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Fundamentals Level ? Skills Module, Paper F9 Financial Management

December 2012 Answers

1 (a) NPV calculation

Year

Sales revenue Variable costs

Contribution Fixed costs

Before-tax cash flow Tax liability CA tax benefits

After-tax cash flow Discount at 12%

Present values

1 $000 5,614 (3,031) ?????? 2,583 (1,530) ?????? 1,053

?????? 1,053 0?893 ??????

940 ??????

2

$000

7,214

(3,931) ?????? 3,283

(1,561) ?????? 1,722

(316)

300 ?????? 1,706

0?797 ?????? 1,360 ??????

3

$000

9,015

(5,135) ?????? 3,880

(1,592) ?????? 2,288

(517)

300 ?????? 2,071

0?712 ?????? 1,475 ??????

4

$000

7,034

(4,174) ?????? 2,860

(1,624) ?????? 1,236

(686)

300 ??????

850

0?636 ??????

541 ??????

5 $000

(371) 300 ?????? (71) 0?567 ?????? (40) ??????

PV of future cash flows Initial investment

$000

4,276

(4,000) ??????

276 ??????

Comment Since the proposed investment has a positive net present value of $276,000, it is financially acceptable.

Workings

Sales revenue

Year Sales of small houses (houses/yr) Sales of large houses (houses/yr) Small house selling price ($000/house) Large house selling price ($000/house)

1

2

3

4

15

20

15

5

7

8

15

15

200

200

200

200

350

350

350

350

Sales revenue (small houses) ($000/yr) Sales revenue (large houses) ($000/yr) Total sales revenue ($/yr)

Inflated sales revenue ($/yr)

3,000 2,450 ?????? 5,450 ??????

5,614

4,000 2,800 ?????? 6,800 ??????

7,214

3,000 5,250 ?????? 8,250 ??????

9,015

1,000 5,250 ?????? 6,250 ??????

7,034

Variable costs of construction

Year Sales of small houses (houses/yr) Sales of large houses (houses/yr) Small house variable cost ($000/house) Large house variable cost ($000/house)

1

2

3

4

15

20

15

5

7

8

15

15

100

100

100

100

200

200

200

200

Variable cost (small houses) ($000/yr) Variable cost (large houses) ($000/yr) Total variable cost ($/yr)

Inflated total variable cost ($/yr)

1,500 1,400 ?????? 2,900 ??????

3,031

2,000 1,600 ?????? 3,600 ??????

3,931

1,500 3,000 ?????? 4,500 ??????

5,135

500 3,000 ?????? 3,500 ??????

4,174

Fixed infrastructure costs

Year Fixed costs ($000/yr) Inflated fixed costs ($000/yr)

1 1,500 1,530

2 1,500 1,561

3 1,500 1,592

4 1,500 1,624

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Alternative NPV calculation Year

Before-tax cash flow Capital allowances Taxable profit Taxation Profit after tax Add back allowances After-tax cash flow Discount at 12% Present values

PV of future cash flows Initial investment

1 $000 1,053 (1,000) ??????

53

?????? 53

1,000 ?????? 1,053 0?893 ??????

940 ??????

$000 4,276 (4,000) ??????

276 ??????

2

$000

1,722

(1,000) ??????

722

(16) ??????

706

1,000 ?????? 1,706

0?797 ?????? 1,360 ??????

3

$000

2,288

(1,000) ?????? 1,288

(217) ?????? 1,071

1,000 ?????? 2,071

0?712 ?????? 1,475 ??????

4

$000

1,236

(1,000) ??????

236

(386) ??????

(150)

1,000 ??????

850

0?636 ??????

541 ??????

5 $000

(71) ??????

(71)

(71) 0?567 ??????

(40) ??????

(b) Calculation of return on capital employed (ROCE)

Total before-tax cash flow Total depreciation

Total accounting profit

$6,299,000

$4,000,000 ??????????? $2,299,000

Average annual profit ($000/year) = 2,299,000/4 = $574,750 Average investment ($000) = 4,000,000/2 = $2,000,000 ROCE (ARR) = 100 x 574,750/2,000,000 = 28?7%

Discussion The ROCE is greater than the 20% target ROCE of the investing company and so the proposed investment is financially acceptable. 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 the discount rate used in the investment appraisal decision-making process and the value of project variables.

Customer financing costs Each customer finances their house purchase through a long-term personal loan from their bank. A substantial rise in interest rates will increase the borrowing costs of existing and potential customers of BQK Co, and will therefore increase the amount of cash they pay to buy one of the houses.

Company financing costs The cost of debt of BQK Co will change with interest rates in the economy. A substantial rise in interest rates will therefore lead to a substantial increase in the cost of debt of the company. This will lead to an increase in the weighted average cost of capital (WACC) of BQK Co, the actual increase depending on the relative proportion of debt compared to equity in the company's capital structure.

The cost of equity will also increase as interest rates rise, contributing to the increase in the WACC. Since most companies have a greater proportion of equity finance as compared to debt finance, the increase in the cost of equity is likely to have a more significant effect on the WACC than the increase in the cost of debt.

Effect on the capital investment appraisal process Since the business of the company is building houses, the WACC of the company is likely to be the discount rate it uses in evaluating investment decisions such as the one under consideration. An increase in WACC will therefore lead to a decrease in 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. This could 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 personal loans 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 accommodate the slower sales process.

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2 (a) Calculation of net cost/benefit

Current receivables = $2,466,000

Receivables paying within 30 days = 15m x 0?5 x 30/365 = $616,438 Receivables paying within 45 days = 15m x 0?3 x 45/365 = $554,795 Receivables paying within 60 days = 15m x 0?2 x 60/365 = $493,151 Revised receivables = 616,438 + 554,795 + 493,151 = $1,664,384

Reduction in receivables = 2,466,000 ? 1,664,384 = $801,616 Reduction 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 days Revised receivables days = (30 x 0?5) + (45 x 0?3) + (60 x 0?2) = 40?5 days Decrease 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 = $48,082 Net cost of proposed changes in receivables policy = 75,000 ? 48,082 = $26,918

Comment The proposed changes in trade receivables policy are not financially acceptable. However, if the trade terms offered are comparable with those of its competitors, KXP Co needs to investigate the reasons for the (on average) late payment of current customers. 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 year Annual ordering cost = 12 x 150 = $1,800 per year Annual 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 year KXP Co will need to increase its order size to 30,000 units to gain the bulk discount Revised number of orders = 180,000/30,000 = 6 orders per year

Revised ordering cost = 6 x 150 = $900 per year Revised 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 unrealistic assumptions. For example, the ordering cost and the holding cost are assumed to be constant, which is unlikely to be true in 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 cash The amount of cash needed for the next period can be forecast using a cash budget, which will net off expected receipts against expected payments. This will determine the transactions need for cash, which is one of the three reasons for holding cash.

The precautionary need for cash Although a cash budget will provide an estimate of the transactions need for cash, it will be based on assumptions about the future 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 cash balance. This is the precautionary need for cash. In determining the optimal level of cash to be held, a company will estimate the size of this cash buffer, for example from past experience, because it will be keen to minimise the opportunity cost of maintaining funds in cash form.

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The speculative need for cash There is always the possibility of an unexpected opportunity occurring in the business world and a company may wish to be prepared to take advantage of such a business opportunity if it arises. It may therefore wish to have some cash available for this purpose. This is the speculative need for cash. Building `a war chest' for possible company acquisitions reflects this reason for holding cash.

The availability of finance A 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, its precautionary 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 receivables collection.

Credit analysis In offering credit, a company must consider that it will be exposed to the risk of late payment and the risk of bad debts. To reduce these risks, the company will assess the creditworthiness of its potential customers. In order to do this, the company needs information, which can come from a variety of sources, such as trade references, bank references, credit reference agencies, published accounts and so on. As a result of assessing the creditworthiness of customers, a company can decide on the amount of credit to offer, the credit terms to offer, or whether to offer credit at all.

Credit control Having extended credit to customers, a company needs to consider ways to ensure that the terms under which credit was granted 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 information can 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 and reminded when payment is due. This can be done by providing regular statements of account and by sending reminder letters when payment is due.

Receivables collection Cash received needs to be banked quickly if payment is not made electronically by credit transfer. Overdue accounts must be followed 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 bond Ordinary share price = 125m/25m = $5?00 per share

Share price in five years' time = 5?00 x 1?045 = $6?08 per share Conversion 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

Using linear interpolation:

Year

Cash flow

0

Market price

1?5

Interest

5

Conversion value

$ (105?00)

4?90 115?52

Discount at 7% 1?000 4?100 0?713

PV ($) (105?00)

20?09 82?37 ????? (2?54) ?????

Year

Cash flow

0

Market price

1?5

Interest

5

Conversion value

$ (105?00)

4?90 115?52

Discount at 6% 1?000 4?212 0?747

PV ($) (105?00)

20?64 86?29 ?????

1?93 ?????

After-tax Kd = 6 + ((7 ? 6) x 1?93)/(1?93 + 2?54)) = 6 + 0?43 = 6?43%

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