acca f9 past year q&a 07-13

Fundamentals Level – Skills Module

Time allowedReading and planning: 15 minutesWriting: 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 untilinstructed by the supervisor.

This question paper must not be removed from the examination hall.

Pape

r F9

FinancialManagement

Thursday 6 December 2007

The Association of Chartered Certified Accountants

ALL FOUR questions are compulsory and MUST be attempted

1 (a) Phobis Co is considering a bid for Danoca Co. Both companies are stock-market listed and are in the samebusiness sector. Financial information on Danoca Co, which is shortly to pay its annual dividend, is as follows:

Number of ordinary shares 5 millionOrdinary share price (ex div basis) $3·30Earnings per share 40·0cProposed payout ratio 60%Dividend per share one year ago 23·3cDividend per share two years ago 22·0cEquity beta 1·4

Other relevant financial informationAverage sector price/earnings ratio 10Risk-free rate of return 4·6%Return on the market 10·6%

Required:

Calculate the value of Danoca Co using the following methods:

(i) price/earnings ratio method;(ii) dividend growth model;

and discuss the significance, to Phobis Co, of the values you have calculated, in comparison to the currentmarket value of Danoca Co. (11 marks)

(b) Phobis Co has in issue 9% bonds which are redeemable at their par value of $100 in five years’ time.Alternatively, each bond may be converted on that date into 20 ordinary shares of the company. The currentordinary share price of Phobis Co is $4·45 and this is expected to grow at a rate of 6·5% per year for theforeseeable future. Phobis Co has a cost of debt of 7% per year.

Required:

Calculate the following current values for each $100 convertible bond:

(i) market value;(ii) floor value;(iii) conversion premium. (6 marks)

(c) Distinguish between weak form, semi-strong form and strong form stock market efficiency, and discuss thesignificance to a listed company if the stock market on which its shares are traded is shown to be semi-strongform efficient. (8 marks)

(25 marks)

2

2 Duo Co needs to increase production capacity to meet increasing demand for an existing product, ‘Quago’, which isused in food processing. A new machine, with a useful life of four years and a maximum output of 600,000 kg ofQuago per year, could be bought for $800,000, payable immediately. The scrap value of the machine after four yearswould be $30,000. Forecast demand and production of Quago over the next four years is as follows:

Year 1 2 3 4Demand (kg) 1·4 million 1·5 million 1·6 million 1·7 million

Existing production capacity for Quago is limited to one million kilograms per year and the new machine would onlybe used for demand additional to this.

The current selling price of Quago is $8·00 per kilogram and the variable cost of materials is $5·00 per kilogram.Other variable costs of production are $1·90 per kilogram. Fixed costs of production associated with the new machinewould be $240,000 in the first year of production, increasing by $20,000 per year in each subsequent year ofoperation.

Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances (tax-allowabledepreciation) on a 25% reducing balance basis. A balancing allowance is claimed in the final year of operation.

Duo Co uses its after-tax weighted average cost of capital when appraising investment projects. It has a cost of equityof 11% and a before-tax cost of debt of 8·6%. The long-term finance of the company, on a market-value basis,consists of 80% equity and 20% debt.

Required:

(a) Calculate the net present value of buying the new machine and advise on the acceptability of the proposedpurchase (work to the nearest $1,000). (13 marks)

(b) Calculate the internal rate of return of buying the new machine and advise on the acceptability of theproposed purchase (work to the nearest $1,000). (4 marks)

(c) Explain the difference between risk and uncertainty in the context of investment appraisal, and describe howsensitivity analysis and probability analysis can be used to incorporate risk into the investment appraisalprocess. (8 marks)

(25 marks)

3 [P.T.O.

3 The following financial information relates to Echo Co:

Income statement information for the last year$m

Profit before interest and tax 12Interest 3

–––Profit before tax 9Income tax expense 3

–––Profit for the period 6Dividends 2

–––Retained profit for the period 4

–––

Balance sheet information as at the end of the last year$m $m

Ordinary shares, par value 50c 5Retained earnings 15

–––Total equity 208% loan notes, redeemable in three years’ time 30

–––Total equity and non-current liabilities 50

–––

Average data on companies similar to Echo Co:Interest coverage ratio 8 timesLong-term debt/equity (book value basis) 80%

The board of Echo Co is considering several proposals that have been made by its finance director. Each proposal isindependent of any other proposal.

Proposal AThe current dividend per share should be increased by 20% in order to make the company more attractive to equityinvestors.

Proposal BA bond issue should be made in order to raise $15 million of new debt capital. Although there are no investmentopportunities currently available, the cash raised would be invested on a short-term basis until a suitable investmentopportunity arose. The loan notes would pay interest at a rate of 10% per year and be redeemable in eight years’ timeat par.

Proposal CA 1 for 4 rights issue should be made at a 20% discount to the current share price of $2·30 per share in order toreduce gearing and the financial risk of the company.

Required:

(a) Analyse and discuss Proposal A. (5 marks)

(b) Evaluate and discuss Proposal B. (7 marks)

(c) Calculate the theoretical ex rights price per share and the amount of finance that would be raised underProposal C. Evaluate and discuss the proposal to use these funds to reduce gearing and financial risk.

(7 marks)

(d) Discuss the attractions of operating leasing as a source of finance. (6 marks)

(25 marks)

4

4 PKA Co is a European company that sells goods solely within Europe. The recently-appointed financial manager ofPKA Co has been investigating the working capital management of the company and has gathered the followinginformation:

Inventory managementThe current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meetproduction requirements during the next year is 625,000 units. The cost of placing and processing an order is €250,while the cost of holding a unit in stores is €0·50 per unit per year. Both costs are expected to be constant duringthe next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week yearand that demand is constant throughout the year.

Accounts receivable managementDomestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show that the averageaccounts receivable period in the last financial year was 75 days. The financial manager also noted that bad debtsas a percentage of sales, which are all on credit, increased in the last financial year from 5% to 8%.

Accounts payable managementPKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in six months’ time. Thefinancial manager is concerned that the cost of these supplies may rise in euro terms and has decided to hedge thecurrency risk of this account payable. The following information has been provided by the company’s bank:

Spot rate ($ per €): 1·998 ± 0·002Six months forward rate ($ per €): 1·979 ± 0·004

Money market rates available to PKA Co:Borrowing Deposit

One year euro interest rates: 6·1% 5·4%One year dollar interest rates: 4·0% 3·5%

Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.

Required:

(a) Identify the objectives of working capital management and discuss the conflict that may arise between them.(3 marks)

(b) Calculate the cost of the current ordering policy and determine the saving that could be made by using theeconomic order quantity model. (7 marks)

(c) Discuss ways in which PKA Co could improve the management of domestic accounts receivable.(7 marks)

(d) Evaluate whether a money market hedge, a forward market hedge or a lead payment should be used to hedgethe foreign account payable. (8 marks)

(25 marks)

5 [P.T.O.

6

Formulae Sheet

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Answers

Fundamentals Level – Skills Module, Paper F9Financial Management December 2007 Answers

1 (a) (i) Price/earnings ratio method valuationEarnings per share of Danoca Co = 40cAverage sector price/earnings ratio = 10Implied value of ordinary share of Danoca Co = 40 x 10 = $4·00Number of ordinary shares = 5 millionValue of Danoca Co = 4·00 x 5m = $20 million

(ii) Dividend growth modelEarnings per share of Danoca Co = 40cProposed payout ratio = 60%Proposed dividend of Danoca Co is therefore = 40 x 0·6 = 24c per share

If the future dividend growth rate is expected to continue the historical trend in dividends per share, the historic dividendgrowth rate can be used as a substitute for the expected future dividend growth rate in the dividend growth model.Average geometric dividend growth rate over the last two years = (24/ 22)1/2 = 1·045 or 4·5%(Alternatively, dividend growth rates over the last two years were 3% (24/23·3) and 6% (23·3/22), with an arithmeticaverage of (6 + 3)/2 = 4·5%)

Cost of equity of Danoca Co using the capital asset pricing model (CAPM)= 4·6 + 1·4 x (10·6 – 4·6) = 4·6 + (1·4 x 6) = 13%

Value of ordinary share from dividend growth model = (24 x 1·045)/(0·13 – 0·045) = $2·95Value of Danoca Co = 2·95 x 5m = $14·75 million

The current market capitalisation of Danoca Co is $16·5m ($3·30 x 5m).The price/earnings ratio value of Danoca Cois higher than this at $20m, using the average price/earnings ratio used for the sector. Danoca’s own price/earnings ratiois 8·25. The difference between the two price/earnings ratios may indicate that there is scope for improving the financialperformance of Danoca Co following the acquisition. If Phobis Co has the managerial skills to effect this improvement,the company and its shareholders may be able to benefit as a result of the acquisition.

The dividend growth model value is lower than the current market capitalisation at $14·75m. This represents aminimum value that Danoca shareholders will accept if Phobis Co makes an offer to buy their shares. In reality theywould want more than this as an inducement to sell. The current market capitalisation of Danoca Co of $16m mayreflect the belief of the stock market that a takeover bid for the company is imminent and, depending on its efficiency,may indicate a fair price for Danoca’s shares, at least on a marginal trading basis. Alternatively, either the cost of equityor the expected dividend growth rate used in the dividend growth model calculation could be inaccurate, or the differencebetween the two values may be due to a degree of inefficiency in the stock market.

(b) Calculation of market value of each convertible bondExpected share price in five years’ time = 4·45 x 1·0655 = $6·10Conversion value = 6·10 x 20 = $122Compared with redemption at par value of $100, conversion will be preferredThe current market value will be the present value of future interest payments, plus the present value of the conversion value,discounted at the cost of debt of 7% per year.Market value of each convertible bond = (9 x 4·100) + (122 x 0·713) = $123·89

Calculation of floor value of each convertible bondThe current floor value will be the present value of future interest payments, plus the present value of the redemption value,discounted at the cost of debt of 7% per year.Floor value of each convertible bond = (9 x 4·100) + (100 x 0·713) = $108·20

Calculation of conversion premium of each convertible bondCurrent conversion value = 4·45 x 20 = $89·00Conversion premium = $123·89 – 89·00 = $34·89This is often expressed on a per share basis, i.e. 34·89/20 = $1·75 per share

(c) Stock market efficiency usually refers to the way in which the prices of traded financial securities reflect relevant information.When research indicates that share prices fully and fairly reflect past information, a stock market is described as weak-formefficient. Investors cannot generate abnormal returns by analysing past information, such as share price movements inprevious time periods, in such a market, since research shows that there is no correlation between share price movementsin successive periods of time. Share prices appear to follow a ‘random walk’ by responding to new information as it becomesavailable.

When research indicates that share prices fully and fairly reflect public information as well as past information, a stock marketis described as semi-strong form efficient. Investors cannot generate abnormal returns by analysing either public information,such as published company reports, or past information, since research shows that share prices respond quickly andaccurately to new information as it becomes publicly available.

11

If research indicates that share prices fully and fairly reflect not only public information and past information, but privateinformation as well, a stock market is described as strong form efficient. Even investors with access to insider informationcannot generate abnormal returns in such a market. Testing for strong form efficiency is indirect in nature, examining forexample the performance of expert analysts such as fund managers. Stock markets are not held to be strong form efficient.

The significance to a listed company of its shares being traded on a stock market which is found to be semi-strong formefficient is that any information relating to the company is quickly and accurately reflected in its share price. Managers willnot be able to deceive the market by the timing or presentation of new information, such as annual reports or analysts’briefings, since the market processes the information quickly and accurately to produce fair prices. Managers should thereforesimply concentrate on making financial decisions which increase the wealth of shareholders.

2 (a) Net present value evaluation of investment

After-tax weighted average cost of capital = (11 x 0·8) + (8·6 x (1 – 0·3) x 0·2) = 10%

Year 1 2 3 4 5$000 $000 $000 $000 $000

Contribution 440 550 660 660Fixed costs (240) (260) (280) (300)

––––– ––––– ––––– –––––Taxable cash flow 200 290 380 360Taxation (60) (87) (114) (108)CA tax benefits 60 45 34 92Scrap value 30

––––– ––––– ––––– ––––– –––––After-tax cash flows 200 290 338 310 (16)Discount at 10% 0·909 0·826 0·751 0·683 0·621

––––– ––––– ––––– ––––– –––––Present values 182 240 254 212 (10)

––––– ––––– ––––– ––––– –––––

$000Present value of benefits 878Initial investment 800

––––Net present value 78

––––

The net present value is positive and so the investment is financially acceptable. However, demand becomes greater thanproduction capacity in the fourth year of operation and so further investment in new machinery may be needed after threeyears. The new machine will itself need replacing after four years if production capacity is to be maintained at an increasedlevel. It may be necessary to include these expansion and replacement considerations for a more complete appraisal of theproposed investment.

A more complete appraisal of the investment could address issues such as the assumption of constant selling price andvariable cost per kilogram and the absence of any consideration of inflation, the linear increase in fixed costs of productionover time and the linear increase in demand over time. If these issues are not addressed, the appraisal of investing in thenew machine is likely to possess a significant degree of uncertainty.

Workings

Annual contributionYear 1 2 3 4Excess demand (kg/yr) 400,000 500,000 600,000 700,000New machine output (kg/yr) 400,000 500,000 600,000 600,000Contribution ($/kg) 1·1 1·1 1·1 1·1

–––––––– –––––––– –––––––– ––––––––Contribution ($/yr) 440,000 550,000 660,000 660,000

–––––––– –––––––– –––––––– ––––––––

Capital allowance (CA) tax benefits

Year Capital allowance ($) Tax benefit ($)1 200,000 (800,000 x 0·25) 60,000 (0·3 x 200,000)2 150,000 (600,000 x 0·25) 45,000 (0·3 x 150,000)3 112,500 (450,000 x 0·25) 33,750 (0·3 x 112,500)

––––––––462,50030,000 (scrap value)

––––––––492,500

4 307,500 (by difference) 92,250 (0·3 x 307,500)––––––––800,000––––––––

12

(b) Internal rate of return evaluation of investment

Year 1 2 3 4 5$000 $000 $000 $000 $000

After-tax cash flows 200 290 338 310 (16)Discount at 20% 0·833 0·694 0·579 0·482 0·402

––––– ––––– ––––– ––––– –––––Present values 167 201 196 149 (6)

––––– ––––– ––––– ––––– –––––

$000Present value of benefits 707Initial investment 800

––––Net present value (93)

––––

Internal rate of return = 10 + [((20 – 10) x 78)/(78 + 93)] = 10 + 4·6 = 14·6%

The investment is financially acceptable since the internal rate of return is greater than the cost of capital used for investmentappraisal purposes. However, the appraisal suffers from the limitations discussed in connection with net present valueappraisal in part (a).

(c) Risk refers to the situation where probabilities can be assigned to a range of expected outcomes arising from an investmentproject and the likelihood of each outcome occurring can therefore be quantified. Uncertainty refers to the situation whereprobabilities cannot be assigned to expected outcomes. Investment project risk therefore increases with increasing variabilityof returns, while uncertainty increases with increasing project life. The two terms are often used interchangeably in financialmanagement, but the distinction between them is a useful one.

Sensitivity analysis assesses how the net present value of an investment project is affected by changes in project variables.Considering each project variable in turn, the change in the variable required to make the net present value zero is determined,or alternatively the change in net present value arising from a fixed change in the given project variable. In this way the keyor critical project variables are determined. However, sensitivity analysis does not assess the probability of changes in projectvariables and so is often dismissed as a way of incorporating risk into the investment appraisal process.

Probability analysis refers to the assessment of the separate probabilities of a number of specified outcomes of an investmentproject. For example, a range of expected market conditions could be formulated and the probability of each market conditionarising in each of several future years could be assessed. The net present values arising from combinations of future economicconditions could then be assessed and linked to the joint probabilities of those combinations. The expected net present value(ENPV) could be calculated, together with the probability of the worst-case scenario and the probability of a negative netpresent value. In this way, the downside risk of the investment could be determined and incorporated into the investmentdecision.

3 (a) Echo Co paid a total dividend of $2 million or 20c per share according to the income statement information. An increase of20% would make this $2·4 million or 24c per share and would reduce dividend cover from 3 times to 2·5 times. It isdebatable whether this increase in the current dividend would make the company more attractive to equity investors, whouse a variety of factors to inform their investment decisions, not expected dividends alone. For example, they will considerthe business and financial risk associated with a company when deciding on their required rate of return.

It is also unclear what objective the finance director had in mind when suggesting a dividend increase. The primary financialmanagement objective is the maximisation of shareholder wealth and if Echo Co is following this objective, the dividend willalready be set at an optimal level. From this perspective, a dividend increase should arise from increased maintainableprofitability, not from a desire to ‘make the company more attractive’. Increasing the dividend will not generate any additionalcapital for Echo Co, since existing shares are traded on the secondary market.

Furthermore, Miller and Modigliani have shown that, in a perfect capital market, share prices are independent of the level ofdividend paid. The value of the company depends upon its income from operations and not on the amount of this incomewhich is paid out as dividends. Increasing the dividend would not make the company more attractive to equity investors, butwould attract equity investors who desired the new level of dividend being offered. Current shareholders who were satisfiedby the current dividend policy could transfer their investment to a different company if their utility had been decreased.

The proposal to increase the dividend should therefore be rejected, perhaps in favour of a dividend increase in line withcurrent dividend policy.

(b) The proposal to raise $15 million of additional debt finance does not appear to be a sensible one, given the current financialposition of Echo Co. The company is very highly geared if financial gearing measured on a book value basis is considered.The debt/equity ratio of 150% is almost twice the average of companies similar to Echo Co. This negative view of the financialrisk of the company is reinforced by the interest coverage ratio, which at only four times is half that of companies similar toEcho Co.

Raising additional debt would only worsen these indicators of financial risk. The debt/equity ratio would rise to 225% on abook value basis and the interest coverage ratio would fall to 2·7 times, suggesting that Echo Co would experience difficultyin making interest payments.

13

The proposed use to which the newly-raised funds would be put merits further investigation. Additional finance should beraised when it is needed, rather than being held for speculative purposes. Until a suitable investment opportunity comesalong, Echo Co will be paying an opportunity cost on the new finance equal to the difference between the interest rate on thenew debt (10%) and the interest paid on short-term investments. This opportunity cost would decrease shareholder wealth.Even if an investment opportunity arises, it is very unlikely that the funds needed would be exactly equal to $15m.

The interest charge in the income statement information is $3m while the interest payable on the 8% loan notes is $2·4m(30 x 0·08). It is reasonable to assume that $0·6m of interest is due to an overdraft. Assuming a short-term interest ratelower than the 8% loan note rate – say 6% – implies an overdraft of approximately $10m (0·6/0·06), which is one-third ofthe amount of the long-term debt. The debt/equity ratio calculated did not include this significant amount of short-term debtand therefore underestimates the financial risk of Echo Co.

The bond issue would be repayable in eight years’ time, which is five years after the redemption date of the current loan noteissue. The need to redeem the current $30m loan note issue cannot be ignored in the financial planning of the company.The proposal to raise £15m of long-term debt finance should arise from a considered strategic review of the long-term andshort-term financing needs of Echo Co, which must also consider redemption or refinancing of the current loan note issueand, perhaps, reduction of the sizeable overdraft, which may be close to, or in excess of, its agreed limit.

In light of the concerns and considerations discussed, the proposal to raise additional debt finance cannot be recommended.

AnalysisCurrent gearing (debt/equity ratio using book values) = 30/20 = 150%Revised gearing (debt/equity ratio using book values) = (30 + 15)/20 = 225%

Current interest coverage ratio = 12/3 = 4 timesAdditional interest following debt issue = 15m x 0·1 = $1·5mRevised interest coverage ratio = 12/(3 + 1·5) = 2·7 times

(c) AnalysisRights issue price = 2·30 x 0·8 = $1·84Theoretical ex rights price = (1·84 + (2·30 x 4))/5 = $2·21 per shareNumber of new shares issued = (5/0·5)/4 = 2·5 millionCash raised = 1·84 x 2·5m = $4·6 millionNumber of shares in issue after rights issue = 10 + 2·5 = 12·5 million

Current gearing (debt/equity ratio using book values) = 30/20 = 150%Revised gearing (debt/equity ratio using book values) = 30/24·6 = 122%

Current interest coverage ratio = 12/3 = 4 timesCurrent return on equity (ROE) = 6/20 = 30%

In the absence of any indication as to the return expected on the new funds, we can assume the rate of return will be thesame as on existing equity, an assumption consistent with the calculated theoretical ex rights price.After-tax return on the new funds = 4·6m x 0·3 = $1·38 millionBefore-tax return on new funds = 1·38m x (9/6) = $2·07 millionRevised interest coverage ratio = (12 + 2·07)/3 = 4·7 times

The current debt/equity and interest coverage ratios suggest that there is a need to reduce the financial risk of Echo Co. Arights issue would reduce the debt/equity ratio of the company from 150% to 122% on a book value basis, which is 50%higher than the average debt/equity ratio of similar companies. After the rights issue, financial gearing is still therefore highenough to be a cause for concern.

The interest coverage ratio would increase from 4 times to 4·7 times, again assuming that the new funds will earn the samereturn as existing equity funds. This is still much lower than the average interest coverage ratio of similar companies, whichis 8 times. While 4·7 times is a safer level of interest coverage, it is still somewhat on the low side.

No explanation has been offered for the amount to be raised by the rights issue. Why has the Finance Director proposed that$4·6m be raised? If the proposal is to reduce financial risk, what level of financial gearing and interest coverage would beseen as safe by shareholders and other stakeholders? What use would be made of the funds raised? If they are used to redeemdebt they will not have a great impact on the financial position of the company, in fact it appears likely that that the overdraftis twice as big as the amount proposed to be raised by the rights issue. The refinancing need therefore appears to be muchgreater than $4·6m. If the funds are to be used for investment purposes, further details of the investment project, its expectedreturn and its level of risk should be considered.

There seems to be no convincing rationale for the proposed rights issue and it cannot therefore be recommended, at least onfinancial grounds.

(d) Operating leasing is a popular source of finance for companies of all sizes and many reasons have been advanced to explainthis popularity. For example, an operating lease is seen as protection against obsolescence, since it can be cancelled at shortnotice without financial penalty. The lessor will replace the leased asset with a more up-to-date model in exchange forcontinuing leasing business. This flexibility is seen as valuable in the current era of rapid technological change, and can alsoextend to contract terms and servicing cover.

14

Operating leasing is often compared to borrowing as a source of finance and offers several attractive features in this area.There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided,existing assets need not be tied up as security and negative effects on return on capital employed can be avoided. Since legaltitle does not pass from lessor to lessee, the leased asset can be recovered by the lessor in the event of default on lease rentals.Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt.

Operating leasing can also be cheaper than borrowing to buy. There are several reasons why the lessor may be able to acquirethe leased asset more cheaply than the lessee, for example by taking advantage of bulk buying, or by having access to lowercost finance by virtue of being a much larger company. The lessor may also be able use tax benefits more effectively than thelessee. A portion of these benefits can be made available to the lessee in the form of lower lease rentals, making operatingleasing a more attractive proposition that borrowing.

Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of theleased asset does not appear in the balance sheet.

4 (a) The objectives of working capital management are profitability and liquidity. The objective of profitability supports the primaryfinancial management objective, which is shareholder wealth maximisation. The objective of liquidity ensures that companiesare able to meet their liabilities as they fall due, and thus remain in business.

However, funds held in the form of cash do not earn a return, while near-liquid assets such as short-term investments earnonly a small return. Meeting the objective of liquidity will therefore conflict with the objective of profitability, which is met byinvesting over the longer term in order to achieve higher returns.

Good working capital management therefore needs to achieve a balance between the objectives of profitability and liquidityif shareholder wealth is to be maximised.

(b) Cost of current ordering policy of PKA CoOrdering cost = €250 x (625,000/100,000) = €1,563 per yearWeekly demand = 625,000/50 = 12,500 units per weekConsumption during 2 weeks lead time = 12,500 x 2 = 25,000 unitsBuffer stock = re-order level less usage during lead time = 35,000 – 25,000 = 10,000 unitsAverage stock held during the year = 10,000 + (100,000/2) = 60,000 unitsHolding cost = 60,000 x €0·50 = €30,000 per yearTotal cost = ordering cost plus holding cost = €1,563 + €30,000 = €31,563 per year

Economic order quantity = ((2 x 250 x 625,000)/0·5)1/2 = 25,000 unitsNumber of orders per year = 625,000/25,000 = 25 per yearOrdering cost = €250 x 25 = €6,250 per yearHolding cost (ignoring buffer stock) = €0·50 x (25,000/2) = €0·50 x 12,500 = €6,250 per yearHolding cost (including buffer stock) = €0·50 x (10,000 + 12,500) = €11,250 per yearTotal cost of EOQ-based ordering policy = €6,250 + €11,250 = €17,500 per year

Saving for PKA Co by using EOQ-based ordering policy = €31,563 – €17,500 = €14,063 per year

(c) The information gathered by the Financial Manager of PKA Co indicates that two areas of concern in the management ofdomestic accounts receivable are the increasing level of bad debts as a percentage of credit sales and the excessive creditperiod being taken by credit customers.

Reducing bad debtsThe incidence of bad debts, which has increased from 5% to 8% of credit sales in the last year, can be reduced by assessingthe creditworthiness of new customers before offering them credit and PKA Co needs to introduce a policy detailing how thisshould be done, or review its existing policy, if it has one, since it is clearly not working very well. In order to do this,information about the solvency, character and credit history of new clients is needed. This information can come from a varietyof sources, such as bank references, trade references and credit reports from credit reference agencies. Whether credit isoffered to the new customer and the terms of the credit offered can then be based on an explicit and informed assessment ofdefault risk.

Reduction of average accounts receivable periodCustomers have taken an average of 75 days credit over the last year rather than the 30 days offered by PKA Co, i.e. morethan twice the agreed credit period. As a result, PKA Co will be incurring a substantial opportunity cost, either from theadditional interest cost on the short-term financing of accounts receivable or from the incremental profit lost by not investingthe additional finance tied up by the longer average accounts receivable period. PKA Co needs to find ways to encourageaccounts receivable to be settled closer to the agreed date.

Assuming that the credit period offered by PKA Co is in line with that of its competitors, the company should determinewhether they too are suffering from similar difficulties with late payers. If they are not, PKA Co should determine in what wayits own terms differ from those of its competitors and consider whether offering the same trade terms would have an impacton its accounts receivable. For example, its competitors may offer a discount for early settlement while PKA Co does not andintroducing a discount may achieve the desired reduction in the average accounts receivable period. If its competitors areexperiencing a similar accounts receivable problem, PKA Co could take the initiative by introducing more favourable earlysettlement terms and perhaps generate increased business as well as reducing the average accounts receivable period.

15

PKA Co should also investigate the efficiency with which accounts receivable are managed. Are statements sent regularly tocustomers? Is an aged accounts receivable analysis produced at the end of each month? Are outstanding accounts receivablecontacted regularly to encourage payment? Is credit denied to any overdue accounts seeking further business? Is interestcharged on overdue accounts? These are all matters that could be included by PKA Co in a revised policy on accountsreceivable management.

(d) Money market hedgePKA Co should place sufficient dollars on deposit now so that, with accumulated interest, the six-month liability of $250,000can be met. Since the company has no surplus cash at the present time, the cost of these dollars must be met by a short-term euro loan.

Six-month dollar deposit rate = 3·5/2 = 1·75%Current spot selling rate = 1·998 – 0·002 = $1·996 per euroSix-month euro borrowing rate = 6·1/2 = 3·05%

Dollars deposited now = 250,000/1·0175 = $245,700Cost of these dollars at spot = 245,700/1·996 = 123,096 eurosEuro value of loan in six months’ time = 123,096 x 1·0305 = 126,850 euros

Forward market hedgeSix months forward selling rate = 1·979 – 0·004 = $1·975 per euroEuro cost using forward market hedge = 250,000/1·975 = 126,582 euros

Lead paymentSince the dollar is appreciating against the euro, a lead payment may be worthwhile.Euro cost now = 250,000/1·996 = 125,251 eurosThis cost must be met by a short-term loan at a six-month interest rate of 3·05%Euro value of loan in six months’ time = 125,251 x 1·0305 = 129,071 euros

Evaluation of hedgesThe relative costs of the three hedges can be compared since they have been referenced to the same point in time, i.e. sixmonths in the future. The most expensive hedge is the lead payment, while the cheapest is the forward market hedge. Usingthe forward market to hedge the account payable currency risk can therefore be recommended.

16

Fundamentals Level – Skills Module, Paper F9Financial Management December 2007 Marking Scheme

Marks Marks1 (a) Price/earnings ratio value of company 2

Proposed dividend per share 1Average dividend growth rate 1Cost of equity using CAPM 1Dividend growth model value of company 2Discussion 4

––––11

(b) Conversion value 1Market value 2Floor value 2Conversion premium 1

––––6

(c) Weak form efficiency 1–2Semi-strong form efficiency 1–2Strong form efficiency 1–2Significance of semi-strong form efficiency 2–3

––––Maximum 8

––––25

2 (a) After-tax weighted average cost of capital 2Annual contribution 2Fixed costs 1Taxation 1Capital allowance tax benefits 3Scrap value 1Discount factors 1Net present value 1Comment 1–2


(b) Net present value calculation 1Internal rate of return calculation 2Comment 1–2


(c) Risk and uncertainty 2–3Discussion of sensitivity analysis 2–3Discussion of probability analysis 2–3


––––25

17

Marks Marks3 (a) Discussion of proposal to increase dividend 5

(b) Evaluation of debt finance proposal 3–4Discussion of debt finance proposal 4–5


(c) Theoretical ex rights price per share 1Amount of finance raised 1Evaluation of rights issue proposal 2–3Discussion of rights issue proposal 3–4


(d) Discussion of attractions of leasing 6––––

25

4 (a) Profitability and liquidity 1Discussion of conflict between objectives 2

––––3

(b) Cost of current ordering policy 3Cost of EOQ-based ordering policy 3Saving by using EOQ model 1

––––7

(c) Reduction of bad debts 3–4Reduction of average accounts receivable period 3–4Discussion of other improvements 1–2


(d) Money market hedge 3Forward market hedge 2Lead payment 2Evaluation 1

––––8

––––25

18








Pape

r F9

Financial Management

Thursday 5 June 2008



1 Burse Co wishes to calculate its weighted average cost of capital and the following information relates to the companyat the current time:

Number of ordinary shares 20 millionBook value of 7% convertible debt $29 millionBook value of 8% bank loan $2 million

Market price of ordinary shares $5·50 per shareMarket value of convertible debt $107·11 per $100 bond

Equity beta of Burse Co 1·2Risk-free rate of return 4·7%Equity risk premium 6·5%

Rate of taxation 30%

Burse Co expects share prices to rise in the future at an average rate of 6% per year. The convertible debt can beredeemed at par in eight years’ time, or converted in six years’ time into 15 shares of Burse Co per $100 bond.

Required:

(a) Calculate the market value weighted average cost of capital of Burse Co. State clearly any assumptions thatyou make. (12 marks)

(b) Discuss the circumstances under which the weighted average cost of capital can be used in investmentappraisal. (6 marks)

(c) Discuss whether the dividend growth model or the capital asset pricing model offers the better estimate ofthe cost of equity of a company. (7 marks)

(25 marks)

2

2 THP Co is planning to buy CRX Co, a company in the same business sector, and is considering paying cash for theshares of the company. The cash would be raised by THP Co through a 1 for 3 rights issue at a 20% discount to itscurrent share price.

The purchase price of the 1 million issued shares of CRX Co would be equal to the rights issue funds raised, lessissue costs of $320,000. Earnings per share of CRX Co at the time of acquisition would be 44·8c per share. As aresult of acquiring CRX Co, THP Co expects to gain annual after-tax savings of $96,000.

THP Co maintains a payout ratio of 50% and earnings per share are currently 64c per share. Dividend growth of 5%per year is expected for the foreseeable future and the company has a cost of equity of 12% per year.

Information from THP Co’s statement of financial position:

Equity and liabilities $000Shares ($1 par value) 3,000Reserves 4,300

––––––7,300

Non-current liabilities8% loan notes 5,000Current liabilities 2,200

–––––––Total equity and liabilities 14,500

–––––––

Required:

(a) Calculate the current ex dividend share price of THP Co and the current market capitalisation of THP Cousing the dividend growth model. (4 marks)

(b) Assuming the rights issue takes place and ignoring the proposed use of the funds raised, calculate:

(i) the rights issue price per share;(ii) the cash raised;(iii) the theoretical ex rights price per share; and(iv) the market capitalisation of THP Co. (5 marks)

(c) Using the price/earnings ratio method, calculate the share price and market capitalisation of CRX Co beforethe acquisition. (3 marks)

(d) Assuming a semi-strong form efficient capital market, calculate and comment on the post acquisition marketcapitalisation of THP Co in the following circumstances:

(i) THP Co does not announce the expected annual after-tax savings; and(ii) the expected after-tax savings are made public. (5 marks)

(e) Discuss the factors that THP Co should consider, in its circumstances, in choosing between equity financeand debt finance as a source of finance from which to make a cash offer for CRX Co. (8 marks)

(25 marks)

3 [P.T.O.

3 FLG Co has annual credit sales of $4·2 million and cost of sales of $1·89 million. Current assets consist of inventoryand accounts receivable. Current liabilities consist of accounts payable and an overdraft with an average interest rateof 7% per year. The company gives two months’ credit to its customers and is allowed, on average, one month’s creditby trade suppliers. It has an operating cycle of three months.

Other relevant information:Current ratio of FLG Co 1·4Cost of long-term finance of FLG Co 11%

Required:

(a) Discuss the key factors which determine the level of investment in current assets. (6 marks)

(b) Discuss the ways in which factoring and invoice discounting can assist in the management of accountsreceivable. (6 marks)

(c) Calculate the size of the overdraft of FLG Co, the net working capital of the company and the total cost offinancing its current assets. (6 marks)

(d) FLG Co wishes to minimise its inventory costs. Annual demand for a raw material costing $12 per unit is 60,000units per year. Inventory management costs for this raw material are as follows:

Ordering cost: $6 per orderHolding cost: $0·5 per unit per year

The supplier of this raw material has offered a bulk purchase discount of 1% for orders of 10,000 units or more.If bulk purchase orders are made regularly, it is expected that annual holding cost for this raw material willincrease to $2 per unit per year.

Required:

(i) Calculate the total cost of inventory for the raw material when using the economic order quantity.(4 marks)

(ii) Determine whether accepting the discount offered by the supplier will minimise the total cost ofinventory for the raw material. (3 marks)

(25 marks)

4

4 SC Co is evaluating the purchase of a new machine to produce product P, which has a short product life-cycle dueto rapidly changing technology. The machine is expected to cost $1 million. Production and sales of product P areforecast to be as follows:

Year 1 2 3 4Production and sales (units/year) 35,000 53,000 75,000 36,000

The selling price of product P (in current price terms) will be $20 per unit, while the variable cost of the product (incurrent price terms) will be $12 per unit. Selling price inflation is expected to be 4% per year and variable costinflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC Co has spare capacityin both space and labour terms.

Producing and selling product P will call for increased investment in working capital. Analysis of historical levels ofworking capital within SC Co indicates that at the start of each year, investment in working capital for product P willneed to be 7% of sales revenue for that year.

SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by capitalallowances on machinery (tax-allowable depreciation), which SC Co can claim on a straight-line basis over the four-year life of the proposed investment. The new machine is expected to have no scrap value at the end of the four-year period.

SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.

Required:

(a) Calculate the net present value of the proposed investment in product P. (12 marks)

(b) Calculate the internal rate of return of the proposed investment in product P. (3 marks)

(c) Advise on the acceptability of the proposed investment in product P and discuss the limitations of theevaluations you have carried out. (5 marks)

(d) Discuss how the net present value method of investment appraisal contributes towards the objective ofmaximising the wealth of shareholders. (5 marks)

(25 marks)

5 [P.T.O.

6

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13

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7 [P.T.O.

Present Value Table

Present value of 1 i.e. (1 + r)–n

Where r = discount rate n = number of periods until payment

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

8

Annuity Table

Present value of an annuity of 1 i.e.

Where r = discount rate n = number of periods

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers

Fundamentals Level – Skills Module, Paper F9Financial Management June 2008 Answers

1 (a) Calculation of weighted average cost of capital (WACC)

Cost of equityCost of equity using capital asset pricing model = 4·7 + (1·2 x 6·5) = 12·5%

Cost of convertible debtAnnual after-tax interest payment = 7 x (1 – 0·3) = $4·90 per bondShare price in six years’ time = 5·50 x 1·066 = $7·80Conversion value = 7·80 x 15 = $117·00 per bondConversion appears likely, since the conversion value is much greater than par value.The future cash flows to be discounted are therefore six years of after-tax interest payments and the conversion value receivedin year 6:

Year Cash flow $ 10% DF PV ($) 5% DF PV ($)0 market value (107·11) 1·000 (107·11) 1·000 (107·11)1–6 interest 4·9 4·355 21·34 5·076 24·876 conversion 117·00 0·564 66·00 0·746 87·28

––––––– ––––––––(19·77) 5·04––––––– ––––––––

Using linear interpolation, after-tax cost of debt = 5 + [(5 x 5·04)/(5·04 + 19·77)] = 6·0%.

(Note that other after-tax costs of debt will arise if different discount rates are used in the linear interpolation calculation.)

We can confirm that conversion is likely and implied by the current market price of $107·11 by noting that the floor value ofthe convertible debt at an after-tax cost of debt of 6% is $93·13 (4·9 x 6·210 + 100 x 0·627).

Cost of bank loanAfter-tax interest rate = 8 x (1 – 0·3) = 5·6%This can be used as the cost of debt for the bank loan.An alternative would be to use the after-tax cost of debt of ordinary (e.g. not convertible) traded debt, but that is not availablehere.

Market valuesMarket value of equity = 20m x 5·50 = $110 millionMarket value of convertible debt = 29m x 107·11/100 = $31·06 millionBook value of bank loan = $2mTotal market value = 110 + 31·06 + 2 = $143·06 million

WACC = [(12·5 x 110) + (6·0 x 31·06) + (5·6 x 2)]/143·06 = 11·0%

(b) The weighted average cost of capital (WACC) can be used as a discount rate in investment appraisal provided that the risksof the investment project being evaluated are similar to the current risks of the investing company. The WACC would thenreflect these risks and represent the average return required as compensation for these risks.

WACC can be used in investment appraisal provided that the business risk of the proposed investment is similar to thebusiness risk of existing operations. Essentially this means that WACC can be used to evaluate an expansion of existingbusiness. If the business risk of the investment project is different from the business risk of existing operations, a project-specific discount rate that reflects the business risk of the investment project should be considered. The capital asset pricingmodel (CAPM) can be used to derive such a project-specific discount rate.

WACC can be used in investment appraisal provided that the financial risk of the proposed investment is similar to thefinancial risk of existing operations. This means that financing for the project should be raised in proportions that broadlypreserve the capital structure of the investing company. If this is not the case, an investment appraisal method called adjustedpresent value (APV) should be used. Alternatively, the CAPM-derived project-specific cost of capital can be adjusted to reflectthe financial risk of the project financing.

A third constraint on using WACC in investment appraisal is that the proposed investment should be small in comparison withthe size of the company. If this were not the case, the scale of the investment project could cause a change to occur in theperceived risk of the investing company, making the existing WACC an inappropriate discount rate.

(c) The dividend growth model has several difficulties attendant on its use as a way of estimating the cost of equity. For example,the model assumes that the future dividend growth rate is constant in perpetuity, an assumption that is not supported by theway that dividends change in practice. Each dividend paid by a company is the result of a dividend decision by managers,who will consider, but not be bound by, the dividends paid in previous periods. Estimating the future dividend growth rate isalso very difficult. Historical dividend trends are usually analysed and on the somewhat risky assumption that the future willrepeat the past, the historic dividend growth rate is used as a substitute for the future dividend growth rate. The model alsoassumes that business risk, and hence business operations and the cost of equity, are constant in future periods, but realityshows us that companies, their business operations and their economic environment are subject to constant change. Perhapsthe one certain thing about the future is its uncertainty.

11

It is sometimes said that the dividend growth model does not consider risk, but risk is implicit in the share price used by themodel to calculate the cost of equity. A moment’s thought will indicate that share prices fall as risk increases, indicating thatincreasing risk will lead to an increasing cost of equity. What is certainly true is that the dividend growth model does notconsider risk explicitly in the same way as the capital asset pricing model (CAPM). Here, all investors are assumed to holddiversified portfolios and as a result only seek compensation (return) for the systematic risk of an investment. The CAPMrepresent the required rate of return (i.e. the cost of equity) as the sum of the risk-free rate of return and a risk premiumreflecting the systematic risk of an individual company relative to the systematic risk of the stock market as a whole. This riskpremium is the product of the company’s equity beta and the equity risk premium. The CAPM therefore tells us what the costof equity should be, given an individual company’s level of systematic risk.

The individual components of the CAPM (the risk-free rate of return, the equity risk premium and the equity beta) are foundby empirical research and so the CAPM gives rise to a much smaller degree of uncertainty than that attached to the futuredividend growth rate in the dividend growth model. For this reason, it is usually suggested that the CAPM offers a betterestimate of the cost of equity than the dividend growth model.

2 (a) Calculation of share priceTHP Co dividend per share = 64 x 0·5 = 32c per shareShare price of THP Co = (32 x 1·05)/(0·12 – 0·05) = $4·80Market capitalisation of THP Co = 4·80 x 3m = $14·4m

(b) Rights issue priceThis is at a 20% discount to the current share price = 4·80 x 0·8 = $3·84 per share

New shares issued = 3m/3 = 1mCash raised = 1m x 3·84 = $3,840,000

Theoretical ex rights price = [(3 x 4·80) + 3·84]/4 = $4·56 per share

Market capitalisation after rights issue = 14·4m + 3·84m = $18·24 – 0·32m = $17·92mThis is equivalent to a share price of 17·92/4 = $4·48 per shareThe issue costs result in a decrease in the market value of the company and therefore a decrease in the wealth of shareholdersequivalent to 8c per share.

(c) Price/earnings ratio valuationPrice/earnings ratio of THP Co = 480/64 = 7·5

Earnings per share of CRX Co = 44·8c per shareUsing the price earnings ratio method, share price of CRX Co = (44·8 x 7·5)/100 = $3·36Market capitalisation of CRX Co = 3·36 x 1m = $3,360,000

(Alternatively, earnings of CRX Co = 1m x 0·448 = $448,000 x 7·5 = $3,360,000)

(d) In a semi-strong form efficient capital market, share prices reflect past and public information. If the expected annual after-tax savings are not announced, this information will not therefore be reflected in the share price of THP Co. In this case,the post acquisition market capitalisation of THP Co will be the market capitalisation after the rights issue, plus the marketcapitalisation of the acquired company (CRX Co), less the price paid for the shares of CRX Co, since this cash has left thecompany in exchange for purchased shares. It is assumed that the market capitalisations calculated in earlier parts of thisquestion are fair values, including the value of CRX Co calculated by the price/earnings ratio method.

Price paid for CRX Co = 3·84m – 0·32m = $3·52mMarket capitalisation = 17·92m + 3·36m – 3·52m = $17·76mThis is equivalent to a share price of 17·76/4 = $4·44 per share

The market capitalisation has decreased from the value following the rights issue because THP Co has paid $3·52m for acompany apparently worth $3·36m. This is a further decrease in the wealth of shareholders, following on from the issue costsof the rights issue.

If the annual after-tax savings are announced, this information will be reflected quickly and accurately in the share price ofTHP Co since the capital market is semi-strong form efficient. The savings can be valued using the price/earnings ratio methodas having a present value of $720,000 (7·5 x 96,000). The revised market capitalisation of THP Co is therefore $18·48m(17·76m + 0·72m), equivalent to a share price of $4·62 per share (18·48/4). This makes the acquisition of CRX Coattractive to the shareholders of THP Co, since it offers a higher market capitalisation than the one following the rights issue.Each shareholder of THP Co would experience a capital gain of 14c per share (4·62 – 4·48).

In practice, the capital market is likely to anticipate the annual after-tax savings before they are announced by THP Co.

(e) There are a number of factors that should be considered by THP Co, including the following.

Gearing and financial riskEquity finance will decrease gearing and financial risk, while debt finance will increase them. Gearing for THP Co is currently68·5% and this will decrease to 45% if equity finance is used, or rise to 121% if debt finance is used. There may also be

12

some acquired debt finance in the capital structure of CRX Co. THP Co needs to consider what level of financial risk isdesirable, from both a corporate and a stakeholder perspective.

Target capital structureTHP Co needs to compare its capital structure after the acquisition with its target capital structure. If its primary financialobjective is to maximise the wealth of shareholders, it should seek to minimise its weighted average cost of capital (WACC).In practical terms this can be achieved by having some debt in its capital structure, since debt is relatively cheaper than equity,while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffersfrom the costs of financial distress).

Availability of securityDebt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a specifiedclass of assets). The amount of finance needed to buy CRX CO would need to be secured by a fixed charge to specific fixedassets of THP Co. Information on these fixed assets and on the secured status of the existing 8% loan notes has not beenprovided.

Economic expectationsIf THP Co expects buoyant economic conditions and increasing profitability in the future, it will be more prepared to take onfixed interest debt commitments than if it believes difficult trading conditions lie ahead.

Control issuesA rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors. The choicebetween offering new shares to existing shareholders and to new shareholders will depend in part on the amount of financethat is needed, with rights issues being used for medium-sized issues and issues to new shareholders being used for largeissues. Issuing traded debt also has control implications however, since restrictive or negative covenants are usually writteninto the bond issue documents.

WorkingsCurrent gearing (debt/equity, book value basis) = 100 x 5,000/7,300 = 68·5%Gearing if equity finance is used = 100 x 5,000/(7,300 + 3,840) = 45%Gearing if debt finance is used = 100 x (5,000 + 3,840)/7,300 = 121%

3 (a) There are a number of factors that determine the level of investment in current assets and their relative importance variesfrom company to company.

Length of working capital cycleThe working capital cycle or operating cycle is the period of time between when a company settles its accounts payable andwhen it receives cash from its accounts receivable. Operating activities during this period need to be financed and as theoperating period lengthens, the amount of finance needed increases. Companies with comparatively longer operating cyclesthan others in the same industry sector, will therefore require comparatively higher levels of investment in current assets.

Terms of tradeThese determine the period of credit extended to customers, any discounts offered for early settlement or bulk purchases, andany penalties for late payment. A company whose terms of trade are more generous than another company in the sameindustry sector will therefore need a comparatively higher investment in current assets.

Policy on level of investment in current assetsEven within the same industry sector, companies will have different policies regarding the level of investment in current assets,depending on their attitude to risk. A company with a comparatively conservative approach to the level of investment incurrent assets would maintain higher levels of inventory, offer more generous credit terms and have higher levels of cash inreserve than a company with a comparatively aggressive approach. While the more aggressive approach would be moreprofitable because of the lower level of investment in current assets, it would also be more risky, for example in terms ofrunning out of inventory in periods of fluctuating demand, of failing to have the particular goods required by a customer, offailing to retain customers who migrate to more generous credit terms elsewhere, and of being less able to meet unexpecteddemands for payment.

Industry in which organisation operatesAnother factor that influences the level of investment in current assets is the industry within which an organisation operates.Some industries, such as aircraft construction, will have long operating cycles due to the length of time needed to manufacturefinished goods and so will have comparatively higher levels of investment in current assets than industries such assupermarket chains, where goods are bought in for resale with minimal additional processing and where many goods haveshort shelf-lives.

(b) Factoring involves a company turning over administration of its sales ledger to a factor, which is a financial institution withexpertise in this area. The factor will assess the creditworthiness of new customers, record sales, send out statements andreminders, collect payment, identify late payers and chase them for settlement, and take appropriate legal action to recoverdebts where necessary.

The factor will also offer finance to a company based on invoices raised for goods sold or services provided. This is usuallyup to 80% of the face value of invoices raised. The finance is repaid from the settled invoices, with the balance being passedto the issuing company after deduction of a fee equivalent to an interest charge on cash advanced.

13

If factoring is without recourse, the factor rather than the company will carry the cost of any bad debts that arise on overdueaccounts. Factoring without recourse therefore offers credit protection to the selling company, although the factor’s fee (apercentage of credit sales) will be comparatively higher than with non-recourse factoring to reflect the cost of the insuranceoffered.

Invoice discounting is a way of raising finance against the security of invoices raised, rather than employing the creditmanagement and administration services of a factor. A number of good quality invoices may be discounted, rather than allinvoices, and the service is usually only offered to companies meeting a minimum turnover criterion.

(c) Calculation of size of overdraftInventory period = operating cycle + payables period – receivables period = 3 + 1 – 2 = 2 monthsInventory = 1·89m x 2/12 = $315,000Accounts receivable = 4·2m x 2/12 = $700,000Current assets = 315,000 + 700,000 = $1,015,000Current liabilities = current assets/current ratio = 1,015,000/1·4 = $725,000Accounts payable = 1·89m x 1/12 = $157,500Overdraft = 725,000 – 157,500 = $567,500

Net working capital = current assets – current liabilities = 1,015,000 – 725,000 = $290,000

Short-term financing cost = 567,500 x 0·07 = $39,725Long-term financing cost = 290,000 x 0·11 = $31,900Total cost of financing current assets = 39,725 + 31,900 = $71,625

(d) (i) Economic order quantity = (2 x 6 x 60,000/0·5)0·5 = 1,200 unitsNumber of orders = 60,000/1,200 = 50 order per yearAnnual ordering cost = 50 x 6 = $300 per yearAverage inventory = 1,200/2 = 600 unitsAnnual holding cost = 600 x 0·5 = $300 per yearInventory cost = 60,000 x 12 = $720,000Total cost of inventory with EOQ policy = 720,000 + 300 + 300 = $720,600 per year

(ii) Order size for bulk discounts = 10,000 unitsNumber of orders = 60,000/10,000 = 6 orders per yearAnnual ordering cost = 6 x 6 = $36 per yearAverage inventory = 10,000/2 =5,000 unitsAnnual holding cost = 5,000 x 2 = $10,000 per yearDiscounted material cost =12 x 0·99 = $11·88 per unitInventory cost = 60,000 x 11·88 = $712,800Total cost of inventory with discount = 712,800 + 36 + 10,000 = $722,836 per year

The EOQ approach results in a slightly lower total inventory cost

4 (a) Calculation of net present value

Year 0 1 2 3 4$ $ $ $ $

Sales revenue 728,000 1,146,390 1,687,500 842,400Variable costs (441,000) (701,190) (1,041,750) (524,880)

––––––––– –––––––––– ––––––––––– –––––––––Contribution 287,000 445,200 645,750 317,520Capital allowances (250,000) (250,000) (250,000) (250,000)

––––––––– –––––––––– ––––––––––– –––––––––Taxable profit 37,000 195,200 395,750 67,520Taxation (11,100) (58,560) (118,725) (20,256)

––––––––– –––––––––– ––––––––––– –––––––––After-tax profit 25,900 136,640 277,025 47,264Capital allowances 250,000 250,000 250,000 250,000

––––––––– –––––––––– ––––––––––– –––––––––After-tax cash flow 275,900 386,640 527,025 297,264Initial investment (1,000,000)Working capital (50,960) (29,287) (37,878) 59,157 58,968

––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––Net cash flows (1,050,960) 246,613 348,762 586,182 356,232Discount at 12% 1·000 0·893 0·797 0·712 0·636

––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––Present values (1,050,960) 220,225 277,963 417,362 226,564

––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––

NPV = $91,154

14

Workings

Sales revenueYear 1 2 3 4Selling price ($/unit) 20·80 21·63 22·50 23·40Sales volume (units) 35,000 53,000 75,000 36,000Sales revenue ($) 728,000 1,146,390 1,687,500 842,400

Variable costsYear 1 2 3 4Variable cost ($/unit) 12·60 13·23 13·89 14·58Sales volume (units) 35,000 53,000 75,000 36,000Variable costs ($) 441,000 701,190 1,041,750 524,880

Total investment in working capitalYear 0 investment = 728,000 x 0·07 = $50,960Year 1 investment = 1,146,390 x 0·07 = $80,247Year 2 investment = 1,687,500 x 0·07 = $118,125Year 3 investment = 842,400 x 0·07 = $58,968

Incremental investment in working capitalYear 0 investment = 728,000 x 0·07 = $50,960Year 1 investment = 80,247 – 50,960 = $29,287Year 2 investment = 118,125 – 80,247 = $37,878Year 3 recovery = 58,968 – 118,125 = $59,157Year 4 recovery = $58,968

(b) Calculation of internal rate of return

Year 0 1 2 3 4$ $ $ $ $

Net cash flows (1,050,960) 246,613 348,762 586,182 356,232Discount at 20% 1·000 0·833 0·694 0·579 0·482

––––––––––– –––––––– –––––––– –––––––– ––––––––Present values (1,050,960) 205,429 242,041 339,399 171,704

––––––––––– –––––––– –––––––– –––––––– ––––––––

NPV at 20% = ($92,387)NPV at 12% = $91,154

IRR = 12 + [(20 – 12) x 91,154/(91,154 + 92,387)] = 12 + 4 = 16%

(c) Acceptability of the proposed investment in Product PThe NPV is positive and so the proposed investment can be recommended on financial grounds.

The IRR is greater than the discount rate used by SC Co for investment appraisal purposes and so the proposed investmentis financially acceptable. The cash flows of the proposed investment are conventional and so there is only one internal rateof return. Furthermore, only one proposed investment is being considered and so there is no conflict between the adviceoffered by the IRR and NPV investment appraisal methods.

Limitations of the investment evaluationsBoth the NPV and IRR evaluations are heavily dependent on the production and sales volumes that have been forecast andso SC Co should investigate the key assumptions underlying these forecast volumes. It is difficult to forecast the length andfeatures of a product’s life cycle so there is likely to be a degree of uncertainty associated with the forecast sales volumes.Scenario analysis may be of assistance here in providing information on other possible outcomes to the proposed investment.

The inflation rates for selling price per unit and variable cost per unit have been assumed to be constant in future periods. Inreality, interaction between a range of economic and other forces influencing selling price per unit and variable cost per unitwill lead to unanticipated changes in both of these project variables. The assumption of constant inflation rates limits theaccuracy of the investment evaluations and could be an important consideration if the investment were only marginallyacceptable.

Since no increase in fixed costs is expected because SC Co has spare capacity in both space and labour terms, fixed costsare not relevant to the evaluation and have been omitted. No information has been offered on whether the spare capacityexists in future periods as well as in the current period. Since production of Product P is expected to more than double overthree years, future capacity needs should be assessed before a decision is made to proceed, in order to determine whetherany future incremental fixed costs may arise.

(d) The primary financial management objective of private sector companies is often stated to be the maximisation of the wealthof its shareholders. While other corporate objectives are also important, for example due to the existence of other corporatestakeholders than shareholders, financial management theory emphasises the importance of the objective of shareholderwealth maximisation.

15

Shareholder wealth increases through receiving dividends and through share prices increasing over time. Changes in shareprices can therefore be used to assess whether a financial management decision is of benefit to shareholders. In fact, theobjective of maximising the wealth of shareholders is usually substituted by the objective of maximising the share price of acompany.

The net present value (NPV) investment appraisal method advises that an investment should be accepted if it has a positiveNPV. If a company accepts an investment with a positive NPV, the market value of the company, theoretically at least,increases by the amount of the NPV. A company with a market value of $10 million investing in a project with an NPV of $1 million will have a market value of $11 million once the investment is made. Shareholder wealth is therefore increasedif positive NPV projects are accepted and, again theoretically, shareholder wealth will be maximised if a company invests inall projects with a positive NPV. This is sometimes referred to as the optimum investment schedule for a company.

The NPV investment appraisal method also contributes towards the objective of maximising the wealth of shareholders byusing the cost of capital of a company as a discount rate when calculating the present values of future cash flows. A positiveNPV represents an investment return that is greater than that required by a company’s providers of finance, offering thepossibility of increased dividends being paid to shareholders from future cash flows.

16

Fundamentals Level – Skills Module, Paper F9Financial Management June 2008 Marking Scheme

Marks Marks1 (a) Calculation of cost of equity 2

Calculation of cost of convertible debt 5Calculation of cost of bank loan 1Calculation of market values 2Calculation of WACC 2

––––12

(b) Discussion of business risk 2–3Discussion of financial risk 1–2Discussion of other relevant factors 1–2


(c) Discussion of dividend growth model 2–3Discussion of capital asset pricing model 2–3Conclusion 1–2


–––25

2 (a) Dividend per share 1Ex dividend share price 2Market capitalisation 1

––––4

(b) Rights issue price 1Cash raised 1Theoretical ex rights price per share 1Market capitalisation 2

––––5

(c) Calculation of price/earnings ratio 1Price/earnings ratio valuation 2

––––3

(d) Calculations of market capitalisation 2–3Comment 3–4


(e) Relevant discussion 6–7Links to scenario in question 2–3


–––25

17

Marks Marks3 (a) Discussion of key factors Maximum 6

(b) Discussion of factoring 4–5Discussion of Invoice discounting 1–2


(c) Value of inventory 1Accounts receivable and accounts payable 1Current liabilities 1Size of overdraft 1Net working capital 1Total cost of financing working capital 1

––––6

(d) (i) Economic order quantity 1Ordering cost and holding cost under EOQ 1Inventory cost under EOQ 1Total cost of inventory with EOQ policy 1

––––4

(ii) Ordering cost and holding cost with discount 1Inventory cost with discount 1Total cost of inventory with bulk purchase discount 1Conclusion 1


–––25

4 (a) Inflated sales revenue 2Inflated variable costs 2Capital allowances 2Taxation 1Working capital 3Discount factors 1Net present value calculation 1

––––12

(b) Net present value calculation 1Internal rate of return calculation 2

––––3

(c) Net present value comment 1Internal rate of return comment 1–2Discussion of limitations 3–4


(d) Discussion of shareholder wealth maximisation 1–2Link to share price maximisation 1–2Discussion of NPV investment appraisal method 2–3


–––25

18








Pape

r F9





1 Dartig Co is a stock-market listed company that manufactures consumer products and it is planning to expand itsexisting business. The investment cost of $5 million will be met by a 1 for 4 rights issue. The current share price ofDartig Co is $2·50 per share and the rights issue price will be at a 20% discount to this. The finance director of DartigCo expects that the expansion of existing business will allow the average growth rate of earnings per share over thelast four years to be maintained into the foreseeable future.

The earnings per share and dividends paid by Dartig over the last four years are as follows:

2003 2004 2005 2006 2007Earnings per share (cents) 27·7 29·0 29·0 30·2 32·4Dividend per share (cents) 12·8 13·5 13·5 14·5 15·0

Dartig Co has a cost of equity of 10%. The price/earnings ratio of Dartig Co has been approximately constant in recentyears. Ignore issue costs.

Required:

(a) Calculate the theoretical ex rights price per share prior to investing in the proposed business expansion.(3 marks)

(b) Calculate the expected share price following the proposed business expansion using the price/earnings ratiomethod. (3 marks)

(c) Discuss whether the proposed business expansion is an acceptable use of the finance raised by the rightsissue, and evaluate the expected effect on the wealth of the shareholders of Dartig Co. (5 marks)

(d) Using the information provided, calculate the ex div share price predicted by the dividend growth model anddiscuss briefly why this share price differs from the current market price of Dartig Co. (6 marks)

(e) At a recent board meeting of Dartig Co, a non-executive director suggested that the company’s remunerationcommittee should consider scrapping the company’s current share option scheme, since executive directors couldbe rewarded by the scheme even when they did not perform well. A second non-executive director disagreed,saying the problem was that even when directors acted in ways which decreased the agency problem, they mightnot be rewarded by the share option scheme if the stock market were in decline.

Required:

Explain the nature of the agency problem and discuss the use of share option schemes as a way of reducingthe agency problem in a stock-market listed company such as Dartig Co. (8 marks)

(25 marks)

2

2 The following financial information related to Gorwa Co:

2007 2006$000 $000

Sales (all on credit) 37,400 26,720Cost of sales 34,408 23,781

––––––– –––––––Operating profit 2,992 2,939Finance costs (interest payments) 355 274

––––––– –––––––Profit before taxation 2,637 2,665

––––––– –––––––

2007 2006$000 $000 $000 $000

Non-current assets 13,632 12,750Current assets

Inventory 4,600 2,400Trade receivables 4,600 2,200

–––––– ––––––9,200 4,600

Current liabilitiesTrade payables 4,750 2,000Overdraft 3,225 1,600

–––––– ––––––7,975 3,600

Net current assets 1,225 1,000––––––– –––––––14,857 13,750

8% Bonds 2,425 2,425––––––– –––––––12,432 11,325––––––– –––––––

Capital and reservesShare capital 6,000 6,000Reserves 6,432 5,325

––––––– –––––––12,432 11,325––––––– –––––––

The average variable overdraft interest rate in each year was 5%. The 8% bonds are redeemable in ten years’ time.

A factor has offered to take over the administration of trade receivables on a non-recourse basis for an annual fee of3% of credit sales. The factor will maintain a trade receivables collection period of 30 days and Gorwa Co will save$100,000 per year in administration costs and $350,000 per year in bad debts. A condition of the factoringagreement is that the factor would advance 80% of the face value of receivables at an annual interest rate of 7%.

Required:

(a) Discuss, with supporting calculations, the possible effects on Gorwa Co of an increase in interest rates andadvise the company of steps it can take to protect itself against interest rate risk. (7 marks)

(b) Use the above financial information to discuss, with supporting calculations, whether or not Gorwa Co isovertrading. (10 marks)

(c) Evaluate whether the proposal to factor trade receivables is financially acceptable. Assume an average costof short-term finance in this part of the question only. (8 marks)

(25 marks)

3 [P.T.O.

3 Rupab Co is a manufacturing company that wishes to evaluate an investment in new production machinery. Themachinery would enable the company to satisfy increasing demand for existing products and the investment is notexpected to lead to any change in the existing level of business risk of Rupab Co.

The machinery will cost $2·5 million, payable at the start of the first year of operation, and is not expected to haveany scrap value. Annual before-tax net cash flows of $680,000 per year would be generated by the investment ineach of the five years of its expected operating life. These net cash inflows are before taking account of expectedinflation of 3% per year. Initial investment of $240,000 in working capital would also be required, followed byincremental annual investment to maintain the purchasing power of working capital.

Rupab Co has in issue five million shares with a market value of $3·81 per share. The equity beta of the companyis 1·2. The yield on short-term government debt is 4·5% per year and the equity risk premium is approximately 5%per year.

The debt finance of Rupab Co consists of bonds with a total book value of $2 million. These bonds pay annual interestbefore tax of 7%. The par value and market value of each bond is $100.

Rupab Co pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax-allowable depreciation)on machinery are on a straight-line basis over the life of the asset.

Required:

(a) Calculate the after-tax weighted average cost of capital of Rupab Co. (6 marks)

(b) Prepare a forecast of the annual after-tax cash flows of the investment in nominal terms, and calculate andcomment on its net present value. (8 marks)

(c) Explain how the capital asset pricing model can be used to calculate a project-specific discount rate anddiscuss the limitations of using the capital asset pricing model in investment appraisal. (11 marks)

(25 marks)

4

4 Three years ago Boluje Co built a factory in its home country costing $3·2 million. To finance the construction of thefactory, Boluje Co issued peso-denominated bonds in a foreign country whose currency is the peso. Interest rates atthe time in the foreign country were historically low. The foreign bond issue raised 16 million pesos and the exchangerate at the time was 5·00 pesos/$.

Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each year of 6·1%. Thebonds will be redeemed in five years’ time at par. The current cost of debt of peso-denominated bonds of similar riskis 7%.

In addition to domestic sales, Boluje Co exports goods to the foreign country and receives payment for export sales inpesos. Approximately 40% of production is exported to the foreign country.

The spot exchange rate is 6·00 pesos/$ and the 12-month forward exchange rate is 6·07 pesos/$. Boluje Co canborrow money on a short-term basis at 4% per year in its home currency and it can deposit money at 5% per yearin the foreign country where the foreign bonds were issued. Taxation may be ignored in all calculation parts of thisquestion.

Required:

(a) Briefly explain the reasons why a company may choose to finance a new investment by an issue of debtfinance. (7 marks)

(b) Calculate the current total market value (in pesos) of the foreign bonds used to finance the building of thenew factory. (4 marks)

(c) Assume that Boluje Co has no surplus cash at the present time:

(i) Explain and illustrate how a money market hedge could protect Boluje Co against exchange rate risk inrelation to the dollar cost of the interest payment to be made in one year’s time on its foreign bonds.

(4 marks)

(ii) Compare the relative costs of a money market hedge and a forward market hedge. (2 marks)

(d) Describe other methods, including derivatives, that Boluje Co could use to hedge against exchange rate risk.(8 marks)

(25 marks)

5 [P.T.O.

6

Formulae Sheet


Miller–Orr Model



The Growth Model



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13

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7 [P.T.O.

Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

8

Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers

11


1 (a) Rights issue price = 2·5 x 0·8 = $2·00 per shareTheoretical ex rights price = ((2·50 x 4) + (1 x 2·00)/5=$2·40 per share

(Alternatively, number of rights shares issued = $5m/$2·00 = 2·5m sharesExisting number of shares = 4 x 2·5m = 10m sharesTheoretical ex rights price per share = ((10m x 2·50) + (2·5m x 2·00))/12·5m = $2·40)

(b) Current price/earnings ratio = 250/32·4 = 7·7 timesAverage growth rate of earnings per share = 100 x ((32·4/27·7)0·25 – 1) = 4·0%Earnings per share following expansion = 32·4 x 1·04 = 33·7 cents per shareShare price predicted by price/earnings ratio method = 33·7 x 7·7 = $2·60Since the price/earnings ratio of Dartig Co has remained constant in recent years and the expansion is of existing business,it seems reasonable to apply the existing price/earnings ratio to the revised earnings per share value.

(c) The proposed business expansion will be an acceptable use of the rights issue funds if it increases the wealth of theshareholders. The share price predicted by the price/earnings ratio method is $2·60. This is greater than the current shareprice of $2·50, but this is not a valid comparison, since it ignores the effect of the rights issue on the share price. The rightsissue has a neutral effect on shareholder wealth, but the cum rights price is changed by the increase in the number of sharesand by the transformation of cash wealth into security wealth from a shareholder point of view. The correct comparison iswith the theoretical ex rights price, which was found earlier to be $2·40. Dartig Co shareholders will experience a capital gaindue to the business expansion of $2·60 – 2·40 = 20 cents per share. However, these share prices are one year apart andhence not directly comparable.

If the dividend yield remains at 6% per year (100 x 15·0/250), the dividend per share for 2008 will be 15·6p (otherestimates of the 2008 dividend per share are possible). Adding this to the capital gain of 20p gives a total shareholder returnof 35·6p or 14·24% (100 x 35·6/240). This is greater than the cost of equity of 10% and so shareholder wealth hasincreased.

(d) In order to use the dividend growth model, the expected future dividend growth rate is needed. Here, it may be assumed thatthe historical trend of dividend per share payments will continue into the future. The geometric average historical dividendgrowth rate = 100 x ((15·0/12·8)0·25 – 1) = 4% per year.

(Alternatively, the arithmetical average of annual dividend growth rates could be used. This will be (5·5 + 0·0 + 7·4 + 3·5)/4= 4·1%. Another possibility is to use the Gordon growth model. The average payout ratio over the last 4 years has been47%, so the average retention ratio has been 53%. Assuming that the cost of equity represents an acceptable return onshareholders’ funds, the dividend growth rate is approximately 53% x 10% = 5·3% per year.)

Using the formula for the dividend growth model from the formula sheet, the ex dividend share price = (15·0 x 1·04)/(0·1– 0·04) = $2·60

This is 10 cents per share more than the current share price of Dartig Co. There are several reasons why there may be adifference between the two share prices. The future dividend growth rate for example, may differ from the average historicaldividend growth rate, and the current share price may factor in a more reasonable estimate of the future dividend growth ratethan the 4% used here. The cost of equity of Dartig Co may not be exactly equal to 10%. More generally, there may be adegree of inefficiency in the capital market on which the shares of Dartig Co are traded.

(e) The primary financial management objective of a company is usually taken to be the maximisation of shareholder wealth. Inpractice, the managers of a company acting as agents for the principals (the shareholders) may act in ways which do notlead to shareholder wealth maximisation. The failure of managers to maximise shareholder wealth is referred to as the agencyproblem.

Shareholder wealth increases through payment of dividends and through appreciation of share prices. Since share pricesreflect the value placed by buyers on the right to receive future dividends, analysis of changes in shareholder wealth focuseson changes in share prices. The objective of maximising share prices is commonly used as a substitute objective for that ofmaximising shareholder wealth.

The agency problem arises because the objectives of managers differ from those of shareholders: because there is a divorceor separation of ownership from control in modern companies; and because there is an asymmetry of information betweenshareholders and managers which prevents shareholders being aware of most managerial decisions.

One way to encourage managers to act in ways that increase shareholder wealth is to offer them share options. These arerights to buy shares on a future date at a price which is fixed when the share options are issued. Share options will encouragemanagers to make decisions that are likely to lead to share price increases (such as investing in projects with positive netpresent values), since this will increase the rewards they receive from share options. The higher the share price in the marketwhen the share options are exercised, the greater will be the capital gain that could be made by managers owning the options.

12

Share options therefore go some way towards reducing the differences between the objectives of shareholders and managers.However, it is possible that managers may be rewarded for poor performance if share prices in general are increasing. It isalso possible that managers may not be rewarded for good performance if share prices in general are falling. It is difficult todecide on a share option exercise price and a share option exercise date that will encourage managers to focus on increasingshareholder wealth while still remaining challenging, rather than being easily achievable.

2 (a) Financial analysisFixed interest debt proportion (2006) = 100 x 2,425/ 2,425 + 1,600) = 60%Fixed interest debt proportion (2007) = 100 x 2,425/(2,425 + 3,225) = 43%Fixed interest payments = 2,425 x 0·08 = $194,000Variable interest payments (2006) = 274 – 194 = $80,000 or 29%Variable interest payments (2007) = 355 – 194 = $161,000 or 45%

(Alternatively, considering the overdraft amounts and the average variable overdraft interest rate of 5% per year:Variable interest payments (2006) = 1·6m x 0·05 = $80,000 or 29%Variable interest payments (2007) = 3·225m x 0·05 = $161,250 or 45%)Interest coverage ratio (2006) = 2,939/ 274 = 10·7 timesInterest coverage ratio (2007) = 2,992/ 355 = 8·4 timesDebt/equity ratio (2006) = 100 x 2,425/ 11,325 = 21%Debt/equity ratio (2007) = 100 x 2,425/ 12,432 = 20%Total debt/equity ratio (2006) = 100 x (2,425 +1,600)/ 11,325 = 35%Total debt/equity ratio (2007) = 100 x (2,425 +3,225)/ 12,432 = 45%

DiscussionGorwa Co has both fixed interest debt and variable interest rate debt amongst its sources of finance. The fixed interest bondshave ten years to go before they need to be redeemed and they therefore offer Gorwa Co long term protection against anincrease in interest rates.

In 2006, 60% of the company’s debt was fixed interest in nature, but in 2007 this had fallen to 43%. The floating-rateproportion of the company’s debt therefore increased from 40% in 2006 to 57% in 2007. The interest coverage ratio fellfrom 10·7 times in 2006 to 8·4 times in 2007, a decrease which will be a cause for concern to the company if it were tocontinue. The debt/equity ratio (including the overdraft due to its size) increased over the same period from 35% to 45% (ifthe overdraft is excluded, the debt/equity ratio declines slightly from 21% to 20%). From the perspective of an increase ininterest rates, the financial risk of Gorwa Co has increased and may continue to increase if the company does not take actionto halt the growth of its variable interest rate overdraft. The proportion of interest payments linked to floating rate debt hasincreased from 29% in 2006 to 45% in 2007. An increase in interest rates will further reduce profit before taxation, whichis lower in 2007 than in 2006, despite a 40% increase in turnover.

One way to hedge against an increase in interest rates is to exchange some or all of the variable-rate overdraft into long-termfixed-rate debt. There is likely to be an increase in interest payments because long-term debt is usually more expensive thanshort-term debt. Gorwa would also be unable to benefit from falling interest rates if most of its debt paid fixed rather thanfloating rate interest.

Interest rate options and interest rate futures may be of use in the short term, depending on the company’s plans to deal withits increasing overdraft.

For the longer term, Gorwa Co could consider raising a variable-rate bank loan, linked to a variable rate-fixed interest rateswap.

(b) Financial analysis2007 2006

Inventory days (365 x 2,400)/23,781 37 days(365 x 4,600)/34,408 49 days

Receivables days (365 x 2,200)/26,720 30 days(365 x 4,600)/37,400 45 days

Payables days (365 x 2,000)/23,781 31 days(365 x 4,750)/34,408 51 days

Current ratio 4,600/3,600 1·3 times9,200/7,975 1·15 times

Quick ratio 2,200/3,600 0·61 times4,600/7,975 0·58 times

Sales/net working capital 26,720/1,000 26·7 times 37,400/1,225 30·5 times

Turnover increase 37,400/26,720 40%Non-current assets increase 13,632/12,750 7%Inventory increase 4,600/2,400 92%Receivables increase 4,600/2,200 109%Payables increase 4,750/2,000 138%Overdraft increase 3,225/1,600 102%

13

DiscussionOvertrading or undercapitalisation arises when a company has too small a capital base to support its level of business activity.Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they falldue. Overtrading is often associated with a rapid increase in turnover and Gorwa Co has experienced a 40% increase inturnover over the last year. Investment in working capital has not matched the increase in sales, however, since the sales/networking capital ratio has increased from 26·7 times to 30·5 times.

Overtrading could be indicated by a deterioration in inventory days. Here, inventory days have increased from 37 days to 49 days, while inventory has increased by 92% compared to the 40% increase in turnover. It is possible that inventory hasbeen stockpiled in anticipation of a further increase in turnover, leading to an increase in operating costs.

Overtrading could also be indicated by deterioration in receivables days. In this case, receivables have increased by 109%compared to the 40% increase in turnover. The increase in turnover may have been fuelled in part by a relaxation of creditterms.

As the liquidity problem associated with overtrading deepens, the overtrading company increases its reliance on short-termsources of finance, including overdraft, trade payables and leasing. The overdraft of Gorwa Co has more than doubled in sizeto $3·225 million, while trade payables have increased by $2·74 million or 137%. Both increases are much greater thanthe 40% increase in turnover. There is evidence here of an increased reliance on short-term finance sources.

Overtrading can also be indicated by decreases in the current ratio and the quick ratio. The current ratio of Gorwa Co hasfallen from 1·3 times to 1·15 times, while its quick ratio has fallen from 0·61 times to 0·58 times.

There are clear indications that Gorwa Co is experiencing the kinds of symptoms usually associated with overtrading. A morecomplete and meaningful analysis could be undertaken if appropriate benchmarks were available, such as key ratios fromcomparable companies in the same industry sector, or additional financial information from prior years so as to establishtrends in key ratios.

(c) Current receivables = $4,600,000Receivables under factor = 37,400,000 x 30/365 = $3,074,000Reduction in receivables = 4,600 – 3,074 = $1,526,000

Reduction in finance cost = 1,526,000 x 0·05 = $76,300 per yearAdministration cost savings = $100,000 per yearBad debt savings = $350,000 per yearFactor’s annual fee = 37,400,000 x 0·03 = $1,122,000 per yearExtra interest cost on advance = 3,074,000 x 80% x (7% – 5%) = $49,184 per yearNet cost of factoring = 76,300 + 100,000 + 350,000 – 1,122,000 – 49,184 = $644,884

The factor’s offer cannot be recommended, since the evaluation shows no financial benefit arising.

3 (a) Calculation of weighted average cost of capital

Cost of equity = 4·5 + (1·2 x 5) = 10·5%The company’s bonds are trading at par and therefore the before-tax cost of debt is the same as the interest rate on the bonds,which is 7%.After-tax cost of debt = 7 x (1 – 0·25) = 5·25%Market value of equity = 5m x 3·81 = $19·05 millionMarket value of debt is equal to its par value of $2 millionSum of market values of equity and debt = 19·05 + 2 = $21·05 millionWACC = (10·5 x 19·05/21·05) + (5·25 x 2/21·05) = 10·0%

(b) Cash flow forecast

Year 0 1 2 3 4 5 6$000 $000 $000 $000 $000 $000 $000

Cash inflows 700·4 721·4 743·1 765·3 788·3Tax on cash inflows 175·1 180·4 185·8 191·4 197·1

–––––– –––––– –––––– –––––– –––––– –––––700·4 546·3 562·7 579·6 596·9 (197·1)

CA tax benefits 125·0 125·0 125·0 125·0 125·0–––––– –––––– –––––– –––––– –––––– –––––

After-tax cash flows 700·4 671·3 687·7 704·6 721·9 (72·1)Initial investment (2,500)Working capital (240) (7·2) (7·4) (7·6) (7·9) 270·1

––––––– –––––– –––––– –––––– –––––– –––––– –––––Net cash flows (2,740) 693·2 663·9 680·1 696·7 992·0 (72·1)Discount factors 1·000 0·909 0·826 0·751 0·683 0·621 0·564

––––––– –––––– –––––– –––––– –––––– –––––– –––––Present values (2,740) 630·1 548·4 510·8 475·9 616·0 (40·7)

––––––– –––––– –––––– –––––– –––––– –––––– –––––

NPV = $500

14

The investment is financially acceptable, since the net present value is positive. The investment might become financiallyunacceptable, however, if the assumptions underlying the forecast financial data were reconsidered. For example, the salesforecast appears to assume constant annual demand, which is unlikely in reality.

Workings

Capital allowance tax benefitsAnnual capital allowance (straight-line basis) = $2·5m/5 = $500,000Annual tax benefit = $500,000 x 0·25 = $125,000 per year

Working capital investmentYear 0 1 2 3 4 5Working capital ($000) 240 247·2 254·6 262·2 270·1Incremental investment ($000) (7·2) (7·4) (7·6) (7·9) 270·1

(c) The capital asset pricing model (CAPM) can be used to calculate a project-specific discount rate in circumstances where thebusiness risk of an investment project is different from the business risk of the existing operations of the investing company.In these circumstances, it is not appropriate to use the weighted average cost of capital as the discount rate in investmentappraisal.

The first step in using the CAPM to calculate a project-specific discount rate is to find a proxy company (or companies) thatundertake operations whose business risk is similar to that of the proposed investment. The equity beta of the proxy companywill represent both the business risk and the financial risk of the proxy company. The effect of the financial risk of the proxycompany must be removed to give a proxy beta representing the business risk alone of the proposed investment. This betais called an asset beta and the calculation that removes the effect of the financial risk of the proxy company is called‘ungearing’.

The asset beta representing the business risk of a proposed investment must be adjusted to reflect the financial risk of theinvesting company, a process called ‘regearing’. This process produces an equity beta that can be placed in the CAPM in orderto calculate a required rate of return (a cost of equity). This can be used as the project-specific discount rate for the proposedinvestment if it is financed entirely by equity. If debt finance forms part of the financing for the proposed investment, a project-specific weighted average cost of capital can be calculated.

The limitations of using the CAPM in investment appraisal are both practical and theoretical in nature. From a practical pointof view, there are difficulties associated with finding the information needed. This applies not only to the equity risk premiumand the risk-free rate of return, but also to locating appropriate proxy companies with business operations similar to theproposed investment project. Most companies have a range of business operations they undertake and so their equity betasdo not reflect only the desired level and type of business risk.

From a theoretical point of view, the assumptions underlying the CAPM can be criticised as unrealistic in the real world. Forexample, the CAPM assumes a perfect capital market, when in reality capital markets are only semi-strong form efficient atbest. The CAPM assumes that all investors have diversified portfolios, so that rewards are only required for acceptingsystematic risk, when in fact this may not be true. There is no practical replacement for the CAPM at the present time,however.

4 (a) Pecking order theory suggests that companies have a preferred order in which they seek to raise finance, beginning withretained earnings. The advantages of using retained earnings are that issue costs are avoided by using them, the decision touse them can be made without reference to a third party, and using them does not bring additional obligations to considerthe needs of finance providers.

Once available retained earnings have been allocated to appropriate uses within a company, its next preference will be fordebt. One reason for choosing to finance a new investment by an issue of debt finance, therefore, is that insufficient retainedearnings are available and the investing company prefers issuing debt finance to issuing equity finance.

Debt finance may also be preferred when a company has not yet reached its optimal capital structure and it is mainly financedby equity, which is expensive compared to debt. Issuing debt here will lead to a reduction in the WACC and hence an increasein the market value of the company. One reason why debt is cheaper than equity is that debt is higher in the creditor hierarchythan equity, since ordinary shareholders are paid out last in the event of liquidation. Debt is even cheaper if it is secured onassets of the company. The cost of debt is reduced even further by the tax efficiency of debt, since interest payments are anallowable deduction in arriving at taxable profit.

Debt finance may be preferred where the maturity of the debt can be matched to the expected life of the investment project.Equity finance is permanent finance and so may be preferred for investment projects with long lives.

(b) Annual interest paid per foreign bond = 500 x 0·061 = 30·5 pesosRedemption value of each foreign bond = 500 pesosCost of debt of peso-denominated bonds = 7% per yearMarket value of each foreign bond = (30·5 x 4·100) + (500 x 0·713) = 481·55 pesosCurrent total market value of foreign bonds = 16m x (481·55/500) = 15,409,600 pesos

15

(c) (i) Interest payment in one year’s time = 16m x 0·061 = 976,000 pesosA money market hedge would involve placing on deposit an amount of pesos that, with added interest, would besufficient to pay the peso-denominated interest in one year. Because the interest on the peso-denominated deposit isguaranteed, Boluje Co would be protected against any unexpected or adverse exchange rate movements prior to theinterest payment being made.Peso deposit required = 976,000/ 1·05 = 929,524 pesosDollar equivalent at spot = 929,524/ 6 = $154,921Dollar cost in one year’s time = 154,921 x 1·04 = $161,118

(ii) Cost of forward market hedge = 976,000/6·07 = $160,790The forward market hedge is slightly cheaper

(d) Boluje receives peso income from its export sales and makes annual peso-denominated interest payments to bond-holders.It could consider opening a peso account in the overseas country and using this as a natural hedge against peso exchangerate risk.

Boluje Co could consider using lead payments to settle foreign currency liabilities. This would not be beneficial as far as peso-denominated liabilities are concerned, as the peso is depreciating against the dollar. It is inadvisable to lag payments to foreignsuppliers, since this would breach sales agreements and lead to loss of goodwill.

Foreign currency derivatives available to Boluje Co could include currency futures, currency options and currency swaps.

Currency futures are standardised contracts for the purchase or sale of a specified quantity of a foreign currency. Thesecontracts are settled on a quarterly cycle, but a futures position can be closed out any time by undertaking the oppositetransaction to the one that opened the futures position. Currency futures provide a hedge that theoretically eliminates bothupside and downside risk by effectively locking the holder into a given exchange rate, since any gains in the currency futuresmarket are offset by exchange rate losses in the cash market, and vice versa. In practice however, movements in the twomarkets are not perfectly correlated and basis risk exists if maturities are not perfectly matched. Imperfect hedges can alsoarise if the standardised size of currency futures does not match the exchange rate exposure of the hedging company. Initialmargin must be provided when a currency futures position is opened and variation margin may also be subsequently required.Boluje Co could use currency futures to hedge both its regular foreign currency receipts and its annual interest payment.

Currency options give holders the right, but not the obligation, to buy or sell foreign currency. Over-the-counter (OTC) currencyoptions are tailored to individual client needs, while exchange-traded currency options are standardised in the same way ascurrency futures in terms of exchange rate, amount of currency, exercise date and settlement cycle. An advantage of currencyoptions over currency futures is that currency options do not need to be exercised if it is disadvantageous for the holder to doso. Holders of currency options can take advantage of favourable exchange rate movements in the cash market and allowtheir options to lapse. The initial fee paid for the options will still have been incurred, however.

Currency swaps are appropriate for hedging exchange rate risk over a longer period of time than currency futures or currencyoptions. A currency swap is an interest rate swap where the debt positions of the counterparties and the associated interestpayments are in different currencies. A currency swap begins with an exchange of principal, although this may be a notionalexchange rather than a physical exchange. During the life of the swap agreement, the counterparties undertake to serviceeach others’ foreign currency interest payments. At the end of the swap, the initial exchange of principal is reversed.

17


Marks Marks1 (a) Rights issue price 1

Theoretical ex rights price per share 2––––

3

(b) Existing price/earnings ratio 1Revised earnings per share 1Share price using price/earnings method 1

––––3

(c) Discussion of share price comparisons 3–4Calculation of effect on shareholder wealth and comment 1–2


(d) Average dividend growth rate 2Ex div market price per share 2Discussion 2

––––6

(e) Discussion of agency problem 4–5Discussion of share option schemes 4–5


–––25

2 (a) Discussion of effects of interest rate increase 3–4Relevant financial analysis 1–2Interest rate hedging 2–3


(b) Financial analysis 5–6Discussion of overtrading 4–5Conclusion as to overtrading 1


(c) Reduction in financing cost 2Admininstration cost and bad debt savings 1Factor’s fee 1Interest on advance 2Net cost of factoring 1Conclusion 1

––––8

–––25

Marks Marks3 (a) Cost of equity 2

Cost of debt 1Market value of equity 1Market value of debt 1WACC calculation 1

––––6

(b) Inflated cash flows 1Tax on cash flows 1Capital allowance tax benefits 1Working capital – initial investment 1Working capital – incremental investment 1Working capital – recovery 1Net present value calculation 1Comment 1

––––8

(c) Explanation of use of CAPM 5–6Discussion of limitations 6–7


–––25

4 (a) Relevant discussion 7

(b) Market value of each foreign bond 3Total market value of foreign bonds 1

––––4

(c) (i) Explanation of money market hedge 2Illustration of money market hedge 2

––––4

(ii) Comparison with forward market hedge 2

(d) Discussion of natural hedge 1–2Description of other hedging methods 6–7


–––25

18








Pape

r F9





1 KFP Co, a company listed on a major stock market, is looking at its cost of capital as it prepares to make a bid to buya rival unlisted company, NGN. Both companies are in the same business sector. Financial information on KFP Coand NGN is as follows:

KFP Co NGN$m $m $m $m

Non-current assets 36 25Current assets 7 7Current liabilities 3 4

––– –––Net current assets 4 3

––– –––Total assets less current liabilities 40 28

––– –––Ordinary shares, par value 50c 15 5Retained earnings 10 3

––– –––Total equity 25 87% bonds, redeemable at par in seven years’ time 159% bonds, redeemable at par in two years’ time 20

––– –––Total equity and non-current liabilities 40 28

––– –––Other relevant financial information:Risk-free rate of return 4·0%Average return on the market 10·5%Taxation rate 30%

NGN has a cost of equity of 12% per year and has maintained a dividend payout ratio of 45% for several years. Thecurrent earnings per share of the company is 80c per share and its earnings have grown at an average rate of 4·5%per year in recent years.

The ex div share price of KFP Co is $4·20 per share and it has an equity beta of 1·2. The 7% bonds of the companyare trading on an ex interest basis at $94·74 per $100 bond. The price/earnings ratio of KFP Co is eight times.

The directors of KFP Co believe a cash offer for the shares of NGN would have the best chance of success. It hasbeen suggested that a cash offer could be financed by debt.

Required:

(a) Calculate the weighted average cost of capital of KFP Co on a market value weighted basis. (10 marks)

(b) Calculate the total value of the target company, NGN, using the following valuation methods:

(i) Price/earnings ratio method, using the price/earnings ratio of KFP Co; and(ii) Dividend growth model. (6 marks)

(c) Discuss the relationship between capital structure and weighted average cost of capital, and comment onthe suggestion that debt could be used to finance a cash offer for NGN. (9 marks)

(25 marks)

2

2 PV Co is evaluating an investment proposal to manufacture Product W33, which has performed well in test marketingtrials conducted recently by the company’s research and development division. The following information relating tothis investment proposal has now been prepared.

Initial investment $2 millionSelling price (current price terms) $20 per unitExpected selling price inflation 3% per yearVariable operating costs (current price terms) $8 per unitFixed operating costs (current price terms) $170,000 per yearExpected operating cost inflation 4% per year

The research and development division has prepared the following demand forecast as a result of its test marketingtrials. The forecast reflects expected technological change and its effect on the anticipated life-cycle of Product W33.

Year 1 2 3 4Demand (units) 60,000 70,000 120,000 45,000

It is expected that all units of Product W33 produced will be sold, in line with the company’s policy of keeping noinventory of finished goods. No terminal value or machinery scrap value is expected at the end of four years, whenproduction of Product W33 is planned to end. For investment appraisal purposes, PV Co uses a nominal (money)discount rate of 10% per year and a target return on capital employed of 30% per year. Ignore taxation.

Required:

(a) Identify and explain the key stages in the capital investment decision-making process, and the role ofinvestment appraisal in this process. (7 marks)

(b) Calculate the following values for the investment proposal:

(i) net present value;(ii) internal rate of return;(iii) return on capital employed (accounting rate of return) based on average investment; and(iv) discounted payback period. (13 marks)

(c) Discuss your findings in each section of (b) above and advise whether the investment proposal is financiallyacceptable. (5 marks)

(25 marks)

3 [P.T.O.

3 The following financial information relates to HGR Co:

Statement of financial position at the current date (extracts)$000 $000 $000

Non-current assets 48,965Current assetsInventory 8,160Accounts receivable 8,775

–––––––16,935

Current liabilitiesOverdraft 3,800Accounts payable 10,200

–––––––14,000–––––––

Net current assets 2,935–––––––

Total assets less current liabilities 51,900–––––––

Cash flow forecasts from the current date are as follows:

Month 1 Month 2 Month 3Cash operating receipts ($000) 4,220 4,350 3,808Cash operating payments ($000) 3,950 4,100 3,750Six-monthly interest on traded bonds ($000) 200Capital investment ($000) 2,000

The finance director has completed a review of accounts receivable management and has proposed staff training andoperating procedure improvements, which he believes will reduce accounts receivable days to the average sector valueof 53 days. This reduction would take six months to achieve from the current date, with an equal reduction in eachmonth. He has also proposed changes to inventory management methods, which he hopes will reduce inventory daysby two days per month each month over a three-month period from the current date. He does not expect any changein the current level of accounts payable.

HGR Co has an overdraft limit of $4,000,000. Overdraft interest is payable at an annual rate of 6·17% per year, withpayments being made each month based on the opening balance at the start of that month. Credit sales for the yearto the current date were $49,275,000 and cost of sales was $37,230,000. These levels of credit sales and cost ofsales are expected to be maintained in the coming year. Assume that there are 365 working days in each year.

Required:

(a) Discuss the working capital financing strategy of HGR Co. (7 marks)

(b) For HGR Co, calculate:

(i) the bank balance in three months’ time if no action is taken; and(ii) the bank balance in three months’ time if the finance director’s proposals are implemented.

Comment on the forecast cash flow position of HGR Co and recommend a suitable course of action.(10 marks)

(c) Discuss how risks arising from granting credit to foreign customers can be managed and reduced.(8 marks)

(25 marks)

4

4 JJG Co is planning to raise $15 million of new finance for a major expansion of existing business and is consideringa rights issue, a placing or an issue of bonds. The corporate objectives of JJG Co, as stated in its Annual Report, areto maximise the wealth of its shareholders and to achieve continuous growth in earnings per share. Recent financialinformation on JJG Co is as follows:

2008 2007 2006 2005Turnover ($m) 28·0 24·0 19·1 16·8Profit before interest and tax ($m) 9·8 8·5 7·5 6·8Earnings ($m) 5·5 4·7 4·1 3·6Dividends ($m) 2·2 1·9 1·6 1·6

Ordinary shares ($m) 5·5 5·5 5·5 5·5Reserves ($m) 13·7 10·4 7·6 5·18% Bonds, redeemable 2015 ($m) 20 20 20 20

Share price ($) 8·64 5·74 3·35 2·67

The par value of the shares of JJG Co is $1·00 per share. The general level of inflation has averaged 4% per year inthe period under consideration. The bonds of JJG Co are currently trading at their par value of $100. The followingvalues for the business sector of JJG Co are available:

Average return on capital employed 25%Average return on shareholders’ funds 20%Average interest coverage ratio 20 timesAverage debt/equity ratio (market value basis) 50%Return predicted by the capital asset pricing model 14%

Required:

(a) Evaluate the financial performance of JJG Co, and analyse and discuss the extent to which the company hasachieved its stated corporate objectives of:

(i) maximising the wealth of its shareholders;(ii) achieving continuous growth in earnings per share.

Note: up to 7 marks are available for financial analysis.(12 marks)

(b) If the new finance is raised via a rights issue at $7·50 per share and the major expansion of business hasnot yet begun, calculate and comment on the effect of the rights issue on:

(i) the share price of JJG Co;(ii) the earnings per share of the company; and(iii) the debt/equity ratio. (6 marks)

(c) Analyse and discuss the relative merits of a rights issue, a placing and an issue of bonds as ways of raisingthe finance for the expansion. (7 marks)

(25 marks)

5 [P.T.O.

6

Formulae Sheet


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7 [P.T.O.

Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

8

Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers

11


1 (a) Weighted average cost of capital (WACC) calculation

Cost of equity of KFP Co = 4·0 + (1·2 x (10·5 – 4·0)) = 4·0 + 7·8 = 11·8% using the capital asset pricing model

To calculate the after-tax cost of debt, linear interpolation is neededAfter-tax interest payment = 100 x 0·07 x (1 – 0·3) = $4·90

Year Cash flow $ 10% discount PV ($) 5% discount PV ($)0 Market value (94·74) 1·000 (94·74) 1·000 (94·74)1 to 7 Interest 4·9 4·868 23·85 5·786 28·357 Redemption 100 0·513 51·30 0·711 71·10

––––– –––––(19·59) 4·71––––– –––––

After-tax cost of debt = 5 + ((10 – 5) x 4·71)/(4·71 + 19·59) = 5 + 1·0 = 6·0%

Number of shares issued by KFP Co = $15m/0·5 = 30 million sharesMarket value of equity = 30m x 4·2 = $126 millionMarket value of bonds issued by KFP Co = 15m x 94·74/100 = $14·211 millionTotal value of company = 126 + 14·211 = $140·211 million

WACC = ((11·8 x 126) + (6·0 x 14·211))/140·211 = 11·2%

(b) (i) Price/earnings ratio methodEarnings per share of NGN = 80c per sharePrice/earnings ratio of KFP Co = 8Share price of NGN = 80 x 8 = 640c or $6·40Number of ordinary shares of NGN = 5/0·5 = 10 million sharesValue of NGN = 6·40 x 10m = $64 million

However, it can be argued that a reduction in the applied price/earnings ratio is needed as NGN is unlisted and thereforeits shares are more difficult to buy and sell than those of a listed company such as KFP Co. If we reduce the appliedprice/earnings ratio by 10% (other similar percentage reductions would be acceptable), it becomes 7·2 times and thevalue of NGN would be (80/100) x 7·2 x 10m = $57·6 million

(ii) Dividend growth modelDividend per share of NGN = 80c x 0·45 = 36c per shareSince the payout ratio has been maintained for several years, recent earnings growth is the same as recent dividendgrowth, i.e. 4·5%. Assuming that this dividend growth continues in the future, the future dividend growth rate will be4·5%.Share price from dividend growth model = (36 x 1·045)/ (0·12 – 0·045) = 502c or $5·02Value of NGN = 5·02 x 10m = $50·2 million

(c) A discussion of capital structure could start from recognising that equity is more expensive than debt because of the relativerisk of the two sources of finance. Equity is riskier than debt and so equity is more expensive than debt. This does not dependon the tax efficiency of debt, since we can assume that no taxes exist. We can also assume that as a company gears up, itreplaces equity with debt. This means that the company’s capital base remains constant and its weighted average cost ofcapital (WACC) is not affected by increasing investment.

The traditional view of capital structure assumes a non-linear relationship between the cost of equity and financial risk. As acompany gears up, there is initially very little increase in the cost of equity and the WACC decreases because the cost of debtis less than the cost of equity. A point is reached, however, where the cost of equity rises at a rate that exceeds the reductioneffect of cheaper debt and the WACC starts to increase. In the traditional view, therefore, a minimum WACC exists and, as aresult, a maximum value of the company arises.

Modigliani and Miller assumed a perfect capital market and a linear relationship between the cost of equity and financial risk.They argued that, as a company geared up, the cost of equity increased at a rate that exactly cancelled out the reductioneffect of cheaper debt. WACC was therefore constant at all levels of gearing and no optimal capital structure, where the valueof the company was at a maximum, could be found.

It was argued that the no-tax assumption made by Modigliani and Miller was unrealistic, since in the real world interestpayments were an allowable expense in calculating taxable profit and so the effective cost of debt was reduced by its taxefficiency. They revised their model to include this tax effect and showed that, as a result, the WACC decreased in a linearfashion as a company geared up. The value of the company increased by the value of the ‘tax shield’ and an optimal capitalstructure would result by gearing up as much as possible.

It was pointed out that market imperfections associated with high levels of gearing, such as bankruptcy risk and agency costs,would limit the extent to which a company could gear up. In practice, therefore, it appears that companies can reduce theirWACC by increasing gearing, while avoiding the financial distress that can arise at high levels of gearing.

It has further been suggested that companies choose the source of finance which, for one reason or another, is easiest forthem to access (pecking order theory). This results in an initial preference for retained earnings, followed by a preference fordebt before turning to equity. The view suggests that companies may not in practice seek to minimise their WACC (andconsequently maximise company value and shareholder wealth).

Turning to the suggestion that debt could be used to finance a cash bid for NGN, the current and post acquisition capitalstructures and their relative gearing levels should be considered, as well as the amount of debt finance that would be needed.Earlier calculations suggest that at least $58m would be needed, ignoring any premium paid to persuade target companyshareholders to sell their shares. The current debt/equity ratio of KFP Co is 60% (15m/25m). The debt of the company wouldincrease by $58m in order to finance the bid and by a further $20m after the acquisition, due to taking on the existing debtof NGN, giving a total of $93m. Ignoring other factors, the gearing would increase to 372% (93m/25m). KFP Co would needto consider how it could service this dangerously high level of gearing and deal with the significant risk of bankruptcy that itmight create. It would also need to consider whether the benefits arising from the acquisition of NGN would compensate forthe significant increase in financial risk and bankruptcy risk resulting from using debt finance.

2 (a) The key stages in the capital investment decision-making process are identifying investment opportunities, screeninginvestment proposals, analysing and evaluating investment proposals, approving investment proposals, and implementing,monitoring and reviewing investments.

Identifying investment opportunitiesInvestment opportunities or proposals could arise from analysis of strategic choices, analysis of the business environment,research and development, or legal requirements. The key requirement is that investment proposals should support theachievement of organisational objectives.

Screening investment proposalsIn the real world, capital markets are imperfect, so it is usual for companies to be restricted in the amount of finance availablefor capital investment. Companies therefore need to choose between competing investment proposals and select those withthe best strategic fit and the most appropriate use of economic resources.

Analysing and evaluating investment proposalsCandidate investment proposals need to be analysed in depth and evaluated to determine which offer the most attractiveopportunities to achieve organisational objectives, for example to increase shareholder wealth. This is the stage whereinvestment appraisal plays a key role, indicating for example which investment proposals have the highest net present value.

Approving investment proposalsThe most suitable investment proposals are passed to the relevant level of authority for consideration and approval. Very largeproposals may require approval by the board of directors, while smaller proposals may be approved at divisional level, andso on. Once approval has been given, implementation can begin.

Implementing, monitoring and reviewing investmentsThe time required to implement the investment proposal or project will depend on its size and complexity, and is likely to beseveral months. Following implementation, the investment project must be monitored to ensure that the expected results arebeing achieved and the performance is as expected. The whole of the investment decision-making process should also bereviewed in order to facilitate organisational learning and to improve future investment decisions.

(b) (i) Calculation of NPV

Year 0 1 2 3 4$ $ $ $ $

Investment (2,000,000)Income 1,236,000 1,485,400 2,622,000 1,012,950Operating costs 676,000 789,372 1,271,227 620,076

–––––––––– –––––––––– –––––––––– –––––––––– ––––––––––Net cash flow (2,000,000) 560,000 696,028 1,350,773 392,874Discount at 10% 1·000 0·909 0·826 0·751 0·683

–––––––––– –––––––––– –––––––––– –––––––––– ––––––––––Present values (2,000,000) 509,040 574,919 1,014,430 268,333

–––––––––– –––––––––– –––––––––– –––––––––– ––––––––––

Net present value $366,722

Workings

Calculation of incomeYear 1 2 3 4Inflated selling price ($/unit) 20·60 21·22 21·85 22·51Demand (units/year) 60,000 70,000 120,000 45,000Income ($/year) 1,236,000 1,485,400 2,622,000 1,012,950

12

13

Calculation of operating costsYear 1 2 3 4Inflated variable cost ($/unit) 8·32 8·65 9·00 9·36Demand (units/year) 60,000 70,000 120,000 45,000Variable costs ($/year) 499,200 605,500 1,080,000 421,200Inflated fixed costs ($/year) 176,800 183,872 191,227 198,876

–––––––––– –––––––––– –––––––––– ––––––––––Operating costs ($/year) 676,000 789,372 1,271,227 620,076

–––––––––– –––––––––– –––––––––– ––––––––––

Alternative calculation of operating costsYear 1 2 3 4Variable cost ($/unit) 8 8 8 8Demand (units/year) 60,000 70,000 120,000 45,000Variable costs ($/year) 480,000 560,000 960,000 360,000Fixed costs ($/year) 170,000 170,000 170,000 170,000

–––––––––– –––––––––– –––––––––– ––––––––––Operating costs ($/year) 650,000 730,000 1,130,000 530,000Inflated costs ($/year) 676,000 789,568 1,271,096 620,025

(ii) Calculation of internal rate of return

Year 0 1 2 3 4$ $ $ $ $

Net cash flow (2,000,000) 560,000 696,028 1,350,773 392,874Discount at 20% 1·000) 0·833 0·694 0·579 0·482

–––––––––– –––––––––– –––––––––– –––––––––– ––––––––––Present values (2,000,000) 466,480 483,043 782,098 189,365

–––––––––– –––––––––– –––––––––– –––––––––– ––––––––––

Net present value ($79,014)

Internal rate of return = 10 + ((20 – 10) x 366,722)/(366,722 + 79,014) = 10 + 8·2 = 18·2%

(iii) Calculation of return on capital employed

Total cash inflow = 560,000 + 696,028 + 1,350,773 + 392,874 = $2,999,675Total depreciation and initial investment are same, as there is no scrap valueTotal accounting profit = 2,999,675 – 2,000,000 = $999,675Average annual accounting profit = 999,675/4 = $249,919Average investment = 2,000,000/2 = $1,000,000Return on capital employed = 100 x 249,919/1,000,000 = 25%

(iv) Calculation of discounted payback

Year 0 1 2 3 4$ $ $ $ $

PV of cash flows (2,000,000) 509,040) 574,919) 1,014,430 268,333Cumulative PV (2,000,000) (1,490,960) (916,041) 98,389 366,722

Discounted payback period = 2 + (916,041/1,014,430) = 2 + 0·9 = 2·9 years

(c) The investment proposal has a positive net present value (NPV) of $366,722 and is therefore financially acceptable. Theresults of the other investment appraisal methods do not alter this financial acceptability, as the NPV decision rule will alwaysoffer the correct investment advice.

The internal rate of return (IRR) method also recommends accepting the investment proposal, since the IRR of 18·2% isgreater than the 10% return required by PV Co. If the advice offered by the IRR method differed from that offered by the NPVmethod, the advice offered by the NPV method would be preferred.

The calculated return on capital employed of 25% is less than the target return of 30%, but as indicated earlier, theinvestment proposal is financially acceptable as it has a positive NPV. The reason why PV Co has a target return on capitalemployed of 30% should be investigated. This may be an out-of-date hurdle rate that has not been updated for changedeconomic circumstances.

The discounted payback period of 2·9 years is a significant proportion of the forecast life of the investment proposal of fouryears, a time period which the information provided suggests is limited by technological change. The sensitivity of theinvestment proposal to changes in demand and life-cycle period should be analysed, since an earlier onset of technologicalobsolescence may have a significant impact on its financial acceptability.

3 (a) When considering the financing of working capital, it is useful to divide current assets into fluctuating current assets andpermanent current assets. Fluctuating current assets represent changes in the level of current assets due to theunpredictability of business activity. Permanent current assets represent the core level of investment in current assets neededto support a given level of turnover or business activity. As turnover or level of business activity increases, the level ofpermanent current assets will also increase. This relationship can be measured by the ratio of turnover to net current assets.

14

The financing choice as far as working capital is concerned is between short-term and long-term finance. Short-term financeis more flexible than long-term finance: an overdraft, for example, is used by a business organisation as the need arises andvariable interest is charged on the outstanding balance. Short-term finance is also more risky than long-term finance: anoverdraft facility may be withdrawn, or a short-term loan may be renewed on less favourable terms. In terms of cost, the termstructure of interest rates suggests that short-term debt finance has a lower cost than long-term debt finance.

The matching principle suggests that long-term finance should be used for long-term investment. Applying this principle toworking capital financing, long-term finance should be matched with permanent current assets and non-current assets. Afinancing policy with this objective is called a ‘matching policy’. HGR Co is not using this financing policy, since of the$16,935,000 of current assets, $14,000,000 or 83% is financed from short-term sources (overdraft and trade payables)and only $2,935,000 or 17% is financed from a long-term source, in this case equity finance (shareholders’ funds) or tradedbonds.

The financing policy or approach taken by HGR Co towards the financing of working capital, where short-term finance ispreferred, is called an aggressive policy. Reliance on short-term finance makes this riskier than a matching approach, but alsomore profitable due to the lower cost of short-term finance. Following an aggressive approach to financing can lead toovertrading (undercapitalisation) and the possibility of liquidity problems.

(b) Bank balance in three months’ time if no action is taken:

Month 1 2 3$000 $000 $000

Receipts 4,220 4,350 3,808Payments (3,950) (4,100) (3,750)Interest on bonds (200)Overdraft interest (19) (18) (18)Capital investment (2,000)

–––––– –––––– –––––––Net cash flow 251 32 (1,960)Opening balance (3,800) (3,549) (3,517)

–––––– –––––– –––––––Closing balance (3,549) (3,517) (5,477)

–––––– –––––– –––––––

Bank balance in three months’ time if the finance director’s proposals are implemented:

Month 1 2 3$000 $000 $000

Receipts 4,220 4,350 3,808Payments (3,950) (4,100) (3,750)Interest on bonds (200)Overdraft interest (19) (15) (13)Capital investment (2,000)Accounts receivable 270 270 270Inventory 204 204 204

–––––– –––––– ––––––Net cash flow 725 509 (1,481)Opening balance (3,800) (3,075) (2,566)

–––––– –––––– ––––––Closing balance (3,075) (2,566) (4,047)

–––––– –––––– ––––––

Workings:

Reduction in accounts receivable daysCurrent accounts receivable days = (8,775/49,275) x 365 = 65 daysReduction in days over six months = 65 – 53 = 12 daysMonthly reduction = 12/6 = 2 daysEach receivables day is equivalent to 8,775,000/65 =$135,000(Alternatively, each receivables day is equivalent to 49,275,000/365 =$135,000)Monthly reduction in accounts receivable = 2 x 135,000 = $270,000

Reduction in inventory daysCurrent inventory days = (8,160/37,230) x 365 = 80 daysEach inventory day is equivalent to 8,160,000/80 = $102,000(Alternatively, each inventory day = 37,230,000/365 = $102,000)Monthly reduction in inventory = 102,000 x 2 = $204,000

Overdraft interest calculationsMonthly overdraft interest rate = 1·06171/12 = 1·005 or 0·5%

If no action is taken: Period 1 interest = 3,800,000 x 0·005 = $19,000Period 2 interest = 3,549,000 x 0·005 = $17,745 or $18,000Period 3 interest = 3,517,000 x 0·005 = $17,585 or $18,000

If action is taken: Period 1 interest = 3,800,000 x 0.005 = $19,000Period 2 interest = 3,075,000 x 0.005 = $15,375 or $15,000Period 3 interest = 2,566,000 x 0.005 = $12,830 or $13,000

DiscussionIf no action is taken, the cash flow forecast shows that HGR Co will exceed its overdraft limit of $4 million by $1·48 millionin three months’ time. If the finance director’s proposals are implemented, there is a positive effect on the bank balance, butthe overdraft limit is still exceeded in three months’ time, although only by $47,000 rather than by $1·47 million.

In each of the three months following that, the continuing reduction in accounts receivable days will improve the bank balanceby $270,000 per month. Without further information on operating receipts and payments, it cannot be forecast whether thebank balance will return to less than the limit, or even continue to improve.

The main reason for the problem with the bank balance is the $2 million capital expenditure. Purchase of non-current assetsshould not be financed by an overdraft, but a long-term source of finance such as equity or bonds. If the capital expenditurewere removed from the area of working capital management, the overdraft balance at the end of three months would be$3·48 million if no action were taken and $2·05 million if the finance director’s proposals were implemented. Given thatHGR Co has almost $50 million of non-current assets that could possibly be used as security, raising long-term debt througheither a bank loan or a bond issue appears to be sensible. Assuming a bond interest rate of 10% per year, current long-termdebt in the form of traded bonds is approximately ($200m x 2)/0·1 = $4m, which is much less than the amount of non-current assets.

A suitable course of action for HGR Co to follow would therefore be, firstly, to implement the finance director’s proposals and,secondly, to finance the capital expenditure from a long-term source. Consideration could also be given to using some long-term debt finance to reduce the overdraft and to reduce the level of accounts payable, currently standing at 100 days.

(c) When credit is granted to foreign customers, two problems may become especially significant. First, the longer distances overwhich trade takes place and the more complex nature of trade transactions and their elements means foreign accountsreceivable need more investment than their domestic counterparts. Longer transaction times increase accounts receivablebalances and hence the level of financing and financing costs. Second, the risk of bad debts is higher with foreign accountsreceivable than with their domestic counterparts. In order to manage and reduce credit risks, therefore, exporters seek toreduce the risk of bad debt and to reduce the level of investment in foreign accounts receivable.

Many foreign transactions are on ‘open account’, which is an agreement to settle the amount outstanding on a predetermineddate. Open account reflects a good business relationship between importer and exporter. It also carries the highest risk of non-payment.

One way to reduce investment in foreign accounts receivable is to agree early payment with an importer, for example bypayment in advance, payment on shipment, or cash on delivery. These terms of trade are unlikely to be competitive, however,and it is more likely that an exporter will seek to receive cash in advance of payment being made by the customer.

One way to accelerate cash receipts is to use bill finance. Bills of exchange with a signed agreement to pay the exporter onan agreed future date, supported by a documentary letter of credit, can be discounted by a bank to give immediate funds.This discounting is without recourse if bills of exchange have been countersigned by the importer’s bank.

Documentary letters of credit are a payment guarantee backed by one or more banks. They carry almost no risk, provided theexporter complies with the terms and conditions contained in the letter of credit. The exporter must present the documentsstated in the letter, such as bills of lading, shipping documents, bills of exchange, and so on, when seeking payment. As eachsupporting document relates to a key aspect of the overall transaction, letters of credit give security to the importer as well asthe exporter.

Companies can also manage and reduce risk by gathering appropriate information with which to assess the creditworthinessof new customers, such as bank references and credit reports.

Insurance can also be used to cover some of the risks associated with giving credit to foreign customers. This would avoidthe cost of seeking to recover cash due from foreign accounts receivable through a foreign legal system, where the exportercould be at a disadvantage due to a lack of local or specialist knowledge.

Export factoring can also be considered, where the exporter pays for the specialist expertise of the factor as a way of reducinginvestment in foreign accounts receivable and reducing the incidence of bad debts.

15

4 (a) Financial Analysis

2008 2007 2006 2005Turnover ($m) 28·0 24·0 19·1 16·8Turnover growth 17% 26% 14%Geometric average growth: 18·6%

Profit before interest and tax ($m) 9·8 8·5 7·5 6·8PBIT growth 15% 13% 10%Geometric average growth: 13·0%

Earnings ($m) 5·5 4·7 4·1 3·6Earnings per share (cents) 100 85 75 66EPS growth 18% 13% 14%Geometric average growth: 14·9%

Dividends ($m) 2·2 1·9 1·6 1·6Dividends per share (cents) 40 35 29 29DPS growth 14% 21% nilGeometric average growth: 11·3%

Ordinary shares ($m) 5·5 5·5 5·5 5·5Reserves ($m) 13·7 10·4 7·6 5·1

––––– ––––– ––––– –––––Shareholders’ funds ($ 19·2 15·9 13·1 10·68% Bonds, redeemable 2015 ($m) 20 20 20 20

––––– ––––– ––––– –––––Capital employed ($m) 39·2 35·9 33·1 30.6

Profit before interest and tax ($m) 9·8 8·5 7·5 6·8Return on capital employed 25% 24% 23% 22%

Earnings ($m) 5·5 4·7 4·1 3·6Return on shareholders’ funds 29% 30% 31% 34%

8% Bonds, redeemable 2015 ($m) 20 20 20 20Market value of equity ($m) 47·5 31·6 18·4 14·7Debt/equity ratio (market value) 42% 63% 109% 136%

Share price (cents) 864 574 335 267Dividends per share (cents) 40 35 29Total shareholder return 58% 82% 36%

Achievement of corporate objectivesJJG Co has shareholder wealth maximisation as an objective. The wealth of shareholders is increased by dividends receivedand capital gains on shares owned. Total shareholder return compares the sum of the dividend received and the capital gainwith the opening share price. The shareholders of JJG Co had a return of 58% in 2008, compared with a return predictedby the capital asset pricing model of 14%. The lowest return shareholders have received was 21% and the highest returnwas 82%. On this basis, the shareholders of the company have experienced a significant increase in wealth. It is debatablewhether this has been as a result of the actions of the company, however. Share prices may increase irrespective of the actionsand decisions of managers, or even despite them. In fact, looking at the dividend per share history of the company, there wasone year (2006) where dividends were constant, even though earnings per share increased. It is also difficult to know whenwealth has been maximised.

Another objective of the company was to achieve a continuous increase in earnings per share. Analysis shows that earningsper share increased every year, with an average increase of 14·9%. This objective appears to have been achieved.

Comment on financial performanceReturn on capital employed (ROCE) has been growing towards the sector average of 25% on a year-by-year basis from 22%in 2005. This steady growth in the primary accounting ratio can be contrasted with irregular growth in turnover, the reasonsfor which are unknown.

Return on shareholders’ funds has been consistently higher than the average for the sector. This may be due more to thecapital structure of JJG Co than to good performance by the company, however, in the sense that shareholders’ funds aresmaller on a book value basis than the long-term debt capital. In every previous year but 2008 the gearing of the companywas higher than the sector average.

(b) Calculation of theoretical ex rights per shareCurrent share price = $8·64 per shareCurrent number of shares = 5·5 million sharesFinance to be raised = $15mRights issue price = $7·50 per shareNumber of shares issued = 15m/7·50 = 2 million sharesTheoretical ex rights price per share = ((5·5m x 8·64) + (2m x 7·50))/7·5m = $8·34 per shareThe share price would fall from $8·64 to $8·34 per shareHowever, there would be no effect on shareholder wealth

16

Effect of rights issue on earnings per shareCurrent EPS = 100 cents per shareRevised EPS = 100 x 5·5m/7·5m = 73 cents per shareThe EPS would fall from 100 cents per share to 73 cents per shareHowever, as mentioned earlier, there would be no effect on shareholder wealth

Effect of rights issue on the debt/equity ratioCurrent debt/equity ratio = 100 x 20/47·5 = 42%Revised market value of equity = 7·5m x 8·34 = $62·55 millionRevised debt/equity ratio = 100 x 20/62·55 = 32%The debt/equity ratio would fall from 42% to 32%, which is well below the sector average value and would signal a reductionin financial risk

(c) The current debt/equity ratio of JJG Co is 42% (20/47·5). Although this is less than the sector average value of 50%, it ismore useful from a financial risk perspective to look at the extent to which interest payments are covered by profits.

2008 2007 2006 2005Profit before interest and tax ($m) 9·8 8·5 7·5 6·8Bond interest ($m) 1·6 1·6 1·6 1·6Interest coverage ratio (times) 6·1 5·3 4·7 4·3

The interest on the bond issue is $1·6 million (8% of $20m), giving an interest coverage ratio of 6·1 times. If JJG Co hasoverdraft finance, the interest coverage ratio will be lower than this, but there is insufficient information to determine if anoverdraft exists. The interest coverage ratio is not only below the sector average, it is also low enough to be a cause forconcern. While the ratio shows an upward trend over the period under consideration, it still indicates that an issue of furtherdebt would be unwise.

A placing, or any issue of new shares such as a rights issue or a public offer, would decrease gearing. If the expansion ofbusiness results in an increase in profit before interest and tax, the interest coverage ratio will increase and financial risk willfall. Given the current financial position of JJG Co, a decrease in financial risk is certainly preferable to an increase.

A placing will dilute ownership and control, providing the new equity issue is taken up by new institutional shareholders,while a rights issue will not dilute ownership and control, providing existing shareholders take up their rights. A bond issuedoes not have ownership and control implications, although restrictive or negative covenants in bond issue documents canlimit the actions of a company and its managers.

All three financing choices are long-term sources of finance and so are appropriate for a long-term investment such as theproposed expansion of existing business.

Equity issues such as a placing and a rights issue do not require security. No information is provided on the non-current assetsof JJG Co, but it is likely that the existing bond issue is secured. If a new bond issue was being considered, JJG Co wouldneed to consider whether it had sufficient non-current assets to offer as security, although it is likely that new non-currentassets would be bought as part of the business expansion.

17


Marks Marks1 (a) Cost of equity calculation 2

Correct use of taxation rate 1Cost of debt calculation 3Market value of equity 1Market value of debt 1WACC calculation 2

–––10

(b) Price/earnings ratio value of company 2Current dividend per share 1Dividend growth model value of company 3

–––6

(c) Traditional view of capital structure 1–2Miller and Modigliani and capital structure 2–3Market imperfections 1–2Other relevant discussion 1–2Comment on debt finance for cash offer 2–3

–––Maximum 9

–––25

–––

2 (a) Identification of decision-making stages 1–2Explanation of decision-making stages 4–6Role of investment appraisal 1–2

–––Maximum 7

(b) Inflated income 2Inflated operating costs 2Discount factors 1Net present value 1Internal rate of return 3Return on capital employed 2Discounted payback 2

–––13

(c) Discussion of investment appraisal findings 4Advice on acceptability of project 1

–––5

–––25

–––

19

Marks Marks3 (a) Analysis of current assets 1–2

Short-term and long-term finance 2–3Matching principle 1–2Financing approach used by company 1–2

–––Maximum 7

(b) Bank balance if no action is taken 2Bank balance if action is taken 5Working capital management implications 1–2Advice on course of action 1–2

–––Maximum 10

(c) Relevant discussion 8–––25

–––

4 (a) Relevant financial analysis 6–7Shareholder wealth discussion 2–3Earnings per share growth discussion 2–3Comment on financial performance 1–2

–––Maximum 12

(b) Share price calculation and comment 2–3Earnings per share calculation and comment 2–3Debt/equity ratio calculation and comment 1–2

–––Maximum 6

(c) Financial analysis 1–2Discussion of rights issue and placing 2–3Discussion of bond issue 2–3

–––Maximum 7

–––25

–––

20








Pape

r F9





1 ASOP Co is considering an investment in new technology that will reduce operating costs through increasing energyefficiency and decreasing pollution. The new technology will cost $1 million and have a four-year life, at the end ofwhich it will have a scrap value of $100,000.

A licence fee of $104,000 is payable at the end of the first year. This licence fee will increase by 4% per year in eachsubsequent year.

The new technology is expected to reduce operating costs by $5·80 per unit in current price terms. This reduction inoperating costs is before taking account of expected inflation of 5% per year.

Forecast production volumes over the life of the new technology are expected to be as follows:

Year 1 2 3 4Production (units per year) 60,000 75,000 95,000 80,000

If ASOP Co bought the new technology, it would finance the purchase through a four-year loan paying interest at anannual before-tax rate of 8·6% per year.

Alternatively, ASOP Co could lease the new technology. The company would pay four annual lease rentals of$380,000 per year, payable in advance at the start of each year. The annual lease rentals include the cost of thelicence fee.

If ASOP Co buys the new technology it can claim capital allowances on the investment on a 25% reducing balancebasis. The company pays taxation one year in arrears at an annual rate of 30%. ASOP Co has an after-tax weightedaverage cost of capital of 11% per year.

Required:

(a) Based on financing cash flows only, calculate and determine whether ASOP Co should lease or buy the newtechnology. (11 marks)

(b) Using a nominal terms approach, calculate the net present value of buying the new technology and advisewhether ASOP Co should undertake the proposed investment. (6 marks)

(c) Discuss and illustrate how ASOP Co can use equivalent annual cost or equivalent annual benefit to choosebetween new technologies with different expected lives. (3 marks)

(d) Discuss how an optimal investment schedule can be formulated when capital is rationed and investmentprojects are either:

(i) divisible; or(ii) non-divisible. (5 marks)

(25 marks)

2

2 DD Co has a dividend payout ratio of 40% and has maintained this payout ratio for several years. The current dividendper share of the company is 50c per share and it expects that its next dividend per share, payable in one year’s time,will be 52c per share.

The capital structure of the company is as follows:

$m $mEquityOrdinary shares (par value $1 per share) 25Reserves 35

–––60

DebtBond A (par value $100) 20Bond B (par value $100) 10

–––30

–––90

–––

Bond A will be redeemed at par in ten years’ time and pays annual interest of 9%. The current ex interest marketprice of the bond is $95·08.

Bond B will be redeemed at par in four years’ time and pays annual interest of 8%. The cost of debt of this bond is7·82% per year. The current ex interest market price of the bond is $102·01.

Bond A and Bond B were issued at the same time.

DD Co has an equity beta of 1·2. The risk-free rate of return is 4% per year and the average return on the market of11% per year. Ignore taxation.

Required:

(a) Calculate the cost of debt of Bond A. (3 marks)

(b) Discuss the reasons why different bonds of the same company might have different costs of debt.(6 marks)

(c) Calculate the following values for DD Co:

(i) cost of equity, using the capital asset pricing model; (2 marks)

(ii) ex dividend share price, using the dividend growth model; (3 marks)

(iii) capital gearing (debt divided by debt plus equity) using market values; and (2 marks)

(iv) market value weighted average cost of capital. (2 marks)

(d) Discuss whether a change in dividend policy will affect the share price of DD Co. (7 marks)

(25 marks)

3 [P.T.O.

3 NG Co has exported products to Europe for several years and has an established market presence there. It now plansto increase its market share through investing in a storage, packing and distribution network. The investment will cost€13 million and is to be financed by equal amounts of equity and debt. The return in euros before interest andtaxation on the total amount invested is forecast to be 20% per year.

The debt finance will be provided by a €6·5 million bond issue on a large European stock market. The interest rateon the bond issue is 8% per year, with interest being payable in euros on a six-monthly basis.

The equity finance will be raised in dollars by a rights issue in the home country of NG Co. Issue costs for the rightsissue will be $312,000. The rights issue price will be at a 17% discount to the current share price. The current shareprice of NG Co is $4·00 per share and the market capitalisation of the company is $100 million.

NG Co pays taxation in its home country at a rate of 30% per year. The currency of its home country is the dollar.The current price/earnings ratio of the company, which is not expected to change as a result of the proposedinvestment, is 10 times.

The spot exchange rate is 1·3000 €/$. All European customers pay on a credit basis in euros.

Required:

(a) Calculate the theoretical ex rights price per share after the rights issue. (4 marks)

(b) Evaluate the effect of the European investment on:

(i) the earnings per share of NG Co; and(ii) the wealth of the shareholders of NG Co.

Assume that the current spot rate and earnings from existing operations are both constant. (9 marks)

(c) Explain the difference between transaction risk and translation risk, illustrating your answer using theinformation provided. (4 marks)

(d) The six-month forward rate is 1·2876 €/$ and the twelve-month forward rate is 1·2752 €/$. NG Co can earn2·8% per year on short-term euro deposits and can borrow short-term in dollars at 5·3% per year.

Identify and briefly discuss exchange rate hedging methods that could be used by NG Co. Providecalculations that illustrate TWO of the hedging methods that you have identified. (8 marks)

(25 marks)

4

4 APX Co achieved a turnover of $16 million in the year that has just ended and expects turnover growth of 8·4% inthe next year. Cost of sales in the year that has just ended was $10·88 million and other expenses were $1·44 million.

The financial statements of APX Co for the year that has just ended contain the following statement of financialposition:

$m $mNon-current assets 22·0Current assetsInventory 2·4Trade receivables 2·2

–––4·6

––––Total assets 26·6

––––

Equity finance: $m $mOrdinary shares 5·0Reserves 7·5

–––12·5

Long-term bank loan 10·0––––22·5

Current liabilitiesTrade payables 1·9Overdraft 2·2

–––4·1

––––Total liabilities 26·6

––––

The long-term bank loan has a fixed annual interest rate of 8% per year. APX Co pays taxation at an annual rate of30% per year.

The following accounting ratios have been forecast for the next year:

Gross profit margin: 30%Operating profit margin: 20%Dividend payout ratio: 50%Inventory turnover period: 110 daysTrade receivables period: 65 daysTrade payables period: 75 days

Overdraft interest in the next year is forecast to be $140,000. No change is expected in the level of non-current assetsand depreciation should be ignored.

Required:

(a) Discuss the role of financial intermediaries in providing short-term finance for use by business organisations.(4 marks)

(b) Prepare the following forecast financial statements for APX Co using the information provided:

(i) an income statement for the next year; and(ii) a statement of financial position at the end of the next year. (9 marks)

(c) Analyse and discuss the working capital financing policy of APX Co. (6 marks)

(d) Analyse and discuss the forecast financial performance of APX Co in terms of working capital management.(6 marks)

(25 marks)

5 [P.T.O.

6

Formulae Sheet


Miller–Orr Model



The Growth Model



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13

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7 [P.T.O.

Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

8

Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers


1 (a) After-tax cost of borrowing = 8·6 x (1 – 0·3) = 6% per year

Evaluation of leasing

Year Cash flow Amount ($) 6% Discount factors Present value ($)0–3 Lease rentals (380,000) 1·000 + 2·673 = 3·673 (1,395,740)2–5 Tax savings 114,000 4·212 – 0·943 = 3·269 372,666

–––––––––––(1,023,074)

–––––––––––

Present value of cost of leasing = $1,023,074

Evaluation of borrowing to buy

Licence Tax Net cash 6% discount PresentYear Capital fee benefits flow factors value

$ $ $ $ $ 0 (1,000,000) (1,000,000) 1·000 (1,000,000)1 (104,000) (104,000) 0·943 (98,072)2 (108,160) 106,200 (1,960) 0·890 (1,744)3 (112,486) 88,698 (23,788) 0·840 (19,982)4 100,000 (116,986) 75,934 58,948 0·792 46,6875 131,659 131,659 0·747 98,349

–––––––––(974,762)

–––––––––

Present value of cost of borrowing to buy = $974,762

Workings

Licence fee Year Capital allowance Tax benefits tax benefits Total

$ $ $ $2 1,000,000 x 0·25 = 250,000 75,000 31,200 106,2003 750,000 x 0·25 = 187,500 56,250 32,448 88,6984 562,500 x 0·25 =140,625 42,188 33,746 75,9345 421,875 – 100,000 = 321,875 96,563 35,096 131,659

ASOP Co should buy the new technology, since the present cost of borrowing to buy is lower than the present cost of leasing.

(b) Nominal terms net present value analysis

Year 1 2 3 4 5$ $ $ $ $

Cost savings 365,400 479,250 637,450 564,000Tax liabilities (109,620) (143,775) (191,235) (169,200)

–––––––– –––––––– ––––––––– ––––––––– –––––––––Net cash flow 365,400 369,630 493,675 372,765 (169,200)Discount at 11% 0·901 0·812 0·731 0·659 0·593

–––––––– –––––––– ––––––––– ––––––––– –––––––––Present values 329,225 300,140 360,876 245,652 (100,336)

–––––––– –––––––– ––––––––– ––––––––– –––––––––

Present value of benefits 1,135,557Present cost of financing (974,762)

––––––––––Net present value 160,795

––––––––––

The investment in new technology is acceptable on financial grounds, as it has a positive net present value of $160,795.

Workings

Year 1 2 3 4Operating cost saving ($/unit) 6·09 6·39 6·71 7·05Production (units/year) 60,000 75,000 95,000 80,000

–––––––– –––––––– –––––––– ––––––––Operating cost savings ($/year) 365,400 479,250 637,450 564,000Tax liabilities at 30% ($/year) 109,620 143,775 191,235 169,200

(Examiner’s note: Including the financing cash flows in the NPV evaluation and discounting them by the WACC of 11% isalso acceptable)

11

(c) The equivalent annual cost or benefit method can be used to calculate the equal annual amount of cost or benefit which,when discounted at the appropriate cost of capital, produces the same present value of cost or net present value as a set ofvarying annual costs or benefits.

For example, the net present value (NPV) of investing in the new technology of $160,795 in part (b) was calculated usinga weighted average cost of capital (WACC) of 11% over an expected life of four years. The annuity factor for 11% and fouryears is 3·102. The equivalent annual benefit (EAB) is therefore 160,795/3·102 = $51,835·9 per year. This can be checkedby multiplying the EAB by the annuity factor, i.e. 51,835·9 x 3·102 = $160,795.

If an alternative investment in similar technology over five years had a lower EAB, the four-year investment would be preferredas it has the higher EAB.

(d) When capital is rationed, the optimal investment schedule is the one that maximises the return per dollar invested. The capitalrationing problem is therefore concerned with limiting factor analysis, but the approach adopted is slightly different dependingon whether the investment projects being evaluated are divisible or indivisible.

With divisible projects, the assumption is made that a proportion rather than the whole investment can be undertaken, withthe net present value (NPV) being proportional to the amount of capital invested. If 70% of a project is undertaken, forexample, the resulting NPV is assumed to be 70% of the NPV of investing in the whole project.

For each divisible project, a profitability index can be calculated, defined either as the net present value of the project dividedby its initial investment, or as the present value of the future cash flows of the project divided by its initial investment. Theprofitability index represents the return per dollar invested and can be used to rank the investment projects. The limitedinvestment funds can then be invested in the projects in the order of their profitability indexes, with the final investmentselection being a proportionate one if there is insufficient finance for the whole project. This represents the optimuminvestment schedule when capital is rationed and projects are divisible.

With indivisible projects, ranking by profitability index will not necessarily indicate the optimum investment schedule, sinceit will not be possible to invest in part of a project. In this situation, the NPV of possible combinations of projects must becalculated. The most likely combinations are often indicated by the profitability index ranking. The combination of projectswith the highest aggregate NPV will then be the optimum investment schedule.

2 (a) The cost of debt of Bond A can be found by linear interpolation.

Using 11%, the difference between the present value of future cash flows and the ex interest market value = (9 x 5·889) +(100 x 0·352) – 95·08 = 53·00 + 35·20 – 95·08 = ($6·88)As the net present value is negative, 11% is higher than the cost of debt.

Using 9%, the difference between the present value of future cash flows and the ex interest market value = (9 x 6·418) +(100 x 0·422) – 95·08 = 57·76 + 42·20 – 95·08 = $4·88As the net present value is positive, 9% is lower than the cost of debt.

Cost of debt = 9 + ((11 – 9) x 4·88)/(4·88 + 6·88) = 9 + 0·83 = 9·83%

Using estimates other than 11% and 9% will give slightly different values of the cost of debt.

(b) A key factor here could be the duration of the bond issues, linked to the term structure of interest rates. Normally, the longerthe time to maturity of a debt, the higher will be the interest rate and the cost of debt. Bond A has the greater time to maturityand therefore would be expected to have a higher interest rate and a higher cost of debt than Bond B, which is the case here.

Liquidity preference theory suggests that investors require compensation for deferring consumption, i.e. for not having accessto their cash in the current period, and so providers of debt finance require higher compensation for lending for longer periods.The premium for lending for longer periods also reflects the way that default risk increases with time.

Expectations theory suggests that the shape of the yield curve depends on expectations as to future interest rates. If theexpectation is that future interest rates will be higher than current interest rates, the yield curve will slope upwards. If theexpectation is that future interest rates will be lower than at present, the yield curve will slope downwards.

Market segmentation theory suggests that future interest rates depend on conditions in different debt markets, e.g. the short-term market, the medium-term market and the long-term market. The shape of the yield curve therefore depends onthe supply of, and demand for, funds in the market segments.

Since the two bonds were issued at the same time by the same company, the business risk of DD Co can be discounted asa reason for the difference between the two costs of debt. If the two bonds had been issued by different companies, a differentbusiness risk might have been a reason for the difference in the costs of debt.

The size of the debt could be a contributory factor, since the Bond A issue is twice the size of the Bond B issue. The greatersize of the Bond A issue could be one of the reasons it has the higher cost of debt.

(c) (i) Cost of equity = 4 + (1·2 x (11 – 4)) = 4 + 8·4 = 12·4%

(ii) Dividend growth rate = 100 x ((52/50) – 1) = 100 x (1·04 – 1) = 4% per yearShare price using DGM = (50 x 1·04)/(0·124 – 0·04) = 52/0·84 = 619c or $6·19

12

(iii) Number of ordinary shares = 25 millionMarket value of equity = 25m x 6·19 = $154·75 millionMarket value of Bond A issue = 20m x 95·08/100 = $19·016mMarket value of Bond B issue = 10m x 102·01/100 = $10·201mMarket value of debt = $29·217mMarket value of capital employed = 154·75m + 29·217m = $183·967m

Capital gearing = 100 x 29·217/183·967 = 15·9%

(iv) WACC = ((12·4 x 154·75) + (9·83 x 19·016) + (7·82 x 10·201))/183·967 = 11·9%

(d) Miller and Modigliani showed that, in a perfect capital market, the value of a company depended on its investment decisionalone, and not on its dividend or financing decisions. In such a market, a change in dividend policy by DD Co would notaffect its share price or its market capitalisation. They showed that the value of a company was maximised if it invested inall projects with a positive net present value (its optimal investment schedule). The company could pay any level of dividendand if it had insufficient finance, make up the shortfall by issuing new equity. Since investors had perfect information, theywere indifferent between dividends and capital gains. Shareholders who were unhappy with the level of dividend declared bya company could gain a ‘home-made dividend’ by selling some of their shares. This was possible since there are notransaction costs in a perfect capital market.

Against this view are several arguments for a link between dividend policy and share prices. For example, it has been arguedthat investors prefer certain dividends now rather than uncertain capital gains in the future (the ‘bird-in-the-hand’ argument).It has also been argued that real-world capital markets are not perfect, but semi-strong form efficient. Since perfectinformation is therefore not available, it is possible for information asymmetry to exist between shareholders and the managersof a company. Dividend announcements may give new information to shareholders and as a result, in a semi-strong formefficient market, share prices may change. The size and direction of the share price change will depend on the differencebetween the dividend announcement and the expectations of shareholders. This is referred to as the ‘signalling properties ofdividends’.

It has been found that shareholders are attracted to particular companies as a result of being satisfied by their dividendpolicies. This is referred to as the ‘clientele effect’. A company with an established dividend policy is therefore likely to havean established dividend clientele. The existence of this dividend clientele implies that the share price may change if there isa change in the dividend policy of the company, as shareholders sell their shares in order to reinvest in another company witha more satisfactory dividend policy. In a perfect capital market, the existence of dividend clienteles is irrelevant, sincesubstituting one company for another will not incur any transaction costs. Since real-world capital markets are not perfect,however, the existence of dividend clienteles suggests that if DD Co changes its dividend policy, its share price could beaffected.

3 (a) Amount of equity finance to be invested in euros = 13m/2 = €6·5 millionAmount of equity to be invested in dollars = 6·5m/1·3000 = $5 millionThe amount of equity finance to be raised in dollars = 5m + 0·312m = $5·312m

Rights issue price = 4·00 x 0·83 = $3·32 per share

Number of new shares issued = 5·312m/3·32 = 1·6 million sharesCurrent number of ordinary shares in issue = $100m/4·00 = 25 million sharesTotal number of shares after the rights issue = 25m + 1·6m = 26·6 million sharesTheoretical ex rights price = ((25m x 4) + (1·6m x 3·32))/26·6 = 105·312/26·6 = $3·96 per share

(b) (i) Effect on earnings per shareCurrent EPS = 100 x 4·00/10 = 40 cents per share

(Alternatively, current profit after tax = 100m/10 = $10 millionCurrent EPS = 100 x 10m/25m = 40 cents per share)

Increase in profit before interest and tax = 13m x 0·2 = €2,600,000Dollar increase in profit before interest and tax = 2,600,000/1·3000 = $2 million

$000Increase in profit before interest and tax 2,000Increase in interest = 6·5m x 0·08 = 0·52m/1·3000 = 400

–––––––Increase in profit before tax 1,600Taxation = 1·6m x 0·3 = 480

–––––––Increase in profit after tax 1,120Current profit after tax = 100m/10 = 10,000

–––––––Revised profit after tax 11,120

–––––––

13

Alternatively, using euros:€000

Increase in profit before interest and tax = 13m x 0·2 = 2,600Increase in interest = 6·5m x 0·08 = 520

–––––––Increase in profit before tax 2,080Taxation = 2·08m x 0·3 = 624

–––––––Increase in profit after tax 1,456

$000Increase in dollar profit after tax = 1·456m/1·300 = 1,120Current profit after tax = 100m/10 = 10,000

–––––––Revised profit after tax 11,120

–––––––

Revised EPS = 100 x 11·12m/26·6m = 41·8 cents/share

(ii) Effect on shareholder wealthExpected share price using PER method = (41·8 x 10)/100 = $4·18 per shareThis should be compared to the theoretical ex rights price per share in order to evaluate any change in shareholderwealth.The investment produces a capital gain of 22 cents per share ($4·18 – $3·96)In the absence of any information about dividend payments, it appears that the investment will increase the wealth ofshareholders.

(c) Transaction risk is exchange rate risk that arises as a result of short-term transactions. Because it is short term in nature, ithas a direct effect on cash flows, which can either increase or decrease, depending on the movement in exchange rates beforethe settlement dates of individual short-term transactions.

NG Co is exposed to transaction risk on its euro-denominated European sales and interest payments. The dollar value of itseuro-denominated sales, for example, would decrease if the dollar appreciated against the euro.

Translation risk is exchange rate risk that arises from the need to consolidate financial performance and financial positionwhen preparing consolidated financial statements. For this reason, it is also referred to as accounting exposure.

NG Co is exposed to translation risk on its euro-denominated non-current assets. The dollar value of the non-current assetsacquired by investing in the storage, packing and distribution network, for example, will change as the euro/dollar exchangerate changes.

(d) NG Co will receive euro-denominated income and will incur euro-denominated expenses as a result of its Europeanoperations. One hedging method is to maintain a euro-denominated bank account for all euro-denominated transactions. Thisnatural hedge will minimise the need for cash to be exchanged from one currency to another.

Transactions that are deemed to have significant exchange-rate risk could be hedged using the forward market, i.e. using aforward exchange contract or FEC. This is a binding contract between a company and a bank for delivery or receipt of anagreed amount of foreign currency at an agreed exchange rate on an agreed future date.

The six-monthly interest payment of €260,000 can be used to illustrate an FEC. The current cost of the interest payment is$200,000. In six months and twelve months, as the euro is expected to strengthen against the dollar, the dollar cost of theinterest payment is expected to rise. In order to protect against unexpected adverse exchange rate movements, NG Co canlock into the six-month and twelve-month forward rates of 1·2876 €/$ and 1·2752 €/$ using forward exchange contracts,thereby guaranteeing the dollar cost of its euro-denominated interest payments. The dollar cost of the six-month interestpayment would be $201,926 (€260,000/1·2876) and the dollar cost of the twelve-month interest payment would be$203,890 (€260,000/1·2752).

An alternative to an FEC is a money market hedge. NG Co could borrow now in dollars in order to make a euro deposit which,with accrued interest, will be sufficient to pay the euro-denominated interest in six months’ time.

The six-month euro deposit rate available to NG Co is 1·39% (100 x (1·0280·5 – 1)) and the six-month dollar borrowing rateavailable to NG Co is 2·62% (100 x (1·0530·5 – 1)). The amount of dollars to deposit now would be €256,436(260,000/1·0139) and to make this payment NG Co would need to borrow $197,259 (256,436/1·3000). The six-monthdollar cost of this debt would be $202,427 (197,259 x 1·0262). This is more expensive than using the six-month forwardexchange contract.

(Examiner’s note: an illustration using the interest payment due in twelve months would also be acceptable. It would also beacceptable to use six-monthly interest rates that are one half of the annual interest rates.)

Other hedging methods that could be identified and briefly discussed are currency futures, currency options and currencyswaps.

14

4 (a) The role of financial intermediaries in providing short-term finance for use by business organisations is to provide a linkbetween investors who have surplus cash and borrowers who have financing needs. The amounts of cash provided byindividual investors may be small, whereas borrowers need large amounts of cash: one of the functions of financialintermediaries is therefore to aggregate invested funds in order to meet the needs of borrowers. In so doing, they provide aconvenient and readily accessible route for business organisations to obtain necessary funds.

Small investors are likely to be averse to losing any capital value, so financial intermediaries will assume the risk of loss onshort-term funds borrowed by business organisations, either individually or by pooling risks between financial intermediaries.This aspect of the role of financial intermediaries is referred to as risk transformation. Financial intermediaries also offermaturity transformation, in that investors can deposit funds for a long period of time while borrowers may require funds on ashort-term basis only, and vice versa. In this way the needs of both borrowers and lenders can be satisfied.

(b) Forecast income statement

$mTurnover = 16·00m x 1·084 = 17·344Cost of sales = 17·344m – 5·203m = 12·141

–––––––Gross profit = 17·344m x 30% = 5·203Other expenses = 5·203m – 3·469m = 1·734

–––––––Net profit = 17·344m x 20% = 3·469Interest = (10m x 0·08) + 0·140m = 0·940

–––––––Profit before tax 2·529Tax = 2·529m x 0·3 = 0·759

–––––––Profit after tax 1·770Dividends = 1·770m x 50% = 0·885

–––––––Retained profit 0·885

–––––––

Forecast statement of financial position

$m $mNon-current assets 22·00Current assetsInventory 3·66Trade receivables 3·09

–––––6·75

––––––Total assets 28·75

––––––

Equity finance: $m $mOrdinary shares 5·00Reserves 8·39

–––––13·39

Bank loan 10·00––––––23·39

Current liabilitiesTrade payables 2·49Overdraft 2·87

–––––5·36

––––––Total liabilities 28·75

––––––

WorkingsInventory = 12·141m x (110/365) = $3·66mTrade receivables = 17·344m x (65/365) = $3·09mTrade payables = 12·141m x (75/365) = $2·49mReserves = 7·5m + 0·885m = $8·39mOverdraft = 28·75m – 23·39m – 2·49 = $2·87m (balancing figure)

(c) Working capital financing policies can be classified into conservative, moderate (or matching) and aggressive, depending onthe extent to which fluctuating current assets and permanent current assets are financed by short-term sources of finance.Permanent current assets are the core level of investment in current assets needed to support a given level of business activityor turnover, while fluctuating current assets are the changes in the levels of current assets arising from the unpredictablenature of some aspects of business activity.

A conservative working capital financing policy uses long-term funds to finance non-current assets and permanent currentassets, as well as a proportion of fluctuating current assets. This policy is less risky and less profitable than an aggressive

15

working capital financing policy, which uses short-term funds to finance fluctuating current assets and a proportion ofpermanent current assets as well. Between these two extremes lies the moderate (or matching) policy, which uses long-termfunds to finance long-term assets (non-current assets and permanent current assets) and short-term funds to finance short-term assets (fluctuating current assets).

The current statement of financial position shows that APX Co uses trade payables and an overdraft as sources of short-termfinance. In terms of the balance between short- and long-term finance, 89% of current assets (100 x 4·1/4·6) are financedfrom short-term sources and only 11% are financed from long-term sources. Since a high proportion of current assets arepermanent in nature, this appears to be a very aggressive working capital financing policy which carries significant risk. If theoverdraft were called in, for example, APX Co might have to turn to more expensive short-term financing.

The forecast statement of financial position shows a lower reliance on short-term finance, since 79% of current assets (100x 5·36/6·75) are financed from short-term sources and 21% are financed from long-term sources. This decreased relianceon an aggressive financing policy is sensible, although with a forecast interest coverage ratio of only 3·7 times (3·469/0·94),APX Co has little scope for taking on more long-term debt. An increase in equity funding to decrease reliance on short-termfinance could be considered.

(d) Working capital management Financial analysis shows deterioration in key working capital ratios. The inventory turnover period is expected to increase from81 days to 110 days, the trade receivables period is expected to increase from 50 days to 65 days and the trade payablesperiod is expected to increase from 64 days to 75 days. It is also a cause for concern here that the values of these workingcapital ratios for the next year are forecast, i.e. APX Co appears to be anticipating a worsening in its working capital position.The current and forecast values could be compared to average or sector values in order to confirm whether this is in fact thecase.

Because current assets are expected to increase by more than current liabilities, the current ratio and the quick ratio are bothexpected to increase in the next year, the current ratio from 1·12 times to 1·26 times and the quick ratio from 0·54 times to0·58 times. Again, comparison with sector average values for these ratios would be useful in making an assessment of theworking capital management of APX Co. The balance between trade payables and overdraft finance is approximately the samein both years (trade payables are 46% of current liabilities in the current statement of financial position and 47% of currentliabilities in the forecast statement of financial position), although reliance on short-term finance is expected to fall slightly inthe next year.

The deteriorating working capital position may be linked to an expected deterioration in the overall financial performance ofAPX Co. For example, the forecast gross profit margin (30%) and net profit margin (20%) are both less than the current valuesof these ratios (32% and 23% respectively), and despite the increase in turnover, return on capital employed (ROCE) isexpected to fall from 16·35% to 14·83%.

Analysis

Extracts from current income statement:

$mTurnover 16·00Cost of sales 10·88

–––––Gross profit 5·12Other expenses 1·44

–––––Net profit 3·68

–––––

Current ForecastGross profit margin (100 x 5·12/16·00) 32%

30%Net profit margin (100 x 3·68/16·00) 23%

20%ROCE (100 x 3·68/22·5) 16·35%

(100 x 3·469/23·39) 14·83%Inventory period (365 x 2·4/10·88) 81 days

110 daysReceivables period (365 x 2·2/16·00) 50 days

65 daysPayables period (365 x 1·9/10·88) 64 days

75 daysCurrent ratio (4·6/4·1) 1·12 times

(6·75/5·36) 1·26 timesQuick ratio (2·2/4·1) 0·54 times

(3·09/5·36) 0·58 times

16


Marks Marks1 (a) Present value of lease rentals 2

Present value of lease rental tax benefits 1Present value of cost of leasing 1Investment and scrap values 1Licence fee 1Capital allowance tax benefits 2Licence fee tax benefits 1Present value of cost of borrowing to buy 1Appropriate decision on leasing versus buying 1

–––11

(b) Inflated cost savings 2Tax liabilities 1Present values of net cash flows 1Net present value 1Advice on acceptability of investment 1

–––6

(c) Definition of equivalent cost or benefit 1Relevant discussion 1Appropriate illustration 1

–––3

(d) Capital rationing 1–2Divisible projects and profitability index 2–3Indivisible projects and combinations 1–2

–––Maximum 5

–––25

2 (a) Calculation of cost of debt of Bond A 3

(b) Term structure of interest rates 1–2Liquidity preference theory 1–2Expectations theory 1–2Market segmentation theory 1–2Other relevant discussion 1–2

–––Maximum 6

(c) Cost of equity 2Dividend growth rate 1Share price using dividend growth model 2Capital gearing 2Weighted average cost of capital 2

–––9

(d) Dividend irrelevance 3–4Dividend relevance 3–4

–––Maximum 7

–––25

17

Marks Marks3 (a) Amount of equity finance to be raised in dollars 1

Rights issue price 1Theoretical ex rights price 2

–––4

(b) Current EPS 1Increase in PBIT from investment 1Interest on bond issue 1Revised dollar profit after tax 2Revised EPS 1Revised share price using PER method 1Comment on effect on shareholder wealth 1–3

–––Maximum 9

(c) Transaction risk 1–2Translation risk 1–2Link to question 1–2

–––Maximum 4

(d) Euro account 1Forward market hedge 1Illustration of forward market hedge 1–2Money-market hedge 1Illustration of money-market hedge 1–2Other hedging strategies, including derivatives 1–2

–––Maximum 8

–––25

4 (a) Relevant discussion on financial intermediaries 4

(b) Gross profit 1Net profit 1Profit before tax 1Retained profit 1Inventory 1Trade receivables 1Trade payables 1Reserves 1Overdraft 1Layout and format 1

–––Maximum 9

(c) Working capital financing policies 2–3Financial analysis 1–2Working capital financing policy of company 2–3

–––Maximum 6

(d) Discussion of working capital management 3–4Financial analysis 2–4

–––Maximum 6

–––25

18


The Association of Chartered Certifi ed Accountants



Time allowed

Reading and planning: 15 minutesWriting: 3 hours


Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7

and 8.


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.


Pape

r F9

2


1 ZSE Co is concerned about exceeding its overdraft limit of $2 million in the next two periods. It has been experiencing considerable volatility in cash fl ows in recent periods because of trading diffi culties experienced by its customers, who have often settled their accounts after the agreed credit period of 60 days. ZSE has also experienced an increase in bad debts due to a small number of customers going into liquidation.

The company has prepared the following forecasts of net cash fl ows for the next two periods, together with their associated probabilities, in an attempt to anticipate liquidity and fi nancing problems. These probabilities have been produced by a computer model which simulates a number of possible future economic scenarios. The computer model has been built with the aid of a fi rm of fi nancial consultants.

Period 1 cash fl ow Probability Period 2 cash fl ow Probability$000 $0008,000 10% 7,000 30%4,000 60% 3,000 50%(2,000) 30% (9,000 ) 20%

ZSE Co expects to be overdrawn at the start of period 1 by $500,000.

Required:

(a) Calculate the following values:

(i) the expected value of the period 1 closing balance;

(ii) the expected value of the period 2 closing balance;

(iii) the probability of a negative cash balance at the end of period 2;

(iv) the probability of exceeding the overdraft limit at the end of period 2.

Discuss whether the above analysis can assist the company in managing its cash fl ows. (13 marks)

(b) Identify and discuss the factors to be considered in formulating a trade receivables management policy for

ZSE Co. (8 marks)

(c) Discuss whether profi tability or liquidity is the primary objective of working capital management. (4 marks)

(25 marks)

3 [P.T.O.

2 YGV Co is a listed company selling computer software. Its profi t before interest and tax has fallen from $5 million to $1 million in the last year and its current fi nancial position is as follows:

$000 $000Non-current assets Property, plant and equipment 3,000

Intangible assets 8,500 11,500 –––––––

Current assets Inventory 4,100

Trade receivables 11,100 15,200 ––––––– –––––––

Total assets 26,700 –––––––

Current liabilitiesTrade payables 5,200Overdraft 4,500 9,700 –––––––

EquityOrdinary shares 10,000Reserves 7,000 17,000 ––––––– –––––––

26,700 –––––––

YGV Co has been advised by its bank that the current overdraft limit of $4·5 million will be reduced to $500,000 in two months’ time. The fi nance director of YGV Co has been unable to fi nd another bank willing to offer alternative overdraft facilities and is planning to issue bonds on the stock market in order to fi nance the reduction of the overdraft. The bonds would be issued at their par value of $100 per bond and would pay interest of 9% per year, payable at the end of each year. The bonds would be redeemable at a 10% premium to their par value after 10 years. The fi nance director hopes to raise $4 million from the bond issue.

The ordinary shares of YGV Co have a par value of $1·00 per share and a current market value of $4·10 per share. The cost of equity of YGV Co is 12% per year and the current interest rate on the overdraft is 5% per year. Taxation is at an annual rate of 30%.

Other fi nancial information:

Average gearing of sector (debt/equity, market value basis): 10% Average interest coverage ratio of sector: 8 times

Required:

(a) Calculate the after–tax cost of debt of the 9% bonds. (4 marks)

(b) Calculate and comment on the effect of the bond issue on the weighted average cost of capital of YGV Co,

clearly stating any assumptions that you make. (5 marks)

(c) Calculate the effect of using the bond issue to fi nance the reduction in the overdraft on:

(i) the interest coverage ratio;

(ii) gearing. (4 marks)

(d) Evaluate the proposal to use the bond issue to fi nance the reduction in the overdraft and discuss alternative

sources of fi nance that could be considered by YGV Co, given its current fi nancial position. (12 marks)

(25 marks)

4

3 The following draft appraisal of a proposed investment project has been prepared for the fi nance director of OKM Co by a trainee accountant. The project is consistent with the current business operations of OKM Co.

Year 1 2 3 4 5Sales (units/yr) 250,000 400,000 500,000 250,000

$000 $000 $000 $000 $000Contribution 1,330 2,128 2,660 1,330Fixed costs (530 ) (562 ) (596 ) (631 )Depreciation (438 ) (438 ) (437 ) (437 )Interest payments (200 ) (200 ) (200 ) (200 ) –––––– –––––– –––––– ––––––Taxable profi t 162 928 1,427 62Taxation (49 ) (278 ) (428 ) (19 ) –––––– –––––– –––––– –––––– ––––––Profi t after tax 162 879 1,149 (366 ) (19 )Scrap value 250 –––––– –––––– –––––– –––––– After–tax cash fl ows 162 879 1,149 (116 ) (19 )Discount at 10% 0·909 0·826 0·751 0·683 0·621 –––––– –––––– –––––– –––––– ––––––Present values 147 726 863 (79 ) (12 ) –––––– –––––– –––––– –––––– ––––––

Net present value = 1,645,000 – 2,000,000 = ($355,000) so reject the project.

The following information was included with the draft investment appraisal:

1. The initial investment is $2 million 2. Selling price: $12/unit (current price terms), selling price infl ation is 5% per year 3. Variable cost: $7/unit (current price terms), variable cost infl ation is 4% per year 4. Fixed overhead costs: $500,000/year (current price terms), fi xed cost infl ation is 6% per year 5. $200,000/year of the fi xed costs are development costs that have already been incurred and are being recovered

by an annual charge to the project 6. Investment fi nancing is by a $2 million loan at a fi xed interest rate of 10% per year 7. OKM Co can claim 25% reducing balance capital allowances on this investment and pays taxation one year in

arrears at a rate of 30% per year 8. The scrap value of machinery at the end of the four-year project is $250,000 9. The real weighted average cost of capital of OKM Co is 7% per year 10. The general rate of infl ation is expected to be 4·7% per year

Required:

(a) Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.

(5 marks)

(b) Prepare a revised calculation of the net present value of the proposed investment project and comment on the

project’s acceptability. (12 marks)

(c) Discuss the problems faced when undertaking investment appraisal in the following areas and comment on

how these problems can be overcome:

(i) assets with replacement cycles of different lengths;

(ii) an investment project has several internal rates of return;

(iii) the business risk of an investment project is signifi cantly different from the business risk of current

operations. (8 marks)

(25 marks)

5 [P.T.O.

4 A shareholder of QSX Co is concerned about the recent performance of the company and has collected the following fi nancial information.

Year to 31 May 2009 2008 2007Turnover $6·8m $6·8m $6·6mEarnings per share 58·9c 64·2c 61·7cDividend per share 40·0c 38·5c 37·0cClosing ex dividend share price $6·48 $8·35 $7·40Return on equity predicted by CAPM 8% 12%

One of the items discussed at a recent board meeting of QSX Co was the dividend payment for 2010. The fi nance director proposed that, in order to conserve cash within the company, no dividend would be paid in 2010, 2011 and 2012. It was expected that improved economic conditions at the end of this three-year period would make it possible to pay a dividend of 70c per share in 2013. The fi nance director expects that an annual dividend increase of 3% per year in subsequent years could be maintained.

The current cost of equity of QSX Co is 10% per year.

Assume that dividends are paid at the end of each year.

Required:

(a) Calculate the dividend yield, capital gain and total shareholder return for 2008 and 2009, and briefl y discuss

your fi ndings with respect to:

(i) the returns predicted by the capital asset pricing model (CAPM);

(ii) the other fi nancial information provided. (10 marks)

(b) Calculate and comment on the share price of QSX Co using the dividend growth model in the following

circumstances:

(i) based on the historical information provided;

(ii) if the proposed change in dividend policy is implemented. (7 marks)

(c) Discuss the relationship between investment decisions, dividend decisions and fi nancing decisions in the

context of fi nancial management, illustrating your discussion with examples where appropriate. (8 marks)

(25 marks)

6

Formulae Sheet


Miller–Orr Model



The Growth Model



The Fisher formula


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spread

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=× ×

334

fflows

interest rate

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⎢⎢

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13

E r R E r Ri f i m f( ) = + ( )( )β –

β βa

e

e de

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V V T

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+ ( )( )⎡

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7 [P.T.O.

Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

8


Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r

Answers

11

Fundamentals Level – Skills Module, Paper F9

Financial Management June 2010 Answers

1 (a) (i) Period 1 closing balance

Opening balance Cash fl ow Closing balance Probability Expected value$000 $000 $000 $000(500) 8,000 7,500 0·1 750(500) 4,000 3,500 0·6 2,100(500) (2,000 ) (2,500 ) 0·3 (750 ) –––––– 2,100 ––––––

The expected value of the period 1 closing balance is $2,100,000

(ii) Period 2 closing balance

Period 1 Probability Period 2 Probability Period 2 Joint Expectedclosing cash fl ow closing Probability valuebalance balance$000 $000 $000 $0007,500 0·1 7,000 0·3 14,500 0·03 435 3,000 0·5 10,500 0·05 525 (9,000 ) 0·2 (1,500 ) 0·02 (30 )3,500 0·6 7,000 0·3 10,500 0·18 1,890 3,000 0·5 6,500 0·30 1,950 (9,000 ) 0·2 (5,500 ) 0·12 (660 )(2,500) 0·3 7,000 0·3 4,500 0·09 405 3,000 0·5 500 0·15 75 (9,000 ) 0·2 (11,500 ) 0·06 (690 ) –––––– 3,900 ––––––

The expected value of the period 2 closing balance is $3,900,000

(iii) The probability of a negative cash balance at the end of period 2 = 0·02 + 0·12 + 0·06 = 20%

(iv) The probability of exceeding the overdraft limit in period 2 is 0·12 + 0·06 = 18%

Discussion

The expected value analysis has shown that, on an average basis, ZSE Co will have a positive cash balance at the end of period 1 of $2·1 million and a positive cash balance at the end of period 2 of $3·9 million. However, the cash balances that are expected to occur are the specifi c balances that have been averaged, rather than the average values themselves.

There could be serious consequences for ZSE Co if it exceeds its overdraft limit. For example, the overdraft facility could be withdrawn. There is a 30% chance that the overdraft limit will be exceeded in period 1 and a lower probability, 18%, that the overdraft limit will be exceeded in period 2. To guard against exceeding its overdraft limit in period 1, ZSE Co must fi nd additional fi nance of $0·5 million ($2·5m – $2·0m). However, to guard against exceeding its overdraft limit in period 2, the company could need up to $9·5 million ($11·5m – $2·0m). Renegotiating the overdraft limit in period 1 would therefore be only a short-term solution.

One strategy is to fi nd now additional fi nance of $0·5 million and then to re-evaluate the cash fl ow forecasts at the end of period 1. If the most likely outcome occurs in period 1, the need for additional fi nance in period 2 to guard against exceeding the overdraft limit is much lower.

The expected value analysis has been useful in illustrating the cash fl ow risks faced by ZSE Co. Although the cash fl ow forecasting model has been built with the aid of a fi rm of fi nancial consultants, the assumptions used in the model must be reviewed before decisions are made based on the forecast cash fl ows and their associated probabilities.

Expected values are more useful for repeat decisions rather than one-off activities, as they are based on averages. They illustrate what the average outcome would be if an activity was repeated a large number of times. In fact, each period and its cash fl ows will occur only once and the expected values of the closing balances are not closing balances that are forecast to arise in practice. In period 1, for example, the expected value closing balance of $2·1 million is not forecast to occur, while a closing balance of $3·5 million is likely to occur.

(b) The factors to be considered in formulating a policy to manage the trade receivables of ZSE Co will relate to the key areas of credit assessment or analysis, credit control and collection procedures. A key factor is the turbulence in the company’s business environment and the way it affects the company’s customers.

Credit analysis

The main objective of credit analysis is to ensure that credit is granted to customers who will settle their account at regular intervals in accordance with the agreed terms of sale. The risk of bad debts must be minimised as much as possible.

12

Key factors to consider here are the source and quality of the information used by ZSE Co to assess customer creditworthiness. The information sources could include bank references, trade references, public information such as published accounts, credit reference agencies and personal experience. The quality of the information needs to be confi rmed as part of the credit analysis process. Some organisations have developed credit scoring systems to assist in the assessment of creditworthiness.

Credit control

Once credit has been granted, it is essential to ensure that agreed terms and conditions are adhered to while the credit is outstanding. This can be achieved by careful monitoring of customer accounts and the periodic preparation of aged debtor analyses. A key factor here is the quality of the staff involved with credit control and the systems and procedures they use to maintain regular contact with customers, for example invoices, statements, reminders, letters and telephone contacts.

ZSE Co has been experiencing diffi culties in collecting amounts due because its customers have been experiencing diffi cult trading conditions. Close contact with customers is essential here in order to determine where revised terms can be negotiated when payment is proving hard, and perhaps to provide advance warning of serious customer liquidity or going concern problems.

Collection procedures

The objective here is to ensure timely and secure transfer of funds when they are due, whether by physical means or by electronic means. A key factor here is the need to ensure that the terms of trade are clearly understood by the customer from the point at which credit is granted. Offering credit represents a cost to the seller and ensuring that payment occurs as agreed prevents this cost from exceeding budgeted expectations.

Procedures for chasing late payers should be clearly formulated and trained personnel must be made responsible for ensuring that these procedures are followed. Legal action should only be considered as a last resort, since it often represents the termination of the business relationship with a customer.

(c) Profi tability and liquidity are usually cited as the twin objectives of working capital management. The profi tability objective refl ects the primary fi nancial management objective of maximising shareholder wealth, while liquidity is needed in order to ensure that fi nancial claims on an organisation can be settled as they become liable for payment.

The two objectives are in confl ict because liquid assets such as bank accounts earn very little return or no return, so liquid assets decrease profi tability. Liquid assets in fact incur an opportunity cost equivalent either to the cost of short-term fi nance or to the profi t lost by not investing in profi table projects.

Whether profi tability is a more important objective than liquidity depends in part on the particular circumstances of an organisation. Liquidity may be the more important objective when short-term fi nance is hard to fi nd, while profi tability may become a more important objective when cash management has become too conservative. In short, both objectives are important and neither can be neglected.

2 (a) Calculation of cost of debt

After-tax interest payment = 9 x 0·7 = $6·30 per bond

Year Cash fl ow $ 8% discount factor Present value ($)0 Issue price (100 ) 1·000 (100·00 )1–10 After-tax interest 6·30 6·710 42·2710 Redemption 110 0·463 50·93 –––––– (6·80 ) ––––––

Year Cash fl ow $ 6% discount factor Present value ($)0 Issue price (100 ) 1·000 (100·00 )1–10 After-tax interest 6·30 7·360 46·3710 Redemption 110 0·558 61·38 –––––– 7·75 ––––––

After-tax cost of debt = 6 + [(8 – 6) x 7·75/(7·75 + 6·8)] = 6 + 1·1 = 7·1%

(b) YGV Co does not currently have any long-term debt and so the current weighted average cost of capital (WACC) is the same as the current cost of equity, which is 12%.

Current market capitalisation = 10m x $4·10 = $41 million

If the company issues $4m of bonds at par with an after-tax cost of debt of 7·1%, the WACC will be [(41m x 12) + (4m x 7·1)]/45m = 11·6%

The effect of the bond issue is therefore to reduce the WACC from 12% to 11·6% per year.

This calculation assumes that the current share price does not change as a result of the bond issue. In reality, the share price might change as a result of the change in fi nancial risk. This calculation also assumes that the overdraft is not relevant in calculating the WACC, when in reality the size of the overdraft might make it a signifi cant factor.

Examiner’s note: WACC calculations that include the overdraft are also acceptable.

13

(c) (i) Interest coverage ratio

Current interest = $4·5m x 5% = $225,000 per year Current interest coverage ratio = 1m/0·225 = 4·4 times

Interest from bond issue = $4m x 9% = $360,000 per year Interest on remaining overdraft = $0·5m x 5% = $25,000 per year Total interest = 360,000 + 25,000 = $385,000 per year Revised interest coverage ratio = 1m/0·385 = 2·6 times

(ii) Gearing

Market capitalisation of YGV plc = 10m shares x $4·10 = $41 million

Current gearing using market values, excluding overdraft = zero Revised gearing using market values, excluding overdraft = 100 x (4,000/41,000) = 9·8%

Current gearing using market values, including overdraft = 100 x (4,500/41,000) = 11·0% Revised gearing using market values, including overdraft = 100 x (4,500/41,000) = 11·0%

Examiner’s note: full credit could have been obtained whether or not the overdraft had been included in the gearing calculations.

(d) Interest coverage ratio

The current interest coverage ratio of 4·4 times is just over half of the sector average value of 8 times, although before the fall in profi t it was 22 times. As a result of the bond issue, the interest coverage ratio would fall to 2·6 times, which is a dangerously low level of cover.

Gearing

Whether the bond issue has an effect on gearing depends on whether the gearing calculation includes the overdraft. If the overdraft is excluded, gearing measured by the debt/equity ratio on a market value basis increases from zero to 9·8%. If the overdraft is included, there is no change in gearing, since the bond issue replaces an equal amount of the overdraft. Given the sector average debt/equity of 10%, there does not appear to be any concerns about gearing as a result of the bond issue.

Security

It is very likely that the bond issue would need to be secured against the tangible non-current assets of YGV Co, especially in light of the recent decline in profi tability. However, the bond issue is for $4 million while the tangible non-current assets ofYGV Co have a value of only $3 million. It is not known whether the intangible non-current assets can be used as security, since their nature has not been disclosed.

Advisability of using the bond issue to reduce the overdraft

Considering the signifi cant decrease in the interest coverage ratio as a result of the bond issue and the lack of tangiblenon-current assets to offer as security, it appears that the proposed bond issue cannot be recommended and would probably be unsuccessful. YGV Co should therefore consider alternative sources of fi nance in order to reduce the overdraft.

Alternative sources of fi nance

Given the recent fall in profi t before interest and tax from $5 million to $1 million, any potential investor would initially seek reassurances that YGV Co would continue to be a viable business. The reason for the decline in profi tability needs to be determined and the longer-term sustainability of the company needs to be confi rmed before further fi nancing is considered.

If longer-term viability is assured, the need for further fi nance could be reduced by taking measures to reduce costs and increase income, for example through improved working capital management.

If the company pays dividends, consideration could be given to reducing or passing the dividend in order to increase the fl ow of retained earnings in the company.

Given the problems with interest coverage and security, and the lack of availability of further overdraft fi nance, equity fi nance is the fi rst alternative choice that could be considered. While no information has been provided on recent share price changes or on the dividend policy of YGV Co, existing shareholders could be consulted about a rights issue. Using a discount to the current market price of 20% gives a rights issue price of $3·28. A 1 for 8 rights issue at this price would raise $4·1 million, increasing the interest coverage ratio to 50 (1m/0·02m) if the proceeds were used to reduce the overdraft to $400,000.

If shares were offered to new shareholders, the dilution of existing ownership and control would be small, given that $4 million is only 9% of $45 million (41 + 4). New shareholders would be unlikely to invest, however, if no dividend were on offer.

Sale and leaseback would not raise suffi cient fi nance, given that tangible non-current assets are only $3 million, but this avenue could be explored in conjunction with another source of fi nance.

Other fi nance sources that could be considered include convertible bonds or bonds with warrants attached. Improved working capital management could also decrease the amount of fi nance required.

14

3 (a) Errors in the original investment appraisal

Infl ation was incorrectly applied to selling prices and variable costs in calculating contribution, since only one year’s infl ation was allowed for in each year of operation.

The fi xed costs were correctly infl ated, but included $200,000 per year before infl ation that was not a relevant cost. Only relevant costs should be included in investment appraisal.

Straight-line accounting depreciation had been used in the calculation, but this depreciation method is not acceptable to the tax authorities. The approved method using 25% reducing balance capital allowances should be used.

Interest payments have been included in the investment appraisal, but these are allowed for by the discount rate used in calculating the net present value.

The interest rate on the debt fi nance has been used as the discount rate, when the nominal weighted average cost of capital should have been used to discount the calculated nominal after-tax cash fl ows.

(b) Nominal weighted average cost of capital = 1·07 x 1·047 = 1·12, i.e. 12% per year

NPV calculation

Year 1 2 3 4 5 $000 $000 $000 $000 $000Contribution 1,330 2,264 3,010 1,600Fixed costs (318 ) (337 ) (357 ) (379 ) –––––– –––––– –––––– ––––––Taxable cash fl ow 1,012 1,927 2,653 1,221Taxation (304 ) (578 ) (796 ) (366 )CA tax benefi ts 150 112 84 178 –––––– –––––– –––––– –––––– ––––––After-tax cash fl ow 1,012 1,773 2,187 509 (188 )Scrap value 250 –––––– –––––– –––––– –––––– ––––––After-tax cash fl ows 1,012 1,773 2,187 759 (188 )Discount at 12% 0·893 0·797 0·712 0·635 0·567 –––––– –––––– –––––– –––––– ––––––Present values 904 1,413 1,557 482 (107 ) –––––– –––––– –––––– –––––– ––––––

$000Present value of future cash fl ows 4,249Initial investment 2,000 ––––––Net present value 2,249 ––––––

The net present value is positive and so the investment is fi nancially acceptable.

Alternative NPV calculation using taxable profi t calculation

Year 1 2 3 4 5 $000 $000 $000 $000 $000Contribution 1,330 2,264 3,010 1,600Fixed costs (318 ) (337 ) (357 ) (379 ) –––––– –––––– –––––– –––––– Taxable cash fl ow 1,012 1,927 2,653 1,221Capital allowances (500 ) (375 ) (281 ) (594 ) –––––– –––––– –––––– –––––– Taxable profi t 512 1,552 2,372 627Taxation (154 ) (466 ) (712 ) (188 ) –––––– –––––– –––––– –––––– ––––––Profi t after tax 512 1,398 1,906 (85 ) (188 )Capital allowances 500 375 281 594 –––––– –––––– –––––– –––––– ––––––After-tax cash fl ow 1,012 1,773 2,187 509 (188 )Scrap value 250 –––––– –––––– –––––– –––––– ––––––After-tax cash fl ows 1,012 1,773 2,187 759 (188 )Discount at 12% 0·893 0·797 0·712 0·635 0·567 –––––– –––––– –––––– –––––– ––––––Present values 904 1,413 1,557 482 (107 ) –––––– –––––– –––––– –––––– ––––––

$000Present value of future cash fl ows 4,249Initial investment 2,000 ––––––Net present value 2,249 ––––––

15

Workings

Annual contribution

Year 1 2 3 4Sales volume (units/yr) 250,000 400,000 500,000 250,000Selling price ($/unit) 12·60 13·23 13·89 14·59Variable cost ($/unit) 7·28 7·57 7·87 8·19 –––––– –––––– –––––– ––––––Contribution ($/unit) 5·32 5·66 6·02 6·40 –––––– –––––– –––––– ––––––

Contribution ($/yr) 1,330,000 2,264,000 3,010,000 1,600,000

Capital allowance (CA) tax benefi ts

Year Capital allowance ($) Tax benefi t ($)1 500,000 150,0002 375,000 112,5003 281,250 84,3754 593,750 178,125Scrap value 250,000 –––––––––– 2,000,000

(c) (i) Asset replacement decisions

The problem here is that the net present value investment appraisal method may offer incorrect advice about when an asset should be replaced. The lowest present value of costs may not indicate the optimum replacement period.

The most straightforward solution to this problem is to use the equivalent annual cost method. The equivalent annual cost of a replacement period is found by dividing the present value of costs by the annuity factor or cumulative present value factor for the replacement period under consideration. The optimum replacement period is then the one that has the lowest equivalent annual cost.

Other solutions that could be discussed are the lowest common multiple method and the limited time horizon method.

(ii) Multiple internal rates of return

An investment project may have multiple internal rates of return if it has unconventional cash fl ows, that is, cash fl ows that change sign over the life of the project. A mining operation, for example, may have initial investment (cash outfl ow) followed by many years of successful operation (cash infl ow) before decommissioning and environmental repair (cash outfl ow). This technical diffi culty makes it diffi cult to use the internal rate of return (IRR) investment appraisal method to offer investment advice.

One solution is to use the net present value (NPV) investment appraisal method instead of IRR, since the non-conventional cash fl ows are easily accommodated by NPV. This is one area where NPV is considered to be superior to IRR.

(iii) Projects with signifi cantly different business risk to current operations

Where a proposed investment project has business risk that is signifi cantly different from current operations, it is no longer appropriate to use the weighted average cost of capital (WACC) as the discount rate in calculating the net present value of the project. WACC can only be used as a discount rate where business risk and fi nancial risk are not signifi cantly affected by undertaking an investment project.

Where business risk changes signifi cantly, the capital asset pricing model should be used to calculate a project-specifi c discount rate which takes account of the systematic risk of a proposed investment project.

4 (a) Dividend yield is calculated as the dividend divided by the share price at the start of the year.

2008: dividend yield = 100 x 38·5/740 = 5·2% 2009: dividend yield = 100 x 40·0/835 = 4·8%

The capital gain is the difference between the opening and closing share prices, and may be expressed as a monetary amount or as a percentage of the opening share price.

2008: capital gain = 835 – 740 = 95c or 12·8% (100 x 95/740) 2009: capital gain = 648 – 835 = (187c) or (22·4%) (100 x –187/835)

The total shareholder return is the sum of the percentage capital gain and the dividend yield, or the sum of the dividend paid and the monetary capital gain, expressed as a percentage of the opening share price.

2008: total shareholder return = 100 x (95 + 38·5)/740 = 18·0% (5·2% + 12·8%) 2009: total shareholder return = 100 x (–187 + 40)/835 = –17·6% (4·8% – 22·4%)

16

(i) The return on equity predicted by the CAPM

The actual return for a shareholder of QSX Co, calculated as total shareholder return, is very different from the return on equity predicted by the CAPM. In 2008 the company provided a better return than predicted and in 2009 the company gave a negative return while the CAPM predicted a positive return.

Year 2009 2008Total shareholder return (17·6% ) 18·0%Return on equity predicted by CAPM 8% 12%

Because the risk-free rate of return is positive and the equity risk premium is either zero or positive, and because negative equity betas are very rare, the return on equity predicted by the CAPM is invariably positive. This refl ects the reality that shareholders will always want a return to compensate for taking on risk. In practice, companies sometimes give negative returns, as is the case here. The return in 2008 was greater than the cost of equity, but the fi gure of 10% quoted here is the current cost of equity; the cost of equity may have been different in 2008.

(ii) Other comments

QSX Co had turnover growth of 3% in 2008, but did not generate any growth in turnover in 2009. Earnings per share grew by 4·1% in 2008, but fell by 8·3% in 2009. Dividends per share also grew by 4·1% in 2008, but unlike earnings per share, dividend per share growth was maintained in 2009. It is common for dividends to be maintained when a company suffers a setback, often in an attempt to give reassurance to shareholders.

There are other negative signs apart from stagnant turnover and falling earnings per share. The shareholder will be concerned about experiencing a capital loss in 2009. He will also be concerned that the decline in the price/earnings ratio in 2009 might be a sign that the market is losing confi dence in the future of QSX Co. If the shareholder was aware of the proposal by the fi nance director to suspend dividends, he would be even more concerned. It might be argued that, in a semi-strong form-effi cient market, the information would remain private. If QSX Co desires to conserve cash because the company is experiencing liquidity problems, however, these problems are likely to become public knowledge fairly quickly, for example through the investigations of capital market analysts.

Workings:

Year 2009 2008 2007Closing share price $6·48 $8·35Earnings per share 58·9c 64·2c 61·7cPER 11 times 13 times

Year 2009 2008 2007Earnings per share 58·9c 64·2c 61·7cDividend per share 40·0c 38·5c 37·0cDividend cover 1·5 times 1·7 times 1·7 timesEarnings per share growth (8·3%) 4·1%Dividend per share growth 3·9% 4·1%Turnover growth nil 3%

(b) Historical dividend growth rate = (40/37)0·5 – 1 = 0·04 or 4% per year Share price using dividend growth model = (40 x 1·04)/(0·1 – 0·04) = 693c or $6·93

In three years’ time, the present value of the dividends received from the fourth year onwards can be calculated by treating the fourth-year dividend as D1 in the dividend growth model and assuming that the cost of equity remains unchanged at 10% per year. Applying the dividend growth model in this way gives the share price in three years’ time:

Share price = 70/(0·1 – 0·03) = 1,000c or $10·00.

For comparison purposes this share price must be discounted back for three years: Share price = 0·751 x 10·00 = $7·51.

The current share price of $6·48 is less than the share price of $6·93 calculated by the dividend growth model, indicating perhaps that the capital market believes that future dividend growth will be less than historic dividend growth.

The share price resulting from the proposed three-year suspension of dividends is higher than the current share price and the share price predicted by the dividend growth model. However, this share price is based on information that is not public and it also relies on future dividends and dividend growth being as predicted. It is very unlikely that a prediction as tentative as this will prove to be accurate.

(c) Investment decisions, dividend decisions and fi nancing decisions have often been called the decision triangle of fi nancial management. The study of fi nancial management is often divided up in accordance with these three decision areas. However, they are not independent decisions, but closely connected.

For example, a decision to increase dividends might lead to a reduction in retained earnings and hence a greater need for external fi nance in order to meet the requirements of proposed capital investment projects. Similarly, a decision to increase capital investment spending will increase the need for fi nancing, which could be met in part by reducing dividends.

The question of the relationship between the three decision areas was investigated by Miller and Modigliani. They showed that, if a perfect capital market was assumed, the market value of a company and its weighted average cost of capital (WACC)

17

were independent of its capital structure. The market value therefore depended on the business risk of the company and not on its fi nancial risk. The investment decision, which determined the operating income of a company, was therefore shown to be important in determining its market value, while the fi nancing decision, given their assumptions, was shown to be not relevant in this context. In practice, it is recognised that capital structure can affect WACC and hence the market value of the company.

Miller and Modigliani also investigated the relationship between dividend policy and the share price of a company, i.e. the market value of a company. They showed that, if a perfect capital market was assumed, the share price of a company did not depend on its dividend policy, i.e. the dividend decision was irrelevant to value of the share. The market value of the company and therefore the wealth of shareholders were shown to be maximised when the company implemented its optimum investment policy, which was to invest in all projects with a positive NPV. The investment decision was therefore shown to be theoretically important with respect to the market value of the company, while the dividend decision was not relevant.

In practice, capital markets are not perfect and a number of other factors become important in discussing the relationship between the three decision areas. Pecking order theory, for example, suggests that managers do not in practice make fi nancing decisions with the objective of obtaining an optimal capital structure, but on the basis of the convenience and relative cost of different sources of fi nance. Retained earnings are the preferred source of fi nance from this perspective, with a resulting pressure for annual dividends to be lower rather than higher.

19

Fundamentals Level – Skills Module, Paper F9

Financial Management June 2010 Marking Scheme

Marks Marks1 (a) Expected value of period 1 closing balance 2 Expected value of period 2 closing balance 5 Probability of negative cash balance 1 Probability of exceeding overdraft limit 2 Discussion of expected value analysis 3 –––– 13

(b) Credit analysis 2–3 Credit control 2–3 Collection procedures 2–3 –––– Maximum 8

(c) Relevant discussion 4 ––– 25

2 (a) Calculation of after-tax interest payment 1 Calculation of after-tax cost of debt 3 –––– 4

(b) Current WACC 1 Calculation of WACC after bond issue 2 Comment on effect of bond issue 1 Comment on assumptions 1 –––– 5

(c) Current interest coverage ratio 1 Revised interest coverage ratio 1 Current gearing 1 Revised gearing 1 –––– 4

(d) Comment on interest coverage ratio 1–2 Comment on gearing 1–2 Comment on need for security 2–3 Comment on advisability of bond issue 1–2 Discussion of alternative sources of fi nance 4–5 Other relevant discussion 1–2 –––– Maximum 12 –––– 25

20

Marks Marks3 (a) Identifi cation of errors in the evaluation 5

(b) Nominal weighted average cost of capital 1 Infl ated selling prices 1 Infl ated variable costs 1 Infl ated contribution 1 Infl ated fi xed costs 1 Capital allowances and/or related tax benefi ts 3 Scrap value 1 Discount factors 1 Net present value 1 Comment 1–2 –––– Maximum 12

(c) Discussion of asset replacement decisions 2–3 Discussion of projects with several IRR 2–3 Discussion of projects with different business risk 3–4 –––– Maximum 8 –––– 25

4 (a) Calculation of dividend yields 2 Calculation of capital gains 2 Calculation of total shareholder returns 2 Discussion of returns relative to the CAPM 1–3 General discussion of returns 1–3 –––– Maximum 10

(b) Calculation of historic dividend growth rate 1 Calculation of share price using DGM 2 Calculation of share price after policy change 3 Comment on shares prices 1–2 –––– Maximum 7

(c) Practical links between the decision areas 1–2 Relevant illustrations 1–2 Miller and Modigliani and dividend decisions 2–3 Miller and Modigliani and fi nancing decisions 2–3 Other relevant discussion 1–3 –––– Maximum 8 –––– 25








Pape

r F9





1 CJ Co is a profitable company which is financed by equity with a market value of $180 million and by debt with amarket value of $45 million. The company is considering two investment projects, as follows.

Project AThis project is an expansion of existing business costing $3·5 million, payable at the start of the project, which willincrease annual sales by 750,000 units. Information on unit selling price and costs is as follows:

Selling price: $2·00 per unit (current price terms)Selling costs: $0·04 per unit (current price terms)Variable costs: $0·80 per unit (current price terms)

Selling price inflation and selling cost inflation are expected to be 5% per year and variable cost inflation is expectedto be 4% per year. Additional initial investment in working capital of $250,000 will also be needed and this isexpected to increase in line with general inflation.

Project BThis project is a diversification into a new business area that will cost $4 million. A company that already operatesin the new business area, GZ Co, has an equity beta of 1·5. GZ Co is financed 75% by equity with a market valueof $90 million and 25% by debt with a market value of $30 million.

Other informationCJ Co has a nominal weighted average after-tax cost of capital of 10% and pays profit tax one year in arrears at anannual rate of 30%. The company can claim capital allowances (tax-allowable depreciation) on a 25% reducingbalance basis on the initial investment in both projects.

Risk-free rate of return: 4%Equity risk premium: 6%General rate of inflation: 4·5% per year

Directors’ views on investment appraisalThe directors of CJ Co require that all investment projects should be evaluated using either payback period or returnon capital employed (accounting rate of return). The target payback period of the company is two years and the targetreturn on capital employed is 20%, which is the current return on capital employed of CJ Co. A project is acceptedif it satisfies either of these investment criteria.

The directors also require all investment projects to be evaluated over a four-year planning period, ignoring any scrapvalue or working capital recovery, with a balancing allowance (if any) being claimed at the end of the fourth year ofoperation.

Required:

(a) Calculate the net present value of Project A and advise on its acceptability if the project were to be appraisedusing this method. (12 marks)

(b) Critically discuss the directors’ views on investment appraisal. (7 marks)

(c) Calculate a project-specific cost of equity for Project B and explain the stages of your calculation.(6 marks)

(25 marks)

2

2 The following financial position statement as at 30 November 2010 refers to Nugfer Co, a stock exchange-listedcompany, which wishes to raise $200m in cash in order to acquire a competitor.

$m $m $mAssetsNon-current assets 300Current assets 211

––––Total assets 511

––––Equity and liabilitiesShare capital 100Retained earnings 121

––––Total equity 221Non-current liabilitiesLong-term borrowings 100Current liabilitiesTrade payables 30Short-term borrowings 160

––––Total current liabilities 190

––––Total liabilities 290

––––Total equity and liabilities 511

––––

The recent performance of Nugfer Co in profitability terms is as follows:

Year ending 30 November 2007 2008 2009 2010$m $m $m $m

Revenue 122·6 127·3 156·6 189·3Operating profit 41·7 43·3 50·1 56·7Finance charges (interest) 6·0 6·2 12·5 18·8Profit before tax 35·7 37·1 37·6 37·9Profit after tax 25·0 26·0 26·3 26·5

Notes:1. The long-term borrowings are 6% bonds that are repayable in 20122. The short-term borrowings consist of an overdraft at an annual interest rate of 8%3. The current assets do not include any cash deposits4. Nugfer Co has not paid any dividends in the last four years5. The number of ordinary shares issued by the company has not changed in recent years6. The target company has no debt finance and its forecast profit before interest and tax for 2011 is $28 million

Required:

(a) Evaluate suitable methods of raising the $200 million required by Nugfer Co, supporting your evaluation withboth analysis and critical discussion. (15 marks)

(b) Briefly explain the factors that will influence the rate of interest charged on a new issue of bonds.(4 marks)

(c) Identify and describe the three forms of efficiency that may be found in a capital market. (6 marks)

(25 marks)

3 [P.T.O.

3 WQZ Co is considering making the following changes in the area of working capital management:

Inventory managementIt has been suggested that the order size for Product KN5 should be determined using the economic order quantitymodel (EOQ).

WQZ Co forecasts that demand for Product KN5 will be 160,000 units in the coming year and it has traditionallyordered 10% of annual demand per order. The ordering cost is expected to be $400 per order while the holding costis expected to be $5·12 per unit per year. A buffer inventory of 5,000 units of Product KN5 will be maintained,whether orders are made by the traditional method or using the economic ordering quantity model.

Receivables managementWQZ Co could introduce an early settlement discount of 1% for customers who pay within 30 days and at the sametime, through improved operational procedures, maintain a maximum average payment period of 60 days for creditcustomers who do not take the discount. It is expected that 25% of credit customers will take the discount if it wereoffered.

It is expected that administration and operating cost savings of $753,000 per year will be made after improvingoperational procedures and introducing the early settlement discount.

Credit sales of WQZ Co are currently $87·6 million per year and trade receivables are currently $18 million. Creditsales are not expected to change as a result of the changes in receivables management. The company has a cost ofshort-term finance of 5·5% per year.

Required:

(a) Calculate the cost of the current ordering policy and the change in the costs of inventory management thatwill arise if the economic order quantity is used to determine the optimum order size for Product KN5.

(6 marks)

(b) Briefly describe the benefits of a just-in-time (JIT) procurement policy. (5 marks)

(c) Calculate and comment on whether the proposed changes in receivables management will be acceptable.Assuming that only 25% of customers take the early settlement discount, what is the maximum earlysettlement discount that could be offered? (6 marks)

(d) Discuss the factors that should be considered in formulating working capital policy on the management oftrade receivables. (8 marks)

(25 marks)

4

4 The following financial information refers to NN Co:

Current statement of financial position

$m $m $mAssetsNon-current assets 101Current assetsInventory 11Trade receivables 21Cash 10

––––42


––––Equity and liabilitiesOrdinary share capital 50Preference share capital 25Retained earnings 19

––––Total equity 94Non-current liabilitiesLong-term borrowings 20Current liabilitiesTrade payables 22Other payables 7

––––Total current liabilities 29

––––Total liabilities 49

––––Total equity and liabilities 143

––––

NN Co has just paid a dividend of 66 cents per share and has a cost of equity of 12%. The dividends of the companyhave grown in recent years by an average rate of 3% per year. The ordinary shares of the company have a par valueof 50 cents per share and an ex div market value of $8·30 per share.

The long-term borrowings of NN Co consist of 7% bonds that are redeemable in six years’ time at their par value of$100 per bond. The current ex interest market price of the bonds is $103·50.

The preference shares of NN Co have a nominal value of 50 cents per share and pay an annual dividend of 8%. Theex div market value of the preference shares is 67 cents per share.

NN Co pay profit tax at an annual rate of 25% per year

Required:

(a) Calculate the equity value of NN Co using the following business valuation methods:

(i) the dividend growth model;(ii) net asset value. (5 marks)

(b) Calculate the after-tax cost of debt of NN Co. (4 marks)

(c) Calculate the weighted average after-tax cost of capital of NN Co. (6 marks)

(d) Discuss the factors to be considered in formulating the dividend policy of a stock-exchange listed company.(10 marks)

(25 marks)

5 [P.T.O.

6

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Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

8

Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers


1 (a) Net present value evaluation

Year 1 2 3 4 5$000 $000 $000 $000 $000

Sales revenue 1,575 1,654 1,736 1,823Selling costs (32) (33) (35) (37)Variable costs (624) (649) (675) (702)

–––––– –––––– –––––– ––––––Before-tax cash flows 919 972 1,026 1,084Taxation at 30% (276) (292) (308) (325)Tax benefits 263 197 148 443

–––––– –––––– –––––– –––––– –––––After-tax cash flows 919 959 931 924 118Working capital (11) (12) (12) (13)

–––––– –––––– –––––– ––––––Project cash flows 908 947 919 911 118Discount at 10% 0·909 0·826 0·751 0·683 0·621

–––––– –––––– –––––– –––––– –––––Present values 825 782 690 622 73

–––––– –––––– –––––– –––––– –––––

$000PV of cash flows: 2,992Working capital: (250)Initial investment: (3,500)

––––––Net present value: (758)

––––––

The NPV is negative, with a value of minus $758,000, and Project A is therefore not financially acceptable.

WorkingsYear 1 2 3 4Selling price ($/unit) 2·100 2·205 2·315 2·431Sales volume (units/year) 750,000 750,000 750,000 750,000Sales revenue ($/years) 1,575,000 1,653,750 1,736,250 1,823,250

Year 1 2 3 4Selling cost ($/unit) 0·042 0·044 0·046 0·049Sales volume (units/year) 750,000 750,000 750,000 750,000Selling cost ($/years) 31,500 33,000 34,500 36,750

Year 1 2 3 4Variable cost ($/unit) 0·832 0·865 0·900 0·936Sales volume (units/year) 750,000 750,000 750,000 750,000Variable cost ($/years) 624,000 648,750 675,000 702,000

Year Capital allowance ($) 30% Tax benefit ($) Year taken1 875,000 262,500 22 656,250 196,875 33 492,188 147,656 44 1,476,562* 442,969 5*This figure includes the balancing allowance

Year Working capital ($) Incremental investment ($)0 250,0001 261,250 11,2502 273,006 11,7563 285,292 12,2864 298,130 12,838

11

Alternative NPV evaluation

An alternative approach to evaluating the NPV of Project A is to subtract and add back the capital allowances, which are notcash flows.

Year 1 2 3 4 5$000 $000 $000 $000 $000

Before-tax cash flows 919 972 1,026 1,084Capital allowances (875) (656) (492) (1,477)

–––– –––– ––––– ––––––Taxable profit 44 316 534 (393)Taxation (13) (95) (160) 118

–––– –––– ––––– –––––– ––––After-tax profit 44 303 439 (553) 118Add capital allowances 875 656 492 1,477

–––– –––– ––––– ––––––After-tax cash flows 919 959 931 924 118

–––– –––– ––––– –––––– ––––

The evaluation will then proceed as earlier.

(b) The directors’ views on investment appraisal are discussed in turn.

Evaluation using either payback or return on capital employedBoth payback period and return on capital employed (ROCE) are inferior to discounted cash flow (DCF) methods such as netpresent value (NPV) and internal rate of return (IRR). Payback ignores the time value of money and cash flows outside of thepayback period. ROCE uses profit instead of cash flow. Both payback and ROCE have difficulty in justifying the target valueused to determine acceptability. Why, for example, use a maximum payback period of two years? DCF methods use theweighted average cost of capital of an investing company as the basis of evaluation, or a project-specific cost of capital, andboth can be justified on academic grounds.

The company should also clarify why either method can be used, since they assess different aspects of an investment project.

Evaluation over a four-year planning periodUsing a planning period or a specified investment appraisal time horizon is a way of reducing the uncertainty associated withinvestment appraisal, since this increases with project life. However, it is important to determine the expected life of aninvestment project if at all possible, since evaluation over the whole life of a project may help a company avoid sub-optimalinvestment decisions. In the case of CJ Co, for example, a further year of operation may lead to Project A generating a positiveNPV.

Scrap value is ignoredScrap value, salvage value or terminal value must be included in the evaluation of a project since it is a cash inflow. Ignoringscrap value will reduce the NPV and may lead to rejection of an otherwise acceptable investment project.

Working capital recovery is ignoredIf an investment project ends, then working capital can be recovered and it must be included in the evaluation of aninvestment project, since it is a cash inflow. In the case of CJ Co, the directors’ decision to ignore working capital recoverymeans ignoring a fourth year cash inflow of $298,130.

A balancing allowance is claimed at the end of the fourth year of operationIntroducing a balancing allowance which can only be claimed when allowed by the taxation authorities will distort the taxationaspects of the investment appraisal. If it is anticipated that a project will continue beyond the fourth year, including abalancing allowance in the evaluation will overstate cash inflows and hence the NPV, potentially leading to incorrectinvestment decisions being made.

(c) The first step is to ungear the equity beta of GZ Co. This removes the effect of the financial risk of the company on the valueof its equity beta. It is usual to assume that the beta of debt is zero and hence the ungearing formula is as follows:

βa = βeVe/(Ve + Vd(1 – T))

Substituting, the asset beta = βa = 1·5 x 90/(90 + (0·7 x 30)) = 1·216

Using percentages: asset beta = βa = 1·5 x 75/(75 + (0·7 x 25)) = 1·216

The asset beta of GZ Co reflects only the business risk of the new business area.

The next stage is to regear the asset beta into an equity beta that reflects the financial risk of the investing company.Rearranging the ungearing formula used earlier gives:

βe = βa (Ve + Vd(1 – T))/Ve

Substituting, the equity beta = βe = 1·216 x (180 + (0·7 x 45))/180 = 1·429

This regeared equity beta can be inserted in the capital asset pricing model equation to give a project-specific cost of equity:

ke = E(ri) = Rf + βe(E(rm) – Rf)

Substituting, the cost of equity = ke = 4 + (1·429 x 6) = 12·6%

12

2 (a) Nugfer Co is looking to raise $200m in cash in order to acquire a competitor. Any recommendation as to the source of financeto be used by the company must take account of the recent financial performance of the company, its current financialposition and its expected financial performance in the future, presumably after the acquisition has occurred.

Recent financial performanceThe recent financial performance of Nugfer Co will be taken into account by potential providers of finance because it will helpthem to form an opinion as to the quality of the management running the company and the financial problems the companymay be facing. Analysis of the recent performance of Nugfer Co gives the following information:

Year 2007 2008 2009 2010Operating profit $41·7m $43·3m $50·1m $56·7mNet profit margin 34% 34% 32% 30%Interest coverage ratio 7 times 7 times 4 times 3 timesRevenue growth 3·8% 23·0% 20·9%Operating profit growth 3·8% 15·7% 13·2%Finance charges growth 3·3% 101·6% 50·4%Profit after tax growth 4·0% 1·2% 0·8%

Geometric average growth in turnover = (189·3/122·6)0·33 – 1 = 15·6%

Geometric average operating profit growth = (56·7/41·7)0·33 – 1 = 10·8%

One positive feature indicated by this analysis is the growth in revenue, which grew by 23% in 2009 and by 21% in 2010.Slightly less positive is the growth in operating profit, which was 16% in 2009 and 13% in 2010. Both years weresignificantly better in revenue growth and operating profit growth than 2008. One query here is why growth in operating profitis so much lower than growth in revenue. Better control of operating and other costs might improve operating profitsubstantially and decrease the financial risk of Nugfer Co.

The growing financial risk of the company is a clear cause for concern. The interest coverage ratio has declined each year inthe period under review and has reached a dangerous level in 2010. The increase in operating profit each year has clearlybeen less than the increase in finance charges, which have tripled over the period under review. The reason for the largeincrease in debt is not known, but the high level of financial risk must be considered in selecting an appropriate source offinance to provide the $200m in cash that is needed.

Current financial positionThe current financial position of Nugfer Co will be considered by potential providers of finance in their assessment of thefinancial risk of the company. Analysis of the current financial position of Nugfer Co shows the following:

Debt/equity ratio = long-term debt/total equity = 100 x (100/221) = 45%

Debt equity/ratio including short-term borrowings = 100 x ((100 + 160)/221) = 118%

The debt/equity ratio based on long-term debt is not particularly high. However, the interest coverage ratio indicated a highlevel of financial risk and it is clear from the financial position statement that the short-term borrowings of $160m are greaterthan the long-term borrowings of $100m. In fact, short-term borrowings account for 62% of the debt burden of Nugfer Co.If we include the short-term borrowings, the debt/equity ratio increases to 118%, which is certainly high enough to be a causefor concern. The short-term borrowings are also at a higher interest rate (8%) than the long-term borrowings (6%) and as aresult, interest on short-term borrowings account for 68% of the finance charges in the income statement.

It should also be noted that the long-term borrowings are bonds that are repayable in 2012. Nugfer Co needs therefore toplan for the redemption and refinancing of $100m of debt in two years’ time, a factor that cannot be ignored when selectinga suitable source of finance to provide the $200m of cash needed.

Recommendation of suitable financing methodThere are strong indications that it would be unwise for Nugfer Co to raise the $200m of cash required by means of debtfinance, for example the low interest coverage ratio and the high level of gearing.

If no further debt is raised, the interest coverage ratio would improve after the acquisition due to the increased level ofoperating profit, i.e. (56·7m + 28m)/18·8 = 4·5 times. Assuming that $200m of 8% debt is raised, the interest coverageratio would fall to ((84·7/(18·8 + 16)) = 2·4 times and the debt/equity ratio would increase to 100 x (260 + 200)/221 =208%.

If convertible debt were used, the increase in gearing and the decrease in interest coverage would continue only untilconversion occurred, assuming that the company’s share price increased sufficiently for conversion to be attractive tobondholders. Once conversion occurred, the debt capacity of the company would increase due both to the liquidation of theconvertible debt and to the issuing of new ordinary shares to bond holders. In the period until conversion, however, thefinancial risk of the company as measured by gearing and interest coverage would remain at a very high level.

If Nugfer Co were able to use equity finance, the interest coverage ratio would increase to 4·5 times and the debt/equity ratiowould fall to 100 x (260/(221 + 200)) = 62%. Although the debt/equity ratio is still on the high side, this would fall if someof the short-term borrowings were able to be paid off, although the recent financial performance of Nugfer Co indicates thatthis may not be easy to do. The problem of redeeming the current long-term bonds in two years also remains to be solved.

13

However, since the company has not paid any dividend for at least four years, it is unlikely that current shareholders wouldbe receptive to a rights issue, unless they were persuaded that dividends would be forthcoming in the near future. Acquisitionof the competitor may be the only way of generating the cash flows needed to support dividend payments.

A similar negative view could be taken by new shareholders if Nugfer Co were to seek to raise equity finance via a placing ora public issue.

Sale and leaseback of non-current assets could be considered, although the nature and quality of the non-current assets isnot known. The financial position statement indicates that Nugfer Co has $300m of non-current assets, $100m of long-termborrowings and $160m of short-term borrowings. Since its borrowings are likely to be secured on some of the existing non-current assets, there appears to be limited scope for sale and leaseback.

Venture capital could also be considered, but it is unlikely that such finance would be available for an acquisition and nobusiness case has been provided for the proposed acquisition.

While combinations of finance could also be proposed, the overall impression is that Nugfer Co is in poor financial healthand, despite its best efforts, it may not be able to raise the $200m in cash that it needs to acquire its competitor.

(b) When a new issue of bonds is made by a company, the interest rate on the bonds will be influenced by factors that are specificto the company, and by factors that relate to the economic environment as a whole.

Company-specific factorsThe interest rate charged on a new issue of bonds will depend upon such factors as the risk associated with the companyand any security offered.

The risk associated with the company will be assessed by considering the ability of the company to meet interest paymentsin the future, and hence its future cash flows and profitability, as well as its ability to redeem the bond issue on maturity.

Where an issue of new bonds is backed by security, the interest rate charged on the issue will be lower than for an unsecuredbond issue. A bond issue will be secured on specific non-current assets such as land or buildings, and as such is referred toas a fixed-charge security.

Economic environment factorsAs far as the duration of a new issue of bonds is concerned, the term structure of interest rates suggests that short-term debtis usually cheaper than long-term debt, so that the yield curve slopes upwards with increasing term to maturity. The longerthe duration of an issue of new bonds, therefore, the higher will be the interest rate charged. The shape of the yield curve,which can be explained by reference to liquidity preference theory, expectations theory and market segmentation theory, willbe independent of any specific company.

The rate of interest charged on a new issue of bonds will also depend on the general level of interest rates in the financialsystem. This is influenced by the general level of economic activity in a given country, such as whether the economy is inrecession (when interest rates tend to fall) or experiencing rapid economic growth (when interest rates are rising as capitalavailability is decreasing). The general level of interest rates is also influenced by monetary policy decisions taken by thegovernment or the central bank. For example, interest rates may be increased in order to exert downward pressure on demandand hence decrease inflationary pressures in an economy.

Examiner’s note: the above answer is longer than would be expected from a candidate under examination conditions.

(c) The three forms of capital market efficiency are weak form, semi-strong form and strong form efficiency. The three forms ofefficiency can be distinguished by considering the different kinds of information that are reflected in security prices.

Weak form efficiencyThis refers to a situation where securities trading on a capital market (e.g. shares and bonds) are shown to reflect all relevantpast information. If a capital market is weak form efficient, it is not possible to predict security prices by studying share pricemovements in the past. There is no correlation between share price movements in successive periods and, in fact, shareprices appear to be following a random walk.

Semi-strong form efficiencyThis refers to a situation where securities trading on a capital market are shown to reflect all past and public information. Ifa capital market is semi-strong form efficient, it is not possible to make above-average (abnormal) returns by studyinginformation in the public domain (this includes past information), because the prices of securities move quickly and accuratelyto reflect new information as it becomes available.

Strong form efficiencyIf a capital market is described as strong form efficient, the prices of securities trading on the market reflect all information,whether past, public or private. It is not possible for this form of capital market efficiency to exist in the real world, since it isalways possible for an individual with access to relevant information which is not public to benefit from it by buying andselling securities.

14

3 (a) Cost of the current ordering policy

Order size = 10% of 160,000 = 16,000 units per orderNumber of orders per year = 160,000/16,000 = 10 orders per yearAnnual ordering cost = 10 x 400 = $4,000 per yearHolding cost ignoring buffer inventory = 5·12 x (16,000/2) = $40,960 per yearHolding cost of buffer inventory = 5·12 x 5,000 = $25,600 per yearTotal cost of current policy = 4,000 + 40,960 + 25,600 = $70,560 per year

Cost of the ordering policy using the EOQ model

Order size = (2 x 400 x 160,000/5·12)0·5 = 5,000 units per orderNumber of orders per year = 160,000/5,000 = 32 orders per yearAnnual ordering cost = 32 x 400 = $12,800 per yearHolding cost ignoring buffer inventory = 5·12 x (5,000/2) = $12,800 per yearHolding cost of buffer inventory = 5·12 x 5,000 = $25,600 per yearTotal cost of EOQ policy = 12,800 + 12,800 + 25,600 = $51,200 per year

Change in costs of inventory management by using EOQ modelDecrease in costs = 70,560 – 51,200 = $19,360

Examiner’s NoteSince the buffer inventory is the same in both scenarios, its holding costs do not need to be included in calculating thechange in inventory management costs.

(b) Holding costs can be reduced by reducing the level of inventory held by a company. Holding costs can be reduced to aminimum if a company orders supplies only when it needs them, avoiding the need to have any inventory at all of inputs tothe production process. This approach to inventory management is called just-in-time (JIT) procurement.

The benefits of a JIT procurement policy include a lower level of investment in working capital, since inventory levels havebeen minimised: a reduction in inventory holding costs; a reduction in materials handling costs, due to improved materialsflow through the production process; an improved relationship with suppliers, since supplier and customer need to workclosely together in order to make JIT procurement a success; improved operating efficiency, due to the need to streamlineproduction methods in order to eliminate inventory between different stages of the production process; and lower reworkingcosts due to the increased emphasis on the quality of supplies, since hold-ups in production must be avoided when inventorybetween production stages has been eliminated.

(c) Evaluation of changes in receivables managementThe current level of receivables days = (18/87·6) x 365 = 75 daysSince 25% of credit customers will take the discount, 75% will not be doing so.The revised level of receivables days = (0·25 x 30) + (0·75 x 60) = 52·5 days

Current level of trade receivables = $18mRevised level of trade receivables = 87·6 x (52·5/365) = $12·6mReduction level of trade receivables = 18 – 12·6 = $5·4m

Cost of short-term finance = 5·5%Reduction in financing cost = 5·4m x 0·055 = $297,000Administration and operating cost savings = $753,000Total benefits = 297,000 + 753,000 = $1,050,000

Cost of early settlement discount = 87·6m x 0·25 x 0·01 = $219,000Net benefit of early settlement discount = 1,050,000 – 219,000 = $831,000

The proposed changes in receivables management are therefore financially acceptable, although they depend heavily on theforecast savings in administration and operating costs.

Maximum early settlement discountComparing the total benefits of $1,050,000 with 25% of annual credit sales of $87,600,000, which is $21,900,000, themaximum early settlement discount that could be offered is 4·8% (100 x (1·050/21·9)).

(d) Factors that should be considered when formulating working capital policy on the management of trade receivables includethe following:

The level of investment in trade receivablesIf the amount of finance tied up in trade receivables is substantial, receivables management policy may be formulated withthe intention of reducing the level of investment by tighter control over the way in which credit is granted and improvedmethods of assessing client creditworthiness.

The cost of financing trade creditIf the cost of financing trade credit is high, there will be pressure to reduce the amount of credit offered and to reduce theperiod for which credit is offered.

15

The terms of trade offered by competitorsIn order to compete effectively, a company will need to match the terms offered by its competitors, otherwise customers willmigrate to competitors, unless there are other factors that will encourage them to be loyal, such as better quality products ora more valuable after-sales service.

The level of risk acceptable to the companySome companies may feel that more relaxed trade credit terms will increase the volume of business to an extent thatcompensates for a higher risk of bad debts. The level of risk of bad debts that is acceptable will vary from company tocompany. Some companies may seek to reduce this risk through a policy of insuring against non-payment by clients.

The need for liquidityWhere the need for liquidity is relatively high, a company may choose to accelerate cash inflow from credit customers byusing invoice discounting or by factoring.

The expertise available within the companyWhere expertise in the assessment of creditworthiness and the monitoring of customer accounts is not to a sufficiently highstandard, a company may choose to outsource its receivables management to a third party, i.e. a factor.

4 (a) Using the dividend growth model, the share price of NN Co will be the present value of its expected future dividends, i.e. (66x 1·03)/(0·12 – 0·03) = 755 cents per share or $7·55 per share

Number of ordinary shares = 50/0·5 = 100m sharesValue of NN Co = 100m x 7·55 = $755m

Net asset value of NN Co = total assets less total liabilities = 143 – 29 – 20 – 25 = $69m

In calculating net asset value, preference share capital is included with long-term liabilities, as it is considered to be priorcharge capital.

(b) The after-tax cost of debt of NN Co can be found by linear interpolation

The annual after-tax interest payment = 7 x (1 – 0·25) = 7 x 0·75 = $5·25 per year

Year Cash flow ($) 5% Discount factor Present value ($)0 (103·50) 1·000 (103·50)1–6 5·25 5·076 26·656 100 0·746 74·60

–––––––(2·25)

–––––––

Year Cash flow ($) 4% Discount factor Present value ($)0 (103·50) 1·000 (103·50)1–6 5·25 5·242 27·526 100 0·790 79·00

–––––––3·02

–––––––

After-tax cost of debt = 4 + [(1 x 3·02)/(3·02 + 2·25)] = 4 + 0·57 = 4·6%

Examiner’s note: the calculated value of the after-tax cost of debt will be influenced by the choice of discount rates used inthe linear interpolation calculation and so other values would also gain credit here.

(c) Annual preference dividend = 8% x 50 cents = 4 cents per shareCost of preference shares = 100 x (4/67) = 6%

Number of ordinary shares = 50/0·5 = 100m sharesMarket value of equity = Ve = 100m shares x 8·30 = $830mNumber of preference shares = 25/0·5 = 50m sharesMarket value of preference shares = Vp = 0·67 x 50m = $33·5mMarket value of long-term borrowings = Vd = 20 x 103·50/100 = $20·7mTotal market value of company = (Ve + Vd + Vp) = (830 + 33·5 + 20·7) = $884·2m

WACC = (keVe + kpVp + kd(1 – T)Vd)/ (Ve + Vp + Vd) = (12 x 830 + 6 x 33·5 + 4·6 x 20·7)/884·2 = 11·6%

(d) A number of factors should be considered in formulating the dividend policy of a stock-exchange listed company, as follows.

ProfitabilityCompanies need to remain profitable and dividends are a distribution of after-tax profit. A company cannot consistently paydividends higher than its profit after tax. A healthy level of retained earnings is needed to finance the continuing businessneeds of the company.

16

LiquidityAlthough a dividend is a distribution of profit, it is a cash payment by the company to its shareholders. A company musttherefore ensure it has sufficient cash to pay a proposed dividend and that paying a dividend will not compromise day-to-daycash financing needs.

Legal and other restrictionsA dividend can only be paid out in accordance with statutory requirements, such as the requirement in the United Kingdomfor dividends to be paid out of accumulated net realised profits. There may also be restrictions on dividend payments imposedby, for example, restrictive covenants in bond issue documents.

The need for financeThere is a close relationship between investment, financing and dividend decisions, and the dividend decision must considerthe investment plans and financing needs of the company. A large investment programme, for example, will require a largeamount of finance, and the need for external finance can be reduced if dividend increases are kept in check. Similarly, thedecision to increase dividends may reduce retained earnings to the extent where external finance is needed in order to meetinvestment needs.

The level of financial riskIf financial risk is high, for example due to a high level of gearing arising from a substantial level of debt finance, maintaininga low level of dividend payments can result in a high level of retained earnings, which will reduce gearing by increasing thelevel of reserves. The cash flow from a higher level of retained earnings can also be used to decrease the amount of debtbeing carried by a company.

The signalling effect of dividendsIn a semi-strong form efficient market, information available to directors is more substantial than that available toshareholders, so that information asymmetry exists. This is one of the causes of the agency problem. If dividend decisionsconvey new information to the market, they can have a signalling effect concerning the current position of the company andits future prospects. The signalling effect also depends on the dividend expectations in the market. A company shouldtherefore consider the likely effect on share prices of the announcement of a proposed dividend.

17


Marks Marks1 (a) Sales revenue 1

Selling costs 1Variable costs 1Capital allowances, years 1 to 3 1Capital allowance/balancing allowance, year 4 1Tax liabilities 1Timing of taxation 1Incremental working capital 2Discount factors 1NPV calculation 1Decision as to financial acceptability 1

–––12

(b) Discussion of payback and ROCE 2–3Discussion of planning period 1–2Discussion of scrap value 1–2Discussion of working capital recovery 1–2Discussion of balancing allowance 1–2

–––Maximum 7

(c) Ungearing equity beta 1Regearing equity beta 1Calculating project-specific cost of equity 1Explaining stages of calculation 3

–––6

–––25–––

2 (a) Analysis of recent financial performance 1–3Discussion of recent financial performance 1–3Analysis of current financial position 1–3Discussion of current financial position 1–2Consideration of suitable sources of finance 4–6Recommendation of suitable source of finance 1

–––Maximum 15

(b) Company-specific factors 2–3Economic environment factors 2–3

–––Maximum 4

(c) Weak form efficiency 2Semi-strong form efficiency 2Strong form efficiency 2

–––6

–––25–––

19

Marks Marks3 (a) Current policy:

Annual ordering cost 1Annual holding cost 1Total annual cost 1EOQ policy:Annual order size 1Annual ordering cost and holding cost 1Change in inventory management cost 1

–––6

(b) Benefits of JIT procurement policy 5

(c) Reduction in trade receivables 2Financing cost saving 1Cost of early settlement discount 1Comment on net benefit 1Maximum early settlement discount 1

–––6

(d) Relevant discussion 8–––25–––

4 (a) Share price using dividend growth model 2Value of company using dividend growth model 1Net asset value of company 2

–––5

(b) Correct use of taxation 1Calculation of after-tax cost of debt 3

–––4

(c) Cost of preference shares 1Market value of equity 1Market value of preference shares 1Market value of debt 1Weighted average cost of capital 2

–––6

(d) Profitability 1–2Liquidity 1–2Legal and other restrictions 1–2The need for finance 1–2The level of financial risk 1–2The signalling effect of dividends 1–2

–––Maximum 10

–––25–––

20








Pape

r F9





1 BRT Co has developed a new confectionery line that can be sold for $5·00 per box and that is expected to havecontinuing popularity for many years. The Finance Director has proposed that investment in the new product shouldbe evaluated over a four-year time-horizon, even though sales would continue after the fourth year, on the groundsthat cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (bothin current price terms) will depend on sales volume, as follows.

Sales volume (boxes) less than 1 million 1–1·9 million 2–2·9 million 3–3·9 millionVariable cost ($ per box) 2·80 3·00 3·00 3·05Total fixed costs ($) 1 million 1·8 million 2·8 million 3·8 million

Forecast sales volumes are as follows.

Year 1 2 3 4Demand (boxes) 0·7 million 1·6 million 2·1 million 3·0 million

The production equipment for the new confectionery line would cost $2 million and an additional initial investmentof $750,000 would be needed for working capital. Capital allowances (tax-allowable depreciation) on a 25%reducing balance basis could be claimed on the cost of equipment. Profit tax of 30% per year will be payable oneyear in arrears. A balancing allowance would be claimed in the fourth year of operation.

The average general level of inflation is expected to be 3% per year and selling price, variable costs, fixed costs andworking capital would all experience inflation of this level. BRT Co uses a nominal after-tax cost of capital of 12% toappraise new investment projects.

Required:

(a) Assuming that production only lasts for four years, calculate the net present value of investing in the newproduct using a nominal terms approach and advise on its financial acceptability (work to the nearest$1,000). (13 marks)

(b) Comment briefly on the proposal to use a four-year time horizon, and calculate and discuss a value that couldbe placed on after-tax cash flows arising after the fourth year of operation, using a perpetuity approach.Assume, for this part of the question only, that before-tax cash flows and profit tax are constant from yearfive onwards, and that capital allowances and working capital can be ignored. (5 marks)

(c) Discuss THREE ways of incorporating risk into the investment appraisal process. (7 marks)

(25 marks)

2

2 The finance director of AQR Co has heard that the market value of the company will increase if the weighted averagecost of capital of the company is decreased. The company, which is listed on a stock exchange, has 100 millionshares in issue and the current ex div ordinary share price is $2·50 per share. AQR Co also has in issue bonds witha book value of $60 million and their current ex interest market price is $104 per $100 bond. The current after-taxcost of debt of AQR Co is 7% and the tax rate is 30%.

The recent dividends per share of the company are as follows.

Year 2006 2007 2008 2009 2010Dividend per share (cents) 19·38 20·20 20·41 21·02 21·80

The finance director proposes to decrease the weighted average cost of capital of AQR Co, and hence increase itsmarket value, by issuing $40 million of bonds at their par value of $100 per bond. These bonds would pay annualinterest of 8% before tax and would be redeemed at a 5% premium to par after 10 years.

Required:

(a) Calculate the market value after-tax weighted average cost of capital of AQR Co in the followingcircumstances:

(i) before the new issue of bonds takes place;(ii) after the new issue of bonds takes place.

Comment on your findings. (12 marks)

(b) Identify and discuss briefly the factors that influence the market value of traded bonds. (5 marks)

(c) Discuss the director’s view that issuing traded bonds will decrease the weighted average cost of capital ofAQR Co and thereby increase the market value of the company. (8 marks)

(25 marks)

3 [P.T.O.

3 The following financial information relates to YNM Co, which has a cost of equity of 12%. Assume that it is now 31 March 2011 and that the ordinary share price of YNM Co is $4·17 per share. YNM Co has been experiencingtrading difficulties due to a continuing depressed level of economic activity:

Income statement information for recent years ending 31 March

2009 2010 2011$m $m $m

Profit before interest and tax 29·3 26·6 25·3Finance charges (interest) 4·8 5·3 5·5

–––– –––– ––––Profit before tax 24·5 21·3 19·8Taxation expense 7·3 6·4 5·9

–––– –––– ––––Profit for the period 17·2 14·9 13·9

–––– –––– ––––

Statement of financial position information as at 31 March 2011

$m $mOrdinary shares, par value $1 19·0Retained earnings 88·5

––––Total equity 107·58% bonds, redeemable in two years’ time 50·0

–––––Total equity and non-current liabilities 157·5

–––––

Note: the statement of financial position takes no account of any dividend to be paid. The ordinary share capital ofYNM Co has not changed during the period under consideration and the 8% bonds were issued in 1998.

Dividend and share price information

2008 2009 2010Total cash dividend paid ($m) 9·5 9·5Share price at end of year ($/share) 5·94 5·10 4·59

Average data on companies similar to YNM Co:

Interest coverage ratio 10 timesLong-term debt/equity (book value basis) 40%

Financial objective of YNM CoYNM Co has a declared objective of maximising shareholder wealth.

Dividend decisionYNM Co is considering two alternative dividend choices for the year ending 31 March 2011:

(1) To pay the same total cash dividend as in 2010(2) To pay no dividend at all for the year ending 31 March 2011

Financing decisionYNM Co is also considering raising $50 million of new debt finance to support existing business operations.

4

Required:

(a) Analyse and discuss the recent financial performance and the current financial position of YNM Co,commenting on:

(i) achievement of the objective of maximising shareholder wealth;(ii) the two dividend choices;(iii) the proposal to raise $50 million of new debt finance. (13 marks)

(b) Discuss the following sources of finance that could be suitable for YNM Co, in its current position, to meetits need for $50m to support existing business operations:

(i) equity finance;(ii) sale and leaseback. (6 marks)

(c) Explain the nature of a scrip (share) dividend and discuss the advantages and disadvantages to a companyof using scrip dividends to reward shareholders. (6 marks)

(25 marks)

5 [P.T.O.

4 (a) ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when pesointerest rates were relatively cheap compared to dollar interest rates. Economic difficulties have now increasedpeso interest rates while dollar interest rates have remained relatively stable. ZPS Co must pay interest of5,000,000 pesos in six months’ time. The following information is available.

Per $Spot rate: pesos 12·500 – pesos 12·582Six-month forward rate: pesos 12·805 – pesos 12·889

Interest rates that can be used by ZPS Co:

Borrow DepositPeso interest rates: 10·0% per year 7·5% per yearDollar interest rates: 4·5% per year 3·5% per year

Required:

(i) Explain briefly the relationships between;

(1) exchange rates and interest rates;(2) exchange rates and inflation rates. (5 marks)

(ii) Calculate whether a forward market hedge or a money market hedge should be used to hedge theinterest payment of 5 million pesos in six months’ time. Assume that ZPS Co would need to borrow anycash it uses in hedging exchange rate risk. (6 marks)

(b) ZPS Co places monthly orders with a supplier for 10,000 components that are used in its manufacturingprocesses. Annual demand is 120,000 components. The current terms are payment in full within 90 days,which ZPS Co meets, and the cost per component is $7·50. The cost of ordering is $200 per order, while thecost of holding components in inventory is $1·00 per component per year.

The supplier has offered either a discount of 0·5% for payment in full within 30 days, or a discount of 3·6% onorders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding componentsin inventory would increase to $2·20 per component per year due to the need for a larger storage facility.

Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 4·5% per year.

Required:

(i) Discuss the factors that influence the formulation of working capital policy; (7 marks)

(ii) Calculate if ZPS Co will benefit financially by accepting the offer of:

(1) the early settlement discount;(2) the bulk purchase discount. (7 marks)

(25 marks)

6

7 [P.T.O.

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8

Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

9

Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers


1 (a) Net present value evaluation of new confectionery investment

Year 1 2 3 4 5$000 $000 $000 $000 $000

Sales 3,605 8,488 11,474 16,884Variable cost (2,019) (5,093) (6,884) (10,299)Fixed costs (1,030) (1,910) (3,060) (4,277)

––––––– ––––––– ––––––– –––––––Taxable cash flow 556 1,485 1,530 2,308Taxation (167) (446) (459) (692)CA tax benefits 150 113 84 253Working capital (23) (23) (24) 820

––––––– ––––––– ––––––– ––––––– ––––––After-tax cash flows 533 1,445 1,173 2,753 (439)Discount at 12% 0·893 0·797 0·712 0·636 0·567

––––––– ––––––– ––––––– ––––––– ––––––Present values 476 1,152 835 1,751 (249)

––––––– ––––––– ––––––– ––––––– ––––––

$000Sum of present values 3,965Working capital (750)Initial investment (2,000)

––––––Net present value 1,215

––––––

Comment:The proposed investment in the new product is financially acceptable, as the NPV is positive.

Examiner’s note:Including capital allowance tax benefits by subtracting capital allowances, calculating tax liability and then adding backthe capital allowances is also acceptable.

WorkingsYear 1 2 3 4Sales volume (boxes) 700,000 1,600,000 2,100,000 3,000,000Inflated selling price ($/box) 5·150 5·305 5·464 5·628

––––––– ––––––––– ––––––––– –––––––––Sales ($000/yr) 3,605 8,488 11,474 16,884

––––––– ––––––––– ––––––––– –––––––––

Year 1 2 3 4Sales volume (boxes) 700,000 1,600,000 2,100,000 3,000,000Variable cost ($/box) 2·80 3·00 3·00 3·05Inflated variable cost ($/box) 2·884 3·183 3·278 3·433

––––––– ––––––––– ––––––––– –––––––––Variable cost ($000/yr) 2,019 5,093 6,884 10,299

––––––– ––––––––– ––––––––– –––––––––

Year 1 2 3 4Sales volume (boxes) 700,000 1,600,000 2,100,000 3,000,000Fixed costs ($000) 1,000 1,800 2,800 3,800Inflated fixed costs ($000) 1,030 1,910 3,060 4,277

Year 1 2 3 4 Total$ $ $ $ $

Capital allowance 500,000 375,000 281,250 843,750 2,000,000Tax benefit (30%) 150,000 112,500 84,375 253,125 600,000

Year 0 1 2 3 4$ $ $ $ $

Working capital 750,000 772,500 795,675 819,545Incremental 22,500 23,175 23,870 (819,545)

(b) The proposal to use a four-year time horizonThe finance director believes that cash flows are too uncertain after four years to be included in the net present valuecalculation, even though sales will continue beyond four years. While it is true that uncertainty increases with project life,cutting off the analysis after four years will underestimate the value of the investment to the extent that cash flows after thecut-off point are ignored. Furthermore, since the new confectionery line is expected to be popular, cash flows after year fourcould be substantial, increasing the extent of the undervaluation.

Artificially terminating the evaluation after four years has accelerated the recovery of working capital and has also led to alarge balancing allowance. These increased cash flows, which arise in years four and five respectively, will overestimate thevalue of the investment.

13

The value of cash flows after the fourth year of operationThe approach here should be to calculate the present value of the expected future cash flows beyond year four. If the before-tax cash flows are assumed to be constant and if the one-year delay in tax liabilities is ignored, the year four presentvalue of future cash flows beyond year four can be estimated using a perpetuity approach. If inflation in year five is ignored,the year four present value of cash flows from year five onwards will be:

2,308,000 x (1 – 0·3)/0·12 = $13,463,000

The year zero present value of these cash flows = 13,463,000 x 0·636 = $8,562,468

If one year’s inflation is included:

2,308,000 x 1·03 x (1 – 0·3))/0·12 = $13,867,000

The year zero present value of these cash flows = 13,867,000 x 0·636 = $8,819,000

Although these calculations ignore the capital allowance tax benefits (which will decrease each year) and the incrementalinvestment in working capital (which will increase slightly each year), the present value of cash flows after year four is stillsubstantial.

(c) Examiner note: only THREE ways of incorporating risk into investment appraisal were required to be discussed.

Risk and uncertaintyRisk in investment appraisal refers to the attachment of probabilities to the possible outcomes from an investment project andtherefore represents a quantified assessment of the variability of expected returns. Uncertainty cannot be quantified byattaching probabilities and although the terms are often used interchangeably, the difference is important in investmentappraisal.

Sensitivity analysisThis assesses the sensitivity of project NPV to changes in project variables. It calculates the relative change in a projectvariable required to make the NPV zero, or the relative change in NPV for a fixed change in a project variable. Only onevariable is considered at a time. When the sensitivities for each variable have been calculated, the key or critical variablescan be identified. These show where assumptions may need to be checked and where managers could focus their attentionin order to increase the likelihood that the project will deliver its calculated benefits. However, since sensitivity analysis doesnot incorporate probabilities, it cannot be described as a way of incorporating risk into investment appraisal, although it isoften described as such.

Probability analysisThis approach involves assigning probabilities to each outcome of an investment project, or assigning probabilities to differentvalues of project variables. The range of net present values that can result from an investment project is then calculated,together with the joint probability of each outcome. The net present values and their joint probabilities can be used to calculatethe mean or average NPV (the expected NPV or ENPV) which would arise if the investment project could be repeated a largenumber of times. Other useful information that could be provided by the probability analysis includes the worst outcome andits probability, the probability of a negative NPV, the best outcome and its probability, and the most likely outcome. Managerscould then make a decision on the investment that took account more explicitly of its risk profile.

Risk-adjusted discount rateIt appears to be intuitively correct to add a risk premium to the ‘normal’ discount rate to assess a project with greater thannormal risk. The theoretical approach here would be to use the capital asset pricing model (CAPM) to determine a project-specific discount rate that reflected the systematic risk of an investment project. This can be achieved by selectingproxy companies whose business activities are the same as the proposed investment project: removing the effect of theirfinancial risk by ungearing their equity betas to give an average asset beta; regearing the asset beta to give an equity betareflecting the financial risk of the investing company; and using the CAPM to calculate a project-specific cost of equity for theinvestment project.

Adjusted paybackPayback can be adjusted for risk, if uncertainty is considered to be the same as risk, by shortening the payback period. Thelogic here is that as uncertainty (risk) increases with the life of the investment project, shortening the payback period for aproject that is relatively risky will require it to pay back sooner, putting the focus on cash flows that are more certain (lessrisky) because they are nearer in time.

Payback can also be adjusted for risk by discounting future cash flows with a risk-adjusted discount rate, i.e. by using thediscounted payback method. The normal payback period target can be applied to the discounted cash flows, which will havedecreased in value due to discounting, so that the overall effect is similar to reducing the payback period with undiscountedcash flows.

14

2 (a) Cost of equityGeometric average dividend growth rate = (21·8/19·38)0·25 – 1 = 0·0298 or 3%Using the dividend growth model, ke = 0·03 + ((21·8 x 1·03)/250) = 0·03 + 0·09 = 12%

Market values of equity and debtMarket value of equity = Ve = 100m x 2·50 = $250 millionMarket value of bonds = Vd = 60m x (104/100) = $62·4 millionTotal market value of AQR Co = Ve + Vd = 250 + 62·4 = $312·4 million

Current WACC calculationThe current after-tax cost of debt is 7%WACC = ((ke x Ve) + (kd(1 – T) x Vd)/(Ve + Vd)) = ((12 x 250m) + (7 x 62·4m))/312·4m = 11%The weighted average after-tax cost of capital before the new issue of bonds is 11%

After-tax cost of debt of new bond issueAfter-tax interest rate = 8 x (1 – 0·3) = 5·6% per year

Using linear interpolation:

Year Cash flow $ 5% Discount PV ($) 6% Discount PV ($)0 Market value (100) 1·000 (100·00) 1·000 (100·00)1–10 Interest 5·6 7·722 43·24 7·360 41·2210 Redemption 105 0·614 64·47 0·558 58·59

–––––– ––––––7·71 (0·19)

–––––– ––––––

After-tax cost of debt = 5 + [((6 – 5) x 7·71)/(7·71 + 0·19)] = 5 + 0·98 = 5·98% or 6%

Examiner’s note: other methods of calculating the after-tax cost of redeemable debt are acceptable.

Revised WACC calculationThe market value of the new issue of bonds is $40 millionThe total market value of AQR Co increases to 312·4 + 40 = $352·4 million

WACC = ((12 x 250m) + (7 x 62·4m) + (6 x 40))/352·4m = 10·4%

After the new issue of bonds, the weighted average after-tax cost of capital has decreased from 11% to 10·4% because theproportion of debt finance, which has a lower required rate of return than equity finance, has increased. Gearing on a marketvalue basis has increased from 20% (62·4/312·4) to 29% (102·4/352·4).

The WACC calculation assumes that the cost of equity has not changed, when in reality the cost of equity might be expectedto rise in response to the increase in financial risk caused by the new issue of debt. The share price of the company has alsobeen assumed to be constant.

(b) The factors that influence the market value of traded bonds are represented in the bond valuation model.

Amount of interest paymentThe market value of a traded bond will increase as the interest paid on the bond increases, since the reward offered for owningthe bond becomes more attractive.

Frequency of interest paymentsIf interest payments are more frequent, say every six months rather than every year, then the present value of the interestpayments increases and hence so does the market value.

Redemption valueIf a higher value than par is offered on redemption, as is the case with the proposed bond issue of AQR Co, the reward offeredfor owning the bond increases and hence so does the market value.

Period to redemptionThe market value of traded bonds is affected by the period to redemption, either because the capital payment becomes moredistant in time or because the number of interest payments increases.

Cost of debtThe present value of future interest payments and the future redemption value are heavily influenced by the cost of debt, i.e.the rate of return required by bond investors. This rate of return is influenced by the perceived risk of a company, for exampleas evidenced by its credit rating. As the cost of debt increases, the market value of traded bonds decreases, and vice versa.

ConvertibilityIf traded bonds are convertible into ordinary shares, the market price will be influenced by the likelihood of the futureconversion and the expected conversion value, which is dependent on the current share price, the future share price growthrate and the conversion ratio.

(c) There is certainly a relationship between the weighted average cost of capital (WACC) and the market value of the company,since the market value can be expressed as the present value of future corporate cash flows, discounted by the WACC.

15

Marginal and average cost of debtAs for decreasing the WACC by issuing traded bonds, if the marginal cost of capital, in this case the cost of debt of the newbond issue, is less than the weighted average cost of capital (WACC), it would seem logical to expect the WACC to decrease.However, as noted in an earlier discussion, increasing gearing will increase financial risk and may lead to an increase in thecost of equity, offsetting the effect of the cheaper debt. The relationship between capital structure and WACC has been debatedfor many years.

Traditional view of capital structureIn the traditional view of capital structure, there is a non-linear relationship between the cost of equity and financial risk, asmeasured by gearing. Equity investors are indifferent to the addition of small amounts of debt, so as a company gears up byreplacing expensive equity with cheaper debt, the WACC initially decreases. Debt is cheaper than equity because of therelative positions of the two sources of finance in the creditor hierarchy (the traditional view of capital structure ignorestaxation). As equity investors start to respond to increasing financial risk, however, the cost of equity begins to increase untila point is reached where WACC ceases to fall. This corresponds to an optimal capital structure, since at this point WACC isat a minimum and hence the market value of the company is at a maximum. After this point, the WACC starts to increaseas the company continues to gear up, rising more quickly at very high levels of gearing due to the appearance of bankruptcyrisk. Under the traditional view the finance director might be correct in his belief that issuing debt will decrease WACC,depending on the position of the company relative to its optimal capital structure.

Miller and ModiglianiMiller and Modigliani showed that in a perfect capital market without corporate taxation, the replacement of expensive equitywith cheaper debt did not lead to a decrease in the WACC, since the effect of adding in cheaper debt was exactly offset bythe increase in the cost of equity, which had a linear relationship with financial risk, as represented by gearing. This meantthat the market value of the company was independent of its capital structure (financial risk) and depended only on itsbusiness operations (business risk).

In their second paper on capital structure Miller and Modigliani showed that, if taxation were allowed (so that the after-taxcost of debt was considered, rather than the before-tax cost of debt), replacing equity with debt led to a linear decrease in theWACC, because of the tax shield on profits gained by interest payments being an allowable deduction in calculating taxliability. Under this contribution to capital structure theory, gearing up as much as possible would maximise the market valueof the company and the finance director would be correct in his belief that issuing traded bonds would decrease the WACCof AQR Co.

Market imperfections viewIn reality, it was noted that companies do not gear up as much as possible because of the dangers of high gearing. Furthermarket imperfections, relative to the idea of a perfect capital market in Miller and Modigliani’s first paper on capital structure,included bankruptcy risk and the costs of financial distress at high levels of gearing. These reduced and finally reversed thetax shield effect noted by Miller and Modigliani, resulting in an optimal capital structure at the point where the WACC was atits lowest and the value of the company was at its highest.

Pecking order theoryIn practice it has been noticed that companies do not appear to base their financing decisions on the objective of achievingan optimal capital structure, but rather have a preference for sources of finance in the order of retained earnings, bank loans,ordinary debt, convertible debt and equity. A number of reasons have been suggested for this ‘pecking order’.

3 (a) Financial Analysis

2009 2010 2011Growth in PBIT –9% –5%Finance charges growth 10% 4%Profit for the period growth –13% –7%Interest coverage ratio (times) 6·1 5·0 4·6Payout ratio 55% 64%

Earnings per share (cents) 90·5 78·4 73·1Price/earnings ratio (times) 5·6 5·9 5·7

Dividend per share (cents) 50 50Dividend yield (on opening price) 8·4% 9·8%Share price growth –14·1% –10·0% –9·2%Total shareholder return –5·7% –0·2

Gearing (before debt issue) (%) 47%Gearing (after debt issue) (%) 93%

Financial performanceIt is clear that the recent financial performance of YNM Co has been poor. Net profit (operating profit) and earnings (profitafter tax) have fallen each year, while finance charges (interest) have increased each year. The share price has also falleneach year.

16

However, there are several positive signs. YNM Co has not made losses in any of the last three years, even though profitshave declined. The rates at which profit before interest and tax and profit for the period have decreased have fallen each year.While profit before interest and tax fell by 9% in 2010, it only fell by 5% in 2011. Similarly, while profit for the period fellby 13% in 2010, it fell by only 7% in 2011. The rate of growth of finance charges (interest) has also fallen, from 10% in2010 to 4% in 2011. It may be that YNM Co has almost started on the path to recovery, which may be why the companyis seeking further funding to support existing business operations.

Financial positionFinancial risk has increased each year as interest cover has fallen, from 6·1 times in 2009 to a more worrying 4·6 times in2011. This ratio has continued to move further away from the average value for similar companies of 10 times every year.The current gearing of 47% is higher than the average for similar companies, which is 40%. There are indications, therefore,that an increased commitment to fixed interest payments from issuing further debt may be dangerous for YNM Co.

Shareholder wealthIt would be easy to claim, by pointing to the continuing fall in the share price, that YNM Co has been decreasing, rather thanincreasing, shareholder wealth. The same conclusion might be reached by pointing to the negative total shareholder returnin 2009 and 2010. In the difficult economic circumstances with which it has been doing battle, however, it could well bethat YNM Co is doing better than its peers in arresting the decline in its financial performance. For example, it maintainedthe level of its dividend payment in 2009 and 2010, even though this caused the payout ratio to increase from 55% in 2009to 64% in 2010.

The two dividend choicesIf YNM Co pays the same dividend of $9·5m in 2011, the payout ratio would be 68%, which is similar to the payout ratioin 2010. The dividend yield would be 11·0% (50/459), which is quite high, and the total shareholder return would be 1·7%((50 + 417 – 459)/459), the first positive figure for three years. However, paying a dividend of $9·5m at a time when thecompany is considering raising $50m of new finance may not be palatable to debt investors.

If YNM Co pays no dividend at all for 2011, shareholders will certainly be disappointed. The current share price is $4·17per share and given the cost of equity of 12%, the market is expecting an unchanged dividend, since 50c/0·12 = $4·17.Paying no dividend would therefore be very likely to lead to a further fall in the share price and increasing difficulty in raisingfurther finance. The fall could be reduced or prevented, however, if YNM Co were to explain the reason for passing thedividend, for example by indicating how the cash savings were planned to be used by the company.

Raising new debt financeThe current financial position of YNM Co, particularly the low level of interest cover, makes it unlikely that a new issue ofdebt would be successful. If $50m of debt were raised at the current interest rate of 8%, interest cover would fall to 2·7 times(25·3/(5·5 + 4)) and gearing would increase to 93%. It is possible that a higher interest rate than 8% might be charged dueto the high level of financial risk being displayed by YNM Co and this would decrease the interest coverage ratio further.

YNM Co would also need to consider whether to raise $50m of short-term, medium-term or long-term debt finance, or a mixof debt of different maturities. As the debt is required to support existing business operations, a combination of overdraftfinance and long-term debt (bank loan or bonds) could be considered. This would give YNM Co exposure to short-termvariable interest rates and long-term fixed interest rates, which might be useful in managing interest rate risk.

Given the current financial position of YNM CO, however, other sources of finance than debt should also be considered, suchas equity finance or sale and leaseback.

Examiner’s note:This analysis and discussion is more than would be expected from a candidate under examination conditions.

(b) (i) YNM Co could raise $50m of equity finance either through a rights issue of shares to existing shareholders, or througha placing or public offer of shares to new shareholders. New equity finance would have a beneficial effect on the gearingof the company. However, existing and new shareholders would need to be persuaded that YNM Co was a soundinvestment, that the decline in the company’s performance was expected to be halted, and that profitability wouldincrease in the near future.

If $50m of equity were raised other than via a rights issue, there would be serious control implications for the currentshareholders of YNM Co. Assuming that shares were issued at the current share price of $4·17 per share, 12m newshares would be issued, a 63% increase on the current number of shares. Existing shareholders would own 61% of thecompany, rather than 100%.

Questions would also be asked about future dividend payments, as maintaining the current dividend per share wouldneed a total dividend payment larger than the current distributable profit. If 12m new shares were issued, for example,the total dividend would be $15·5m if the dividend per share were 50 cents.

(ii) If YNM Co were able to use sale and leaseback in order to raise $50 million, existing non-current assets such asbuildings could be sold for cash and then leased back for the company’s continuing use. Since the use would be long-term in nature, a finance lease would be appropriate. No information is provided about the nature of the non-currentassets of YNM Co, so the feasibility of this possibility cannot be assessed, but sale and leaseback has been used inreality to raise much larger sums of money than $50m.

17

(c) A scrip (or share) dividend is an offer of shares in a company as an alternative to a cash dividend. It is offered pro rata toexisting shareholdings.

From a company point of view, it has the advantage that, if taken up by shareholders, it will conserve cash, i.e. it will reducethe cash outflow from a company compared to a cash dividend. This is useful when liquidity is a problem, or when cash isneeded to meet capital investment or other financing needs. Another advantage is that a scrip dividend will lead to a decreasein gearing, whether on a book value or a market value basis, because of the increase in issued shares. This decrease ingearing will increase debt capacity.

A disadvantage of a scrip dividend is that in future years, because the number of shares in issue has increased, the total cashdividend will increase, assuming the dividend per share is maintained or increased.

4 (a) (i) Movements in exchange rates can be related to changes in interest rates and to changes in inflation rates. Therelationship between exchange rates and interest rates is called interest rate parity, while the relationship betweenexchange rates and inflation rates is called purchasing power parity.

Interest rate parity holds that the relationship between the spot exchange rate and the forward exchange rate betweentwo currencies can be linked to the relative nominal interest rates of the two countries. The forward rate can be foundby multiplying the spot rate by the ratio of the interest rates of the two countries. The currency of the country with thehigher nominal interest rate will be forecast to weaken against the currency of the country with the lower nominal interestrate. Both the spot rate and the forward rate are available in the current foreign exchange market, and the forward ratecan be guaranteed by using a forward contract.

Purchasing power parity holds that the current spot exchange rate and the future spot exchange rate between twocurrencies can be linked to the relative inflation rates of the two countries. The future spot rate is the spot rate that occursat the end of a given period of time. The currency of the country with the higher inflation rate will be forecast to weakenagainst the currency of the country with the lower inflation rate. Purchasing power parity is based on the law of oneprice, which suggests that, in equilibrium, identical goods should sell for the same price in different countries, allowingfor the exchange rate. Purchasing power parity holds in the longer term rather than the shorter term and so is often usedto provide long-term forecasts of exchange rate movements, for example for use in investment appraisal.

(ii) The costs of the two exchange rate hedges need to be compared at the same point in time, e.g. in six months’ time.

Forward market hedgeInterest payment = 5,000,000 pesosSix-month forward rate for buying pesos = 12·805 pesos per $Dollar cost of peso interest using forward market = 5,000,000/12·805 = $390,472

Money market hedgeZPS Co has a 5 million peso liability in six months and so needs to create a 5 million peso asset at the same point intime. The six-month peso deposit rate is 7·5%/2 = 3·75%. The quantity of pesos to be deposited now is therefore5,000,000/1·0375 = 4,819,277 pesos.

The quantity of dollars needed to purchase these pesos is 4,819,277/12·500 = $385,542 and ZPS Co would borrowthis quantity of dollars now. The six-month dollar borrowing rate = 4·5%/2 = 2·25% and so in six months’ time thedebt will be 385,542 x 1·0225 = $394,217. This is the dollar cost of the peso interest using a money market hedge.

Comparing the $390,472 cost of the forward market hedge with the $394,217 cost using a money market hedge, it isclear that the forward market should be used to hedge the peso interest payment as it is cheaper by $3,745.

(b) (i) Working capital policies can cover the level of investment in current assets, the way in which current assets are financed,and the procedures to follow in managing elements of working capital such as inventory, trade receivables, cash andtrade payables. The twin objectives of working capital management are liquidity and profitability, and working capitalpolicies support the achievement of these objectives. There are several factors that influence the formulation of workingcapital policies, as follows.

Nature of the businessThe nature of the business influences the formulation of working capital policy because it influences the size of theelements of working capital. A manufacturing company, for example, may have high levels of inventory and tradereceivables, a service company may have low levels of inventory and high levels of trade receivables, and a supermarketchain may have high levels of inventory and low levels of trade receivables.

The operating cycleThe length of the operating cycle, together with the desired level of investment in current assets, will determine theamount of working capital finance needed. Working capital policies will therefore be formulated so as to optimise asmuch as possible the length of the operating cycle and its components, which are the inventory conversion period, thereceivables conversion period and payables deferral period.

Terms of tradeSince a company must compete with other companies to be successful, a key factor in the formulation of working capitalpolicy will be the terms of trade offered by competitors. The terms of trade must be comparable with those of competitors

18

and the level of receivables will be determined by the credit period offered and the average credit period taken bycustomers.

Risk appetite of companyA risk-averse company will tend to operate with higher levels of inventory and receivables than a company which is morerisk-seeking.

Similarly, a risk-averse company will seek to use long-term finance for permanent current assets and some of itsfluctuating current assets (conservative policy), while a more risk-seeking company will seek to use short-term financefor fluctuating current assets as well as for a portion of the permanent current assets of the company (an aggressivepolicy).

(ii) Early settlement discountAnnual cost of components = 120,000 x 7·50 = $900,000 per yearValue of discount offered = 900,000 x 0·005 = $4,500

Current level of payables = 900,000 x 90/365 = $221,918Revised level of payables = 900,000 x 30/365 = $73,973(Alternatively, 221,918 x 1/3 = $73,973)Reduction in payables = 221,918 – 73,973 = $147,945(Alternatively, 221,918 x 2/3 = $147,945, or 900,000 x 60/365 = $147,945)Annual cost of borrowing = 4·5% per yearIncrease in financing cost by taking discount = 147,945 x 0·045 = $6,657

Since the increase in financing cost is $2,157 greater than the discount offered, ZPS Co will not benefit financially bytaking the early settlement discount.

Bulk purchase discountCurrent number of orders = 120,000/10,000 = 12 ordersCurrent ordering cost = 12 x 200 = $2,400 per yearCurrent holding cost = (10,000/2) x 1 = $5,000 per yearAnnual cost of components = $900,000 per yearInventory cost under current policy = 900,000 + 2,400 + 5,000 = $907,400 per year

To gain the bulk purchase discount, the order size must increase to 30,000 componentsThe number of orders will decrease to 120,000/30,000 = 4 orders per yearThe revised ordering cost will be 4 x 200 = $800 per yearThe revised holding cost will be (30,000/2) x 2·2 = $33,000 per yearThe annual cost of components will be 120,000 x 7·50 x 0·964 = $867,600 per yearInventory cost using discount = 867,600 + 800 + 33,000 = $901,400 per year

ZPS Co will benefit financially if it takes the bulk discount offered by the supplier, as it saves $6,000 per year ininventory costs or 0·66% of current inventory costs.

19


Marks Marks1 (a) Inflated selling price per box 1

Sales 1Inflated variable cost per box 1Variable cost 1Inflated fixed costs 1Tax payable 1Capital allowance tax benefits 1Balancing allowance 1Timing of tax payments or benefits 1Initial working capital investment 1Incremental working capital investment 1Working capital recovery 1Discount factors 1Net present value 1Comment on acceptability 1

–––Maximum 13

(b) Comment on time horizon 1–2Calculation of PV of cash flows after year four 1–2Discussion of PV of cash flows after year four 1–2

–––Maximum 5

(c) Discussion of three methods, 2–3 marks per method Maximum 7–––25–––

2 (a) Calculation of historic dividend growth rate 1Calculation of cost of equity using DGM 2Calculation of market weights 1Calculation of pre-issue WACC 2Correct use of tax as regards new debt 1Setting up linear interpolation calculation 1Calculating after-tax cost of debt of new debt 1Calculation of post-issue WACC 2Comment 1

–––12

(b) Amount of interest payment 1–2Frequency of interest payments 1–2Redemption value 1–2Period to redemption 1–2Cost of debt 1–2Convertibility 1–2

–––Maximum 5

(c) Marginal and average cost of debt 1–2Traditional view of capital structure 1–2Miller and Modigliani 1 and 2 1–3Market imperfections view 1–2Pecking order theory 1–2Other relevant discussion 1–2

–––Maximum 8

–––25–––

21

Marks Marks3 (a) Financial performance – analysis and comment 2–3

Financial position – analysis and comment 1–2Comment on shareholder wealth 2–3Comment on dividend choices 3–4Comment on proposal to raise new debt 2–3

–––Maximum 13

(b) Discussion of equity finance 3–4Discussion of sale and leaseback 2–3

–––Maximum 6

(c) Explanation of scrip dividend 1–2Advantages of scrip dividend to company 2–3Disadvantages of scrip dividend to company 2–3

–––Maximum 6

–––25–––

4 (a) (i) Explanation of interest rate parity 2–3Explanation of purchasing power parity 2–3

–––Maximum 5

(ii) Dollar cost of forward market hedge 1Calculation of six-month interest rates 1Use of correct spot rate 1Dollar cost of money market hedge 2Comparison of cost of hedges 1

–––6

(b) (i) Nature of the business 1–2Operating cycle 1–2Terms of trade 1–2Risk appetite 1–2Other relevant factors 1–2

–––Maximum 7

(ii) Value of early settlement discount offered 1Increase in financing cost 1Loss if early settlement discount taken 1Inventory cost under current ordering policy 1Revised holding and ordering costs 1Inventory cost if discount is taken 1Benefit if bulk purchase discount taken 1

–––7

–––25–––

22








Pape

r F9


Friday 9 December 2011



1 Warden Co plans to buy a new machine. The cost of the machine, payable immediately, is $800,000 and themachine has an expected life of five years. Additional investment in working capital of $90,000 will be required atthe start of the first year of operation. At the end of five years, the machine will be sold for scrap, with the scrap valueexpected to be 5% of the initial purchase cost of the machine. The machine will not be replaced.

Production and sales from the new machine are expected to be 100,000 units per year. Each unit can be sold for$16 per unit and will incur variable costs of $11 per unit. Incremental fixed costs arising from the operation of themachine will be $160,000 per year.

Warden Co has an after-tax cost of capital of 11% which it uses as a discount rate in investment appraisal. Thecompany pays profit tax one year in arrears at an annual rate of 30% per year. Capital allowances and inflation shouldbe ignored.

Required:

(a) Calculate the net present value of investing in the new machine and advise whether the investment isfinancially acceptable. (7 marks)

(b) Calculate the internal rate of return of investing in the new machine and advise whether the investment isfinancially acceptable. (4 marks)

(c) (i) Explain briefly the meaning of the term ‘sensitivity analysis’ in the context of investment appraisal;(1 mark)

(ii) Calculate the sensitivity of the investment in the new machine to a change in selling price and to achange in discount rate, and comment on your findings. (6 marks)

(d) Discuss the nature and causes of the problem of capital rationing in the context of investment appraisal, andexplain how this problem can be overcome in reaching the optimal investment decision for a company.

(7 marks)

(25 marks)

2

2 Extracts from the recent financial statements of Bold Co are given below.

$000Turnover 21,300Cost of sales 16,400

–––––––Gross profit 4,900

–––––––

$000 $000Non-current assets 3,000Current assets

Inventory 4,500Trade receivables 3,500

––––––8,000

–––––––Total assets 11,000

–––––––

Current liabilitiesTrade payables 3,000Overdraft 3,000

––––––6,000

EquityOrdinary shares 1,000Reserves 1,000

––––––2,000

Non-current liabilitiesBonds 3,000

–––––––11,000–––––––

A factor has offered to manage the trade receivables of Bold Co in a servicing and factor-financing agreement. Thefactor expects to reduce the average trade receivables period of Bold Co from its current level to 35 days; to reducebad debts from 0·9% of turnover to 0·6% of turnover; and to save Bold Co $40,000 per year in administration costs.The factor would also make an advance to Bold Co of 80% of the revised book value of trade receivables. The interestrate on the advance would be 2% higher than the 7% that Bold Co currently pays on its overdraft. The factor wouldcharge a fee of 0·75% of turnover on a with-recourse basis, or a fee of 1·25% of turnover on a non-recourse basis.Assume that there are 365 working days in each year and that all sales and supplies are on credit.

Required:

(a) Explain the meaning of the term ‘cash operating cycle’ and discuss the relationship between the cashoperating cycle and the level of investment in working capital. Your answer should include a discussion ofrelevant working capital policy and the nature of business operations. (7 marks)

(b) Calculate the cash operating cycle of Bold Co. (Ignore the factor’s offer in this part of the question).(4 marks)

(c) Calculate the value of the factor’s offer:

(i) on a with-recourse basis;(ii) on a non-recourse basis. (7 marks)

(d) Comment on the financial acceptability of the factor’s offer and discuss the possible benefits to Bold Co offactoring its trade receivables. (7 marks)

(25 marks)

3 [P.T.O.

3 Recent financial information relating to Close Co, a stock market listed company, is as follows.

$mProfit after tax (earnings) 66·6Dividends 40·0

Statement of financial position information:

$m $mNon-current assets 595Current assets 125


––––

Current liabilities 70EquityOrdinary shares ($1 nominal) 80Reserves 410

––––490

Non-current liabilities6% Bank loan 408% Bonds ($100 nominal) 120

––––160––––720––––

Financial analysts have forecast that the dividends of Close Co will grow in the future at a rate of 4% per year. Thisis slightly less than the forecast growth rate of the profit after tax (earnings) of the company, which is 5% per year.The finance director of Close Co thinks that, considering the risk associated with expected earnings growth, anearnings yield of 11% per year can be used for valuation purposes.

Close Co has a cost of equity of 10% per year and a before-tax cost of debt of 7% per year. The 8% bonds will beredeemed at nominal value in six years’ time. Close Co pays tax at an annual rate of 30% per year and the ex-dividendshare price of the company is $8·50 per share.

Required:

(a) Calculate the value of Close Co using the following methods:

(i) net asset value method;(ii) dividend growth model;(iii) earnings yield method. (5 marks)

(b) Discuss the weaknesses of the dividend growth model as a way of valuing a company and its shares.(5 marks)

(c) Calculate the weighted average after-tax cost of capital of Close Co using market values where appropriate.(8 marks)

(d) Discuss the circumstances under which the weighted average cost of capital (WACC) can be used as adiscount rate in investment appraisal. Briefly indicate alternative approaches that could be adopted whenusing the WACC is not appropriate. (7 marks)

(25 marks)

4

4 Bar Co is a stock exchange listed company that is concerned by its current level of debt finance. It plans to make arights issue and to use the funds raised to pay off some of its debt. The rights issue will be at a 20% discount to itscurrent ex-dividend share price of $7·50 per share and Bar Co plans to raise $90 million. Bar Co believes that payingoff some of its debt will not affect its price/earnings ratio, which is expected to remain constant.

Income statement information

$mTurnover 472Cost of sales 423

––––Profit before interest and tax 49Interest 10

––––Profit before tax 39Tax 12

––––Profit after tax 27

––––

Statement of financial position information

$mEquityOrdinary shares ($1 nominal) 60Reserves 80

––––140

Long-term liabilities8% bonds ($100 nominal) 125

––––265––––

The 8% bonds are currently trading at $112·50 per $100 bond and bondholders have agreed that they will allowBar Co to buy back the bonds at this market value. Bar Co pays tax at a rate of 30% per year.

Required:

(a) Calculate the theoretical ex rights price per share of Bar Co following the rights issue. (3 marks)

(b) Calculate and discuss whether using the cash raised by the rights issue to buy back bonds is likely to befinancially acceptable to the shareholders of Bar Co, commenting in your answer on the belief that thecurrent price/earnings ratio will remain constant. (7 marks)

(c) Calculate and discuss the effect of using the cash raised by the rights issue to buy back bonds on thefinancial risk of Bar Co, as measured by its interest coverage ratio and its book value debt to equity ratio.

(4 marks)

(d) Compare and contrast the financial objectives of a stock exchange listed company such as Bar Co and thefinancial objectives of a not-for-profit organisation such as a large charity. (11 marks)

(25 marks)

5 [P.T.O.

6

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Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

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Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers


1 (a) Calculation of net present value (NPV)

Year 1 2 3 4 5 6$000 $000 $000 $000 $000 $000

Sales revenue 1,600 1,600 1,600 1,600 1,600Variable costs (1,100) (1,100) (1,100) (1,100) (1,100)

–––––– –––––– –––––– –––––– ––––––Contribution 500 500 500 500 500Fixed costs (160) (160) (160) (160) (160)

–––––– –––––– –––––– –––––– ––––––Taxable cash flow 340 340 340 340 340Tax liabilities (102) (102) (102) (102) (102)

–––––– –––––– –––––– –––––– –––––– –––––After-tax cash flow 340 238 238 238 238 (102)Working capital 90Scrap value 40

–––––– –––––– –––––– –––––– –––––– –––––Net cash flow 340 238 238 238 368 (102)Discount factors 0·901 0·812 0·731 0·659 0·593 0·535

–––––– –––––– –––––– –––––– –––––– –––––Present values 306 193 174 157 218 (55)

$000Present value of cash inflows 993Working capital investment (90)Cost of machine (800)

–––––NPV 103

–––––

Since the investment has a positive NPV, it is financially acceptable.

Alternative layout of NPV calculation

$000PV of sales revenue = 100,000 x 16 x 3·696 = 5,914PV of variable costs = 100,000 x 11 x 3·696 = (4,066)

––––––PV of contribution 1,848PV of fixed costs = 160,000 x 3·696 = (591)

––––––PV of taxable cash flow 1,257PV of tax liabilities = (340,000 x 0·3 x 3·696) x 0·901 = (340)

––––––917

PV of working capital recovered = 90,000 x 0·593 = 53PV of scrap value = 800,000 x 0·05 x 0·593 = 24

––––––PV of cash inflows 994Initial working capital investment (90)Initial purchase cost of new machine (800)

––––––Net present value 104

––––––

(b) Calculation of internal rate of return (IRR)

NPV at 11% was found to be $103,000

NPV at 17%:Net cash flow 340 238 238 238 368 (102)Discount factors 0·855 0·731 0·624 0·534 0·456 0·390

–––––– –––––– –––––– –––––– –––––– –––––Present values 291 174 149 127 168 (40)

$000Present value of cash inflows 869Working capital investment (90)Cost of machine (800)

–––––NPV (21)

–––––

IRR = 11 + (((17 – 11) x 103,000)/(103,000 + 21,000)) = 11 + 5·0 = 16·0%

11

Since the internal rate of return of the investment (16%) is greater than the cost of capital of Warden Co, the investment isfinancially acceptable.

Examiner’s note: although the value of the calculated IRR will depend on the two discount rates used in linear interpolation,other discount rate choices should produce values close to 16%.

(c) Sensitivity analysis indicates which project variable is the key or critical variable, i.e. the variable where the smallest relativechange makes the net present value (NPV) zero. Sensitivity analysis can show where management should focus attention inorder to make an investment project successful, or where underlying assumptions should be checked for robustness.

The sensitivity of an investment project to a change in a given project variable can be calculated as the ratio of the NPV tothe present value (PV) of the project variable. This gives directly the relative change in the variable needed to make the NPVof the project zero.

Selling price sensitivityThe PV of sales revenue = 100,000 x 16 x 3·696 = $5,913,600The tax liability associated with sales revenue needs be considered, as the NPV is on an after-tax basis.Tax liability arising from sales revenue = 100,000 x 16 x 0·3 = $480,000 per yearThe PV of the tax liability without lagging = 480,000 x 3·696 = $1,774,080(Alternatively, PV of tax liability without lagging = 5,913,600 x 0·3 = $1,774,080)Lagging by one year, PV of tax liability = 1,774,080 x 0·901 = $1,598,446After-tax PV of sales revenue = 5,913,600 – 1,598,446 = $4,315,154Sensitivity = 100 x 103,000/4,315,154 = 2·4%

Discount rate sensitivityIncrease in discount rate needed to make NPV zero = 16 – 11 = 5%Relative change in discount rate needed to make NPV zero = 100 x 5/11 = 45%

Of the two variables, the key or critical variable is selling price, since the investment is more sensitive to a change in thisvariable (2·4%) than it is to a change in discount rate (45%).

(d) In real-world capital investment decisions, companies are limited in the funds that are available for investment. However, thebasis for investment decisions should still be to maximise the wealth of shareholders. The NPV decision rule calls for acompany to invest in all projects with a positive net present value, but this is theoretically possible only in a perfect capitalmarket, i.e. a capital market where there is no limit on the finance available. Since investment funds are limited in the realworld, it is not possible in the real world for a company to invest in all projects with a positive NPV.

The reasons why investment funds are limited in the real world are either external to the company (hard capital rationing) orinternal to the company (soft capital rationing).

Several reasons have been suggested for hard capital rationing, such as that investors may feel that a company is too riskyto invest in, with its credit rating being seen as too low for the amount of investment it needs. Perhaps capital markets maybe depressed, so that there is a general unwillingness by investors to provide funds for capital investment. Capital may be inshort supply due to ‘crowding-out’ as a result of high government borrowing, for example in order to finance a Keynsianinjection of funds into the circular flow of income so as to encourage or assist recovery from an economic recession.

Soft capital rationing may be due to reluctance by a company to raise finance. For example, the amount of funds needed maybe small in relation to the costs of raising the finance: or the company may wish to avoid dilution of control or earnings pershare by issuing new equity; or the company may wish to avoid a commitment to paying fixed interest because it believesfuture economic conditions may put its profitability under pressure. Alternatively, the company may limit the funds availablefor capital investment in order to encourage competition between potential investment projects, so that only robust investmentprojects are accepted. This is the ‘internal capital market’ reason for soft capital rationing.

If a company cannot invest in all projects with a positive NPV, it must ensure that it generates the maximum return per dollarinvested. With single-period capital rationing, where investment funds are limited in the first year only, divisible investmentprojects can be ranked in order of desirability using the profitability index. This can be defined either as the NPV divided bythe initial investment, or as the present value of future cash flows divided by the initial investment. The optimal investmentdecision for a company is then to invest in the projects in turn, moving from highest profitability index downwards, until allthe funds have been exhausted. This may require partial investment in the last desirable project selected, which is possiblewith divisible investment projects.

Where investment projects are not divisible, the total NPV of various combinations of projects must be compared, within thelimit of the investment funds available, in order to select the combination of projects with the highest NPV. This will be theoptimum investment decision. Surplus funds may be left over, but since the highest-NPV combination has been selected, theamount of surplus funds is irrelevant to the selection of the optimal investment schedule. Investing these surplus funds in abank or in the money market would have an NPV of zero.

12

2 (a) The cash operating cycle is the average length of time between paying trade payables and receiving cash from tradereceivables. It is the sum of the average inventory holding period, the average production period and the average tradereceivables credit period, less the average trade payables credit period. Using working capital ratios, the cash operating cycleis the sum of the inventory turnover period and the accounts receivable days, less the accounts payable days.

The relationship between the cash operating cycle and the level of investment in working capital is that an increase in thelength of the cash operating cycle will increase the level of investment in working capital. The length of the cash operatingcycle depends on working capital policy in relation to the level of investment in working capital, and on the nature of thebusiness operations of a company.

Working capital policyCompanies with the same business operations may have different levels of investment in working capital as a result ofadopting different working capital policies. An aggressive policy uses lower levels of inventory and trade receivables than aconservative policy, and so will lead to a shorter cash operating cycle. A conservative policy on the level of investment inworking capital, in contrast, with higher levels of inventory and trade receivables, will lead to a longer cash operating cycle.The higher cost of the longer cash operating cycle will lead to a decrease in profitability while also decreasing risk, for examplethe risk of running out of inventory.

Nature of business operationsCompanies with different business operations will have different cash operating cycles. There may be little need for inventory,for example, in a company supplying business services, while a company selling consumer goods may have very high levelsof inventory. Some companies may operate primarily with cash sales, especially if they sell direct to the consumer, while othercompanies may have substantial levels of trade receivables as a result of offering trade credit to other companies.

(b) Inventory days = 365 x 4,500/16,400 = 100 daysTrade receivables days = 365 x 3,500/21,300 = 60 daysTrade payables days = 365 x 3,000/16,400 = 67 daysCash operating cycle = 100 + 60 – 67 = 93 days

(c) Calculation of value of with-recourse offer

As the factor’s offer is with recourse, Bold Co will gain the benefit of bad debts reducing from 0·9% of turnover to 0·6% ofturnover.

$Current trade receivables 3,500,000Revised trade receivables = 21,300,000 x 35/365 = 2,042,466

––––––––––Reduction in trade receivables under factor 1,457,534

––––––––––

$Finance cost saving = 1,457,534 x 0·07 = 102,027Administration cost saving 40,000Bad debt saving = 21,300,000 x (0·009 – 0·006) = 63,900

––––––––Total saving 205,927Additional interest on advance = 2,042,466 x 0·8 x 0·02 = 32,680

––––––––Net benefit before factor fee 173,247With-recourse factor fee = 21,300,000 x 0·0075 = 159,750

––––––––Net benefit of with-recourse offer 13,497

––––––––

Calculation of value of non-recourse offer

As the offer is without recourse, the bad debts of Bold Co will reduce to zero, as these will be carried by the factor, and sothe company will gain a further benefit of 0·6% of turnover.

$Net benefit before with-recourse factor fee 173,247Non-recourse factor fee = 21,300,000 x 0·0125 = 266,250

––––––––Net cost before adjusting for bad debts (93,003)Remaining bad debts eliminated = 21,300,000 x 0·006 = 127,800

––––––––Net benefit of non-recourse offer 34,797

––––––––

(d) The factor’s offer is financially acceptable on a with-recourse basis, giving a net benefit of $13,497. On a non-recourse basis,the factor’s offer is not financially acceptable, giving a net loss of $93,003, if the elimination of bad debts is ignored. Thedifference between the two factor fees ($106,500 or 0·5% of sales), which represents insurance against the risk of bad debts,is less than the remaining bad debts ($127,800 or 0·6% of sales), which will be eliminated under non-recourse factoring.When this elimination of bad debts is considered, the non-recourse offer from the factor is financially more attractive than thewith-recourse offer.

13

There are a number of benefits of factoring that could be discussed, as follows.

The expertise of the factorIt is possible the factor can improve the efficiency of the receivables management of Bold Co due to its expertise in the areasof credit analysis, credit control and receivables collection. This would lead to a lower level of bad debts, as indicated by thefactor’s offer.

Insurance against bad debtsNon-recourse factoring offers protection from bad debts, although the factor’s fee will include the cost of this insuranceelement, as indicated by the difference between the factor’s fees.

Factor financeA factor will advance up to 80% of the value of invoices raised, allowing a company quicker access to cash from sales thanwould be possible if it had to wait for accounts receivable to be settled. Bold Co could pay trade payables promptly, perhapsbenefiting from early settlement discounts.

Lower administration costsSince administration of trade receivables would be taken over by the factor, administration costs of the company woulddecrease over time, although some incremental short-term costs, such as redundancy costs, might be incurred.

3 (a) Net asset valuationIn the absence of any information about realisable values and replacement costs, net asset value is on a book value basis. Itis the sum of non-current assets and net current assets, less long-term debt, i.e. 595 + 125 – 70 – 160 = $490 million.

Dividend growth modelTotal dividends of $40 million are expected to grow at 4% per year and Close Co has a cost of equity of 10%.Value of company = (40m x 1·04)/(0·1 – 0·04) = $693 million

Earnings yield methodProfit after tax (earnings) is $66·6 million and the finance director of Close Co thinks that an earnings yield of 11% per yearcan be used for valuation purposes.Ignoring growth, value of company = 66·6m/0·11 = $606 million

Alternatively, profit after tax (earnings) is expected to grow at an annual rate of 5% per year and earnings growth can beincorporated into the earnings yield method using the growth model.Value of company = (66·6m x 1·05)/(0·11 – 0·05) = $1,166 million

Examiner’s note: full credit would be gained whether or not growth is incorporated in the earnings yield method.

(b) The dividend growth model (DGM) is used widely in valuing ordinary shares and hence in valuing companies, but there area number of weaknesses associated with its use.

The future dividend growth rateThe DGM is based on the assumption that the future dividend growth rate is constant, but experience shows that a constantdividend growth rate is, in reality, very rare. This may be seen as less of a problem if the future dividend growth rate isregarded as an average growth rate.

Estimating the future dividend growth rate is very difficult in practice and the DGM is very sensitive to small changes in thiskey variable. It is common practice to estimate the future dividend growth rate by calculating the historical dividend growth,but the assumption that the future will reflect the past is an easy one to challenge.

The cost of equityThe DGM assumes that the future cost of equity is constant, when in reality it changes quite frequently. The cost of equitycan be calculated using the capital asset pricing model, but this model usually employs historical information, which may notreflect accurately expectations about the future.

Zero dividendsIt is sometimes claimed that the DGM cannot be used when no dividends are paid, but this depends on whether dividendsare expected in the future. If dividends are forecast to be paid from a future date, the dividend growth model can be appliedat that point to calculate a share price, which can then be discounted to give the current ex dividend share price. Only in thecase where no dividends are paid and no dividends are expected to be paid will the DGM have no application.

(c) Market value of equityClose Co has 80 million shares in issue and each share is worth $8·50 per share.The market value of equity is therefore 80 x 8·50 = $680 million

Cost of equityThis is given as 10% per year.

Market value of 8% bondsThe market value of each bond will be the present value of the expected future cash flows (interest and principal) that arisefrom owning the bond. Annual interest is 8% per year and the bonds will be redeemed at their nominal value of $100 perbond in six years’ time. The before-tax cost of debt is given as 7% per year and this is used as a discount rate.

14

Present value of future interest = (8 x 4·767) = $38·14Present value of future principal payment = (100 x 0·666) = $66·60Ex interest bond value = 38·14 + 66·60 = $104·74 per bondMarket value of bonds = 120m x (104·74/100) = $125·7 million

After-tax cost of debt of 8% bondsThe before-tax cost of debt of the bonds is given as 7% per year.After-tax cost of debt of bonds = 7 x (1 – 0·3) = 7 x 0·7 = 4·9% per year

Value of the 6% bank loanThe bank loan has no market value and so its book value of $40 million is used in calculating the weighted average cost ofcapital.

After-tax cost of debt of 6% bank loanThe interest rate of the bank loan can be used as its before-tax cost of debt.After-tax cost of debt of bank loan = 6 x (1 – 0·3) = 6 x 0·7 = 4·2% per year

Calculation of weighted average after-tax cost of capital (WACC)Total value of company = 680m + 125·7m + 40m = $845·7m

After-tax WACC = ((680m x 10) + (125·7m x 4·9) + (40 x 4·2))/845·7 = 9·0 % per year

Examiner’s note: the after-tax cost of debt of the 8% bonds could have been calculated using linear interpolation, althoughthe result would be close to 4·9%.

(d) The weighted average cost of capital (WACC) is the average return required by current providers of finance. The WACCtherefore reflects the current risk of a company’s business operations (business risk) and way in which the company iscurrently financed (financial risk). When the WACC is used as discount rate to appraise an investment project, an assumptionis being made that the project’s business risk and financial risk are the same as those currently faced by the investingcompany. If this is not the case, a marginal cost of capital or a project-specific discount rate must be used to assess theacceptability of an investment project.

The business risk of an investment project will be the same as current business operations if the project is an extension ofexisting business operations, and if it is small in comparison with current business operations. If this is the case, existingproviders of finance will not change their current required rates of return. If these conditions are not met, a project-specificdiscount rate should be calculated, for example by using the capital asset pricing model.

The financial risk of an investment project will be the same as the financial risk currently faced by a company if debt andequity are raised in the same proportions as currently used, thus preserving the existing capital structure. If this is the case,the current WACC can be used to appraise a new investment project. It may still be appropriate to use the current WACC asa discount rate even when the incremental finance raised does not preserve the existing capital structure, providing that theexisting capital structure is preserved on an average basis over time via subsequent finance-raising decisions.

Where the capital structure is changed by finance raised for an investment project, it may be appropriate to use the marginalcost of capital rather than the WACC.

4 (a) Theoretical ex rights price

Rights issue price = 7·50 x 0·8 = $6·00 per shareNumber of shares issued = $90m/6·00 = 15 million sharesNumber of shares currently in issue = 60 million sharesThe rights issue is on a 1 for 4 basisTheoretical ex rights price = ((4 x 7·50) + (1 x 6·00))/5 = $7·20 per share

Alternatively, theoretical ex rights price = ((60m x 7·50) + (15m x 6·00))/75m = $7·20 per share, where 75 million is thenumber of shares after the rights issue.

(b) Financial acceptability to shareholders of buying back bonds

The financial acceptability to shareholders of the proposal to buy back bonds can be assessed by calculating whethershareholder wealth is increased or decreased as a result.

The bonds are being bought back by Bar Co at their market value of $112·50 per bond, rather than their nominal value of$100 per bond. The total nominal value of the bonds redeemed will therefore be less than the $90 million spent redeemingthem.

Nominal value of bonds redeemed = 90m x (100/112·50) = $80 millionInterest saved by redeeming bonds = 80m x 0·08 = $6·4 million per year

Earnings per share will be affected by the redemption of the bonds and the issue of new shares.Revised profit before tax = 49m – (10m – 6·4m) = $45·4 millionRevised profit after tax (earnings) = 45·4m x 0·7 = $31·78 millionRevised earnings per share = 100 x (31·78m/75m) = 42·37 cents per share

15

Current earnings per share = 100 x (27m/60m) = 45 cents per shareCurrent price/earnings ratio = 750/45 = 16·7 times

The revised earnings per share can be used to calculate a revised share price if the price/earnings ratio is assumed to beconstant.Revised share price = 16·7 x 42·37 = 708 cents or $7·08 per share

This share price is less than the theoretical ex rights price per share ($7·20) and so the effect of using the rights issue fundsto redeem the bonds is to decrease shareholder wealth. From a shareholder perspective, therefore, this use of the funds cannotbe recommended.

However, this conclusion depends heavily on the assumption that the price/earnings ratio remains constant, as this ratio wasused to calculate the revised share price from the revised earning per share. In reality, the share price after the redemptionof bonds will be set by the capital market and it is this market-determined share price that will determine the price/earningsratio, rather than the price/earnings ratio determining the share price. Since the financial risk of Bar Co has decreasedfollowing the redemption of bonds, the cost of equity is likely to fall and the share price is likely to rise, leading to a higherprice/earnings ratio. If the share price increases to above the theoretical ex rights price per share, corresponding to an increasein the price/earnings ratio to more than 17 times (720/42·37), shareholders will experience a capital gain and so using thecash raised by the rights issue to buy back bonds will become financially acceptable from their perspective.

(c) Current interest coverage ratio = 49m/10m = 4·9 timesRevised interest coverage ratio = 49m/(10m – 6·4m) = 49m/3·6m = 13·6 times

Current debt/equity ratio = 100 x (125m/140m) = 89%

Revised book value of bonds = 125m – 80m = $45 millionRevised book value of equity = 140m + 90m – 10m = $220 million

A loss of $10 million is deducted here because $90 million has been spent to redeem bonds with a total nominal value (bookvalue) of $80 million.Revised debt/equity ratio = 100 x (45m/220m) = 20·5%

Redeeming bonds with a book value of $80m has reduced the financial risk of Bar Co, as shown by the significant reductionin gearing from 89% to 20·5%, and by the significant increase in the interest coverage ratio from 4·9 times to 13·6 times.

Examiner’s note: full credit would be given to a revised gearing calculation (19·6%) that omits the loss due to buying backbonds at a premium to nominal value.

(d) A key financial objective for a stock exchange listed company is to maximise the wealth of shareholders. This objective isusually replaced by the objective of maximising the company’s share price, since maximising the market value of the companyrepresents the maximum capital gain over a given period. The need for dividends can be met by recognising that share pricescan be seen as the sum of the present values of future dividends.

Maximising the company’s share price is the same as maximising the equity market value of the company, since equity marketvalue (market capitalisation) is equal to number of issued shares multiplied by share price. Maximising equity market valuecan be achieved by maximising net corporate cash income and the expected growth in that income, while minimising thecorporate cost of capital. Listed companies therefore have maximising net cash income as a key financial objective.

Not-for-profit (NFP) organisations seek to provide services to the public and this requires cash income. Maximising net cashincome is therefore a key financial objective for NFP organisations as well as listed companies. A large charity seeks to raiseas much funds as possible in order to achieve its charitable objectives, which are non-financial in nature.

Both listed companies and NFP organisations need to control the use of cash within a given financial period, and both typesof organisations therefore use budgets. Another key financial objective for both organisations is therefore to keep spendingwithin budget.

The objective of value for money (VFM) is often identified in connection with NFP organisations. This objective refers to afocus on economy, efficiency and effectiveness. These three terms can be linked to input (economy refers to securingresources as economically as possible), process (resources need to be employed efficiently within the organisation) and output(the effective use of resources in achieving the organisation’s objectives).

Described in these terms, it is clear that a listed company also seeks to achieve value for money in its business operations.There is a difference in emphasis, however, which merits careful consideration. A listed company has a profit motive, and soVFM for a listed company can be related to performance measures linked to output, e.g. maximising the equity market valueof the company. An NFP organisation has service-related outputs that are difficult to measure in quantitative terms and so itfocuses on performance measures linked to input, e.g. minimising the input cost for a given level of output.

Both listed companies and NFP organisations can use a variety of accounting ratios in the context of financial objectives. Forexample, both types of organisation may use a target return on capital employed, or a target level of income per employee,or a target current ratio.

Comparing and contrasting the financial objectives of a stock exchange listed company and a not-for-profit organisation,therefore, shows that while significant differences can be found, there is a considerable amount of common ground in termsof financial objectives.

16


Marks Marks1 (a) Sales income 0·5

Variable costs 0·5Fixed costs 0·5Tax liabilities 1Working capital recovered 0·5Scrap value 0·5Initial working capital investment 0·5Initial investment 0·5Discount factors 0·5Net present value 1Comment on financial acceptability 1

––––7

(b) Calculation of revised NPV 1Calculation of IRR 2Comment on financial acceptability 1

––––4

(c) (i) Explanation of sensitivity analysis 1

(ii) After-tax present value of sales revenue 2Selling price sensitivity 2Discount rate sensitivity 1Comment on findings 1

––––6

(d) Nature of the capital rationing problem 1–2Causes of the capital rationing problem 3–4Overcoming the capital rationing problem 2–4


–––25–––

17

Marks Marks2 (a) Explanation of cash operating cycle 1–2

Cash operating cycle and working capital policy 2–3Cash operating cycle and business operations 2–3Other relevant discussion 1–2


(b) Inventory days 1Trade payables days 1Trade receivables days 1Cash operating cycle 1

––––4

(c) Revised trade receivables 0·5Reduction in trade receivables 0·5Reduction in finance cost 1Administration costs 0·5Saving in bad debts 0·5Interest on advance 1With-recourse factor fee 0·5Net benefit of with-recourse offer 0·5Without-recourse factor fee 0·5Elimination of bad debts 1Net benefit of non-recourse offer 0·5

––––7

(d) Comment on financial acceptability of offer 1–2Benefits of factoring (1–2 marks per benefit) 5–6


–––25–––

3 (a) Net asset value 1Dividend growth model value 2Earnings yield method 2

––––5

(b) Dividend growth rate 2–3The cost of equity 1–2Zero dividends and other relevant discussion 1–2


(c) Market value of equity 1Market value per bond 2Market value of bonds 1After-tax cost of debt 1After-tax cost of bank loan 1Weighted average cost of capital 2

––––8

(d) Business risk 2–3Financial risk 2–3Project-specific discount rate 1–2Marginal cost of capital 1–2


–––25–––

18

Marks Marks4 (a) Rights issue price 1

Theoretical ex rights price 2––––

3

(b) Nominal value of bonds redeemed 1Interest saved on redeemed bonds 1Earnings per share after redemption 1Current price/earnings ratio 1Revised share price 1Comment on acceptability to shareholders 1–2Comment on constant price/earnings ratio 1–2


(c) Current interest coverage 0·5Revised interest coverage 1Current debt/equity ratio 0·5Revised debt/equity ratio 1Comment on financial risk 1

––––4

(d) Maximising shareholder wealth 2–3Maximising cash income 2–3Controlling spending with budgets 2–3Value for money 2–3Other relevant discussion 2–3


–––25–––

19








Pape

r F9


Friday 15 June 2012


This is a blank page.The question paper begins on page 3.

2


1 Ridag Co is evaluating two investment projects, as follows.

Project 1

This is an investment in new machinery to produce a recently-developed product. The cost of the machinery, whichis payable immediately, is $1·5 million, and the scrap value of the machinery at the end of four years is expected tobe $100,000. Capital allowances (tax-allowable depreciation) can be claimed on this investment on a 25% reducingbalance basis. Information on future returns from the investment has been forecast to be as follows:

Year 1 2 3 4Sales volume (units/year) 50,000 95,000 140,000 75,000Selling price ($/unit) 25·00 24·00 23·00 23·00Variable cost ($/unit) 10·00 11·00 12·00 12·50Fixed costs ($/year) 105,000 115,000 125,000 125,000

This information must be adjusted to allow for selling price inflation of 4% per year and variable cost inflation of 2·5%per year. Fixed costs, which are wholly attributable to the project, have already been adjusted for inflation. Ridag Copays profit tax of 30% per year one year in arrears.

Project 2

Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has an initialcost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an initial cost of $225,000and will have a scrap value of $50,000 after three years. Annual maintenance costs of the two machines are asfollows:

Year 1 2 3 4Machine 1 ($/year) 25,000 29,000 32,000 35,000Machine 2 ($/year) 15,000 20,000 25,000

Where relevant, all information relating to Project 2 has already been adjusted to include expected future inflation.Taxation and capital allowances must be ignored in relation to Machine 1 and Machine 2.

Other information

Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax weighted averagecost of capital of 7%.

Required:

(a) Calculate the net present value of Project 1 and comment on whether this project is financially acceptableto Ridag Co. (12 marks)

(b) Calculate the equivalent annual costs of Machine 1 and Machine 2, and discuss which machine should bepurchased. (6 marks)

(c) Critically discuss the use of sensitivity analysis and probability analysis as ways of including risk in theinvestment appraisal process, referring in your answer to the relative effectiveness of each method.

(7 marks)

(25 marks)

3 [P.T.O.

2 The following financial information relates to Wobnig Co.

Income statement extracts

2011 2010$000 $000

Revenue 14,525 10,375Cost of sales 10,458 6,640

––––––– –––––––Profit before interest and tax 4,067 3,735Interest 355 292

––––––– –––––––Profit before tax 3,712 3,443Taxation 1,485 1,278

––––––– –––––––Distributable profit 2,227 2,165

––––––– –––––––

Statement of financial position extracts

2011 2010$000 $000 $000 $000

Non-current assets 15,284 14,602Current assets

Inventory 2,149 1,092Trade receivables 3,200 1,734

–––––– ––––––5,349 2,826

––––––– –––––––Total assets 20,633 17,428

––––––– –––––––

Current liabilitiesTrade payables 2,865 1,637Overdraft 1,500 250

–––––– ––––––4,365 1,887

EquityOrdinary shares 8,000 8,000Reserves 4,268 3,541

–––––– ––––––12,268 11,541

Long-term liabilities7% Bonds 4,000 4,000

––––––– –––––––Total liabilities 20,633 17,428

––––––– –––––––

Average ratios for the last two years for companies with similar business operations to Wobnig Co are as follows:

Current ratio 1·7 timesQuick ratio 1·1 timesInventory days 55 daysTrade receivables days 60 daysTrade payables days 85 daysSales revenue/net working capital 10 times

4

Required:

(a) Using suitable working capital ratios and analysis of the financial information provided, evaluate whetherWobnig Co can be described as overtrading (undercapitalised). (12 marks)

(b) Critically discuss the similarities and differences between working capital policies in the following areas:

(i) Working capital investment;(ii) Working capital financing. (9 marks)

(c) Wobnig Co is considering using the Miller-Orr model to manage its cash flows. The minimum cash balance wouldbe $200,000 and the spread is expected to be $75,000.

Required:

Calculate the Miller-Orr model upper limit and return point, and explain how these would be used to managethe cash balances of Wobnig Co. (4 marks)

(25 marks)

5 [P.T.O.

3 Zigto Co is a medium-sized company whose ordinary shares are all owned by the members of one family. It hasrecently begun exporting to a European country and expects to receive €500,000 in six months’ time. The prospectof increased exports to the European country means that Zigto Co needs to expand its existing business operations inorder to be able to meet future orders. All of the family members are in favour of the planned expansion, but none arein a position to provide additional finance. The company is therefore seeking to raise external finance of approximately$1 million. At the same time, the company plans to take action to hedge the exchange rate risk arising from itsEuropean exports.

Zigto Co could put cash on deposit in the European country at an annual interest rate of 3% per year, and borrow at5% per year. The company could put cash on deposit in its home country at an annual interest rate of 4% per year,and borrow at 6% per year. Inflation in the European country is 3% per year, while inflation in the home country ofZigto Co is 4·5% per year.

The following exchange rates are currently available to Zigto Co:

Current spot exchange rate 2·000 euro per $Six-month forward exchange rate 1·990 euro per $One-year forward exchange rate 1·981 euro per $

Required:

(a) Discuss the reasons why small and medium-sized entities (SMEs) might experience less conflict between theobjectives of shareholders and directors than large listed companies. (4 marks)

(b) Discuss the factors that Zigto Co should consider when choosing a source of debt finance and the factorsthat may be considered by providers of finance in deciding how much to lend to the company. (8 marks)

(c) Explain the nature of a mudaraba contract and discuss briefly how this form of Islamic finance could be usedto finance the planned business expansion. (5 marks)

(d) Calculate whether a forward exchange contract or a money market hedge would be financially preferred byZigto Co to hedge its future euro receipt. (5 marks)

(e) Calculate the one-year expected (future) spot rate predicted by purchasing power parity theory and explainbriefly the relationship between the expected (future) spot rate and the current forward exchange rate.

(3 marks)

(25 marks)

6

4 Corhig Co is a company that is listed on a major stock exchange. The company has struggled to maintain profitabilityin the last two years due to poor economic conditions in its home country and as a consequence it has decided notto pay a dividend in the current year. However, there are now clear signs of economic recovery and Corhig Co isoptimistic that payment of dividends can be resumed in the future. Forecast financial information relating to thecompany is as follows:

Year 1 2 3Earnings ($000) 3,000 3,600 4,300Dividends ($000) nil 500 1,000

The company is optimistic that earnings and dividends will increase after Year 3 at a constant annual rate of 3% peryear.

Corhig Co currently has a before-tax cost of debt of 5% per year and an equity beta of 1·6. On a market value basis,the company is currently financed 75% by equity and 25% by debt.

During the course of the last two years the company acted to reduce its gearing and was able to redeem a largeamount of debt. Since there are now clear signs of economic recovery, Corhig Co plans to raise further debt in orderto modernise some of its non-current assets and to support the expected growth in earnings. This additional debtwould mean that the capital structure of the company would change and it would be financed 60% by equity and40% by debt on a market value basis. The before-tax cost of debt of Corhig Co would increase to 6% per year andthe equity beta of Corhig Co would increase to 2.

The risk-free rate of return is 4% per year and the equity risk premium is 5% per year. In order to stimulate economicactivity the government has reduced profit tax rate for all large companies to 20% per year.

The current average price/earnings ratio of listed companies similar to Corhig Co is 5 times.

Required:

(a) Estimate the value of Corhig Co using the price/earnings ratio method and discuss the usefulness of thevariables that you have used. (4 marks)

(b) Calculate the current cost of equity of Corhig Co and, using this value, calculate the value of the companyusing the dividend valuation model. (6 marks)

(c) Calculate the current weighted average after-tax cost of capital of Corhig Co and the weighted average after-tax cost of capital following the new debt issue, and comment on the difference between the two values.

(6 marks)

(d) Discuss how the shareholders of Corhig Co can assess the extent to which they face the following risks,explaining in each case the nature of the risk being assessed:

(i) Business risk;(ii) Financial risk;(iii) Systematic risk. (9 marks)

(25 marks)

7 [P.T.O.

8

Formulae Sheet


Miller–Orr Model



The Growth Model



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13

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9 [P.T.O.

Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

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10

Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r

10·36811·25512·13413·00413·865

10·57511·34812·10612·849

10·63511·29611·938

10·56311·118 10·380


Answers


1 (a) Calculation of net present value (NPV)

As nominal after-tax cash flows are to be discounted, the nominal after-tax weighted average cost of capital of 7% must beused.

Year 1 2 3 4 5$000 $000 $000 $000 $000

Sales revenue 1,300 2,466 3,622 2,018Variable costs (513) (1,098) (1,809) (1,035)

–––––– –––––– –––––– ––––––Contribution 787 1,368 1,813 983Fixed costs (105) (115) (125) (125)

–––––– –––––– –––––– ––––––Taxable cash flow 682 1,253 1,688 858Tax liabilities (205) (376) (506) (257)CA tax benefits 113 84 63 160

–––––– –––––– –––––– –––––– –––––After-tax cash flow 682 1,161 1,396 415 (97)Scrap value 100

–––––– –––––– –––––– –––––– –––––Net cash flow 682 1,161 1,396 515 (97)Discount at 7% 0·935 0·873 0·816 0·763 0·713

–––––– –––––– –––––– –––––– –––––Present values 638 1,014 1,139 393 (69)

–––––– –––––– –––––– –––––– –––––

$000Present value of cash inflows 3,115Cost of machine (1,500)

––––––NPV 1,615

––––––

Project 1 has a positive NPV of $1,615,000 and so it is financially acceptable to Ridag Co. However, the discount rate usedhere is the current weighted average after-tax cost of capital. As this is a recently-developed product, it may be appropriateto use a project-specific discount rate that reflects the risk of the new product launch.

Workings

Sales revenue

Year 1 2 3 4Selling price ($/unit) 25·00 24·00 23·00 23·00Inflated selling price ($/unit) 26·00 25·96 25·87 26·91Sales volume (units/year) 50,000 95,000 140,000 75,000Sales revenue ($/year) 1,300,000 2,466,200 3,621,800 2,018,250

Variable cost

Year 1 2 3 4Variable cost ($/unit) 10·00 11·00 12·00 12·50Inflated variable cost ($/unit) 10·25 11·56 12·92 13·80Sales volume (units/year) 50,000 95,000 140,000 75,000Variable costs ($/year) 512,500 1,098,200 1,808,800 1,035,000

Capital allowance tax benefits

Year Capital allowance Tax benefit Year benefit received1 1,500,000 x 0·25 = $375,000 375,000 x 0·3 = $112,500 22 1,125,000 x 0·25 = $281,250 281,250 x 0·3 = $84,375 33 843,750 x 0·25 = $210,938 210,938 x 0·3 = $63,281 44 $532,812* 532,812 x 0·3 = $159,844 5

*843,750 – 210,938 – 100,000 = $532,812

13

Alternative calculation of net cash flow

Year 1 2 3 4 5$000 $000 $000 $000 $000

Taxable cash flow 682 1,253 1,688 858Capital allowances (375) (281) (211) (533)

–––––– –––––– –––––– –––––– –––––Taxable profit 307 972 1,477 325Taxation (92) (292) (443) (98)

–––––– –––––– –––––– –––––– –––––After-tax profit 307 880 1,185 (118) (98)Add back allowances 375 281 211 533

–––––– –––––– –––––– –––––– –––––After-tax cash flow 682 1,161 1,396 415 (98)Scrap value 100

–––––– –––––– –––––– –––––– –––––Net cash flow 682 1,161 1,396 515 (98)Discount at 7% 0·935 0·873 0·816 0·763 0·713

–––––– –––––– –––––– –––––– –––––Present values 638 1,014 1,139 393 (70)

–––––– –––––– –––––– –––––– –––––

There are slight differences due to rounding.

(b) Calculation of equivalent annual cost for machine 1

Since taxation and capital allowances are to be ignored, and where relevant all information relating to project 2 has alreadybeen adjusted to include future inflation, the correct discount rate to use here is the nominal before-tax weighted average costof capital of 12%.

Year 0 1 2 3 4Maintenance costs ($) (25,000) (29,000) (32,000) (35,000)Investment and scrap ($) (200,000) 25,000

––––––––– –––––––– –––––––– –––––––– –––––––Net cash flow ($) (200,000) (25,000) (29,000) (32,000) (10,000)Discount at 12% 1·000 0·893 0·797 0·712 0·636

––––––––– –––––––– –––––––– –––––––– –––––––Present values (200,000) (22,325) (23,113) (22,784) (6,360)

––––––––– –––––––– –––––––– –––––––– –––––––

Present value of cash flows $274,582Cumulative present value factor 3·037Equivalent annual cost = 274,582/3·037 = $90,412

Calculation of equivalent annual cost for machine 2

Year 0 1 2 3Maintenance costs ($) (15,000) (20,000) (25,000)Investment and scrap ($) (225,000) 50,000

––––––––– –––––––– –––––––– ––––––––Net cash flow ($) (225,000) (15,000) (20,000) 25,000Discount at 12% 1·000 0·893 0·797 0·712

––––––––– –––––––– –––––––– ––––––––Present values (225,000) (13,395) (15,940) 17,800

––––––––– –––––––– –––––––– ––––––––

Present value of cash flows $236,535Cumulative present value factor 2·402Equivalent annual cost = 236,535/2·402 = $98,474

The machine with the lowest equivalent annual cost should be purchased and calculation shows this to be Machine 1. If thepresent value of future cash flows had been considered alone, Machine 2 (cost of $236,535) would have been preferred toMachine 1 (cost of $274,582). However, the lives of the two machines are different and the equivalent annual cost methodallows this to be taken into consideration.

(c) Within the context of investment appraisal, risk relates to the variability of returns and so it can be quantified, for example byforecasting the probabilities related to future cash flows. From this point of view, risk can be differentiated from uncertainty,which cannot be quantified. Uncertainty can be said to increase with project life, while risk increases with the variability ofreturns.

It is commonly said that risk can be included in the investment appraisal process by using sensitivity analysis, whichdetermines the effect on project net present value of a change in individual project variables. The analysis highlights theproject variable to which the project net present value is most sensitive in relative terms. However, since sensitivity analysischanges only one variable at a time, it ignores interrelationships between project variables.

While sensitivity analysis can indicate the key or critical variable, it does not indicate the likelihood of a change in the futurevalue of this variable, i.e. sensitivity analysis does not indicate the probability of a change in the future value of the key orcritical variable. For this reason, given the earlier comments on risk and uncertainty, it can be said that sensitivity analysis isnot a method of including risk in the investment appraisal process.

14

Probability analysis, as its name implies, attaches probabilities to the expected future cash flows of an investment project anduses these to calculate the expected net present value (ENPV). The ENPV is the average NPV that would be expected to occurif an investment project could be repeated a large number of times. The ENPV can also be seen as the mean or expectedvalue of an NPV probability distribution. Given the earlier discussion of risk and uncertainty, it is clear that probability analysisis a way of including a consideration of risk in the investment appraisal process. It is certainly a more effective way ofconsidering the risk of investment projects than sensitivity analysis.

A weakness of probability analysis, however, lies in the difficulty of estimating the probabilities that are to be attached toexpected future cash flows. While these probabilities can be based on expert judgement and previous experience of similarinvestment projects, there remains an element of subjectivity which cannot be escaped.

2 (a) Overtrading arises when a company does not have enough long-term finance to support its level of trading activity. There area number of signs of overtrading, which are referred to in the following discussion.

Rapid increase in revenue or turnover compared to long-term finance

Revenue has increased by 40%, from $10,375,000 to $14,525,000, while long-term finance has increased by only 4·7%($16,268,000/$15,541,000).

Increase in trade receivables days

A rapid increase in revenue may be due to offering more generous credit terms to customers, in which case the tradereceivables ratio would be expected to increase. Trade receivables days have in fact increased from 61 days to 80 days, anincrease of 31%. In 2010 trade receivables days were close to the average value for similar companies of 60 days, but theyare now 33% more than this. While revenue has increased by 40%, trade receivables have increased by 85%($3,200,000/$1,734,000). It appears that Wobnig Co has offered more generous credit terms to its customers, althoughanother explanation could be that the company’s customers are struggling to settle their accounts on time due a downturn ineconomic activity, for example a recession, leading to an increase in overdue payments and outstanding invoices.

Decrease in profitability

A rapid increase in revenue may also be due to offering lower prices on products sold, affecting gross profit margin or netprofit margin. The net profit margin of Wobnig Co has decreased from 36% in 2010 to 28% in 2011. While revenueincreased by 40%, profit before interest and tax increased by only 8·9% ($4,067,000/$3,735,000). While this decrease inprofitability supports the possibility that Wobnig Co has decreased selling prices in order to increase sales volume, such adecrease in profitability may also be caused by an increase in cost of sales or other operating costs.

Rapid increase in current assets

The increase in trade receivables has already been discussed. Inventory increased by 97% ($2,149,000/$1,092,000)compared to the revenue increase of 40%, indicating perhaps that further increases in sales volume are being planned byWobnig Co. Inventory days also increased from 60 days in 2010 to 75 days in 2011, well above the average value for similarcompanies of 55 days. There has therefore been a rapid increase in current assets of 89% ($5,349,000/$2,826,000),compared to the increase in long-term finance of only 4·7%.

An increased dependence on short-term finance

Wobnig Co has certainly increased its dependence on short-term finance and this can be shown in several ways. The salesrevenue/net working capital ratio has increased from 11 times in 2010 to 15 times in 2011, compared to the average valuefor similar companies of 10 times. There has been a 500% increase in the company’s overdraft ($1,500,000/$250,000)and a 75% increase in trade payables ($2,865,000/$1,637,000). Furthermore, trade payables days rose from 90 days in2010 to 100 days in 2011, higher than the average value for similar companies of 85 days. Short-term debt as a proportionof total debt increased from 6% in 2010 ($250,000/$4,250,000) to 27% in 2011 ($1,500,000/$5,500,000). Thisanalysis supports the view that Wobnig Co is more dependent on short-term finance in 2011 than in 2010.

A decrease in liquidity

A key problem arising from overtrading is a decrease in liquidity and a shortage of cash. The current ratio of Wobnig Co hasfallen from 1·5 times in 2010 to 1·2 times in 2011, compared to an average value for similar companies of 1·7 times. Thequick ratio or acid test ratio, which is a more sensitive measure of liquidity, has fallen from 0·9 times in 2010 to 0·7 timesin 2011, compared to an average value for similar companies of 1·1 times. There are therefore clear indications that liquidityhas fallen over the period and that Wobnig Co has a weaker liquidity position than similar companies on an average basis.However, the current assets of the company do still exceed its current liabilities, so it does not yet have a liquid deficit.

Conclusion

Overall, it can be concluded that there are several indications that Wobnig Co is moving, or has moved, into an overtrading(undercapitalisation) position.

Workings

Increase in revenue = 100 x (14,525 – 10,375)/10,375 = 40%Increase in long-term finance = 100 x (16,268 – 15,541)/15,541 = 4·7%

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2011 2010Net profit margin 100 x 4,067/14,525 = 28% 100 x 3,735/10,375 = 36%Current ratio 5,349/4,365 = 1·2 times 2,826/1,887 = 1·5 timesQuick ratio 3,200/4,365 = 0·7 times 1,734/1,887 = 0·9 timesInventory days 365 x 2,149/10,458 = 75 days 365 x 1,092/6,640 = 60 daysReceivables days 365 x 3,200/14,525 = 80 days 365 x 1,734/10,375 = 61 daysPayables days 365 x 2,865/10,458 = 100 days 365 x 1,637/6,640 = 90 daysNet working capital 5,349 – 4,365 = $984,000 2,826 – 1,887 = $939,000Sales/net working capital 14,525/984 = 15 times 10,375/939 = 11 times

(b) Working capital investment policy is concerned with the level of investment in current assets, with one company beingcompared with another. Working capital financing policy is concerned with the relative proportions of short-term and long-term finance used by a company. While working capital investment policy is therefore assessed on an inter-companycomparative basis, assessment of working capital financing policy involves analysis of financial information for one companyalone.

Working capital financing policy uses an analysis of current assets into permanent current assets and fluctuating currentassets. Working capital investment policy does not require this analysis. Permanent current assets represent the core level ofinvestment in current assets that supports a given level of business activity. Fluctuating current assets represent the changesin the level of current assets that arise through, for example, the unpredictability of business operations, such as the level oftrade receivables increasing due to some customers paying late or the level of inventory increasing due to demand being lessthan predicted.

Working capital financing policy relies on the matching principle, which is not used by working capital investment policy. Thematching principle holds that long-term assets should be financed from a long-term source of finance. Non-current assets andpermanent current assets should therefore be financed from a long-term source, such as equity finance or bond finance, whilefluctuating current assets should be financed from a short-term source, such as an overdraft or a short-term bank loan.

Both working capital investment policy and working capital financing policy use the terms conservative, moderate andaggressive. In investment policy, the terms are used to indicate the comparative level of investment in current assets on aninter-company basis. One company has a more aggressive approach compared to another company if it has a lower level ofinvestment in current assets, and vice versa for a conservative approach to working capital investment policy. In workingcapital financing policy, the terms are used to indicate the way in which fluctuating current assets and permanent currentassets are matched to short-term and long-term finance sources.

An aggressive financing policy means that fluctuating current assets and a portion of permanent current assets are financedfrom a short-term finance source. A conservative financing policy means that permanent current assets and a portion offluctuating current assets are financed from a long-term source. An aggressive financing policy will be more profitable than aconservative financing policy because short-term finance is cheaper than long-term finance, as indicated for debt finance bythe normal yield curve (term structure of interest rates). However, an aggressive financing policy will be riskier than aconservative financing policy because short-term finance is riskier than long-term finance. For example, an overdraft isrepayable on demand, while a short-term loan may be renewed on less favourable terms than an existing loan. Providedinterest payments are made, however, long-term debt will not lead to any pressure on a company and equity finance ispermanent capital.

Overall, therefore, it can be said that while working capital investment policy and working capital financing policy use similarterminology, the two policies are very different in terms of their meaning and application. It is even possible, for example, fora company to have a conservative working capital investment policy while following an aggressive working capital financingpolicy.

(c) Calculation of upper limit

The upper limit is the sum of the lower limit and the spread. If we use the minimum cash balance as the lower limit, theupper limit = 200,000 + 75,000 = $275,000

Calculation of return point

The return point is the sum of the lower limit and one-third of the spread.Return point = 200,000 + (75,000/3) = 200,000 + 25,000 = $225,000

Use in managing cash balances

The Miller-Orr model provides decision rules about when to invest surplus cash (if a cash balance increases to a high level),and about when to sell short-term investments (if a cash balance falls to a low level). By using these decision rules, the cashbalance is kept between the upper and lower limits set by the Miller-Orr model. When the cash balance reaches the upperlimit, $50,000 is invested in short-term securities. This is equal to the upper limit minus the return point ($275,000 –$225,000). When the cash balance falls to the lower limit, short-term securities worth $25,000 are sold for cash. This isequal to the return point minus the lower limit ($225,000 – $200,000).

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3 (a) Conflict between the objectives of shareholders and directors in a listed company is associated with the agency problem,which has three main causes. First, the objectives of shareholders and directors may be different. Second, there is asymmetryof information, so that shareholders have access to less information about the company than directors, making it hard forshareholders to monitor the actions and decisions of directors. Third, there is a separation between ownership and control,as shareholders and directors are different people.

One reason why small and medium-sized entities (SMEs) might experience less conflict between shareholders and directorsthan larger listed companies is that in many cases shareholders are not different from directors, for example in a family-owned company. Where that is the case, there is no separation between ownership and control, there is no differencebetween the objectives of shareholders and directors, and there is no asymmetry of information. Conflict between theobjectives of shareholders and directors will therefore not arise.

Another reason why there may be less conflict between the objectives of shareholders and directors in SMEs than in largerlisted companies is that the shares of SMEs are often owned by a small number of shareholders, who may be in regularcontact with the company and its directors. In these circumstances, the possibility of conflict is very much reduced.

(b) Factors to consider when choosing a source of debt finance

There are a number of factors that should be considered when choosing a suitable source of debt finance. Essentially acompany should look to match the characteristics of the debt finance with its corporate needs.

CostZigto Co should consider both issue costs and the rate of interest to be charged on the funds borrowed. The company shouldalso consider the repayment terms. With a bank loan, for example, there may be an annual capital payment in addition tothe annual interest payment. Additionally, some types of debt have early repayment penalties.

MaturityThe period over which the debt is taken should be matched against the period for which the company needs the finance andthe ability of the company to meet the financial commitments associated with the debt finance selected. Another factor toconsider is that short-term finance can be more flexible than long-term finance. If a company takes on long-term debt financeit takes on a long-term commitment to which it has a contractual obligation.

Financial riskDebt will increase gearing and hence the financial risk of Zigto Co. The company should consider how gearing will changeover the life of the debt finance selected and how the company will be viewed from a risk perspective by future investors.

AvailabilityThe kinds of debt finance available to Zigto Co will depend upon the relative size of the company, its relationship with itsbank and the capital markets to which it has access. It is likely that a bank loan, rather than any other kind of debt finance,will be selected by Zigto Co, since very few SMEs are able to issue traded bonds.

Factors to be considered by providers of finance

There are a number of factors that may be considered by providers of finance in deciding how much to lend to a company.

Risk and the ability to meet financial obligationsWhen considering the amount and the terms of the funds to be made available to Zigto Co, providers of debt finance willassess the ability of the company to meets its future financial obligations and the risk of the company. The previous recordof the company can be used as a guide to the ability of its board of directors to manage its finances in a responsible andeffective manner. The business plan of Zigto Co relating to the proposed business expansion will be carefully scrutinised bypotential investors in order to make sure that it rests on reasonable assumptions and that the forecast cash flows can beachieved. This helps to reduce the uncertainty associated with the proposed expansion.

SecurityThe amount of funds made available to Zigto Co will also depend on the availability of assets to offer as security. Debt investorswill expect security in order to reduce the risk of the investment from their point of view. If security is not available or is limited,Zigto Co will have to pay a higher rate of interest in compensation for the higher level of risk.

Legal restrictions on borrowingAnother factor to consider is whether there are any legal restrictions on the amount of debt that the company can take on, forexample in existing debt contracts (restrictive or negative covenants), or in the company’s memorandum or articles ofassociation.

(c) One central principle of Islamic finance is that making money out of money is not acceptable, i.e. interest is prohibited. Amudaraba contract, in Islamic finance, is a partnership between one party that brings finance or capital into the contract andanother party that brings business expertise and personal effort into the contract. The first party is called the owner of capital,while the second party is called the agent, who runs or manages the business. The mudaraba contract specifies how profitfrom the business is shared proportionately between the two parties. Any loss, however, is borne by the owner of capital, andnot by the agent managing the business. It can therefore be seen that three key characteristics of a mudaraba contract arethat no interest is paid, that profits are shared, and that losses are not shared.

If Zigto Co were to decide to seek Islamic finance for the planned business expansion and if the company were to enter intoa mudaraba contract, the company would therefore be entering into a partnership as an agent, managing the business and

17

sharing profits with the Islamic bank that provided the finance and which was acting as the owner of capital. The Islamicbank would not interfere in the management of the business and this is what would be expected if Zigto Co were to financethe business expansion using debt such as a bank loan. However, while interest on debt is likely to be at a fixed rate, themudaraba contract would require a sharing of profit in the agreed proportions.

(d) Forward exchange contract

Zigto Co needs to use the six-month forward exchange rate to hedge its six-month euro receipt.

Dollar value in six months’ time = 500,000/1·990 = $251,256

Money market hedge

The six-month euro receipt is a future asset and needs to be hedged by a future euro liability. Zigto Co needs to borrowsufficient euros now so that in six months’ time the debt is equal to €500,000. The six month euro borrowing rate is 2·5%(5%/2).

Euros borrowed now = 500,000/1·025 = €487,805Dollar value of this euro debt = 487,805/2·000 = $243,903The six-month dollar deposit rate is 2% (4%/2)Future value of these dollars placed on deposit = 243,903 x 1·02 = $248,781

The forward contract gives the higher value and hence is preferred to the money market hedge.

(e) Expected (future) spot exchange rate

Using purchasing power parity, the expected (future) spot exchange rate can be calculated from the relative inflation rates,i.e. expected spot rate = 2·00 x (1·03/1·045) = €1·971 per $. The change in the spot rate over time can therefore,according to purchasing power parity, be related to relative inflation rates. This expected spot rate can be compared with thecurrent twelve-month forward rate of €1·981 per $

Relationship between the expected (future) spot rate and the current forward rate

The twelve-month forward exchange rate is a rate currently offered in the forward exchange market and a company can lockinto this rate using a forward exchange contract. Forward rates are set using interest rate parity, i.e. by relative interest ratesbetween two countries.

If there were equilibrium between relative inflation rates and relative interest rates between two countries, the expected spotrate and the current forward rate would be the same. This is referred to as expectations theory. In practice, purchasing powerparity tends to hold over long periods of time, and the existence of short-term disequilibrium leading to a difference betweenthe expected spot rate and the current forward rate is not unusual.

4 (a) Price/earnings ratio valuation

The value of the company using this valuation method is found by multiplying future earnings by a price/earnings ratio. Usingthe earnings of Corhig Co in Year 1 and the price/earnings ratio of similar listed companies gives a value of 3,000,000 x 5= $15,000,000.

Using the current average price/earnings ratio of similar listed companies as the basis for the valuation rests on twoquestionable assumptions. First, in terms of similarity, the valuation assumes similar business operations, similar capitalstructures, similar earnings growth prospects, and so on. In reality, no two companies are identical. Second, in terms of usingan average price/earnings ratio, this may derive from companies that are large and small, successful and failing, low-gearedand high-geared, and domestic or international in terms of markets served. The calculated company value therefore has alarge degree of uncertainty attached to it.

The earnings figure used in the valuation does not include expected earnings growth. If average forecast earnings over thenext three years are used ($3·63 million), the price/earning ratio value increases by 21% to $18·15 million (3·63 x 5).Although earnings growth beyond the third year is still ignored, $18·15 million is likely to be a better estimate of the valueof the company than $15 million because it recognises that earnings are expected to increase by almost 50% in the nextthree years.

(b) Value of company using the dividend valuation model

The current cost of equity using the capital asset pricing model = 4 + (1·6 x 5) = 12%

Since a dividend will not be paid in Year 1, the dividend growth model cannot be applied straight away. However, dividendsafter Year 3 are expected to grow at a constant annual rate of 3% per year and so the dividend growth model can be appliedto these dividends. The present value of these dividends is a Year 3 present value, which will need discounting back to year0. The market value of the company can then be found by adding this to the present value of the forecast dividends in Years2 and 3.

PV of year 2 dividend = 500,000/1·122 = $398,597PV of year 3 dividend = 1,000,000/1·123 = $711,780

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Year 3 PV of dividends after year 3 = (1,000,000 x 1·03)/(0·12 – 0·03) = $11,444,444Year 0 PV of these dividends = 11,444,444/1·123 = $8,145,929

Market value from dividend valuation model = 398,597 + 711,780 + 8,145,929 = $9,256,306 or approximately $9·3 million

Alternative calculation of dividend valuation method market value

The year 3 dividend of $1m can be treated as D1 from the perspective of year 2

The year 2 value of future dividends using the dividend growth model will then be:

$1,000,000/(0·12 – 0·03) = $11,111,111

Year 0 PV of these dividends = 11,111,111/1·122 = $8,857,710

Adding the PV of the year 2 dividend gives a market value of 8,857,710 + 398,597 = $9,256,308 which, allowing forrounding, is the same as the earlier calculated value.

(c) Current weighted average after-tax cost of capital

Current cost of equity using the capital asset pricing model = 12%After-tax cost of debt = 5 x (1 – 0·2) = 5 x 0·8 = 4%Current after-tax WACC = (12 x 0·75) + (4 x 0·25) = 10% per year

Weighted average after-tax cost of capital after new debt issue

Revised cost of equity = Ke = 4 + (2·0 x 5) = 14%Revised after-tax cost of debt = 6 x (1 – 0·2) = 6 x 0·8 = 4·8%Revised after-tax WACC = (14 x 0·6) + (4·8 x 0·4) = 10·32% per year

Comment

The after-tax WACC has increased slightly from 10% to 10·32%. This change is a result of the increases in the cost of equityand the after-tax cost of debt, coupled with the change in gearing. Although the cost of equity has increased, the effect of theincrease has been reduced because the proportion of equity finance has fallen from 75% to 60% of the long-term capitalemployed. Although the after-tax cost of debt has increased, the cost of debt is less than the cost of equity and the proportionof cheaper debt finance has increased from 25% to 40% of the long-term capital employed.

(d) Nature and assessment of business risk

Business risk arises due to the nature of a company’s business operations, which determines the business sector into whichit is classified, and to the way in which a company conducts its business operations. Business risk is the variability inshareholder returns that arises as a result of business operations. It can therefore be related to the way in which profit beforeinterest and tax (PBIT or operating profit) changes as revenue or turnover changes. This can be assessed from a shareholderperspective by calculating operational gearing, which essentially looks at the relative proportions of fixed operating costs tovariable operating costs. One measure of operational gearing that can be used is (100 x contribution/PBIT), although othermeasures are also used.

Nature and assessment of financial risk

Financial risk arises due to the use of debt as a source of finance, and hence is related to the capital structure of a company.Financial risk is the variability in shareholder returns that arises due to the need to pay interest on debt. Financial risk can beassessed from a shareholder perspective in two ways. Firstly, balance sheet gearing can be calculated. There are a numberof gearing measures that can be used, such as the debt/equity ratio, the debt ratio and financial gearing, and the calculationcan be based on either market values or book values. Secondly, the interest coverage ratio can be calculated.

Nature and assessment of systematic risk

From a shareholder perspective, systematic risk is the sum of business risk and financial risk. Systematic risk is the risk thatremains after a shareholder has diversified investments in a portfolio, so that the risk specific to individual companies hasbeen diversified away and the shareholder is faced with risk relating to the market as a whole. Market risk and undiversifiablerisk are therefore other names for systematic risk.

From a shareholder perspective, the systematic risk of a company can be assessed by the equity beta of the company. If thecompany has debt in its capital structure, the systematic risk reflected by the equity beta will include both business risk andfinancial risk. If a company is financed entirely by equity, the systematic risk reflected by the equity beta will be business riskalone, in which case the equity beta will be the same as the asset beta.

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Marks Marks1 (a) Sales revenue 2

Variable costs 1Fixed costs 0·5Tax liabilities 1Balancing allowance 1Capital allowance tax benefits 2Timing of taxation benefits and liabilities 1Scrap value 0·5Initial investment 0·5Using correct discount rate 0·5Net present value 1Comment on financial acceptability 1

––––12

(b) Equivalent annual cost of Machine 1 2Equivalent annual cost of Machine 2 2Discussion of which machine to purchase 2

––––6

(c) Explanation of risk and uncertainty 1Discussion of sensitivity analysis 2–3Discussion of probability analysis 2–3Other relevant discussion 1–2


––––25

––––

2 (a) Rapid increase in revenue 1–2Increase in trade receivables days 2–3Decrease in profitability 2–3Rapid increase in current assets 2–3Increased dependence on short-term finance 2–3Decrease in liquidity 2–3Conclusion as regards overtrading 1


(b) Working capital investment policy 3–4Working capital financing policy 5–6


(c) Calculation of upper limit 1Calculation of return point 1Explanation of use in managing cash balances 2

––––4

––––25

––––

21

Marks Marks3 (a) Causes of conflict between objectives 2–3

Reasons for less conflict in SMEs 1–2––––

Maximum 4

(b) Factors to consider when choosing source of debt 4–5Factors considered by providers of finance 4–5


(c) Nature of a mudaraba contract 3Financing business expansion using mudaraba 2

––––5

(d) Calculated value of a forward exchange contract 1Calculated value of a money market hedge 3Comment on hedge to select 1

––––5

(e) Calculation of one-year future spot rate 1Link between future spot rate and forward rate 2

––––3

––––25

––––

4 (a) Price/earnings value using year 1 earnings 1Price/earnings value using average earnings 1Discussion of variables 2

––––4

(b) Calculation of current cost of equity using CAPM 1PV of year 2 dividends 0·5PV of year 3 dividends 0·5Year 3 DGM value 2Year 0 PV of year 3 DGM value 1Company value using dividend valuation model 1

––––6

(c) After-tax cost of debt 1After-tax WACC 1Revised cost of equity using CAPM 1Revisied after-tax cost of debt 1Revised after-tax WACC 1Comment on change in WACC 1

––––6

(d) Nature of business risk 1–2Assessment of business risk 1–2Nature of financial risk 1–2Assessment of financial risk 1–2Nature of systematic risk 1–2Assessment of systematic risk 1–2


––––25

––––

22








Pape

r F9





1 BQK Co, a house-building company, plans to build 100 houses on a development site over the next four years. Thepurchase cost of the development site is $4,000,000, payable at the start of the first year of construction. Two typesof house will be built, with annual sales of each house expected to be as follows:

Year 1 2 3 4Number of small houses sold: 15 20 15 5Number of large houses sold: 7 8 15 15

Houses are built in the year of sale. Each customer finances the purchase of a home by taking out a long-termpersonal loan from their bank. Financial information relating to each type of house is as follows:

Small house Large houseSelling price: $200,000 $350,000Variable cost of construction: $100,000 $200,000

Selling prices and variable cost of construction are in current price terms, before allowing for selling price inflation of3% per year and variable cost of construction inflation of 4·5% per year.

Fixed infrastructure costs of $1,500,000 per year in current price terms would be incurred. These would not relateto any specific house, but would be for the provision of new roads, gardens, drainage and utilities. Infrastructure costinflation is expected to be 2% per year.

BQK Co pays profit tax one year in arrears at an annual rate of 30%. The company can claim capital allowances onthe purchase cost of the development site on a straight-line basis over the four years of construction.

BQK Co has a real after-tax cost of capital of 9% per year and a nominal after-tax cost of capital of 12% per year.New investments are required by the company to have a before-tax return on capital employed (accounting rate ofreturn) on an average investment basis of 20% per year.

Required:

(a) Calculate the net present value of the proposed investment and comment on its financial acceptability. Workto the nearest $1,000. (13 marks)

(b) Calculate the before-tax return on capital employed (accounting rate of return) of the proposed investmenton an average investment basis and discuss briefly its financial acceptability. (5 marks)

(c) Discuss the effect of a substantial rise in interest rates on the financing cost of BQK Co and its customers,and on the capital investment appraisal decision-making process of BQK Co. (7 marks)

(25 marks)

2

2 KXP Co is an e-business which trades solely over the internet. In the last year the company had sales of $15 million.All sales were on 30 days’ credit to commercial customers.

Extracts from the company’s most recent statement of financial position relating to working capital are as follows:

$000Trade receivables 2,466Trade payables 2,220Overdraft 3,000

In order to encourage customers to pay on time, KXP Co proposes introducing an early settlement discount of 1% forpayment within 30 days, while increasing its normal credit period to 45 days. It is expected that, on average, 50%of customers will take the discount and pay within 30 days, 30% of customers will pay after 45 days, and 20% ofcustomers will not change their current paying behaviour.

KXP Co currently orders 15,000 units per month of Product Z, demand for which is constant. There is only onesupplier of Product Z and the cost of Product Z purchases over the last year was $540,000. The supplier has offereda 2% discount for orders of Product Z of 30,000 units or more. Each order costs KXP Co $150 to place and theholding cost is 24 cents per unit per year.

KXP Co has an overdraft facility charging interest of 6% per year.

Required:

(a) Calculate the net benefit or cost of the proposed changes in trade receivables policy and comment on yourfindings. (6 marks)

(b) Calculate whether the bulk purchase discount offered by the supplier is financially acceptable and commenton the assumptions made by your calculation. (6 marks)

(c) Identify and discuss the factors to be considered in determining the optimum level of cash to be held by acompany. (5 marks)

(d) Discuss the factors to be considered in formulating a trade receivables management policy. (8 marks)

(25 marks)

3 [P.T.O.

3 The statement of financial position of BKB Co provides the following information:

$m $mEquity finance

Ordinary shares ($1 nominal value) 25Reserves 15 40

–––Non-current liabilities

7% Convertible bonds ($100 nominal value) 205% Preference shares ($1 nominal value) 10 30

–––Current liabilities

Trade payables 10Overdraft 15 25

––– –––Total liabilities 95

–––

BKB Co has an equity beta of 1·2 and the ex-dividend market value of the company’s equity is $125 million. The ex-interest market value of the convertible bonds is $21 million and the ex-dividend market value of the preferenceshares is $6·25 million.

The convertible bonds of BKB Co have a conversion ratio of 19 ordinary shares per bond. The conversion date andredemption date are both on the same date in five years’ time. The current ordinary share price of BKB Co is expectedto increase by 4% per year for the foreseeable future.

The overdraft has a variable interest rate which is currently 6% per year and BKB Co expects this to increase in thenear future. The overdraft has not changed in size over the last financial year, although one year ago the overdraftinterest rate was 4% per year. The company’s bank will not allow the overdraft to increase from its current level.

The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. BKB Co pays profit tax at anannual rate of 30% per year.

Required:

(a) Calculate the market value after-tax weighted average cost of capital of BKB Co, explaining clearly anyassumptions you make. (12 marks)

(b) Discuss why market value weighted average cost of capital is preferred to book value weighted average costof capital when making investment decisions. (4 marks)

(c) Comment on the interest rate risk faced by BKB Co and discuss briefly how this risk can be managed.(5 marks)

(d) Discuss the attractions to a company of convertible debt compared to a bank loan of a similar maturity as asource of finance. (4 marks)

(25 marks)

4

4 GWW Co is a listed company which is seen as a potential target for acquisition by financial analysts. The value of thecompany has therefore been a matter of public debate in recent weeks and the following financial information isavailable:

Year 2009 2010 2011 2012Profit after tax ($m) 8·5 8·9 9·7 10·1Total dividends ($m) 5·0 5·2 5·6 6·0

Statement of financial position information for 2012

$m $mNon-current assets 91·0Current assets

Inventory 3·8Trade receivables 4·5 8·3

–––– –––––Total assets 99·3

–––––

Equity financeOrdinary shares 20·0Reserves 47·2 67·2

––––Non-current liabilities

8% bonds 25·0Current liabilities 7·1

–––––Total liabilities 99·3

–––––

The shares of GWW Co have a nominal (par) value of 50c per share and a market value of $4·00 per share. The costof equity of the company is 9% per year. The business sector of GWW Co has an average price/earnings ratio of 17 times. The 8% bonds are redeemable at nominal (par) value of $100 per bond in seven years’ time and the before-tax cost of debt of GWW Co is 6% per year.

The expected net realisable values of the non-current assets and the inventory are $86·0m and $4·2m, respectively.In the event of liquidation, only 80% of the trade receivables are expected to be collectible.

Required:

(a) Calculate the value of GWW Co using the following methods:

(i) market capitalisation (equity market value);(ii) net asset value (liquidation basis);(iii) price/earnings ratio method using the business sector average price/earnings ratio;(iv) dividend growth model using:

(1) the average historic dividend growth rate;(2) Gordon’s growth model (the bre model).

The total marks will be split equally between each part. (10 marks)

(b) Discuss the relative merits of the valuation methods in part (a) above in determining a purchase price forGWW Co. (8 marks)

(c) Calculate the following values for GWW Co:

(i) the before-tax market value of the bonds of GWW Co;(ii) debt/equity ratio (book value basis);(iii) debt/equity ratio (market value basis).

Discuss the usefulness of the debt/equity ratio in assessing the financial risk of GWW Co.

The total marks will be split equally between each part. (7 marks)

(25 marks)

5 [P.T.O.

6

Formulae Sheet


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13

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7 [P.T.O.

Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

8

Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers


1 (a) NPV calculation

Year 1 2 3 4 5$000 $000 $000 $000 $000

Sales revenue 5,614 7,214 9,015 7,034Variable costs (3,031) (3,931) (5,135) (4,174)

–––––– –––––– –––––– ––––––Contribution 2,583 3,283 3,880 2,860Fixed costs (1,530) (1,561) (1,592) (1,624)

–––––– –––––– –––––– ––––––Before-tax cash flow 1,053 1,722 2,288 1,236Tax liability (316) (517) (686) (371)CA tax benefits 300 300 300 300

–––––– –––––– –––––– –––––– ––––––After-tax cash flow 1,053 1,706 2,071 850 (71)Discount at 12% 0·893 0·797 0·712 0·636 0·567

–––––– –––––– –––––– –––––– ––––––Present values 940 1,360 1,475 541 (40)

–––––– –––––– –––––– –––––– ––––––

$000PV of future cash flows 4,276Initial investment (4,000)

––––––276

––––––

CommentSince the proposed investment has a positive net present value of $276,000, it is financially acceptable.

Workings

Sales revenue

Year 1 2 3 4Sales of small houses (houses/yr) 15 20 15 5Sales of large houses (houses/yr) 7 8 15 15Small house selling price ($000/house) 200 200 200 200Large house selling price ($000/house) 350 350 350 350

Sales revenue (small houses) ($000/yr) 3,000 4,000 3,000 1,000Sales revenue (large houses) ($000/yr) 2,450 2,800 5,250 5,250

–––––– –––––– –––––– ––––––Total sales revenue ($/yr) 5,450 6,800 8,250 6,250

–––––– –––––– –––––– ––––––

Inflated sales revenue ($/yr) 5,614 7,214 9,015 7,034

Variable costs of construction

Year 1 2 3 4Sales of small houses (houses/yr) 15 20 15 5Sales of large houses (houses/yr) 7 8 15 15Small house variable cost ($000/house) 100 100 100 100Large house variable cost ($000/house) 200 200 200 200

Variable cost (small houses) ($000/yr) 1,500 2,000 1,500 500Variable cost (large houses) ($000/yr) 1,400 1,600 3,000 3,000

–––––– –––––– –––––– ––––––Total variable cost ($/yr) 2,900 3,600 4,500 3,500

–––––– –––––– –––––– ––––––

Inflated total variable cost ($/yr) 3,031 3,931 5,135 4,174

Fixed infrastructure costs

Year 1 2 3 4Fixed costs ($000/yr) 1,500 1,500 1,500 1,500Inflated fixed costs ($000/yr) 1,530 1,561 1,592 1,624

11

Alternative NPV calculation

Year 1 2 3 4 5$000 $000 $000 $000 $000

Before-tax cash flow 1,053 1,722 2,288 1,236Capital allowances (1,000) (1,000) (1,000) (1,000)

–––––– –––––– –––––– ––––––Taxable profit 53 722 1,288 236Taxation (16) (217) (386) (71)

–––––– –––––– –––––– –––––– ––––––Profit after tax 53 706 1,071 (150) (71)Add back allowances 1,000 1,000 1,000 1,000

–––––– –––––– –––––– ––––––After-tax cash flow 1,053 1,706 2,071 850 (71)Discount at 12% 0·893 0·797 0·712 0·636 0·567

–––––– –––––– –––––– –––––– ––––––Present values 940 1,360 1,475 541 (40)

–––––– –––––– –––––– –––––– ––––––

$000PV of future cash flows 4,276Initial investment (4,000)

––––––276

––––––

(b) Calculation of return on capital employed (ROCE)

Total before-tax cash flow $6,299,000Total depreciation $4,000,000

–––––––––––Total accounting profit $2,299,000

Average annual profit ($000/year) = 2,299,000/4 = $574,750Average investment ($000) = 4,000,000/2 = $2,000,000ROCE (ARR) = 100 x 574,750/2,000,000 = 28·7%

DiscussionThe ROCE is greater than the 20% target ROCE of the investing company and so the proposed investment is financiallyacceptable. However, the investment decision should be made on the basis of information provided by a discounted cash flow(DCF) method, such as net present value or internal rate of return.

(c) A substantial increase in interest rates will increase the financing costs of BQK Co and its customers. These will affect thediscount rate used in the investment appraisal decision-making process and the value of project variables.

Customer financing costsEach customer finances their house purchase through a long-term personal loan from their bank. A substantial rise in interestrates will increase the borrowing costs of existing and potential customers of BQK Co, and will therefore increase the amountof cash they pay to buy one of the houses.

Company financing costsThe cost of debt of BQK Co will change with interest rates in the economy. A substantial rise in interest rates will thereforelead to a substantial increase in the cost of debt of the company. This will lead to an increase in the weighted average costof capital (WACC) of BQK Co, the actual increase depending on the relative proportion of debt compared to equity in thecompany’s capital structure.

The cost of equity will also increase as interest rates rise, contributing to the increase in the WACC. Since most companieshave a greater proportion of equity finance as compared to debt finance, the increase in the cost of equity is likely to have amore significant effect on the WACC than the increase in the cost of debt.

Effect on the capital investment appraisal processSince the business of the company is building houses, the WACC of the company is likely to be the discount rate it uses inevaluating investment decisions such as the one under consideration. An increase in WACC will therefore lead to a decreasein the NPV of investment projects and some projects may no longer be attractive.

In order to make the investment project more attractive, the prices of the houses offered for sale might have to increase. Thiscould make the houses more difficult to sell and lead to increased costs due to slower sales.

Houses could also be more difficult to sell as customers would be more reluctant to commit themselves to long-term personalloans when interest rates are historically high.

Construction and infrastructure costs might increase as suppliers seek to pass on their higher borrowing costs.

Overall, income per year could decrease and the time period for the investment might need to be extended to accommodatethe slower sales process.

12

2 (a) Calculation of net cost/benefit

Current receivables = $2,466,000

Receivables paying within 30 days = 15m x 0·5 x 30/365 = $616,438Receivables paying within 45 days = 15m x 0·3 x 45/365 = $554,795Receivables paying within 60 days = 15m x 0·2 x 60/365 = $493,151Revised receivables = 616,438 + 554,795 + 493,151 = $1,664,384

Reduction in receivables = 2,466,000 – 1,664,384 = $801,616Reduction in financing cost = 801,616 x 0·06 = $48,097

Cost of discount = 15m x 0·5 x 0·01 = $75,000

Net cost of proposed changes in receivables policy = 75,000 – 48,097 = $26,903

Alternative approach to calculation of net cost/benefit

Current receivables days = (2,466/15,000) x 365 = 60 daysRevised receivables days = (30 x 0·5) + (45 x 0·3) + (60 x 0·2) = 40·5 daysDecrease in receivables days = 60 – 40·5 = 19·5 days

Decrease in receivables = 15m x 19·5/365 = $801,370(The slight difference compared to the earlier answer is due to rounding)

Decrease in financing cost = 801,370 x 0·06 = $48,082Net cost of proposed changes in receivables policy = 75,000 – 48,082 = $26,918

CommentThe proposed changes in trade receivables policy are not financially acceptable. However, if the trade terms offered arecomparable with those of its competitors, KXP Co needs to investigate the reasons for the (on average) late payment of currentcustomers. This analysis also assumes constant sales and no bad debts, which is unlikely to be the case in reality.

(b) Cost of current inventory policy

Cost of materials = $540,000 per yearAnnual ordering cost = 12 x 150 = $1,800 per yearAnnual holding cost = 0·24 x (15,000/2) = $1,800 per year

Total cost of current inventory policy = 540,000 + 1,800 + 1,800 = $543,600 per year

Cost of inventory policy after bulk purchase discount

Cost of materials after bulk purchase discount = 540,000 x 0·98 = $529,200 per year

Annual demand = 12 x 15,000 = 180,000 units per yearKXP Co will need to increase its order size to 30,000 units to gain the bulk discountRevised number of orders = 180,000/30,000 = 6 orders per year

Revised ordering cost = 6 x 150 = $900 per yearRevised holding cost = 0·24 x (30,000/2) = $3,600 per year

Revised total cost of inventory policy = 529,200 + 900 + 3,600 = $533,700 per year

Evaluation of offer of bulk purchase discount

Net benefit of taking bulk purchase discount = 543,600 – 533,700 = $9,900 per year

The bulk purchase discount looks to be financially acceptable. However, this evaluation is based on a number of unrealisticassumptions. For example, the ordering cost and the holding cost are assumed to be constant, which is unlikely to be truein reality. Annual demand is assumed to be constant, whereas in practice seasonal and other changes in demand are likely.

(c) The following factors should be considered in determining the optimum level of cash to be held by a company, for example,at the start of a month or other accounting control period.

The transactions need for cashThe amount of cash needed for the next period can be forecast using a cash budget, which will net off expected receiptsagainst expected payments. This will determine the transactions need for cash, which is one of the three reasons for holdingcash.

The precautionary need for cashAlthough a cash budget will provide an estimate of the transactions need for cash, it will be based on assumptions about thefuture and will therefore be subject to uncertainty. The actual need for cash may be greater than the forecast need for cash.In order to provide for any unexpected need for cash, a company can include some spare cash (a cash buffer) in its cashbalance. This is the precautionary need for cash. In determining the optimal level of cash to be held, a company will estimatethe size of this cash buffer, for example from past experience, because it will be keen to minimise the opportunity cost ofmaintaining funds in cash form.

13

The speculative need for cashThere is always the possibility of an unexpected opportunity occurring in the business world and a company may wish to beprepared to take advantage of such a business opportunity if it arises. It may therefore wish to have some cash available forthis purpose. This is the speculative need for cash. Building ‘a war chest’ for possible company acquisitions reflects thisreason for holding cash.

The availability of financeA company may choose to hold higher levels of cash if it has difficulty gaining access to cash when it needs it. For example,if a company’s bank makes it difficult to access overdraft finance, or if a company is refused an overdraft facility, itsprecautionary need for cash will increase and its optimum cash level will therefore also increase.

(d) The factors to be considered in formulating a trade receivables policy relate to credit analysis, credit control and receivablescollection.

Credit analysisIn offering credit, a company must consider that it will be exposed to the risk of late payment and the risk of bad debts. Toreduce these risks, the company will assess the creditworthiness of its potential customers. In order to do this, the companyneeds information, which can come from a variety of sources, such as trade references, bank references, credit referenceagencies, published accounts and so on. As a result of assessing the creditworthiness of customers, a company can decideon the amount of credit to offer, the credit terms to offer, or whether to offer credit at all.

Credit controlHaving extended credit to customers, a company needs to consider ways to ensure that the terms under which credit wasgranted are followed. It is important that customers settle outstanding accounts on time and keep to agreed credit limits.Factors to consider here are, therefore, the number of overdue accounts and the amount of outstanding cash. This informationcan be provided by an aged receivables analysis.

Another factor to consider is that customers need to be made aware of the amounts outstanding on their accounts andreminded when payment is due. This can be done by providing regular statements of account and by sending reminder letterswhen payment is due.

Receivables collectionCash received needs to be banked quickly if payment is not made electronically by credit transfer. Overdue accounts must befollowed up in order to assess the likelihood of payment and to determine what further action is needed. In the worst cases,legal steps may need to be taken in order to recover outstanding amounts.

A key factor to consider here is that the benefit gained from chasing overdue amounts must not exceed the costs incurred.

3 (a) Calculation of cost of equity

The cost of equity can be calculated using the capital asset pricing model

Ke = 4 + (1·2 x 5) = 10%

Calculation of cost of debt of convertible bonds

Market value of bond = 100 x 21m/20m = $105 per bondOrdinary share price = 125m/25m = $5·00 per share

Share price in five years’ time = 5·00 x 1·045 = $6·08 per shareConversion value = 6·08 x 19 = $115·52

It is assumed that conversion is likely to occur, as the conversion value is greater than the alternative $100 redemption value.

After-tax interest payment = 0·07 x 100 x (1 – 0·3) = $4·90 per bond


Year Cash flow $ Discount at 7% PV ($)0 Market price (105·00) 1·000 (105·00)1–5 Interest 4·90 4·100 20·095 Conversion value 115·52 0·713 82·37

–––––(2·54)–––––

Year Cash flow $ Discount at 6% PV ($)0 Market price (105·00) 1·000 (105·00)1–5 Interest 4·90 4·212 20·645 Conversion value 115·52 0·747 86·29

–––––1·93

–––––

After-tax Kd = 6 + ((7 – 6) x 1·93)/(1·93 + 2·54)) = 6 + 0·43 = 6·43%

14

Calculation of cost of preference shares

Kp = 100 x (0·05 x 10m/6·25m) = 8%

Alternatively, the preference dividend per share can be compared with the preference share price to find the cost of preferenceshares

Calculation of weighted average after-tax cost of capital

Total value of company = 125m + 6·25m + 21m = $152·25 million

After-tax WACC = ((10% x 125m) + (8% x 6·25m) + (6·43% x 21m))/152·25m = 9·4%

It is assumed that the overdraft can be ignored in calculating the WACC, even though it persists from year to year and is asignificant source of finance for BKB Co.

(b) Market values of different sources of finance are preferred to their book values when calculating weighted average cost ofcapital (WACC) because market values reflect the current conditions in the capital market. The relative proportions of thedifferent sources of finance in the capital structure reflect more appropriately their relative importance to a company if marketvalues are used as weights. For example, the market value of equity is usually much greater than its book value, so usingbook values for weights would seriously underestimate the relative importance of the cost of equity in the weighted averagecost of capital.

If book values are used as weights, the WACC will be lower than if market values were used, due to the understatement ofthe contribution of the cost of equity, which is higher than the cost of capital of other sources of finance. This can be seen inthe case of BKB Co, where the market value after-tax WACC was found to be 9·4% and the book value after-tax WACC is8·7% (10% x 40 + 8% x 10 + 6·43% x 20/70).

If book value WACC were used as the discount rate in investment appraisal, investment projects would be accepted that wouldbe rejected if market value WACC were used. Using book value WACC as the discount rate will therefore lead to sub-optimalinvestment decisions.

As far as the cost of debt is concerned, using book values rather than market values for weights may make little difference tothe WACC, since bonds often trade on the capital market at or close to their nominal (par) value. In addition, the cost of debtis lower than the cost of equity and will therefore make a smaller contribution to the WACC. It is still possible, however, thatusing book values as weights may under- or over-estimate the contribution of the cost of debt to the WACC.

(c) BKB Co expects the variable interest rate on its overdraft to increase in the near future and therefore faces the risk of higherinterest payments. The expected increase in the overdraft interest rate may be due to the particular position of BKB Co, whichis at its overdraft limit as its bank will not allow any further increase in this borrowing facility. Alternatively, the expectedincrease in the overdraft interest rate may be due to a general increase in short-term interest rates, for example, as a resultof government action to reduce inflationary pressures in the economy.

BKB Co is protected against interest rate increases to the extent that it has fixed-rate debt. The proportion of fixed-rate debtto total debt is 57% (100 x 20/35), while the proportion of fixed-rate interest to total interest is 61% (100 x 1·4/2·3). Anincrease of 1% in the overdraft interest rate will increase the annual interest payments on the overdraft of BKB Co by$150,000 or 6·5%.

There are several ways that BKB can manage its interest rate risk. One way is to reduce the exposure of the company to theidentified risk, in this case an interest rate increase. The company could therefore look to reduce the size of its overdraft, anaction which would be welcomed by its bank. This could be achieved, for example, by using cash income to reduce theoverdraft or by replacing part of the overdraft with fixed interest debt, such as a bank loan or an issue of traded bonds. Anissue of longer-term debt, however, could potentially lead to a bigger increase in interest payments than expected from theincrease in short-term interest rates. Furthermore, maintaining a balance between fixed-rate and floating-rate debt is itself ahedging method (smoothing) and BKB Co may already have chosen this internal hedging method over external hedgingmethods due to its lower relative cost.

Forward rate agreements would not help BKB Co manage its interest rate risk as these relate to future borrowing rather thanto current debt. Interest rate futures would allow BKB Co to protect itself against an interest rate increase by locking intocurrent interest rates. Interest rate swaps would be more suitable for hedging a long-term interest rate exposure, rather thanthe short-term interest rate exposure represented by an increase in the overdraft interest rate.

Workings

Total debt = 20m + 15m = $35 millionFixed rate interest = 20m x 7% = $1·4 million per yearVariable rate interest = 15m x 6% = $0·9 million per yearTotal interest = 1·4m + 0·9m = $2·3 million

(d) Convertible debt is debt that, at the option of the holder, can be converted into ordinary shares. If not converted, it will beredeemed like ordinary or straight debt on maturity. Convertible debt has a number of attractions compared with a bank loanof similar maturity, as follows:

15

Self-liquidatingProvided that the conversion terms are pitched correctly and expected share price growth occurs, conversion will be anattractive choice for bond holders as it offers more wealth than redemption. This occurs when the conversion value is greaterthan the redemption value (if conversion and redemption are on the same date), or when the conversion value is greater thanthe floor value on the conversion date (if conversion is at an earlier date than the redemption date). If the debt is convertedinto ordinary shares, it will not need to be redeemed, i.e. self-liquidation has occurred. A bank loan of a similar maturity willneed to have all of the capital repaid.

Lower interest rateThe interest rate on convertible debt will be lower than the interest rate on ordinary debt such as a bank loan because of thevalue of the option to convert. The returns on fixed-interest debt will not increase with corporate profitability, so debt providerswill have a limited share of the benefits from the investment of the funds they have provided. When debt has been converted,however, bond holders become shareholders and will potentially have unlimited returns, or at least returns that are higherthan the returns on debt finance.

Increase in debt capacity on conversionGearing will increase with a bank loan for the time that the debt is outstanding, and gearing will then return to its previouslevel when the bank loan has been paid off. Gearing also increases when convertible debt is issued, but if conversion occurs,the gearing will fall not only because the debt has been removed, but will fall even further because equity has replaced thedebt. The capacity of the company to service debt (debt capacity) will therefore be enhanced by conversion, compared toredemption of a bank loan of a similar maturity.

More attractive than ordinary debtIt may be possible to issue convertible debt even when ordinary debt such as a bank loan is not attractive to lenders, sincethe option to convert offers a little extra that ordinary debt does not. This is the option to convert in the future, which can beattractive to optimists, even when the short- and medium-term economic outlook may be poor.

4 (a) (i) Market capitalisation of GWW Co

Value of ordinary shares in statement of financial position = $20·0 millionNominal (par) value of ordinary shares = 50 centsNumber of ordinary shares of company = 20m/0·5 = 40 million sharesOrdinary share price = $4·00 per shareMarket capitalisation = 40m x 4 = $160 million

(ii) Net asset value (liquidation basis)

Current net asset value (NAV) = 91·0m + 8·3m – 7·1m – 25·0m = $67·2 million

Decrease in value of non-current assets on liquidation = 86·0m – 91·0m = $5 millionIncrease in value of inventory on liquidation = 4·2m – 3·8m = $0·4 millionDecrease in value of trade receivables = 4·5m x 0·2 = $0·9 million

NAV (liquidation basis) = 67·2m – 5m + 0·4m – 0·9m = $61·7 million

(iii) Price/earnings ratio value

Historic earnings of GWW Co = $10·1 millionAverage price/earnings ratio of GWW Co business sector = 17 timesPrice/earnings ratio value of GWW Co = 17 x 10·1m = $171·7 million

(Tutorial note: Price/earnings ratio calculation using forecast earnings would receive full credit)

(iv) (1) Dividend growth model value (using historic dividend growth rate)

Historic dividend growth rate = [(6·0m/5·0m)1/3 – 1] x 100 = 6·27%

An assumption is made that future dividend growth is similar to historic dividend growth.

Value of GWW Co = (6m x 1·0627)/(0·09 – 0·0627) = $234 million

(2) Dividend growth model value (using Gordon’s growth model)

Gordon’s growth model estimates the dividend growth rate using g = breHistoric retention ratio (b) = 100 x (3·5 + 3·7 + 4·1 + 4·1)/(8·5 + 8·9 + 9·7 + 10·1) = 41%Current return on shareholders’ funds (re) = 100 x 10·1/67·2 = 15%Dividend growth rate = 41 x 0·15 = 6·15%Value of GWW Co = (6m x 1·0615)/(0·09 – 0·0615) = $224 million

(b) Net asset value is an asset-based valuation method, while the price/earnings ratio method and the dividend growth modelare both income-based methods. Market capitalisation can be seen as an objective measure of company value provided bythe capital markets.

16

Market capitalisationWhile market capitalisation is often seen as an objective measure of company value, it must be recognised that marketcapitalisation is not fixed, but constantly changing as share prices change with the random arrival of new information on thecapital market. In terms of determining a purchase price for GWW Co, market capitalisation represents a minimum value thatexisting shareholders can currently obtain on the capital market. Shareholders will therefore expect to be offered more thanthe current market price of their shares if they are to be persuaded to sell their shares to a bidding company.

Compared with other valuation methods, however, market capitalisation offers a value that is immediately verifiable for a listedcompany and existing shareholders will use it as a benchmark against which to measure any offer that is made to them.

Net asset value (liquidation basis)In terms of determining a purchase price for GWW Co, liquidation NAV is arguably more useful than book value NAV orreplacement cost NAV, provided that information needed to calculate it can be reliably established, since it values a courseof action open to the shareholders that is a real alternative to accepting an offer from a bidder. That said, it is usually foundto be a value much lower than any possible purchase price because it does not value a company as a going concern, andfew companies are purchased with the sole objective of liquidation.

Price/earnings ratio methodThis is a widely-used valuation method and provided that appropriate information is used, it can be useful in helping todetermine a purchase price.

Appropriate information will include expected future earnings rather than historical earnings, since it is future income from acompany that is purchased, not past income. In the case of GWW Co, the earnings one year forward could be forecast to be$10·7m (10·1m x 1·059), using the historical earnings growth rate of 5·9%. With these earnings rather than the most recentearnings of $10·1m, the price/earnings ratio value becomes $181·9m (17 x 10·7), an increase of $10·2m on the previouslycalculated value of $171·2m. This increase would need to be considered in determining a purchase price for GWW Co,provided that earnings growth was expected to continue in the future.

Appropriate information will also include the price/earnings ratio used in the valuation, and the origin and meaning of theapplied price/earnings ratio must be carefully considered if the calculated company value is to have any significance. Usinga sector average price/earnings ratio implies that GWW Co is an average company, and this may be an inappropriateassumption to make.

Dividend growth modelThis valuation method provides a deprival value for target company shareholders, i.e. it values what they give up (the rightto receive future dividends) if they accept an offer for their shares. Like market capitalisation, it represents a minimum valuewhen considering the purchase price of a company, in this case a minimum value for shareholders who do not controldividend policy. While the dividend growth model has many weaknesses, the value it provides is useful in determining apurchase price, providing its limitations are kept in mind.

(c) (i) Calculation of market value of bond

The market value of the bond is the present value of the future cash flows from the bond, discounted at the before-taxcost of debt.

Market value of bond = (8 x 5·582) + (100 x 0·665) = 44·66 + 66·50 = $111·16

(ii) Debt/equity ratio (book value basis)

D/E = 100 x 25·0/67·2 = 37·2%

(iii) Debt/equity ratio (market value basis)

Market value of debt = 25·0 x 111·16/100 = $27·8 millionMarket value of equity = 4·00 x 20·0/0·5 = $160·0 millionD/E = 100 x 27·8/160·0 = 17·4%

Debt/equity ratio and assessing financial riskFinancial risk relates to the variability in shareholder returns (profit after tax or earnings) that is caused by the use ofdebt in a company’s capital structure. The debt/equity ratio is therefore useful in assessing financial risk as it measuresthe relative proportion of debt to equity. Financial risk will increase as the debt/equity ratio increases, whether the ratiouses a book value basis or a market value basis.

In assessing financial risk, however, the debt/equity ratio, like other accounting ratios, needs a basis for comparison. Itis often said that a ratio in isolation has no meaning. In assessing financial risk, therefore, the trend over time in acompany’s debt/equity ratio can be considered, a rising trend indicating increasing financial risk. A comparison can alsobe made with the debt/equity ratios of similar companies, or with sector average debt/equity ratio, in order to assessrelative financial risk.

Since financial risk relates to the variability in shareholder returns in the income statement, another commonly used wayof assessing financial risk is the interest coverage ratio, sometimes calculated as interest gearing. This can be a moresensitive measure of financial risk than the debt/equity ratio, in that it can indicate when a company is experiencingincreasing difficulty in meeting its interest payments. It should be noted that difficulty in meeting interest payments canbe a problem even when the debt/equity ratio is low.

17


Marks Marks1 (a) Sales income without inflation 1

Inflation of sales income 1Variable costs without inflation 1Inflation of variable costs 1Inflated fixed costs 1Calculation of capital allowances 1Correct use of capital allowances 1Calculation of tax liabilities 1Correct timing of tax liabilities 1Selection of correct discount rate 1Selection of discount factors 1Calculation of net present value 1Comment on financial acceptability 1

––––13

(b) Calculation of average annual accounting profit 1Correct use of depreciation 1Calculation of average investment 1Calculation of before-tax ROCE (ARR) 1Discussion on financial acceptability 1–2


(c) Customer financing costs 2–3Company financing costs 2–3Effect on investment appraisal process 2–3


–––25–––

19

Marks Marks2 (a) Revised trade receivables 1

Reduction in trade receivables 1Reduction in financing cost 1Cost of early settlement discount 1Net cost of change in receivables policy 1Comment on findings 1

––––6

(b) Current annual ordering cost 0·5Current holding cost 0·5Total cost of current inventory policy 1Revised cost of materials 0·5Revised number of orders 0·5Revised ordering cost 0·5Revised holding cost 0·5Net benefit of bulk purchase discount 1Comment on assumptions 1

––––6

(c) Transactions need for cash 1–2Precautionary need for cash 1–2Speculative need for cash 1–2Other relevant discussion 1–2


(d) Credit analysis 2–3Credit control 2–3Receivables collection 2–3Cost and benefits of trade receivables policy 1–2


–––25–––

20

Marks Marks3 (a) Calculation of cost of equity using CAPM 2

Calculation of bond market price 0·5Calculation of current share price 0·5Calculation of future share price 1Calculation of conversion value 1After-tax interest payment 1Setting up interpolation calculation 1Calculation of after-tax cost of debt 1Calculation of cost of preference shares 1Calculation of after-tax WACC 2Explanation of any assumptions made 1

––––12

(b) Market values reflect current market conditions 1–2Market values and optimal investment decisions 1–2Other relevant discussion or illustration 1–2


(c) Comment on interest rate risk faced by company 1–2Reducing interest rate risk 1–2Other relevant discussion 2–3


(d) Self-liquidating 1Lower interest rate 1Increase in debt capacity on conversion 1Other relevant advantages of convertible debt 1–3


–––25–––

4 (a) Market capitalisation 1Calculation of NAV (liquidation basis) 2Calculation of price/earnings ratio value 2Calculation of historic dividend growth rate 1Dividend growth model value using this growth rate 1Calculation of Gordon model dividend growth rate 2Dividend growth model value using this growth rate 1

––––10

(b) Discussion of market capitalisation 1–2Discussion of net asset value 1–2Discussion of price/earnings ratio method 1–2Discussion of dividend growth model 1–2Other relevant discussion 1–2


(c) Calculation of before-tax market value of bond 2Calculation of book value debt/equity ratio 1Calculation of market value debt/equity ratio 1Discussion of debt/equity ratio and financial risk 3–4


–––25–––

21








Pape

r F9


Friday 7 June 2013



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 themachinery is expected to be 5% of the initial cost. Capital allowances would be available on the cost of the machineryon 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 besold as they are produced. Relevant financial information in current price terms is as follows:

Forecast inflationSelling price $650 per unit 4·0% per yearVariable cost $250 per unit 5·5% per yearIncremental fixed costs $250,000 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 (moneyterms) 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 (moneyterms) 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 calculatingnet present value. (5 marks)

(c) Identify TWO financial objectives of a listed company such as HDW Co and discuss how each of thesefinancial 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 followingfinancial information relates to AMH Co:

Financial position statement extracts as at 31 December 2012

$000 $000Equity

Ordinary shares (nominal value 50 cents) 4,000Reserves 18,000 22,000

–––––––Long-term liabilities

4% Preference shares (nominal value $1) 3,0007% Bonds redeemable after six years 3,000Long-term bank loan 1,000 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 2008 2009 2010 2011Dividends per share (cents) 30·9 32·2 33·6 35·0

The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share. The7% bonds are redeemable at a 5% premium to their nominal value of $100 per bond and have an ex interest marketvalue 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 forAMH 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)

3 [P.T.O.

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. Financialinformation relating to TGA Co is as follows:

$000 $000Inventory 473·4Trade receivables 1,331·5 1,804·9

–––––––Trade payables 177·5Overdraft 1,326·6 1,504·1

––––––– –––––––Net working capital 300·8

–––––––

TGA Co plans to change working capital policy in order to improve its profitability. This policy change will not affectthe current levels of credit sales, cost of sales or net working capital. As a result of the policy change, the followingworking capital ratio values are expected:

Inventory days 50 daysTrade receivables days 62 daysTrade payables days 45 days

Other relevant financial information is as follows:

Short-term dollar borrowing rate 5% per yearShort-term dollar deposit rate 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 currentratio 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 €1·687per $1 has been offered by the company’s bank and the spot rate is €1·675 per $1. TGA Co can borrow shortterm in the euro at 9% per year.

Required:

Calculate the dollar income from a forward market hedge and a money market hedge, and indicate whichhedge 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 companyneeds to raise $3,200,000 for research and development and is considering three financing options.

Option 1GXG Co could suspend dividends for two years, and then pay dividends of 25 cents per share from the end of thethird year, increasing dividends annually by 4% per year in subsequent years. Dividends in recent years have grownby 3% per year.

Option 2GXG Co could seek a stock market listing, raising $3·2 million after issue costs of $100,000 by issuing new sharesto new shareholders at a price of $2·50 per share.

Option 3GXG 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:

$000Operating profit 3,450Interest 200

––––––Profit before taxation 3,250Taxation 650

––––––Profit after taxation 2,600Dividends 1,600

$000Ordinary shares (nominal value 50 cents) 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 newdebt (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 andventure capital as sources of finance. (9 marks)

(25 marks)

5 [P.T.O.

6

Formulae Sheet


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7 [P.T.O.

Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

8

Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers


1 (a) Net present value of investment in new machinery

Year 1 2 3 4 5$000 $000 $000 $000 $000

Sales income 6,084 6,327 6,580 6,844Variable cost (2,374) (2,504) (2,642) (2,787)

–––––– –––––– –––––– ––––––Contribution 3,710 3,823 3,938 4,057Fixed costs (263) (276) (289) (304)

–––––– –––––– –––––– ––––––Cash flow 3,447 3,547 3,649 3,753Taxation (689) (709) (730) (751)CA tax benefits 250 188 141 372

–––––– –––––– –––––– –––––– ––––––After-tax cash flow 3,447 3,108 3,128 3,164 (379)Working capital (24) (25) (26) (27)Scrap value 250

–––––– –––––– –––––– –––––– ––––––Net cash flow 3,423 3,083 3,102 3,387 (379)Discount at 12% 0·893 0·797 0·712 0·636 0·567

–––––– –––––– –––––– –––––– ––––––Present values 3,057 2,457 2,209 2,154 (215)

–––––– –––––– –––––– –––––– ––––––

$000PV of future cash flows 9,662Initial investment (5,000)Working capital (500)

––––––NPV 4,162

––––––

As the net present value of $4·161 million is positive, the expansion can be recommended as financially acceptable.

Workings

Year 1 2 3 4Selling price ($/unit) 676·00 703·04 731·16 760·41Sales (units/year) 9,000 9,000 9,000 9,000Sales income ($000) 6,084 6,327 6,580 6,844

Year 1 2 3 4Variable cost ($/unit) 263·75 278·26 293·56 309·71Sales (units/year) 9,000 9,000 9,000 9,000Variable cost ($000) 2,374 2,504 2,642 2,787

Year 1 2 3 4$000 $000 $000 $000

Capital allowance 1,250·0 937·5 703·1 1,859·4Tax benefit 250 188 141 372

Year 1 2 3 4$000 $000 $000 $000

Working capital 523·50 548·11 573·87 600·84Incremental 24 25 26 27

11

Alternative NPV calculation where capital allowances are subtracted and added back

Year 1 2 3 4 5$000 $000 $000 $000 $000

Cash flow 3,447 3,547 3,649 3,753Capital allowances (1,250) (938) (703) (1,859)

–––––– –––––– –––––– ––––––Taxable profit 2,197 2,609 2,946 1,894Taxation (439) (522) (589) (379)

–––––– –––––– –––––– –––––– ––––––After-tax profit 2,197 2,170 2,424 1,305 (379)Capital allowances 1,250 938 703 1,859

–––––– –––––– –––––– –––––– ––––––After-tax cash flow 3,447 3,108 3,127 3,164 (379)Working capital (24) (25) (26) (27)Scrap value 250

–––––– –––––– –––––– –––––– ––––––Net cash flow 3,423 3,083 3,101 3,387 (379)Discount at 12% 0·893 0·797 0·712 0·636 0·567

–––––– –––––– –––––– –––––– ––––––Present values 3,057 2,457 2,208 2,154 (215)

–––––– –––––– –––––– –––––– ––––––

NPV = 9,661 – 5,000 – 500 = $4·161 million

(b) A nominal (money terms) approach to investment appraisal discounts nominal cash flows with a nominal cost of capital.Nominal cash flows are found by inflating forecast values from current price estimates, for example, using specific inflation.Applying specific inflation means that different project cash flows are inflated by different inflation rates in order to generatenominal project cash flows.

A real terms approach to investment appraisal discounts real cash flows with a real cost of capital. Real cash flows are foundby deflating nominal cash flows by the general rate of inflation. The real cost of capital is found by deflating the nominal costof capital by the general rate of inflation, using the Fisher equation:

(1 + real discount rate) x (1 + inflation rate) = (1 + nominal discount rate)

The net present value for an investment project does not depend on whether a nominal terms approach or a real termsapproach is adopted, since nominal cash flows and the nominal discount rate are both discounted by the general rate ofinflation to give real cash flows and the real discount rate, respectively. Both approaches give the same net present value.

Tutorial note for illustrative purposes:The real after-tax cost of capital of HDW Co can be found as follows:

1·12/1·047 = 1·07, i.e. the real after-tax cost of capital is 7%.

The following illustration deflates nominal net cash flows (NCF) by the general rate of inflation (4·7%) to give real NCF, whichare then discounted by the real cost of capital (7%).

Year 1 2 3 4 5$000 $000 $000 $000 $000

Nominal NCF 3,423 3,083 3,102 3,387 (379)Real NCF 3,269 2,812 2,703 2,819 (301)Discount at 7% 0·935 0·873 0·816 0·763 0·713

–––––– –––––– –––––– –––––– –––––Present values 3,057 2,455 2,206 2,151 (215)

–––––– –––––– –––––– –––––– –––––

Allowing for rounding, the illustration shows that the present values of the real cash flows are the same as the present valuesof the nominal cash flows, and that the real terms approach NPV of $4·154 million is the same as the nominal termsapproach NPV of $4·161 million. The two approaches produce identical NPVs and offer the same investment advice.

(c) A listed company such as HDW Co is likely to have a range of financial objectives. Maximisation of shareholder wealth isoften suggested to be the primary financial objective, and this can be substituted by the objective of maximising thecompany’s share price. Other financial objectives that might be used by HDW Co could relate to earnings per share (forexample, a target EPS value for a given period), operating profit (for example, a target level of profit before tax or PBIT),revenue (for example, a desired increase in revenue or sales) and so on. These examples of financial objectives can all bequantified, so that progress towards meeting them can be measured over time.

The investment in the new machine will enable HDW Co to meet increased demand for its products and the company expectsto be able to sell all of the increased production at a profit. This will lead to increased revenue and operating profit (profitbefore interest and tax), so financial objectives relating to these accounting figures will be supported.

Whether a financial objective relating to increasing earnings per share (EPS) will be supported will depend on how theinvestment is financed. For example, raising equity finance by issuing new shares will dilute (decrease) EPS, while raisingdebt finance will increase interest payments, which will also dilute EPS.

12

The investment in the new machine has a positive net present value (NPV), so the market value of the company is expectedto increase by the amount of the NPV. This increases the wealth of shareholders irrespective of how the investment isfinanced, since financing costs were accounted for by the discount rate (whether nominal or real). The investment in the newmachine will therefore support the objective of shareholder wealth maximisation.

2 (a) Cost of equity

The geometric average dividend growth rate in recent years:(36·3/30·9)0·25 – 1 = 1·041 – 1 = 0·041 or 4·1% per year

Using the dividend growth model:Ke = 0·041 + [(36·3 x 1·041)/470] = 0·041 + 0·080 = 0·121 or 12·1%

Cost of preference shares

As the preference shares are not redeemable:Kp = 100 x [(0·04 x 100)/40] = 10%

Cost of debt of bonds

The annual after-tax interest payment is 7 x 0·7 = $4·9 per bond.


Year Cash flow $ 5% DF PV ($) 4% DF PV ($)0 Market price (104·50) 1·000 (104·50) 1·000 (104·5)1–6 Interest 4·9 5·076 24·87 5·242 25·696 Redemption 105 0·746 78·33 0·790 82·95

–––––– ––––––(1·30) 4·14

–––––– ––––––

After-tax cost of debt = 4 + [((5 – 4) x 4·14)/(4·14 + 1·30)] = 4 + 0·76 = 4·8%

Cost of debt of bank loan

If the bank loan is assumed to be perpetual (irredeemable), the after-tax cost of debt of the bank loan will be its after-taxinterest rate, i.e. 4% x 0·7 = 2·8% per year.

Market values

Number of ordinary shares = 4,000,000/0·5 = 8 million shares

$000Equity: 8m x 4·70 = 37,600Preference shares: 3m x 0·4 = 1,200Redeemable bonds: 3m x 104·5/100 = 3,135Bank loan (book value used) 1,000

–––––––Total value of AMH Co 42,935

–––––––

WACC calculation

[(12·1 x 37,600) + (10 x 1,200) + (4·8 x 3,135) + (2·8 x 1,000)]/42,935 = 11·3%

(b) The capital asset pricing model (CAPM) assumes that investors hold diversified portfolios, so that unsystematic risk has beendiversified away. Companies using the CAPM to calculate a project-specific discount rate are therefore concerned only withdetermining the minimum return that must be generated by an investment project as compensation for its systematic risk.

The CAPM is useful where the business risk of an investment project is different from the business risk of the investingcompany’s existing business operations. In such a situation, one or more proxy companies are identified that have similarbusiness risk to the investment project. The equity beta of the proxy company represents the systematic risk of the proxycompany, and reflects both the business risk of the proxy company’s business operations and the financial risk arising fromthe proxy company’s capital structure.

Since the investing company is only interested in the business risk of the proxy company, the proxy company’s equity beta is‘ungeared’ to remove the effect of its capital structure. ‘Ungearing’ converts the proxy company’s equity beta into an assetbeta, which represents business risk alone. The asset betas of several proxy companies can be averaged in order to removeany small differences in business operations.

The asset beta can then be ‘regeared’, giving an equity beta whose systematic risk takes account of the financial risk of theinvesting company as well as the business risk of an investment project. Both ungearing and regearing use the weightedaverage beta formula, which equates the asset beta with the weighted average of the equity beta and the debt beta.

The project-specific equity beta resulting from the regearing process can then be used to calculate a project-specific cost ofequity using the CAPM. This can be used as the discount rate when evaluating the investment project with a discounted cash(DCF) flow investment appraisal method such as net present value or internal rate of return. Alternatively, the project-specific

13

cost of equity can be used in calculating a project-specific weighted average cost of capital, which can also be used in a DCFevaluation.

(c) The cost of equity is the return required by ordinary shareholders (equity investors), in order to compensate them for the riskassociated with their equity investment, i.e. their investment in the ordinary shares of a company. If the risk of an investmentincreases, the return expected by the investor also increases. If the risk of a company increases, therefore, its cost of equityalso increases.

If a company is liquidated, the order in which the claims of creditors are settled is a factor in determining their relative risk.The claims of providers of debt finance (debt holders) must be paid off before any cash can be distributed to ordinaryshareholders (the owners). The risk faced by shareholders is therefore greater than the risk faced by debt holders, and thecost of equity is therefore greater than the cost of debt.

Interest on debt finance must be paid before dividends can be paid to ordinary shareholders, so the risk faced by ordinaryshareholders is greater than the risk faced by debt holders, since the necessity of paying interest may mean that dividendshave to be reduced.

3 (a) (i) The current operating cycle is the sum of the current inventory days and trade receivables days, less the current tradepayables days.

Current inventory days = (473,400/2,160,000) x 365 = 80 daysCurrent trade receivables days = (1,331,500/5,400,000) x 365 = 90 daysCurrent trade payables days = (177,500/2,160,000) x 365 = 30 days

Current operating cycle = 80 + 90 – 30 = 140 days

Operating cycle after policy changes = 50 + 62 – 45 = 67 days

The change in the operating cycle is therefore a decrease of 73 days.

(ii) At present, the current ratio is 1,804,900/1,504,100 = 1·20 times.

The current net working capital is $300,800.

The revised figures for inventory, trade receivables, trade payables and overdraft must be calculated in order to find thecurrent ratio after the planned working capital policy changes.

Revised inventory = 2,160,000 x 50/365 =$295,890Revised trade receivables = 5,400,000 x 62/365 = $917,260Revised trade payables = $2,160,000 x 45/365 = $266,301

Revised overdraft level = 295,890 + 917,260 – 266,301 – 300,800 = $646,049

Revised current assets = 295,890 + 917,260 = $1,213,150Revised current liabilities = 266,301 + 646,049 = $912,350

Revised current ratio = 1,213,150/912,350 = 1·33 times

The effect on the current ratio is to increase it from 1·20 to 1·33 times.

(iii) The finance cost saving arises from the decrease in the overdraft from $1,326,600 to $646,049, a reduction of$680,551, with a saving of 5% per year or $34,028 per year.

(b) The key elements of a trade receivables policy are credit analysis, credit control and receivables collection.

Credit analysisCredit analysis helps a company to minimise the possibility of bad debts by offering credit only to customers who are likelyto pay the money they owe. Credit analysis also helps a company to minimise the likelihood of customers paying late, causingthe company to incur additional costs on the money owed, by indicating which customers are likely to settle their accountsas they fall due.

Credit analysis, or the assessment of creditworthiness, is undertaken by analysing and evaluating information relating to acustomer’s financial history. This information may be provided by trade references, bank references, the annual accounts ofa company or credit reports provided by a credit reference agency. The depth of the credit analysis will depend on the potentialvalue of sales to the client, in terms of both order size and expected future trading. As a result of credit analysis, a companywill decide on whether to extend credit to a customer.

Credit controlHaving granted credit to customers, a company needs to ensure that the agreed terms are being followed. The tradereceivables management policy will stipulate the content of the initial sales invoice that is raised. It will also advise on thefrequency with which statements are sent to remind customers of outstanding amounts and when they are due to be paid. Itwill be useful to prepare an aged receivables analysis at regular intervals (e.g. monthly), in order to focus managementattention on areas where action needs to be taken to encourage payment by clients.

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Receivables collectionIdeally, all customers will settle their outstanding accounts as and when they fall due. Any payments not receivedelectronically should be banked quickly in order to decrease costs and increase profitability. If accounts become overdue, stepsshould be taken to recover the outstanding amount by sending reminders, making customer visits and so on. Legal actioncould be taken if necessary, although only as a last resort.

(c) Foreign currency risk can be divided into transaction risk, translation risk and economic risk.

Transaction riskThis is the foreign currency risk associated with short-term transactions, such as receiving money from customers insettlement of foreign currency accounts receivable. The risk here is that the actual profit or cost associated with the futuretransaction may be different from the expected or forecast profit or cost. The expected profit on goods or service sold on creditto a foreign client, for example, invoiced in the foreign currency, could be decreased by an adverse exchange rate movement.Transaction risk is therefore cash exposure, since cash transactions are affected by it. This type of foreign currency risk isusually hedged.

Translation riskThis is the foreign currency risk associated with the consolidation of foreign currency denominated assets and liabilities.Movements in exchange rates can change the value of such assets and liabilities, resulting in unrealised foreign currencylosses or gains when financial statements are consolidated for financial reporting purposes. These gains and losses exist onlyon paper and do not have a cash effect. Translation exposure is often referred to as accounting exposure. Translation exposurecan be hedged using asset and liability management, but hedging this type of foreign currency risk may be deemedunnecessary.

Economic riskThis is the foreign currency risk associated with longer-term movements in exchange rates. It refers to the possibility that thepresent value of a company’s future cash flows may be affected by future exchange rate movements, or that the competitiveposition of a company may be affected by future exchange rate movements. From one point of view, transaction exposure isshort-term economic exposure. All companies face economic exposure and it is difficult to hedge against.

(d) Income from forward market hedge = 500,000/1·687 = $296,384

Three-month euro borrowing rate = 9/4 = 2·25%Three-month dollar deposit rate = 4/4 = 1%

Euros borrowed now = 500,000/1·0225 = €488,998Dollar value of this borrowing = 488,998/1·675 = $291,939Dollar income on this deposited sum = 291,939 x 1·01 = $294,858

The forward hedge gives $1,526 more income and hence will be preferred financially by TGA Co.

4 (a) The dividend growth model can give a value of GXG Co at the end of the second year of not paying dividends, based on thedividends paid from the end of the third year onwards. The company has 10 million shares in issue ($5 million/50 centsnominal value) and so the total dividend proposed at the end of the third year will be $2·5 million (25 cents per share x10m). If these dividends increase by 4% per year in subsequent years, their capital value at the end of the second year willbe:

2·5/(0·09 – 0·04) = $50 million

The dividend valuation model value (the capital value of the dividends at year 0) will be:

50/1·092 = $42·1 million

The current present value of dividends to shareholders, using the existing 3% dividend growth rate:

(1·6 x 1·03)/(0·09 – 0·03) = $27·5 million

The proposal will increase shareholder wealth by 42·1 – 27·5 = $14·6 million and so is likely to be acceptable toshareholders.

(Examiner note: Calculations on a per share basis could also be used to evaluate the effect of the proposal on shareholderwealth)

(b) The cash to be raised = 3,200,000 + 100,000 = $3,300,000The number of shares issued = 3,300,000/2·50 = 1,320,000 sharesTotal number of shares after the stock market listing = 11,320,000 shares

Increase in before-tax income = 0·18 x 3·2m = $576,000Increase in after-tax income = 576,000 x 0·8 = $460,800Revised earnings = 2,600,000 + 460,800 = $3,060,800

Revised earnings per share = 100 x (3,060,800/11,320,000) = 27 cents per share

Current earnings per share = 100 x (2,600,000/10,000,000) = 26 cents per share

15

The earnings per share has increased by 1 cent per share, which existing shareholders may find acceptable. However, thebalance of ownership and control will change as a result of the new shareholders, and no information has been providedabout expected future dividends.

(c) Increase in before-tax income = 0·18 x 3·2m = $576,000Revised operating profit = 576,000 + 3,450,000 = $4,026,000

Interest on new debt = 3,200,000 x 0·06 = $192,000Revised interest = 192,000 + 200,000 = $392,000

Revised profit before tax = 4,026,000 – 392,000 = $3,634,000Revised profit after tax = 3,634,000 x 0·8 = $2,907,200

Revised earnings per share = 100 x (2,907,200/10,000,000) = 29·1 cents per shareEarnings per share would increase by 3·1 cents per share.

Current interest cover = 3,450,000/200,000 = 17 timesRevised interest cover = 4,026,000/392,000 = 10 times

The increase in earnings per share would be welcomed by shareholders, but further information on the future of the companyfollowing the investment in research and development would be needed for a more comprehensive answer. The decrease ininterest cover is not serious and the increase in financial risk is unlikely to upset shareholders.

(d) Traded bonds are debt securities issued onto the capital market in exchange for cash received by the issuing company. Thecash raised must be repaid on the redemption date, usually between five and fifteen years after issue. Bonds are usuallysecured on non-current assets of the issuing company, which reduces the risk to the lender. In the event of default on interestpayments by the borrower, the bond holders can appoint a receiver to sell the assets and recover their investment. Interestpaid on the bonds is tax-deductible, which reduces the cost of debt to the issuing company. Provided the borrower continuesto pay the interest, however, bond finance is a low risk financing choice by the issuer.

There are a number of differences between bond finance and a new equity issue via a placing that will influence the choicebetween them. Equity finance does not need to be redeemed, since ordinary shares are truly permanent finance. While bondinterest is usually fixed, the return to shareholders in the form of dividends depends on the dividend decision made by thedirectors of a company, and so these returns can increase, decrease or be passed. Furthermore, since dividends are adistribution of after-tax profit, they are not tax-deductible like interest payments, and so equity finance is not tax-efficient likedebt finance.

Venture capital is found in specific financing situations, i.e. where risk finance is needed, for example, in a managementbuyout. Both equity and debt finance can be part of a venture capital financing package, but the return expected on venturecapital is very high because of the level of risk faced by the investor.

16


Marks Marks1 (a) Inflated selling price per box 1

Sales income 1Inflated total variable cost 1Inflated incremental fixed costs 1Tax liability 1Capital allowance, years 1 to 3 1Balancing allowance, year 4 1Capital allowance tax benefits, years 1 to 4 1Timing of tax liabilities and benefits 1Incremental working capital investment 1Scrap value 1Discount at 12% 1Calculated value for NPV 1Comment on financial acceptability 1

––––14

(b) Discussion of nominal terms approach 2–3Discussion of real terms approach 2–3


(c) Identification of two financial objectives 1Discussion of support for objectives of planned investment 5

––––6

–––25–––

2 (a) Calculation of historic dividend growth rate 1Calculation of cost of equity using DGM 2Calculation of cost of preference shares 1Calculation of after-tax interest payment on bond 1Setting up linear interpolation calculation 1Calculation of after-tax cost of debt of bond 1Calculation of after-tax cost of debt of bank loan 1Calculation of market values 2Calculation of WACC 2

––––12

(b) Ungearing proxy company equity beta 1–2Averaging and regearing asset betas 1–2Project-specific cost of equity using CAPM 1–2Project-specific WACC 1–2Appropriate reference to business risk 1Appropriate reference to financial risk 1


(c) Relationship between risk and return 1–2Creditor hierarchy and related discussion 3–4


–––25–––

17

Marks Marks3 (a) Current inventory days 0·5

Current trade receivables days 0·5Current trade payables days 0·5Current operating cycle 0·5Revised operating cycle 0·5Reduction in operating cycle 0·5Current ratio 0·5Revised inventory 0·5Revised trade receivables 0·5Revised trade payables 0·5Revised overdraft 0·5Revised current ratio 0·5Finance cost saving 1Comment on findings 1

––––8

(b) Discussion of credit analysis 2–3Discussion of credit control 2–3Discussion of receivables collection 2–3


(c) Transaction risk 2Translation risk 2Economic risk 2

––––6

(d) Income from forward market hedge 1Income from money market hedge 2Indication of financially preferred hedge 1

––––4

–––25–––

18

Marks Marks4 (a) Value of company at end of two years using DGM 2

Value of company at year zero 1Current value of company using Dividend Valuation Model 2Acceptability of option 1 to shareholders 1

––––6

(b) Cash raised by issuing shares 0·5Number of shares issued 0·5Current earnings per share 0·5Increase in after-tax income 1Revised earnings per share 1Change in earnings per share 0·5Comment on acceptability of option 1

––––5

(c) Revised operating profit 0·5Revised interest 0·5Revised profit after tax 0·5Revised earnings per share 0·5Current interest cover 0·5Revised interest cover 0·5Comment on earnings per share 1Comment on findings 1

––––5

(d) Discussion of bond finance 3–4Discussion of equity finance via placing 3–4Discussion of venture capital 3–4


–––25–––

19








Paper F9





1 Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future cash flows of aninvestment project with an expected life of four years, as follows:

Year 1 2 3 4Sales revenue ($000) 1,250 2,570 6,890 4,530Costs ($000) 500 1,000 2,500 1,750

These forecast cash flows are before taking account of general inflation of 4·7% per year. The capital cost of theinvestment project, payable at the start of the first year, will be $2,000,000. The investment project will have zeroscrap value at the end of the fourth year. The level of working capital investment at the start of each year is expectedto 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 hasa 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 financialacceptability. (12 marks)

(b) Calculate the net present value of the investment project in real terms and comment on its financialacceptability. (7 marks)

(c) Explain ways in which the directors of Darn Co can be encouraged to achieve the objective of maximisationof 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 centsper share for 2013 has just been paid. The pattern of recent dividends is as follows:

Year 2010 2011 2012 2013Dividends per share (cents) 55·1 57·9 59·1 62·0

Card Co also has in issue 8·5% bonds redeemable in five years’ time with a total nominal value of $5 million. Themarket 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 hasidentified a proxy company with a similar business risk to the joint venture. The proxy company has an equity betaof 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 rateof 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 calculatethe 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 capitaland hence to an increase in the value of the company. (8 marks)

(25 marks)

3 [P.T.O.

3 Plot Co sells both Product P and Product Q, with sales of both products occurring evenly throughout the year.

Product PThe annual demand for Product P is 300,000 units and an order for new inventory is placed each month. Each ordercosts $267 to place. The cost of holding Product P in inventory is 10 cents per unit per year. Buffer inventory equalto 40% of one month’s sales is maintained.

Product QThe 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 informationPlot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365 days in eachyear.

Required:

(a) Calculate the following values for Product P:

(i) The total cost of the current ordering policy; (3 marks)

(ii) The total cost of an ordering policy using the economic order quantity; (3 marks)

(iii) The net cost or saving of introducing an ordering policy using the economic order quantity. (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 capitalmanagement 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 fiveyears. There are two financing options.

Option 1The machine could be leased for an annual lease payment of $155,000 per year, payable at the start of each year.

Option 2The 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 evaluationmethod 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 financialinstruments. (5 marks)

(d) Discuss briefly the reasons why interest rates may differ between loans of different maturity. (5 marks)

(25 marks)

5 [P.T.O.

6

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7 [P.T.O.

Present Value Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

8

Annuity Table



Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r


Answers


1 (a) Calculating the net present value of the investment project using a nominal terms approach requires the discounting ofnominal (money terms) cash flows using a nominal discount rate, which is given as 12%.

Year 1 2 3 4 5$000 $000 $000 $000 $000

Sales revenue 1,308·75 2,817·26 7,907·87 5,443·58Costs (523·50) (1,096·21) (2,869·33) (2,102·93)

–––––––– ––––––––– ––––––––– –––––––––Net revenue 785·25 1,721·05 5,038·54 3,340·65Tax payable (235·58) (516·32) (1,511·56) (1,002·20)CA tax benefits 150·00 112·50 84·38 253·13

–––––––– ––––––––– ––––––––– ––––––––– –––––––––After-tax cash flow 785·25 1,635·47 4,634·72 1,913·47 (749·07)Working capital (150·86) (509·06) 246·43 544·36

–––––––– ––––––––– ––––––––– ––––––––– –––––––––Project cash flow 634·39 1,126·41 4,881·15 2,457·83 (749·07)Discount at 12% 0·893 0·797 0·712 0·636 0·567

–––––––– ––––––––– ––––––––– ––––––––– –––––––––Present values 566·51 897·75 3,475·38 1,563·18 (424·72)

–––––––– ––––––––– ––––––––– ––––––––– –––––––––

$000PV of future cash flows 6,078·10Initial investment (2,000·00)Working capital (130·88)

–––––––––NPV 3,947·22

–––––––––

The net present value is $3,947,220 and so the investment project is financially acceptable.

Workings

Year 1 2 3 4Sales revenue ($000) 1,250 2,570 6,890 4,530Inflated sales revenue ($000) 1,308·75 2,817·26 7,907·87 5,443·58

Year 1 2 3 4Costs ($000) 500 1,000 2,500 1,750Inflated costs ($000) 523·50 1,096·21 2,869·33 2,102·93

Year 1 2 3 4Inflated sales revenue ($000) 1,308·75 2,817·26 7,907·87 5,443·58Working capital ($000) 130·88 281·73 790·79 544·36Incremental ($000) (130·88) (150·86) (509·06) 246·43

Year 1 2 3 4Capital allowance ($000) 500·00 375·00 281·25 843·75Tax benefit ($000) 150·00 112·50 84·38 253·13

(b) Calculating the net present value of the investment project using a real terms approach requires discounting real terms cashflows with a real discount rate.

Real terms cash flows are found by deflating nominal cash flows by the general rate of inflation. Since only the general rateof inflation is available, the real terms operating cash flows are those given in the question.

The nominal discount rate is 12% and the general rate of inflation is 4·7%. The real discount rate is therefore 7%(1·12/1·047).

Year 1 2 3 4 5$000 $000 $000 $000 $000

Sales revenue 1,250 2,570 6,890 4,530Costs (500) (1,000) (2,500) (1,750)

––––––– ––––––––– ––––––––– –––––––––Net revenue 750·00 1,570·00 4,390·00 2,780·00Tax payable (225·00) (471·00) (1,317·00) (834·00)CA tax benefits 150·00 112·50 84·38 253·13

––––––– ––––––––– ––––––––– ––––––––– –––––––After-tax cash flow 750·00 1,495·00 4,031·50 1,547·38 (580·87)Working capital (132·00) (432·00) 236·00 453·00

––––––– ––––––––– ––––––––– ––––––––– –––––––Project cash flow 618·00 1,063·00 4,267·5 2,000·38 (580·87)Discount at 7% 0·935 0·873 0·816 0·763 0·713

––––––– ––––––––– ––––––––– ––––––––– –––––––Present values 577·83 928·00 3,482·28 1,526·29 (414·16)

––––––– ––––––––– ––––––––– ––––––––– –––––––

11

$000PV of future cash flows 6,100·24Initial investment (2,000·00)Working capital (125·00)

–––––––––NPV 3,975·24

–––––––––

The net present value is $3,975,240 and so the investment project is financially acceptable. The difference between thenominal terms NPV ($3,947,220) and the real terms NPV is due primarily to two factors. First, the tax benefits from capitalallowances are not affected by inflation and so will have different present values due to the change in discount rate. Second,the working capital cash flows are timed differently to the sales income on which they depend, and so their inflation effectsare timed differently to the related inflation effects in the discount rate.

Working

Year 1 2 3 4Sales revenue ($000) 1,250 2,570 6,890 4,530Working capital ($000) 125 257 689 453Incremental ($000) (125) (132) (432) 236

Examiner’s note

An alternative approach is to deflate the nominal project cash flows from part (a) by 4.7% per year to give real terms projectcash flows, before discounting by the real discount rate of 7%.

Year 1 2 3 4 5$000 $000 $000 $000 $000

Project cash flow 634.39 1,126.41 4,881.15 2,457.83 (749.07)Deflate at 4.7% 605.91 1,027.55 4,252.87 2,045.34 (595.37)Discount at 7% 0.935 0.873 0.816 0.763 0.713

––––––––– ––––––––– ––––––––– ––––––––– –––––––––Present values 566.53 897.05 3,470.34 1,560.59 (424.50)

––––––––– ––––––––– ––––––––– ––––––––– –––––––––

$000PV of future cash flows 6,070.01Initial investment (2,000.00)Working capital (130.88)

–––––––––NPV 3,939.13

–––––––––

(c) The directors of Darn Co can be encouraged to achieve the objective of maximising shareholder wealth through managerialreward schemes and through regulatory requirements.

Managerial reward schemesAs agents of the company’s shareholders, the directors of Darn Co may not always act in ways which increase the wealth ofshareholders, a phenomenon called the agency problem. They can be encouraged to increase or maximise shareholder wealthby managerial reward schemes such as performance-related pay and share option schemes. Through these methods, thegoals of shareholders and directors may increase in congruence.

Performance-related pay links part of the remuneration of directors to some aspect of corporate performance, such as levelsof profit or earnings per share. One problem here is that it is difficult to choose an aspect of corporate performance which isnot influenced by the actions of the directors, leading to the possibility of managers influencing corporate affairs for their ownbenefit rather than the benefit of shareholders, for example, focusing on short-term performance while neglecting the longerterm.

Share option schemes bring the goals of shareholders and directors closer together to the extent that directors becomeshareholders themselves. Share options allow directors to purchase shares at a specified price on a specified future date,encouraging them to make decisions which exert an upward pressure on share prices. Unfortunately, a general increase inshare prices can lead to directors being rewarded for poor performance, while a general decrease in share prices can lead tomanagers not being rewarded for good performance. However, share option schemes can lead to a culture of performanceimprovement and so can bring continuing benefit to stakeholders.

Regulatory requirementsRegulatory requirements can be imposed through corporate governance codes of best practice and stock market listingregulations.

Corporate governance codes of best practice, such as the UK Corporate Governance Code, seek to reduce corporate risk andincrease corporate accountability. Responsibility is placed on directors to identify, assess and manage risk within anorganisation. An independent perspective is brought to directors’ decisions by appointing non-executive directors to create abalanced board of directors, and by appointing non-executive directors to remuneration committees and audit committees.

12

Stock exchange listing regulations can place obligations on directors to manage companies in ways which support theachievement of objectives such as the maximisation of shareholder wealth. For example, listing regulations may requirecompanies to publish regular financial reports, to provide detailed information on directorial rewards and to publish detailedreports on corporate governance and corporate social responsibility.

2 (a) Cost of equity of Card Co using DGM

The average dividend growth rate in recent years is 4%:(62·0/55·1)0·333 – 1 = 1·040 – 1 = 0·04 or 4% per year

Using the dividend growth model:Ke = 0·04 + [(62 x 1·04)/716] = 0·04 + 0·09 = 0·13 or 13%

(b) The dividend growth model calculates the apparent cost of equity in the capital market, provided that the current market priceof the share, the current dividend and the future dividend growth rate are known. While the current market price and thecurrent dividend are readily available, it is very difficult to find an accurate value for the future dividend growth rate. Acommon approach to finding the future dividend growth rate is to calculate the average historic dividend growth rate and thento assume that the future dividend growth rate will be similar. There is no reason why this assumption should be true.

The capital asset pricing model tends to be preferred to the dividend growth model as a way of calculating the cost of equityas it has a sound theoretical basis, relating the cost of equity or required return of well-diversified shareholders to thesystematic risk they face through owning the shares of a company. However, finding suitable values for the variables used bythe capital asset pricing model (risk-free rate of return, equity beta and equity risk premium) can be difficult.

(c) Cost of debt of Card Co

The annual after-tax interest payment is 8·5 x (1 – 0·3) = $5·95 per bond


Year Cash flow $ 5% DF PV ($) 6% DF PV ($)0 Market price (103·42) 1·000 (103·42) 1·000 (103·42)1–5 Interest 5·95 4·329 25·76 4·212 25·065 Redemption 100 0·784 78·40 0·747 74·70

–––––– ––––––0·74 (3·66)

After-tax cost of debt = 5 + [((6 – 5) x 0·74)/(0·74 + 3·66)] = 5 + 0·17 = 5·17%

Market values

$000Equity: 8m x 7·16 = 57,280Bonds: 5m x 103·42/100 = 5,171

–––––––Total value of Card Co 62,451

–––––––

WACC calculation

WACC of Card Co = [(12 x 57,280) + (5·17 x 5,171)]/62,451 = 11·4%

(d) First, the proxy company equity beta must be ungeared:

Asset beta = (1·038 x 0·75)/(0·75 + (0·25 x 0·7)) = 0·842

The asset beta must then be regeared to reflect the financial risk of Card Co:

Equity beta = 0·842 x (57,280 + (5,171 x 0·7))/57,280 = 0·895

Project-specific cost of equity = 4 + (0·895 x 5) = 8·5%

(e) The value of a company can be expressed as the present value of its future cash flows, discounted at its weighted averagecost of capital (WACC). The value of a company can therefore theoretically be maximised by minimising its WACC. If theWACC depends on the capital structure of a company, i.e. on the balance between debt and equity, then the minimum WACCwill arise when the capital structure is optimal.

The idea of an optimal capital structure has been debated for many years. The traditional view of capital structure suggeststhat the WACC decreases as debt is introduced at low levels of gearing, before reaching a minimum and then increasing asthe cost of equity responds to increasing financial risk.

Miller and Modigliani originally argued that the WACC is independent of a company’s capital structure, depending only on itsbusiness risk rather than on its financial risk. This suggestion that it is not possible to minimise the WACC, and hence thatit is not possible to maximise the value of a company by selecting a particular capital structure, depends on the assumptionof a perfect capital market with no corporate taxation.

13

However, real world capital markets are not perfect and companies pay taxes on profit. Since interest is a tax-allowablededuction in calculating taxable profit, debt is a tax-efficient source of finance and replacing equity with debt will decreasethe WACC of a company. In the real world, therefore, increasing gearing will decrease the WACC of a company and henceincrease its value.

At high levels of gearing, the WACC of a company will increase due, for example, to increasing bankruptcy risk. Therefore, itcan be argued that use of debt in a company’s capital structure can reduce its WACC and increase its value, provided thatgearing is kept to an acceptable level.

3 (a) (i) Cost of current ordering policy

Ordering cost = 12 x 267 = $3,204 per year

Monthly order = monthly demand = 300,000/12 = 25,000 unitsBuffer inventory = 25,000 x 0·4 = 10,000 unitsAverage inventory excluding buffer inventory = 25,000/2 = 12,500 unitsAverage inventory including buffer inventory = 12,500 + 10,000 = 22,500 unitsHolding cost = 22,500 x 0·1 = $2,250 per year

Total cost = 3,204 + 2,250 = $5,454 per year

(ii) Cost of ordering policy using economic order quantity (EOQ)

EOQ = ((2 x 267 x 300,000)/0·10)0·5 = 40,025 or 40,000 units per order

Number of orders per year = 300,000/40,000 = 7·5 orders per yearOrder cost = 7·5 x 267 = $2,003

Average inventory excluding buffer inventory = 40,000/2 = 20,000 unitsAverage inventory including buffer inventory = 20,000 + 10,000 = 30,000 unitsHolding cost = 30,000 x 0·1 = $3,000 per year

Total cost = $2,003 + $3,000 = $5,003 per year

(iii) Saving from introducing EOQ ordering policy = 5,454 – 5,003 = $451 per year

(b) Product Q trade payables at end of year = 456,000 x 1 x 60/365 = $74,959Product Q trade payables after discount = 456,000 x 1 x 0·99 x 30/365 = $37,105Decrease in Product Q trade payables = 74,959 – 37,105 = $37,854Increase in financing cost = 37,854 x 0·05 = $1,893Value of discount = 456,000 x 0·01 = $4,560Net value of offer of discount = 4,560 – 1,893 = $2,667

(c) Invoice discounting refers to the purchase of selected invoices by a financial company at a discount to their face value. Invoicediscounting can provide immediate cash to a company rather than waiting for the invoices to be settled. It tends to be usedas an occasional source of short-term finance, rather than a regular source of cash. Invoice discounting can therefore aid inthe management of trade receivables by accelerating cash inflow from trade receivables when short-term cash flow problemsarise.

Factoring refers to a commercial arrangement whereby a financial company takes over the management of a company’s tradereceivables. This will include invoicing customers, accounting for sales and collections of amounts owed. Factors will advancecash to a company against the amounts outstanding. If the client requires, insurance against bad debts may also be provided(non-recourse factoring).

Factoring can assist in the management of trade receivables through the expertise offered by the factoring company. This maylead to a reduction in bad debts, a decrease in the level of trade receivables, a decrease in the amount of managerial timedevoted to chasing slow payers, and taking advantage of early settlement discounts from trade suppliers due to the availabilityof cash from trade receivables.

(d) The objectives of working capital management are usually taken to be profitability and liquidity. Profitability is allied to thefinancial objective of maximising shareholder wealth, while liquidity is needed in order to settle liabilities as they fall due. Acompany must have sufficient cash to meet its liabilities, since otherwise it may fail. However, these two objectives are inconflict, since liquid resources have no return or low levels of return and hence decrease profitability. A conservative approachto working capital management will decrease the risk of running out of cash, favouring liquidity over profitability anddecreasing risk. Conversely, an aggressive approach to working capital management will emphasise profitability over liquidity,increasing the risk of running out of cash while increasing profitability.

Working capital management is central to financial management for several reasons. First, cash is the life-blood of acompany’s business activities and without enough cash to meet short-term liabilities, a company would fail. Second, currentassets can account for more than half of a company’s assets, and so must be carefully managed. Poor management of currentassets can lead to loss of profitability and decreased returns to shareholders. Third, for SMEs current liabilities are a majorsource of finance and must be carefully managed in order to ensure continuing availability of such finance.

14

4 (a) In order to evaluate whether Spot Co should use leasing or borrowing, the present value of the cost of leasing is comparedwith the present value of the cost of borrowing.

LeasingThe lease payments should be discounted using the cost of borrowing of Spot Co. Since taxation must be ignored, the before-tax cost of borrowing must be used. The 7% interest rate of the bank loan can be used here.

The five lease payments will begin at year 0 and the last lease payment will be at the start of year 5, i.e. at the end of year 4. The appropriate annuity factor to use will therefore be 4·387 (1·000 + 3·387).

Present value of cost of leasing = 155,000 x 4·387= $679,985

BorrowingThe purchase cost and the present value of maintenance payments will be offset by the present value of the future scrapvalue. The appropriate discount rate is again the before-tax cost of borrowing of 7%.

Year Cash flow $ 7% Discount factor Present value ($)0 Purchase (750,000) 1·000 (750,000)1–5 Maintenance (20,000) 4·100 (82,000)5 Scrap value 75,000 0·713 53,475Present value of cost of borrowing = 750,000 + 82,000 – 53,475 = $778,525

The cheaper source of financing is leasing, since the present value of the cost of leasing is $98,540 less than the presentvalue of the cost of borrowing.

(b) Operating leasing can act as a source of short-term finance, while finance leasing can act as a source of long-term finance.

Operating leasing offers a solution to the obsolescence problem, whereby rapidly aging assets can decrease competitiveadvantage. Where keeping up-to-date with the latest technology is essential for business operations, operating leasingprovides equipment on short-term contracts which can usually be cancelled without penalty to the lessee. Operating leasingcan also provide access to skilled maintenance, which might otherwise need to be bought in by the lessee, although therewill be a charge for this service.

Both operating leasing and finance leasing provide access to non-current assets in cases where borrowing may be difficult oreven not possible for a company. For example, the company may lack assets to offer as security, or it may be seen as toorisky to lend to. Since ownership of the leased asset remains with the lessor, it can be retrieved if lease rental payments arenot forthcoming.

(c) Interest (riba) is the predetermined amount received by a provider of finance, over and above the principal amount of financeprovided. Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from the perspective of the borrower,the lender and the economy. For the borrower, riba can turn a profit into a loss when profitability is low. For the lender, ribacan provide an inadequate return when unanticipated inflation arises. In the economy, riba can lead to allocationalinefficiency, directing economic resources to sub-optimal investments.

Islamic financial instruments require that an active role be played by the provider of funds, so that the risks and rewards ofownership are shared. In a Mudaraba contract, for example, profits are shared between the partners in the proportions agreedin the contract, while losses are borne by the provider of finance. In a Musharaka contract, profits are shared between thepartners in the proportions agreed in the contract, while losses are shared between the partners according to their capitalcontributions. With Sukuk, certificates are issued which are linked to an underlying tangible asset and which also transfer therisk and rewards of ownership. The underlying asset is managed on behalf of the Sukuk holders.

In a Murabaha contract, payment by the buyer is made on a deferred or instalment basis. Returns are made by the supplieras a mark-up is paid by the buyer in exchange for the right to pay after the delivery date. In an Ijara contract, which isequivalent to a lease agreement, returns are made through the payment of fixed or variable lease rental payments.

(d) There are several reasons which can be discussed in explaining why interest rates may differ between loans of differentmaturity, as follows:

Liquidity preference theoryThis theory suggests that investors prefer to have cash now and so require compensation for lending money. The longer theperiod for which money is lent, the higher will be the interest rate to compensate the lender for deferring their use of theloaned cash. The higher interest rate for long-term debt over short-term debt will also compensate lenders for increasing riskover time, for example, the increasing risk of default with increasing maturity. Liquidity preference theory can therefore explainwhy the yield curve is normally upward sloping.

Expectations theoryThis theory suggests that the relationship between short-term and long-term interest rates can be explained by expectationsregarding interest rate movements. Where future interest rates are expected to rise compared to short-term interest rates, theyield curve will slope upwards. Where future interest rates are expected to fall compared to short-term interest rates, the yieldcurve will slope downwards.

Market segmentation theoryThe reason why interest rates may differ between loans of different maturity could be because the balance between supply

15

and demand differs between markets for loans of different maturity. If demand for long-term loans is greater than the supply,for example, because of a high public sector borrowing requirement, interest rates in the long-term loan market will increaseto restore equilibrium between demand and supply. Differing interest rates between markets for loans of different maturity canalso explain why the yield curve may not be smooth, but kinked.

Fiscal policyGovernments may use fiscal policy to support the achievement of economic objectives. For example, the government orcentral bank may act to increase short-term interest rates in order to reduce inflation. This can result in short-term interestrates being higher than long-term interest rates, an effect which can be compounded if there is a decrease in the anticipatedinflation reflected in long-term interest rates.

16


Marks Marks1 (a) Inflated sales revenue 1

Inflated costs 1Tax liability 1Capital allowance, years 1 to 3 1Balancing allowance, year 4 1Capital allowance tax benefits 1Timing of tax liabilities and benefits 1Incremental working capital investment 1Recovery of working capital 1Market research omitted as sunk cost 1Calculation of nominal terms NPV 1Comment on financial acceptability 1

––––12

(b) Calculation of real cost of capital 2Real terms net revenue 1Real terms after-tax cash flow 1Real terms working capital investment and recovery 1Calculation of real terms NPV 1Comment on financial acceptability 1–2


(c) Managerial reward schemes 3–5Regulatory requirements 3–4Other relevant discussion 1–2


–––25–––

2 (a) Calculation of historic dividend growth rate 1Calculation of cost of equity using DGM 2

––––3

(b) Dividend growth model discussion 2–3Capital asset pricing model discussion 2–3


(c) After-tax interest payment 1Setting up linear interpolation calculation 1Calculation of after-tax cost of debt 1Calculation of market value of equity 0·5Calculation of market value of debt 0·5Calculation of WACC 1

––––5

(d) Ungearing proxy company equity beta 1Regearing asset beta 1Project-specific cost of equity using CAPM 2

––––4

(e) Traditional view of capital structure 1–2Miller and Modigliani views of capital structure 3–4Market imperfections view of capital structure 2–3Other relevant discussion 1–2


–––25–––

17

Marks Marks3 (a) (i) Current ordering cost 1

Buffer inventory 0·5Average inventory 0·5Holding cost 0·5Total cost 0·5

––––3

(ii) Economic order quantity 1EOQ order cost 1Holding cost 0·5Total cost 0·5

––––3

(iii) Saving from EOQ ordering policy 1

(b) Current trade payables 1Trade payables after discount 1Increase in finance costs 1Value of discount 1Net value of discount offer 1

––––5

(c) Invoice discounting 2–3Factoring 3–4


(d) Objectives of working capital management 3–4Role of working capital management 3–4


–––25–––

4 (a) Timing of lease payments 1Present value of cost of leasing 1Present value of maintenance costs 1Present value of salvage value 1Present value of cost of borrowing 2Evaluation of financing choice 1Explanation of evaluation of financing method 3

––––10

(b) Attractions of leasing as short-term finance source 2–3Attractions of leasing as long-term finance source 2–3


(c) Explanation of interest (riba) 1–2Explanation of returns on Islamic financial instruments 3–4


(d) Liquidity preference theory 1–2Expectations theory 1–2Market segmentation theory 1–2Fiscal policy 1–2


–––25–––

18


Time allowed Reading and planning: 15 minutesWriting: 3 hours



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.


Fundamentals Pilot Paper – Skills module

Pape

r F9


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1 Droxfol Co is a listed company that plans to spend $10m on expanding its existing business. It has been suggested

that the money could be raised by issuing 9% loan notes redeemable in ten years’ time. Current financial information on Droxfol Co is as follows.

Incomestatementinformationforthelastyear $000 Profit before interest and tax 7,000 Interest (500) Profit before tax 6,500 Tax (1,950) Profit for the period 4,550

Balancesheetforthelastyear $000 $000 Non-current assets 20,000 Current assets 20,000 Total assets 40,000 Equityandliabilities Ordinary shares, par value $1 5,000 Retained earnings 22,500 Total equity 27,500 10% loan notes 5,000 9% preference shares, par value $1 2,500 Total non-current liabilities 7,500 Current liabilities 5,000 Total equity and liabilities 40,000

The current ex div ordinary share price is $4.50 per share. An ordinary dividend of 35 cents per share has just been paid and dividends are expected to increase by 4% per year for the foreseeable future. The current ex div preference share price is 76.2 cents. The loan notes are secured on the existing non-current assets of Droxfol Co and are redeemable at par in eight years’ time. They have a current ex interest market price of $105 per $100 loan note. Droxfol Co pays tax on profits at an annual rate of 30%.

The expansion of business is expected to increase profit before interest and tax by 12% in the first year. Droxfol Co has no overdraft.

Averagesectorratios: Financial gearing: 45% (prior charge capital divided by equity capital on a book value basis) Interest coverage ratio: 12 times

Required:

(a) Calculate the current weighted average cost of capital of Droxfol Co. (9 marks)

(b) Discuss whether financial management theory suggests that Droxfol Co can reduce its weighted average cost of capital to a minimum level. (8 marks)

(c) Evaluate and comment on the effects, after one year, of the loan note issue and the expansion of business on the following ratios:

(i) interest coverage ratio; (ii) financial gearing; (iii) earnings per share.

Assume that the dividend growth rate of 4% is unchanged. (8 marks)

(25 marks)

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2 Nedwen Co is a UK-based company which has the following expected transactions..

One month: Expected receipt of $240,000 One month: Expected payment of $140,000 Three months: Expected receipts of $300,000

The finance manager has collected the following information:

Spot rate ($ per £): 1.7820 ± 0.0002 One month forward rate ($ per £): 1.7829 ± 0.0003 Three months forward rate ($ per £): 1.7846 ± 0.0004

Money market rates for Nedwen Co: Borrowing Deposit One year sterling interest rate: 4.9% 4.6 One year dollar interest rate: 5.4% 5.1

Assume that it is now 1 April.

Required:

(a) Discuss the differences between transaction risk, translation risk and economic risk. (6 marks)

(b) Explain how inflation rates can be used to forecast exchange rates. (6 marks)

(c) Calculate the expected sterling receipts in one month and in three months using the forward market. (3 marks)

(d) Calculate the expected sterling receipts in three months using a money-market hedge and recommend whether a forward market hedge or a money market hedge should be used. (5 marks)

(e) Discuss how sterling currency futures contracts could be used to hedge the three-month dollar receipt. (5 marks)

(25 marks)

3 Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit, although customers on average take ten days more than this to pay. Contribution represents 60% of sales and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of 7%.

Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days and to extend the maximum credit offered to 60 days. The company expects that these changes will increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay.

Required:

(a) Evaluate whether the proposed changes in credit policy will increase the profitability of Ulnad Co. (6 marks)

(b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of $7,500. The average cost to the company of making deposits or selling investments is $18 per transaction and the standard deviation of its cash flows was $1,000 per day during the last year. The average interest rate on investments is 5.11%.

Determine the spread, the upper limit and the return point for the cash account of Renpec Co using the Miller-Orr model and explain the relevance of these values for the cash management of the company. (6 marks)

(c) Identify and explain the key areas of accounts receivable management. (6 marks)

(d) Discuss the key factors to be considered when formulating a working capital funding policy. (7 marks)

(25 marks)

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4 Trecor Co plans to buy a new machine to meet expected demand for a new product, Product T. This machine will cost $250,000 and last for four years, at the end of which time it will be sold for $5,000. Trecor Co expects demand for Product T to be as follows:

Year 1 2 3 4 Demand (units) 35,000 40,000 50,000 25,000

The selling price for Product T is expected to be $12.00 per unit and the variable cost of production is expected to be $7.80 per unit. Incremental annual fixed production overheads of $25,000 per year will be incurred. Selling price and costs are all in current price terms.

Selling price and costs are expected to increase as follows:

Increase Selling price of Product T: 3% per year Variable cost of production: 4% per year Fixed production overheads: 6% per year

Other information

Trecor Co has a real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in arrears. It can claim capital allowances on a 25% reducing balance basis. General inflation is expected to be 5% per year.

Trecor Co has a target return on capital employed of 20%. Depreciation is charged on a straight-line basis over the life of an asset.

Required:

(a) Calculate the net present value of buying the new machine and comment on your findings (work to the nearest $1,000). (13 marks)

(b) Calculate the before-tax return on capital employed (accounting rate of return) based on the average investment and comment on your findings. (5 marks)

(c) Discuss the strengths and weaknesses of internal rate of return in appraising capital investments. (7 marks)

(25 marks)

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Answers

10

Pilot Paper F9 AnswersFinancial Management

1 (a) Calculation of weighted average cost of capital (WACC)

Market values Market value of equity = 5m x 4.50 = $22.5 million Market value of preference shares = 2.5m x .0762 = $1.905 million Market value of 10% loan notes = 5m x (105/ 100) = $5.25 million Total market value = 22.5m + 1.905m + 5.25m = $29.655 million

Cost of equity using dividend growth model = [(35 x 1.04)/ 450] + 0.04 = 12.08%

Cost of preference shares = 100 x 9/ 76.2 = 11.81%

Annual after-tax interest payment = 10 x 0.7 = $7

Year Cashflow $ 10%DFPV($)5%DFPV($) 0 market value (105) 1.000 (105) 1.000 (105) 1–8 interest 7 5.335 37.34 6.463 45.24 8 redemption 100 0.467 46.70 0.677 67.70 (20.96) 7.94

Using interpolation, after-tax cost of loan notes = 5 + [(5 x 7.94)/ (7.94 + 20.96)] = 6.37%

WACC = [(12.08 x 22.5) + (11.81 x 1.905) + (6.37 x 5.25)]/ 29.655 = 11.05%

(b) Droxfol Co has long-term finance provided by ordinary shares, preference shares and loan notes. The rate of return required by each source of finance depends on its risk from an investor point of view, with equity (ordinary shares) being seen as the most risky and debt (in this case loan notes) seen as the least risky. Ignoring taxation, the weighted average cost of capital (WACC) would therefore be expected to decrease as equity is replaced by debt, since debt is cheaper than equity, i.e. the cost of debt is less than the cost of equity.

However, financial risk increases as equity is replaced by debt and so the cost of equity will increase as a company gears up, offsetting the effect of cheaper debt. At low and moderate levels of gearing, the before-tax cost of debt will be constant, but it will increase at high levels of gearing due to the possibility of bankruptcy. At high levels of gearing, the cost of equity will increase to reflect bankruptcy risk in addition to financial risk.

In the traditional view of capital structure, ordinary shareholders are relatively indifferent to the addition of small amounts of debt in terms of increasing financial risk and so the WACC falls as a company gears up. As gearing up continues, the cost of equity increases to include a financial risk premium and the WACC reaches a minimum value. Beyond this minimum point, the WACC increases due to the effect of increasing financial risk on the cost of equity and, at higher levels of gearing, due to the effect of increasing bankruptcy risk on both the cost of equity and the cost of debt. On this traditional view, therefore, Droxfol Co can gear up using debt and reduce its WACC to a minimum, at which point its market value (the present value of future corporate cash flows) will be maximised.

In contrast to the traditional view, continuing to ignore taxation but assuming a perfect capital market, Miller and Modigliani demonstrated that the WACC remained constant as a company geared up, with the increase in the cost of equity due to financial risk exactly balancing the decrease in the WACC caused by the lower before-tax cost of debt. Since in a prefect capital market the possibility of bankruptcy risk does not arise, the WACC is constant at all gearing levels and the market value of the company is also constant. Miller and Modigliani showed, therefore, that the market value of a company depends on its business risk alone, and not on its financial risk. On this view, therefore, Droxfol Co cannot reduce its WACC to a minimum.

When corporate tax was admitted into the analysis of Miller and Modigliani, a different picture emerged. The interest payments on debt reduced tax liability, which meant that the WACC fell as gearing increased, due to the tax shield given to profits. On this view, Droxfol Co could reduce its WACC to a minimum by taking on as much debt as possible.

However, a perfect capital market is not available in the real world and at high levels of gearing the tax shield offered by interest payments is more than offset by the effects of bankruptcy risk and other costs associated with the need to service large amounts of debt. Droxfol Co should therefore be able to reduce its WACC by gearing up, although it may be difficult to determine whether it has reached a capital structure giving a minimum WACC.

(c) (i) Interest coverage ratio Current interest coverage ratio = 7,000/ 500 = 14 times Increased profit before interest and tax = 7,000 x 1.12 = $7.84m Increased interest payment = (10m x 0.09) + 0.5m = $1.4m Interest coverage ratio after one year = 7.84/ 1.4 = 5.6 times

The current interest coverage of Droxfol Co is higher than the sector average and can be regarded as quiet safe. Following the new loan note issue, however, interest coverage is less than half of the sector average, perhaps indicating that Droxfol Co may not find it easy to meet its interest payments.

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(ii) Financial gearing This ratio is defined here as prior charge capital/equity share capital on a book value basis Current financial gearing = 100 x (5,000 + 2,500)/ (5,000 + 22,500) = 27% Ordinary dividend after one year = 0.35 x 5m x 1.04 = $1.82 million Total preference dividend = 2,500 x 0.09 = $225,000

Incomestatementafteroneyear $000 $000 Profit before interest and tax 7,840 Interest (1,400) Profit before tax 6,440 Income tax expense (1,932) Profit for the period 4,508 Preference dividends 225 Ordinary dividends 1,820 (2,045) Retained earnings 2,463

Financial gearing after one year = 100 x (15,000 + 2,500)/ (5,000 + 22,500 + 2,463) = 58%

The current financial gearing of Droxfol Co is 40% less (in relative terms) than the sector average and after the new loan note issue it is 29% more (in relative terms). This level of financial gearing may be a cause of concern for investors and the stock market. Continued annual growth of 12%, however, will reduce financial gearing over time.

(iii) Earnings per share Current earnings per share = 100 x (4,550 – 225)/ 5,000 = 86.5 cents Earnings per share after one year = 100 x (4,508 - 225)/ 5,000 = 85.7 cents

Earnings per share is seen as a key accounting ratio by investors and the stock market, and the decrease will not be welcomed. However, the decrease is quiet small and future growth in earnings should quickly eliminate it.

The analysis indicates that an issue of new debt has a negative effect on the company’s financial position, at least initially. There are further difficulties in considering a new issue of debt. The existing non-current assets are security for the existing 10% loan notes and may not available for securing new debt, which would then need to be secured on any new non-current assets purchased. These are likely to be lower in value than the new debt and so there may be insufficient security for a new loan note issue. Redemption or refinancing would also pose a problem, with Droxfol Co needing to redeem or refinance $10 million of debt after both eight years and ten years. Ten years may therefore be too short a maturity for the new debt issue.

An equity issue should be considered and compared to an issue of debt. This could be in the form of a rights issue or an issue to new equity investors.

2 (a) Transaction risk This is the risk arising on short-term foreign currency transactions that the actual income or cost may be different from the

income or cost expected when the transaction was agreed. For example, a sale worth $10,000 when the exchange rate is $1.79 per £ has an expected sterling value is $5,587. If the dollar has depreciated against sterling to $1.84 per £ when the transaction is settled, the sterling receipt will have fallen to $5,435. Transaction risk therefore affects cash flows and for this reason most companies choose to hedge or protect themselves against transaction risk.

Translationrisk This risk arises on consolidation of financial statements prior to reporting financial results and for this reason is also known as

accounting exposure. Consider an asset worth €14 million, acquired when the exchange rate was €1.4 per $. One year later, when financial statements are being prepared, the exchange rate has moved to €1.5 per $ and the balance sheet value of the asset has changed from $10 million to $9.3 million, resulting an unrealised (paper) loss of $0.7 million. Translation risk does not involve cash flows and so does not directly affect shareholder wealth. However, investor perception may be affected by the changing values of assets and liabilities, and so a company may choose to hedge translation risk through, for example, matching the currency of assets and liabilities (eg a euro-denominated asset financed by a euro-denominated loan).

Economicrisk Transaction risk is seen as the short-term manifestation of economic risk, which could be defined as the risk of the present

value of a company’s expected future cash flows being affected by exchange rate movements over time. It is difficult to measure economic risk, although its effects can be described, and it is also difficult to hedge against it.

(b) The law of one price suggests that identical goods selling in different countries should sell at the same price, and that exchange rates relate these identical values. This leads on to purchasing power parity theory, which suggests that changes in exchange rates over time must reflect relative changes in inflation between two countries. If purchasing power parity holds true, the expected spot rate (Sf) can be forecast from the current spot rate (S0) by multiplying by the ratio of expected inflation rates ((1 + if)/ (1 + iUK)) in the two counties being considered. In formula form: Sf = S0 (1 + if)/ (1 + iUK).

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This relationship has been found to hold in the longer-term rather than the shorter-term and so tends to be used for forecasting exchange rates several years in the future, rather than for periods of less than one year. For shorter periods, forward rates can be calculated using interest rate parity theory, which suggests that changes in exchange rates reflect differences between interest rates between countries.

(c) Forward market evaluation

Net receipt in 1 month = 240,000 – 140,000 = $100,000 Nedwen Co needs to sell dollars at an exchange rate of 1.7829 + 0.003 = $1.7832 per £ Sterling value of net receipt = 100,000/ 1.7832 = $56,079

Receipt in 3 months = $300,000 Nedwen Co needs to sell dollars at an exchange rate of 1.7846 + 0.004 = $1.7850 per £ Sterling value of receipt in 3 months = 300,000/ 1.7850 = $168,067

(d) Evaluation of money-market hedge

Expected receipt after 3 months = $300,000 Dollar interest rate over three months = 5.4/ 4 = 1.35% Dollars to borrow now to have $300,000 liability after 3 months = 300,000/ 1.0135 = $296,004 Spot rate for selling dollars = 1.7820 + 0.0002 = $1.7822 per £ Sterling deposit from borrowed dollars at spot = 296,004/ 1.7822 = $166,089 Sterling interest rate over three months = 4.6/ 4 = 1.15% Value in 3 months of sterling deposit = 166,089 x 1.0115 = $167,999

The forward market is marginally preferable to the money market hedge for the dollar receipt expected after 3 months.

(e) A currency futures contract is a standardised contract for the buying or selling of a specified quantity of foreign currency. It is traded on a futures exchange and settlement takes place in three-monthly cycles ending in March, June, September and December, ie a company can buy or sell September futures, December futures and so on. The price of a currency futures contract is the exchange rate for the currencies specified in the contract.

When a currency futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin. If losses are incurred as exchange rates and hence the prices of currency futures contracts change, the buyer or seller may be called on to deposit additional funds (variation margin) with the exchange. Equally, profits are credited to the margin account on a daily basis as the contract is ‘marked to market’.

Most currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to the initial futures transaction, ie if buying currency futures was the initial transaction, it is closed out by selling currency futures. A gain made on the futures transactions will offset a loss made on the currency markets and vice versa.

Nedwen Co expects to receive $300,000 in three months’ time and so is concerned that sterling may appreciate (strengthen) against the dollar, since this would result in a lower sterling receipt. The company can hedge the receipt by buying sterling currency futures contracts in the US and since it is 1 April, would buy June futures contracts. In June, Nedwen Co could sell the same number of US sterling currency futures it bought in April and sell the $300,000 it received on the currency market.

3 (a) Evaluation of change in credit policy

Current average collection period = 30 + 10 = 40 days Current accounts receivable = 6m x 40/ 365 = $657,534 Average collection period under new policy = (0.3 x 15) + (0.7 x 60) = 46.5 days New level of credit sales = $6.3 million Accounts receivable after policy change = 6.3 x 46.5/ 365 = $802,603 Increase in financing cost = (802,603 – 657,534) x 0.07 = $10,155

$ Increase in financing cost 10,155 Incremental costs = 6.3m x 0.005 = 31,500 Cost of discount = 6.3m x 0.015 x 0.3 = 28,350 Increase in costs 70,005 Contribution from increased sales = 6m x 0.05 x 0.6 = 180,000 Net benefit of policy change 109,995

The proposed policy change will increase the profitability of Ulnad Co

(b) Determination of spread: Daily interest rate = 5.11/ 365 = 0.014% per day Variance of cash flows = 1,000 x 1,000 = $1,000,000 per day Transaction cost = $18 per transaction

Spread = 3 x ((0.75 x transaction cost x variance)/interest rate)1/3

= 3 x ((0.75 x 18 x 1,000,000)/ 0.00014)1/3 = 3 x 4,585.7 = $13,757

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Lower limit (set by Renpec Co) = $7,500 Upper limit = 7,500 + 13,757 =$21,257 Return point = 7,500 + (13,757/ 3) = $12,086

The Miller-Orr model takes account of uncertainty in relation to receipts and payment. The cash balance of Renpec Co is allowed to vary between the lower and upper limits calculated by the model. If the lower limit is reached, an amount of cash equal to the difference between the return point and the lower limit is raised by selling short-term investments. If the upper limit is reached an amount of cash equal to the difference between the upper limit and the return point is used to buy short-term investments. The model therefore helps Renpec Co to decrease the risk of running out of cash, while avoiding the loss of profit caused by having unnecessarily high cash balances.

(c) There are four key areas of accounts receivable management: policy formulation, credit analysis, credit control and collection of amounts due.

Policyformulation This is concerned with establishing the framework within which management of accounts receivable in an individual company

takes place. The elements to be considered include establishing terms of trade, such as period of credit offered and early settlement discounts: deciding whether to charge interest on overdue accounts; determining procedures to be followed when granting credit to new customers; establishing procedures to be followed when accounts become overdue, and so on.

Creditanalysis Assessment of creditworthiness depends on the analysis of information relating to the new customer. This information is often

generated by a third party and includes bank references, trade references and credit reference agency reports. The depth of credit analysis depends on the amount of credit being granted, as well as the possibility of repeat business.

Creditcontrol Once credit has been granted, it is important to review outstanding accounts on a regular basis so overdue accounts can be

identified. This can be done, for example, by an aged receivables analysis. It is also important to ensure that administrative procedures are timely and robust, for example sending out invoices and statements of account, communicating with customers by telephone or e-mail, and maintaining account records.

Collectionofamountsdue Ideally, all customers will settle within the agreed terms of trade. If this does not happen, a company needs to have in place

agreed procedures for dealing with overdue accounts. These could cover logged telephone calls, personal visits, charging interest on outstanding amounts, refusing to grant further credit and, as a last resort, legal action. With any action, potential benefit should always exceed expected cost.

(d) When considering how working capital is financed, it is useful to divide assets into non-current assets, permanent current assets and fluctuating current assets. Permanent current assets represent the core level of working capital investment needed to support a given level of sales. As sales increase, this core level of working capital also increases. Fluctuating current assets represent the changes in working capital that arise in the normal course of business operations, for example when some accounts receivable are settled later than expected, or when inventory moves more slowly than planned.

The matching principle suggests that long-term finance should be used for long-term assets. Under a matching working capital funding policy, therefore, long-term finance is used for both permanent current assets and non-current assets. Short-term finance is used to cover the short-term changes in current assets represented by fluctuating current assets.

Long-term debt has a higher cost than short-term debt in normal circumstances, for example because lenders require higher compensation for lending for longer periods, or because the risk of default increases with longer lending periods. However, long-term debt is more secure from a company point of view than short-term debt since, provided interest payments are made when due and the requirements of restrictive covenants are met, terms are fixed to maturity. Short-term debt is riskier than long-term debt because, for example, an overdraft is repayable on demand and short-term debt may be renewed on less favourable terms.

A conservative working capital funding policy will use a higher proportion of long-term finance than a matching policy, thereby financing some of the fluctuating current assets from a long-term source. This will be less risky and less profitable than a matching policy, and will give rise to occasional short-term cash surpluses.

An aggressive working capital funding policy will use a lower proportion of long-term finance than a matching policy, financing some of the permanent current assets from a short-term source such as an overdraft. This will be more risky and more profitable than a matching policy.

Other factors that influence a working capital funding policy include management attitudes to risk, previous funding decisions, and organisation size. Management attitudes to risk will determine whether there is a preference for a conservative, an aggressive or a matching approach. Previous funding decisions will determine the current position being considered in policy formulation. The size of the organisation will influence its ability to access different sources of finance. A small company, for example, may be forced to adopt an aggressive working capital funding policy because it is unable to raise additional long-term finance, whether equity of debt.

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4 (a) Calculation of NPV

Nominal discount rate using Fisher effect: 1.057 x 1.05 = 1.1098 ie 11%

Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales (W1) 433 509 656 338 Variable cost (W2) 284 338 439 228 Contribution 149 171 217 110 Fixed production overheads 27 28 30 32 Net cash flow 122 143 187 78 Tax (37) (43) (56) (23) CA tax benefits (W3) 19 14 11 30 After-tax cash flow 122 125 158 33 7 Disposal 5 After-tax cash flow 122 125 158 38 7 Discount factors 0.901 0.812 0.731 0.659 0.593 Present values 110 102 115 25 4

$ PV of benefits 356,000 Investment 250,000 NPV 106,000

Since the NPV is positive, the purchase of the machine is acceptable on financial grounds.

Workings

(W1)Year 1 2 3 4 Demand (units) 35,000 40,000 50,000 25,000 Selling price ($/unit) 12.36 12.73 13.11 13.51 Sales ($/year) 432,600 509,200 655,500 337,750

(W2)Year 1 2 3 4 Demand (units) 35,000 40,000 50,000 25,000 Variable cost ($/unit) 8.11 8.44 8.77 9.12 Variable cost ($/year) 283,850 337,600 438,500 228,000

(W3)Year Capitalallowances Taxbenefits 1 250,000 x 0.25 = 62,500 62,500 x 0.3 = 18,750 2 62,500 x 0.75 = 46,875 46,875 x 0.3 = 14,063 3 46,875 x 0.75 = 35,156 25,156 x 0.3 = 10,547 4 By difference 100,469 100,469 x 0.3 = 30,141 250,000 – 5.000 = 245,000 73,501

(b) Calculation of before-tax return on capital employed

Total net before-tax cash flow = 122 + 143 + 187 + 78 = $530,000 Total depreciation = 250,000 – 5,000 = $245,000 Average annual accounting profit = (530 – 245)/ 4 = $71,250

Average investment = (250,000 + 5,000)/ 2 = $127,500

Return on capital employed = 100 x 71,250/ 127,500 = 56%

Given the target return on capital employed of Trecor Co is 20% and the ROCE of the investment is 56%, the purchase of the machine is recommended.

(c) One of the strengths of internal rate of return (IRR) as a method of appraising capital investments is that it is a discounted cash flow (DCF) method and so takes account of the time value of money. It also considers cash flows over the whole of the project life and is sensitive to both the amount and the timing of cash flows. It is preferred by some as it offers a relative measure of the value of a proposed investment, ie the method calculates a percentage that can be compared with the company’s cost of capital, and with economic variables such as inflation rates and interest rates.

IRR has several weaknesses as a method of appraising capital investments. Since it is a relative measurement of investment worth, it does not measure the absolute increase in company value (and therefore shareholder wealth), which can be found using the net present value (NPV) method. A further problem arises when evaluating non-conventional projects (where cash

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flows change from positive to negative during the life of the project). IRR may offer as many IRR values as there are changes in the value of cash flows, giving rise to evaluation difficulties. There is a potential conflict between IRR and NPV in the evaluation of mutually exclusive projects, where the two methods can offer conflicting advice as which of two projects is preferable. Where there is conflict, NPV always offers the correct investment advice: IRR does not, although the advice offered can be amended by considering the IRR of the incremental project. There are therefore a number of reasons why IRR can be seen as an inferior investment appraisal method compared to its DCF alternative, NPV.

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Pilot Paper F9 Marking SchemeFinancial Management

Marks Marks1 (a) Calculation of market values 2 Calculation of cost of equity 2 Calculation of cost of preference shares 1 Calculation of cost of debt 2 Calculation of WACC 2 9

(b) Relative costs of equity and debt 1 Discussion of theories of capital structure 7–8 Conclusion 1 Maximum 8

(c) Analysis of interest coverage ratio 2–3 Analysis of financial gearing 2–3 Analysis of earnings per share 2–3 Comment 2–3 Maximum 8 25

2 (a) Transaction risk 2 Translation risk 2 Economic risk 2 6

(b) Discussion of purchasing power parity 4–5 Discussion of interest rate parity 1–2 Maximum 6

(c) Netting 1 Sterling value of 3-month receipt 1 Sterling value of 1-year receipt 1 3

(d) Evaluation of money market hedge 4 Comment 1 5

(e) Definition of currency futures contract 1–2 Initial margin and variation margin 1–2 Buying and selling of contracts 1–2 Hedging the three-month receipt 1–2 Maximum 5 25

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Marks Marks3 (a) Increase in financing cost 2 Incremental costs 1 Cost of discount 1 Contribution from increased sales 1 Conclusion 1 6

(b) Calculation of spread 2 Calculation of upper limit 1 Calculation of return point 1 Explanation of findings 2 6

(c) Policy formulation 1–2 Credit analysis 1–2 Credit control 1–2 Collection of amounts due 1–2 Maximum 6

(d) Analysis of assets 1–2 Short-term and long-term debt 2–3 Discussion of policies 2–3 Other factors 1–2 Maximum 7 25

4 (a) Discount rate 1 Inflated sales revenue 2 Inflated variable cost 1 Inflated fixed production overheads 1 Taxation 2 Capital allowance tax benefits 3 Discount factors 1 Net present value 1 Comment 1 13

(b) Calculation of average annual accounting profit 2 Calculation of average investment 2 Calculation of return on capital employed 1 5

(c) Strengths of IRR 2–3 Weaknesses of IRR 5–6 Maximum 7 25

acca f9 past year q&a 07-13

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