ACCA Paper F9 Financial Management December 204 to June 205 Interim Assessment Answers To gain maximum benefit, do not refer to these answers until you have completed the interim assessment questions and submitted them for marking.
ACCA F9 : FINANCIAL MANAGEMENT Kaplan Financial Limited, 204 The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials. All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing. 2 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS SECTION A C The IRR is based on discounted cash flow principles. It therefore considers all of the cash flows in a project (A), does not include accounting costs such as depreciation (B) and it considers the time value of money (D). It is not an absolute measure of return, however, as the IRR is expressed as a percentage. Two projects can have the same IRR but very different cash flows. 2 B Maximising profits and cash flows should only be the objective if this would maximise shareholder wealth. Shareholder wealth is the primary consideration, not total company value (shares plus long-term debt capital.) 3 C Depreciation and profits and losses on sales are accounting entries only. The only amount that will appear in the cash budget is the receipt of the $7,600 sale proceeds. 4 B The transactions motive means that a business holds cash to meet its current day-to-day financial obligations. 5 C NPV $ Project E 6,000 + 900 / 0. 3,000 Project F 8,000 +,000 / 0. 2,000 Project G 0,000 + 3,500 / 0. 25,000 Project H 2,000 + 3,600 / 0. 24,000 Project I 20,000 + 4,600 / 0. 26,000 The projects are indivisible, the maximum NPV must be determined by trial and error. Feasible combination NPV $ E + F 5,000 E + G 28,000 E + H 27,000 F + G 27,000 F + H 26,000 I 26,000 The best combination is E + G, where NPV = $28,000 6 B The payback is most likely to take post-tax cash flows. KAPLAN PUBLISHING 3
ACCA F9 : FINANCIAL MANAGEMENT 7 A 8 A 9 C 0 B D 2 B Time Tax Tax cash flow Time paid WDV $ $ 0 24,000 0 25% tax-allowable depreciation (6,000),800 t 0 8,000 25% tax-allowable depreciation (4,500),350 t 3,500 2 25% tax-allowable depreciation (3,375),03 t 2 0,25 The other objectives are non-financial ( + Money rate) = ( + Real rate) ( + Inflation rate).989 = (.3) ( + Inflation rate) Inflation rate = 6.% The quick (liquidity) ratio is current assets (excluding inventory) divided by current liabilities. As inventory is excluded from the ratio any change in inventory levels would have no effect on the ratio unless either other current assets (such as cash at bank) or current liabilities are also affected. If inventory levels are financed by an increase in the bank overdraft then the denominator of the ratio would increase, reducing the ratio itself. This will always be the case, regardless of the relative values of current assets and current liabilities. 5% + ((3,670 / (3,670 +,390)) (8% - 5%) = 7.2% Project because it has the higher net present value. The PV method is superior to all other criteria for investment appraisal. 4 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS 3 A 4 B 5 B This is calculated as follows: Year Cash flow ($) Cumulative cash flow ($) 0 (325,000) (325,000) 50,000 (275,000) 2 50,000 (225,000) 3 50,000 (75,000) 4 50,000 (25,000) 5 50,000 (75,000) 6 50,000 (25,000) 7 25,000 0 This means the payback period is exactly 7 years. The ARR in this question is defined as average annual profits divided by the average investment. In year profits are $2,000 less depreciation of ($60,000/0), i.e. -$8,000 In year 2 profits are $3,000 less depreciation of $6,000, i.e. $7,000 In year 3 profits are $20,000 less depreciation of $6,000, i.e. $4,000 In year 4 to 6 profits are $25,000 less depreciation of $6,000, i.e. $9,000 In year 7 to 0 profits are $30,000 less depreciation of $6,000, i.e. $24,000 The average profits are therefore: ( 8,000 + 7,000 + 4,000 + (9,000 x 3) + (24,000 4)) / 0 = $66,000 / 0 = $6,600 The investment in year is $60,000 and the investment in year 0 is $nil. The average investment is therefore ($60,000) / 2 = $30,000 The ARR is therefore $6,600 / $30,000 = 55% The EV technique ignores the investor s attitude to risk (A). Sensitivity analysis does not assess the likelihood of a variable changing (C). It only identifies how far a variable needs to change and does not look at the probability of such a change. The lower the sensitivity margin, the more sensitive the decision to the particular parameter being considered (D), i.e. Small changes in the estimate could change the project decision from accept to reject. KAPLAN PUBLISHING 5
ACCA F9 : FINANCIAL MANAGEMENT 6 A 7 A 8 B 9 A Project Weather Probability (p) Project NPV (x) px $000 $000 Sunshine 0.7 00 70 Rain 0.3,400 420 490 Project 2 Weather Probability (p) Project NPV (x) px $000 $000 Sunshine 0.7 0 0 Rain 0.3 600 80 80 Project 3 Weather Probability (p) Project NPV (x) px $000 $000 Sunshine 0.7 80 26 Rain 0.3 200 60 86 Project 4 Weather Probability (p) Project NPV (x) px $000 $000 Sunshine 0.7 50 35 Rain 0.3 600 80 25 Both statements are true. An organisation achieving economy, efficiency and effectiveness in each part of its system is considered to be providing good value for money. At least half of the members of the board, excluding the chairman, should be independent non-executive directors. 6 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS 20 C This is simply a standard perpetuity with one additional payment at T0. Step : Calculate the perpetuity factor: /0.0 = 0 Step 2: Add : 0 + = Step 3: Calculate the present value: 2,000 = $23,000 KAPLAN PUBLISHING 7
ACCA F9 : FINANCIAL MANAGEMENT SECTION B AGD CO Key answer tips To evaluate lease v buy in part (a) the examiner s preferred approach is to perform two separate calculations. A combined approach will also gain credit but be careful of the signs of cash flows. (a) Tutorial note Particular care is needed regarding the timing of the cash flows. The asset would be bought on the first day of a new accounting period and, in this question, the tax flows are paid one year in arrears. When evaluating the leasing option remember that the lease payments are in made advance. Borrowing to buy evaluation Year 0 Year Year 2 Year 3 Year 4 $000 $000 $000 $000 $000 Purchase and sale (320) 50 Capital allowance tax benefits 24 8 Maintenance costs (25) (25) (25) Maintenance cost tax benefits 8 8 8 Net cash flow (320) (25) 7 5 47 Discount factors (7%).000 0.935 0.873 0.86 0.763 Present values (320) (23) 6 42 36 PV of borrowing to buy = $259,000 Workings: Capital allowance tax benefits Year Capital allowance Tax benefit Timing 320,000 0.25 = 80,000 80,000 0.3 = 24,000 Year 2 2 80,000 0.75 = 60,000 60,000 0.3 = 8,000 Year 3 3 Balancing allowance =30,000 30,000 0.3 = 39,000 Year 4 Balancing allowance = (320,000 50,000) (80,000 + 60,000) = $30,000 8 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS Leasing evaluation Year 0 Year Year 2 Year 3 Year 4 $000 $000 $000 $000 $000 Lease rentals (20) (20) (20) Lease rental tax benefits 36 36 36 Net cash flow (20) (20) (84) 36 36 Discount factors (7%).000 0.935 0.873 0.86 0.763 Present values (20) (2) (73) 29 27 PV of leasing = $249,000 On financial grounds, leasing is to be preferred as it is cheaper by $0,000. Note that the first lease rental is taken as being paid at year 0 as it is paid in the first month of the first year of operation. Tutorial note An alternative form of evaluation combines the cash flows of the above two evaluations. Because this evaluation is more complex, it is more likely to lead to computational errors. Combined evaluation Year 0 Year Year 2 Year 3 Year 4 $000 $000 $000 $000 $000 Purchase and sale (320) 50 Capital allowance tax benefits 24 8 39 Maintenance costs (25) (25) (25) Maintenance cost tax benefits 8 8 8 Lease rentals saved 20 20 20 Lease rental tax benefits lost (36) (36) (36) Net cash flow (200) 95 9 5 Discount factors (7%).000 0.935 0.873 0.86 0.763 Present values (200) 89 79 2 8 The PV of $2,000 indicates that leasing would be $2,000 cheaper than borrowing. The difference between this and the previous evaluation is due to rounding. (b) (i) The use of the after-tax cost of borrowing as the discount rate reflects that the lease v buy decision is actually a financing decision and not an investment decision. When evaluating whether the investment in the machine would be of benefit to the company (including all associated costs and revenue) the appropriate discount rate would be the company s cost of capital. KAPLAN PUBLISHING 9
ACCA F9 : FINANCIAL MANAGEMENT (a) ACCA marking scheme Purchase price Sales proceeds Tax-allowable depreciation including balancing allowance Capital allowance tax benefits Maintenance costs Maintenance costs tax benefits Discount factors NPV of borrowing to buy Lease rentals Lease rentals tax benefits NPV of leasing Selection of cheapest option Maximum Marks 0.5 0.5 3.5 0.5 3 (b) Total Use of after-tax borrowing cost 2 5 0 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS 2 OBJECTIVES AND STAKEHOLDERS Key answer tips In part (a) ensure you cover both the explanation of what causes the differences in objectives as well as the potential conflicts. Many students will find part (b) tricky in the absence of any scenario to guide them. The highlighted words are key phrases that markers are looking for. (a) (b) It may be argued that managers and owners of a business may not have the same interests because of the divorce between ownership and control. In many organisations, the shareholders will have very little influence over the day to day operations and management of the business. Managers will be aware of the need to seek to increase the wealth of the shareholders, but at the same time they may be equally concerned to serve their own needs/interests. For example, shareholders may be highly risk averse, looking only for reasonable and steady income from their investment. By contrast, a manager may by nature be more of a risk taker, because he considers that his career may progress faster if he is successful in the risks taken. In such a scenario, if the manager follows his instincts in selecting business opportunities, then the shareholders objectives are not met. The reverse situation may be equally true, whereby shareholders believe that management are excessively cautious in their selection of business opportunities, but management are very wary of taking risks as they wish to avoid large scale losses which might threaten their personal position. In both instances there is a gulf between the objectives of the manager and owners. Another example of where objectives might conflict is in the case of mergers and takeovers. If a company has been reporting poor results and becomes the victim of a take-over bid, the shareholders are likely to be pleased as they will see an increase in the value of their investment. In contrast, the managers of the victim company may well be very unhappy, as they sense the risk of redundancy. Williamson suggested that many of the aims of managers actually work in direct conflict with those of the owners, because managers look for perquisites and self aggrandisement, which add to company costs. Shareholders may be happy if the managers owned Ford Mondeos for company cars. The managers may well seek to have Mercedes instead! Similarly, having a large office and many staff to supervise is good for a manger s self esteem, but they may not be essential to the efficient running of the business; owners may be better off without them. One key area where owner-manager objectives may conflict is in terms of the time horizon used to judge success. Owners are often looking long-term in setting their objectives whereas a manager may need to have short-term successes on order to further his/her career prospects. The concept that the primary financial objective of the firm is to maximize the wealth of shareholders, by which is meant the net present value of estimated future cash flows, underpins much of modern financial theory. Achievement of this goal can be pursued, at least in part, through the setting of specific subsidiary targets in terms of items such as return on investment and risk adjusted returns. KAPLAN PUBLISHING
ACCA F9 : FINANCIAL MANAGEMENT A widely adopted approach is to seek to maximize the present value of the projected cash flows. In this way, the objective is both made measurable and can be translated into a yardstick for financial decision making. It cannot be defined as a single attainable target but rather as a criterion for the continuing allocation of the company s resources. There is some debate as to whether wealth maximisation should or can be the only true objective. The stakeholder view of corporate objectives is that many groups of people have a stake in what the company does. Each of these groups, which include suppliers, employees, customers and governments as well as shareholders, has its own objectives, as this means that a compromise is required. The company has responsibilities towards many groups in addition to the shareholders, including: Employees: to provide good working conditions and remuneration, the opportunity for personal development, outplacement help in the event of redundancy etc. Customers: to provide a product of good and consistent quality, good service and communication, and open and fair commercial practice The public: to ensure responsible disposal of waste products There are many other interest groups that should also be included in the discussion process. Non-financial objectives may often work indirectly to the financial benefit of the company in the long term, but in the short term they do often appear to compromise the primary financial objectives. ACCA marking scheme Marks (a) Separation of ownership and control Importance of different time horizons Importance of different attitudes to risk Examples of potential conflicts mark each maximum of 2 Maximum 2 5 (b) Total 2 marks for each valid point, to a maximum of 5 0 2 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS 3 DONAC CO Key answer tips There is plenty you could write about to answer this question, so much so that you need to be disciplined to ensure you don t go over the top. For each part of the requirement, think about how many points you will need to cover in order to score the number of marks available. This should help to ensure you address all areas within the time available. The highlighted words in the written sections are key phrases that markers are looking for. (a) Overtrading occurs when a company is growing rapidly but does not have enough long-term finance. Imagine starting a business with $,000 borrowed from the bank when the business expands rapidly. As the scale of operations continues that $,000 won't go far and the business will soon run out of cash. In particular: it won't have enough cash to buy inventory it won't have enough cash to buy non-current assets it won't have enough cash to pay expenses. The implications of these constraints are likely to be that the business will: buy inventory on credit and take as long as possible to pay rent or lease non-current assets rather than buy them delay paying business expenses. Such a business badly needs more long-term finance to underpin its rapidly expanding operations. Instead overtrading firms rely on short-term finance like trade payables or bank overdrafts. Their desire for cash flow will encourage them to get the money owed from receivables as quickly as possible (usually by offering cash discounts for early payment) or give discounts (i.e. earn lower profit margins) for cash purchases. (b) (i) The operating cycle is the period of time between paying for materials and receiving the cash from the eventual sale. The significance of it is that funds will be needed for this period of time. For 20X the operating cycle is as follows: Closing inventory Inventory days 365 Cost of sales + Receivable s Receivables days 365 Sales Payables Payables days 365 Cost of sales = Operating cycle 420 365 = 58 days (2,900 260) 570 2,900 365 = 72 days 50 365 = 7 days (2,900 260) 59 days KAPLAN PUBLISHING 3
ACCA F9 : FINANCIAL MANAGEMENT (ii) The three main ways that this cycle can be reduced are by: taking longer to pay payables selling inventory more quickly getting receivables money in more quickly. None of these options is necessarily the right strategy: If paying payables is delayed by too long this may jeopardise future availability of credit. Increasing inventory turnover can be achieved by holding less inventory; but this increases the risk of a stockout. It can also be achieved by lowering prices thereby reducing profit margins. If customers are not offered similar credit terms to what is available elsewhere, then they might transfer their business. Giving high cash discounts can be expensive. ACCA marking scheme Marks (a) Up to 2 marks for each valid point, to a maximum of 5 (b) (i) Explanation 2 Calculation 4 Maximum 6 (ii) 2 marks for each valid point, to a maximum of 4 Total 5 4 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS 4 NUTCRACKER Key answer tips This is a reasonably straightforward question that tests your ability to use two of the investment appraisal techniques The highlighted words in the written sections are key phrases that markers are looking for. (a) (i) Year 0 2 3 4 $000 $000 $000 $000 $000 Revenue see Note 2) 7,200 7,560 7,938 8,335 Variable production costs (5,600) (5,824) (6,057) (6,299) (see Note 2) Fixed production costs (see Note 3) (20) (22) (232) (244) Investment (4,000) Working capital (see Note 4) (500) 500 Net cash flow (4,500),390,55,649 2,292 Discount factor 5% (Note 5).000 0.870 0.756 0.658 0.572 Present value (4,500),209,45,085,3 The Net Present Value is $250,000 the project seems acceptable. Notes: () The research and development costs of $00,000 are sunk and are therefore ignored. (2) The price and variable production cost information is for year so start inflating for year 2. (3) The fixed production costs include depreciation. For DCF techniques, we only use cash flows, so depreciation must be removed. The investment is $4 million with no residual value. Since depreciation is straight line, and the expected life is four years, this amounts to $ million per annum so the incremental fixed production overheads cash flow is $200,000 in current day terms. This will inflate by 5% per annum (4) It is assumed that the working capital will be released at the end of the project. (5) Since we have money cash flows, use the money rate of interest. KAPLAN PUBLISHING 5
ACCA F9 : FINANCIAL MANAGEMENT (ii) To calculate the IRR, calculate the NPV at a higher rate of interest, for example 20%: Year 0 2 3 4 Net cash flow (4,500),390,55,649 2,292 Discount factor (20%).000 0.833 0.694 0.579 0.482 Present value (4,500),58,05 955,05 (b) Net present value = ($23,000) 250 The IRR = 5 + (20 5) = 7.6% this exceeds the cost of capital (250 + 23) and hence also shows the project to be acceptable. The investment proposal has a positive NPV of $250,000 at the company s money cost of capital of 5% and is therefore financially acceptable. The results of the other investment appraisal methods will not change this conclusion of financial acceptability since only the NPV method is directly linked to the objective of maximisation of shareholder wealth. The IRR method would also indicate that the project should be accepted since the return delivered is 7.6%, higher than the return required by the company (cost of capital) of 5%. (a) (i) Revenue Variable production costs Fixed production costs R&D sunk cost Investment Working capital Discount factors NPV ACCA marking scheme (ii) NPV at a higher percentage than 5% Calculation of IRR Maximum Maximum Marks.5.5 0.5 0.5 0.5 0.5 6 2 (b) Total Discussion of investment appraisal findings Advice on acceptability of project Maximum 2 0 6 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS 5 LVM CO Key answer tips Part (a) involves some fairly straightforward calculations although to score well you must ensure you comment on your findings. Part (b) offers an opportunity for some relatively easy marks but you must ensure you relate your comments to the scenario presented. The highlighted words are key phrases that markers are looking for. (a) (b) Cost of the current ordering policy Annual demand = $4,000,000 $50 = 80,000 Order size = 0% of 80,000 = 8,000 units per order Number of orders per year = 80,000 8,000 = 0 orders per year Annual ordering cost = 0 $300 = $3,000 per year Holding cost = $3.00 (8,000 2) = $2,000 per year Total cost of current policy = $3,000 + $2,000 = $5,000 per year Cost of the ordering policy using the EOQ model Order size = (2 $300 80,000 $3.00) 0.5 = 4,000 units Number of orders per year = 80,000 4,000 = 20 orders per year Annual ordering cost = 20 $300 = $6,000 per year Holding cost = $3.00 (4,000 2) = $6,000 per year Total cost of amended policy = $6,000 + $6,000 = $2,000 per year Change in costs of inventory management by using EOQ model Decrease in costs = $5,000 $2,000 = $3,000 Tutor s top tips: When answering this part of the requirement you can easily draw upon the calculations you performed in part (a). The objectives of working capital management are often stated to be profitability and liquidity. These objectives are often in conflict, since liquid assets earn the lowest return and so liquidity is achieved at the expense of profitability. However, liquidity is needed in the sense that a company must meet its liabilities as they fall due if it is to remain in business. For this reason cash is often called the lifeblood of the company, since without cash a company would quickly fail. Good working capital management is therefore necessary if the company is to survive and remain profitable. KAPLAN PUBLISHING 7
ACCA F9 : FINANCIAL MANAGEMENT The fundamental objective of the company is to maximise the wealth of its shareholders and good working capital management helps to achieve this by minimising the cost of investing in current assets. Good credit management, for example, aims to minimise the risk of bad debts and expedite the prompt payment of money due from customers in accordance with agreed terms of trade. Taking steps to optimise the level and age of receivables will minimise the cost of financing them, leading to an increase in the returns available to shareholders. A similar case can be made for the management of inventory. It is likely that LVM Co will need to have a good range of inventory on its premises if customers needs are to be quickly met and their custom retained. Good inventory management, for example using techniques such as the economic order quantity model, ABC analysis, stock rotation and buffer stock management can minimise the costs of holding and ordering stock. The application of just-in-time methods of stock procurement and manufacture can reduce the cost of investing in inventory. Taking steps to improve inventory management can therefore reduce costs and increase shareholder wealth. Management of accounts payable is another area where LVM Co could improve. Accounts payable are effectively a free source of finance and so LVM Co could seek to take as long a credit period from its suppliers as possible. Care must be taken not to damage relationships as this could lead to indirect costs such as loss of goodwill, price increases or even lost sales if a supplier was to refuse to supply further items until payment is made. Taking further credit must also be balanced against the possibility of obtaining discounts for prompt payment. Cash budgets can help to determine the transactions need for cash in each budget control period, although the optimum cash position will also depend on the precautionary and speculative need for cash. Cash management models such as the Baumol model and the Miller-Orr model can help to maintain cash balances close to optimum levels. The different elements of good working capital management therefore combine to help the company to achieve its primary financial objective. (a) Current policy: Annual ordering cost Annual holding cost Total annual cost EOQ policy: Annual order size Annual ordering an holding cost Change in inventory management cost ACCA marking scheme Maximum Marks 0.5 0.5 5 (b) Total Objectives of working capital management Receivables management Inventory management Trade payables management Cash management Discussion and link to LVM Co Maximum Maximum 2 2 5 0 8 KAPLAN PUBLISHING