acca f9 revision mock - ans j11(with marks)

KAPLAN PUBLISHING 1

ACCA

Paper F9

Financial Management June 2011

Revision Mock – Answers

To gain maximum benefit, do not refer to these answers until you have completed the revision mock questions and submitted them for marking.

ACCA F9 Financial Management

2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2011

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Revision Mock Answers

KAPLAN PUBLISHING 3

1 SPIDER CO

Key answer tips

To successfully calculate the NPV of the proposed project, you must focus on the relevant costs (i.e. those costs that will change as a direct result of the project). You can save some time by structuring your answer to part (a) in a way that will give you some of the numbers you’ll require to work out the sensitivities in part (b).

Part (c) gives an opportunity to pick up some easy marks but don’t forget to tailor your comments to the scenario presented.

The highlighted words in the written sections are key phrases that markers are looking for.

(a) Annual cash savings

$000 Additional contribution (W1) 140 Additional fixed costs (200) Reduction in variable cost for existing units (W2) 350 ––––– Additional annual cash flows 290 ––––– Workings

(W1) New variable cost is $15 - $5 = $10

Unit contribution will therefore be $30 − $10 = $20

Number of additional units is 7,000

Total additional contribution from new units is 7,000 × $20 = $140,000

(W2) Reduction = $5 per unit × 70,000 units = $350,000

Capital allowance calculations

Annual capital allowance = $800,000 / 4 = $200,000

Cash flow effect = $200,000 × 30% = $60,000

Net present value calculation

Year 0 1 2 3 4 $000 $000 $000 $000 $000 Annual savings 290 290 290 290Tax payable (30%) (87) (87) (87) (87)Initial investment (800) Capital allowances 60 60 60 60 ––––––– ––––––– ––––––– ––––––– –––––––Net cash flows (800) 263 263 263 263Discount factor @ 10% 1 ––––––– 0.909 0.826 0.751 0.683 ––––––– ––––––– ––––––– –––––––Present value (800) 239 217 198 180 ––––––– ––––––– ––––––– ––––––– ––––––– NPV 34 –––––––

As the NPV is positive, the project should be undertaken.


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(b) (i) Sensitivity to the increase in fixed costs

Using the sensitivity margin formula:

Sensitivity margin =

The flow under consideration is post-tax additional fixed costs.

PV of fixed costs (less tax saved)

Year Cash flow $000

Discount factor (10%) Present value $000

1 - 4 Fixed costs (200) 3.17 634 1 - 4 Tax 60 3.17 (190) ––––– NPV 444 –––––

Sensitivity margin = %66.710044434 =×

This means that the additional fixed costs can increase by 7.66% (to $215,000) before the project is no longer viable.

(ii) Sensitivity to the additional annual sales units

Again, using the same sensitivity margin except this time the flow under consideration is post-tax contribution on the additional units sold.

PV of contribution (less tax)

Year Cash flow $000

Discount factor (10%) Present value $000

1 - 4 Contribution 140 3.17 444 1 - 4 Tax (42) 3.17 (133) ––––– NPV 311 –––––

Sensitivity margin = %9.1010031134 =×

This means that additional annual sales can fall by 10.9% (to 6,237) before the project is no longer viable.

(iii) Sensitivity to the cost of capital is the internal rate of return

To find the IRR, discount at a higher rate than 10%. Say 15%.

NPV = -$800k + ($263k × 15% AF 1-4)

= -$800k + ($263k × 2.855)

= -$800k - $751k

= -$49k

IRR = %12)1015(49)(34

3410 =−×+

+

This means that, if the cost of capital is higher than 12%, the project will have a negative NPV and will no longer be viable.

ionconsiderat underflow ofPV NPV


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(c) Operational gearing is the risk in relation to the cost structure.

Buying a machine with higher fixed costs but lower variable costs is risky because it needs high volumes to justify the additional fixed costs. If the additional volumes are not achieved, the company could suffer high losses; if high volumes are achieved, it could be very profitable.

One way of calculating the operational gearing ratio is:

For Spider, before the investment the operational gearing ratio was:

%3.32)15$k70( $500k

$500k =×+

If the investment goes ahead, the operational gearing ratio will be:

%6.47

$10)(77k$200kl$500k$200k$500k =

×+++

This increase in operational gearing indicates the business is now exposed to more risk.

ACCA marking scheme

Marks (a) Annual cash flows 2.5 Tax thereon 1 Initial investment 0.5 Capital allowances 1 NPV calculation 2 Decision 1 ––– 8 (b) (i) PV of after tax fixed costs 2 Sensitivity margin 1 Comment 1 (ii) PV of contribution 2 Sensitivity margin 1 Comment 1 (iii) Recognising that the IRR was required 1 Calculation of IRR 2 Comment 1 ––– 12 (c) Commentary 3 Calculation for Spider, with explanations (give credit for

different methods of calculation) 2

––– 5 ––– Total 25 –––

costs Totalcosts Fixed


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2 CBS CO

Key answer tips

This question requires a reasonable depth of knowledge on hedging methods for both interest rate and foreign exchange risk.

You must ensure you are able to list the basic features of each of these methods. If you are able to, this question should represent some easy marks.


(a) Forward rate agreement

Entering into an FRA will allow the company to effectively lock into an interest rate for a specified future period, here for a six month period starting in 3 months’ time and ending in 9 months’ time. That is, we should use a 3 – 9 FRA which should lock us into a borrowing rate of 5.26%.

Tutorial note:

Note that the borrowing rate is always the higher of the two quoted rates.

The FRA is independent of the loan itself upon which the prevailing rate must be paid, however any difference between the actual rate and the FRA rate will result in a cash flow from the FRA that offsets the higher or lower interest cost.

Net outcome

Fixed interest rate 3.9% 5.8% Actual rate 3.9% 5.8% FRA rate 5.26% 5.26% Gain / (loss) (1.36%) 0.54%

FRA Receipt / (Payment) $10m × 1.36% × 126 $10m × 0.54% ×

126

($68,000) $27,000 Interest on $10m for 6 months ($195,000) ($290,000) Net payment ($263,000) ($263,000)

Net payment at 5.26% is $10m × 5.26% ×126 = $263,000

Hence the FRA has locked us in to a rate of 5.26%

(b) Interest rate guarantees (IRG) or short-term interest rate caps offer the opportunity to limit the impact of any adverse movement in interest rates whilst still benefitting from any favourable rate movement.

They represent an interest rate option giving the holder the right, but not the obligation, to deal at an agreed interest rate at a future maturity date. An IRG can effectively be considered an option on a FRA.


KAPLAN PUBLISHING 7

This means that if rates rise the option would be exercised by CBS Co, locking the rate. If rates fall however, CBS Co would allow the option to lapse and would benefit from lower than envisaged rates. However a premium is payable – the flexibility of an IRG has a cost.

(c)

Tutor’s top tips

Only 3 methods need to be covered to earn full marks.

CBS Co could hedge against foreign exchange risk on the transaction in the following ways:

Forward contract hedge

A forward market hedge would bind CBS Co into a contract to buy €1m in 6 months time at a rate of exchange that is determined at the time of entering into the contract. The company cannot allow the forward contract to lapse if the spot rate on the expiry date of the forward contract makes it unattractive and hence any upside potential is foregone. However a forward contract is easy and cheap to set up, can be tailored to the needs of CBS Co and will be available from the bank.

Money Market hedge

A money market hedge would involve CBS Co in investing sufficient funds in € now so that in 6m the company has the €1m required to pay for the machine. Hence the company would have to raise $ now in order to exchange them into € to fund the necessary investment. A money market hedge generally creates a similar outcome to a forward market hedge but will require the company to borrow now unless it has sufficient funds available. Additionally some interest rate risk arises.

Currency futures hedge

A currency futures hedge is similar to a forward contract in the sense that CBS Co could effectively fix the rate of exchange to be used. However, a futures contract differs from a forward contract in that the futures contract is for a standardised amount of currency, whereas a forward contract can be for any amount of currency. In addition, each futures contract has a fixed maturity date, usually operating to a three-month cycle of maturity, i.e. June, September, December, March. Also, futures contracts are traded on currency exchanges rather than being available through banks. Effectively the futures contract works like a bet – a winning bet cancels out any actual loss on a transaction and vice versa, so the futures contract, like the forward contract, would put CBS Co in a no win / no loss position.

Currency options hedge

An option would give CBS Co the right but not the obligation to buy €1m in 6 months at a rate of exchange that is determined at the time of entering into the contract. If the exchange rate moves against the company, then the option can be used to limit the company’s forex loss, but if rates move in the company’s favour the company can allow the option contract to lapse and profit from the favourable exchange rate movement by translating at the spot rate. However, an option premium is payable in return for this flexibility. Options are available either from banks (over the counter options tailored to a customer’s needs) or from markets such as the London International Financial Futures Exchange (exchange traded options).


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Recommendation

CBS Co should use a forward contract hedge as it will have much the same outcome as a money market or futures hedge and will be easier to arrange. CBS Co should only consider paying for the flexibility of a currency option if favourable exchange rate moves are expected or if the purchase of the machine is not yet certain.

(d) If CBS Co purchases ATC Co it will suffer the following additional exchange rate risks due to the overseas operations:

Transaction risk

To the extent that the company will have day to day transactions expressed in foreign currencies and if exchange rates move between the transaction date and the settlement date then the company will suffer cash flow gains or losses. If these gains or losses could be material they could increase or decrease the company value. To avoid this CBS Co may consider hedging such transactions.

Economic risk

When trading overseas a company faces economic risk, which can be defined as changes in the present value of future after-tax cash flows due to changes in exchange rates.

The changes arise from your company seeming to be more or less competitive in the overseas markets as a result of exchange rate fluctuations. For example, if CBS were to sell overseas in Euros then a strengthening in the dollar would result in a lower margin. Alternatively, they could try to maintain the margin by increasing the Euro price, but this would result in falling sales as the price would be higher than competitors.

By purchasing a company with overseas operations, CBS will be less susceptible to economic risk than if it were to supply overseas customers from its home country as both costs and revenues will be collected in the same currency. The strategy of purchasing ATC will therefore help to preserve value.

Translation risk

As a result of exchange rate changes gains or losses may arise when converting the results of overseas operations into $ prior to consolidation. These gains or losses are not immediate cash flows and hence may not immediately impact on the value of CBS Co. However to the extent that they give warning of likely future cash flow gains or losses there may be an impact on the value of CBS Co. Furthermore there will be an impact on the reported profits of CBS Co and as the financial statements are important information to investors the value of CBS Co could be affected.


KAPLAN PUBLISHING 9

ACCA marking scheme Marks

(a) Explanation 2.0 Illustration: 5.8% 1.5 Illustration: 3.9% 1.5 Conclusion 1 ––– 6

(b) 1 mark per relevant point 3

––– (c) 3 marks max per method explained 8 Max

Suitable justified recommendation 1 ––– 9

(d) Transaction risk & impact on value 2 Economic risk & impact on value 2 Translation risk & impact on value 3 ––– 7 –––

Total 25 –––

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.


(a) Overtrading occurs when a company is growing rapidly but does not have enough long-term finance. Imagine starting a business with $1,000 borrowed from the bank when the business expands rapidly. As the scale of operations continues that $1,000 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.


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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)

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 61% and assets by 30%.

Cash constraints: trade payables have increased by 82% and other payables by 67%. Payables payment period has increased from 64 to 71 days (W1). The current ratio is down from 1.48:1 to 1.15:1 and the acid test from 0.77:1 to 0.66:1.

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 31% (480/1,530) to 43% (860/1,990).

Squeeze on profit margins: gross margin is down from 11.7% to 9% and the profit margin before tax is down from 6.7% to 5.5%.

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 reflects both of these. Sales/gross assets has increased from 1.18 to 1.46 and the rate of inventory turnover (cost of sales/closing inventory) has increased from 4.7 to 6.3.

Receivables payment period is largely unchanged at around 72 days. Receivables will usually be expected to increase less than the increase in sales as attempts are made to get the money in quickly.


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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.

(W1) For 20X7: Cost of sales = 1,800 – 210 = 1,590

Payables payment period = , 365 = 64 days

For 20X8: Cost of sales = 2,900 – 260 = 2,640

Payables payment period = , 365 = 71 days

(c) (i) The operating cycle is the period of time between paying for materials and receiving the cash from eventual sale. The significance of it is that funds will be needed for this period of time. For 20X8 the operating cycle is as follows:

Inventory days 365salesof Cost

inventory Closing × days 58365)260900,2(

420 =×−

+

Receivables days 365Sales

sReceivable × days 72365900,2

570 =×

–

Payables days 365salesof Cost

Payables × days 71365)260900,2(

510 =×−

= =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 receivables 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 6 (b) Up to 2 marks for each valid point, to a maximum of 8 (c) (i) Explanation 2 Calculation 4 ––– 6 (ii) 1 – 2 marks for each valid point, to a maximum of 5 ––– Total 25 –––



4 FMY CO

Key answer tips

The requirement in part (a) is fairly general so to provide a comprehensive answer you will need to think through the different theories of business valuation and what influences it.

Parts (b) and (c) offer an opportunity to pick up some easier marks provided you tailor your comments to the scenario presented.


(a) The effect of method of financing on company value

Tutor’s top tips

Before starting to answer this section you should think about what factors you know that will influence business valuation. Don’t confine yourself to just the business valuation part of the syllabus; try to think more broadly and consider how different elements of the syllabus inter-relate. The sorts of things you should identify are:

– TERP calculations (rights issues only)

– P/E ratio method (with a focus on changes in earnings and the market forces that will influence the P/E ratio)

– Discounted future cash flows (and the as capital structure changes so to may the WACC leading to changes in business valuation)

– Market efficiency

Rights issue

If the funds were raised via a rights issue, the theoretical ex-rights price (TERP) can be calculated as:

Current share price = $2.20 per share

Current number of shares = 10 million shares

Finance to be raised = $5m

Number of shares issued = 10m ÷ 4 = 2.5 million shares

Theoretical ex rights price per share = ((10m × 2.20) + $5m) / (10m + 2.5m) = $2.16 per share

The share price would theoretically fall from $2.20 to $2.16 per share although there would be no effect on overall shareholder wealth and total market capitalisation would only increase by the proceeds raised.

However, this does not take account of the benefits of the project. The investment made would result in an overall increase in shareholder wealth equal to the NPV of the project. This could be expected to increase the value of each share by a further 10 cents ($1.2m ÷ 12.5m shares).



Tutorial note

You would never be expected to include the NPV of a project in a TERP calculation but, as we see here, you may be required to recognise that investing in a project will lead to an increase in shareholder wealth equal to the value of the positive NPV.

Effect of rights issue on earnings per share

Current EPS = $4.5m ÷ 10m = 45 cents per share

Revised EPS = ($4.5m + $1.0m) ÷ 12·5m = 44 cents per share

The EPS would fall from 45 cents per share to 44 cents per share. As mentioned earlier, there would be no effect on shareholder wealth in the short term, although in the longer term, a fall in this key investor ratio could lead to some investors disposing of their shares, which would cause the share price to fall.

FMY would therefore have to persuade investors of the benefits of the project and of management’s ability to deliver these on schedule. This is really an issue of investors’ faith in management competence. If investors are convinced then the current P/E ratio of 4.9 ($0.45 ÷ $2.20) might be expected to increase to reflect the expectation of higher growth rates in the future.

Effect of rights issue on the debt/equity ratio

The company is currently 100% finance by equity. A rights issue would preserve this meaning there would be no change in the company’s cost of capital, and therefore no additional movements in the valuation of the business other than those noted above.

Issue of debt

Effect of debt issue on earnings per share

Tutorial note

The trick with this calculation is to recognise the impact of the additional interest on the post-tax earnings of the business.

Interest payments on debt finance = $5m × 8.6% = $0.43m

Post tax fall in earnings = $0.43m × (1 – 0.3) = $0.3m

Revised EPS = ($4.5m + $1.0m – $0.3m) ÷ 10m = 52 cents per share

The EPS would increase from 45 cents per share to 52 cents per share. As mentioned earlier, there would be no effect on shareholder wealth in the short term, although in the longer term, an increase in this key investor ratio could attract investors and cause the share price to rise.

Effect of debt issue on the debt/equity ratio

In theory, the value of the firm is found by discounting all post-tax operating cash flows available for investors at the company’s WACC. The method of financing has an impact as if it is possible to reduce the WACC, the value of the company will be increased.



The company is currently ungeared (100% equity financed).

Assuming the market value of equity remained unchanged, the revised debt/equity ratio would be: $5m ÷ (10m × $2.20) = 23%

Capital structure theories provide a useful guide to assessing the impact of methods of financing on the value of the firm.

The traditional view

The traditional view is that as a company first introduces debt into its capital structure, the impact of the cheap debt exceeds the impact of any increase in the cost of equity or debt due to the increased financial risk. Hence, the final impact is that WACC will fall.

As FMY is currently all equity financed, raising more equity is likely to maintain the current WACC and company value. If debt was raised, WACC is likely to fall and company value will be raised.

Modigliani & Miller (M&M)

M&M originally claimed that company value was independent of capital structure. However, once they considered the impact of tax relief that is available when debt interest is paid, they concluded that the WACC of a company would be minimized and its value maximised if debt made up 99.9% of a company’s capital. Whilst real world factors such as bankruptcy risk preclude such high levels of gearing, FMY currently has no gearing. Hence, M&M’s theory would also support the idea that raising more equity is likely to maintain the current WACC and company value, but that if debt was raised WACC is likely to fall and company value will be raised.

Conclusion

The company should investigate further the use of debt finance as this could enhance the value of the company.

(b) Additional factors to consider when raising new equity through a rights issue

The terms of the issue

Rights issue price = $5m ÷ 2.5m shares = $2.00 per share

Based on the terms suggested the subscription price of $2 represents only a 9% discount to the current share price, and may not provide sufficient an incentive to motivate shareholders to invest further funds. There is also a risk that the share price could fall to this level in the period between announcing the rights issue and the closure of the offer.

Ability of owners to invest

Some shareholders may be unwilling or unable to provide funds to the extent required. The take-up of the new shares is thus by no means guaranteed. The issue could be underwritten by financial institutions, but this would be expensive.

Failure to sell the target amount of shares might spell inability to invest as planned, or having to fill the gap with borrowing.

Implications for control

To the extent that shares are offered to new investors and at a discount, the equity of existing owners could be diluted and this may alter the balance of control.



Legal aspects

We must check that the firm’s Articles of Association allow finance to be raised in this quantity and for these purposes.

Cost

Equity is usually more costly than debt finance and so it should be considered whether or not the debt finance might be cheaper and more appropriate.

Risk

The company should aim to keep total risk at a level acceptable to both management and shareholders. Equity finance is low risk to the company and it should be considered whether the risk of the company as a whole is too low and the company could benefit from some riskier but cheaper debt finance.

Costs of issue

Issuing equity is costly. There are legal and administrative costs involved in drawing up the necessary documents and circularising shareholders. For instance, an Extraordinary General Meeting, with its associated costs, might be necessary.

(c) Islamic finance

Islamic finance rests on the application of Islamic, or Shariah, law.

The main principles of Islamic finance are that:

• Wealth must be generated from legitimate trade and asset-based investment. The use of money for the purposes of making money is forbidden.

• Investment should also have a social and an ethical benefit to wider society beyond pure return.

• Risk should be shared. • Harmful activities (such as gambling, alcohol and the sale of certain foods)

should be avoided.

The issue of debt finance as proposed by FMY Co (where the lender would make a straight interest charge, irrespective of how the underlying assets fare) would violate the principle of sharing risk and of not using money for the purposes of making money. Under Islamic finance, the charging and receiving of interest (riba) is strictly prohibited. This is in stark contrast to more conventional, western forms of finance.

One alternative form of finance would be Murabaha, a form of trade credit for asset acquisition. Here the provider of finance would buy the item and then sell it on to FMY Co at a price that includes an agreed mark-up for profit. The mark-up is fixed in advance and cannot be increased and the payment is made by instalments.

Another form of finance would be Islamic bonds, known as sukuk. To be Shariah-compliant, the sukuk holders must have a proprietary interest in the assets which are being financed. The sukuk holders’ return for providing finance is a share of the income generated by the assets. The key distinction between sukuk and murabaha is that sukuk holders have ownership of the cash flows but not the assets themselves.



ACCA marking scheme Marks

(a) TERP calculation 2 Impact of positive NPV on share value 2 EPS calculation under rights issue 2 Impact on P/E of expected growth 2 EPS calculation under debt issue 2 Revised equity gearing calculation 2 Capital structure theories 2 Conclusion 1 ––– Max 12 (b) 1 mark per relevant factor Max 5 (c) Explanation of Islamic finance 1 Underlying principles v conventional finance 3 1 mark per financial instrument identified Max 3 1 mark per relevant point on the discussion of each instrument Max 3 ––– Max 8 ––– Total 25

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acca f9 revision mock - ans j11(with marks)

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