Institute of Chartered Accountant Ghana (ICAG) Paper 3.3 Advanced Financial Management

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1 Institute of Chartered Accountant Ghana (ICAG) Paper 3.3 Advanced Financial Management Final Mock Exam 1 Question paper Time allowed 3 hours Instructions: All five questions in this exam are compulsory and must be attempted. DO NOT OPEN THIS PAPER UNTIL YOU ARE READY TO START UNDER EXAMINATION CONDITIONS

2 ii Final Mock Exam 1: Questions Advanced Financial Management The Institute of Chartered Accountants Ghana First edition 2015 ISBN 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. Published by BPP Learning Media Ltd BPP House, Aldine Place London W12 8AA The Institute of Chartered Accountants Ghana 2015

3 ALL FIVE questions are compulsory and MUST be attempted Question 1 Final Mock Exam 1: Questions 1 DEF Ltd, a listed Ghanaian company, has a US subsidiary, ABC Co. ABC Co is expecting to receive $48,000,000 on 1 February 20X4, which will be invested until it is required for a large project on 1 June 20X4. Due to uncertainty in the markets, the company is of the opinion that it is likely that interest rates will fluctuate significantly over the coming months, although it is difficult to predict whether they will increase or decrease. ABC Co's treasury team want to hedge the company against adverse movements in interest rates using one of the following derivative products: Forward rate agreements (FRAs); Interest rate futures; or Options on interest rate futures. ABC Co can invest funds at the relevant inter-bank rate less 20 basis points. The current inter-bank rate is 4.09%. However, ABC Co is of the opinion that interest rates could increase or decrease by as much as 0.9% over the coming months. The following information and quotes are provided from an appropriate exchange on $ futures and options. Margin requirements can be ignored. Three-month $ futures, $2,000,000 contract size Prices are quoted in basis points at 100 annual % yield December 20X3: March 20X4: June 20X4: Options on three-month $ futures, $2,000,000 contract size, option premiums are in annual %. Calls Puts December March June Strike December March June V Bank has offered the following FRA rates to ABC Co: 1 7: 4.37% 3 4: 4.78% 3 7: 4.82% 4 7: 4.87% It can be assumed that settlement for the futures and options contracts is at the end of the month and that basis diminishes to zero at contract maturity at a constant rate, based on monthly time intervals. Assume that it is 1 November 20X3 now and that there is no basis risk. (a) Based on the three hedging choices ABC Co is considering, recommend a hedging strategy for the $48,000,000 investment, if interest rates increase or decrease by 0.9%. Support your answer with appropriate calculations and discussion. (15 marks) (b) A member of ABC Co's treasury team has suggested that if option contracts are purchased to hedge against the interest rate movements, then the number of contracts purchased should be determined by a hedge ratio based on the delta value of the option. Discuss how the delta value of an option could be used in determining the number of contracts purchased. (5 marks)

4 2 Final Mock Exam 1: Questions Question 2 The directors of M Ltd, a food retailer with 20 superstores, are proposing to make a takeover bid for S Ltd, a company with six superstores. M Ltd will offer four of its ordinary shares for every three ordinary shares of S Ltd. The bid has not yet been made public. Summarised statements of financial position as at 31 March 20X0 M Ltd S Ltd GHSm GHSm GHSm GHSm GHSm GHSm Land and buildings (net) Non-current assets (net) Current assets Inventory Receivables Cash Payables: amounts falling due in less than one year Trade payables* Taxation (481) (50.1) (97) 12.9 Payables: amounts falling due after more than one year 14% loan stock (200) Floating rate bank term loans (114) (17.5) Shareholders' Funds Original shares 25 Gp par Gp par 20.0 Reserves * Trade payables include dividends of GHS12m for M Ltd and GHS2m for S Ltd. Summarised income statements for the year ending 31 March 20X0 GHSm GHSm Turnover 1, Earnings before interest and tax Net interest (40) (2) Profit before tax Taxation (25) (4) Available to shareholders 50 8 Dividend (24) (5) Retained earnings 26 3 The current share price of M Ltd is 232 Gp, and of S Ltd 295 Gp. The current loan stock price of M Ltd is GHS125. Recent annual growth trends: M Ltd S Ltd Dividends 7% 8% EPS 7% 10% Rationalisation following the acquisition will involve the following transactions (all net of tax effects): (a) Sale of surplus warehouse facilities for GHS6.8m (b) Redundancy payments costing GHS9.0m (c) Wage savings of GHS2.7m per year for at least five years M Ltd's cost of equity is estimated to be 14.5%, and weighted average cost of capital 12%. S Ltd's cost of equity is estimated to be 13%.

5 Final Mock Exam 1: Questions 3 (a) Discuss and evaluate whether or not the bid is likely to be viewed favourably by the shareholders of both M Ltd and S Ltd. Include discussion of the factors that are likely to influence the views of the shareholders. All relevant calculations must be shown. (12 marks) (b) Discuss the possible effects on the likely success of the bid if the offer terms were to be amended to 325 Gp per share cash. (3 marks) (c) The directors of S Ltd have decided to fight the bid and have proposed the following measures: (i) Announce that their company's profits are likely to be doubled next year. (ii) Alter the Articles of Association to require that at least 75% of shareholders need to approve an acquisition. (iii) Persuade, for a fee, a third party investor to buy large quantities of the company's shares. (iv) Introduce an advertising campaign criticising the performance and management ability of M Ltd. (v) Revalue non-current assets to current values so that shareholders are aware of the company's true market values. Acting as a consultant to the company, give reasoned advice on whether or not the company should adopt each of these measures. (5 marks)

6 4 Final Mock Exam 1: Questions Question 3 The financial management team of T Ltd is discussing how the company should appraise new investments. There is a difference of opinion between two managers. Manager A believes that net present value should be used as positive NPV investments are quickly reflected in increases in the company's share price. It is also simpler to calculate than MIRR and APV. Manager B states that NPV is not good enough as it is only valid in potentially restrictive conditions, and should be replaced by APV (adjusted present value). T Ltd has produced estimates of relevant cash flows and other financial information associated with a new investment. These are shown below: GHS'000 Year Investment pre-tax operating cash flows 1,250 1,400 1,600 1,800 Notes 1 The investment will cost GHS5,400,000 payable immediately, including GHS600,000 for working capital and GHS400,000 for issue costs. GHS300,000 of issue costs is for equity, and GHS100,000 for debt. Issue costs are not tax allowable. 2 The investment will be financed 50% equity, 50% debt which is believed to reflect its debt capacity. 3 Expected company gearing after the investment will change to 60% equity, 40% debt by market values. 4 The investment equity beta is Debt finance for the investment will be an 8% fixed rate debenture. 6 Capital allowances are at 25% per year on a reducing balance basis. 7 The corporate tax rate is 30%. Tax is payable in the year that the taxable cash flow arises. 8 The risk free rate is 4% and the market return 10%. 9 The after tax realisable value of the investment as a continuing operation is estimated to be GHS1.5m (including working capital) at the end of year Working capital may be assumed to be constant during the four years. (a) Calculate the expected NPV, MIRR and APV of the proposed investment. (13 marks) (b) Discuss briefly the validity of the views of the two managers. Use your calculations in (a) to illustrate and support the discussion. (7 marks)

7 Question 4 Final Mock Exam 1: Questions 5 L Ltd is a large company manufacturing hand-held electronic devices such as mobile phones and tablet computers. The company has been growing rapidly over the last few years, but it also has high research and development expenditure. It is involved in a number of projects worldwide, developing new and innovative products and systems in a rapidly changing industry. Due to the nature of the industry, this significant growth in earnings has never been stable, but has depended largely on the success of the new innovations and competitor actions. However, in the last two years it seems that the rapid period of growth is slowing, with fewer products coming to market compared to previous years. L Ltd has never paid dividends and has financed projects through internally generated funds and with occasional rights issues of new share capital. It currently has insignificant levels of debt. The retained cash reserves have recently grown because of a drop in the level of investment in new projects. The company has an active treasury division which invests spare funds in traded equities, bonds and other financial instruments; and releases the funds when required for new projects. The division also manages cash flow risk using money and derivative markets. The treasury division is currently considering investing in three companies with the following profit after tax (PAT) and dividend history: Year T Ltd O Ltd K Ltd PAT Dividends PAT Dividends PAT Dividends GHS'000 GHS'000 GHS'000 GHS'000 GHS'000 GHS'000 20X7 57,100 22,840 93,300 60, ,400 44,100 20X6 54,400 21,760 90,600 57, ,500 34,200 20X5 52,800 21,120 88,000 54, ,900 26,300 20X4 48,200 19,280 85,400 52, ,700 20,250 20X3 45,500 18,200 82,900 49,740 78,300 15,700 All of the three companies' share capital has remained largely unchanged since 20X3. Recently, L Ltd's Board of Directors (BoD) came under pressure from the company's larger shareholders to start returning some of the funds, currently retained by the company, back to the shareholders. The BoD thinks that the shareholders have a strong case to ask for repayments. However, it is unsure whether to pay a special, one-off large dividend from its dividend capacity and retained funds, followed by small annual dividend payments; or to undertake a periodic share buyback scheme over the next few years. L Ltd is due to prepare its statement of profit or loss shortly and estimates that the annual sales revenue will be GHS600m, on which its profit before tax is expected to be 23% of sales revenue. It charges depreciation of 25% on a straight-line basis on its non-current assets of GHS220m. It estimates that GHS67m investment in current and non-current assets was spent during the year. It is due to receive GHS15m in dividends from its subsidiary companies, on which annual tax of 20% on average has been paid. L Ltd itself pays annual tax at 26%, and the tax authorities where L Ltd is based charge tax on dividend remittances made by overseas subsidiary companies, but give full credit on tax already paid on those remittances. In order to fund the new policy of returning funds to shareholders, L Ltd's BoD wants to increase the current estimated dividend capacity by 10%, by asking the overseas subsidiary companies for higher repatriations. (a) Discuss L Ltd's current dividend, financing and risk management policies, and suggest how the decision to return retained funds back to the shareholders will affect these policies. (6 marks) (b) Evaluate the dividend policies of each of the three companies that L Ltd is considering investing in, and discuss which company L Ltd might select. (6 marks) (c) Calculate, and briefly comment on, how much the dividends from overseas companies need to increase by, to increase L Ltd's dividend capacity by 10%. (6 marks) (d) Discuss the benefits to L Ltd's shareholders of receiving repayments through a share buyback scheme as opposed to the dividend scheme described above. (2 marks)

8 6 Final Mock Exam 1: Questions Question 5 T Ltd is a listed company based in Ghana and manufactures electronic devices. One of its devices, the X-IT, is produced exclusively for the Ghanaian market. T Ltd is considering ceasing the domestic production of the X-IT gradually over a period of four years because it needs the manufacturing facilities to make other products. The government of Gamala, a country based in south-east Asia, is keen to develop its manufacturing industry and has offered T Ltd first rights to produce the X-IT in Gamala and sell it to the Ghana market for a period of four years. At the end of the four-year period, the full production rights will be sold to a government-backed company for Gamalan Rupiahs. T Ltd has to decide whether to continue production of the X-IT in Ghana for the next four years or to move the production to Gamala immediately. It is anticipated that after four years the production of the X-IT will stop. It is expected that the financial impact of the gradual closure over the four years will be cost neutral (the revenue from sale of assets will equal the closure costs). The annual corporation tax rate in Gamala is 20% and T Ltd currently pays corporation tax at a rate of 30% per year. A bi-lateral tax treaty exists between Ghana and Gamala, which permits offset of overseas tax against any Ghanaian tax liability on overseas earnings. The Ghana and Gamalan tax authorities allow losses to be carried forward and written off against future profits for taxation purposes. T Ltd has decided to finance the project by borrowing the funds required in Gamala. The commercial borrowing rate is 13% but the Gamalan government has offered T Ltd a 6% subsidised loan for the entire amount of the initial funds required. The Gamalan government has agreed that it will not ask for the loan to be repaid as long as T Ltd fulfils its contract to undertake the project for the four years. T Ltd can borrow Cedi funds at an interest rate of 5%. All net cash flows arising from the project will be remitted back to T Ltd at the end of each year. There are two main political parties in Gamala: the Gamala Liberal (GL) Party and the Gamala Republican (GR) Party. Gamala is currently governed by the GL Party but general elections are due to be held soon. If the GR Party wins the election, it promises to increase taxes of international companies operating in Gamala and review any commercial benefits given to these businesses by the previous government. T Ltd has conducted a traditional Adjusted Present Value calculation which proved positive for the base case NPV calculation and funding implications. On this basis they are poised to go ahead, but are concerned about some of the wider implications of the project. (a) Discuss the potential change in government and business factors (other than the formal financial investment appraisal already conducted) that T Ltd should consider before deciding whether to proceed. (10 marks) (b) Although not mandatory for external reporting purposes, one of the members of the BoD suggested that adopting a triple bottom line approach when monitoring the X-IT investment after its implementation, would provide a better assessment of how successful it has been. (c) Discuss how adopting aspects of triple bottom line reporting may provide a better assessment of the success of X-IT. (5 marks) A member of the Board of Directors felt that, despite T Ltd having a wide range of shareholders holding well diversified portfolios of investments, moving the production of the X-IT to Gamala would result in further risk diversification benefits. Discuss whether moving the production of the X-IT to Gamala may result in further risk diversification for the shareholders already holding well diversified portfolios. (5 marks)

Institute of Chartered Accountant Ghana (ICAG) Paper 3.3 Advanced Financial Management

Institute of Chartered Accountant Ghana (ICAG) Paper 3.3 Advanced Financial Management Final Mock Exam 1 Marking scheme and suggested solutions DO NOT TURN THIS PAGE UNTIL YOU HAVE COMPLETED THE MOCK EXAM