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Fundamentals Level Skills Module

Financial Management
Thursday 9 June 2011

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FOUR questions are compulsory and MUST be attempted. Formulae Sheet, Present Value and Annuity Tables are on pages 7, 8 and 9. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

ALL FOUR questions are compulsory and MUST be attempted 1 BRT Co has developed a new confectionery line that can be sold for $500 per box and that is expected to have continuing popularity for many years. The Finance Director has proposed that investment in the new product should be evaluated over a four-year time-horizon, even though sales would continue after the fourth year, on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both in current price terms) will depend on sales volume, as follows. Sales volume (boxes) Variable cost ($ per box) Total fixed costs ($) less than 1 million 280 1 million 119 million 300 18 million 229 million 300 28 million 339 million 305 38 million

Forecast sales volumes are as follows. Year Demand (boxes) 1 07 million 2 16 million 3 21 million 4 30 million

The production equipment for the new confectionery line would cost $2 million and an additional initial investment of $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 one year 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 and working capital would all experience inflation of this level. BRT Co uses a nominal after-tax cost of capital of 12% to appraise new investment projects. Required: (a) Assuming that production only lasts for four years, calculate the net present value of investing in the new product 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 could be 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 year five 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)

The finance director of AQR Co has heard that the market value of the company will increase if the weighted average cost of capital of the company is decreased. The company, which is listed on a stock exchange, has 100 million shares in issue and the current ex div ordinary share price is $250 per share. AQR Co also has in issue bonds with a book value of $60 million and their current ex interest market price is $104 per $100 bond. The current after-tax cost 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 Dividend per share (cents) 2006 1938 2007 2020 2008 2041 2009 2102 2010 2180

The finance director proposes to decrease the weighted average cost of capital of AQR Co, and hence increase its market value, by issuing $40 million of bonds at their par value of $100 per bond. These bonds would pay annual interest 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 following circumstances: (i) before the new issue of bonds takes place; (ii) after the new issue of bonds takes place. Comment on your findings. (b) Identify and discuss briefly the factors that influence the market value of traded bonds. (12 marks) (5 marks)

(c) Discuss the directors view that issuing traded bonds will decrease the weighted average cost of capital of AQR Co and thereby increase the market value of the company. (8 marks) (25 marks)

[P.T.O.

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 $417 per share. YNM Co has been experiencing trading difficulties due to a continuing depressed level of economic activity: Income statement information for recent years ending 31 March 2009 $m 293 48 245 73 172 2010 $m 266 53 213 64 149 2011 $m 253 55 198 59 139

Profit before interest and tax Finance charges (interest) Profit before tax Taxation expense Profit for the period

Statement of financial position information as at 31 March 2011 Ordinary shares, par value $1 Retained earnings Total equity 8% bonds, redeemable in two years time Total equity and non-current liabilities $m 190 885 $m

1075 500 1575

Note: the statement of financial position takes no account of any dividend to be paid. The ordinary share capital of YNM Co has not changed during the period under consideration and the 8% bonds were issued in 1998. Dividend and share price information 2008 Total cash dividend paid ($m) Share price at end of year ($/share) Average data on companies similar to YNM Co: Interest coverage ratio Long-term debt/equity (book value basis) 10 times 40% 594 2009 95 510 2010 95 459

Financial objective of YNM Co YNM Co has a declared objective of maximising shareholder wealth. Dividend decision YNM 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 decision YNM Co is also considering raising $50 million of new debt finance to support existing business operations.

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 meet its 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 company of using scrip dividends to reward shareholders. (6 marks) (25 marks)

[P.T.O.

(a) ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when peso interest rates were relatively cheap compared to dollar interest rates. Economic difficulties have now increased peso interest rates while dollar interest rates have remained relatively stable. ZPS Co must pay interest of 5,000,000 pesos in six months time. The following information is available. Spot rate: Six-month forward rate: Interest rates that can be used by ZPS Co: Peso interest rates: Dollar interest rates: Required: (i) Explain briefly the relationships between; (1) exchange rates and interest rates; (2) exchange rates and inflation rates. (5 marks) Borrow 100% per year 45% per year Deposit 75% per year 35% per year Per $ pesos 12500 pesos 12582 pesos 12805 pesos 12889

(ii) Calculate whether a forward market hedge or a money market hedge should be used to hedge the interest payment of 5 million pesos in six months time. Assume that ZPS Co would need to borrow any cash 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 manufacturing processes. 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 $750. The cost of ordering is $200 per order, while the cost of holding components in inventory is $100 per component per year. The supplier has offered either a discount of 05% for payment in full within 30 days, or a discount of 36% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding components in inventory would increase to $220 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 45% 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)

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 = Rf + i E rm Rf

()

(( ) )
(

The asset beta formula Vd 1 T Ve + a = e d Ve + Vd 1 T Ve + Vd 1 T

))

))

The Growth Model D0 1 + g

Po =

(r

Gordons growth approximation g = bre The weighted average cost of capital V V e d ke + k 1 T WACC = 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 b

F0 = S0

(1 + i ) (1 + i )
c b

[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 11 12 13 14 15 1% 0990 0980 0971 0961 0951 0942 0933 0923 0941 0905 0896 0887 0879 0870 0861 2% 0980 0961 0942 0924 0906 0888 0871 0853 0837 0820 0804 0788 0773 0758 0743 3% 0971 0943 0915 0888 0863 0837 0813 0789 0766 0744 0722 0701 0681 0661 0642 4% 0962 0925 0889 0855 0822 0790 0760 0731 0703 0676 0650 0625 0601 0577 0555 5% 0952 0907 0864 0823 0784 0746 0711 0677 0645 0614 0585 0557 0530 0505 0481 6% 0943 0890 0840 0792 0747 0705 0665 0627 0592 0558 0527 0497 0469 0442 0417 7% 0935 0873 0816 0763 0713 0666 0623 0582 0544 0508 0475 0444 0415 0388 0362 8% 0926 0857 0794 0735 0681 0630 0583 0540 0500 0463 0429 0397 0368 0340 0315 9% 0917 0842 0772 0708 0650 0596 0547 0502 0460 0422 0388 0356 0326 0299 0275 10% 0909 0826 0751 0683 0621 0564 0513 0467 0424 0386 0305 0319 0290 0263 0239 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

(n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

11% 0901 0812 0731 0659 0593 0535 0482 0434 0391 0352 0317 0286 0258 0232 0209

12% 0893 0797 0712 0636 0567 0507 0452 0404 0361 0322 0287 0257 0229 0205 0183

13% 0885 0783 0693 0613 0543 0480 0425 0376 0333 0295 0261 0231 0204 0181 0160

14% 0877 0769 0675 0592 0519 0456 0400 0351 0308 0270 0237 0208 0182 0160 0140

15% 0870 0756 0658 0572 0497 0432 0376 0327 0284 0247 0215 0187 0163 0141 0123

16% 0862 0743 0641 0552 0476 0410 0354 0305 0263 0227 0195 0168 0145 0125 0108

17% 0855 0731 0624 0534 0456 0390 0333 0285 0243 0208 0178 0152 0130 0111 0095

18% 0847 0718 0609 0516 0437 0370 0314 0266 0225 0191 0162 0137 0116 0099 0084

19% 0840 0706 0593 0499 0419 0352 0296 0249 0209 0176 0148 0124 0104 0088 0074

20% 0833 0694 0579 0482 0402 0335 0279 0233 0194 0162 0135 0112 0093 0078 0065 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

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

Where

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

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1% 0990 1970 2941 3902 4853 5795 6728 7652 8566 9471 1037 1126 1213 1300 1387 11% 0901 1713 2444 3102 3696 4231 4712 5146 5537 5889 6207 6492 6750 6982 7191

2% 0980 1942 2884 3808 4713 5601 6472 7325 8162 8983 9787 1058 1135 1211 1285 12% 0893 1690 2402 3037 3605 4111 4564 4968 5328 5650 5938 6194 6424 6628 6811

3% 0971 1913 2829 3717 4580 5417 6230 7020 7786 8530 9253 9954 1063 1130 1194 13% 0885 1668 2361 2974 3517 3998 4423 4799 5132 5426 5687 5918 6122 6302 6462

4% 0962 1886 2775 3630 4452 5242 6002 6733 7435 8111 8760 9385 9986 1056 1112 14% 0877 1647 2322 2914 3433 3889 4288 4639 4946 5216 5453 5660 5842 6002 6142

5% 0952 1859 2723 3546 4329 5076 5786 6463 7108 7722 8306 8863 9394 9899 1038 15% 0870 1626 2283 2855 3352 3784 4160 4487 4772 5019 5234 5421 5583 5724 5847

6% 0943 1833 2673 3465 4212 4917 5582 6210 6802 7360 7887 8384 8853 9295 9712 16% 0862 1605 2246 2798 3274 3685 4039 4344 4607 4833 5029 5197 5342 5468 5575

7% 0935 1808 2624 3387 4100 4767 5389 5971 6515 7024 7499 7943 8358 8745 9108 17% 0855 1585 2210 2743 3199 3589 3922 4207 4451 4659 4836 4988 5118 5229 5324

8% 0926 1783 2577 3312 3993 4623 5206 5747 6247 6710 7139 7536 7904 8244 8559 18% 0847 1566 2174 2690 3127 3498 3812 4078 4303 4494 4656 4793 4910 5008 5092

9% 0917 1759 2531 3240 3890 4486 5033 5535 5995 6418 6805 7161 7487 7786 8061 19% 0840 1547 2140 2639 3058 3410 3706 3954 4163 4339 4486 4611 4715 4802 4876

10% 0909 1736 2487 3170 3791 4355 4868 5335 5759 6145 6495 6814 7103 7367 7606 20% 0833 1528 2106 2589 2991 3326 3605 3837 4031 4192 4327 4439 4533 4611 4675 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

End of Question Paper