Financial Management: Friday 7 June 2013 [PDF]

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Financial Management Friday 7 June 2013

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FOUR questions are compulsory and MUST be attempted. Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7 and 8. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level – Skills Module

ALL FOUR questions are compulsory and MUST be attempted 1

HDW Co is a listed company which plans to meet increased demand for its products by buying new machinery costing $5 million. The machinery would last for four years, at the end of which it would be replaced. The scrap value of the machinery is expected to be 5% of the initial cost. Capital allowances would be available on the cost of the machinery on a 25% reducing balance basis, with a balancing allowance or charge claimed in the final year of operation. This investment will increase production capacity by 9,000 units per year and all of these units are expected to be sold as they are produced. Relevant financial information in current price terms is as follows: Selling price Variable cost Incremental fixed costs

$650 per unit $250 per unit $250,000 per year

Forecast inflation 4·0% per year 5·5% per year 5·0% per year

In addition to the initial cost of the new machinery, initial investment in working capital of $500,000 will be required. Investment in working capital will be subject to the general rate of inflation, which is expected to be 4·7% per year. HDW Co pays tax on profits at the rate of 20% per year, one year in arrears. The company has a nominal (money terms) after-tax cost of capital of 12% per year. Required: (a) Calculate the net present value of the planned purchase of the new machinery using a nominal (money terms) approach and comment on its financial acceptability. (14 marks) (b) Discuss the difference between a nominal (money terms) approach and a real terms approach to calculating net present value. (5 marks) (c) Identify TWO financial objectives of a listed company such as HDW Co and discuss how each of these financial objectives is supported by the planned investment in new machinery. (6 marks) (25 marks)

2

2

AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal. The following financial information relates to AMH Co: Financial position statement extracts as at 31 December 2012 $000 Equity Ordinary shares (nominal value 50 cents) Reserves

4,000 18,000 –––––––

Long-term liabilities 4% Preference shares (nominal value $1) 7% Bonds redeemable after six years Long-term bank loan

3,000 3,000 1,000 –––––––

$000

22,000

7,000 ––––––– 29,000 –––––––

The ordinary shares of AMH Co have an ex div market value of $4·70 per share and an ordinary dividend of 36·3 cents per share has just been paid. Historic dividend payments have been as follows: Year Dividends per share (cents)

2008 30·9

2009 32·2

2010 33·6

2011 35·0

The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share. The 7% bonds are redeemable at a 5% premium to their nominal value of $100 per bond and have an ex interest market value of $104·50 per bond. The bank loan has a variable interest rate that has averaged 4% per year in recent years. AMH Co pays profit tax at an annual rate of 30% per year. Required: (a) Calculate the market value weighted average cost of capital of AMH Co.

(12 marks)

(b) Discuss how the capital asset pricing model can be used to calculate a project-specific cost of capital for AMH Co, referring in your discussion to the key concepts of systematic risk, business risk and financial risk. (8 marks) (c) Discuss why the cost of equity is greater than the cost of debt.

(5 marks) (25 marks)

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3

TGA Co, a multinational company, has annual credit sales of $5·4 million and related cost of sales are $2·16 million. Approximately half of all credit sales are exports to a European country, which are invoiced in euros. Financial information relating to TGA Co is as follows: Inventory Trade receivables Trade payables Overdraft Net working capital

$000 473·4 1,331·5 ––––––– 177·5 1,326·6 –––––––

$000 1,804·9 1,504·1 ––––––– 300·8 –––––––

TGA Co plans to change working capital policy in order to improve its profitability. This policy change will not affect the current levels of credit sales, cost of sales or net working capital. As a result of the policy change, the following working capital ratio values are expected: Inventory days Trade receivables days Trade payables days

50 days 62 days 45 days

Other relevant financial information is as follows: Short-term dollar borrowing rate Short-term dollar deposit rate

5% per year 4% per year

Assume there are 365 days in each year. Required: (a) For the change in working capital policy, calculate the change in the operating cycle, the effect on the current ratio and the finance cost saving. Comment on your findings. (8 marks) (b) Discuss the key elements of a trade receivables management policy.

(7 marks)

(c) Explain the different types of foreign currency risk faced by a multinational company.

(6 marks)

(d) 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. TGA Co can borrow short term in the euro at 9% per year. Required: Calculate the dollar income from a forward market hedge and a money market hedge, and indicate which hedge would be financially preferred by TGA Co. (4 marks) (25 marks)

4

4

GXG Co is an e-business which designs and sells computer applications (apps) for mobile phones. The company needs to raise $3,200,000 for research and development and is considering three financing options. Option 1 GXG Co could suspend dividends for two years, and then pay dividends of 25 cents per share from the end of the third year, increasing dividends annually by 4% per year in subsequent years. Dividends in recent years have grown by 3% per year. Option 2 GXG Co could seek a stock market listing, raising $3·2 million after issue costs of $100,000 by issuing new shares to new shareholders at a price of $2·50 per share. Option 3 GXG Co could issue $3,200,000 of bonds paying annual interest of 6%, redeemable after ten years at par. Recent financial information relating to GXG Co is as follows: Operating profit Interest Profit before taxation Taxation Profit after taxation Dividends Ordinary shares (nominal value 50 cents)

$000 3,450 200 –––––– 3,250 650 –––––– 2,600 1,600 $000 5,000

Under options 2 and 3, the funds invested would earn a before-tax return of 18% per year. The profit tax rate paid by the company is 20% per year. GXG Co has a cost of equity of 9% per year, which is expected to remain constant. Required: (a) Using the dividend valuation model, calculate the value of GXG Co under option 1, and advise whether option 1 will be acceptable to shareholders. (6 marks) (b) Calculate the effect on earnings per share of the proposal to raise finance by a stock market listing (option 2), and comment on the acceptability of the proposal to existing shareholders. (5 marks) (c) Calculate the effect on earnings per share and interest cover of the proposal to raise finance by issuing new debt (option 3), and comment on your findings. (5 marks) (d) Discuss the factors to be considered in choosing between traded bonds, new equity issued via a placing and venture capital as sources of finance. (9 marks) (25 marks)

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Financial Management Friday 6 December 2013

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FOUR questions are compulsory and MUST be attempted. Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7 and 8. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level – Skills Module

ALL FOUR questions are compulsory and MUST be attempted 1

Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future cash flows of an investment project with an expected life of four years, as follows: Year Sales revenue ($000) Costs ($000)

1 1,250 500

2 2,570 1,000

3 6,890 2,500

4 4,530 1,750

These forecast cash flows are before taking account of general inflation of 4·7% per year. The capital cost of the investment project, payable at the start of the first year, will be $2,000,000. The investment project will have zero scrap value at the end of the fourth year. The level of working capital investment at the start of each year is expected to be 10% of the sales revenue in that year. Capital allowances would be available on the capital cost of the investment project on a 25% reducing balance basis. Darn Co pays tax on profits at an annual rate of 30% per year, with tax being paid one year in arrears. Darn Co has a nominal (money terms) after-tax cost of capital of 12% per year. Required: (a) Calculate the net present value of the investment project in nominal terms and comment on its financial acceptability. (12 marks) (b) Calculate the net present value of the investment project in real terms and comment on its financial acceptability. (7 marks) (c) Explain ways in which the directors of Darn Co can be encouraged to achieve the objective of maximisation of shareholder wealth. (6 marks) (25 marks)

2

2

Card Co has in issue 8 million shares with an ex dividend market value of $7·16 per share. A dividend of 62 cents per share for 2013 has just been paid. The pattern of recent dividends is as follows: Year Dividends per share (cents)

2010 55·1

2011 57·9

2012 59·1

2013 62·0

Card Co also has in issue 8·5% bonds redeemable in five years’ time with a total nominal value of $5 million. The market value of each $100 bond is $103·42. Redemption will be at nominal value. Card Co is planning to invest a significant amount of money into a joint venture in a new business area. It has identified a proxy company with a similar business risk to the joint venture. The proxy company has an equity beta of 1·038 and is financed 75% by equity and 25% by debt, on a market value basis. The current risk-free rate of return is 4% and the average equity risk premium is 5%. Card Co pays profit tax at a rate of 30% per year and has an equity beta of 1·6. Required: (a) Calculate the cost of equity of Card Co using the dividend growth model.

(3 marks)

(b) Discuss whether the dividend growth model or the capital asset pricing model should be used to calculate the cost of equity. (5 marks) (c) Calculate the weighted average after-tax cost of capital of Card Co using a cost of equity of 12%. (5 marks) (d) Calculate a project-specific cost of equity for Card Co for the planned joint venture.

(4 marks)

(e) Discuss whether changing the capital structure of a company can lead to a reduction in its cost of capital and hence to an increase in the value of the company. (8 marks) (25 marks)

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Plot Co sells both Product P and Product Q, with sales of both products occurring evenly throughout the year. Product P The annual demand for Product P is 300,000 units and an order for new inventory is placed each month. Each order costs $267 to place. The cost of holding Product P in inventory is 10 cents per unit per year. Buffer inventory equal to 40% of one month’s sales is maintained. Product Q The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per unit on 60 days credit. The supplier has offered an early settlement discount of 1% for settlement of invoices within 30 days. Other information Plot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365 days in each year. Required: (a) Calculate the following values for Product P: (i)

The total cost of the current ordering policy;

(ii) The total cost of an ordering policy using the economic order quantity; (iii) The net cost or saving of introducing an ordering policy using the economic order quantity.

(3 marks) (3 marks) (1 mark)

(b) Calculate the net value in dollars to Plot Co of accepting the early settlement discount for Product Q. (5 marks) (c) Discuss how invoice discounting and factoring can aid the management of trade receivables.

(6 marks)

(d) Identify the objectives of working capital management and discuss the central role of working capital management in financial management. (7 marks) (25 marks)

4

4

Spot Co is considering how to finance the acquisition of a machine costing $750,000 with an operating life of five years. There are two financing options. Option 1 The machine could be leased for an annual lease payment of $155,000 per year, payable at the start of each year. Option 2 The machine could be bought for $750,000 using a bank loan charging interest at an annual rate of 7% per year. At the end of five years, the machine would have a scrap value of 10% of the purchase price. If the machine is bought, maintenance costs of $20,000 per year would be incurred. Taxation must be ignored. Required: (a) Evaluate whether Spot Co should use leasing or borrowing as a source of finance, explaining the evaluation method which you use. (10 marks) (b) Discuss the attractions of leasing as a source of both short-term and long-term finance.

(5 marks)

(c) In Islamic finance, explain briefly the concept of riba (interest) and how returns are made by Islamic financial instruments. (5 marks) (d) Discuss briefly the reasons why interest rates may differ between loans of different maturity.

(5 marks) (25 marks)

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Financial Management Friday 6 June 2014

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FOUR questions are compulsory and MUST be attempted. Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7 and 8. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level – Skills Module

ALL FOUR questions are compulsory and MUST be attempted 1

The Board of OAP Co has decided to limit investment funds to $10 million for the next year and is preparing its capital budget. The company is considering five projects, as follows: Project Project Project Project Project

A B C D E

Initial investment $2,500,000 $2,200,000 $2,600,000 $1,900,000 $5,000,000

Net present value $1,000,000 $1,550,000 $1,350,000 $1,500,000 To be calculated

All five projects have a project life of four years. Projects A, B, C and D are divisible, and Projects B and D are mutually exclusive. All net present values are in nominal, after-tax terms. Project E This is a strategically important project which the Board of OAP Co have decided must be undertaken in order for the company to remain competitive, regardless of its financial acceptability. Information relating to the future cash flows of this project is as follows: Year Sales volume (units) Selling price ($/unit) Variable cost ($/unit) Fixed costs ($000)

1 12,000 450 260 750

2 13,000 475 280 750

3 10,000 500 295 750

4 10,000 570 320 750

These forecasts are before taking account of selling price inflation of 5·0% per year, variable cost inflation of 6·0% per year and fixed cost inflation of 3·5% per year. The fixed costs are incremental fixed costs which are associated with Project E. At the end of four years, machinery from the project will be sold for scrap with a value of $400,000. Tax allowable depreciation on the initial investment cost of Project E is available on a 25% 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 of operation. OAP Co has a nominal after-tax cost of capital of 13% per year. Required: (a) Calculate the nominal after-tax net present value of Project E and comment on the financial acceptability of this project. (14 marks) (b) Calculate the maximum net present value which can be obtained from investing the fund of $10 million, assuming here that the nominal after-tax NPV of Project E is zero. (5 marks) (c) Discuss the reasons why the Board of OAP Co may have decided to limit investment funds for the next year. (6 marks) (25 marks)

2

2

The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows: Inventory Trade receivables Trade payables Overdraft Net current assets

$000 5,700 6,575 –––––– 2,137 4,682 ––––––

$000 12,275 6,819 ––––––– 5,456 –––––––

For the year to end of March 2014, CSZ Co had domestic and foreign sales of $40 million, all on credit, while cost of sales was $26 million. Trade payables related to both domestic and foreign suppliers. For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at $40 million while cost of sales will fall to 60% of sales. The company expects current assets to consist of inventory and trade receivables, and current liabilities to consist of trade payables and the company’s overdraft. CSZ Co also plans to achieve the following target working capital ratio values for the year to the end of March 2015: Inventory days: Trade receivables days: Trade payables days: Current ratio:

60 days 75 days 55 days 1·4 times

Required: (a) Calculate the working capital cycle (cash collection cycle) of CSZ Co at the end of March 2014 and discuss whether a working capital cycle should be positive or negative. (6 marks) (b) Calculate the target quick ratio (acid test ratio) and the target ratio of sales to net working capital of CSZ Co at the end of March 2015. (5 marks) (c) Analyse and compare the current asset and current liability positions for March 2014 and March 2015, and discuss how the working capital financing policy of CSZ Co would have changed. (8 marks) (d) Briefly discuss THREE internal methods which could be used by CSZ Co to manage foreign currency transaction risk arising from its continuing business activities. (6 marks) (25 marks)

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3

The equity beta of Fence Co is 0·9 and the company has issued 10 million ordinary shares. The market value of each ordinary share is $7·50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. 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 company in the same business area as the project, Hex Co. The equity beta of Hex Co is 1·2 and the company has an equity market value of $54 million. The market value of the debt of Hex Co is $12 million. The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both companies pay corporation tax at a rate of 20% per year. Required: (a) Calculate the current weighted average cost of capital of Fence Co.

(7 marks)

(b) Calculate a cost of equity which could be used in appraising the new project.

(4 marks)

(c) Explain the difference between systematic and unsystematic risk in relation to portfolio theory and the capital asset pricing model. (6 marks) (d) Discuss the differences between weak form, semi-strong form and strong form capital market efficiency, and discuss the significance of the efficient market hypothesis (EMH) for the financial manager. (8 marks) (25 marks)

4

4

The following financial information relates to MFZ Co, a listed company: Year Profit before interest and tax ($m) Profit after tax ($m) Dividends ($m) Equity market value ($m)

2014 18·3 12·8 5·1 56·4

2013 17·7 12·4 5·1 55·2

2012 17·1 12·0 4·8 54·0

MFZ Co has 12 million ordinary shares in issue and has not issued any new shares in the period under review. The company is financed entirely by equity, and is considering investing $9·2 million of new finance in order to expand existing business operations. This new finance could be either long-term debt finance or new equity via a rights issue. The rights issue price would be at a 20% discount to the current share price. Issue costs of $200,000 would have to be met from the cash raised, whether the new finance was equity or debt. The annual report of MFZ Co states that the company has three financial objectives: Objective 1: To achieve growth in profit before interest and tax of 4% per year Objective 2: To achieve growth in earnings per share of 3·5% per year Objective 3: To achieve total shareholder return of 5% per year MFZ Co has a cost of equity of 12% per year. Required: (a) Analyse and discuss the extent to which MFZ Co has achieved each of its stated objectives.

(7 marks)

(b) Calculate the total equity market value of MFZ Co for 2014 using the dividend growth model and briefly discuss why the dividend growth model value may differ from the current equity market value. (5 marks) (c) Calculate the theoretical ex rights price per share for the proposed rights issue.

(5 marks)

(d) Discuss the sources and characteristics of long-term debt finance which may be available to MFZ Co. (8 marks) (25 marks)

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Financial Management Friday 5 December 2014

Time allowed Reading and planning: Writing:

15 minutes 3 hours

This paper is divided into two sections: Section A – ALL 20 questions are compulsory and MUST be attempted Section B – ALL FIVE questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 11, 12 and 13. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level – Skills Module

Section A – ALL 20 questions are compulsory and MUST be attempted Please use the space provided on the inside cover of the Candidate Answer Booklet to indicate your chosen answer to each multiple choice question. Each question is worth 2 marks. 1

TKQ Co has just paid a dividend of 21 cents per share and its share price one year ago was $3·10 per share. The total shareholder return for the year was 19·7%. What is the current share price? A B C D

2

3

4

$3·50 $3·71 $3·31 $3·35

Which of the following statements is/are correct? 1 2 3

Securitisation is the conversion of illiquid assets into marketable securities The reverse yield gap refers to equity yields being higher than debt yields Disintermediation arises where borrowers deal directly with lending individuals

A B C D

2 only 1 and 3 only 2 and 3 only 1, 2 and 3

Which of the following statements are correct? 1 2 3

Maximising market share is an example of a financial objective Shareholder wealth maximisation is the primary financial objective for a company listed on a stock exchange Financial objectives should be quantitative so that their achievement can be measured

A B C D

1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3

A company whose home currency is the dollar ($) expects to receive 500,000 pesos in six months’ time from a customer in a foreign country. The following interest rates and exchange rates are available to the company: Spot rate Six-month forward rate Borrowing interest rate Deposit interest rate

15·00 peso per $ 15·30 peso per $ Home country 4% per year 3% per year

Foreign country 8% 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 B C D

$32,500 $33,700 $31,800 $31,900

2

5

Which of the following statements is correct? A B C D

6

Which of the following statements is correct? A B C D

7

A bonus issue can be used to raise new equity finance A share repurchase scheme can increase both earnings per share and gearing Miller and Modigliani argued that the financing decision is more important than the dividend decision Shareholders usually have the power to increase dividends at annual general meetings of a company

Tax allowable depreciation is a relevant cash flow when evaluating borrowing to buy compared to leasing as a financing choice Asset replacement decisions require relevant cash flows to be discounted by the after-tax cost of debt If capital is rationed, divisible investment projects can be ranked by the profitability index when determining the optimum investment schedule Government restrictions on bank lending are associated with soft capital rationing

An investment project has a cost of $12,000, payable at the start of the first year of operation. The possible future cash flows arising from the investment project have the following present values and associated probabilities: PV of Year 1 cash flow ($) 16,000 12,000 (4,000)

Probability 0·15 0·60 0·25

PV of Year 2 cash flow ($) 20,000 (2,000)

Probability 0·75 0·25

What is the expected value of the net present value of the investment project? A B C D

8

Which of the following statements is correct? A B C D

9

$11,850 $28,700 $11,100 $76,300

Once purchased, currency futures have a range of close-out dates Currency swaps can be used to hedge exchange rate risk over longer periods than the forward market Banks will allow forward exchange contracts to lapse if they are not used by a company Currency options are paid for when they are exercised

A company has 7% loan notes in issue which are redeemable in seven years’ time at a 5% premium to their nominal value of $100 per loan note. The before-tax cost of debt of the company is 9% and the after-tax cost of debt of the company is 6%. What is the current market value of each loan note? A B C D

$92·67 $108·90 $89·93 $103·14

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10 Which of the following statements concerning working capital management are correct? 1 2 3

Working capital should increase as sales increase An increase in the cash operating cycle will decrease profitability Overtrading is also known as under-capitalisation

A B C D

1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3

11 Which of the following is LEAST likely to fall within financial management? A B C D

The dividend payment to shareholders is increased Funds are raised to finance an investment project Surplus assets are sold off Non-executive directors are appointed to the remuneration committee

12 Which of the following statements concerning profit are correct? 1 2 3

Accounting profit is not the same as economic profit Profit takes account of risk Accounting profit can be manipulated by managers

A B C D

1 and 3 only 1 and 2 only 2 and 3 only 1, 2 and 3

13 A company has annual credit sales of $27 million and related cost of sales of $15 million. The company has the following targets for the next year: Trade receivables days Inventory days Trade payables

50 days 60 days 45 days

Assume there are 360 days in the year. What is the net investment in working capital required for the next year? A B C D

$8,125,000 $4,375,000 $2,875,000 $6,375,000

14 An investor believes that they can make abnormal returns by studying past share price movements. In terms of capital market efficiency, to which of the following does the investor’s belief relate? A B C D

Fundamental analysis Operational efficiency Technical analysis Semi-strong form efficiency

4

15 Which of the following statements is/are correct? 1 2 3

An increase in the cost of equity leads to a fall in share price Investors faced with increased risk will expect increased return as compensation The cost of debt is usually lower than the cost of preference shares

A B C D

2 only 1 and 3 only 2 and 3 only 1, 2 and 3

16 Governments have a number of economic targets as part of their fiscal policy. Which of the following government actions relate predominantly to fiscal policy? 1 2 3 4

Decreasing interest rates in order to stimulate consumer spending Reducing taxation while maintaining public spending Using official foreign currency reserves to buy the domestic currency Borrowing money from the capital markets and spending it on public works

A B C D

1 only 1 and 3 2 and 4 only 2, 3 and 4

17 The following are extracts from the statement of financial position of a company: $000 Equity Ordinary shares Reserves Non-current liabilities Bonds Bank loans Preference shares Current liabilities Overdraft Trade payables

Total equity and liabilities

8,000 20,000 –––––––

4,000 6,200 2,000 –––––––

1,000 1,500 –––––––

$000

28,000

12,200

2,500 ––––––– 42,700 –––––––

The ordinary shares have a nominal value of 50 cents per share and are trading at $5·00 per share. The preference shares have a nominal value of $1·00 per share and are trading at 80 cents per share. The bonds have a nominal value of $100 and are trading at $105 per bond. What is the market value based gearing of the company, defined as prior charge capital/equity? A B C D

15·0% 13·0% 11·8% 7·3%

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18 Which of the following statements is correct? A B C D

Governments may choose to raise interest rates so that the level of general expenditure in the economy will increase The normal yield curve slopes upward to reflect increasing compensation to investors for being unable to use their cash now The yield on long-term loan notes is lower than the yield on short-term loan notes because long-term debt is less risky for a company than short-term debt Expectations theory states that future interest rates reflect expectations of future inflation rate movements

19 A company has just paid an ordinary share dividend of 32·0 cents and is expected to pay a dividend of 33·6 cents in one year’s time. The company has a cost of equity of 13%. What is the market price of the company’s shares to the nearest cent on an ex dividend basis? A B C D

$3·20 $4·41 $2·59 $4·20

20 Which of the following is/are usually seen as forms of market failure where regulation may be a solution? 1 2 3

Imperfect competition Social costs or externalities Imperfect information

A B C D

1 only 1 and 2 only 2 and 3 only 1, 2 and 3 (40 marks)

6

Section B – ALL FIVE questions are compulsory and MUST be attempted 1

Flit Co is preparing a cash flow forecast for the three-month period from January to the end of March. The following sales volumes have been forecast: Sales (units)

December 1,200

January 1,250

February 1,300

March 1,400

April 1,500

Notes: 1. The selling price per unit is $800 and a selling price increase of 5% will occur in February. Sales are all on one month’s credit. 2. Production of goods for sale takes place one month before sales. 3. Each unit produced requires two units of raw materials, costing $200 per unit. No raw materials inventory is held. Raw material purchases are on one months’ credit. 4. Variable overheads and wages equal to $100 per unit are incurred during production, and paid in the month of production. 5. The opening cash balance at 1 January is expected to be $40,000. 6. A long-term loan of $300,000 will be received at the beginning of March. 7. A machine costing $400,000 will be purchased for cash in March. Required: (a) Calculate the cash balance at the end of each month in the three-month period.

(5 marks)

(b) Calculate the forecast current ratio at the end of the three-month period.

(2 marks)

(c) Assuming that Flit Co expects to have a short-term cash surplus during the three-month period, discuss whether this should be invested in shares listed on a large stock market. (3 marks) (10 marks)

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2

Recent information on the earnings per share and share price of Par Co is as follows: Year Earnings per share (cents) Year-end share price ($)

2011 64 9·15

2012 68 9·88

2013 70 10·49

2014 62 10·90

Par Co currently has the following long-term capital structure: $m Equity finance Ordinary shares Reserves Non-current liabilities Bank loans 8% convertible loan notes Total equity and liabilities

$m

30·0 38·4 ––––– 15·0 40·0 –––––

68·4

55·0 –––––– 123·4 ––––––

The 8% loan notes are convertible into eight ordinary shares per loan note in seven years’ time. If not converted, the loan notes can be redeemed on the same future date at their nominal value of $100. Par Co has a cost of debt of 9% per year. The ordinary shares of Par Co have a nominal value of $1 per share and have been traded on a large stock exchange for many years. Listed companies similar to Par Co have been recently reported to have an average price/earnings ratio of 12 times. Required: (a) Calculate the market price of the convertible loan notes of Par Co, commenting on whether conversion is likely. (5 marks) (b) Calculate the share price of Par Co using the price/earnings ratio method and discuss the problems in using this method of valuing the shares of a company. (5 marks) (10 marks)

3

PZK Co, whose home currency is the dollar, trades regularly with customers in a number of different countries. The company expects to receive €1,200,000 in six months’ time from a foreign customer. Current exchange rates in the home country of PZK Co are as follows: Spot exchange rate: Six-month forward exchange rate: Twelve-month forward exchange rate:

4·1780–4·2080 euros per $ 4·2302–4·2606 euros per $ 4·2825–4·3132 euros per $

Required: (a) Calculate the loss or gain compared to its current dollar value which PZK Co will incur by taking out a forward exchange contract on the future euro receipt, and explain why taking out a forward exchange contract may be preferred by PZK Co to not hedging the future euro receipt. (4 marks) (b) If the interest rate in the home country of PZK Co is 4% per year, calculate the annual interest rate in the foreign customer’s country implied by the spot exchange rate and the twelve-month forward exchange rate. (2 marks) (c) Discuss whether PZK Co should avoid exchange rate risk by invoicing foreign customers in dollars. (4 marks) (10 marks)

8

4

Uftin Co is a large company which is listed on a major stock market. The company has been evaluating an investment proposal to manufacture Product K3J. The initial investment of $1,800,000 will be payable at the start of the first year of operation. The following draft evaluation has been prepared by a junior employee. Year Sales (units/year) Selling price ($/unit) Variable costs ($/unit)

1 95,000 25 11

2 100,000 25 12

3 150,000 26 12

4 150,000 27 13

(Note: The above selling prices and variable costs per unit have not been inflated.) Sales revenue Variable costs Fixed costs Interest payments Cash flow before tax Tax allowable depreciation Taxable profit Taxation Net cash flow Discount at 12% Present values

Present value of cash inflows Cost of machine NPV

$000 2,605 (1,260) (155) (150) –––––– 1,040 (450) –––––– 590 (137) –––––– 453 0·797 –––––– 361 ––––––

$000 2,475 (1,097) (155) (150) –––––– 1,073 (450) –––––– 623 –––––– 623 0·893 –––––– 556 ––––––

$000 4,064 (1,890) (155) (150) –––––– 1,869 (450) –––––– 1,419 (130) –––––– 1,289 0·712 –––––– 918 ––––––

$000 4,220 (2,048) (155) (150) –––––– 1,867 (450) –––––– 1,417 (312) –––––– 1,105 0·636 –––––– 703 ––––––

$000 2,538 (1,800) –––––– 738 ––––––

The junior employee also provided the following information: 1. 2. 3. 4. 5. 6. 7. 8. 9.

Relevant fixed costs are forecast to be $150,000 per year. Sales and production volumes are the same and no finished goods inventory is held. The corporation tax rate is 22% per year and tax liabilities are payable one year in arrears. Uftin Co can claim tax allowable depreciation of 25% per year on a reducing balance basis on the initial investment. A balancing charge or allowance can be claimed at the end of the fourth year. It is expected that selling price inflation will be 4·2% per year, variable cost inflation will be 5% per year and fixed cost inflation will be 3% per year. The investment has no scrap value. The investment will be partly financed by a $1,500,000 loan at 10% per year. Uftin Co has a weighted average cost of capital of 12% per year.

Required: (a) Prepare a revised draft evaluation of the investment proposal and comment on its financial acceptability. (11 marks) (b) Explain any TWO revisions you have made to the draft evaluation in part (a) above.

(4 marks) (15 marks)

9

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5

Tinep Co is planning to raise funds for an expansion of existing business activities and in preparation for this the company has decided to calculate its weighted average cost of capital. Tinep Co has the following capital structure: $m Equity Ordinary shares Reserves Non-current liabilities Loan notes

$m

200 650 ––––

850 200 –––––– 1,050 ––––––

The ordinary shares of Tinep Co have a nominal value of 50 cents per share and are currently trading on the stock market on an ex dividend basis at $5·85 per share. Tinep Co has an equity beta of 1·15. The loan notes have a nominal value of $100 and are currently trading on the stock market on an ex interest basis at $103·50 per loan note. The interest on the loan notes is 6% per year before tax and they will be redeemed in six years’ time at a 6% premium to their nominal value. The risk-free rate of return is 4% per year and the equity risk premium is 6% per year. Tinep Co pays corporation tax at an annual rate of 25% per year. Required: (a) Calculate the market value weighted average cost of capital and the book value weighted average cost of capital of Tinep Co, and comment briefly on any difference between the two values. (9 marks) (b) Discuss the factors to be considered by Tinep Co in choosing to raise funds via a rights issue.

(6 marks) (15 marks)

10

Financial Management Friday 5 June 2015

Time allowed Reading and planning: Writing:

15 minutes 3 hours

This paper is divided into two sections: Section A – ALL 20 questions are compulsory and MUST be attempted Section B – ALL FIVE questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 10, 11 and 12. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. Do NOT record any of your answers on the exam paper. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level – Skills Module

Section A – ALL 20 questions are compulsory and MUST be attempted Please use the grid provided on page two of the Candidate Answer Booklet to record your answers to each multiple choice question. Do not write out the answers to the MCQs on the lined pages of the answer booklet. Each question is worth 2 marks. 1

Which of the following statements is/are correct? (1) Monetary policy seeks to influence aggregate demand by increasing or decreasing the money raised through taxation (2) When governments adopt a floating exchange rate system, the exchange rate is an equilibrium between demand and supply in the foreign exchange market (3) Fiscal policy seeks to influence the economy and economic growth by increasing or decreasing interest rates A B C D

2

2 only 1 and 2 only 1 and 3 only 1, 2 and 3

Which of the following statements are correct? (1) The general level of interest rates is affected by investors’ desire for a real return (2) Market segmentation theory can explain kinks (discontinuities) in the yield curve (3) When interest rates are expected to fall, the yield curve could be sloping downwards A B C D

3

1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3

The following information relates to a company: Year Earnings per share (cents) Dividends per share (cents) Share price at start of year ($)

0 30·0 13·0 1·95

1 31·8 13·2 1·98

2 33·9 13·3 2·01

3 35·7 15·0 2·25

Which of the following statements is correct? A B C D

4

The dividend payout ratio is greater than 40% in every year in the period Mean growth in dividends per share over the period is 4% Total shareholder return for the third year is 26% Mean growth in earnings per share over the period is 6% per year

Which of the following statements is correct? A B C D

One of the problems with maximising accounting profit as a financial objective is that accounting profit can be manipulated A target for a minimum level of dividend cover is a target for a minimum dividend payout ratio The welfare of employees is a financial objective One reason shareholders are interested in earnings per share is that accounting profit takes account of risk

2

5

Which of the following statements is NOT correct? A B C D

6

Return on capital employed can be defined as profit before interest and tax divided by the sum of shareholders’ funds and prior charge capital Return on capital employed is the product of net profit margin and net asset turnover Dividend yield can be defined as dividend per share divided by the ex dividend share price Return on equity can be defined as profit before interest and tax divided by shareholders’ funds

Which of the following statements are correct? (1) The sensitivity of a project variable can be calculated by dividing the project net present value by the present value of the cash flows relating to that project variable (2) The expected net present value is the value expected to occur if an investment project with several possible outcomes is undertaken once (3) The discounted payback period is the time taken for the cumulative net present value to change from negative to positive A B C D

7

1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3

Which of the following statements is/are correct? (1) The asset beta reflects both business risk and financial risk (2) Total risk is the sum of systematic risk and unsystematic risk (3) Assuming that the beta of debt is zero will understate financial risk when ungearing an equity beta A B C D

8

2 only 1 and 3 only 2 and 3 only 1, 2 and 3

Which of the following statements are correct? (1) Share option schemes always reward good performance by managers (2) Performance-related pay can encourage dysfunctional behaviour (3) Value for money as an objective in not-for-profit organisations requires the pursuit of economy, efficiency and effectiveness A B C D

9

1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3

Which of the following are financial intermediaries? (1) Venture capital organisation (2) Pension fund (3) Merchant bank A B C D

2 only 1 and 3 only 2 and 3 only 1, 2 and 3

3

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10 A company has in issue loan notes with a nominal value of $100 each. Interest on the loan notes is 6% per year, payable annually. The loan notes will be redeemed in eight years’ time at a 5% premium to nominal value. The before-tax cost of debt of the company is 7% per year. What is the ex interest market value of each loan note? A B C D

$94·03 $96·94 $102·91 $103·10

11 Which of the following statements are correct? (1) Capital market securities are assets for the seller but liabilities for the buyer (2) Financial markets can be classified into exchange and over-the-counter markets (3) A secondary market is where securities are bought and sold by investors A B C D

1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3

12 Which of the following statements are correct? (1) A certificate of deposit is an example of a money market instrument (2) Money market deposits are short-term loans between organisations such as banks (3) Treasury bills are bought and sold on a discount basis A B C D

1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3

13 A company is evaluating an investment project with the following forecast cash flows: Year Cash flow ($m)

0 (6·5)

1 2·4

2 3·1

3 2·1

4 1·8

Using discount rates of 15% and 20%, what is the internal rate of return of the investment project? A B C D

15·8% 17·2% 17·8% 19·4%

14 Which of the following statements are correct? (1) Interest rate options allow the buyer to take advantage of favourable interest rate movements (2) A forward rate agreement does not allow a borrower to benefit from a decrease in interest rates (3) Borrowers hedging against an interest rate increase will buy interest rate futures now and sell them at a future date A B C D

1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3

4

15 A company needs $150,000 each year for regular payments. Converting the company’s short-term investments into cash to meet these regular payments incurs a fixed cost of $400 per transaction. These short-term investments pay interest of 5% per year, while the company earns interest of only 1% per year on cash deposits. According to the Baumol Model, what is the optimum amount of short-term investments to convert into cash in each transaction? A B C D

$38,730 $48,990 $54,772 $63,246

16 Which of the following statements is/are correct? (1) Factoring with recourse provides insurance against bad debts (2) The expertise of a factor can increase the efficiency of trade receivables management for a company A B C D

2 only 1 only Neither 1 nor 2 1 and 2

17 An investor plans to exchange $1,000 into euros now, invest the resulting euros for 12 months, and then exchange the euros back into dollars at the end of the 12-month period. The spot exchange rate is €1·415 per $1 and the euro interest rate is 2% per year. The dollar interest rate is 1·8% per year. Compared to making a dollar investment for 12 months, at what 12-month forward exchange rate will the investor make neither a loss nor a gain? A B C D

€1·223 €1·412 €1·418 €1·439

per per per per

$1 $1 $1 $1

18 Which of the following statements are correct? (1) If a capital market is weak form efficient, an investor cannot make abnormal returns by using technical analysis (2) Operational efficiency means that efficient capital markets direct funds to their most productive use (3) Tests for semi-strong form efficiency focus on the speed and accuracy of share price responses to the arrival of new information A B C D

1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3

19 On a market value basis, GFV Co is financed 70% by equity and 30% by debt. The company has an after-tax cost of debt of 6% and an equity beta of 1·2. The risk-free rate of return is 4% and the equity risk premium is 5%. What is the after-tax weighted average cost of capital of GFV Co? A B C D

5·4% 7·2% 8·3% 8·8%

5

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20 The following financial information relates to QK Co, whose ordinary shares have a nominal value of $0·50 per share: $m Non-current assets Current assets Inventory Trade receivables Total assets Equity Ordinary shares Reserves Non-current liabilities Current liabilities

$m 120

8 12 –––

20 –––– 140 ––––

25 80 –––

105 20 15 –––– 140 ––––

Total equity and liabilities

On an historic basis, what is the net asset value per share of QK Co? A B C D

$2·10 $2·50 $2·80 $4·20

per per per per

share share share share (40 marks)

6

Section B – ALL FIVE questions are compulsory and MUST be attempted. Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet. 1

Rose Co expects to receive €750,000 from a credit customer in the European Union in six months’ time. The spot exchange rate is €2·349 per $1 and the six-month forward rate is €2·412 per $1. The following commercial interest rates are available to Rose Co: Euros Dollars

Deposit rate 4·0% per year 2·0% per year

Borrow rate 8·0% per year 3·5% per year

Rose Co does not have any surplus cash to use in hedging the future euro receipt. Required: (a) Evaluate whether a money market hedge or a forward market hedge would be preferred on financial grounds by Rose Co. (5 marks) (b) Briefly explain the nature of a forward rate agreement and discuss how a company can use a forward rate agreement to manage interest rate risk. (5 marks) (10 marks)

2

Chad Co is a stock-market-listed company which has managed to increase earnings over the last year. As a result, the board of directors has increased the dividend payout ratio from 40·0% for the year to March 2014 to 41·4% for the year to March 2015. Chad Co has a cost of equity of 12·5%. The following information is also available: Year to March Earnings Ordinary shares

2014 $000 13,200 8,000

2015 $000 13,840 8,000

The nominal value of the ordinary shares of Chad Co is $0·50 per share. Listed companies similar to Chad Co have an earnings yield of 8·2%. Required: (a) Calculate the equity market value of Chad Co using the dividend growth model.

(3 marks)

(b) Calculate the equity market value of Chad Co using the earnings yield method.

(2 marks)

(c) Discuss the relative merits of the dividend growth model and the earnings yield method as a way of valuing Chad Co. (5 marks) (10 marks)

7

[P.T.O.

3

The finance director of Widnor Co has been looking to improve the company’s working capital management. Widnor Co has revenue from credit sales of $26,750,000 per year and although its terms of trade require all credit customers to settle outstanding invoices within 40 days, on average customers have been taking longer. 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. The finance director is considering a proposal from a factoring company, Nokfe Co, which was invited to tender to manage the sales ledger of Widnor Co on a with-recourse basis. Nokfe Co believes that it can use its expertise to reduce average trade receivables days to 35 days, while cutting bad debts by 70% and reducing administration costs by $50,000 per year. A condition of the factoring agreement is that the company would also advance Widnor Co 80% of the value of invoices raised at an interest rate of 7% per year. Nokfe Co would charge an annual fee of 0·75% of credit sales. Assume that there are 360 days in each year. Required: (a) Advise whether the factor’s offer is financially acceptable to Widnor Co.

(7 marks)

(b) Briefly discuss how the creditworthiness of potential customers can be assessed.

(3 marks) (10 marks)

4

Grenarp Co is planning to raise $11,200,000 through a rights issue. The new shares will be offered at a 20% discount to the current share price of Grenarp Co, which is $3·50 per share. The rights issue will be on a 1 for 5 basis and issue costs of $280,000 will be paid out of the cash raised. The capital structure of Grenarp Co is as follows: $m Equity Ordinary shares ($0·50 nominal) Reserves

$m

10 75 –––

85

Non-current liabilities 8% Loan notes

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 nominal value of $100 and an ex interest market value of $104. A clause in the bond issue contract allows Grenarp Co to redeem the loan notes at a 5% premium to market price at any time prior to their redemption date. The price/earnings ratio of Grenarp Co is not expected to be affected by the redemption of the loan notes. The earnings per share of Grenarp Co is currently $0·42 per share and total earnings are $8,400,000 per year. The company pays corporation tax of 30% per year. Required: (a) Evaluate the effect on the wealth of the shareholders of Grenarp Co of using the net rights issue funds to redeem the loan notes. (8 marks) (b) Discuss whether Grenarp Co might achieve its optimal capital structure following the rights issue. (7 marks) (15 marks)

8

5

Hraxin Co is appraising an investment project which has an expected life of four years and which will not be repeated. The initial investment, payable at the start of the first year of operation, is $5 million. Scrap value of $500,000 is expected to arise at the end of four years. There is some uncertainty about what price can be charged for the units produced by the investment project, as this is expected to depend on the future state of the economy. The following forecast of selling prices and their probabilities has been prepared: Future economic state Probability of future economic state Selling price in current price terms

Weak 35% $25 per unit

Medium 50% $30 per unit

Strong 15% $35 per unit

These selling prices are expected to be subject to annual inflation of 4% per year, regardless of which economic state prevails in the future. Forecast sales and production volumes, and total nominal variable costs, have already been forecast, as follows: Year Sales and production (units) Nominal variable cost ($000)

1 150,000 2,385

2 250,000 4,200

3 400,000 7,080

4 300,000 5,730

Incremental overheads of $400,000 per year in current price terms will arise as a result of undertaking the investment project. A large proportion of these overheads relate to energy costs which are expected to increase sharply in the future because of energy supply shortages, so overhead inflation of 10% per year is expected. The initial investment will attract tax-allowable depreciation on a straight-line basis over the four-year project life. The rate of corporation tax is 30% and tax liabilities are paid in the year in which they arise. Hraxin Co has traditionally used a nominal after-tax discount rate of 11% per year for investment appraisal. Required: (a) Calculate the expected net present value of the investment project and comment on its financial acceptability. (9 marks) (b) Critically discuss if sensitivity analysis will assist Hraxin Co in assessing the risk of the investment project. (6 marks) (15 marks)

9

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Financial Management September/December 2015

Time allowed Reading and planning: Writing:

15 minutes 3 hours

This question paper is divided into two sections: Section A – ALL 20 questions are compulsory and MUST be attempted Section B – ALL FIVE questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7 and 8. Do NOT open this question paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. Do NOT record any of your answers on the question paper. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level – Skills Module

Section B – ALL FIVE questions are compulsory and MUST be attempted Please write your answers to all parts of these question on the lined pages within the Candidate Answer Booklet. 1

Gemlo Co is a company listed on a large stock market. Extracts from its current statement of financial position are as follows: $m Equity Ordinary shares ($1 nominal) Reserves Non-current liabilities 6% Irredeemable loan notes 7% Loan notes

$m

15 153 ––––

168

10 12 ––––

22 –––– 190 ––––

Gemlo Co is planning an expansion of existing business operations costing $10 million in the near future and is assessing its current financial position as part of preparing a business case in support of seeking new finance. The business expansion is expected to increase the profit before interest and tax of Gemlo Co by 20% in the first year. The planned business expansion by Gemlo Co has already been announced to the stock market. Information on the expected increase in profit before interest and tax has not yet been announced and the company has not decided on how the expansion is to be financed. The ordinary shares of the company are currently trading at $3·75 per share on an ex dividend basis. The irredeemable loan notes have a cost of debt of 7%. The 7% loan notes have a cost of debt of 6% and will be redeemed at a 5% premium to nominal value after seven years. The interest cover of Gemlo Co is 6 times. Companies operating in the same business sector as Gemlo Co have an average debt/equity ratio of 40% on a market value basis and an average interest cover of 9 times. Required: (a) Calculate the debt/equity ratio of Gemlo Co based on market values and comment on your findings. (4 marks) (b) Gemlo Co agrees with a bank that its business expansion will be financed by a new issue of 8% loan notes. The company then announces to the stock market both this financing decision and the expected increase in profit before interest and tax arising from the business expansion. Required: Assuming the stock market is semi-strong form efficient, analyse and discuss the effect of the financing and profitability announcement on the financial risk and share price of Gemlo Co. Note: Up to 2 marks for relevant calculations.

(6 marks) (10 marks)

2

2

GXJ Co, whose home currency is the dollar, wishes to borrow €12 million for a period of six months in three months’ time. The lending bank will fix the interest rate for the loan period at its prevailing lending interest rate when the loan is taken out. The finance director of GXJ Co believes this lending interest rate could be a minimum of 3·5% per year or a maximum of 5·5% per year. The uncertainty regarding the future interest rate is caused by the volatile state of the economy and impending elections which could lead to a change in political leadership and direction. Interest on the euro loan would be payable at the end of the loan period. The finance director of GXJ Co would like to hedge the interest rate risk arising from the future loan and the company’s bank has offered a 3–9, 4·5%–3·5% forward rate agreement. The finance director is also concerned about the foreign currency risk associated with the euro interest payment which would be due in nine months’ time. The following exchange rates are available: Spot rate (euro per $1) Nine-month forward rate (euro per $1)

1·7964–1·8306 1·7191–1·7505

Required: (a) Evaluate the proposed forward rate agreement as a way of managing the interest rate risk anticipated by GXJ Co. (3 marks) (b) Analyse the foreign currency risk associated with the future interest payment of GXJ Co and briefly discuss ways that this risk might be hedged. (4 marks) (c) Explain the nature of four-way equivalence in the relationship between spot exchange rates, forward exchange rates and future (expected) spot rates. (3 marks) (10 marks)

3

ZXC Co currently has income of $30 million per year, of which 80% is from credit sales, and a net profit margin of 10%. Due to fierce competition, ZXC Co has lost market share and is looking for ways to win back former customers and to keep the loyalty of existing customers. The sales director has pointed out that a major competitor of ZXC Co currently offers an early settlement discount of 0·5% for settlement within 30 days, while ZXC Co itself does not offer an early settlement discount. He suggests that if ZXC Co could match this early settlement discount, annual income from credit sales would increase by 20%. Credit customers of ZXC Co take an average of 51 days to settle invoices. Approximately 0·5% of the company’s credit sales have historically become bad debts each year and written off as irrecoverable. The finance director has been advised that offering an early settlement discount of 0·5% for payment within 30 days would increase administration costs by $35,000 per year, while 75% of credit customers would be likely to take the discount. The credit controller believes that bad debts would fall to 0·375% of credit sales if the early settlement discount were introduced. ZXC Co has an average short-term cost of finance of 4% per year. Assume that there are 360 days in each year. Required: (a) Evaluate whether ZXC Co should introduce the early settlement discount.

(6 marks)

(b) Discuss TWO ways in which a company could reduce the risk associated with foreign accounts receivable. (4 marks) (10 marks)

3

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4

KQK Co wants to raise $20 million in order to expand its business and wishes to evaluate one possibility, which is an issue of 8% loan notes. Extracts from the financial statements of KQK Co are as follows. Income Cost of sales and other expenses Profit before interest and tax Finance charges (interest) Profit before tax Taxation Profit after tax

Equity finance Ordinary shares ($1 nominal) Reserves Non-current liabilities Current liabilities

$m 140·0 112·0 –––––– 28·0 2·8 –––––– 25·2 7·6 –––––– 17·6 –––––– $m

$m

25·0 118·5 ––––––

143·5 36·0 38·3 –––––– 217·8 ––––––

Total equity and liabilities

It is expected that investing $20 million in the business will increase income by 5% over the first year. Approximately 40% of cost of sales and other expenses are fixed, the remainder of these costs are variable. Fixed costs will not be affected by the business expansion, while variable costs will increase in line with income. KQK Co pays corporation tax at a rate of 30%. The company has a policy of paying out 40% of profit after tax as dividends to shareholders. Current liabilities are expected to increase by 3% by the end of the first year following the business expansion. Average values of other companies similar to KQK Co: Debt/equity ratio (book value basis): Interest cover: Operational gearing (contribution/PBIT): Return on equity:

30% 10 times 2 times 15%

Required: (a) Assess the impact of financing the business expansion by the loan note issue on financial position, financial risk and shareholder wealth after one year, using appropriate measures. (10 marks) (b) Discuss the circumstances under which the current weighted average cost of capital of a company could be used in investment appraisal and indicate briefly how its limitations as a discount rate could be overcome. (5 marks) (15 marks)

4

5

Argnil Co is appraising the purchase of a new machine, costing $1·5 million, to replace an existing machine which is becoming out of date and which has no resale value. The forecast levels of production and sales for the goods produced by the new machine, which has a maximum capacity of 400,000 units per year, are as follows: Year Sales volume (units/year)

1 350,000

2 380,000

3 400,000

4 400,000

The new machine will incur fixed annual maintenance costs of $145,000 per year. Variable costs are expected to be $3·00 per unit and selling price is expected to be $5·65 per unit. These costs and selling price estimates are in current price terms and do not take account of general inflation, which is forecast to be 4·7% per year. It is expected that the new machine will need replacing in four years’ time due to advances in technology. The resale value of the new machine is expected to be $200,000 at that time, in future value terms. The purchase price of the new machine is payable at the start of the first year of the four-year life of the machine. Working capital investment of $150,000 will already exist at the start of the four-year period, due to the operation of the existing machine. This investment in working capital is expected to increase in nominal terms in line with the general rate of inflation. Argnil Co pays corporation tax one year in arrears at an annual rate of 27% and can claim 25% reducing balance tax-allowable depreciation on the purchase price of the new machine. The company has a real after-tax weighted average cost of capital of 6% and a nominal after-tax weighted average cost of capital of 11%. Required: (a) Using a nominal terms net present value approach, evaluate whether purchasing the new machine is financially acceptable. (10 marks) (b) Discuss the reasons why investment finance may be limited, even when a company has attractive investment opportunities available to it. (5 marks) (15 marks)

5

[P.T.O.

Financial Management March/June 2016 – Sample Questions

Time allowed Reading and planning: Writing:

15 minutes 3 hours

This question paper is divided into two sections: Section A – ALL 20 questions are compulsory and MUST be attempted Section B – ALL FIVE questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7 and 8. Do NOT open this question paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. Do NOT record any of your answers on the question paper. This question paper must not be removed from the examination hall.

Paper F9

Fundamentals Level – Skills Module

The Association of Chartered Certified Accountants

Section B – ALL FIVE questions are compulsory and MUST be attempted Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet. 1

Crago Co is concerned that it may be overtrading. Financial information relating to the company is as follows. 20X5 $000 Credit sales income Cost of sales Current assets Inventory Trade receivables Current liabilities Trade payables Overdraft

2,500 2,000 ––––––

1,900 2,400 ––––––

Net working capital Long-term debt

20X4

$000 17,100 8,550

4,500

4,300 ––––––– 200 ––––––– 3,000

$000

2,100 1,000 ––––––

1,250 850 ––––––

$000 12,000 7,500

3,100

2,100 ––––––– 1,000 ––––––– 3,000

Companies which are similar to Crago Co have the following average values for 20X5: Inventory days Trade receivables days Trade payables days Current ratio Quick ratio

65 days 30 days 50 days 1·7 times 0·8 times

Assume there are 360 days in each year. Required: Evaluate whether Crago can be considered to be overtrading and discuss how overtrading can be overcome. Note: Up to 4 marks are available for calculations. (10 marks)

2

2

The directors of Plam Co expect that interest rates will fall over the next year and they are looking forward to paying less interest on the company’s debt finance. The dollar is the domestic currency of Plam Co. The company has a number of different kinds of debt finance, as follows: Denomination Nominal value Interest rate Interest type Interest due Redemption

Loan notes Dollar

Loan notes Peso

Bank loan Dollar

Overdraft Dollar

$20m 7% per year Fixed rate 6 months’ time 8 years’ time at nominal value

300m pesos 10% per year Fixed rate 6 months’ time 8 years’ time at nominal value

$4m 8% per year Variable rate 6 months’ time Instalments over 8 years

$3m 10% per year Variable rate monthly Continuing at current level

The 7% loan notes were issued domestically while the 10% loan notes were issued in a foreign country. The interest rate on the long-term bank loan is reset to bank base rate plus a fixed percentage at the end of each year. The annual payment on the bank loan consists of interest on the year-end balance plus a capital repayment. Relevant exchange rates are as follows: Spot rate (pesos/$) Six-month forward rate (pesos/$)

Offer 58·335 56·585

Bid 58·345 56·597

Plam Co can place pesos on deposit at 3% per year and borrow dollars at 10% per year. The company has no cash available for hedging purposes. Required: (a) Evaluate the risk faced by Plam Co on its peso-denominated interest payment in six months’ time and advise how this risk might be hedged. (5 marks) (b) Identify and discuss the different kinds of interest rate risk faced by Plam Co.

(5 marks) (10 marks)

3

Darlga Co is partly financed by 7% loan notes which are redeemable at their nominal value of $1,000 per loan note in eight years’ time. Alternatively, the loan notes are convertible after seven years into 110 ordinary shares of Darlga Co per loan note. The ordinary shares of Darlga Co are currently trading at $6·50 per share on an ex dividend basis. The current cost of debt of the convertible loan notes is 8%. Required: (a) Justifying any assumptions which you make, calculate the current market value of the loan notes of Darlga Co, using future share price increases of: (i) 4% per year; (ii) 6% per year.

(6 marks)

(b) Discuss the limitations of the dividend growth model as a way of valuing the ordinary shares of a company. (4 marks) (10 marks)

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4

Dinla Co has the following capital structure. Equity and reserves Ordinary shares Reserves Non-current liabilities 5% Preference shares 6% Loan notes Bank loan

$000

$000

23,000 247,000 ––––––––

270,000

5,000 11,000 3,000 ––––––––

19,000 –––––––– 289,000 ––––––––

The ordinary shares of Dinla Co are currently trading at $4·26 per share on an ex dividend basis and have a nominal value of $0·25 per share. Ordinary dividends are expected to grow in the future by 4% per year and a dividend of $0·25 per share has just been paid. The 5% preference shares have an ex dividend market value of $0·56 per share and a nominal value of $1·00 per share. These shares are irredeemable. The 6% loan notes of Dinla Co are currently trading at $95·45 per loan note on an ex interest basis and will be redeemed at their nominal value of $100 per loan note in five years’ time. The bank loan has a fixed interest rate of 7% per year. Dinla Co pays corporation tax at a rate of 25%. Required: (a) Calculate the after-tax weighted average cost of capital of Dinla Co on a market value basis.

(8 marks)

(b) Discuss the connection between the relative costs of sources of finance and the creditor hierarchy. (3 marks) (c) Explain the differences between Islamic finance and other conventional finance.

(4 marks) (15 marks)

4

5

Degnis Co is a company which installs kitchens and bathrooms to customer specifications. It is planning to invest $4,000,000 in a new facility to convert vans and trucks into motorhomes. Each motorhome will be designed and built according to customer requirements. Degnis Co expects motorhome production and sales in the first four years of operation to be as follows. Year Motorhomes produced and sold

1 250

2 300

3 450

4 450

The selling price for a motorhome depends on the van or truck which is converted, the quality of the units installed and the extent of conversion work required. Degnis Co has undertaken research into likely sales and costs of different kinds of motorhomes which could be selected by customers, as follows: Motorhome type Probability of selection Selling price ($/unit) Conversion cost ($/unit)

Basic 20% 30,000 23,000

Standard 45% 42,000 29,000

Deluxe 35% 72,000 40,000

Fixed costs of the production facility are expected to depend on the volume of motorhome production as follows: Production volume (units/year) Fixed costs ($000/year)

200–299 4,000

300–399 5,000

400–499 5,500

Degnis Co pays corporation tax of 28% per year, with the tax liability being settled in the year in which it arises. The company can claim tax allowable depreciation on the cost of the investment on a straight-line basis over ten years. Degnis Co evaluates investment projects using an after-tax discount rate of 11%. Required: (a) Calculate the expected net present value of the planned investment for the first four years of operation. (7 marks) (b) After the fourth year of operation, Degnis Co expects to continue to produce and sell 450 motorhomes per year for the foreseeable future. Required: Calculate the effect on the expected net present value of the planned investment of continuing to produce and sell motorhomes beyond the first four years and comment on the financial acceptability of the planned investment. (3 marks) (c) Critically discuss the use of probability analysis in incorporating risk into investment appraisal.

(5 marks) (15 marks)

5

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Financial Management Friday 9 September 2016

Time allowed: 3 hours 15 minutes This question paper is divided into three sections: Section A – ALL 15 questions are compulsory and MUST be attempted Section B – ALL 15 questions are compulsory and MUST be attempted Section C – BOTH questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 13–15. Do NOT open this question paper until instructed by the supervisor. Do NOT record any of your answers on the question paper. This question paper must not be removed from the examination hall.

Paper F9

Fundamentals Level – Skills Module

The Association of Chartered Certified Accountants

Section A – ALL 15 questions are compulsory and MUST be attempted Please use the grid provided on page two of the Candidate Answer Booklet to record your answers to each multiple choice question. Do not write out the answers to the MCQs on the lined pages of the answer booklet. Each question is worth 2 marks. 1

The owners of a private company wish to dispose of their entire investment in the company. The company has an issued share capital of $1m of $0·50 nominal value ordinary shares. The owners have made the following valuations of the company’s assets and liabilities. Non-current assets (book value) Current assets Non-current liabilities Current liabilities

$30m $18m $12m $10m

The net realisable value of the non-current assets exceeds their book value by $4m. The current assets include $2m of accounts receivable which are thought to be irrecoverable. What is the minimum price per share which the owners should accept for the company? A B C D

2

Which of the following financial instruments will NOT be traded on a money market? A B C D

3

$14 $25 $28 $13

Commercial paper Convertible loan notes Treasury bills Certificates of deposit

Andrew Co is a large listed company financed by both equity and debt. In which of the following areas of financial management will the impact of working capital management be smallest? A B C D

4

Liquidity management Interest rate management Management of relationship with the bank Dividend policy

Which of the following are descriptions of basis risk? (1) (2) (3) (4)

It It It It

is is is is

the difference between the spot exchange rate and currency futures exchange rate the possibility that the movements in the currency futures price and spot price will be different the difference between fixed and floating interest rates one of the reasons for an imperfect currency futures hedge

A B C D

1 only 1 and 3 2 and 4 only 2, 3 and 4

2

5

Crag Co has sales of $200m per year and the gross profit margin is 40%. Finished goods inventory days vary throughout the year within the following range: Maximum 120

Inventory (days)

Minimum 90

All purchases and sales are made on a cash basis and no inventory of raw materials or work in progress is carried. Crag Co intends to finance permanent current assets with equity and fluctuating current assets with its overdraft. In relation to finished goods inventory and assuming a 360-day year, how much finance will be needed from the overdraft? A B C D

6

In relation to an irredeemable security paying a fixed rate of interest, which of the following statements is correct? A B C D

7

$10m $17m $30m $40m

As As As As

risk risk risk risk

rises, rises, rises, rises,

the the the the

market market market market

value value value value

of of of of

the the the the

security security security security

will will will will

fall to ensure that investors receive an increased yield fall to ensure that investors receive a reduced yield rise to ensure that investors receive an increased yield rise to ensure that investors receive a reduced yield

Pop Co is switching from using mainly long-term fixed rate finance to fund its working capital to using mainly short-term variable rate finance. Which of the following statements about the change in Pop Co’s working capital financing policy is true? A B C D

8

In relation to an operating lease, which of the following statements is correct? A B C D

9

Finance costs will increase Re-financing risk will increase Interest rate risk will decrease Overcapitalisation risk will decrease

All the risks and rewards of ownership transfer to the lessee The asset and lease obligation will be recorded in the statement of financial position The lease period will cover almost all of the leased asset’s useful economic life The lessor will be responsible for repairs and maintenance of the leased asset

A company has annual after-tax operating cash flows of $2 million per year which are expected to continue in perpetuity. The company has a cost of equity of 10%, a before-tax cost of debt of 5% and an after-tax weighted average cost of capital of 8% per year. Corporation tax is 20%. What is the theoretical value of the company? A B C D

$20m $40m $50m $25m

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10 Which of the following would you expect to be the responsibility of financial management? A B C D

Producing annual accounts Producing monthly management accounts Advising on investment in non-current assets Deciding pay rates for staff

11 Lane Co has in issue 3% convertible loan notes which are redeemable in five years’ time at their nominal value of $100 per loan note. Alternatively, each loan note can be converted in five years’ time into 25 Lane Co ordinary shares. The current share price of Lane Co is $3·60 per share and future share price growth is expected to be 5% per year. The before-tax cost of debt of these loan notes is 10% and corporation tax is 30%. What is the current market value of a Lane Co convertible loan note? A B C D

$82·71 $73·47 $67·26 $94·20

12 Country X uses the dollar as its currency and country Y uses the dinar. Country X’s expected inflation rate is 5% per year, compared to 2% per year in country Y. Country Y’s nominal interest rate is 4% per year and the current spot exchange rate between the two countries is 1·5000 dinar per $1. According to the four-way equivalence model, which of the following statements is/are true? (1) Country X’s nominal interest rate should be 7·06% per year (2) The future (expected) spot rate after one year should be 1·4571 dinar per $1 (3) Country X’s real interest rate should be higher than that of country Y A B C D

1 only 1 and 2 only 2 and 3 only 1, 2 and 3

13 Which of the following government actions would lead to an increase in aggregate demand? (1) (2) (3) (4)

Increasing taxation and keeping government expenditure the same Decreasing taxation and increasing government expenditure Decreasing money supply Decreasing interest rates

A B C D

1 only 1 and 3 2 and 4 only 2, 3 and 4

4

14 Peach Co’s latest results are as follows: Profit before interest and taxation Profit before taxation Profit after tax

$000 2,500 2,250 1,400

In addition, extracts from its latest statement of financial position are as follows: Equity Non-current liabilities

$000 10,000 2,500

What is Peach Co’s return on capital employed (ROCE)? A B C D

14% 18% 20% 25%

15 Drumlin Co has $5m of $0·50 nominal value ordinary shares in issue. It recently announced a 1 for 4 rights issue at $6 per share. Its share price on the announcement of the rights issue was $8 per share. What is the theoretical value of a right per existing share? A B C D

$1·60 $0·40 $0·50 $1·50 (30 marks)

5

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Section B – ALL 15 questions are compulsory and MUST be attempted Please use the grid provided on page two of the Candidate Answer Booklet to record your answers to each multiple choice question. Do not write out the answers to the MCQs on the lined pages of the answer booklet. Each question is worth 2 marks. The following scenario relates to questions 16 to 20. Herd Co is based in a country whose currency is the dollar ($). The company expects to receive €1,500,000 in six months’ time from Find Co, a foreign customer. The finance director of Herd Co is concerned that the euro (€) may depreciate against the dollar before the foreign customer makes payment and she is looking at hedging the receipt. Herd Co has in issue loan notes with a total nominal value of $4 million which can be redeemed in 10 years’ time. The interest paid on the loan notes is at a variable rate linked to LIBOR. The finance director of Herd Co believes that interest rates may increase in the near future. The spot exchange rate is €1·543 per $1. The domestic short-term interest rate is 2% per year, while the foreign short-term interest rate is 5% per year.

16 What is the six-month forward exchange rate predicted by interest rate parity? A B C D

€1·499 €1·520 €1·566 €1·588

per per per per

$1 $1 $1 $1

17 As regards the euro receipt, what is the primary nature of the risk faced by Herd Co? A B C D

Transaction risk Economic risk Translation risk Business risk

18 Which of the following hedging methods will NOT be suitable for hedging the euro receipt? A B C D

Forward exchange contract Money market hedge Currency futures Currency swap

19 Which of the following statements support the finance director’s belief that the euro will depreciate against the dollar? (1) The dollar inflation rate is greater than the euro inflation rate (2) The dollar nominal interest rate is less than the euro nominal interest rate A B C D

1 only 2 only Both 1 and 2 Neither 1 nor 2

6

20 As regards the interest rate risk faced by Herd Co, which of the following statements is correct? A B C D

In exchange for a premium, Herd Co could hedge its interest rate risk by buying interest rate options Buying a floor will give Herd Co a hedge against interest rate increases Herd Co can hedge its interest rate risk by buying interest rate futures now in order to sell them at a future date Taking out a variable rate overdraft will allow Herd Co to hedge the interest rate risk through matching

7

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The following scenario relates to questions 21 to 25. Ring Co has in issue ordinary shares with a nominal value of $0·25 per share. These shares are traded on an efficient capital market. It is now 20X6 and the company has just paid a dividend of $0·450 per share. Recent dividends of the company are as follows: Year Dividend per share

20X6 $0·450

20X5 $0·428

20X4 $0·408

20X3 $0·389

20X2 $0·370

Ring Co also has in issue loan notes which are redeemable in seven years’ time at their nominal value of $100 per loan note and which pay interest of 6% per year. The finance director of Ring Co wishes to determine the value of the company. Ring Co has a cost of equity of 10% per year and a before-tax cost of debt of 4% per year. The company pays corporation tax of 25% per year. 21 Using the dividend growth model, what is the market value of each ordinary share? A B C D

$8·59 $9·00 $9·45 $7·77

22 What is the market value of each loan note? A B C D

$109·34 $112·01 $116·57 $118·68

23 The finance director of Ring Co has been advised to calculate the net asset value (NAV) of the company. Which of the following formulae calculates correctly the NAV of Ring Co? A B C D

Total assets less current liabilities Non-current assets plus net current assets Non-current assets plus current assets less total liabilities Non-current assets less net current assets less non-current liabilities

24 Which of the following statements about valuation methods is true? A B C D

The The The The

earnings yield method multiplies earnings by the earnings yield equity market value is number of shares multiplied by share price, plus the market value of debt dividend valuation model makes the unreasonable assumption that average dividend growth is constant price/earnings ratio method divides earnings by the price/earnings ratio

25 Which of the following statements about capital market efficiency is/are correct? (1) Insider information cannot be used to make abnormal gains in a strong form efficient capital market (2) In a weak form efficient capital market, Ring Co’s share price reacts to new information the day after it is announced (3) Ring Co’s share price reacts quickly and accurately to newly-released information in a semi-strong form efficient capital market A B C D

1 and 2 only 1 and 3 only 3 only 1, 2 and 3 8

The following scenario relates to questions 26 to 30. The following information relates to an investment project which is being evaluated by the directors of Fence Co, a listed company. The initial investment, payable at the start of the first year of operation, is $3·9 million. Year Net operating cash flow ($000) Scrap value ($000)

1 1,200

2 1,500

3 1,600

4 1,580 100

The directors believe that this investment project will increase shareholder wealth if it achieves a return on capital employed greater than 15%. As a matter of policy, the directors require all investment projects to be evaluated using both the payback and return on capital employed methods. Shareholders have recently criticised the directors for using these investment appraisal methods, claiming that Fence Co ought to be using the academically-preferred net present value method. The directors have a remuneration package which includes a financial reward for achieving an annual return on capital employed greater than 15%. The remuneration package does not include a share option scheme.

26 What is the payback period of the investment project? A B C D

2·75 1·50 2·65 1·55

years years years years

27 Based on the average investment method, what is the return on capital employed of the investment project? A B C D

13·3% 26·0% 52·0% 73·5%

28 Which of the following statements about investment appraisal methods is correct? A B C D

The return on capital employed method considers the time value of money Return on capital employed must be greater than the cost of equity if a project is to be accepted Riskier projects should be evaluated with longer payback periods Payback period ignores the timing of cash flows within the payback period

29 Which of the following statements about Fence Co is/are correct? (1) Managerial reward schemes of listed companies should encourage the achievement of stakeholder objectives (2) Requiring investment projects to be evaluated with return on capital employed is an example of dysfunctional behaviour encouraged by performance-related pay (3) Fence Co has an agency problem as the directors are not acting to maximise the wealth of shareholders A B C D

1 and 2 only 1 only 2 and 3 only 1, 2 and 3

9

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30 Which of the following statements about Fence Co directors’ remuneration package is/are correct? (1) Directors’ remuneration should be determined by senior executive directors (2) Introducing a share option scheme would help bring directors’ objectives in line with shareholders’ objectives (3) Linking financial rewards to a target return on capital employed will encourage short-term profitability and discourage capital investment A B C D

2 only 1 and 3 only 2 and 3 only 1, 2 and 3 (30 marks)

10

Section C – BOTH questions are compulsory and MUST be attempted Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet. 31 Nesud Co has credit sales of $45 million per year and on average settles accounts with trade payables after 60 days. One of its suppliers has offered the company an early settlement discount of 0·5% for payment within 30 days. Administration costs will be increased by $500 per year if the early settlement discount is taken. Nesud Co buys components worth $1·5 million per year from this supplier. From a different supplier, Nesud Co purchases $2·4 million per year of Component K at a price of $5 per component. Consumption of Component K can be assumed to be at a constant rate throughout the year. The company orders components at the start of each month in order to meet demand and the cost of placing each order is $248·44. The holding cost for Component K is $1·06 per unit per year. The finance director of Nesud Co is concerned that approximately 1% of credit sales turn into irrecoverable debts. In addition, she has been advised that customers of the company take an average of 65 days to settle their accounts, even though Nesud Co requires settlement within 40 days. Nesud Co finances working capital from an overdraft costing 4% per year. Assume there are 360 days in a year. Required: (a) Evaluate whether Nesud Co should accept the early settlement discount offered by its supplier.

(4 marks)

(b) Evaluate whether Nesud Co should adopt an economic order quantity approach to ordering Component K. (6 marks) (c) Critically discuss how Nesud Co could improve the management of its trade receivables.

(10 marks) (20 marks)

11

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32 Hebac Co is preparing to launch a new product in a new market which is outside its current business operations. The company has undertaken market research and test marketing at a cost of $500,000, as a result of which it expects the new product to be successful. Hebac Co plans to charge a lower selling price initially and then increase the selling price on the assumption that the new product will establish itself in the new market. Forecast sales volumes, selling prices and variable costs are as follows: Year Sales volume (units/year) Selling price ($/unit) Variable costs ($/unit)

1 200,000 15 9

2 800,000 18 9

3 900,000 22 9

4 400,000 22 9

Selling price and variable cost are given here in current price terms before taking account of forecast selling price inflation of 4% per year and variable cost inflation of 5% per year. Incremental fixed costs of $500,000 per year in current price terms would arise as a result of producing the new product. Fixed cost inflation of 8% per year is expected. The initial investment cost of production equipment for the new product will be $2·5 million, payable at the start of the first year of operation. Production will cease at the end of four years because the new product is expected to have become obsolete due to new technology. The production equipment would have a scrap value at the end of four years of $125,000 in future value terms. Investment in working capital of $1·5 million will be required at the start of the first year of operation. Working capital inflation of 6% per year is expected and working capital will be recovered in full at the end of four years. Hebac Co pays corporation tax of 20% per year, with the tax liability being settled in the year in which it arises. The company can claim tax-allowable depreciation on a 25% reducing balance basis on the initial investment cost, adjusted in the final year of operation for a balancing allowance or charge. Hebac Co currently has a nominal after-tax weighted average cost of capital (WACC) of 12% and a real after-tax WACC of 8·5%. The company uses its current WACC as the discount rate for all investment projects. Required: (a) Calculate the net present value of the investment project in nominal terms and comment on its financial acceptability. (12 marks) (b) Discuss how the capital asset pricing model can assist Hebac Co in making a better investment decision with respect to its new product launch. (8 marks) (20 marks)

12

Financial Management March/June 2017 – Sample Questions

Time allowed: 3 hours 15 minutes This question paper is divided into three sections: Section A – ALL 15 questions are compulsory and MUST be attempted Section B – ALL 15 questions are compulsory and MUST be attempted Section C – BOTH questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 4–6. Do NOT open this question paper until instructed by the supervisor. Do NOT record any of your answers on the question paper. This question paper must not be removed from the examination hall.

Paper F9

Fundamentals Level – Skills Module

The Association of Chartered Certified Accountants

Section C – BOTH questions are compulsory and MUST be attempted Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet. 31 It is the middle of December 20X6 and Pangli Co is looking at working capital management for January 20X7. Forecast financial information at the start of January 20X7 is as follows: Inventory Trade receivables Trade payables Overdraft

$455,000 $408,350 $186,700 $240,250

All sales are on credit and they are expected to be $3·5m for 20X6. Monthly sales are as follows: November 20X6 (actual) December 20X6 (forecast) January 20X7 (forecast)

$270,875 $300,000 $350,000

Pangli Co has a gross profit margin of 40%. Although Pangli Co offers 30 days credit, only 60% of customers pay in the month following purchase, while the remaining customers take an additional month of credit. Inventory is expected to increase by $52,250 during January 20X7. Pangli Co plans to pay 70% of trade payables in January 20X7 and defer paying the remaining 30% until the end of February 20X7. All suppliers of the company require payment within 30 days. Credit purchases from suppliers during January 20X7 are expected to be $250,000. Interest of $70,000 is due to be paid in January 20X7 on fixed rate bank debt. Operating cash outflows are expected to be $146,500 in January 20X7. Pangli Co has no cash and relies on its overdraft to finance daily operations. The company has no plans to raise long-term finance during January 20X7. Assume that each year has 360 days. Required: (a) (i)

Calculate the cash operating cycle of Pangli Co at the start of January 20X7.

(2 marks)

(ii) Calculate the overdraft expected at the end of January 20X7.

(4 marks)

(iii) Calculate the current ratios at the start and end of January 20X7.

(4 marks)

(b) Discuss FIVE techniques that Pangli Co could use in managing trade receivables.

(10 marks) (20 marks)

2

32 Vyxyn Co is evaluating a planned investment in a new product costing $20m, payable at the start of the first year of operation. The product will be produced for four years, at the end of which production will cease. The investment project will have a terminal value of zero. Financial information relating to the investment project is as follows: Year Sales volume (units/year) Selling price ($/unit) Fixed cost ($/year)

1 440,000 26·50 1,100,000

2 550,000 28·50 1,121,000

3 720,000 30·00 1,155,000

4 400,000 26·00 1,200,000

These selling prices have not yet been adjusted for selling price inflation, which is expected to be 3·5% per year. The annual fixed costs are given above in nominal terms. Variable cost per unit depends on whether competition is maintained between suppliers of key components. The purchasing department has made the following forecast: Competition Probability Variable cost ($/unit)

Strong 45% 10·80

Moderate 35% 12·00

Weak 20% 14·70

The variable costs in this forecast are before taking account of variable cost inflation of 4·0% per year. Vyxyn Co can claim tax-allowable depreciation on a 25% per year reducing balance basis on the full investment cost of $20m and pays corporation tax of 28% per year one year in arrears. It is planned to finance the investment project with an issue of 8% loan notes, redeemable in ten years’ time. Vyxyn Co has a nominal after-tax weighted average cost of capital of 10%, a real after-tax weighted average cost of capital of 7% and a cost of equity of 11%. Required: (a) Discuss the difference between risk and uncertainty in relation to investment appraisal.

(3 marks)

(b) Calculate the expected net present value of the investment project and comment on its financial acceptability and on the risk relating to variable cost. (9 marks) (c) Critically discuss how risk can be considered in the investment appraisal process.

(8 marks) (20 marks)

3

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Financial Management September/December 2017 – Sample Questions

Time allowed: 3 hours 15 minutes This question paper is divided into three sections: Section A – ALL 15 questions are compulsory and MUST be attempted Section B – ALL 15 questions are compulsory and MUST be attempted Section C – BOTH questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 4–6. Do NOT open this question paper until instructed by the supervisor. Do NOT record any of your answers on the question paper. This question paper must not be removed from the examination hall.

Paper F9

Fundamentals Level – Skills Module

The Association of Chartered Certified Accountants

Section C – BOTH questions are compulsory and MUST be attempted Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet. 31 The following statement of financial position information relates to Tufa Co, a company listed on a large stock market which pays corporation tax at a rate of 30%. $m Equity and liabilities Share capital Retained earnings

17 15 –––

Total equity Non-current liabilities Long-term borrowings Current liabilities

13 21 –––

Total liabilities Total equity and liabilities

$m

32

34 ––– 66 –––

The share capital of Tufa Co consists of $12m of ordinary shares and $5m of irredeemable preference shares. The ordinary shares of Tufa Co have a nominal value of $0·50 per share, an ex dividend market price of $7·07 per share and a cum dividend market price of $7·52 per share. The dividend for 20X7 will be paid in the near future. Dividends paid in recent years have been as follows: Year Dividend ($/share)

20X6 0·43

20X5 0·41

20X4 0·39

20X3 0·37

The 5% preference shares of Tufa Co have a nominal value of $0·50 per share and an ex dividend market price of $0·31 per share. The long-term borrowings of Tufa Co consist of $10m of loan notes and a $3m bank loan. The bank loan has a variable interest rate. The 7% loan notes have a nominal value of $100 per loan note and a market price of $102·34 per loan note. Annual interest has just been paid and the loan notes are redeemable in four years’ time at a 5% premium to nominal value. Required: (a) Calculate the after-tax weighted average cost of capital of Tufa Co on a market value basis.

(11 marks)

(b) Discuss the circumstances under which it is appropriate to use the current WACC of Tufa Co in appraising an investment project. (3 marks) (c) Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of long-term finance. (6 marks) (20 marks)

2

32 The directors of Pelta Co are considering a planned investment project costing $25m, payable at the start of the first year of operation. The following information relates to the investment project: Sales volume (units/year) Selling price ($/unit) Variable costs ($/unit) Fixed costs ($/year)

Year 1 520,000 30·00 10·00 700,000

Year 2 624,000 30·00 10·20 735,000

Year 3 717,000 30·00 10·61 779,000

Year 4 788,000 30·00 10·93 841,000

This information needs adjusting to take account of selling price inflation of 4% per year and variable cost inflation of 3% per year. The fixed costs, which are incremental and related to the investment project, are in nominal terms. The year 4 sales volume is expected to continue for the foreseeable future. Pelta Co pays corporation tax of 30% one year in arrears. The company can claim tax-allowable depreciation on a 25% reducing balance basis. The views of the directors of Pelta Co are that all investment projects must be evaluated over four years of operations, with an assumed terminal value at the end of the fourth year of 5% of the initial investment cost. Both net present value and discounted payback must be used, with a maximum discounted payback period of two years. The real after-tax cost of capital of Pelta Co is 7% and its nominal after-tax cost of capital is 12%. Required: (a) (i)

Calculate the net present value of the planned investment project.

(ii) Calculate the discounted payback period of the planned investment project.

(9 marks) (2 marks)

(b) Discuss the financial acceptability of the investment project.

(3 marks)

(c) Critically discuss the views of the directors on Pelta Co’s investment appraisal.

(6 marks) (20 marks)

3

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Financial Management March/June 2018 – Sample Questions

F9 ACCA

Time allowed: 3 hours 15 minutes This question paper is divided into three sections: Section A – ALL 15 questions are compulsory and MUST be attempted Section B – ALL 15 questions are compulsory and MUST be attempted Section C – BOTH questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 4–6. Do NOT open this question paper until instructed by the supervisor. Do NOT record any of your answers on the question paper. This question paper must not be removed from the examination hall.

Paper F9

Fundamentals Level – Skills Module

The Association of Chartered Certified Accountants

Section C – BOTH questions are compulsory and MUST be attempted Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet. 31 Tin Co is planning an expansion of its business operations which will increase profit before interest and tax by 20%. The company is considering whether to use equity or debt finance to raise the $2m needed by the business expansion. If equity finance is used, a 1 for 5 rights issue will be offered to existing shareholders at a 20% discount to the current ex dividend share price of $5·00 per share. The nominal value of the ordinary shares is $1·00 per share. If debt finance is used, Tin Co will issue 20,000 8% loan notes with a nominal value of $100 per loan note. Financial statement information prior to raising new finance: Profit before interest and tax Finance costs (interest) Taxation Profit after tax

$’000 1,597 (315) (282) –––––– 1,000 –––––– $’000

Equity Ordinary shares Retained earnings Long-term liabilities: 7% loan notes Total equity and long-term liabilities

2,500 5,488 4,500 ––––––– 12,488 –––––––

The current price/earnings ratio of Tin Co is 12·5 times. Corporation tax is payable at a rate of 22%. Companies undertaking the same business as Tin Co have an average debt/equity ratio (book value of debt divided by book value of equity) of 60·5% and an average interest cover of 9 times. Required: (a) (i)

Calculate the theoretical ex rights price per share.

(2 marks)

(ii) Assuming equity finance is used, calculate the revised earnings per share after the business expansion. (4 marks) (iii) Assuming debt finance is used, calculate the revised earnings per share after the business expansion. (3 marks) (iv) Calculate the revised share prices under both financing methods after the business expansion. (1 mark) (v) Use calculations to evaluate whether equity finance or debt finance should be used for the planned business expansion. (4 marks) (b) Discuss TWO Islamic finance sources which Tin Co could consider as alternatives to a rights issue or a loan note issue. (6 marks) (20 marks)

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32 Copper Co is concerned about the risk associated with a proposed investment and is looking for ways to incorporate risk into its investment appraisal process. The company has heard that probability analysis may be useful in this respect and so the following information relating to the proposed investment has been prepared: Year 1 Cash flow ($) 1,000,000 2,000,000 3,000,000

Year 2 Probability 0·1 0·5 0·4

Cash flow ($) 2,000,000 3,000,000 5,000,000

Probability 0·3 0·6 0·1

However, the company is not sure how to interpret the results of an investment appraisal based on probability analysis. The proposed investment will cost $3·5m, payable in full at the start of the first year of operation. Copper Co uses a discount rate of 12% in investment appraisal. Required: (a) Using a joint probability table: (i)

Calculate the mean (expected) NPV of the proposed investment;

(8 marks)

(ii) Calculate the probability of the investment having a negative NPV;

(1 mark)

(iii) Calculate the NPV of the most likely outcome;

(1 mark)

(iv) Comment on the financial acceptability of the proposed investment.

(2 marks)

(b) Discuss TWO of the following methods of adjusting for risk and uncertainty in investment appraisal: (i) Simulation; (ii) Adjusted payback; (iii) Risk-adjusted discount rates.

(8 marks) (20 marks)

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Applied Skills

September/December 2018 – Sample Questions

FM ACCA

FM

Financial Management (FM)

Time allowed: 3 hours 15 minutes This question paper is divided into three sections: Section A – ALL 15 questions are compulsory and MUST be attempted Section B – ALL 15 questions are compulsory and MUST be attempted Section C – BOTH questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 4–6. Do NOT open this question paper until instructed by the supervisor. Do NOT record any of your answers on the question paper. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Section C – BOTH questions are compulsory and MUST be attempted Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet. 31 Melanie Co is considering the acquisition of a new machine with an operating life of three years. The new machine could be leased for three payments of $55,000, payable annually in advance. Alternatively, the machine could be purchased for $160,000 using a bank loan at a cost of 8% per year. If the machine is purchased, Melanie Co will incur maintenance costs of $8,000 per year, payable at the end of each year of operation. The machine would have a residual value of $40,000 at the end of its three-year life. Melanie Co’s production manager estimates that if maintenance routines were upgraded, the new machine could be operated for a period of four years with maintenance costs increasing to $12,000 per year, payable at the end of each year of operation. If operated for four years, the machine’s residual value would fall to $11,000. Taxation should be ignored. Required: (a) (i)

Assuming that the new machine is operated for a three-year period, evaluate whether Melanie Co should use leasing or borrowing as a source of finance. (6 marks)

(ii) Using a discount rate of 10%, calculate the equivalent annual cost of purchasing and operating the machine for both three years and four years, and recommend which replacement interval should be adopted. (6 marks) (b) Critically discuss FOUR reasons why NPV is regarded as superior to IRR as an investment appraisal technique. (8 marks) (20 marks)

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32 Oscar Co designs and produces tracking devices. The company is managed by its four founders, who lack business administration skills. The company has revenue of $28m, and all sales are on 30 days’ credit. Its major customers are large multinational car manufacturing companies and are often late in paying their invoices. Oscar Co is a rapidly growing company and revenue has doubled in the last four years. Oscar Co has focused in this time on product development and customer service, and managing trade receivables has been neglected. Oscar Co’s average trade receivables are currently $5·37m, and bad debts are 2% of credit sales revenue. Partly as a result of poor credit control, the company has suffered a shortage of cash and has recently reached its overdraft limit. The four founders have spent large amounts of time chasing customers for payment. In an attempt to improve trade receivables management, Oscar Co has approached a factoring company. The factoring company has offered two possible options: Option 1 Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection, on a full recourse basis. The factor would charge a service fee of 0·5% of credit sales revenue per year. Oscar Co estimates that this would result in savings of $30,000 per year in administration costs. Under this arrangement, the average trade receivables collection period would be 30 days. Option 2 Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection on a non-recourse basis. The factor would charge a service fee of 1·5% of credit sales revenue per year. Administration cost savings and average trade receivables collection period would be as Option 1. Oscar Co would be required to accept an advance of 80% of credit sales when invoices are raised at an interest rate of 9% per year. Oscar Co pays interest on its overdraft at a rate of 7% per year and the company operates for 365 days per year. Required: (a) Calculate the costs and benefits of each of Option 1 and Option 2 and comment on your findings. (8 marks) (b) Discuss reasons (other than costs and benefits already calculated) why Oscar Co may benefit from the services offered by the factoring company. (6 marks) (c) Discuss THREE factors which determine the level of a company’s investment in working capital.

(6 marks) (20 marks)

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Applied Skills

March/June 2019 – Sample Questions

FM ACCA

FM

Financial Management (FM)

Time allowed: 3 hours 15 minutes This question paper is divided into three sections: Section A – ALL 15 questions are compulsory and MUST be attempted Section B – ALL 15 questions are compulsory and MUST be attempted Section C – BOTH questions are compulsory and MUST be attempted Formulae Sheet, Present Value and Annuity Tables are on pages 11–13. Do NOT open this question paper until instructed by the supervisor. Do NOT record any of your answers on the question paper. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Section B – ALL 15 questions are compulsory and MUST be attempted Please use the grid provided on page two of the Candidate Answer Booklet to record your answers to each multiple choice question. Do not write out the answers to the MCQs on the lined pages of the answer booklet. Each question is worth 2 marks. The following scenario relates to questions 16–20 Tulip Co is a large company with an equity beta of 1·05. The company plans to expand existing business by acquiring a new factory at a cost of $20m. The finance for the expansion will be raised from an issue of 3% loan notes, issued at nominal value of $100 per loan note. These loan notes will be redeemable after five years at nominal value or convertible at that time into ordinary shares in Tulip Co with a value expected to be $115 per loan note. The risk-free rate of return is 2·5% and the equity risk premium is 7·8%. Tulip Co is seeking additional finance and is considering using Islamic finance and, in particular, would require a form which would be similar to equity financing.

16 What is the cost of equity of Tulip Co using the capital asset pricing model? A B C D

13·3% 10·7% 8·1% 10·3%

17 Using estimates of 5% and 6%, what is the cost of debt of the convertible loan notes? A B C D

3·0% 5·2% 6·9% 5·7%

18 In relation to using the dividend growth model to value Tulip Co, which of the following statements is correct? A B C D

The model assumes that all shareholders of Tulip Co have the same required rate of return The model assumes a constant share price and a constant dividend growth for Tulip Co The model assumes that capital markets are semi-strong form efficient The model assumes that Tulip Co’s interim dividend is equal to the final dividend

19 Which of the following statements about equity finance is correct? A B C D

Equity finance reserves represent cash which is available to a company to invest Additional equity finance can be raised by rights issues and bonus issues Retained earnings are a source of equity finance Equity finance includes both ordinary shares and preference shares

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20 Regarding Tulip Co’s interest in Islamic finance, which of the following statements is/are correct? (1) Murabaha could be used to meet Tulip Co’s financing needs (2) Mudaraba involves an investing partner and a managing or working partner A B C D

1 only 2 only Both 1 and 2 Neither 1 nor 2

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The following scenario relates to questions 21–25 Extracts from the financial statements of Bluebell Co, a listed company, are as follows: Profit before interest and tax Finance costs Profit before tax Corporation tax Profit after tax

$m 238 (24) –––– 214 (64) –––– 150 –––– $m

Assets Non-current assets Property, plant and equipment Goodwill (internally generated)

Current assets Inventories Trade receivables

Total assets Equity and liabilities Total equity Non-current liabilities Long-term borrowings Current liabilities Trade payables Short-term borrowings Total current liabilities Total liabilities Total equity and liabilities

768 105 –––––– 873 –––––– 285 192 –––––– 477 –––––– 1,350 –––––– 688 250 312 100 –––––– 412 –––––– 662 –––––– 1,350 ––––––

A similar size competitor company has a price/earnings ratio of 12·5 times. This competitor believes that if Bluebell Co were liquidated, property, plant and equipment would only realise $600m, while 10% of trade receivables would be irrecoverable and inventory would be sold at $30m less than its book value. Separately, Bluebell Co is considering the acquisition of Dandelion Co, an unlisted company which is a supplier of Bluebell Co.

21 What is the value of Bluebell Co on a net realisable value basis? A B C D

$140·8m $470·8m $365·8m $1,027·8m

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22 What is the value of Bluebell Co using the earnings yield method? A B C D

$2,675m $1,200m $1,875m $2,975m

23 When valuing Bluebell Co using asset-based valuations, which of the following statements is correct? A B C D

An asset-based valuation would be useful for an asset-stripping acquisition Bluebell Co’s workforce can be valued as an intangible asset Asset-based valuations consider the present value of Bluebell Co’s future income Replacement cost basis provides a deprival value for Bluebell Co

24 Which of the following is/are indicators of market imperfections? (1) Low volume of trading in shares of smaller companies (2) Overreaction to unexpected news A B C D

1 only 2 only Both 1 and 2 Neither 1 nor 2

25 Which of the following statements is correct? A B C D

Dandelion Co is easier to value than Bluebell Co because a small number of shareholders own all the shares Bluebell Co will have to pay a higher price per share to take control of Dandelion Co than if it were buying a minority holding Scrip dividends decrease the liquidity of shares by retaining cash in a company Dandelion Co’s shares will trade at a premium to similar listed shares because it will have a lower cost of equity

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The following scenario relates to questions 26–30 Peony Co’s finance director is concerned about the effect of future interest rates on the company and has been looking at the yield curve. Peony Co, whose domestic currency is the dollar ($), plans to take out a $100m loan in three months’ time for a period of nine months. The company is concerned that interest rates might rise before the loan is taken out and its bank has offered a 3 v 12 forward rate agreement at 7·10–6·85. The loan will be converted into pesos and invested in a nine-month project which is expected to generate income of 580m pesos, with 200m pesos being paid in six months’ time (from today) and 380m pesos being paid in 12 months’ time (from today). The current spot exchange rate is 5 pesos per $1. The following information on current short-term interest rates is available: Dollars Pesos

6·5% per year 10·0% per year

As a result of the general uncertainty over interest rates, Peony Co is considering a variety of ways in which to manage its interest rate risk, including the use of derivatives.

26 In relation to the yield curve, which of the following statements is correct? A B C D

Expectations theory suggests that deferred consumption requires increased compensation as maturity increases An inverted yield curve can be caused by government action to increase its long-term borrowing A kink (discontinuity) in the normal yield curve can be due to differing yields in different market segments Basis risk can cause the corporate yield curve to rise more steeply than the government yield curve

27 If the interest rate on the loan is 6·5% when it is taken out, what is the nature of the compensatory payment under the forward rate agreement? A B C D

Peony Co pays bank $600,000 Peony Co pays bank $250,000 Peony Co pays bank $450,000 Bank pays Peony Co $600,000

28 Using exchange rates based on interest rate parity, what is the dollar income received from the project? A B C D

$112·3m $114·1m $116·0m $112·9m

29 In respect of Peony Co managing its interest rate risk, which of the following statements is/are correct? (1) Smoothing is an interest rate risk hedging technique which involves maintaining a balance between fixed-rate and floating-rate debt (2) Asset and liability management can hedge interest rate risk by matching the maturity of assets and liabilities A B C D

1 only 2 only Both 1 and 2 Neither 1 nor 2

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30 In relation to the use of derivatives by Peony Co, which of the following statements is correct? A B C D

Interest rate options must be exercised on their expiry date, if they have not been exercised before then Peony Co can hedge interest rate risk on borrowing by selling interest rate futures now and buying them back in the future An interest rate swap is an agreement to exchange both principal and interest rate payments Peony Co can hedge interest rate risk on borrowing by buying a floor and selling a cap (30 marks)

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Section C – BOTH questions are compulsory and MUST be attempted Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet. 31 The following information has been taken from the statement of financial position of Corfe Co, a listed company: $m Non-current assets Current assets Cash and cash equivalents Other current assets Total assets Equity and reserves Ordinary shares Reserves Non-current liabilities 6% preference shares 8% loan notes Bank loan Current liabilities

4 16 –––

15 29 ––– 6 8 5 –––

Total equity and liabilities

$m 50

20 ––– 70 –––

44

19 ––– 7 ––– 70 –––

The ordinary shares of Corfe Co have a nominal value of $1 per share and a current ex-dividend market price of $6·10 per share. A dividend of $0·90 per share has just been paid. The 6% preference shares of Corfe Co have a nominal value of $0·75 per share and an ex-dividend market price of $0·64 per share. The 8% loan notes of Corfe Co have a nominal value of $100 per loan note and a market price of $103·50 per loan note. Annual interest has just been paid and the loan notes are redeemable in five years’ time at a 10% premium to nominal value. The bank loan has a variable interest rate. The risk-free rate of return is 3·5% per year and the equity risk premium is 6·8% per year. Corfe Co has an equity beta of 1·25. Corfe Co pays corporation tax at a rate of 20%. Investment in facilities Corfe Co’s board is looking to finance investments in facilities over the next three years, forecast to cost up to $25m. The board does not wish to obtain further long-term debt finance and is also unwilling to make an equity issue. This means that investments have to be financed from cash which can be made available internally. Board members have made a number of suggestions about how this can be done: Director A has suggested that the company does not have a problem with funding new investments, as it has cash available in the reserves of $29m. If extra cash is required soon, Corfe Co could reduce its investment in working capital. Director B has suggested selling the building which contains the company’s headquarters in the capital city for $20m. This will raise a large one-off sum and also save on ongoing property management costs. Head office support functions would be moved to a number of different locations rented outside the capital city. Director C has commented that although a high dividend has just been paid, dividends could be reduced over the next three years, allowing spare cash for investment.

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Required: (a) Calculate the after-tax weighted average cost of capital of Corfe Co on a market value basis. (b) Discuss the views expressed by the three directors on how the investment should be financed.

(11 marks) (9 marks) (20 marks)

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32 Pinks Co is a large company listed on a major stock exchange. In recent years, the board of Pinks Co has been criticised for weak corporate governance and two of the company’s non-executive directors have just resigned. A recent story in the financial media has criticised the performance of Pinks Co and claims that the company is failing to satisfy the objectives of its key stakeholders. Pinks Co is appraising an investment project which it hopes will boost its performance. The project will cost $20m, payable in full at the start of the first year of operation. The project life is expected to be four years. Forecast sales volumes, selling price, variable cost and fixed costs are as follows: Year Sales (units/year) Selling price ($/unit) Variable cost ($/unit) Fixed costs ($’000/year)

1 300,000 125 71 3,000

2 410,000 130 71 3,100

3 525,000 140 71 3,200

4 220,000 120 71 3,000

Selling price and cost information are in current price terms, before applying selling price inflation of 5% per year, variable cost inflation of 3·5% per year and fixed cost inflation of 6% per year. Pinks Co pays corporation tax of 26%, with the tax liability being settled in the year in which it arises. The company can claim tax-allowable depreciation on the full initial investment of $20m on a 25% reducing balance basis. The investment project is expected to have zero residual value at the end of four years. Pinks Co has a nominal after-tax cost of capital of 12% and a real after-tax cost of capital of 8%. The general rate of inflation is expected to be 3·7% per year for the foreseeable future. Required: (a) (i)

Calculate the nominal net present value of Pinks Co’s investment project.

(8 marks)

(ii) Calculate the real net present value of Pinks Co’s investment project and comment on your findings. (4 marks) (b) Discuss FOUR ways to encourage managers to achieve stakeholder objectives.

(8 marks) (20 marks)

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Financial Management Sample Questions – September/December 2019 Get to know your exam These graphical representations are intended to give an indication of past exam requirements and associated question content. Please note that you will not be able to complete answers within these documents and in isolation they will not sufficiently prepare you for your exam. We encourage you to visit the ACCA Practice Platform in order to attempt up to date practice exams within the computerbased exam environment.

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Exam summary screen

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Sample exam questions Scenario 1

8 Note: See page 12 for example view of full CBE constructed response workspace

Scenario 1: requirements

9 Note: See page 12 for example view of full CBE constructed response workspace

Scenario 2

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Requirements for Scenario 2

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Example view of full CBE constructed response workspace

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