Financial Management

September/December 2015

Time allowed
Reading and planning:
Writing:

15 minutes
3 hours

This question paper is divided into two sections:

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

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level Skills Module

Section B ALL FIVE questions are compulsory and MUST be attempted

Please write your answers to all parts of these question on the lined pages within the Candidate Answer Booklet.
1

Gemlo Co is a company listed on a large stock market. Extracts from its current statement of financial position are as
follows:
$m
Equity
Ordinary shares ($1 nominal)
Reserves

$m

15
153

168

Non-current liabilities
6% Irredeemable loan notes
7% Loan notes

10
12

22

190

Gemlo Co is planning an expansion of existing business operations costing $10 million in the near future and is
assessing its current financial position as part of preparing a business case in support of seeking new finance. The
business expansion is expected to increase the profit before interest and tax of Gemlo Co by 20% in the first year.
The planned business expansion by Gemlo Co has already been announced to the stock market. Information on the
expected increase in profit before interest and tax has not yet been announced and the company has not decided on
how the expansion is to be financed.
The ordinary shares of the company are currently trading at $375 per share on an ex dividend basis. The
irredeemable loan notes have a cost of debt of 7%. The 7% loan notes have a cost of debt of 6% and will be redeemed
at a 5% premium to nominal value after seven years. The interest cover of Gemlo Co is 6 times.
Companies operating in the same business sector as Gemlo Co have an average debt/equity ratio of 40% on a market
value basis and an average interest cover of 9 times.
Required:
(a) Calculate the debt/equity ratio of Gemlo Co based on market values and comment on your findings.
(4 marks)
(b) Gemlo Co agrees with a bank that its business expansion will be financed by a new issue of 8% loan notes. The
company then announces to the stock market both this financing decision and the expected increase in profit
before interest and tax arising from the business expansion.
Required:
Assuming the stock market is semi-strong form efficient, analyse and discuss the effect of the financing and
profitability announcement on the financial risk and share price of Gemlo Co.
Note: Up to 2 marks for relevant calculations.

(6 marks)
(10 marks)

GXJ Co, whose home currency is the dollar, wishes to borrow 12 million for a period of six months in three months
time. The lending bank will fix the interest rate for the loan period at its prevailing lending interest rate when the loan
is taken out. The finance director of GXJ Co believes this lending interest rate could be a minimum of 35% per year
or a maximum of 55% per year. The uncertainty regarding the future interest rate is caused by the volatile state of
the economy and impending elections which could lead to a change in political leadership and direction. Interest on
the euro loan would be payable at the end of the loan period.
The finance director of GXJ Co would like to hedge the interest rate risk arising from the future loan and the companys
bank has offered a 39, 45%35% forward rate agreement.
The finance director is also concerned about the foreign currency risk associated with the euro interest payment which
would be due in nine months time.
The following exchange rates are available:
Spot rate (euro per $1)
Nine-month forward rate (euro per $1)

1796418306
1719117505

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

ZXC Co currently has income of $30 million per year, of which 80% is from credit sales, and a net profit margin of
10%. Due to fierce competition, ZXC Co has lost market share and is looking for ways to win back former customers
and to keep the loyalty of existing customers. The sales director has pointed out that a major competitor of ZXC Co
currently offers an early settlement discount of 05% for settlement within 30 days, while ZXC Co itself does not offer
an early settlement discount. He suggests that if ZXC Co could match this early settlement discount, annual income
from credit sales would increase by 20%.
Credit customers of ZXC Co take an average of 51 days to settle invoices. Approximately 05% of the companys credit
sales have historically become bad debts each year and written off as irrecoverable. The finance director has been
advised that offering an early settlement discount of 05% for payment within 30 days would increase administration
costs by $35,000 per year, while 75% of credit customers would be likely to take the discount. The credit controller
believes that bad debts would fall to 0375% of credit sales if the early settlement discount were introduced.
ZXC Co has an average short-term cost of finance of 4% per year. Assume that there are 360 days in each year.
Required:
(a) Evaluate whether ZXC Co should introduce the early settlement discount.

(6 marks)

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

[P.T.O.

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

Equity finance
Ordinary shares ($1 nominal)
Reserves

$m
1400
1120

280
28

252
76

176

$m

$m

250
1185

1435

Non-current liabilities
Current liabilities

360
383

2178

Total equity and liabilities

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

30%
10 times
2 times
15%

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

Argnil Co is appraising the purchase of a new machine, costing $15 million, to replace an existing machine which
is becoming out of date and which has no resale value. The forecast levels of production and sales for the goods
produced by the new machine, which has a maximum capacity of 400,000 units per year, are as follows:
Year
Sales volume (units/year)

1
350,000

2
380,000

3
400,000

4
400,000

The new machine will incur fixed annual maintenance costs of $145,000 per year. Variable costs are expected to be
$300 per unit and selling price is expected to be $565 per unit. These costs and selling price estimates are in
current price terms and do not take account of general inflation, which is forecast to be 47% per year.
It is expected that the new machine will need replacing in four years time due to advances in technology. The resale
value of the new machine is expected to be $200,000 at that time, in future value terms.
The purchase price of the new machine is payable at the start of the first year of the four-year life of the machine.
Working capital investment of $150,000 will already exist at the start of the four-year period, due to the operation of
the existing machine. This investment in working capital is expected to increase in nominal terms in line with the
general rate of inflation.
Argnil Co pays corporation tax one year in arrears at an annual rate of 27% and can claim 25% reducing balance
tax-allowable depreciation on the purchase price of the new machine. The company has a real after-tax weighted
average cost of capital of 6% and a nominal after-tax weighted average cost of capital of 11%.
Required:
(a) Using a nominal terms net present value approach, evaluate whether purchasing the new machine is
financially acceptable.
(10 marks)
(b) Discuss the reasons why investment finance may be limited, even when a company has attractive investment
opportunities available to it.
(5 marks)
(15 marks)

[P.T.O.

Formulae Sheet
Economic order quantity
2C0D

Ch
MillerOrr Model
Return point = Lower limit + (

1
spread)
3
1

3 transaction cost variance of cash flows 3

Spread = 3 4

interest rate

The Capital Asset Pricing Model

(( ) )

()

E ri = R f + i E rm Rf

The asset beta formula

Vd 1 T
Ve

a =
e +
d

V
+
V
1

T
V
+
V
1

T
d
d
e
e

))

))

The Growth Model

Po =

D0 1 + g

(r

Gordons growth approximation

g = bre
The weighted average cost of capital
V

e
d
k +
k 1 T
WACC =
e
Ve + Vd
Ve + Vd d

The Fisher formula

(1 + i) = (1 + r ) (1 + h)
Purchasing power parity and interest rate parity

S1 = S0

(1 + h )
(1 + h )
c

F0 = S0

(1 + i )
(1 + i )
c

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
2
3
4
5

0990
0980
0971
0961
0951

0980
0961
0942
0924
0906

0971
0943
0915
0888
0863

0962
0925
0889
0855
0822

0952
0907
0864
0823
0784

0943
0890
0840
0792
0747

0935
0873
0816
0763
0713

0926
0857
0794
0735
0681

0917
0842
0772
0708
0650

0909
0826
0751
0683
0621

1
2
3
4
5

6
7
8
9
10

0942
0933
0923
0914
0905

0888
0871
0853
0837
0820

0837
0813
0789
0766
0744

0790
0760
0731
0703
0676

0746
0711
0677
0645
0614

0705
0665
0627
0592
0558

0666
0623
0582
0544
0508

0630
0583
0540
0500
0463

0596
0547
0502
0460
0422

0564
0513
0467
0424
0386

6
7
8
9
10

11
12
13
14
15

0896
0887
0879
0870
0861

0804
0788
0773
0758
0743

0722
0701
0681
0661
0642

0650
0625
0601
0577
0555

0585
0557
0530
0505
0481

0527
0497
0469
0442
0417

0475
0444
0415
0388
0362

0429
0397
0368
0340
0315

0388
0356
0326
0299
0275

0350
0319
0290
0263
0239

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0901
0812
0731
0659
0593

0893
0797
0712
0636
0567

0885
0783
0693
0613
0543

0877
0769
0675
0592
0519

0870
0756
0658
0572
0497

0862
0743
0641
0552
0476

0855
0731
0624
0534
0456

0847
0718
0609
0516
0437

0840
0706
0593
0499
0419

0833
0694
0579
0482
0402

1
2
3
4
5

6
7
8
9
10

0535
0482
0434
0391
0352

0507
0452
0404
0361
0322

0480
0425
0376
0333
0295

0456
0400
0351
0308
0270

0432
0376
0327
0284
0247

0410
0354
0305
0263
0227

0390
0333
0285
0243
0208

0370
0314
0266
0225
0191

0352
0296
0249
0209
0176

0335
0279
0233
0194
0162

6
7
8
9
10

11
12
13
14
15

0317
0286
0258
0232
0209

0287
0257
0229
0205
0183

0261
0231
0204
0181
0160

0237
0208
0182
0160
0140

0215
0187
0163
0141
0123

0195
0168
0145
0125
0108

0178
0152
0130
0111
0095

0162
0137
0116
0099
0084

0148
0124
0104
0088
0074

0135
0112
0093
0078
0065

11
12
13
14
15

[P.T.O.

Annuity Table

(1 + r)n
Present value of an annuity of 1 i.e. 1
r
Where

r = discount rate
n = number of periods
Discount rate (r)

Periods
(n)

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0990
1970
2941
3902
4853

0980
1942
2884
3808
4713

0971
1913
2829
3717
4580

0962
1886
2775
3630
4452

0952
1859
2723
3546
4329

0943
1833
2673
3465
4212

0935
1808
2624
3387
4100

0926
1783
2577
3312
3993

0917
1759
2531
3240
3890

0909
1736
2487
3170
3791

1
2
3
4
5

6
7
8
9
10

5795
6728
7652
8566
9471

5601
6472
7325
8162
8983

5417
6230
7020
7786
8530

5242
6002
6733
7435
8111

5076
5786
6463
7108
7722

4917
5582
6210
6802
7360

4767
5389
5971
6515
7024

4623
5206
5747
6247
6710

4486
5033
5535
5995
6418

4355
4868
5335
5759
6145

6
7
8
9
10

11
12
13
14
15

10368
11255
12134
13004
13865

9787
10575
11348
12106
12849

9253
9954
10635
11296
11938

8760
9385
9986
10563
11118

8306
8863
9394
9899
10380

7887
8384
8853
9295
9712

7499
7943
8358
8745
9108

7139
7536
7904
8244
8559

6805
7161
7487
7786
8061

6495
6814
7103
7367
7606

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0901
1713
2444
3102
3696

0893
1690
2402
3037
3605

0885
1668
2361
2974
3517

0877
1647
2322
2914
3433

0870
1626
2283
2855
3352

0862
1605
2246
2798
3274

0855
1585
2210
2743
3199

0847
1566
2174
2690
3127

0840
1547
2140
2639
3058

0833
1528
2106
2589
2991

1
2
3
4
5

6
7
8
9
10

4231
4712
5146
5537
5889

4111
4564
4968
5328
5650

3998
4423
4799
5132
5426

3889
4288
4639
4946
5216

3784
4160
4487
4772
5019

3685
4039
4344
4607
4833

3589
3922
4207
4451
4659

3498
3812
4078
4303
4494

3410
3706
3954
4163
4339

3326
3605
3837
4031
4192

6
7
8
9
10

11
12
13
14
15

6207
6492
6750
6982
7191

5938
6194
6424
6628
6811

5687
5918
6122
6302
6462

5453
5660
5842
6002
6142

5234
5421
5583
5724
5847

5029
5197
5342
5468
5575

4836
4988
5118
5229
5324

4656
4793
4910
5008
5092

4486
4611
4715
4802
4876

4327
4439
4533
4611
4675

11
12
13
14
15

End of Question Paper