ACCA Paper F9 Financial Management Mock Exam Commentary, Marking scheme and Suggested solutions
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Suggested solutions Section A D Statement A is incorrect: Matching (not smoothing) is where liabilities and assets with a common interest rate are combined (matched). Statement B is incorrect: A futures contract is binding on both parties. Statement C is incorrect: A forward rate agreement (FRA) is an over the counter (OTC) contract. Statement D is correct: This is one of the benefits of an option. Syllabus area G4b 2 D The discounted payback period is the time it takes for a project's cumulative NPV to become positive. With a cost of capital of 0% and the cash flows shown below, we can calculate a discounted payback period. Discount Present Cumulative Year Cash flow factor value NPV $'000 0% $'000 $'000 0 (450).000 (450) (450) 30 0.909 8 (332) 2 30 0.826 07 (225) 3 30 0.75 98 (27) 4 30 0.683 89 (38) 5 50 0.62 93 55 The DPP is during year 5. DPP = 4 + (38/93) = 4.4 years Syllabus area D3d 3 A Both statements are true. Chartists attempt to predict share price movements by assuming that past patterns will be repeated. There is, however, no real theoretical justification for this approach. Efficient markets follow a random walk and therefore cannot be predicted. Syllabus area F4a/c 4 A Statement is true. By encouraging capital inflows, higher interest rates will tend to lead to an appreciation of the currency's exchange rate. Statement 2 is false. A higher interest rate encourages savings at the expense of consumer expenditure. Syllabus area Bc 5 A and 2 only. Statement is true. The wealth of shareholders in a company comes from dividends received and the market value of the shares. Statement 2 is true. Share prices may increase regardless of the decisions made by managers. Statement 3 is not true. EPS can be manipulated and does not reflect risk so a rise in EPS may not increase shareholder wealth. Syllabus area A2b 6 B Effectiveness can only be measured in terms of achieved performance. Economy consists of minimising costs, for example, by obtaining suitable inputs at the lowest price. Efficiency, in the narrow sense used here, consists of achieving the greatest output per unit of input: avoiding waste of inputs would contribute to this. Achieving a given level of profit is a measure of overall efficiency in its wider sense and would require proper attention to all three of these matters. Syllabus area A4b 3
7 A Statement is true. Companies can use money markets to create a transaction hedge. By using money markets they can bring forward the conversion from one currency to another so that the money can be converted at today's spot rate and currency risk can be avoided. Statement 2 is false. An option is a derivative which allows the buyer and seller to agree today to buy or sell an asset at some time in the future at a fixed price. Statement 3 is false. Certificates of deposit are negotiable ie they can be sold. Syllabus area B3a/c 8 C Statement is true and statement 2 is false. Operational gearing refers to the proportion of costs that are fixed. One approach to measuring this is to calculate contribution/profit before interest and tax (PBIT). Contribution only contains variable cost, whereas PBIT is after both variable and fixed cost. A higher ratio indicates a higher proportion of fixed costs. 9 B Optimal order size = 500 units Syllabus area E3d EOQ = EOQ = 2 order cost demand holding cost 2 200 0,000 $4 + (3% $400) EOQ = 500 Syllabus area C2c 0 A and 2 only. Statement is true and statement 2 is true. Statement 3 refers to financial accounting rather than financial management. Syllabus area Aa B P o = = d o (+ g) (r e g) 30 (.05) (0.7 0.05) From formula sheet = 262.5 = $2.625 Syllabus area F2c 2 D Both statements are false. Transaction risk (rather than translation risk) will arise on the interest payments. Transaction risk is the risk of a gain or loss in a transaction as a result of exchange movements. Translation risk is the risk that the organisation will make exchange losses when the accounting results are translated into home currency. 3 C 64.3 days Days Inventory days ((77/40) 365) 200.8 Receivables days ((56/280) 365) 73.0 Payables days ((42/40) 365) (09.5) 64.3 Syllabus area C3a 4
4 B Statement is false derivatives (eg futures) are money market instruments and these are exchange traded. Syllabus area B2a 5 A 8.84% P 0 = $95 = i ( T) K dnet $2 ( 0.3) K dnet $2 ( 0.3) K dnet = $95 = 0.0884 or 8.84% Syllabus area F3a 5
Section B 6 D Receivables period = Average receivables Credit sales 365 = 0.5 (700,000 + 750,000) 2 270,000 = 82 days Payables period = 7 B Inventory period = Average payables Cost of sales Average inventory Cost of sales 365 = 365 = 0.5 (650,000 + 595,000) 2 20,000 0.5 (400,000 + 468,000) 2 20,000 = 90 days = 63 days Cash operating cycle = 82 + 63 90 = 55 days 8 A Paying suppliers sooner would mean lower payables and therefore a higher operating cycle. Having lower receivables or holding lower inventory would create a lower operating cycle. Undercapitalisation means that too little capital has been raised this has no direct impact on the operating cycle. 9 C One of the features of overtrading is that there is a rapid increase in the volume of current assets. This may lead to a rise in the operating cycle, and can cause delays in payments to suppliers. 20 B Both the cash operating cycle and reported profits will reduce. Receivables paying sooner will reduce receivables days and hence reduce the length of the cash operating cycle. The cost of the discount (approximately 5% annual sales of $3.24m 0.75 = $2,500) outweighs the interest saved on the overdraft (approximately 0.75 /2 $3.24m 0.08 = $6,200) hence the net effect will be reduced profit. 2 D A is a financial reporting implication of retranslating foreign assets/liabilities, and not immediately related to cash. B is the impact on business value of long-term exchange rate trends. D is correct: transaction risk refers to the fact that the spot rate may move between the point of sale (denominated in foreign exchange) and when the customer pays, such that the net domestic receipt differs from expected. 22 A The company should take out a three-month forward contract to sell,650,000 at.2567 + 0.0034 =.260 per W$. This rate is agreed today for exchange in three months, converting to,650,000/.260 = W$,309,420. 23 B Statements and 3 are true: As they are binding contracts, forward contracts fix the rate to that rate noted in the contract. The contract contains named parties so the contracts cannot be sold on to someone else (statement 2 is false). By the same token therefore they are not flexible (statement 4 is false). 24 C W$ will be deposited now for three months at 2.6% 3/2 = 0.65% will be borrowed now for three months at.4% 3/2 = 0.35% 6
25 B GSF needs to borrow now to match the receipts it will receive. Borrowing rate in Germany =.4/4 = 0.35% Amount to be borrowed =,650,000/.0035 =,644,245 Current spot =.2558 + 0.0006 =.2564 Converting at spot rate =,644,245/.2564 = W$,308,695 Investment proceeds =,308,695 ( + (0.026/4)) = W$,37,202 26 D This method values HSD according to the value of its net assets. The book value of HSD's net assets attributable to equity shareholders is $4m. This figure should be increased by $0.75m to $4.75m to allow for the excess of the realisable value of the non-current assets above their book value, and then $3m added for goodwill, making a total of $7.75m. 27 A Taking the 2.5% growth figure given, next year's earnings would be $0.738m (.2m shares at 60c per share.025) VVS's P/E ratio is 450/45 = 0 Applying the P/E ratio that currently applies to VVS to the estimated earnings next year of HSD gives a valuation of HSD of 0 $0.738m = $7.38m. 28 B HSD is likely to be typical of a lot of service companies, a large part of whose value lies in the reputation of its personnel. This is not reflected in net asset values, and renders this method inappropriate. Option A is not always true, and even where it is, negotiations will generally take expected market values into account. Option C does not always hold true shareholders will be reluctant to sell for less than the net asset value, but they may be prepared to sell at net asset value if there are going concern problems or they are looking to sell (as may be the case for HSD). Option D is similarly inaccurate because, as an example, in property investment companies the market values of the assets will indeed bear a close relationship to their earning capacities. 29 C Last year, total dividends paid by HSD were.2m 30 cents = $0.36m. A 3% increase next year would give $0.3708m. A dividend growth model valuation, assuming constant annual dividend growth of 3% in perpetuity, would give a valuation of: $0.3708m/(0.3 0.03) = $3.708m. 30 B Not all of the influences on share price are taken into account. Factors other than the expected dividend, the cost of equity and the dividend growth rate are ignored. 7
Section C Question 3 Marking scheme (a) (i) Cash inflows (incl scrap) Investment and scrap Costs Tax and tax benefits Working capital NPV calculation with correct discount factors 5% Recommendation (ii) 2nd NPV calculation Interpolation Recommendation 2 Marks (b) One mark per fully explained point Max (c) One mark per fully explained point Max 4 20 Suggested solution (a) (i) Year 0 2 3 4 5 $ $ $ $ $ $ Sales,08,500,686,990 2,458,500,25,720 Variable cost (588,000) (934,920) (,389,000) (700,200) Fixed costs (350,000) (350,000) (350,000) (350,000) Net cash flow 43,500 402,070 79,500 65,520 Tax at 30% (43,050) (20,62) (25,850) (49,656) TAD tax benefits (W) 75,000 56,250 42,88 7,563 Working capital (00,000) (20,000) (30,000) 40,000 0,000 Capital Investment (500,000) (500,000) 30,000 After-tax cash flow (600,000) (376,500) 404,020 695,29 3,858 67,907 Discount factors 5%.000 0.870 0.756 0.658 0.572 0.497 Present values (600,000) (327,555) 305,439 457,395 75,423 33,750 $ NPV (55,548) The NPV of the proposed project is negative, and it therefore should be rejected. Workings Tax allowable depreciation Tax benefits $ $,000,000 0.25 = 250,000 250,000 0.3 = 75,000 2 250,000 0.75 = 87,500 87,500 0.3 = 56,250 3 87,500 0.75 = 40,625 40,625 0.3 = 42,88 4 By difference 578,25 39,875 0.3 = 7,563,000,000 30,000 578,25 = 39,875 8 3 5 8
(b) (c) (ii) Calculation of internal rate of return Year 0 2 3 4 5 $ $ $ $ $ $ After-tax cash flow (600,000) (376,500) 404,020 695,29 3,858 67,907 Discount factors 0%.000 0.909 0.826 0.75 0.683 0.62 Present values (600,000) (342,239) 333,72 522,042 90,059 42,70 Net present value $45,737 IRR = 0% + [(45,737/(45,737 + 55,548)](5 0) = 2.3% At 2.3%, the IRR of the project is less than PLK's cost of capital of 5%. A project is financially viable under IRR criteria if the IRR is greater than the cost of capital. The internal rate of return (IRR) is the rate of return that results in a NPV of zero. The rule with the internal rate of return (IRR) method of project evaluation is that a project should be undertaken if it is expected to achieve a return in excess of the company's cost of capital. A project that has an IRR in excess of the cost of capital must have a positive NPV. As we can see from PLK's proposed investment, its IRR at 2.3% is less than the cost of capital of 5%, and the project has a negative NPV when its cashflows are discounted at 5%. Strengths As a discounting technique, IRR, like NPV, takes account of the time value of money and considers all future incremental cash flows The main advantage of the IRR method is that the information it provides may be more easily understood by managers, especially non-financial managers for this reason it is widely used in practice. Both NPV and IRR are easy to calculate with a spreadsheet. Weaknesses The IRR method ignores the relative size of investments: for example a project with an annual return of $50 on an initial investment of $00 would have the same IRR as a project with an annual return of $5,000 on an initial investment of $0,000, although the latter is clearly preferable as an absolute increase in company value. When discount rates are expected to differ over the life of a project, these can be incorporated easily into NPV calculations, but not IRR. The net present value method of investment appraisal has a number of advantages over the other methods referred to by the PLK board. (i) It is based on cash flows, not accounting profit, unlike ROCE. Accounting profits are subject to a number of different accounting treatments which can distort the true picture of an investment's acceptability. (ii) NPV looks at cash flows throughout the whole of an investment period, unlike payback, which ignores cash flows after the end of the payback period. This avoids the incorrect rejection of projects with later high returns, although it is unlikely in practice that payback would be used in isolation. (iii) NPV incorporates the time value of money by using discounted cash flows whereas ROCE and payback do not. This means that it takes account of the fact that $ today is worth more than $ in one year's time. Discounted payback can be used but this will still ignore cash flows after the payback period. (iv) NPV reflects the value of the investment rather than a measure of return and represents the theoretical change in total market value that will occur if the investment project is accepted. ROCE and payback do not directly show the potential increase in shareholder wealth, which is a primary financial management objective. 9
Question 32 Marking scheme (a) Calculation of cost of equity Calculation of cost of debt Calculation of WACC 2 3 3 Marks 8 (b) (c) Impact of new bank loan one mark per fully explained point under each heading Convertible debt issue one mark per fully explained point Max 8 4 20 Suggested solution (a) Cost of equity d k e = o ( g) + g P0 = ( 0.04) 0.40 =4% + 0.04 Cost of debt Cash Discount Discount Year Flow Factor PV Factor PV $ 0% $ 5% $ 0 Market value (00.84).000 (00.84).000 (00.84) 3 Interest (after tax) 6.30 2.487 5.67 2.723 7.5 3 Capital repayment 00.00 0.75 75.0 0.864 86.40 (0.07) 2.7 2.7 k d = (5+ (0 5) 2.70.07 = 6.06% WACC V WACC = E VE V D V E = 00 0.40 = $,040m V D = 200.0084 = $20.68m V k e + E VE V D k d,040 WACC = 4 + (,040 20.68) = 2.7% 20.68 (,040 20.68) 6.06 0
(b) (i) Cost of equity (c) (ii) (iii) Convertibles The cost of equity will rise if the company takes out extra loans. The interest and debt repayment burden will increase the risk that FlyHi will not be able to pay dividends, and also increase the risk that FlyHi will run into financial difficulties through not being able to meet its loan commitments. If liquidation occurs, debtholders will rank before equity holders. Equity investors will demand an increased level of return to compensate for this risk. Cost of debt According to the traditional view, the cost of debt will remain unchanged up to a certain level of gearing. Above that level it will increase, because of the financial risk that the company will not be able to meet its commitments, and hence interest and even the principal may be jeopardised. Weighted average cost of capital According to the traditional view, the weighted average cost of capital will fall initially as debt capital is introduced, because debt at first has a lower cost than equity, being a lower-risk investment. Ultimately however the weighted average cost of capital will rise as risk levels increase, resulting in the rise in the cost of equity becoming more significant, and ultimately the cost of debt will rise. The optimum level of gearing is where the company's weighted average cost of capital is minimised. Companies normally issue convertibles in the expectation that the holders will exercise their options. Convertibles can therefore be seen as a form of delayed equity. (i) (ii) (iii) (iv) They are attractive to the firm when the price of the ordinary shares is abnormally low at the date of issue, and at times when to issue a further tranche of equity would result in a significant drop in earnings per share. However they also carry the risk that the share price will not rise in line with expectations at the time of issue and that holders will not therefore convert. If the loan notes are dated, then the company must have funds in place to allow redemption on the due date. Convertibles also have a short-term benefit in that interest payments are allowable against tax. Strategic implications of convertibles Convertibles therefore may form part of the strategy of a company whose objective is to raise new equity, but which for various reasons does not wish to go directly to the market in the short term. (i) (ii) They are often preferable to straight loan notes since they do not commit the company indefinitely to the payment of large interest bills. They further allow the company to widen the investment base by attracting investors looking for a guaranteed short term income plus the possibility of a capital gain at a later date.
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