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Financial Management F9FM-MK1-Z16-A Answers & Marking Scheme

©2016 DeVry/Becker Educational Development Corp.

®

Mock One

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©2016 DeVry/Becker Educational Development Corp. All rights reserved. 2

Question Answer Mark Question Answer Mark

Section A Section B

1 A 2 16 C 2

2 B 2 17 D 2

3 C 2 18 A 2

4 B 2 19 D 2

5 B 2 20 C 2

6 B 2 21 B 2

7 C 2 22 A 2

8 A 2 23 C 2

9 B 2 24 D 2

10 C 2 25 A 2

11 D 2 26 D 2

12 A 2 27 C 2

13 D 2 28 C 2

14 B 2 29 D 2

15 B 2 30 A 2

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Section A

Item Answer Justification

1 A A certificate of deposit is a savings certificate issued at nominal value by a bank which pays a fixed interest rate on that nominal value.

2 B Sharia-compliant debt can be issued in the form of “sukuk loan notes”.

3 C Weight After-tax cost Weighted cost Debt 50% 6% × (1 − 0.4) = 3.6% 1.80% Preference shares 10% 7% 0.70% Ordinary shares 40% 11.5% 4.60% –––––– Total 7.10% ––––––

Tutorial note: Only the debt component carries a tax deduction and is multiplied by one minus the tax rate.

4 B Agency costs arise when management fail to act in the best interest of shareholders. A well designed long term incentive plan should motivate management to focus on sustainable value-adding business strategies and align their goals with those of shareholders.

5 B $

Cost of new machine 180,000 Sale of old machine (30,000) Tax on sale of old machine (W) 3,000 ––––––– Net relevant cost 153,000 ––––––– WORKING

Balancing charge on the disposal = disposal proceeds – tax written down value = 30,000 – 20,000 = 10,000. This taxable gain creates a tax payment of 10,000 × 30% = 3,000

6 B $ Fee ($1,200,000 × 1%) 12,000 Finance charge ($1,200,000 × (30/360) × 90% × 18%) 16,200 –––––– Cost of factoring 28,200 Admin costs saved (10,000) –––––– Net cost of factoring 18,200 ––––––

7 C Setting the mission statement would usually be a role for the chief executive and/or chairman rather than the financial manager.

8 A An increase in debt leads to a higher level of interest expense. As a committed fixed cost interest expense leads to more volatile net income – an increase in financial risk. However as long as the firm has enough operating profit (or, more importantly, operating cash flow) to service the debt there is not necessarily a risk of default.

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9 B If there is no frost, then there is no difference between Sweet’s income with or without the insurance; the crop is worth $60,000 either way. However, if the insurance is purchased and a frost occurs, Sweet earns $50,000 more with insurance ($90,000 − $40,000) than he would without the insurance.

Sweet will be indifferent to spending $10,000 for frost protection when the expected value of the insurance equals the cost of the insurance:

Probability of frost × $50,000 = $10,000 Therefore, probability = 20%

10 C Cost of sales = revenue × (1 – gross margin) = $36m × 0.8 = $28.8m

Receivables days

368 × 365 = 81

Inventory days

8.286 × 365 = 76

Payables days

8.283 × 365 = (38)

––––– Operating cycle 119 ––––– 11 D According to the semi-strong level of the efficient markets hypothesis share prices

quickly react to newly available public information about the issuer of the shares.

12 A If the firm’s debt to equity ratio is below the optimal level then raising equity would increase WACC. There is no unique optimal capital structure applicable to every firm. Modigliani and Miller’s theory assumed a linear relationship between risk and required return.

13 D Shortening the operating cycle will reduce the level of working capital and hence reduce annual finance costs.

14 B PO =

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g = rb = 0.4 × 15% = 6%

P0 = 0.06 0.21.06 $180,000

= $1,362,857

15 B Time DF @ 10% PV $ $ 0 (100) 1 (100) 1-10 7 6.145 43.015 10 x 0.386 0.386x

To give a 10% return, 43.015 + 0.386x = 100, i.e. x = $147.63, so the premium is $(147.63 – 100) = $47.63.

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Section B


16 C Geometric average dividend growth rate = (21·8 ÷ 19·38)0·25 – 1 = 0·0298 or 3%. Using the dividend growth model, ke = ((21·8 × 1·03) ÷ 250) + 0·03 = 0·09 + 0·03 = 12%

17 D Interest on debt is a fixed cost which leads to more volatile returns to shareholders. This is known as financial risk which increases the cost of equity.

18 A After-tax interest = $8 × (1 – 0·3) = $5·6 per year

Using linear interpolation:

Year Cash flow $ 5% Discount PV ($) 6% Discount PV ($) 0 Issue price (100) 1·000 (100·00) 1·000 (100·00) 1–10 Interest 5·6 7·722 43·24 7·360 41·22 10 Redemption 105 0·614 64·47 0·558 58·59 –––––– –––––– 7·71 (0·19) –––––– –––––– After-tax cost of debt = 5 + [((6 – 5) × 7·71) ÷ (7·71 + 0·19)] = 5 + 0·98 = 5·98% or 6%

Tutorial note: other chosen discount rates for linear interpolation should also lead to an answer of approximately 6%. .

19 D The quick or “acid test” ratio = (cash + receivables)/current liabilities. The reduction of inventory and recording of a loss would have no impact on “quick assets”. The addition of cash, however, would increase cash with no impact on current liabilities. The quick ratio therefore would improve.

20 C Unlike bank deposits peer-to-peer loans are not covered by government deposit insurance schemes.

21 B Interest rate parity is used by banks to set forward exchange rates such that speculators cannot make risk-free profits through borrowing a currency with a low interest rate and changing it into a currency with a high deposit rate. The theory operates using nominal interest rates. Long-term exchange rate forecasts should be made using purchasing power parity.

22 A Interest payment = 2,000,000 pesos. Six-month forward rate for buying pesos = 22·805 pesos per £. Sterling cost of peso interest using forward market = 2,000,000 ÷ 22·805 = £87,700

23 C A money market hedge would involve borrowing sterling today, converting at spot in pesos and then depositing these pesos.

The six-month peso deposit rate is ½ × 7·5% = 3·75%. The six-month sterling borrowing rate = ½ × 4·5% = 2·25%

24 D A currency swap represents a series of forward exchange rates written into a face-to-face agreement between two counterparties. If both parties agree then the swap could be effective over several years and therefore hedge medium-term economic risk.

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25 A An inverted yield curve is where short-term interest rates are higher than long-term interest rates. This can occur where there is a high demand for long-term loan notes, pushing up their market values and hence bringing down their yields.

26 D Working capital policies will be formulated so as to optimise, as much as possible, the length of the operating cycle and its components.

Working capital policy regarding receivables will be influenced by the terms of trade (credit period) offered by competitors to their customers.

A risk-averse company will tend to operate with higher levels of inventory and receivables than a company which is more risk-seeking.

Similarly, a risk-averse company will seek to use long-term finance for permanent current assets and some of its fluctuating current assets (conservative policy), while a more risk-seeking company will seek to use short-term finance for fluctuating current assets as well as for a portion of the permanent current assets of the company (an aggressive policy).

27 C Rise in payables (342,000 × 60/365) is $56,219 $ Increase in financing cost (56,219 × 0·045) (2,530) Discount received (342,000 × 0.8%) 2,736 ––––– Net benefit 206 –––––

28 C Paying suppliers quickly is consistent with corporate social responsibility. However the fall in creditors days would lengthen the operating cycle and have no impact on the current ratio as the fall in creditors would be matched by a rise in the overdraft.

29 D Current policy – costs per year: $ Ordering cost (12 × $100) 1,200 Holding cost (½ × 5,000 × $0·5) 1,250 Purchases 342,000 ––––––– Total cost under current policy 344,450 ––––––– Revised policy – costs per year Number of orders (60,000 ÷ 15,000) = 4 orders per year Ordering cost (4 × $100) 400 Holding cost (½ × 15,000 × $1) 7,500 Cost of components (342,000 × 0·97) 331,740 ––––––– Total cost using discount 339,640 ––––––– Annual saving ($344,450 – $339,640) 4,810 –––––––

30 A New shares will be issued at a discount to the existing share price. Hence the share price will fall from the cum-rights price to the ex-rights price. The total value of the firm’s equity will increase as new capital has been subscribed. If existing shareholders sell their rights the new shares will be bought by new investors, changing the firm’s control structure.

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Section C

31 BRT CO

(a) Net present value evaluation of new confectionery investment

Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales 3,605 8,488 11,474 16,884 Variable cost (2,019) (5,093) (6,884) (10,299) Fixed costs (1,030) (1,910) (3,060) (4,277) –––––– –––––– –––––– –––––– Taxable cash flow 556 1,485 1,530 2,308 Taxation (167) (446) (459) (692) Tax benefits of allowable depn. 150 113 84 253 Working capital (23) (23) (24) 820 –––––– –––––– –––––– –––––– –––––– After-tax cash flows 533 1,445 1,173 2,753 (439) Discount at 12% 0·893 0·797 0·712 0·636 0·567 –––––– –––––– –––––– –––––– –––––– Present values 476 1,152 835 1,751 (249) –––––– –––––– –––––– –––––– –––––– $000 Sum of present values 3,965 Initial working capital (750) Initial investment (2,000) –––––– Net present value 1,215 ––––––

Comment

The proposed investment in the new product is financially acceptable, as the NPV is positive.

Tutorial note: subtracting tax-allowable depreciation to calculate taxable profits and then adding back the tax-allowable depreciation to find cash flows is also acceptable.

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WORKINGS

Year 1 2 3 4 Sales volume (boxes) 700,000 1,600,000 2,100,000 3,000,000 Inflated selling price ($/box) 5·150 5·305 5·464 5·628 –––––––– –––––––– –––––––– –––––––– Sales ($000/yr) 3,605 8,488 11,474 16,884 –––––––– –––––––– –––––––– –––––––– Year 1 2 3 4 Sales volume (boxes) 700,000 1,600,000 2,100,000 3,000,000 Variable cost ($/box) 2·80 3·00 3·00 3·05 Inflated variable cost ($/box) 2·884 3·183 3·278 3·433 –––––––– –––––––– –––––––– –––––––– Variable cost ($000/yr) 2,019 5,093 6,884 10,299 –––––––– –––––––– –––––––– –––––––– Year 1 2 3 4 Sales volume (boxes) 700,000 1,600,000 2,100,000 3,000,000 Fixed costs ($000) 1,000 1,800 2,800 3,800 Inflated fixed costs ($000) 1,030 1,910 3,060 4,277 Year 1 2 3 4 Total $ $ $ $ $ Tax- allowable depreciation 500,000 375,000 281,250 843,750 2,000,000 Tax benefit (30%) 150,000 112,500 84,375 253,125 600,000 Year 0 1 2 3 4 $ $ $ $ $ Working capital 750,000 772,500 795,675 819,545 Incremental 22,500 23,175 23,870 (819,545)

(b) NPV and shareholder wealth

If a proposed project has a positive net present value (NPV) then this proves that the project’s expected return is higher than the minimum required return of the firm’s providers of long-term finance (as measured by the weighted average cost of capital).

This surplus return increases the total market value of the firm’s long-term finance. As debt investors receive fixed contractual returns this added value accrues to the firm’s participating equity investors, leading to a rise in the value of equity, and with it shareholder wealth.

In the case of a listed firm the demand for the firm’s shares would increase when the project becomes publically available information. The market price of each share should rise to the point where the total market capitalisation has increased to incorporate the project’s NPV. However in the case of an unquoted firm this rise in shareholder wealth cannot be directly observed.

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32 YNM CO

Financial analysis

20X4 20X5 20X6 Growth in PBIT –9% –5% Growth in finance charges 10% 4% Growth in profit after tax –13% –7% Interest coverage ratio (times) 6·1 5·0 4·6 Payout ratio 55% 64% Earnings per share ($) $0.905 $0.784 $0.731 Price/earnings ratio (times) 5·6 5·9 5·7 Dividend per share ($) $0.50 $0.50 Dividend yield (on opening price) 8·4% 9·8% Share price growth –14·1% –10·0% –9·2% Total shareholder return –5·7% –0·2 Gearing (before debt issue) (debt/equity using book values) 47% Gearing (after debt issue) 93%

(a) Discussion of financial performance and position

Financial performance

It is clear that the recent financial performance of YNM has been poor. Operating profit and profit after tax have fallen each year, while finance charges (interest) have increased each year. The share price has also fallen each year.

However, there are several positive signs. YNM has not made losses in any of the last three years, even though profits have declined. The rate of profit falls has slowed. While profit before interest and tax fell by 9% in 20X5, it only fell by 5% in 20X6. Similarly, while profit after tax fell by 13% in 20X5, it fell by only 7% in 20X6.

The rate of growth of finance charges (interest) has also fallen, from 10% in 20X5 to 4% in 20X6. It may be that YNM has almost started on the path to recovery, which may be why the company is seeking further funding to support existing business operations.

Financial position

Financial risk has increased each year as interest cover has fallen, from 6·1 times in 20X4 to a more worrying 4·6 times in 20X6. This ratio has continued to move further away from the average value for similar companies of 10 times every year.

The current gearing of 47% is higher than the average for similar companies, which is 40%. There are indications, therefore, that an increased commitment to fixed interest payments from issuing further debt may be dangerous for YNM.

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(b) Shareholder wealth

It would be easy to claim, by pointing to the continuing fall in the share price, that YNM has been decreasing, rather than increasing, shareholder wealth. The same conclusion might be reached by pointing to the negative total shareholder return in 20X4 and 20X5.

In the difficult economic circumstances with which it has been doing battle, however, it could well be that YNM is doing better than its peers in limiting the decline in its financial performance. For example, it maintained the level of its dividend payment in 20X4 and 20X5, even though this caused the payout ratio to increase from 55% in 20X4 to 64% in 20X5.

(c) The two dividend choices

If YNM pays the same dividend of $9·5m in 20X6, the payout ratio would be 68%, which is similar to the payout ratio in 20X5. The dividend yield would be 11·0% (50 ÷ 459), which is quite high, and the total shareholder return would be 1·7% ((50 + 417 – 459) ÷ 459), the first positive figure for three years. However, paying a dividend of $9·5m at a time when the company is considering raising $50m of new finance may not be acceptable to debt investors.

If YNM pays no dividend at all for 20X6, shareholders will certainly be disappointed. The current share price is $4·17 per share and given the cost of equity of 12%, the market is expecting an unchanged dividend, since $0·50 ÷ 0·12 = $4·17. Paying no dividend would therefore be very likely to lead to a further fall in the share price and increasing difficulty in raising further finance. The fall could be reduced or prevented, however, if YNM were to explain the reason for missing the dividend, for example by indicating how the cash savings were planned to be used by the company.

(d) Raising new debt finance

The current financial position of YNM, particularly the low level of interest cover, makes it unlikely that a new issue of debt would be successful. If $50m of debt were raised at the current interest rate of 8%, interest cover would fall to 2·7 times (25·3 ÷ (5·5 + 4)) and gearing would increase to 93%. It is possible that a higher interest rate than 8% might be charged due to the high level of financial risk being displayed by YNM and this would decrease the interest coverage ratio further.

YNM would also need to consider whether to raise $50m of short-term, medium-term or long-term debt finance, or a mix of debt of different maturities. As the debt is required to support existing business operations, a combination of overdraft finance and long-term debt (bank loan or loan notes) could be considered. This would give YNM exposure to short-term variable interest rates and long-term fixed interest rates, which might be useful in managing interest rate risk.

Any issue of finance has to be considered in the context of the economic environment and YNM has been “experiencing trading difficulties due to a continuing depressed level of economic activity”. Given the current financial position of YNM CO, therefore, other sources of finance than debt should also be considered, such as internal equity finance or share issues.

Tutorial note: This analysis and discussion is more than would be expected from a candidate under examination conditions.

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Marking Scheme

31 BRT CO

(a) Revenue forecast 2 Variable costs 2 Fixed costs 1 Tax paid 2 Tax saved on allowable depreciation 3 Working capital 2 Present value of returns 1 NPV 1 Comment 1 ––– 15 (b) One mark per fully explained point 5 ––– 20 ––– 32 YNM CO

(a) Analysis and discussion of financial performance 4 Analysis and discussion of financial position 2 ––– 6 (b) Analysis and discussion of total shareholder returns 2 (c) Three marks for fully analysing and discussing each dividend strategy 6 (d) One mark per fully explained point 6 ––– 20 –––

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MOCK EXAM FEEDBACK SUMMARY – PAPER F9 MOCK 1 SECTION C


Q Part Topic Study Text ref

RQB Commentary

31 (a) NPV with inflation, tax and working capital

5 Q18 HDW

As the requirement demands a “nominal terms approach” it is necessary to inflate the stated sales price and costs from “current price terms” to nominal terms. Note that it is the change in the level of working capital that causes a cash flow, and assume that the investment in working capital is recovered at the end of the project.

Tax allowable depreciation is not a cash flow, but the related tax savings are relevant. In the year of disposal there will be a balancing allowance (loss of disposal) as the scrap value is zero – the balancing allowance is not a cash flow but will save tax (at 30% in the following year).

(b) NPV and shareholder wealth

4 Q14 Directors’

Views

As the requirement is to “explain” (and 5 marks are allocated) a few brief bullet points would not score high marks. A properly developed answer would include an explanation that positive NPV shows the project’s returns exceed the average required return of (equity and debt) investors, the surplus return would be attributable to the equity investors (as debt investors receive fixed contractual returns) and hence there would be an increase in shareholder wealth. In the case of a listed firm (whose shares are quoted on the stock market) this would be realised by increased demand for the shares pushing up the share price to the point where the firm’s market capitalisation has risen to incorporate the project’s NPV.

32 (a) Evaluation of financial performance and position

19 Q30 Nugfer

As the requirement is to “analyse and discuss” the approach should be to calculate a selection of relevant ratios (noting any industry average or “sector” data given in the scenario) as a basis for comments. The trend in performance indicators is important, hence profit margins, for example, should be calculated for each year.

(b) Evaluation of shareholder wealth

19 Q6 QSX Key ratios here as (i) dividend yield (ii) capital gain/(loss) (iii) total shareholder returns. Comments should be put in the context of the scenario which states the firm operates in an environment of a “continuing depressed level of economic activity”. Do not be afraid to identify the need for additional information such as the share price performance of firms in the same business sector.

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MOCK EXAM FEEDBACK SUMMARY – PAPER F9 MOCK 1 SECTION C


Q Part Topic Study Text ref

RQB Commentary

(c) Dividend policy

8 Q30 Nugfer part (c)

Relevant discussion must refer to the fact that the firm in the scenario is listed on the stock market (as evidenced by the share price data). The directors of a listed firm must manage shareholder expectations regarding dividends – a decision to suspend dividends may cause key investors (e.g. pension fund managers who rely on dividend income) to sell the firm’s shares, potentially causing a sharp fall in the share price.

(d) Increasing debt

11 Q30 Nugfer

Key calculations are the forecast impact on financial risk (interest cover and the debt/equity ratio). Comments must be made in the context of the scenario – can we advise a form which is “experiencing trading difficulties” to take on more debt?

mock one financial management school - free acca books … acca books/ready... · 2020. 7. 13. ·...

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