ACCA Professional Level Paper P4 Advanced Financial Management

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1 ACCA Professional Level Paper P4 Advanced Financial Management Mock Exam You are allowed three hours and 15 minutes to answer this question paper. You are strongly advised to carefully read ALL the question requirements before attempting the question concerning (that is, all parts and/or sub-questions). Answer ALL of the question in Section A. Answer TWO questions only from Section B. Maths Tables and Formulae are provided. The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper. Instructions: Take a few moments to review the notes on the inside of this page titled, 'Get into good exam habits now!' before attempting this exam. DO NOT OPEN THIS PAPER UNTIL YOU ARE READY TO START UNDER EXAMINATION CONDITIONS

2 Get into good exam habits now! Take a moment to focus on the right approach for this exam. Effective time management Watch the clock, allocate 1.95 minutes to each mark and move on if you get behind. Take a few moments to think what the requirements are asking for and how you are going to answer them. Remember one mark is usually allocated for each valid point you give in a discursive question. Effective planning This paper is in exactly the same format as the real exam. Read the requirements carefully: focus on mark allocation, question words (see below) and potential overlap between requirements. Identify and make sure you pick up the easy marks available in each question. Effective layout Present your numerical solutions using the standard layouts you have seen. Show and reference your workings clearly. With written elements try and make a number of distinct points using headings and short paragraphs. You should aim to make a separate point for each mark. Ensure that you explain the points you are making ie why is the point a strength, criticism or opportunity? Give yourself plenty of space to add extra lines as necessary, it will also make it easier for the examiner to mark. 2

3 Common terminology Advise To counsel, inform or notify Analyse Examine in detail the structure of Calculate/compute To ascertain or reckon mathematically Compare and contrast Show the similarities and/or differences Define Give the exact meaning of Describe Communicate the key features of Discuss To examine in detail by argument Distinguish Highlight the differences between Evaluate To appraise or assess the value of Explain Make clear or intelligible/state the meaning of Identify Recognise, establish or select after consideration Interpret Process information to explain its meaning Justify To produce reasons in support of List State short pieces of information on separate lines Prepare To make or get ready for use Recommend To advise on a course of action Summarise To express the most important facts of 3

4 SECTION A 50 MARKS [the indicative time for answering this section is 98 minutes] Compulsory question 1 Valtick Valtick plc is a company located in Wales which specialises in the production of digital clocks. A slump in demand during the last two years has meant that the company has moved into a loss-making situation. Prospects for the future are poor, unless the company can find new markets. Valtick's managing director has been to South America where she has been discussing a possible joint venture in the country of Marantinta. A company in Marantinta would like to use the technical expertise and patent rights of Valtick, and set up a manufacturing operation in Marantinta, which would sell clocks to the South American market, an area to which Valtick has never exported. Due to differences in labour costs the Marantintan company expects to manufacture the clocks for 40% less than it costs to manufacture in Wales. The Marantintan company has agreed that it would not export to Europe within the next four years. Valtick would be required to: (i) Provide 30% of the total capital of 45 million pesos required to establish production in Marantinta. 5 million pesos of the total capital would be for working capital, the remainder for depreciable fixed assets. (ii) Grant full patent rights to produce the clocks in Marantinta. The patent has four years until it expires. (iii) Provide technical expertise to assist in setting up the joint venture. (iv) Provide ongoing technical aid. The joint venture agreement would be for a period of four years, after which time a new agreement would be negotiated, or the Marantintan company would guarantee to buy Valtick's share of the venture, including future patent rights to produce the clocks for a sum of 30 million pesos, after any tax liabilities. The joint venture agreement would provide for equal share of profits or losses from the venture. The clocks are expected to sell in South America for a price in year 1 of 480 pesos per unit. Prices will then increase by the expected rate of inflation in Marantinta. 40,000 units are expected to be sold in South America in the first year, rising by 10% per year for the next three years. The joint venture would also sell an expected 10,000 units per year to the USA at a constant price of $30 per unit. Valtick currently exports similar clocks to the USA, providing a pre-tax contribution of 80,000 per year. Because of the cheaper price of clocks manufactured in Marantinta it is expected that 40% of these exports would be lost. Provision of initial technical assistance would cost Valtick 105,000, and ongoing aid would cost 50,000 per year in salaries, at current prices. Neither would be tax allowable expenses in Marantinta, although the salaries would be tax allowable in the UK. Use of the patent would have no cash cost, but would mean that the patent could not be sold to another South American company which was willing to pay a constant 40,000 per year for the patent. In year 1, direct costs in Marantinta will be 200 pesos per unit, and fixed costs 4 million pesos per annum; both of these costs are expected to increase by the inflation rate in Marantinta. Tax allowable depreciation in Marantinta is available at 50% per year on a reducing balance basis. The tax rate in Marantinta is 20% and in the UK 30%. A bilateral tax agreement exists between Marantinta and the UK. Tax is payable one year in arrears. 4

5 Expected inflation rates (%): UK Marantinta USA Years Years Spot exchange rates: Marantintan pesos 32.78/ Marantintan pesos 18.32/US$ Valtick's cost of capital is 14%. Because of the risk of operating in South America Valtick's finance director is proposing to use 18% as the cost of capital for the joint venture. Required (a) Discuss the advantages and disadvantages of establishing international operations by means of joint ventures. (11 marks) (b) Produce a report, to the Board, which evaluates whether Valtick plc should participate in the joint venture. Include as part of your evaluation discussion of: (i) The proposed financial contribution of Valtick and the Marantintan company to the joint venture, and (ii) Any other factors that you consider to be relevant to the decision State clearly any assumptions that you make. Relevant calculations should be included as part of your evaluation. (35 marks) Approximately 24 marks available for calculations, and 11 marks for discussion. Professional marks will be awarded for the report s clarity, presentation & style. (4 marks) (Total = 50 marks) (Total for Section A = 50 marks) 5

6 SECTION B 50 MARKS: TWO questions ONLY to be attempted [the indicative time for answering this section is 98 minutes] 2 Macawber Assume that it is now mid December. The finance director of Macawber lnc, has recently reviewed the company's monthly cash budgets for the next year. As a result of buying new machinery in three months time, his company is expected to require short-term financing of $20m for a period of six months until the proceeds from a factory disposal became available. The finance director is concerned that, as a result of increasing wage settlements, the Central Bank will increase interest rates in the near future. LIBOR is currently 6% per annum and Macawber can borrow at LIBOR + 0.9%. Derivative contracts may be assumed to mature at the end of the relevant month. Three types of hedge are available: (1) Three month futures ($500,000 contract size, $12.50 tick size) December March June (2) Options on three month sterling futures ($500,000 contract size, premium cost in annual %) Calls Puts December March June December March June (3) FRA prices: 3 v v v Required (a) Prepare a report for the finance director, which: (i) Discusses the relative advantages and disadvantages of the three types of hedge (ii) Illustrates how the short-term interest rate risk might be hedged, and the possible results of the alternative hedges, if interest rates increase by 0.5% All relevant calculations must be shown. (17 marks) (b) The following five-year loan interest rates are available to Stentor Ltd, an AA credit rated company in the Macawber group, and to Evnor Ltd, a BB+ rated company. Stentor wants to borrow at a floating rate of interest, and Evnor wants to borrow at a fixed rate of interest. Fixed rate Floating rate Stentor 8.75% LIBOR % Evnor 9.50% LIBOR % A bank is willing to act as an intermediary to facilitate a five year swap, for an annual fee of 0.05% of the swap value. Both of these fees are payable by EACH of the companies. Taxation may be ignored. Evaluate, using an illustrative swap, whether or not an interest rate swap may be arranged that is beneficial to both companies. (8 marks) (Total = 25 marks) 6

7 3 Semer A proposal has been put to the board of directors of Semer Inc that the company should increase its capital gearing to at least 50%, in order to reduce the company's cost of capital and increase its market value. The managing director of Semer is not convinced by the logic of the proposal, or the accuracy of the calculations, but is unable to explain the reasons for his reservations. A summary of the proposal and its implications is shown below. Proposal to increase the capital gearing of Semer Inc The company's current weighted average cost of capital is estimated to be 10.6%. If the proportion of debt is increased to 50% of total capital, by the repurchase of ordinary shares at their current market value, the cost of capital may be reduced to 9.9%. A reduced cost of capital means that the value of the company will increase which will be welcomed by our shareholders. Calculations supporting the above proposal are shown below: Existing cost of capital Cost of equity using the capital asset pricing model: 4% + (10.5% 4%) 1.2 = 11.8% Cost of debt: 8% Weighted average cost of capital: 11.8% $350m + 8% $519m Estimated new cost of capital 11.8% $259.5m + 8% $519m $169m = 10.56% $519m $259.5m = 9.90% $519m Impact on the value of the company: $60m Current value = $568 million $60m Expected new value = $606 million Other information (a) The current price of Semer's ordinary shares is 410 cents. (b) The market price per $100 nominal value of 8% loan stock is $112. (c) The market return is 10.5% and the risk free rate 4.0%. (d) Semer's equity beta is 1.2. (e) Semer currently pays $15 million in dividends. (f) Most recent summarised statement of financial position Semer Inc $m Non-current assets (net) 442 Current assets 345 Less current liabilities (268) 519 Issued ordinary shares (50 cents par) 80 Reserves 270 Liabilities falling due after one year: 8% loan stock redeemable in 5 years ($100 par value) (g) The corporate tax rate is 30%. (h) The company currently generates a free cash flow of $60 million (after tax) per year, which is expected to increase by approximately 3% per year. 7

8 Required (a) Produce revised estimates of the company's current cost of capital and current value which correct for any mistakes. Brief explanation of the reasons for any revisions should be included. (13 marks) (b) Assuming that the cost of equity and cost of debt do not alter, estimate the effect of the share repurchase on the company's cost of capital and value. Discuss the advantages of the proposed strategy to increase gearing, and explain whether or not these estimates are likely to be accurate. (12 marks) (Total = 25 marks) 8

9 4 Lammer Lammer plc is a UK based company that regularly trades with companies in the USA. Several large transactions are due in five months' time. These are shown below. The transactions are in '000' units of the currencies shown. Assume that it is now 1 June and that futures and options contracts mature at the relevant month end. Exports to Imports from Company 1 $ Company 2 $890 Company $750 Exchange rates $US per Spot months forward year forward Annual interest rates available to Lammer plc Borrowing Investing Sterling up to 6 months 5.5% 4.2% Dollar up to 6 months 4.0% 2.0% CME $ per currency futures ( 62,500) September December CME currency options prices, $ per options 31,250 (cents per pound) CALLS PUTS Sept Dec Sept Dec Required (a) Prepare a report for the managers of Lammer plc on how the five-month currency risk should be hedged. Include in your report all relevant calculations relating to the alternative types of hedge. (20 marks) (15 marks are available for calculations and 5 marks for discussion) (b) In a typical financial year Lammer plc has net dollar imports of $4.2m. This is expected to continue for five years. The company's cost of capital is estimated to be 11% per year. Taxation may be ignored, and cash flows may be assumed to occur at the year end. Assuming that there is no change in the physical volume or dollar price of imports, estimate the effect on the expected market value of Lammer plc if the market expects the dollar to strengthen by 3% per year against the pound. (5 marks) (Total = 25 marks) 9

10 Formulae sheet Present value table Present value of 1 ie (1+r) n where Discount rates (r) Periods r = discount rate, n = number of periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% % 12% 13% 14% 15% 16% 17% 18% 19% 20%

11 Annuity Table 1 (1 r) n Present value of an annuity ie where r = discount rate, n = no. of periods r Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% % 12% 13% 14% 15% 16% 17% 18% 19% 20%

12 Standard normal distribution table (x ) Z This table can be used to calculate N(d 1), the cumulative normal distribution functions needed for the Black- Scholes model of option pricing. If d 1>0, add 0.5 to the relevant number above. If d 1<0, subtract the relevant number above from

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15 Student self-assessment Having completed this paper take a few minutes to consider what you did well and what you found difficult. Use this as a basis to focus your future study on effectively improving your performance. Common problems Future emphasis if you answer Yes Timing and planning Did you finish too early? Y/N Focus your planning time on generating more ideas. Use models to help develop breadth to your thinking. Did you overrun? Y/N Focus on allocating your time better. Practise questions under strict timed conditions. If you get behind leave space and move on. Did you waffle? Y/N Focus your planning time on developing a logical structure to your answer. Layout Was your answer difficult to follow? Y/N Use headings and subheadings. Use numbering sequences when identifying points. Leave space between each point. Did you fail to explain each point clearly? Y/N Show why the point identified answers the question set. Did you fail to show any workings or were your workings unclear? Y/N Give yourself time and space to make the marker's job easy. Content Did you struggle with: Interpreting the questions? Y/N Learn the meaning of common terminology (inside front cover). Learn subject jargon (key terms in study text). Read questions carefully noting all the parts. Practise as many questions as possible. Understanding the subject? Y/N Review your notes/text. Work through easier examples first. Classroom students please contact your tutor for further help. Home Study students please contact ACCA queries for further help (accaqueries@bpp.com). Remembering the notes/text? Y/N Quiz yourself constantly as you study. You need to develop your memory as well as your understanding of a subject. 15

16 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media Ltd. The contents of this book are intended as a guide and not professional advice. Although every effort has been made to ensure that the contents of this book are correct at the time of going to press, BPP Learning Media makes no warranty that the information in this book is accurate or complete and accept no liability for any loss or damage suffered by any person acting or refraining from acting as a result of the material in this book. BPP House, Aldine Place, London W12 8AA Tel: (for orders within the UK) Tel: +44 (0) Fax: +44 (0)

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