ACCA Paper F9 Financial Management 03 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, 03 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. KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS AGD CO Key answer tips Part (a): To evaluate lease v buy 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. In part (b) the key is to recognise that the present value of the repayments, discounted at the interest rate on the loan, will equal the present value of the amount borrowed. In part (c) ensure you cover both the explanation of what causes the differences in objectives as well as the potential conflicts. The highlighted words are key phrases that markers are looking for. (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 Year 3 Year 4 $000 $000 $000 $000 $000 Purchase and sale (30) 50 Capital allowance tax benefits 4 8 Maintenance costs (5) (5) (5) Maintenance cost tax benefits 8 8 8 Net cash flow (30) (5) 7 5 47 Discount factors (7%).000 0.935 0.873 0.86 0.763 Present values (30) (3) 6 4 36 PV of borrowing to buy = $59,000 Workings: Capital allowance tax benefits Year Capital allowance Tax benefit Timing 30,000 = 80,000 80,000 0.3 = 4,000 Year 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 = (30,000 50,000) (80,000 + 60,000) = $30,000 KAPLAN PUBLISHING 3
ACCA F9: FINANCIAL MANAGEMENT Leasing evaluation Year 0 Year Year Year 3 Year 4 $000 $000 $000 $000 $000 Lease rentals (0) (0) (0) Lease rental tax benefits 36 36 36 Net cash flow (0) (0) (84) 36 36 Discount factors (7%).000 0.935 0.873 0.86 0.763 Present values (0) () (73) 9 7 PV of leasing = $49,000 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 Year 3 Year 4 $000 $000 $000 $000 $000 Purchase and sale (30) 50 Capital allowance tax benefits 4 8 39 Maintenance costs (5) (5) (5) Maintenance cost tax benefits 8 8 8 Lease rentals saved 0 0 0 Lease rental tax benefits lost (36) (36) (36) Net cash flow (00) 95 9 5 Discount factors (7%).000 0.935 0.873 0.86 0.763 Present values (00) 89 79 8 The PV of $,000 indicates that leasing would be $,000 cheaper than borrowing. The difference between this and the previous evaluation is due to rounding. 4 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS (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. (ii) To calculate the repayment schedule use: PV of repayments = PV of amount borrowed Here we have a simple annuity, so Instalment (A) annuity factor = $30,000 where we want an annuity discount factor for five years and a rate of 0%. Using annuity tables: A = $30,000/3.79 = $84,40 (c) 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. KAPLAN PUBLISHING 5
ACCA F9: FINANCIAL MANAGEMENT (a) (b) (c) Total Purchase price Sales proceeds Capital allowances 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 Use of after-tax borrowing cost Amount of equal installments ACCA marking scheme Separation of ownership and control Importance of different time horizons Importance of different attitudes to risk Examples of potential conflicts mark each maximum of 3 Marks.5 3 5 3 8 5 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. 6 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS The implications of these constraints are likely to be that the business will: (b) 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. Tutor s top tips This is quite an open-ended requirement. The verb evaluate implies you will need to do some calculations and comment on them. Before jumping in and calculating lots of ratios, you should think about which ones will tell you the most. For any company that is over-trading there are two key things to look for before anything else; significant growth in the business (evidenced by a sizeable increase in sales) and an increased reliance on short-term finance. These should therefore be your starting point. Any additional calculations will merely support your findings from these first two. With 8 marks available in total, you should aim to do another couple of calculations and comment on them. Try not to overlap with calculations you ll be performing when working out the length of the cash operating cycle in the third part of the requirement. Note the answer below covers far more than would be needed to earn the full 8 marks. Translating some of the above tendencies into accounting ratios, it is possible to examine whether Donac is starting to show signs of overtrading. Rapid expansion: sales have increased by 6% and assets by 30%. Cash constraints: trade payables have increased by 8% and other payables by 67%. Payables payment period has increased from 64 to 7 days (W). The current ratio is down from.48: to.5: and the acid test from 0.77: to 0.66:. Dependence on short-term rather than long-term financing: as well as the increase in payables there has been a 79% increase in the overdraft. No new long or medium-term finance has been obtained. Thus short-term financing of total assets has increased from 3% (480/,530) to 43% (860/,990). Squeeze on profit margins: gross margin is down from.7% to 9% and the profit margin before tax is down from 6.7% to 5.5%. KAPLAN PUBLISHING 7
ACCA F9: FINANCIAL MANAGEMENT Other signals of overtrading to look out for are an increase in asset and inventory turnovers as the firm fails to increase its investment in non-current assets and inventory in line with the increase in sales. Donac has experienced both of these. Sales/gross assets has increased from.8 to.46 and the rate of inventory turnover (cost of sales/closing inventory) has increased from 4.7 to 6.3. Clearly Donac shows many of the signs of overtrading. Although profitable at the moment, the company risks running out of cash. In addition, reliance on short-term finance can be precarious, for example, the overdraft might be called in. (W) For 0X0: Cost of sales =,800 0 =,590 80 Payables payment period = 365.590 = 64 days For 0X: Cost of sales =,900 60 =,640 50 Payables payment period = 365.640 = 7 days (c) (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 0X the operating cycle is as follows: Inventory days Closing inventory 40 365 365 = 58 days Cost of sales (,900 60) + Receivables days Receivable s 570 365 365 = 7 days Sales,900 Payables days Payables 50 365 365 = 7 days Cost of sales (,900 60) = = Operating cycle 59 days (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. 8 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS ACCA marking scheme Marks (a) Up to marks for each valid point, to a maximum of 6 (b) Up to marks for each valid point, to a maximum of 8 (c) (i) Explanation Calculation 4 6 (ii) marks for each valid point, to a maximum of 5 Total 5 3 NUTCRACKER Key answer tips This is a reasonably straightforward question that tests your ability to use all four of the investment appraisal techniques Part (c) offers the opportunity to pick up some easy marks and so you may want to consider completing this part first. The highlighted words in the written sections are key phrases that markers are looking for. (a) (i) Year 0 3 4 $000 $000 $000 $000 $000 Revenue (see Note ) 7,00 7,560 7,938 8,335 Variable production costs (5,600) (5,84) (6,057) (6,99) (see Note ) Fixed production costs (see Note 3) (0) () (3) (44) Investment (4,000) Working capital (see Note 4) (500) 500 Net cash flow (4,500),390,55,649,9 Discount factor 5% (Note 5).000 0.870 0.756 0.658 7 Present value (4,500),09,45,085,3 The Net Present Value is $50,000 the project seems acceptable. KAPLAN PUBLISHING 9
ACCA F9: FINANCIAL MANAGEMENT (ii) Notes: () The research and development costs of $00,000 are sunk and are therefore ignored. () The price and variable production cost information is for year so start inflating for year. (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 $00,000 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. To calculate the IRR, calculate the NPV at a higher rate of interest, for example 0%: Year 0 3 4 Net cash flow (4,500),390,55,649,9 Discount factor (0%).000 0.833 0.694 79 0.48 Present value (4,500),58,05 955,05 (iii) Net present value = ($3,000) 50 The IRR = 5 + (0 5) = 7.6% this exceeds the cost of (50 + 3) capital and hence also shows the project to be acceptable. Tutor s top tips: Remember that the ARR (or ROCE) is the only investment appraisal method that uses profits rather than cash flows in the calculation. This means that the cash flows relating to working capital can be ignored. ARR = Average annual profit/average investment Average annual profit $000 Total net cash flows (excluding investment and 6,346 working capital) Less depreciation (4,000) Equals total profit,346 Number of years 4 years 0 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS (b) (c) (iv) Equals average profit 586.5 Average investment Initial investment 4,000 = Average investment =,000 ARR = 586.5/,000 00% = 9.3% Discounted payback Year 0 3 4 $000 $000 $000 $000 $000 Present value of cash (4,500),09,45,085,3 flows @ 5% Cumulative present (4,500) (3,9) (,46) (,06) 50 value Discounted payback period = 3 + (,06k /,3k) = 3 + 0.8 = 3.8 years The investment proposal has a positive NPV of $50,000 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%. The proposal s ROCE of 9.3% is marginally lower than the company target of 30%. However, since there is no justification given as to why 30% has been set as a target rate, this would not give grounds to reject the project. A target payback period has not been specified. However, the discounted payback period of 3.8 years is a significant proportion of the forecast life of the investment proposal of four years. The sensitivity of the investment proposal to changes in demand and life-cycle period should be analysed since a decline in demand for the product as it reaches maturity in the market could have a significant impact on its financial acceptability. The payback period is the time that elapses before the initial cash outlay is recovered. Advantages of payback () Exposure to risk. It is widely recognised that long-term forecasting is less reliable than short-term forecasts. Projects with short paybacks tend to be less risky than projects with long paybacks. A project with a one-year payback is less risky than a project with a 0-year payback. Management can have very little confidence in forecasts of events ten years from now. () Liquidity. Investment opportunities often require significant capital outlay. It may be important to recover this capital expenditure quickly for the company to maintain a strong position. Payback illustrates how quickly the capital can be recovered. KAPLAN PUBLISHING
ACCA F9: FINANCIAL MANAGEMENT (3) Simple measure. The payback period is not a complicated measure. Technical expertise is not required to understand the meaning of payback. (4) Not subjective. Payback period uses cash flows. Some investment appraisal methods use the rather more subjective measure of accounting profit (for example the accounting rate of return). Disadvantages of payback () The time value of money is ignored. Payback period fails to recognise that as time elapses the present value of this cash diminishes. It would be possible to overcome this problem by calculating a discounted payback period. () Cash flows after the payback are ignored. It does not reveal that some projects continue to generate cash in further years. (3) Not a measure of absolute profitability. Payback fails to indicate HOW MUCH each project is worth. It seems naive to select a project on the basis of payback without considering the amount of benefit received. (a) (i) Revenue Variable production costs Fixed production costs R&D sunk cost Investment Working capital Discount factors NPV (b) (c) Total ACCA marking scheme (ii) NPV at a higher percentage than 5% Calculation of IRR (iii) (iv) Average annual profit Average investment ARR Cumulative present value of cash flows Discounted payback period Discussion of investment appraisal findings Advice on acceptability of project mark for each advantage and disadvantage to a max of Marks 8 3 4 5 5 5 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS 4 LVM CO Key answer tips Part (a) involves some fairly straightforward calculations although to score well you must ensure you comment on your findings. To answer part (b), you will need to evaluate both the costs and benefits associated with offering the discount. This is best tackled on a line by line basis and even if your answer is not 00% accurate, you will still earn marks for each element you calculate correctly. Parts (c) and (d) offer 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 ) = $,000 per year Total cost of current policy = $3,000 + $,000 = $5,000 per year Cost of the ordering policy using the EOQ model Order size = ( $300 80,000 $3.00) = 4,000 units Number of orders per year = 80,000 4,000 = 0 orders per year Annual ordering cost = 0 $300 = $6,000 per year Holding cost = $3.00 (4,000 ) = $6,000 per year Total cost of amended policy = $6,000 + $6,000 = $,000 per year Change in costs of inventory management by using EOQ model Decrease in costs = $5,000 $,000 = $3,000 Tutor s top tips: To reach a decision on a change in policy like this you must directly compare the costs (the discount itself) with the benefits (reduction in financing costs resulting from a lower level of receivables, reduction in the level of bad debts and salary savings). KAPLAN PUBLISHING 3
ACCA F9: FINANCIAL MANAGEMENT (c) The benefits of the proposed policy change are as follows. Trade terms are 40 days, but customers are taking 365 $550,000/4 million = 50 days. Current level of receivables = $550,000. Cost of % discount = 0.0 $4m /3 = $6,667. Proposed level of receivables = $4,000,000 (6/365) = $84,93. Reduction in receivables = $550,000 $84,93 = $65,068. Receivables appear to be financed by the overdraft at an annual rate of 9%. $ Reduction in financing cost $65,068 9% 3,856 Reduction of 0.6% in bad debts 0.6% $4 million 4,000 Salary saving from early retirement,000 Total benefits 59,856 Cost of % discount (see above) (6,667) Net benefit of discount 33,89 A discount for early payment of one per cent will therefore lead to an increase in profitability for LVM Co. Working capital policies on the method of financing working capital can be characterised as conservative, moderate and aggressive. A conservative financing policy would involve financing working capital needs predominantly from long-term sources of finance. If current assets are analysed into permanent and fluctuating current assets, a conservative policy would use longterm finance for permanent current assets and some of the fluctuating current assets. Such a policy would increase the amount of lower-risk finance used by the company, at the expense of increased interest payments and lower profitability. LVM Co is clearly not pursuing a conservative financing policy, since long-term debt only accounts for 4.7% (40/850) of non-cash current assets. Rather, it seems to be following an aggressive financing policy, characterised by shortterm finance being used for all of fluctuating current assets and most of the permanent current assets as well. Such a policy will decrease interest costs and increase profitability, but at the expense of an increase in the amount of higherrisk finance used by the company. Between these two extremes in policy terms lies a moderate or matching approach, where short-term finance is used for fluctuating current assets and long-term finance is used for permanent current assets. This is an expression of the matching principle, which holds that the maturity of the finance should match the maturity of the assets. 4 KAPLAN PUBLISHING
INTERIM ASSESSMENT ANSWERS (d) 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. 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. KAPLAN PUBLISHING 5
ACCA F9: FINANCIAL MANAGEMENT (a) (b) (c) (d) Total 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 Reduction in receivables Cost of discount Reduction in financing costs Reduction in bad debts Calculation of net benefit and conclusion Permanent and fluctuating current assets Explanation of financing policies Discussion and link to LVM Co Objectives of working capital management Receivables management Inventory management Trade payables management Cash management Discussion and link to LVM Co Marks 5 6 4 7 Max 3 Max 7 5 6 KAPLAN PUBLISHING