
5.076
24.87

6 Conversionvalue
117.03
0.564
66.00
0.746
87.30




(19.77)

5.06

Calculate the cost of convertible debt using an IRR calculation.


IRR = a%
NPVa  

NPV – NPV
(b – a)%

 a b 
= 5% + 5.06(10% 5%) = 6.02%
5.06 19.77
The after tax cost of convertible debt is therefore 6.02%




194 Mock exam 1:answers

Cost of bank loan
After-tax interest rate = 8% x (1 – 0.3)
= 5.6%
Market values
Market value of equity = 20m x $5.50 = $110m
Marketvalueofconvertibledebt=29mx107.11/100=$31.06m Market value of bank loan =$2m
Total market value = $(110.00 + 31.06 + 2)m = $143.06m
Weighted average cost of capital


WACC= VE
ke+ VD
kd

V V  V V
E D E D
In this case, we have two costs of debt so:

WACC = 110 × 12.5% + 31.06 × 6.02% + 
2 ×5.6%



143.06 
143.06
143.06 

= 9.61% + 1.31% + 0.08%
= 11%
Dividend growthmodel
Thereareanumberofproblemswiththedividendgrowthmodel.Itusesasetfigureforgwhichassumes thatdividendsgrowsmoothly.Inreality,dividendschangeaccordingtodecisionsmadebymanagerswho do not necessarily repeat historical trends. It is therefore very difficult to accurately predict the future dividend growthrate.
Theothermainproblemishowtoincorporaterisk.Thedividendgrowthmodeldoesnotexplicitlyconsider risk,particularlybusinessrisk.Thecompanymaychangeitsareaofbusinessoperationsandtheeconomic environment is notoriously uncertain. The share price will however fall as risk increases, leading to an increased cost ofequity.
The model also ignores the effects of taxation and assumes there are no issue costs for new shares.
Capital asset pricing model
ThemainadvantagethattheCAPMhasoverthedividendvaluationmodelisthatitdoesexplicitlyconsider risk.TheCAPMisbasedonacomparisonofthesystematicriskofindividualinvestmentswiththerisksof allsharesinthemarket.Systematicriskisriskthatcannotbediversifiedawayandaninvestorwillrequirea higherreturntocompensateforhigherrisk.Thishigherreturnisthehighercostofequitythatiscalculated using the CAPMformula.
The formula does however require estimates to be made of excess return, the risk-free rate and beta values.Allofthesecanbedifficulttoestimate,butaremorereliablethanthedividendgrowthrateusedin the dividend valuationmodel.
Conclusion
TheCAPMdoesexplicitlyconsiderriskandusesestimatedvaluesthataremorereliablethanthoseusedin thedividendvaluationmodel.ItcanthereforebesaidthatCAPMoffersthebetterestimateofthecostof equity of acompany.








Mock exam1:answers 195


























































196 Mock exam 1:answers

ACCA
Paper F9
Financial Management

Mock Examination2



Question Paper

Time allowed: 3 hours 15 minutes

ALL questions are compulsory and MUST be attempted









DONOTOPENTHISPAPERUNTILYOUAREREADYTOSTARTUNDER EXAMINATIONCONDITIONS










197


























































198

Section A – ALL 15 questions are compulsory and MUST be attempted
Aschoolchangesitsstationerysupplierstosavemoney,andincreasesclasssizes.Asaresultthelatestset of exam results are lower than previousyears.
How has the school performed in terms of the value for money framework?
Welloneconomyandefficiency,butatthecostofeffectiveness Wellonefficiency,butnotwellwitheconomyoreffectiveness Wellonefficiencyandelasticity,badlyoneffectiveness
Welloneffectivenessandeconomy,butbadlyonefficiency. (2marks)
The government in a country is following an expansionary fiscalpolicy.
How might this affect many businesses?
Highertaxes,lessgovernmentcontractsbeingoffered,lesssubsidies,lowerdemand. Lowerinterestrates,increasedavailabilityofcreditfrombanks,higherdemand.
Lower taxes, increased government subsidies and contracts being offered, higher demand.
Higherinterestrates,lessavailabilityofcreditfrombanks,lowerdemand. (2marks)
What does 'primary market' referto?
The biggest stock market in an economy
Themarketfornewfinancebeingobtainedbybusinesses Themarketfortradingexistingfinancialinstruments
Themostseniormarketinaneconomy. (2marks)
TKQCohasjustpaidadividendof21cpershareanditssharepriceis$3.50pershare.Oneyearagoits share price was $3.10 pershare.
Working to one decimal place, what is the total shareholder return over the period (to 1 dp)?
% (2marks)
TW Co needs to purchase raw supplies of 2,000 kgs of material M each year. There is a standing chargeof
$10perorder.Purchasepriceis$5perkg,anditcostsTW10%ofpurchasepricetostoreoneunitfora year.
What is the annual inventory related cost at the economic order quantity to the nearest $10?
$ (2marks)
WhichTHREEofthefollowingmoneymarketinstrumentswouldbeclassedas'discount'instrumentsas opposed to 'interestbearing'?
Commercial paper Treasury bills Certificate of deposit Bankers acceptance
(2 marks)









Mock exam2:questions 199

ThefollowinginformationisrelevanttoABCCo: Receivablesdays: 56days
Inventory turnover: 10 times Payablesdays: 45days
Daysperyear: 360days
ABC implements an inventory holding policy that reduces inventory days by 6.
What is the new length of the working capital cycle?

days (2marks)
QWE Co is appraising a new 5-year project that will generate net cash inflows of $50,000 for an initial investmentinmachineryof$250,000.Themachineryhasanestimatedwrittendownvalueandscrapvalue of $100,000 at the end of fiveyears.
What is the return on capital employed (ROCE) for the project (using the average investment method)? Give your answer to 1 dp.
% (2marks)
Aprojectrequiresaninitialoutlayof$100,000andwillgeneratenetcashinflowsof$40,000perannum.
At a cost of capital of 10%, what is the adjusted payback period to the nearest month?
years 6months
years
years 10months
years2months (2marks)
ACBCoisappraisingaprojectwithaninitialinvestmentof$1millionthatwillgeneratenetcashinflowsafter tax of $150,000 per annum indefinitely. ACB Co estimates its cost of capital to be12%.
What is ACB's percentage sensitivity to their estimate of a 12% cost of capital?
3%
15%
25%
20% (2marks)
Are the following statements about capital rationing true orfalse?


A capital expenditure budget is evidence of a soft capital constraint.
Whetherprojectsaredivisibleorindivisible,theinvestmentplanshouldseekto maximise net present value per $invested.
True False








(2 marks)

Which of the following is NOT an advantage of withholding a dividend as a source offinance?
Retainedprofitsareafreesourceoffinance Investment plans need less justification Issue costs arelower
Itisquick (2marks)






200 Mock exam 2:questions

Acompanyhasjustpaidanordinarysharedividendof32.0centsandisexpectedtopayadividendof33.6 cents in one year's time. The company has a cost of equity of13%.
What is the market price of the company's shares to the nearest cent on an ex dividend basis?
$3.20
$4.41
$2.59
$4.20 (2marks)
Company A's shares have a higher beta factor than companyB's.
Which of the following is true about company A?
Total risk is higher than company B
ItisexposedtomoresystematicriskfactorsthancompanyB Its shares are underpriced
It is exposed to higher levels of systematic risk than company B
(2 marks)
WhichofthefollowingisLEASTdirectlyrelevanttothediscountedcashflowvaluationofabusiness?
Forecast synergies
Realisable value of operating assets
Cost of equity to appraise the investment
Value ofsurplusassets (2 marks)
(Total = 30 marks)



































Mock exam2:questions 201

Section B – ALL 15 questions are compulsory and MUST be attempted
The following scenario relates to questions 16-20.
GuilderCoisappraisingfourdifferentprojectsbutisexperiencingcapitalrationinginYear0.Nocapitalrationingis expected in future periods but none of the four projects that Guilder Co is considering can be postponed, so a decision must be made now. Guilder Co’s cost of capital is12%.
The following information is available.

Project Outlayin PV
Year 0
$ $
NPV

$

Amster 100,000 111,400 11,400
Eind 56,000 62,580 6,580
Utrec 60,000 68,760 8,760
Tilbur 90,000 102,400 12,400
If the projects are ranked in terms of profitability index (PI), which order iscorrect?
Tilbur,Amster,Utrec,Eind Amster,Tilbur,Utrec,Eind Amster,Eind,Tilbur,Utrec Utrec,Tilbur,Eind,Amster

WhichofthefollowingstatementsaboutGuilderCo’sdecisiontousePIistrue?
ThePItakesaccountoftheabsolutesizeoftheindividualprojects PIhighlightstheprojectswhichareslowestingeneratingreturns PI can only be used if projects aredivisible
PI allows for uncertainty about the outcome of each project










(2 marks)







(2 marks)

Several years later, there is no capital rationing and Guilder Co decides to replace an existing machine. GuilderCohasthechoiceofeitheraSupermachine(lasting4years)oraGreatmachine(lasting3years).
The following present value table includes the figures for a Super machine.
0 1 2 3 4
Maintenancecosts (20,000) (29,000) (32,000) (35,000)
Investment and scrap
(250,000)



25,000

Net cash flow
(250,000)
(20,000)
(29,000)
(32,000)
10,000

Discount at 12%
1.000
0.893
0.797
0.712
0.636

Present values
(250,000)
(17,860)
(23,113)
(22,784)
(6,360)

Tax and tax allowable depreciation should be ignored.
What is the equivalent annual cost (EAC) of the Super machine (to the nearest whole number)?
$ (2marks)








202 Mock exam 2:questions

WhichofthefollowingstatementsconcerningGuilderCo’suseoftheEACaretrue?
The use of equivalent annual cost is appropriate in periods of highinflation
TheEACmethodassumesthatthemachinecanbereplacedbyexactlythesamemachinein perpetuity
Bothstatementsaretrue Bothstatementsarefalse
Statement1istrueandstatement2isfalse Statement1isfalseandstatement2istrue
(2 marks)
The following potential cash flows are predicted for maintenance costs for the Greatmachine:

Year
Cash flow
Probability


($)


2
19,000
0.55

2
26,000
0.45

3
21,000
0.3

3
25,000
0.25

3
31,000
0.45

What is the expected present value of the maintenance costs for year 2 (to the nearest whole number)?
$
(2 marks)
The following scenario relates to questions 21-25.
TGA Co's sales are exported to a European country and are invoiced in euros.
TGA Co expects to receive €500,000 from export sales at the end of three months. A forward rate of €1.687 per $1 has been offered by the company's bank and the spot rate is €1.675 per $1.
Otherrelevantfinancialinformationisasfollows: Short-term dollarborrowingrate 5% per year Short-term dollardepositrate 4% peryear
TGA Co can borrow short term in the euro at 9% per year Assume there are 365 days in each year.
WhatcouldTGACodotoreducetheriskoftheeurovaluedroppingrelativetothedollarbeforethe
€500,000 is received?
Deposit €500,000immediately
Enter into a forward contract to sell €500,000 in threemonths
Enter into an interest rate swap for threemonths
or 2only
only
only
1, 2or3 (2marks)
What is the dollar value of a forward market hedge (to the nearest wholenumber)?
$ (2marks)







Mock exam2:questions 203

What is the dollar value of a money markethedge?
$284,814
$292,761
$294,858
$297,770

TGACoisconsideringfuturescontracts.
Whichofthefollowingstatementsaretrueoffuturescontracts?

Transactionscostsarelowerthanotherhedgingmethods TheycanbetailoredtoTGACo’sexactrequirements

Thefollowingstatementsrefertotypesofforeigncurrencyrisk.









True False








(2 marks)







(2 marks)

TheriskthatTGACowillmakeexchangelosseswhentheaccountingresultsofitsforeignbranches are expressed in the homecurrency
TheriskthatexchangeratemovementswillaffecttheinternationalcompetitivenessofTGACo
What types of risk do the statements refer to?


Statement 1
Statement 2
Economic Translation Transaction


(2 marks)


The following scenario relates to questions 26-30.
DFECoishopingtoinvestinanewproject.DFECo'sgearingisslightlyabovetheindustryaverage,sowhen seeking finance for the new project DFE Co opts for equityfinance.
TheboardofDFECorecentlyappointedaMediaLiaisonofficerastheybelievethetimingandmethodofpublic announcements(suchastheinvestmentinalargeproject)isimportantinmanagingthevalueofDFE’sshares.
DFE Co has 8% convertible loan notes in issue which are redeemable in five years' time at their nominal value of
$100perloannote.Alternatively,eachloannotecouldbeconvertedafterfiveyearsinto70equityshareswitha nominal value of $1each.
TheequitysharesofDFECoarecurrentlytradingat$1.25pershareandthissharepriceisexpectedtogrowby4% peryear.Thebefore-taxcostofdebtofDFECois 10%andtheafter-taxcostofdebtofDFECois7%.
WhatisthecapitalstructuretheorythatDFECoappearstosubscribeto?
Traditionalview
Modigliani-Miller (no tax) C Modigliani-Miller (withtax)
D Residualview (2marks)
How efficient does the DFE Co board believe the markets tobe?
Completelyinefficient
Weak formefficient
Semi-strong formefficient
Strongformefficient (2marks)
What is the current market value of each convertible loan note (to 2dp)?
$ (2marks)


204 Mock exam 2:questions

In relation to DFE Co hedging interest rate risk, which of the following statements iscorrect?
Theflexiblenatureofinterestratefuturesmeansthattheycanalwaysbematchedwithaspecific interest rateexposure
Interestrateoptionscarryanobligationtotheholdertocompletethecontractatmaturity Forwardrateagreements aretheinterestrateequivalentofforwardexchangecontracts
Matchingiswhereabalanceismaintainedbetweenfixedrateandfloatingratedebt (2marks)
Which of the following could cause the interest yield curve tosteepen?
Increased uncertainty about thefuture
Heightened expectations of an increase in interestrates
The expectation that interest rate decreases will happen earlier than previouslythought.
and 2only
1,2 and 3
and 3only
1only (2marks)
(Total = 30 marks)









































Mock exam2:questions 205

Section C – BOTH questions are compulsory and MUST be attempted
Dartig Co is a stock-market listed company that manufactures consumer products and it is planning to expand its existing business. The investment cost of $5 million will be met by a 1 for 4 rights issue. The current share price of Dartig Co is $2.50 per share and the rights issue price will be at a 20% discount to this.ThefinancedirectorofDartigCoexpectsthattheexpansionofexistingbusinesswillallowtheaverage growthrateofearningspershareoverthelastfouryearstobemaintainedintotheforeseeablefuture.
The earnings per share and dividends paid by Dartig over the last four years are as follows:


20X3
20X4
20X5
20X6
20X7

Earnings per share (cents)
27.7
29.0
29.0
30.2
32.4

Dividend per share (cents)
12.8
13.5
13.5
14.5
15.0

DartigCohasacostofequityof10%.Theprice/earningsratioofDartigCohasbeenapproximatelyconstant in recent years. Ignore issuecosts.
Required
Calculate the theoretical ex rights price per share prior to investing in the proposed business expansion. (4 marks)
Calculate the expected share price following the proposed business expansion using the price/earningsratiomethod. (4 marks)
Discusswhethertheproposedbusinessexpansionisanacceptableuseofthefinanceraisedbythe rightsissue,andevaluatetheexpectedeffectonthewealthoftheshareholdersofDartigCo.
(6 marks)
Usingtheinformationprovided,calculatetheexdivsharepricepredictedbythedividendgrowth modelanddiscussbrieflywhythissharepricediffersfromthecurrentmarketpriceofDartigCo.
(6 marks)(Total = 20 marks)
SC Co is evaluating the purchase of a new machine to produce product P, which has a short product life- cycleduetorapidlychangingtechnology.Themachineisexpectedtocost$1million.Productionandsales of product P are forecast to be asfollows:

Year
1
2
3
4

Production and sales (units/year)
35,000
53,000
75,000
36,000

The selling price of product P (in current price terms) will be $20 per unit, while the variable cost of the product(incurrentpriceterms)willbe$12perunit.Sellingpriceinflationisexpectedtobe4%peryearand variablecostinflationisexpectedtobe5%peryear.NoincreaseinexistingfixedcostsisexpectedsinceSC Co has spare capacity in both space and labourterms.
ProducingandsellingproductPwillcallforincreasedinvestmentinworkingcapital.Analysisofhistorical levelsofworkingcapitalwithinSCCoindicatesthatatthestartofeachyear,investmentinworkingcapital for product P will need to be 7% of sales revenue for thatyear.
SCCopaystaxof30%peryearintheyearinwhichthetaxableprofitoccurs.Liabilitytotaxisreducedby taxallowabledepreciationonmachinery,whichSCCocanclaimonastraight-linebasisoverthefour-year lifeoftheproposedinvestment.Thenewmachineisexpectedtohavenoscrapvalueattheendofthefour- yearperiod.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.
Required
CalculatethenetpresentvalueoftheproposedinvestmentinproductP. (12marks)
CalculatetheinternalrateofreturnoftheproposedinvestmentinproductP. (3marks)

206 Mock exam 2:questions

AdviseontheacceptabilityoftheproposedinvestmentinproductPanddiscussthelimitationsoftheevaluationsyouhavecarriedout. (5marks)
(Total = 20 marks)




























































Mock exam2:questions 207


























































208 Mock exam 2:questions























Answers




DONOTTURNTHISPAGEUNTILYOUHAVECOMPLETEDTHEMOCKEXAM










209


























































210

A PLAN OF ATTACK
Managing your nerves
As you turn the pages to start this mock exam a number of thoughts are likely to cross your mind. At best, examinationscauseanxietysoitisimportanttostayfocusedonyourtaskforthenextthreehours!Developingan awareness of what is going on emotionally within you may help you manage your nerves. Remember, you are unlikelytobanishtheflowofadrenaline,butthekeyistoharnessittohelpyouworksteadilyandquicklythrough youranswers.
Workingthroughthismockexamwillhelpyoudeveloptheexamstaminayouwillneedtokeepgoingforthree hours and 15minutes.
Managing your time
Planningandtimemanagementaretwoofthekeyskillswhichcomplementthetechnicalknowledgeyouneedto succeed.Tokeepyourselfontime,donotbeafraidtojotdownyourtargetcompletiontimesforeachquestion, perhapsnexttothetitleofthequestiononthepaper.Asallthequestionsarecompulsory,youdonothaveto spend time wondering which question toanswer!
Doing the exam
Actuallydoingtheexamisapersonalexperience.Thereisnotasinglerightway.Aslongasyousubmitcomplete answers to all questions after the three hours are up, then your approach obviouslyworks.
Looking through the paper
SectionAhas15objectivetestquestions.Thisisthesectionofthepaperwheretheexaminercantestknowledge acrossthebreadthofthesyllabus.Makesureyoureadthesequestionscarefully.Thedistractorsaredesignedto presentplausible,butincorrect,answers.Don’tletthemmisleadyou.Ifyoureallyhavenoidea–guess.Youmay even beright.
SectionBhasthreequestions,eachwithascenarioandfiveobjectivetestquestions. Section C has two longerquestions:
Question 31 is a valuations question, – show all your workings and don't panic! Part (a) isstraightforward.
Question32requiresyoutocalculateNPV,withinflation.Don'tgetswampedbyinflation–showclear workingsandlayyourthinkingonthepagelikearoadmapforthemarker.Readthedetailinpart(a) carefully so that you deal with tax allowable depreciationcorrectly.
Allocating your time
BPP's advice is to always allocate your time according to the marks for the question. However, use common sense.Ifyou'redoingaquestionbuthaven'tacluehowtodopart(b),youmightbebetteroffre-allocatingyour timeandgettingmoremarksonanotherquestion,whereyoucanaddsomethingyoudidn'thavetimeforearlier on.MakesureyouleavetimetorechecktheMCQsandmakesureyouhaveansweredthemall.
















Mock exam2:answers 211

Section A
Well on economy and efficiency, but at the cost ofeffectiveness
Economyisthecostofinputshencesavingmoneybyswitchingsuppliersisgoodperformancein thisregard.
Efficiencyisthevolumeofoutputperunitofinput–inthisexampleincreasedclasssizesmeans increasedefficiencyasmorechildrenarereceivinganeducationperteacher/classroom.
Effectivenessisthequalityofoutputs.Inthiscase,examresultshavereducedhencetheeducation 'produced' is less effective thanpreviously.
Syllabus area A4b
Lowertaxes,increasedgovernmentsubsidiesandcontractsbeingoffered,higherdemand Statement 1 describes a contractionary fiscalpolicy.
Statement 2 describes an expansionary monetary policy.
Statement3iscorrect:fiscalpolicyreferstothebalanceoftaxationandgovernmentspending.Inan effort to boost demand, the government would reduce taxes and increase government spending, injecting demand into theeconomy.
Statement 4 describes a contractionary monetary policy.
Syllabus area B1c
The market for new finance being obtained bybusinesses
Thetermreferstoacapitalmarketswherenewsecuritiesareissuedandsoldtoinvestors.The secondarymarketiswhereexistingfinancialinstrumentsaretradedbetweeninvestors.
Syllabus area B2c
4 19.7%
Totalreturntoshareholdersisacombinationofincomeandcapitalgain.Thecapitalgainoverthe periodis$3.50–$3.10=40cashare.Dividendswere21csototalreturnwas(40+21)=61c.Asa percentage of the opening share price, the return = 61/310 =19.7%


5 $10,140
EOQ = √[(2 × Co× D) / Ch] = √[(2 × $10 × 2,000)/(10% × $5)] = 283 units
Totalcost = purchase cost + order costs + holdingcosts
= (2,000 × $5) + [(2,000/283) × $10] + [(283/2) × ($5 × 10%)]
= $10,000 + $70.67 + $70.75 = $10,141.42
= $10,140 to the nearest $10
Syllabus area A3d








Syllabus area C2c

Commercialpaper,treasurybillsandbankersacceptancesdonotpayinterest.Theyareissuedata discountandredeemedatahighervalue.Acertificateofdepositdoesearnandpayinteresthowever.
Syllabus area B3c
41days
Current inventory days = 360/10 = 36 days. After new policy: 36 – 6 = 30 days.
Length of the working capital cycle = receivables days + inventory days – payables days
= 56 + 30 – 45 = 41 days.
Syllabus area C3a



212 Mock exam 2:answers

8 11.4%
ROCE = Average annual accounting profits / Average investment
Averageannualaccountingprofits=(Totalcashinflows–totaldepreciation)/5
= [(5 × $50,000) – (250,000 – 100,000)] / 5
= $20,000 per year Average investment = ($250,000 + $100,000) / 2 = $175,000 ROCE = $20,000 / $175,000 = 0.114 = 11.4% per year

3years









Syllabus area D1e

Time
Cashflow
Discount factor
Present value
Cumulative


$
10%
$
PV $

0
(100,000)
1
(100,000)
(100,000)

1
40,000
0.909
36,360
(63,640)

2
40,000
0.826
33,040
(30,600)

3
40,000
0.751
30,040
(560)

4
40,000
0.683
27,320
26,760

Adjusted payback period = 3 years + [(560/27,320) × 12] months = 3 years to the nearest month.
Syllabus area D3d
25% Thedecisionwillchangeshouldthecostofcapitalchangesufficientlytoforcethenetpresentvalue to equal zero. This will occur at theIRR.
(150,000/IRR) – 1,000,000 = 0 ie the NPV will be zero at the IRR. 150,000/IRR =1,000,000.
IRR = 150,000/1,000,000 = 0.15 = 15%.
The current estimated cost of capital is 12%, hence sensitivity = (15 – 12)/12 = 25% sensitivity.
Syllabus area D3b
‘Acapitalexpenditurebudgetisevidenceofasoftcapitalconstraint’istrue.‘Whetherprojectsare divisibleorindivisible,theinvestmentplanshouldseektomaximisenetpresentvalueper$invested’ isfalse.Asoftcapitalconstraintisinternallyimposed.Acapitalexpenditurebudgetisaninternallimit of capital investment hence it is evidence of a soft capitalconstraint.
Theinvestmentplanshouldseektomaximisenetpresentvalueoverall,notperdollarinvested.This lattermightsuggestonlyinvestingintheprojectwiththehighestprofitabilityindex.Otherprojects may have a lower profitability index, but this does not mean they should be rejected if there is sufficient capital available to invest in themalso.
Syllabus area D4c
Retained profits are a free source offinance
Althoughfreetoraise,usingretainedearningsasasourceoffinance(bywithholdingadividend)is notfreetouse.Itisequityfinanceandrequiresthecostofequitytobegeneratedasareturn.
Bisanadvantage.Otherformsoffinancerequireup-frontjustificationtobeconsideredbypotential investors before funds are made available forinvestment.
C is an advantage. There are no issue costs.
D is an advantage. As the funds are already on hand, availability is essentially instant.
Syllabus area E1e





Mock exam2:answers 213

$4.20 Dividend growth rate = 33.6 - 1 = 1.05 = 5% peryear
32


MV =
33.6 =$4.20
0.13 0.05


Syllabus area F2c


It is exposed to higher levels of systematic risk than companyB
Statement1isnotnecessarilycorrect.Betafactorsonlymeasuresystematicrisk,nottotalrisk (which also includes specific/unsystematicrisk).
Statement2isincorrect.Companieswithdifferentbetafactorsmayfacethesamesystematicrisk factors, only to a differingdegree.
Statement3isincorrect.This(assumed)temporarymispricingisunlikelytoaffectthebetafactor overall.
Statement 4 is correct. Beta factors measure the level of systematic risk associated with a share.
Syllabus area E2a
Realisable value of operatingassets
Therealisablevalueofoperatingassetsislessrelevantasthisvaluationtechniqueisprimarily involvedinvaluingtheincomeofagoingconcern,hencevaluesforthestatementoffinancial positionassetsusedtogeneratethatincomearenotimmediatelyrelevant.
Thevalueofsurplusassetswouldberelevanthoweverastheyarelikelytobesoldoffimmediately- theywillcreateanimmediateincomewithoutaffectingforecastoperationalflows.
Syllabus area F2c
































214 Mock exam 2:answers

Section B
Utrec, Tilbur, Eind,Amster
PI = PV of future cash flows / PV of capital investment
Project
Outlay in
PV
NPV
Ratio
Ranking


Year 0


(PV / outlay)



$
$
$



Amster
100,000
111,400
11,400
1.114
4th

Eind
56,000
62,580
6,580
1.118
3rd

Utrec
60,000
68,760
8,760
1.146
1st

Tilbur
90,000
102,400
12,400
1.138
2nd

PIcanonlybeusedifprojectsaredivisible The weaknesses of the PI methodare:
Itdoesnottakeintoaccounttheabsolutesizeoftheindividualprojects.Aprojectwithahighindex might be very small and therefore only generate a smallNPV.
Itdoesnothighlighttheprojectswhichareslowestingeneratingreturns.Itispossiblethatthe project with the highest PI is the slowest in generatingreturns’
Itdoesnotallowforuncertaintyabouttheoutcomeofeachproject.Infactitassumesthatthereis complete certainty about eachoutcome.
18 $105,406
Present value of cash flows = (250,000 + 17,860 + 23,113 + 22,784 + 6,360) = ($320,117) Cumulative present value factor 3.037
Equivalent annual cost = $320,117/3.037 = $105,406
19 Statement 1 is false and statement 2 istrue
Theequivalentannualcostmethodisthemostconvenientmethodofanalysistouseinaperiodofno inflation,becauseitisconvertingtheNPVofthecostofbuyingandusingtheassetintoanequivalent annualcost.Intimesofhighinflation,thiscostwouldkeepincreasing(sostatement1isfalse).
The EAC method assumes that the machine can be replaced by exactly the same machine in perpetuityandthisisoneoftheweaknessoftheEACmethod.Itisnotusuallypossibletoreplace somethingwithexactlythesamethingasassetsareconstantlydeveloping.Computersinparticular, aredevelopingveryquicklyandsoitcanmakesensetoreplacecertainassetsmoreoftenthanthe EAC methoddictates.
20 $17,654
EV of year 2 cash flow = (19,000 0.55) + (26,000 0.45) = 22,150 PV discounted at 12% = 22,150 0.797 = $17,654
21 2only
TGA Co should enter into a forward contract to sell €500,000 in three months. Statement 1 is incorrect.TGACocoulduseamoneymarkethedgebut€500,000wouldhavetobeborrowed,then convertedintodollarsandthenplacedondeposit.Statement3isincorrect.Aninterestrateswap, swaps one type of interest payment (such as fixed interest) for another (such as floating rate interest). Therefore it would not besuitable.
22 $296,384
Forward market hedge
Receipt from forward contract = €500,000/1.687 = $296,384 .





Mock exam2:answers 215

23 $294,858
Money market hedge
3-montheuroborrowingrate=9%×3/12=2.25% 3-month dollar deposit rate = 4% × 3/12 = 1% Borroweurosnow 500,000/1.0225 = €488,998 Convert to$now 488,998/1.675 =$291,939
$afterinvesting $291,939 × 1.01 =$294,858
Statement 1 is true and statement 2 isfalse.
Oneoftheadvantagesoffuturescontractsisthatthetransactioncostsarelowerthanotherhedging methods. One of the disadvantages is that they cannot be tailored to the user’s requirements. So statement 1 is true and statement 2 isfalse.
Statement 1 refers to translation risk. Statement 2 relates to economicrisk.
Traditionalview
Thetraditionalviewassumesthereisanoptimalbalancebetweendebtandequity(thereisa'U' shapedweightedaveragecostofcapital(WACC)curve)hencechoosingfinancetoaimforthe optimum suggests the traditional view isadopted.
Modigliani-Miller(notax)concludestheWACCisunaffectedbythefinancedecisionhencethechoice of debt compared to equity isirrelevant.
Modigliani-Miller(withtax)concludesthatduetothetaxbenefitsofpayinginterest,asmuchfinance aspossibleshouldbeintheformofdebtasincreasinggearingwillreducetheWACC.Henceequity would never bechosen.
Residualview/theoryisnotdirectlyrelevanttothecapitalstructuredecision.Thistermmoredirectly relates to dividendpolicy.
Semi-strong formefficient
Sharepriceinasemi-strongformmarketreflectsallpubliclyavailableinformation,butnotprivately held information. Thus the majority of share price reaction occurs to and around public announcements.
28 $96.40
The conversion value is $100 cash or 70 shares, whichever is worth more (as conversion is at the investor'soption).Thesharepriceonconversionispredictedtobe$1.25×(1.04)5=$1.52,henceif convertedtheshareswouldbeworth70×$1.52=$106.40.Asthisismorethanthecashalternative ($100) investors would choose to convert, hence the conversion value =$106.40.
Theinvestorpaysmarketprice,andtheyreceivethepretaxinteresthencethepretaxcostofdebtis used to value the loannote:

Time

Cash flow ($)
Discount factor 10%
Present value ($)

1-5
Interest
8% × $100 = $8
3.791
30.33

5
Conversion value
$106.4
0.621
66.07





96.40










216 Mock exam 2:answers

Forward rate agreements are the interest rate equivalent of forward exchangecontracts
Statement1isincorrect:Althoughfuturesareflexiblewithtiming,theyareforstandardisedamounts which may therefore not match the size of hedge neededexactly.
Statement 2 is incorrect: Options afford the holder the right but not the obligation to exercise an option.Theycanbeallowedtolapse.Inthecaseofexchangetradedoptionstheycanalsobesoldon mid-term.
Statement3iscorrect:Aforwardrateagreement('FRA')createsanobligationfora'top-up'payment or receipt. In the case of a loan, when the FRA payment it is added to the underlying loan interest payment, the net interest payment is fixed at the FRArate.
Statement4isincorrect:Thestatementreferstosmoothing(amixoffixedandfloatingratestomake effectiveinterestrateslessvariable.)Matching–generallyemployedbybanks–referstomatching interest rates on assets to the interest rate onliabilities.
1 and 2only
Statement1:Increaseduncertaintywillincreasethepreferenceforliquidity,andwillincrease required yields into thefuture.
Statement2:Ifthemarketsfeelinterestratesaregoingtorise,therequiredreturnonlongerdated bonds will increase in line with theseexpectations.
Statement 3 is false. This will lead to the curve flattening.






































Mock exam2:answers 217

Section C Question 31
Textreferences.RightsissuesarecoveredinChapter12,estimatingthegrowthrateandthedividendgrowth model are covered in Chapter 15 and the P/E ratio is covered in Chapter14..
Toptips.Youneedtorecognisetheneedtocalculatethegrowthrateofdividendsinthisquestionforbothparts(b) and(d).Ifthisistootricky,stateasuitablefigureandcarryonwiththecalculations.Makesureyouwritesuitably detailedpointsinthediscussionpartsanddon'tjustfocusonthecalculations.
Easy marks. There are easy marks available for the calculations in part (a) and (d).
Examiner's comments. In part (a) many candidates gained full marks for their calculations. Weaker answers made errorsasregardstheformoftheissue(itwas1for4,not4for1),orthoughtthetheoreticalexrightspricewasthe rightsissueprice,orcalculatedthevalueoftherights.Inpart(b)anumberofcandidateswerenotabletocalculatethe price/earningsratiobydividingthecurrentsharepricebythecurrentEPS.CalculatingtheEPSaftertheexpansionby multiplyingthecurrentEPSbytheaveragehistoricEPSgrowthratewasalsoaproblemforsomecandidates,who wereunabletocalculateaveragehistoricgrowthrate,orwhoappliedthegrowthratetotheaverageEPSratherthan thecurrentEPS.SomestudentswerealsounfamiliarwiththeP/Evaluationmethod,eventhoughthisisdiscussedin the studytexts.
Betteranswersinpart(c)lookedtocomparethetheoreticalrightspricepershare(thesharepricebeforetherights issuefundswereinvested)withthesharepriceaftertheinvestmenthadtakenplace(forexampletheshareprice calculatedinpart(b)),ortocomparethereturnfromtheinvestment(forexample,totalshareholderreturn,whichis thesumofcapitalgainanddividedyield)withthecostofequity.
Manycandidatesgainedfullmarksinpart(d).MarkswerelostwherecandidatesusedEPSratherthandividendper shareinthedividendgrowthmodel,orwerenotabletocalculatethedividendgrowthrate,orusedincorrectvaluesin thedividendgrowthmodel.Asurprisingnumberofcandidatesdidnotusethedividendgrowthmodelgiveninthe formula sheet, but used the rearranged version of the formula that is used to calculate the cost of equity. Some candidatesmistakenlythoughtthatthecostofequitycalculatedbythisformulawasthesameastheshareprice.




Rightsissueprice 2
Theoretical ex-rights pricepershare 2
ExistingP/Eratio 1
RevisedEPS 1
Share price usingP/Emethod 2
Discussion of sharepricecomparisons 4
Calculation of capital gainandcomment 2
Average dividendgrowthrate 2
Ex-div market pricepershare 2
Discussion 2
Marks


4


4


6


6
20










218 Mock exam 2:answers

Rights issue price = $2.50 × 80% = $2.00 pershare
Theoretical ex-rights price
$
4 shares@$2.50 10.00
1share@$2.00 2.00
5 12.00

Theoretical ex-rights price (TERP) = 12.00/5 = $2.40
Averagegrowthrateofearningspershare: 1 + g=
1 + g = 1.03996
g = 4%
EPS following expansion = 32.4 1.04 = 33.7 cents per share Current P/E ratio = 250/32.4 = 7·7 times
Share price following expansion = $0.3377.7 = $2.60
Acompanywillonlybeabletoraisefinanceifinvestorsthinkthereturnstheycanexpectaresatisfactoryin viewoftheriskstheyaretaking.Theproposedbusinessexpansionwillbeanacceptableuseoftherights issue funds if it increases shareholderwealth.
Thiscanbemeasuredbylookingattheeffectontheshareprice.Thecurrentsharepriceis$2.50andthe future share price predicted by the P/E method is $2.60. This indicates that shareholder wealth would increase.However,thecapitalgainisactuallylargerthanthisasshareholderswillobtainnewsharesata discount,resultinginatheoreticalex-rightspriceof$2.40.Thecapitalgainforshareholdersistherefore
$2.60 – $2.40 = 20 cents per share.
Alternatively, we can consider the effect on total shareholder wealth. The rights issue involves 2.5 million shares ($5m/$2 per share). There were therefore 10 million shares (2.5 4) before the investment and Dartig was worth $25m (10m $2.50). After the investment, Dartig is worth $27.5m (12.5m $2.60 –
$5m) which is a capital gain of $2.5m.
Ifinvestorsbelievethattheexpansionwillenablethebusinesstogrowevenfurther,thecapitalgaincouldbe even greater. If, however, investors do not share the company's confidence in the future, the share price couldfall.
Dividend growthmodel
P = D0(1+ g)
re - g
Cost of equity (re) = 10%

g = =4%

Alternative approach
Using the Gordon growth model g = bre
Averagepayoutratiooverthelast4yearshasbeen47%,sotheaverageretentionratiohasbeen53%. g = 53% 10% =5·3%

D0= $0.15
P = 0.15 (10.04)
0 0.10.04
= $2.60


Mock exam2:answers 219

This is 10 cents per share more than the current share price of Dartig Co.
Reasons for difference in share price
Thedividendgrowthmodelassumesthatthehistoricaltrendofdividendpersharepaymentswillcontinue into the future. The future dividend growth rate may however differ from the average historical dividend growthrate,andthecurrentsharepricemayincorporateamoreconservativeestimateofthefuturedividend growthrate.
ThecostofequityofDartigComaynotbe10%.Itmaybedifficulttomakeaconfidentestimateofthecost ofcapital.
Thedividendvaluationmodelassumesthatinvestorsactrationallyandhomogenously.Inreality,different shareholderswillhavedifferentexpectationsandtheremaybeadegreeofinefficiencyinthecapitalmarket on which the shares of Dartig Co aretraded.

Question 32
Text references. Investment appraisal is covered in Chapters 8 and 9.
Toptips.Thisquestioncoversinvestmentappraisal.Readthedetailinthequestioncarefullysothatyoudealwith part(a)correctly.Forexample,wWorkingcapitalisrecoveredinthelasttwoyearsoftheinvestment.Makean assumption and carry on if you get stuck on anypart.
Makesureyouanswerthespecificrequirementsofthediscussioninpart(c)anddonotjustwriteeverythingyou know aboutNPV.
Easy marks. Using the standard proforma for the calculations in part (a) will help you to gain easy marks even if yougetstuckontheharderaspects.Part(b)shouldprovideaneasythreemarksifyouaresufficientlyfamiliarwith thistechnique.
Examiner’s comments. Many answers to part (a) gained high marks and dealt correctly with most of the issues involvedwiththecalculation.Thetreatmentofworkingcapitalinvestmentwasasourceofregularerrors,however. Manyanswersputtheinvestmentinworkingcapitalattheend,ratherthanatthestart,ofeachyear,andincluded totalinvestmentratherthanincrementalinvestment.Anothercommonerrorwastotreatinvestmentinworking capitalastax-allowable(andeventocallitafixedcost),wheninfactithasnotaxeffectatall.
Manyanswersgainedhighmarksinpart(b)andproducedaresultconsistentwithfindingsinpart(a).Markers notedthatsomecandidatesmadeillogicalchoicesofdiscountratesintheircalculations,choosingtoworkfor example with two negative NPV values, rather with one positive and one negative NPV value. While linear interpolation and linear extrapolation use the same mathematical approach, candidates should note that interpolation is more likely to be accurate than extrapolation in calculatingIRR.
ItwaspleasingtonotethatveryfewcandidatesconfusedIRRwithaccountingrateofreturn(returnoncapital employed).
Part(c)askedforadviceontheacceptabilityoftheinvestmentprojectanddiscussionofthelimitationsoftheNPV andIRRevaluationsperformed.Mostanswerscorrectlyadvisedonacceptabilityintermsthatwereconsistentwith theirearlierevaluations.Manyanswersstruggledtodiscussthelimitationsoftheevaluationsinanydepth,tending toofferoneortwogeneralcriticismsoftheNPVandIRRappraisalmethods.Betteranswersdiscussedthelimiting assumptionsunderlyingthevaluesselectedfortheprojectvariablesandthereasonswhy,forexample,fixedcosts had beenomitted.











220 Mock exam 2:answers




Marks

(a)
Inflated sales revenue
2



Inflated variable costs
2



Tax allowable depreciation
2



Taxation
1



Working capital
3



Discount factors
1



Net present value calculation
1





12

(b)
Net present value calculation
1



Internal rate of return calculation
2





3

(c)
Net present value comment
1



Internal rate of return comment
1-2



Discussion of limitations
3-4




Maximum
5




20


Calculation ofNPV
Year
0
1
2
3
4


$
$
$
$
$

Sales revenue (W1)

728,000
1,146,390
1,687,500
842,400

Variable costs (W2)

441,000
701,190
1,041,750
524,880

Contribution

287,000
445,200
645,750
317,520

Taxation @ 30%

(86,100)
(133,560) (193,725)
(95,256)

Capital expenditure
(1,000,000)





Working capital (W3)
(50,960)
(29,287)
(37,878) 59,157
58,968

Tax benefit of tax

75,000
75,000
75,000
75,000

depreciation (W4)






Net cash flow
(1,050,960)
246,613
348,762
586,182
356,232


Discount factor @ 12%
1.000
0.893
0.797
0.712
0.636


Present value
(1,050,960)
220,225
277,963
417,362
226,564


NPV
$91,154






Workings







(1) Salesrevenue







Year

1
2
3
4


Selling price (1.04)

$20.80
$21.63
$22.50
$23.40


Sales volume in units

35,000
53,000
75,000
36,000


Sales revenue

$728,000
$1,146,390
$1,687,500
$842,400


(2) Variablecosts







Year

1

2
3

4


Variable cost (1.05)
$12.60
$13,23
$13.89
$14.58

Sales volume in units
35,000
53,000
75,000
36,000

Variable cost
$441,000
$701,190
$1,041,75
$524,880







Mock exam2:answers 221

(3)
Working capital



Year

Sales revenue
0
$ 728,000
1
$ 1,146,390
2
$ 1,687,500
3
$ 842,400
4
$


Working capital requirement @ 7%
50,960
80,247
118,125
58,968



Incremental working capital cash flow
(50,960)
(29,287)
(37,878)
59,157
58,968

(4)
Tax benefit of tax depreciation






Depreciation=$1,000,000/4=$250,000peryear Tax benefit = 30% $250,000 =$75,000
Calculation of internal rate ofreturn

Net cash flow
(1,050,960)
246,613

348,762

586,182

356,232

Discount factor @ 20%
1.000
0.833

0.694

0.579

0.482

Present value
(1,050,960)
205,429

242,041

339,399

171,704

NPV
(92,387)










IRR a + 
NPVa
(b 

NPV
NPV 
a)%


IRR 12 + 
a b
91,154

(20 - 12)% = 16%

91,15492,387 
Acceptability of the proposed investment in productP
The NPV is positive so the proposed investment can be recommended on financial grounds.
The IRR is greater than the discount rate of 12% used by SC Co for investment appraisal purposes so the proposedinvestmentisagainfinanciallyacceptable.Theinvestmenthasconventionalcashflows(aninitial cash outflow followed by a series of inflows) and will therefore only have oneIRR.
Limitations of the evaluations
Forecast sales volumes have been used for both investment appraisal methods and the accuracy of the resultsisthereforeheavilydependantontheaccuracyoftheseforecasts.ProductPhasashortproductlife- cycle which makes forecast sales volumes particularlyunpredictable.
Itwouldbeusefultocarryout‘whatif’andsensitivityanalysistogiveamoreinformedpictureofwhat would happen if sales volumes were better or worse thanpredicted.
The analysis has used predicted inflation rates for sales price and variable costs which do not change over the four year period. This is unlikely in reality as price increases will vary according to prevailing economic conditions and unexpected events. Again, sensitivity analysis would help to assess the effects on the viability of the product if inflation was higher than expected.
Fixed costs have not been included in the investment appraisal. This is because SC has spare capacity in bothspaceandlabourtermssoitisassumedthatfixedcostswillnotchangeasaresultoftheinvestment. Thisassumptionmaybequestionableinthelongerterm,especiallyasproductionofproductPinYear3will be double that in Year1.













222 Mock exam 2:answers

ACCA
Paper F9
Financial Management

Mock Examination 3 Specimenexam



Question Paper

Time allowed: 3 hours 15 minutes

ALL questions are compulsory and MUST be attempted









DONOTOPENTHISPAPERUNTILYOUAREREADYTOSTARTUNDER EXAMINATIONCONDITIONS








223


























































224

Section A – ALL 15 questions are compulsory and MUST be attempted
Each question is worth 2 marks.
ThehomecurrencyofACBCoisthedollar($)andittradeswithacompanyinaforeigncountrywhose home currency is the Dinar. The following information isavailable:


Home country
Foreign country

Spot rate
20.00 Dinar per $


Interest rate
3% per year
7% per year

Inflation rate
2% per year
5% per year

What is the six-month forward exchange rate?
20.39 Dinar per$
20.30 Dinar per$
20.59 Dinar per$
20.78 Dinar per$
The following financial information relates to an investmentproject:
$'000
Present value of sale revenue
50,025

Present value of variable costs
25,475

Present value of contribution
24,550

Present value of fixed costs
18,250

Present value of operating income
6,300

Initial investment
5,000

Net present value
1,300

What is the sensitivity of the net present value of the investment project to a change in sales volume?
A 7.1%
B 2.6%
C 5.1%
D 5.3%
Gurdipplotsthehistoricmovementsofsharepricesandusesthisanalysistomakeherinvestment decisions.
To what extent does Gurdip believe capital markets to be efficient?
Not efficient atall
Weak formefficient
Semi-strongformefficient D Strong formefficient
Which of the following statements concerning capital structure theory iscorrect?
A Inthetraditionalview,thereisalinearrelationshipbetweenthecostofequityandfinancialrisk B ModiglianiandMillersaidthat,intheabsenceoftax,thecostofequitywouldremainconstant
Peckingordertheoryindicatesthatpreferencesharesarepreferredtoconvertibledebtasasourceof finance
Business risk is assumed to be constant as the capital structurechanges







Mock exam 3 (Specimenexam):questions 225

5
Which
of the following actions is LEAST likely to increase shareholder wealth?


A B C D
Theweightedaveragecostofcapitalisdecreasedbyarecentfinancingdecision The financial rewards of directors are linked to increasing earnings per share TheboardofdirectorsdecidestoinvestinaprojectwithapositiveNPV
Theannualreportdeclaresfullcompliancewiththecorporategovernancecode

6
Which
of the following statements are features of money market instruments?


(1)
A negotiable security can be sold before maturity


(2)
The yield on commercial paper is usually lower than that on treasury bills


(3)
Discount instruments trade at less than face value


A B C D
2 only
and 3only
and 3only
1, 2 and 3

The following are extracts from the statement of profit or loss of CQBCo:



Sales income
$'000
60,000

Cost of sales
50,000

Profit before interest and tax
10,000

Interest
4,000

Profit before tax
6,000

Tax
4,500

Profit after tax
1,500

60% of the cost of sales is variables costs.


What is the operational gearing of CQB Co?


5.0times
2.0times
0.5times
3.0times
ThemanagementofXYZCohasannualcreditsalesof$20millionandaccountsreceivableof$4million. Workingcapitalisfinancedbyanoverdraftat12%interestperyear.Assume365daysinayear.
What is the annual finance cost saving if the management reduces the collection period to 60 days?
A $85,479
B $394,521
C $78,904
D $68,384
Which of the following statements concerning financial management arecorrect?
It is concerned with investment decisions, financing decisions and dividenddecisions
It is concerned with financial planning and financialcontrol
It considers the management ofrisk
1 and 2only
1 and 3only
2 and 3only
1, 2 and3







226 Mock exam 3 (Specimen exam):questions

SKV Co has paid the following dividends per share in recentyears:

Year
20X4
20X3
20X2
20X1

Dividend ($ per share)
0.360
0.338
0.328
0.311

The dividend for 20X4 has just been paid and SKV Co has a cost of equity of 12%.
Using the geometric average historical dividend growth rate and the dividend growth model, what is the market price of SKV Co shares on an ex dividend basis?
A $4.67
B $5.14
C $5.40
D $6.97
‘Thereisariskthatthevalueofourforeigncurrency-denominatedassetsandliabilitieswillchangewhenwe prepare ouraccounts’
To which risk does the above statement refer?
Translationrisk
Economicrisk
Transactionrisk
Interestraterisk
The following information has been calculated for ACo:
Tradereceivablescollectionperiod: 52days
Rawmaterialinventoryturnoverperiod: 42days
Workinprogressinventoryturnoverperiod: 30days
Tradepayablespaymentperiod: 66days
Finishedgoodsinventoryturnoverperiod: 45days
What is the length of the working capital cycle?
103days
131days
235days
31days
Which of the following is/are usually seen as benefits of financialintermediation?
Interest ratefixing
Riskpooling
Maturitytransformation
1only
1 and 3only
2 and 3only
1, 2 and3
Which of the following statements concerning working capital management arecorrect?
The twin objectives of working capital management are profitability andliquidity
Aconservativeapproachtoworkingcapitalinvestmentwillincreaseprofitability
Working capital management is a key factor in a company’s long-termsuccess
1 and 2only
1 and 3only
2 and 3only
1, 2 and3





Mock exam 3 (Specimenexam):questions 227

Governmentshaveanumberofeconomictargetsaspartoftheirmonetarypolicy.
Which of the following targets relate predominantly to monetary policy?
Increasing taxrevenue
Controlling the growth in the size of the moneysupply
Reducing publicexpenditure
Keeping interest rateslow
1only
1 and3
2 and 4only
2, 3 and4
(Total = 30 marks)


















































228 Mock exam 3 (Specimen exam):questions

Section B – ALL 15 questions are compulsory and MUST be attempted
Each question is worth 2 marks.
The following scenario relates to questions 16–20.
Par Co currently has the following long-term capital structure:
$m $m

Equity finance
Ordinaryshares 30.0
Reserves 38.4


68.4



Non-current liabilities
Bankloans 15.0
8% convertibleloannotes 40.0
5% redeemablepreferenceshares 15.0



70.0

Total equityandliabilities 138.4
The8%loannotesareconvertibleintoeightordinarysharesperloannoteinsevenyears’time.Ifnotconverted,the loannotescanberedeemedonthesamefuturedateattheirnominalvalueof$100.ParCohasacostofdebtof9% peryear.
The ordinary shares of Par Co have a nominal value of $1 per share. The current ex dividend share price of the companyis$10.90pershareandsharepricesareexpectedtogrowby6%peryearfortheforeseeablefuture.The equity beta of Par Co is1.2.
Theloannotesaresecuredonnon-currentassetsofParCoandthebankloanissecuredbyafloating charge on the current assets of thecompany.
In terms of risk to the investor, what are the riskiest and least risky sources of finance for Par Co?


Riskiest
Least risky

A
Redeemable preference shares
Bank loan

B
Ordinary shares
Bank loan

C
Bank loan
Loan notes

D
Ordinary shares
Loan notes

Whatistheconversionvalueofthe8%loannotesofParCoaftersevenyears?
A $16.39
B $111.98
C $131.12
D $71.72
Assuming the conversion value after seven years is $126·15, what is the current market value of the 8% loan notes of ParCo?
A $115.20
B $109.26
C $94.93
D $69.00
Which of the following statements relating to the capital asset pricing model iscorrect?
The equity beta of Par Co considers only businessrisk
The capital asset pricing model considers systematic risk and unsystematicrisk
TheequitybetaofParCoindicatesthatthecompanyismoreriskythanthemarketasawhole D The debt beta of Par Co iszero

Mock exam 3 (Specimenexam):questions 229

Which of the following statements are problems in using the price/earnings ratio method to valuea company?
It is the reciprocal of the earningsyield
It combines stock market information and corporateinformation
It is difficult to select a suitable price/earningsratio
The ratio is more suited to valuing the shares of listedcompanies
1 and 2only
3 and 4only
1, 3 and 4only
D 1, 2, 3 and4
The following scenario relates to questions 21–25
ZPSCo,whosehomecurrencyisthedollar,tookoutafixed-interestpesobankloanseveralyearsagowhenpeso interestrateswererelativelycheapcomparedtodollarinterestrates.ZPSCodoesnothaveanyincomeinpesos. Economicdifficultieshavenowincreasedpesointerestrateswhiledollarinterestrateshaveremainedrelatively stable.
ZPSComustpayinterestonthedatessetbythebank.Apaymentof5,000,000pesosisdueinsixmonths’time. The following information isavailable:
Spotrate 12.500–12.582 pesos per$
Six-monthforwardrate 12.805–12.889 pesos per$ Interest rates which can be used by ZPSCo:
Borrow Deposit
Pesointerestrates 10.0%peryear 7.5% peryear
Dollarinterestrates 4.5%peryear 3.5% peryear
What is the dollar cost of a forward markethedge?
A $390,472
B $387,928
C $400,000
D $397,393
Which of the following statements relate to purchasing power paritytheory?
The theory holds in the long term rather than the shortterm
The exchange rate reflects the different cost of living in twocountries
Theforwardratecanbefoundbymultiplyingthespotratebytheratiooftheinterestratesofthetwo countries
1, 2 and3
1 and 2only
1 and 3only
2only
Whataretheappropriatesix-monthinterestratesforZPSCotouseifthecompanyhedgesthepeso payment using a money markethedge?
Deposit rate Borrowingrate
A
7.5%
4.5%

B
1.75%
5.0%

C
3.75%
2.25%

D
3.5%
10.0%






230 Mock exam 3 (Specimen exam):questions

Which of the following methods are possible ways for ZPS Co to hedge its existing foreign currencyrisk?
Matching receipts andpayments
Currencyswaps
Leading orlagging
Currencyfutures
A 1, 2, 3 and4
1 and 3only
2 and 4only
2, 3 and 4only

ZPSCoalsotradeswithcompaniesinEuropewhichusetheEuroastheirhomecurrency.Inthreemonths’ time ZPS Co will receive €300,000 from acustomer.
Which of the following is the correct procedure for hedging this receipt using a money market hedge?

A
Step 1
Step 2
Step 3
Step 4
BorrowanappropriateamountinEuronow Convert the Euro amount intodollars
Place the dollars on deposit
Use the customer payment to repay the loan

B
Step 1
Step 2
Step 3
Step 4
Borrowanappropriateamountindollarsnow Place the dollars on depositnow
ConvertthedollarsintoEurointhreemonths’time Usethecustomerpaymenttorepaytheloan

C
Step 1
Step 2
Step 3
Step 4
Borrowanappropriateamountindollarsnow Convert the dollar amount intoEuro
Place the Euro on deposit
Use the customer payment to repay the loan

D
Step 1
Step 2
Step 3
Step 4
BorrowanappropriateamountinEuronow Place the Euro on depositnow
ConverttheEurointodollarsinthreemonths’time
Use the customer payment to repay the loan

The following scenario relates to questions 26–30
RidagCooperatesinanindustrywhichhasrecentlybeenderegulatedasthegovernmentseekstoincrease competition in theindustry.
RidagCoplanstoreplaceanexistingmachineandmustchoosebetweentwomachines.Machine1hasaninitial costof$200,000andwillhaveascrapvalueof$25,000afterfouryears.Machine2hasaninitialcostof$225,000 and will have a scrap value of $50,000 after three years. Annual maintenance costs of the two machines are as follows:

Year
1
2
3
4

Machine 1 ($ per year)
25,000
29,000
32,000
35,000

Machine 2 ($ per year)
15,000
20,000
25,000


Whererelevant,allinformationrelatingtothisprojecthasalreadybeenadjustedtoincludeexpectedfutureinflation. TaxationandtaxallowabledepreciationmustbeignoredinrelationtoMachine1andMachine2.
RidagCohasanominalbefore-taxweightedaveragecostofcapitalof12%andanominalafter-taxweighted average cost of capital of7%.









Mock exam 3 (Specimenexam):questions 231

In relation to Ridag Co, which of the following statements about competition and deregulation aretrue?
Increased competition should encourage Ridag Co to reducecosts
Deregulation will lead to an increase in administrative and compliance costs for RidagCo
Deregulation should mean an increase in economies of scale for RidagCo
Deregulation could lead to a decrease in the quality of Ridag Co’sproducts
1 and4
2 and3
1 and3
2 and4
What is the equivalent annual cost of Machine1?
A $90,412
B $68,646
C $83,388
D $70,609
Which of the following statements about Ridag Co using the equivalent annual cost method aretrue?
RidagCocannotusetheequivalentannualcostmethodtocompareMachine1andMachine2 because they have different usefullives
ThemachinewhichhasthelowesttotalpresentvalueofcostsshouldbeselectedbyRidagCo A 1only
Both 1 and2
2only
Neither 1 nor2
Doubthasbeencastovertheaccuracyoftheyear2andyear3maintenancecostsforMachine2.Onfurther investigation it was found that the following potential cash flows are nowpredicted:
Year
Cash flow
Probability


($)


2
18,000
0.3

2
25,000
0.7

3
23,000
0.2

3
24,000
0.35

3
30,000
0.45

What is the expected present value of the maintenance costs for year 3?
A $26,500
B $18,868
C $21,624
D $35,173
RidagCoisappraisingadifferentproject,withapositiveNPV.Itisconcernedabouttheriskanduncertainty associated with this otherproject.
Which of the following statements about risk, uncertainty and the project is true?
A Sensitivityanalysistakesintoaccounttheinterrelationshipbetweenprojectvariables B Probabilityanalysiscanbeusedtoassesstheuncertaintyassociatedwiththeproject
C Uncertaintycanbesaidtoincreasewithprojectlife,whileriskincreaseswiththevariabilityofreturns D Adiscountrateof5%couldbeusedtolessentheeffectoflatercashflowsonthedecision
(Total = 30 marks)








232 Mock exam 3 (Specimen exam):questions

Section C – BOTH questions are compulsory and MUST be attempted
PVCo,alargestock-exchange-listedcompany,isevaluatinganinvestmentproposaltomanufactureProduct W33,whichhasperformedwellintestmarketingtrialsconductedrecentlybythecompany’sresearchand development division. Product W33 will be manufactured using a fully-automated process which would significantlyincreasenoiselevelsfromPVCo’sfactory.Thefollowinginformationrelatingtothisinvestment proposal has now beenprepared:
Initialinvestment $2million
Selling price (currentpriceterms) $20perunit
Expected sellingpriceinflation 3% peryear Variableoperatingcosts(currentpriceterms) $8 perunit Fixedoperatingcosts(currentpriceterms) $170,000peryear Expectedoperatingcostinflation 4% peryear
Theresearchanddevelopmentdivisionhaspreparedthefollowingdemandforecastasaresultofitstest marketingtrials.Theforecastreflectsexpectedtechnologicalchangeanditseffectontheanticipatedlife- cycle of ProductW33.

Year
1
2
3
4

Demand (units)
60,000
70,000
120,000
45,000

It is expected that all units of Product W33 produced will be sold, in line with the company’s policy of keepingnoinventoryoffinishedgoods.Noterminalvalueormachineryscrapvalueisexpectedattheendof fouryears,whenproductionofProductW33isplannedtoend.Forinvestmentappraisalpurposes,PVCo usesanominal(money)discountrateof10%peryearandatargetreturnoncapitalemployedof30%per year. Ignoretaxation.
Required
Calculate the following values for the investmentproposal:
netpresentvalue; (5 marks)
internalrateofreturn;and (3 marks)
return on capital employed (accounting rate of return) based on averageinvestment.
(3 marks)
Brieflydiscussyourfindingsineachsectionof(a)aboveandadvisewhethertheinvestmentproposal isfinanciallyacceptable. (4marks)
Discuss how the objectives of PV Co’s stakeholders may be in conflict if the project isundertaken.
(5 marks)
(20 marks)
DD Co has a dividend payout ratio of 40% and has maintained this payout ratio for several years. The currentdividendpershareofthecompanyis50cpershareanditexpectsthatitsnextdividendpershare, payable in one year’s time, will be 52c pershare.
The capital structure of the company is as follows:
$m $m
Equity

Ordinary shares(nominal value $1pershare) 25
Reserves 35
Debt
Bond A (nominalvalue$100) 20
Bond B (nominalvalue$100) 10


60


30
90




Mock exam 3 (Specimenexam):questions 233

BondAwillberedeemedatnominalvalueintenyears’timeandpaysannualinterestof9%.Thecostofdebt of this bond is 9.83% per year. The current ex interest market price of the bond is$95.08.
BondBwillberedeemedatnominalvalueinfouryears’timeandpaysannualinterestof8%.Thecostof debtofthisbondis7.82%peryear.Thecurrentexinterestmarketpriceofthebondis$102.1.
DD Co has a cost of equity of 12.%. Ignore taxation.
Required
Calculate the following values for DDCo:
Exdividendshareprice,usingthedividendgrowthmodel; (3marks)
Capitalgearing(debtdividedbydebtplusequity)usingmarketvalues;and (2marks)
Marketvalueweightedaveragecostofcapital. (2marks)
DiscusswhetherachangeindividendpolicywillaffectthesharepriceofDDCo. (8 marks)
ExplainwhyDDCo’scapitalinstrumentshavedifferentlevelsofriskandreturn. (5 marks)
(Total = 20 marks)













































234 Mock exam 3 (Specimen exam):questions























Answers




DONOTTURNTHISPAGEUNTILYOUHAVECOMPLETEDTHEMOCKEXAM










235














236

Section A
1 A 20 (1.035/1.015) = 20.39 Dinar per$
D Sensitivity to a change in sales volume = 100 1,300/24,550 =5.3%
A Gurdipisbasingherinvestmentdecisionsontechnicalanalysis,whichmeansthatshebelievesthe stock market is not efficient at all, not even weak formefficient.
D The statement about business risk iscorrect.
B Increases in shareholder wealth will depend on increases in cash flow, rather than increases in earningspershare,ieincreasesinprofit.Ifthefinancialrewardsofdirectorsarelinkedtoincreasing earningspershare,forexample,throughaperformance-relatedrewardscheme,thereisanincentive toincreasingshort-termprofitattheexpenseoflongergrowthincashflowsandhenceshareholder wealth.
B Both statements 1 and 3 arecorrect.
D Operationalgearing=Contribution/PBIT=[60,000–(50,0000.6)]/10m=3times 8 A Finance cost saving = 13/365 $20m 0.12 =$85,479
D All three statements concerning financial management arecorrect.
C Thegeometricaveragedividendgrowthrateis(36.0/31.1)1/3–1=5% The ex div share price = (36.0 1.05)/(0.12 – 0.05) =$5·40
A The statement refers to translationrisk.
A The length of the operating cycle is 52 + 42 + 30 – 66 + 45 = 103 days.
C Riskpoolingandmaturitytransformationarealwaysincludedinalistofbenefitsoffinancial intermediation.
B Both statements 1 and 3 arecorrect.
C Thetwotargetsrelatingpredominantlytomonetarypolicyarecontrollingthegrowthinthesizeofthe money supply and keeping interest rates low (2 and4).

Section B
D The secured loan notes are safer than the bank loan, which is secured on a floating charge. The redeemablepreferencesharesareabovedebtinthecreditorhierarchy.Ordinarysharesarehigherin the creditor hierarchy than preferenceshares.
C Futuresharepriceaftersevenyears=10.901.067=$16·39pershare Conversionvalueofeachloannote=16.398=$131.12perloannote
18 B Market value of each loan note = (8 5.033) + (126.15 0.547) = 40.26 + 69.00 =$109.26
C Anequitybetaofgreaterthan1indicatesthattheinvestmentismoreriskythanthemarketasa whole.
B Itiscorrectthattheprice/earningsratioismoresuitedtovaluingthesharesoflistedcompanies,and itisalsotruethatitisdifficulttofindasuitablepriceearningsratioforthevaluation.
A Interestpayment=5,000,000pesos
Six-month forward rate for buying pesos = 12.805 pesos per $
Dollar cost of peso interest using forward market = 5,000,000/12.805 = $390,472
B Exchangeratesreflectingthedifferentcostoflivingbetweentwocountriesisstatedbythetheoryof purchasing powerparity.
The theory holds in the long term rather than the short term.


Mock exam 3 (Specimenexam):answers 237

Theforwardrateisfoundbymultiplyingthespotratebytheratiooftheinflationratesofthetwo countries.
C Dollarswillbeborrowednowforsixmonthsat4.56/12=2.25% Pesoswillbedepositednowforsixmonthsat7.56/12=3.75%
C Currencyfuturesandswapscouldbothbeused.Aspaymentmustbemadeonthedatesetbythe bank,leadingorlaggingarenotappropriate.Matchingisalsoinappropriateastherearenopeso incomestreams.
A Thecorrectprocedureisto:Borroweuronow,converttheeurointodollarsandplacethedollarson deposit for three months, use the customer receipt to pay back the euroloan.
A Deregulationtoincreasecompetitionshouldmeanmanagersacttoreducecostsinordertobe competitive.Theneedtoreducecostsmaymeanthatqualityofproductsdeclines.
ASince taxation and capital allowances are to be ignored, and where relevant all information relating to project2hasalreadybeenadjustedtoincludefutureinflation,thecorrectdiscountratetousehereis the nominal before-tax weighted average cost of capital of12%.
0 1 2 3 4
Maintenancecosts (25,000) (29,000) (32,000) (35,000)
Investment and scrap
(200,000)



25,000

Net cash flow
(200,000)
(25,000)
(29,000)
(32,000)
10,000

Discount at 12%
1.000
0.893
0.797
0.712
0.636

Present values
(200,000)
(22,325)
(23,113)
(22,784)
(6,360)

Present value of cash flows ($274,582) Cumulative present value factor 3.037
Equivalent annual cost = 274,582/3.037 = $90,412
DBoth statements are false. The machine with the lowest equivalent annual cost should be purchased notthepresentvalueoffuturecashflowsalone.Thelivesofthetwomachinesaredifferentandthe equivalent annual cost method allows this to be taken intoconsideration.
29 B EV of year 3 cash flow = (23,000 0.2) + (24,000 0.35) + (30,000 0.45) =26,500
PV discounted at 12% = 26,500 0.712 = $18,868
30 C The statement about uncertainty increasing with project life istrue.























238 Mock exam 3 (Specimen exam):answers

Section C
Question 31



Inflatedincome 2
Inflatedoperatingcosts 2
Netpresentvalue 1
Internal rateofreturn 3
Return oncapitalemployed 3
Discussion of investmentappraisalfindings 3
Advice on acceptabilityofproject 1
Maximisation ofshareholderwealth 1–2
Conflict from automation ofproductionprocess 1–2
Conflict fromadditionalnoise 1–2
Marks





11


4

Maximum 5
20




(a)
(i)
Calculation of NPV




Year
0
1
2
3
4




$
$
$
$
$



Investment Income
(2,000,000)

1,236,000

1,485,400

2,622,000

1,012,950



Operating costs

676,000
789,372
1,271,227
620,076



Net cash flow
(2,000,000)
560,000
696,028
1,350,773
392,874



Discount at 10%
1.000
0.909
0.826
0.751
0.683



Present values
(2,000,000)
509,040
574,919
1,014,430
268,333



Net present value:
$366,722







Workings







Calculation of income


Year
1
2
3
4

Inflated selling price ($/unit)
20.60
21.22
21.85
22.51

Demand (units/year)
60,000
70,000
120,000
45,000

Income ($/year)
1,236,000
1,485,400
2,622,000
1,012,950

Calculation of operating costs





Year
1
2
3
4

Inflated variable cost ($/unit)
8.32
8.65
9.00
9.36

Demand (units/year)
60,000
70,000
120,000
45,000

Variable costs ($/year)
499,200
605,500
1,080,000
421,200

Inflated fixed costs ($/year)
176,800
183,872
191,227
198,876

Operating costs ($/year)
676,000
789,372
1,271,227
620,076








Mock exam 3 (Specimenexam):answers 239

Alternative calculation of operating costs


Year 1
2
3
4


Variablescost($/unit) 8
8
8
8


Demand (units/year) 60,000
70,000
120,000
45,000


Variablecosts($/year) 480,000
560,000
960,000
360,000


Fixedcosts($/year) 170,000
170,000
170,000
170,000


Operatingcosts($/year) 650,000
730,000
1,130,000
530,000


Inflatedcosts($/year) 676,000
789,568
1,271,096
620,025

(ii)
Calculation of internal rate of return





Year 0 1
2
3
4


$ $
Netcashflow (2,000,000) 560,000
$
696,028
$ 1,350,773
$
392,874


Discountat20% 1.000 0.833
0.694
0.579
0.482


Presentvalues (2,000,000) 466,480
483,043
782,098
189,365

Net present value: ($79,014)


IRR = a +
NPVa (NPVa – NPVb )

(b–a) = 10% + [(366,722/(366,722 + 79,014)](20 – 10) = 18.2%



(iii) Calculation of return on capitalemployed
Total cash inflow = 560,000 + 696,028 + 1,350,773 + 392,874 = $2,999,675
Totaldepreciationandinitialinvestmentaresame,asthereisnoscrapvalue. Total accounting profit = 2,999,675 – 2,000,000 =$999,675
Averageannualaccountingprofit=999,675/4=$249,919 Average investment = 2,000,000/2 =$1,000,000
Return on capital employed = 100 249,919/1,000,000 = 25%
The investment proposal has a positive net present value (NPV) of $366,722 and is therefore financially acceptable.Theresultsoftheotherinvestmentappraisalmethodsdonotalterthisfinancialacceptability,as the NPV decision rule will always offer the correct investmentadvice.
Theinternalrateofreturn(IRR)methodalsorecommendsacceptingtheinvestmentproposal,sincetheIRR of18·2%isgreaterthanthe10%returnrequiredbyPVCo.IftheadviceofferedbytheIRRmethoddiffered fromthatofferedbytheNPVmethod,theadviceofferedbytheNPVmethodwouldbepreferred.
The calculated return on capital employed of 25% is less than the target return of 30%, but as indicated earlier,theinvestmentproposalisfinanciallyacceptableasithasapositiveNPV.ThereasonwhyPVCohas atargetreturnoncapitalemployedof30%shouldbeinvestigated.Thismaybeanout-of-datehurdlerate which has not been updated for changed economiccircumstances.
As a large listed company, PV Co’s primary financial objective is assumed to be the maximisation of shareholderwealth.Inordertopursuethisobjective,PVCoshouldundertakeprojects,suchasthisone, which have a positive NPV and generate additional value forshareholders.
However,notallofPVCo’sstakeholdershavethesameobjectivesandtheacceptanceofthisprojectmay create conflict between the differentobjectives.
DuetoProductW33beingproducedusinganautomatedproductionprocess,itwillnotmeetemployees’ objectivesofcontinuityorsecurityintheiremployment.Itcouldalsomeanemployeeswillbepaidlessthan theycurrentlyearn.Ifthismoveispartofalonger-termmoveawayfrommanualprocesses,itcouldalso conflict with government objectives of having a low rate ofunemployment.
TheadditionalnoisecreatedbytheproductionofProductW33willaffectthelocalcommunityandmay conflictwithobjectivesrelatingtohealthyliving.Thismayalsoconflictwithobjectivesfromenvironmental pressure groups and government standards on noise levels aswell.




240 Mock exam 3 (Specimen exam):answers

Question 32



Dividendgrowthrate 1
Share price using dividendgrowthmodel 2
Capitalgearing 2
Weighted average costofcapital 2
Dividendirrelevance 3–4
Dividendrelevance 3–4
Marks




7

Maximum 8
Discussionofequity 1–2
Debt and recognising business risk isnotrelevant 1–2
Time until maturityofbonds 1–2
Different valueofbonds 1
Maximum 5
20




(a) (i) Dividend growth rate = 100 ((52/50) – 1) = 100 (1.04 – 1) = 4% per year SharepriceusingDGM=(501.04)/(0.124–0·04)=52/0.84=619cor$6.19
(ii) Number of ordinary shares = 25million
Market value of equity = 25m 6.19 = $154.75 million MarketvalueofBondAissue=20m95.08/100=$19.016m
MarketvalueofBondBissue=10m102.01/100=$10.201m Market value of debt =$29.217m
Marketvalueofcapitalemployed=154.75m+29.217m=$183.967m Capital gearing = 100 29.217/183.967 =15.9%
(iii) WACC = ((12·4 154.75) + (9.83 19.016) + (7.82 10.201))/183.967 =11·9%
Miller and Modigliani showed that, in a perfect capital market, the value of a company depended on its investment decision alone, and not on its dividend or financing decisions. In such a market, a change in dividendpolicybyDDCowouldnotaffectitssharepriceoritsmarketcapitalisation.Theyshowedthatthe valueofacompanywasmaximisedifitinvestedinallprojectswithapositivenetpresentvalue(itsoptimal investmentschedule).Thecompanycouldpayanylevelofdividendandifithadinsufficientfinance,make uptheshortfallbyissuingnewequity.Sinceinvestorshadperfectinformation,theywereindifferentbetween dividends and capital gains. Shareholders who were unhappy with the level of dividend declared by a companycouldgaina‘home-madedividend’bysellingsomeoftheirshares.Thiswaspossiblesincethere are no transaction costs in a perfect capitalmarket.
Againstthisviewareseveralargumentsforalinkbetweendividendpolicyandshareprices.Forexample,it hasbeenarguedthatinvestorsprefercertaindividendsnowratherthanuncertaincapitalgainsinthefuture (the ‘bird-in-the-hand’argument).
Ithasalsobeenarguedthatreal-worldcapitalmarketsarenotperfect,butsemi-strongformefficient.Since perfect information is therefore not available, it is possible for information asymmetry to exist between shareholders and the managers of a company. Dividend announcements may give new information to shareholdersandasaresult,inasemi-strongformefficientmarket,sharepricesmaychange.Thesizeand directionofthesharepricechangewilldependonthedifferencebetweenthedividendannouncementand theexpectationsofshareholders.Thisisreferredtoasthe‘signallingpropertiesofdividends’.




Mock exam 3 (Specimenexam):answers 241

Ithasbeenfoundthatshareholdersareattractedtoparticularcompaniesasaresultofbeingsatisfiedby theirdividendpolicies.Thisisreferredtoasthe‘clienteleeffect’.Acompanywithanestablisheddividend policyisthereforelikelytohaveanestablisheddividendclientele.Theexistenceofthisdividendclientele implies that the share price may change if there is a change in the dividend policy of the company, as shareholdersselltheirsharesinordertoreinvestinanothercompanywithamoresatisfactorydividend policy.Inaperfectcapitalmarket,theexistenceofdividendclientelesisirrelevant,sincesubstitutingone companyforanotherwillnotincuranytransactioncosts.Sincereal-worldcapitalmarketsarenotperfect, however,theexistenceofdividendclientelessuggeststhatifDDCochangesitsdividendpolicy,itsshare price could beaffected.
Thereisatrade-offbetweenriskandreturnonDD’scapitalinstruments.Investorsinriskierassetsrequirea higherreturnincompensationforthisadditionalrisk.Inthecaseofordinaryshares,investorsrankbehind allothersourcesoffinanceintheeventofaliquidationsoarethemostriskycapitalinstrumenttoinvestin. This is partly why DD Co’s cost of equity is more expensive than its debtfinancing.
Similarlyfordebtfinancing,higher-riskborrowersmustpayhigherratesofinterestontheirborrowingto compensate lenders for the greater risk involved. DD Co has two bonds, with Bond A having the higher interestrateandthereforethehigherrisk.Sincebothbondswereissuedatthesametime,businessriskis not a factor in the higher level ofrisk.
Instead, this additional risk is likely to be due to the fact that Bond A has a greater time until maturity, meaningthatitscashflowsaremoreuncertainthanBondB.Inparticularwhereinterestratesareexpected toincreaseinthefuture,longer-termdebtwillhaveahigherrateofinteresttocompensateinvestorsfor investing for a longerperiod.
Afurtherfactoristhatthetotalnominalvalue(bookvalue)ofBondAistwiceaslargeasBondBand therefore may be perceived to beriskier.


































242 Mock exam 3 (Specimen exam):answers












Mathematical tables
























243


























































244








Mathematicaltables 245
















246 Mathematicaltables


















Mathematicaltables 247


























































248 Mathematicaltables


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes


























































Notes




Review Form – Paper F9 Financial Management (02/16)
Name: Address:




How have you used this Kit?
(Tick one box only)
On its own (book only)
On a BPPin-centrecourse On a BPP onlinecourse
On a course with another college
Other
Why did you decide to purchase this Kit?
(Tick one box only)
Have used the complimentary Study Text Have used other BPP products in the past Recommendation by friend/colleague Recommendation by a lecturer at college Saw advertising
Other
During the past six months do you recall seeing/receiving any of the following? (Tick as many boxes as are relevant)
Our advertisement in Student Accountant
Our advertisement in Pass
Our advertisement in PQ
Ourbrochurewithaletterthroughthepost Our websitewww.bpp.com
Which (if any) aspects of our advertising do you find useful?
(Tick as many boxes as are relevant)
Pricesandpublicationdatesofneweditions Information on productcontent
Facility to order books None of the above




Which BPP products have you used?
StudyText Passcards Other
Practice &RevisionKit i-Pass

Your ratings, comments and suggestions would be appreciated on the following areas.
Veryuseful Useful Notuseful
Passing F9 Questions
Top Tips etc in answers
Content and structure of answers Mock exam answers


OverallopinionofthisPractice& RevisionKit
Excellent Good Adequate Poor

Do you intend to continue usingBPPproducts? Yes No

The BPP author of this edition can be emailed at: [email protected]
Please return this form to: Head of ACCA & FIA Programmes, BPP Learning Media Ltd, FREEPOST, London, W12 8AA

Review Form (continued)

TELL US WHAT YOU THINK

Please note any further comments and suggestions/errors below.