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Advanced Financial Management June 2016
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.
Some of these answers are longer than the examiner would have expected from students in the time available. See the marking schemes to assess how many points were needed to achieve a pass.
ACCA P4: ADVAN CED F INAN CIAL MAN AGEME NT
2 KAPLAN PUBLISHIN G
Kaplan Financial Limited, 2016
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1 BUGG CO
REPORT To: The Directors, Bugg Co From: An Advisor Date: Today Subject: The proposed Runan investment
I have evaluated the proposed Runan investment by calculating its APV (see Appendix). I have also discussed the impact of austerity measures, the use of WACC and APV in investment appraisal, and the other factors that need to be considered before undertaking the project.
(a) Austerity measures
The austerity measures introduced by European governments have generally focussed on increasing tax rates and reducing government spending, in order to enable the governments to reduce budget deficits and pay off debt.
This has led to citizens having less money to spend, so demand has been reduced for many goods in Europe.
However, we are told that Bugg Cos sales and profits have grown slightly over the last few years, which initially seems odd given the general downturn in the recessionary markets.
Perhaps the reason for this is the nature of the product being manufactured by Bugg Co. Oven heating elements are not a luxury purchase, where purchase could be delayed in a time of austerity. Instead, a heating element is a necessity, so demand for the heating elements is likely to be extremely inelastic.
Admittedly in these recessionary times, demand for new ovens in newly built homes has probably reduced, which might be why the sales and profits of Bugg Co have not grown dramatically.
However, sales of replacement heating elements for ovens that have broken down is likely to be just the same as ever, so this is probably why Bugg Cos overall sales and profits have not been adversely affected by the austerity measures.
(b) Use of WACC and APV in investment appraisal
The weighted average cost of capital (WACC) is the effective after-tax cost of the different sources of finance used by a company. The costs of the different sources are normally weighted by their market values.
WACC - merits
WACC is often used to discount the incremental cash flows of an investment in order to estimate the NPV (net present value), the expected change in corporate value resulting from the investment. In order to add value for shareholders it is necessary for the return from an investment to exceed the WACC. WACC is therefore a very useful tool to assist in project evaluation and the measurement of wealth creation.
ACCA P4: ADVAN CED F INAN CIAL MAN AGEME NT
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WACC - problems
However, it has some problems and limitations. It is sometimes not clear about whether or not to include short-term finance such as overdrafts in the estimate of the weighted average cost of capital and in theory WACC should not be used when:
(i) There is a significant change in the capital structure of the company as a result of the investment.
(ii) The operating risk of the company changes as a result of the investment.
(iii) The investment has complex tax payments and tax allowances, and/or periods when tax is not paid.
(iv) There are subsidised loans or other benefits associated explicitly with an individual project.
In such circumstances the adjusted present value (APV) may be a better technique to analyse investments than the WACC with NPV.
APV - merits
APV requires the estimation of the base case NPV of operating cash flows (discounted at the ungeared cost of equity) and, separately, the present value of any financing side effects. It allows more complex financing situations to be dealt with, and the different types of cash flow, with different risks, to be discounted at a rate specific to the individual risk.
APV - problems
However, APV also has theoretical and practical problems.
In order to estimate the APV, it is necessary to correctly identify all of the financing side effects, and the risk of each individual side effect. This is not an easy task, especially for international investments. APV also relies on some of the unrealistic assumptions of the Modigliani and Miller model (with tax), for example the equation for asset betas used in most APV estimates assumes that cash flows are perpetuities, which is normally not the case.
(c) Investment appraisal
The information provided has been used to assess whether the production of the BBB should be moved to Runa from Europe. Initially a base case net present value calculation is conducted to assess the impact of the production in Runa. This is then adjusted to show the impact of cash flows in Europe as a result of the move, the immediate impact of ceasing production and the impact of issue costs, the subsidy and the tax shield benefits from the loan borrowing.
The calculations presented in the appendix show that the move will result in a positive adjusted present value of approximately 3.9 million.
On this basis, the production of BBB should cease in Europe and the production moved to Runa instead.
Several assumptions have been made in preparing the calculations:
It has been assumed that the borrowing rate of 6% is used to calculate the benefits from the tax shield, since this reflects the risk associated with these cashflows. It could be argued that the risk free rate of 3% could be used as the discount rate
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instead of 6% to calculate the present value of benefits from the tax shields and the subsidies (in line with Modigliani and Millers assumptions). In adjusted present value calculations, the tax shield benefit is normally related to the debt capacity of the investment, not necessarily the actual amount of debt finance used. Since this is not given, it is assumed that the increase in debt capacity is equal to the debt finance used for the capital investment and the working capital. It has been assumed that the arrangement fee on the loan would be paid out of existing cash resources, so would not need to be covered by increased borrowings. The project NPV has been computed using Bugg Cos existing all-equity discount rate. This assumes that the business risk associated with the new project is identical to the existing risk of Bugg Cos operations in Europe. Given that the new project will be based in a different country, this is unlikely to be the case.
It has been assumed that many of the input variables, such as for example the tax and capital allowances rates, the various costs and prices, units produced and sold, the rate of inflation and the prediction of future exchange rates based on the purchasing power parity, are accurate over the five-year period of the project. In reality any of these estimates could be subject to change to a greater or lesser degree and it would be appropriate for Bugg Co to conduct uncertainty assessments like sensitivity analysis to assess the impact of the changes to the initial predictions.
(Note: credit will be given for alternative relevant assumptions)
(d) Other factors to consider
The calculations in the Appendix indicate that the new project is very likely to increase shareholder wealth.
However, before a final decision is made, the following factors should also be considered:
A change of government could have a significant impact on whether or not the project is beneficial to Bugg Co. The current government of Runa has agreed to provide the finance at a subsidised rate, and (through a public sector company) to buy the business from Bugg Co in five years time.
If the government changes in the next five years, either because of democratic elections or even a coup, the new governments policies may be very different and less favourable to Bugg Co. The directors should seek written assurances from the existing government, and should also assess the likelihood of a new government recognising such assurances in the future.
If Runa is perceived to be a country with an unstable government, perhaps it would be better for Bugg Co to abandon the plans now before the initial investment is made.
Bugg Co should consider the possibility of becoming established in Runa, and this may lead to follow-on projects. The r