CIMA F3 Workbook Questions

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1 CIMA F3 Workbook Questions

2 Lecture 1 Financial Strategy

3 Shareholder Wealth - Illustration 1 Year Share Price Dividend Paid c c c c c There are 2 million shares in issue.!!!!!!!!!!!! Calculate the increase in shareholder wealth for each year: II. Per share III. As a percentage IV. For the business as a whole

4 EPS - Illustration $ $ 000 PBIT Interest Tax Profit After Tax Preference Dividend Dividend Retained Earnings Share Capital (50c) Reserves Share Price $2.50 $2.80 Calculate the EPS for 2010 and 2011.

5 Lecture 2 Performance Measurement

6 Performance Analysis Illustration X1 X2 X3 Non Current Assets Current Assets Ordinary Shares ($1) Reserves Loan Notes Payables Revenue COS Gross Profit Admin Costs Distribution Costs PBIT Interest Tax Profit After Tax Dividends Retained Earnings Share Price $3.30 $4.00 $2.20 Using the information calculate and comment on the following Ratios: I. Return on Capital Employed II. Return on Equity III. Gross Margin IV. Net Margin V. Operating Margin VI. Revenue Growth VII. Gearing VIII. Interest Cover IX. Dividend Cover X. Dividend Yield XI. P/E Ratio

7 Lecture 3 Finance Sources

8 Rights Issue - Illustration 1 XYZ Ltd. intends to raise capital via a rights issue. The current share price is $8. They are offering a 1 for 4 issue at a price of $6. Calculate the Theoretical Ex-rights Price. Rights Issue - Illustration 2 ABC Ltd. has decided to raise capital via a rights issue. The share price is currently $5.50 and ABC intends to raise $5m. There are currently 6.25m shares in issue and ABC is offering a 1 for 5 rights issue. Calculate the Theoretical Ex-Rights Price.

9 Lecture 5 Investment Appraisal I

10 ARR - Illustration 1 ABC Ltd are considering expanding their internet cafe business by buying a business which will cost $275,000 to buy and a further $175,000 to refurbish. They expect the following cash to come in: Year Net Cash Profits ( ) 1 45, , , , , ,000 The equipment will be depreciated to a zero resale value over the same period and, after the sixth year, they can sell the business for $200,000 Calculate the ARR or ROCE of this investment

11 Relevant Cash Flow Criteria - Illustration 2 A business is considering investing in a new project. They have already spent $20,000 on a feasibility study which suggests that the project will be profitable. The headquarters of the company has spare floor space which will be allocated to the project with $7,000 of the current monthly rent allocated to the project. New equipment costing $2.5m will have to be bought and will be depreciated on a straight line basis over 10 years. A manager who earns $30,000 per year and currently runs a similar project will also manage the new project taking up 25% of his time. State whether each of the following items are relevant cash flows and explain your answer. I. The cost of the feasibility study. II. The rent charged to the project. III. The new equipment. IV. The depreciation on the new equipment. V. The Managers salary.

12 Payback Period - Illustration 3 Initial Investment of $5.8m. Annual Cash Flows of $400,000. Calculate the Payback Period. Payback Period - Illustration 4 Initial Investment of $6.2m. Cash Flows of: Year 1:! $1,200,000 Year 2:! $2,200,000 Year 3:! $2,500,000 Year 4:! $1,700,000 Calculate the Payback Period.

13 Discounted Cash-flows - Illustration 5 An investor wants a real return of 10%. Inflation is 5% What is the MONEY/NOMINAL rate required? Discounted Cash-flows - Illustration 6 A company undertakes a project with the following cash-flows: Year Cash-Flows 1 5, , , , , ,000 The company has a cost of capital of 10%. Calculate the present value of the cash flows for each of the six years and in total.

14 Discounted Cash-flows - Illustration 7 A company undertakes a project with the following cash-flows: Year Cash-Flows 1 5, , , , , ,000 The company has a cost of capital of 10%. Calculate the present value of the total cash flows for the six years Discounted Cash-flows - Illustration 8 A company expects to receive $100,000 per year forever. Their cost of capital is 10%. Calculate the present value of the perpetuity.

15 Lecture 6 Investment Appraisal II

16 WDA - Illustration 1 A business buys a piece of equipment for $100. Capital allowances are available at 25% reducing balance. The tax rate is 30% After the 4 year project the equipment can be sold for $25. Working Capital - Illustration 2 A business requires the following working capital investment into a four year project: Initial Investment:!! 30,000 Year 1!!! 35,000 Year 2!!! 45,000 Year 3!!! 32,000 Show the working capital line in the NPV calculation.

17 NPV - Illustration 3 A business is evaluating a project for which the following information is relevant: I. Sales will be $100,000 in the first year and are expected to increase by 5% per year. II. Costs will be $50,000 and are expected to increase by 7% per year. III. Capital investment will be $200,000 and attracts tax allowable depreciation of the full value of the investment over the 5 year length of the project. IV. The tax rate is 30% and tax is payable in the following year. V. Working Capital invested will be 20% of projected sales for the following year. VI. General inflation is expected to be 3% over the course of the project and the business uses a real discount rate of 9%. Calculate the NPV for the project.

18 Lecture 7 - Investment Appraisal III

19 Illustration 1 ABC has evaluated a project and come to the following conclusions. At a discount rate of 10% the NPV will be $100,000 At a discount rate of 15% the NPV will be -$75,000 What is the IRR?

20 Illustration 2 Initial Investment (5,000) Period Cash Flows 1 2,000 2 (1,000) 3 3, ,800 Cost of Capital 10% NPV = 1,216 IRR = 19% Calculate the MIRR.

21 Lecture 8 - Foreign NPV

22 Illustration 1 Item costs $1,000 /$ 1 : 2 However inflation in US is 5% and Eurozone 3% Calculate the exchange rate in one years time. Illustration 2 (i) US Interest rate = 10% UK Interest rate = 8% Exchange rate = /$ 1 : 2 Predict the exchange rate in 1 year Illustration 2 (ii) Current spot rate $/ 1 : 1 The dollar is expected to strengthen by 7% per anum Forecast the $: rate for the next 4 years.

23 Illustration 3 ABC Ltd. is a UK company intending to undertake a project in Foreignland where the currency is the Franc (FR). ABC uses a discount rate of 10% to evaluate projects in the UK and the current spot rate is / FR The risk free rate of interest in Foreignland is 5% with the UK rate being 7%. The initial investment in the project will be FR 400,000 with net cash inflows over a 5 year project of FR 150,000 per year. Ignore Tax. Calculate the NPV of the project. Illustration 4 ABC Ltd. is a UK company intending to undertake a project in Foreignland where the currency is the Franc (FR). ABC uses a discount rate of 16% to evaluate projects in the UK and the current spot rate is / FR The risk free rate of interest in Foreignland is 7% with the UK rate being 9%.

24 Illustration 5 ABC Ltd. is a UK company intending to undertake a project in Foreignland where the currency is the Franc (FR). ABC uses a discount rate of 20% to evaluate projects in the UK and the current spot rate is / FR Sterling is expected to appreciate against the Franc by 10% per year. Illustration 6 ABC Ltd. is a UK company intending to undertake a project in Foreignland where the currency is the Franc (FR). ABC uses a discount rate of 10% to evaluate projects in the UK and the current spot rate is / FR The risk free rate of interest in Foreignland is 5% with the UK rate being 7%. The initial investment in the project will be FR 400,000 with net cash inflows over a 5 year project of FR 150,000 per year. Ignore Tax. Calculate the NPV of the project by adjusting the discount rate.

25 Lecture 9 WACC I

26 Cost of Equity using DVM - Illustration 1 ABC Company has just paid a dividend of 35c. The current share price is $3.25. Calculate the Cost of Equity (Ke) using DVM. Cost of Equity using DVM - Illustration 2 ABC Company has just paid a dividend of 35c. The dividend paid has grown by 4% per year for the past 5 years. The current share price is $3.25. Calculate the Cost of Equity (Ke) using DVM. Cost of Equity using CAPM - Illustration 3 Company A has a Beta of 1.2. Government bonds are currently trading at 4%. The average return than investors in the market can expect is 15%. Calculate the Cost of Equity using CAPM.

27 Cost of Equity using CAPM - Illustration 4 Company A has a Beta of 1.2. Company B has a Beta of 1. Government bonds are currently trading at 5%. The average return than investors in the market can expect is 12%. Calculate the Cost of Equity using CAPM for each company. Cost of Equity using CAPM Illustration 5 Company A has a Beta of 1.3. Company B has a Beta of 1.2. Government bonds are currently trading at 5%. The average market risk premium is 6%. Calculate the Cost of Equity using CAPM for each company.

28 Lecture 10 WACC II

29 Irredeemable Debt - Illustration 1 A company has issued 10% irredeemable debt. The market value of the debt is $90. The tax rate is 30% Calculate the cost of debt (Kd). Redeemable Debt - Illustration 2 A Company has issued debt which is redeemable in 5 years time. Interest is payable at 8%. The current market value of the debt is $102. Ignore taxation. Calculate the Cost of Debt (Kd). Redeemable Debt - Illustration 3 A Company has issued debt which is redeemable in 5 years time. Interest is payable at 10%. The current market value of the debt is $104. Tax is payable at 30%. Calculate the Cost of Debt (Kd).

30 Convertible Debt - Illustration 4 A Company has issued debt which is convertible in 5 years time. Interest is payable at 10%. The current market value of the debt is $120. On conversion, investors will have a choice of either: I. Cash at a 15% premium; or II. 18 shares per loan note. The current share price is $6 and it is expected to grow in value by 4% per year. Tax is payable at 30%. Calculate the Cost of Debt (Kd). Preference Shares - Illustration 5 A company has issued 8% preference shares with a nominal value of $1. The market value of the shares is 80c. The tax rate is 30%. Calculate the cost of the preference shares (Kd).

31 Bank Debt - Illustration 6 A company has a bank loan of $2m at an interest rate of 10%. The tax rate is 30%. Calculate the cost of debt (Kd). WACC - Illustration 7 Company A is funded as follows: Item Capital Structure Cost Equity 85% 15% Debt 15% 7% Calculate the Weighted Average Cost of Capital.

32 WACC - Illustration 8 Company A is funded as follows: Balance Sheet Extract Ordinary Shares (50c) 3000 Loan Notes 2000 Bank Loan 1000 The cost to the company of each of the above items has been calculated as: Ordinary Shares 13% Loan Notes 8% Bank Loan 5% The Loan notes are currently trading at $94. The current share price is $1.50 Calculate the Weighted Average Cost of Capital.

33 WACC - Illustration 9 Company A is funded as follows: Balance Sheet Extract Ordinary Shares (50c) % Loan Notes % Preference Shares ($1) 500 Bank Loan 750 Details on these are as follows. The company has an equity beta of 1.2. Government bonds are currently trading at 6% and the average market risk premium is 7%. The Loan notes are currently trading at $106 and are redeemable at par in 5 years time. The preference shares are trading at 92c. The bank loan has an interest rate of 10%. The current share price is $1.25. The tax rate is 30%. Calculate the Weighted Average Cost of Capital.

34 Lecture 11 Capital Structure

35 Capital Structure - Illustration 1 A company has total capital of $1,000 with debt making up $300 and equity making up $700 of the total. The company s cost of debt is 5% and cost of equity is 14%. I. Calculate the company s current WACC. II. Calculate the WACC if the company substitutes $200 of equity for $200 of debt causing their cost of equity to rise to 16%. III. Calculate the WACC if the company substitutes $300 of equity for $300 of debt causing their cost of equity to rise to 25%.

36 Lecture 12 M & M Formulae

37 Illustration 1 ABC Ltd has a share price of 350c and 1m shares in issue. It currently has no debt. Current cost of capital is 13%. The directors have decided to replace $2m of equity with 10% debt. The tax rate is 30%. Required (i) Calculate the new value of the geared firm. (ii)calculate the value of the Equity in the geared firm. Illustration 2 ABC Co. and CD Co. operate in the same industry and are identical in their ability to generate cash flows. ABC Co. is financed by Equity only of 3m shares with current value of $1 and has a cost of equity calculated at 15%. CD Co. has the same total capital but within it has irredeemable debt with a market value of $0.9m. The tax rate is 33%. Required (i) Calculate the value of CD Co. (ii)calculate the value of the Equity in CD Co.

38 Illustration 3 ABC Co. and CD Co. operate in the same industry and are identical in their ability to generate cash flows. ABC Co. is financed by Equity only of 3m shares with current value of $1 and has a cost of equity calculated at 15%. CD Co. has the same total capital but within it has irredeemable debt with a market value of $0.9m and cost of debt of 8%. The tax rate is 33%. Required (i) Calculate the Cost of Equity for CD Co. Illustration 4 ABC Co. and CD Co. operate in the same industry and are identical in their ability to generate cash flows. ABC Co. is financed by Equity only of 3m shares with current value of $1 and has a cost of equity calculated at 15%. CD Co. has the same total capital but within it has irredeemable debt with a market value of $0.9m and cost of debt of 8%. The tax rate is 33%. Required (i) Calculate the WACC for CD Co.

39 Lecture 13 Risk Adjusted WACC

40 Risk Adjusted WACC - Illustration 1 Company A intends to undertake a project in an unrelated industry. The following details are relevant: Item Company A Proxy Company Equity Beta (βe) Value of Equity Value of Debt The risk free rate is 4%. The average return on the market is 12%. The post tax cost of debt is 7%. Calculate the risk adjusted WACC to be used in evaluating the project. Ignore Tax

41 Risk Adjusted WACC - Illustration 2 Company A intends to undertake a project in an unrelated industry. The following details are relevant: Item Company A Proxy Company Equity Beta (βe) Value of Equity Value of Debt The risk free rate is 4%. The average return on the market is 12%. The tax rate is 30%. The post tax cost of debt is 8%. Calculate the risk adjusted WACC to be used in evaluating the project.

42 Illustration 3 Company A Company B Debt/Equity 1/3 1/4 Equity Beta 1.2 Debt Beta 0.3 Assume that the Asset Beta and the Debt Beta of each firm is the same. Calculate the Equity Beta for Company B.

43 Lecture 14 APV

44 Illustration 1 Cost of Equity in Geared Firm = 12% Cost of Debt = 8% Debt/Equity ratio = 1/2 Tax rate = 30% Calculate the cost of equity in an ungeared firm. Illustration 2 Company AB has used $5m of 10% debentures to finance a project lasting for 4 years. The tax rate is 35%. Issue costs are 3% and are tax deductible. What is the PV of the issue costs for APV purposes? Illustration 3 Company AB has used $5m of 10% debentures to finance a project lasting for 4 years. The tax rate is 35%. Issue costs are 3% and are tax deductible. These are to be raised along with the finance. What is the PV of the issue costs for APV purposes?

45 Illustration 4 Company AB has used $5m of 10% debentures to finance a project lasting for 4 years. The tax rate is 35%. What is the PV of the tax relief available for APV purposes? Illustration 5 Company AC needs to raise $10m in debt finance for 4 years. Company AB has raised $7m of 10% debentures and the rest is provided by a subsidised government loan of $3m at 5%. The tax rate is 30%. Calculate the financing effects of the debt for APV purposes. Illustration 6 ABC Co. is considering a project which is expected to generate cash inflows of $500,000 per year for 5 years and cost $500,000 of initial investment. Costs have been estimated at $350,000 per year. ABC has a current cost of equity of 14% and a cost of debt of 7% and a current debt to equity ratio of 1/3. To undertake the the project the $500,000 will be raised through a bond issue of 8% with issue costs of 4% to be raised in addition to the finance. The tax rate is 30%.

46 Lecture 15 More Risk

47 Illustration 1 ABC Ltd is undertaking a project costing $900m with expected net cash flows of $400m in years 1 & 2 then $600m in year 3. The FD considers that these cash flows may be overestimated by as much as 10% in year 1, 15% in year 2 and 20% in year 3. The risk free rate is 5% Required Using certainty equivalents calculate the expected NPV of the project.

48 Lecture 16 Further Appraisal

49 Expected Values - Illustration 1 A business is considering 2 different projects. The likely profit made from each project is outlined below: Project A Project B Projected Profit Percentage Likely-hood Projected Profit Percentage Likely-hood $10,000 10% $10,000 15% $15,000 30% $15,000 25% $20,000 40% $20,000 30% $23,000 20% $23,000 30% Calculate the expected value for each of the projects. Sensitivity Margin - Illustration 2 A business is considering a project which will cost them an initial 20,000 The sales expected for the 2 year duration are 20,000pa. The variable costs are 2,000pa Cost of capital 10% Calculate the sensitivity margin of: I. The initial investment. II. III. The variable costs of the projects. The sales of the project.

50 Lease V Buy - Illustration 3 Machine cost $10,000 The Machine has a useful economic life of 5 years with no scrap value Capital allowances available at 25% reducing balance Finance choices 1) 5 year loan 14.28% pre tax cost 2) 5 year Finance $2,200 pa in advance If the machine is purchased then maintenance costs of $100 per year will be incurred. The tax rate is 30%. The leasing company will maintain the machine if it is leased. Should the company lease or buy the machine.

51 Equivalent Annual Cost - Illustration 4 Machine Cost 30,000 Running costs Year 1 10,000 Year 2 11,500 Residual Value (if sold after..) Year 1 19,000 Year 2 16,000 Cost of capital = 10% Is it better to replace the machine every year or to replace it every 2 years?

52 Lecture 17 Further Appraisal II

53 Profitability Index - Illustration 1 A business has identified the following projects. They have $200,000 to invest and the projects are divisible. Project Investment NPV A 90,000 15,000 B 110,000 25,000 C 50,000 10,000 D 75,000 22,000 E 70,000-8,000 Which projects should the business undertake?

54 Investment Choices - Illustration 2 A business has identified the following projects. They have $200,000 to invest and the projects are non-divisible. Project Investment NPV A 90,000 15,000 B 110,000 25,000 C 50,000 10,000 D 75,000 22,000 Which projects should the business undertake? Equivalent Annual Annuity - Illustration 3!!!! NPV Duration Project yrs Project yrs Project yrs Calculate the EEA of each project given a cost of capital of 10%

55 Lecture18 Working Capital

56 Working Capital Illustration Balance Sheet $ 000 ASSETS Non Current Assets 1000 Inventory 300 Receivables 200 Cash LIABILITIES Ordinary Shares 800 Reserves 200 Long term Liabilities 700 Payables 100 Overdraft Income Statement $ 000 Revenue 1000 COS 800 Gross Profit 200 Other Costs 100 Net Profit 100 Other Information: All sales are made on credit. Required: Calculate the Cash Operating Cycle for Inter Ltd.

57 Working Capital Illustration Part II Show the journal entries and calculate the Revised Balance sheet if the operating cycle changes to: Item Days Inventory Period 200 Collection Period 100 Less: Payables Period

58 Working Capital Illustration Part III Show the journal entries and calculate the Revised Balance sheet if the operating cycle changes to: Item Days Inventory Period 90 Collection Period 30 Less: Payables Period 60 60

59 Lecture 19 Business Valuations I

60 Net Assets Valuation Method Illustration 1 Non Current Assets 550,000 Current Assets 170,000 Current Liabilities -80,000 Share Capital 300,000 Reserves 200,000 10% Loan Notes 150,000 The Market Value of property in the Non Current Assets is $50,000 more than the book value. The Loan Notes are redeemable at a 5% premium. What is the value of a 70% holding using the net assets valuation basis?

61 DVM - Illustration 2 ABC pays a constant dividend of 45c. It has 3m ordinary shares. The shareholders require a return of 15%. What is the Value of the business? DVM - Illustration 3 A business has Share Capital made up of 50c shares of $3 million Dividend per share (just paid) 30c Dividend paid four years ago 22c Required Return = 12% Calculate the Value of the business using the dividend valuation method.

62 P/E Ratio Method - Illustration 4 X1 X2 X3 $ 000 $ 000 $ 000 Revenue COS Gross Profit Admin Costs Distribution Costs PBIT Interest Tax Profit After Tax Dividends Retained Earnings Industry P/E Average Calculate the Value of the Company for each of the 3 years using the P/E Ratio method.

63 P/E Ratio Method - Illustration 5 X1 X2 X3 $ 000 $ 000 $ 000 Revenue COS Gross Profit Admin Costs Distribution Costs PBIT Interest Tax Profit After Tax Dividends Retained Earnings Industry P/E Average Number of Shares 3m 3m 3m Calculate the Earnings Per Share for each of the 3 years Calculate the Value of the Company for each of the 3 years using the EPS you calculate.

64 Earnings Yield - Illustration 6 X1 X2 X3 $ 000 $ 000 $ 000 Revenue COS Gross Profit Admin Costs Distribution Costs PBIT Interest Tax Profit After Tax Dividends Retained Earnings Earnings Yield Number of Shares 4m 4m 4m Calculate the Earnings Per Share for each of the 3 years and the share price using the earnings yield.

65 Present Value of Future Cash Flows - Illustration 7 ABC Company earned $100,000 in cash inflows this year. They expect this to increase in each of the next 5 years by 5% and after that to increase by 2% forever. The company uses a cost of capital of 10%. Calculate the value of the company using the present value of future cash flows method.

66 Lecture19 Business Valuations I

67 Illustration 1 Company A has 100m shares at 3 each. Company B has 50m shares of 1 each. Company A makes an offer of 1 new shares for every 5 held in B and has worked out that the synergies available are valued at 20m Calculate the expected value of a share in the combined company. Illustration 2 Post Tax Profit P/E Ratio Pre Aq. Value Company A 150m m Company B 10m 7 70m Estimating the post acquisition value of the combined business is done by applying the P/E ratio of Company A to the combined earnings of the new combination.

F3 CIMA Q & A! CIMA F3 Workbook Questions & Solutions

F3 CIMA Q & A! CIMA F3 Workbook Questions & Solutions CIMA F3 Workbook Questions & s Lecture 1 Financial Strategy Shareholder Wealth - Illustration 1 Year Share Price Dividend Paid 2007 3.30 40c 2008 3.56 42c 2009 3.47 44c 2010 3.75 46c 2011 3.99 48c There