Financial Management - Yola



ACCA

Paper F9

Financial Management

December 2014

Revision Mock 2 – Marking Scheme

Section A

|1. |C |Increasing the exchange rate will increase the price of exported goods and lower the price of imported goods, this|

| | |is likely to lead to a fall in domestic economic activity (C). |

| | |Increasing public expenditure should increase the level of consumer demand (A). |

| | |Lowering interest rates should stimulate investment (by companies) and consumer expenditure, even if only after a |

| | |time lag (B). |

| | |Decreasing taxation has the opposite effect (D). |

|2. |A | |

|3. |C |Shares would not be converted (at $3·30 x 30 = $99), instead the loan notes would be redeemed at $105. |

| | |$8 x 0·909 + $113 x 0·826 = approx. $101. |

| | | |

| | |Option A assumes loan notes are converted and not redeemed. |

| | |Options C and D, use the 8% as the discount rate and the 10% as the coupon receipts. Option C does not convert the|

| | |loan notes and option D converts the loan notes. |

|4. |D |Neither statement is true. Finance house deposits are non-negotiable i.e. they cannot be sold to another investor.|

| | |Treasury bills are issued at a discount and redeemed at face value but do not pay any interest. |

|5. |D |Both statements are false. |

| | |Markets which are semi-strong form efficient will not react to or be affected by window dressing or creative |

| | |accounting. |

| | |Share prices in markets which are weak-form efficient follow a random pattern of movement and it is not possible |

| | |to predict future movements by studying past patterns. |

|6. |C |An investor could invest in A$ at 5% or invest in UK£. |

| | | |

| | | |

| | |A$ |

| | | |

| | |Assume £100 is converted to A$ at spot |

| | |175.74 |

| | | |

| | |Invest at 5.0% for six months |

| | |4.39 |

| | | |

| | | |

| | |180.13 |

| | | |

| | | |

| | | |

| | | |

| | |Convert to UK£ at the forward rate |

| | |(A$180.13 / $1.7245) |

| | | |

| | |£104.45 |

| | | |

| | | |

| | |Interest rate is 4.45% for six months or 8.9% per year. |

| | | |

| | |Alternatively, by interest rate parity: |

| | |[pic] |

|7. |C |Overtrading will lead to liquidity problems. This, in turn, may lead to a lower than average acid test ratio and a|

| | |higher than average payment period for trade payables. |

|8. |B |The shares of Aralia Co are overpriced and those of Corylus Co are underpriced. |

| | | |

| | |The expected return for Aralia Co is: |

| | |5% + 1·2 (8% – 5%) = 8·6% |

| | |The predicted value of a share is = (D0 /Ke) |

| | |= $0·30/0·086 = $3·49 |

| | | |

| | |The expected return for Corylus Co is: |

| | |5% + 0·9 (8% – 5%) = 7·7% |

| | |The predicted value of a share is ($0·30/0·077) = $3·90 |

|9. |A |Both statements are correct. |

|10. |B |Impact of discount: 2% x 60% x $9,000,000 = $108,000 cash loss |

| | |Impact of reduction in debtors: 11% x ($1,500,000 – $1,050,000) = $49,500 cash gain |

| | |Net result = $58,500 cash loss |

| | | |

| | |Option A ignores the cash gain from the reduction in debtors. |

| | |Option C takes the whole new debtors figure to calculate the cash gain before netting it off against the cash loss|

| | |of the discount. |

| | |Option D ignores the cash loss from giving a discount. |

|11. |D | |

| | |% |

| | | |

| | |Company borrows at LIBOR + 50 b.p. |

| | |3.75 |

| | | |

| | |Borrowing fixed at 3.63 + 50 b.p. |

| | |4.13 |

| | | |

| | |Compensation payment to FRA bank |

| | |0.38 |

| | | |

|12. |D |The retention ratio is 75%. Thus, dividend growth is 75% x 12% = 9%. |

| | |The dividend payout for the forthcoming year is 25% x $0·30 = $0·075 |

| | |Predicted market value per share = [d1/(ke – g)] |

| | |= [0·075/(0·12 – 0·09)] = $2·50 |

|13. |D |The company is receiving US$ and so, on receipt of those dollars, will need to sell them. |

| | | |

| | | |

| | |$ |

| | | |

| | |Contracts bought at |

| | |1.6450 |

| | | |

| | |Current settlement price |

| | |1.6510 |

| | | |

| | |Gain |

| | |0.0060 |

| | | |

|14. |B |As there are different rates of inflation the money approach must be used, i.e. the cash flows must be inflated at|

| | |their specific rates and discounted at the money cost of capital. |

| | |By Fisher’s equation: Money cost of capital = 1.1 × 1.08 – 1 = 18.8% |

|15. |C |Statement 1 is false. An offer for sale involves the sale of shares already in issue. |

|16. |A |All statements are correct. |

|17. |B |Forward rate $(1·4545 – 0·0020) = $1·4525 |

| | |£ sterling received = $300,000/1·4525 = £206,540 |

| | | |

| | |Option A adds the premium to the spot rate. |

| | |Forward rate $(1·4545 + 0·0020) = $1·4565 |

| | |£ sterling received = $300,000/1·4565 = £205,973 |

| | | |

| | |Option C takes the higher premium. |

| | |Forward rate $(1·4545 – 0·0025) = $1·4520 |

| | |£ sterling received = $300,000/1·4520 = £206,612 |

| | | |

| | |Option D uses the higher spot rate and higher premium. |

| | |Forward rate $(1·4505 – 0·0025) = $1·4480 |

| | |£ sterling received = $300,000/1·4480 = £207,182 |

|18. |C |Underwriting is a form of insurance. An underwriter will purchase any unsold shares for an agreed price. |

| | |Sponsoring member firm ensures that the company meets the requirements for listing. |

| | |Issuing house tries to ensure that an issue of shares will be successful. |

| | |An intermediary is used to allocate shares to the intermediary’s clients. |

|19. |D |Statement 1 is talking about default by the customers and therefore is part of credit risk which is an example of |

| | |financial risk. |

| | |Statement 2 refers to purchasing processes, which would be part of process risk. Statement 3 refers to people |

| | |risk. Both statements 2 and 3 would fall within operational risk. |

|20. |A |The cost of equity will increase and the cost of borrowing will remain unchanged. |

Answer 1

(a)

The effect on profit can be calculated as follows:

| |$000 |$000 |$000 |Marks |

|Increase in sales | | | | |

|Category A customers (20% × $4m) | |800.0 | | |

|Category B customers (30% × $4m) | |1,200.0 | | |

|Category C customers (50% × $4m) | |2,000.0 |4,000.0 |[1.5] |

| | | | | |

|Increase in variable costs | | | | |

|Materials ($4m/$50 × $10) |800.0 | | | |

|Overheads ($4m/$50 × $5) |400.0 |1,200.0 | |[1] |

| | | | | |

|Increase in marketing costs | |1,500.0 | |[0.5] |

| | | | | |

|Increase in bad debts | | | | |

|Category A customers (1% × $800) |8.0 | | | |

|Category B customers (3% × $1,200) |36.0 | | | |

|Category C customers (5% × $2,000) |100.0 |144.0 | |[1.5] |

| | | | | |

|Increase in financing costs (W1) | | | | |

|Category A customers |6.6 | | | |

|Category B customers |13.2 | | | |

|Category C customers |27.4 |47.2 |2,891.2 |[3] |

|Net profit | | |1,108.8 |[0.5] |

| | | | |[8] |

W1 Financing costs

|Customer category |A |B |C | |

| |$000 |$000 |$000 |Marks |

|Increase in sales |800.0 |1,200.0 |2,000.0 | |

| | | | | |

|Additional debtors | | | | |

|($800 × 30/365) |65.8 | | | |

|($1,200 × 40/365) | |131.5 | | |

|($2,000 × 50/365) | | |274.0 | |

| | | | | |

|Interest charges (10%) |6.6 |13.2 |27.4 | |

(b)

The calculations in (a) above show that profits will increase by approximately $1·1m as a result of a $4m increase in sales. This return on sales, of approximately 28%, is achieved despite a marketing campaign which adds a further $1·5m to the total expenses of the company.

This relatively high return on sales can be explained by the fact that most of the costs of producing the device are fixed. The contribution per device is $35 per unit (that is, $50 selling price less $15 variable costs) which gives a contribution-to-sales ratio of 70%. Hence, any additional output will make a significant contribution to profit.

[3 marks]

(c)

A number of policies can be adopted to ensure that credit customers pay on time.

These include the following:

– Issue invoices promptly and ensure that the payment terms are specified on the invoice;

– Send out regular monthly statements and issue reminders when payment is overdue;

– Monitor debtors by producing an ageing analysis of debtors;

– Deal with outstanding queries quickly and efficiently;

– Chase slow payers by letter, e-mail and telephone;

– Ensure that no further credit is given to delinquent debtors.

– Offer financial incentives, such as discounts, to encourage prompt payment.

[1 mark for each point, maximum 4 marks]

Answer 2

(a)

EV = (0.3 × 0.50) + (0.5 × 1.40) + (0.2 × 2.0)

= 0.15 + 0.70 + 0.40 = 1.25 (i.e.) $ 1.25m [1]

To determine the NPV of the project, Blackwater must weigh the present value of the costs incurred i.e. the outlay and the increased production costs, against the benefits in the form of the two sets of tax reliefs relating to the increased operating costs and to the writing-down allowance and also the present value of the fines avoided. These are set out in the following table.

| | | | | | | |Marks |

| |0 |1 |2 |3 |4 |5 | |

| |$m |$m |$m |$m |$m |$m | |

|Outlay |(1.000) | | | | | |[0.5] |

|EU grant | |0.25 | | | | |[0.5] |

|FSL’s fee | |(0.050) | | | | |[1] |

|Increase costs | |(0.315) |(0.331) |(0.347) |(0.365) | |[1] |

|Tax saving of costs | | |0.104 |0.109 |0.115 |0.120 |[1] |

|CA tax benefits | |0.083 |0.062 |0.047 |0.035 |0.104 |[2] |

|Net cash flows |(1.000) |(0.032) |(0.165) |(0.191) |(0.215) |0.224 | |

|DF @ 12% |1.000 |0.893 |0.797 |0.712 |0.636 |0.567 | |

|PV |(1.000) |(0.029) |(0.132) |(0.136) |(0.137) |0.127 | |

NPV = (1.307), i.e. ($1.307m) [1]

|Year |WDV ($) | |CA ($m) |Tax rate |Tax benefit |

|1 |1.000 |× 25% = |0.25 |× 33% = |0.083 |

|2 |0.75 |× 25% = |0.1875 |× 33% = |0.062 |

|3 |0.5625 |× 25% = |0.141 |× 33% = |0.047 |

|4 |0.4215 |× 25% = |0.1054 |× 33% = |0.035 |

|5 |0.3161 |(bal. allow.) | |× 33% = |0.104 |

Since the negative NPV exceeds the expected present value of the fines ($1~250m) over the same period, it appears that the project is not viable in financial terms (i.e. ) it is cheaper to risk the fines. [1]

(b)

On purely non-financial criteria, it can be suggested that as a regular violator of the environmental regulation, our company has a moral responsibility to install this equipment, so long as it does not jeopardise the long-term survival of the company.

But the figures appended suggest that the project is not wealth-creating for Blackwater’s shareholders as the EV of the fines is less than the expected NPV of the project. However, this conclusion relies on accepting the validity of the probability distribution, which is debatable. Not only are the magnitudes of the fines merely estimates, but the probabilities shown are subjective. Different decision-makers may well arrive at different assessments which could lead to the opposite decision on financial criteria.

More fundamentally, the use of the expected value principle is only reliable when the probability distribution approximates to the normal. In this case, it is slightly skewed toward the lower outcomes. But more significantly, if the distribution itself is examined more closely, it appears to indicate that there is a 70% chance (0.5 + 0.2) of fines of at least $ 1.4m, which exceeds the NPV of the costs of the pollution control project. In other words, there is a 70% chance that the project will not be worthwhile. It therefore seems perverse to reject it on these figures.

Moreover, given that Blackwater is a persistent offender, and that the green lobby is becoming more influential, there must be a strong likelihood that the level of fines will increase in the future, suggesting that the data given are under-estimates. Higher expected fines would further enhance the appeal of the project.

It is also possible that the company may sell more output, perhaps at a higher price, if it is perceived to be more environmentally friendly and if customers are swayed by this. This may be less likely for industrial companies although it would create opportunities for self-publicity on both sides. In addition, there may be more general image effects which may foster enhanced self-esteem among the workforce, as well as increasing the acceptability of the company in the local community.

Finally, this may be only a short-term solution. As the operating life of the equipment is only four years, we will face a further investment decision after this period, although technological and legal changes may well have altered the situation by then.

[1 mark for each point, maximum 6 marks]

Answer 3

(a)(i)

Share price in 4 years’ time = GBP 3.60 × 1.064 = GBP 4.54

Forecast conversion value = GBP 4.54 × 23 = GBP 104.42 [1 mark]

(a)(ii)

|Year | |Cash flow ($) |DF |PV |DF |PV |

| | | |7% |($) |5% |($) |

|0 |Market value |(93.00) |1.000 |(93.00) |1.000 |(93.00) |

|1 – 4 |Interest [$3 x (1 – 30%)] |2.1 |3.387 |7.11 |3.546 |7.45 |

|4 |Redemption value |104.42 |0.763 |79.67 |0.823 |85.94 |

| | | | |(6.22) | |0.39 |

[2 marks]

The approximate cost of convertible bond is, therefore:

[pic] [1 marks]

(a)(iii)

| |Cost of capital |Market value (GBP in million) |GBP |

| | | |million |

|Share capital |Ke = 11.56% (W1) [1 mark] |= 280m × GBP 3.60 = |1.008 |

|Preference shares |Kp = [pic] [1 mark] |= 195m × GBP 1.05 = |204.75 |

|Debt |Kd = 5.12% ((a)(ii)) | |250 |

| | | |1,462.75 |

[1 mark]

WACC = [pic] = 9.64%

[1 marks]

W1 Cost of equity

By dividend growth model:

D1 = GBP 0.45 × 50% × 1.05 = GBP 0.23625 per share

Ke = [pic]

(b)

Treasury is likely to be involved in:

• Determining conversion ratio(s) and coupon interest rate on the instrument.

• Managing the relationship with the investment bank or issuing house supporting the bond issue.

• Calculating costs of capital and ensuring that new debt will not adversely affect the value of the company. Ensuring earnings are sufficient to cover interest payments and maintain dividend levels to preference and ordinary shareholders.

• Preparing all paperwork and a timetable for the issue.

[2 marks]

Answer 4

(a)

Rights issue price = $2.50 × 80% = $2.00 per share [1]

Theoretical ex-rights price

|4 |Shares × $2.50 = |10.00 |

|1 |Share × $2.00 = |2.00 |

|5 | |12.00 |

Theoretical ex-rights price = 12.00/5 = $2.40 [2]

(b)

Average growth rate of EPS:

27.7 × (1 + g)4 = 32.4

g = 4%

EPS following expansion = 32.4 × 1.04 = 33.7 cents per share [1]

Current P/E ratio = 250/32.4 = 7.7 times [1]

Share price following expansion = $0.337 × 7.7 = $2.60 [1]

(c)

A company will only be able to raise finance if investors think the returns they can expect are satisfactory in view of the risks they are taking. The proposed business expansion will be an acceptable use of the rights issue funds if it increases shareholder wealth.

This can be measured by looking at the effect on the share price. The current share price is $2.50 and the future share price predicted by the P/E method is $2.60. This indicates that shareholder wealth would increase. However, the capital gain is actually larger than this as shareholders will obtain new shares at a discount, resulting in a theoretical ex-rights price of $2.40. The capital gain for shareholders is therefore $2.60 – $2.40 = 20 cents per share.

Alternatively, we can consider the effect on total shareholder wealth. The rights issue involves 2.5 million shares ($5m/$2 per share). There were therefore 10 million shares (2.5 × 4) before the investment and Dartig was worth $25m (10m × $2.50). After the investment, Dartig is worth $27.5m (12.5m × $2.60 – $5m) which is a capital gain of $2.5m.

If investors believe that the expansion will enable the business to grow even further, the capital gain could be even greater. If, however, investors do not share the company’s confidence in the future, the share price could fall.

[1 mark for each point, maximum 4 marks]

Answer 5

(a)(i)

| |Shares |Loan notes |

| |$m |$m |

|Operating profit (36.0 + 10.0) |46.0 |46.0 |

|Loan interest payable |(4.0) |(7.2) |

|Profit before taxation |42.0 |38.8 |

|Tax (25%) |(10.5) |(9.7) |

|Profit for the year |31.5 |29.1 |

[2]

(a)(ii)

Expected EPS

Share issue = $31.5m / 76.0 (W1) = $0.41 [1]

W1 $30m/$0.50 + 40m/($0.50 + $2.0) = 76.0

Loan notes issue = $29.1m / 60.0 = $0.49 [1]

(a)(iii)

Expected level of gearing

Share issue = [pic] [1]

Loan notes issue = [pic] [1]

(b)

The calculations in (a) above indicate that expected EPS is higher under the loan notes option than under the share option. It is also higher than the current earnings per share figure of 40·0p. This increase in return, however, comes at the cost of higher risk. The gearing ratio is much higher under the loan notes option than under the share option. It is also much higher than the current gearing ratio of 33·8%. Nevertheless, the interest cover ratios suggest that, under both options, operating profits comfortably cover interest charges. The interest cover ratio is 11·4 times for the share option and 6·4 times for the loan option. Shareholders must, therefore, consider whether the expected increase in the level of risk is acceptable for the expected increase in returns.

[2 marks]

Under the share option there would be an almost 27% increase in the number of shares in issue. This is a significant increase and, if existing shareholders are expected to subscribe to the share issue, will represent a substantial additional investment on their part. If shareholders, however, are unable or unwilling to participate in the issue, the amount to be raised will have to come from outside investors. As a consequence, existing shareholders will suffer a significant dilution in their ownership and control of the company.

[2 marks]

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