Fundamentals Level Skills Module

Time allowedReading and planning: 15 minutesWriting: 3 hours

This question paper is divided into two sections:

Section A ALL 20 questions are compulsory and MUST be attempted

Section B ALL FIVE questions are compulsory and MUST be attempted

Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7and 8.

Do NOT open this question paper until instructed by the supervisor.

During reading and planning time only the question paper may beannotated. You must NOT write in your answer booklet until instructedby the supervisor.

Do NOT record any of your answers on the question paper.

This question paper must not be removed from the examination hall.

Pape

r F9

Financial Management

September/December 2015

The Association of Chartered Certified Accountants

Section B ALL FIVE questions are compulsory and MUST be attempted

Please write your answers to all parts of these question on the lined pages within the Candidate Answer Booklet.

1 Gemlo Co is a company listed on a large stock market. Extracts from its current statement of financial position are asfollows:

$m $mEquity

Ordinary shares ($1 nominal) 15Reserves 153

168

Non-current liabilities6% Irredeemable loan notes 107% Loan notes 12

22

190

Gemlo Co is planning an expansion of existing business operations costing $10 million in the near future and isassessing its current financial position as part of preparing a business case in support of seeking new finance. Thebusiness expansion is expected to increase the profit before interest and tax of Gemlo Co by 20% in the first year.

The planned business expansion by Gemlo Co has already been announced to the stock market. Information on theexpected increase in profit before interest and tax has not yet been announced and the company has not decided onhow the expansion is to be financed.

The ordinary shares of the company are currently trading at $375 per share on an ex dividend basis. Theirredeemable loan notes have a cost of debt of 7%. The 7% loan notes have a cost of debt of 6% and will be redeemedat a 5% premium to nominal value after seven years. The interest cover of Gemlo Co is 6 times.

Companies operating in the same business sector as Gemlo Co have an average debt/equity ratio of 40% on a marketvalue basis and an average interest cover of 9 times.

Required:

(a) Calculate the debt/equity ratio of Gemlo Co based on market values and comment on your findings.(4 marks)

(b) Gemlo Co agrees with a bank that its business expansion will be financed by a new issue of 8% loan notes. Thecompany then announces to the stock market both this financing decision and the expected increase in profitbefore interest and tax arising from the business expansion.

Required:

Assuming the stock market is semi-strong form efficient, analyse and discuss the effect of the financing andprofitability announcement on the financial risk and share price of Gemlo Co.

Note: Up to 2 marks for relevant calculations. (6 marks)

(10 marks)

2

2 GXJ Co, whose home currency is the dollar, wishes to borrow 12 million for a period of six months in three monthstime. The lending bank will fix the interest rate for the loan period at its prevailing lending interest rate when the loanis taken out. The finance director of GXJ Co believes this lending interest rate could be a minimum of 35% per yearor a maximum of 55% per year. The uncertainty regarding the future interest rate is caused by the volatile state ofthe economy and impending elections which could lead to a change in political leadership and direction. Interest onthe euro loan would be payable at the end of the loan period.

The finance director of GXJ Co would like to hedge the interest rate risk arising from the future loan and the companysbank has offered a 39, 45%35% forward rate agreement.

The finance director is also concerned about the foreign currency risk associated with the euro interest payment whichwould be due in nine months time.

The following exchange rates are available:

Spot rate (euro per $1) 1796418306Nine-month forward rate (euro per $1) 1719117505

Required:

(a) Evaluate the proposed forward rate agreement as a way of managing the interest rate risk anticipated by GXJ Co. (3 marks)

(b) Analyse the foreign currency risk associated with the future interest payment of GXJ Co and briefly discussways that this risk might be hedged. (4 marks)

(c) Explain the nature of four-way equivalence in the relationship between spot exchange rates, forwardexchange rates and future (expected) spot rates. (3 marks)

(10 marks)

3 ZXC Co currently has income of $30 million per year, of which 80% is from credit sales, and a net profit margin of10%. Due to fierce competition, ZXC Co has lost market share and is looking for ways to win back former customersand to keep the loyalty of existing customers. The sales director has pointed out that a major competitor of ZXC Cocurrently offers an early settlement discount of 05% for settlement within 30 days, while ZXC Co itself does not offeran early settlement discount. He suggests that if ZXC Co could match this early settlement discount, annual incomefrom credit sales would increase by 20%.

Credit customers of ZXC Co take an average of 51 days to settle invoices. Approximately 05% of the companys creditsales have historically become bad debts each year and written off as irrecoverable. The finance director has beenadvised that offering an early settlement discount of 05% for payment within 30 days would increase administrationcosts by $35,000 per year, while 75% of credit customers would be likely to take the discount. The credit controllerbelieves that bad debts would fall to 0375% of credit sales if the early settlement discount were introduced.

ZXC Co has an average short-term cost of finance of 4% per year. Assume that there are 360 days in each year.

Required:

(a) Evaluate whether ZXC Co should introduce the early settlement discount. (6 marks)

(b) Discuss TWO ways in which a company could reduce the risk associated with foreign accounts receivable.(4 marks)

(10 marks)

3 [P.T.O.

4 KQK Co wants to raise $20 million in order to expand its business and wishes to evaluate one possibility, which isan issue of 8% loan notes. Extracts from the financial statements of KQK Co are as follows.

$mIncome 1400Cost of sales and other expenses 1120

Profit before interest and tax 280Finance charges (interest) 28

Profit before tax 252Taxation 76

Profit after tax 176

$m $mEquity finance

Ordinary shares ($1 nominal) 250Reserves 1185 1435

Non-current liabilities 360Current liabilities 383

Total equity and liabilities 2178

It is expected that investing $20 million in the business will increase income by 5% over the first year. Approximately40% of cost of sales and other expenses are fixed, the remainder of these costs are variable. Fixed costs will not beaffected by the business expansion, while variable costs will increase in line with income.

KQK Co pays corporation tax at a rate of 30%. The company has a policy of paying out 40% of profit after tax asdividends to shareholders.

Current liabilities are expected to increase by 3% by the end of the first year following the business expansion.

Average values of other companies similar to KQK Co:

Debt/equity ratio (book value basis): 30%Interest cover: 10 timesOperational gearing (contribution/PBIT): 2 timesReturn on equity: 15%

Required:

(a) Assess the impact of financing the business expansion by the loan note issue on financial position, financialrisk and shareholder wealth after one year, using appropriate measures. (10 marks)

(b) Discuss the circumstances under which the current weighted average cost of capital of a company could beused in investment appraisal and indicate briefly how its limitations as a discount rate could be overcome.

(5 marks)

(15 marks)

4

5 Argnil Co is appraising the purchase of a new machine, costing $15 million, to replace an existing machine whichis becoming out of date and which has no resale value. The forecast levels of production and sales for the goodsproduced by the new machine, which has a maximum capacity of 400,000 units per year, are as follows:

Year 1 2 3 4Sales volume (units/year) 350,000 380,000 400,000 400,000

The new machine will incur fixed annual maintenance costs of $145,000 per year. Variable costs are expected to be$300 per unit and selling price is expected to be $565 per unit. These costs and selling price estimates are incurrent price terms and do not take account of general inflation, which is forecast to be 47% per year.

It is expected that the new machine will need replacing in four years time due to advances in technology. The resalevalue of the new machine is expected to be $200,000 at that time, in future value terms.

The purchase price of the new machine is payable at the start of the first year of the four-year life of the machine.Working capital investment of $150,000 will already exist at the start of the four-year period, due to the operation ofthe existing machine. This investment in working capital is expected to increase in nominal terms in line with thegeneral rate of inflation.

Argnil Co pays corporation tax one year in arrears at an annual rate of 27% and can claim 25% reducing balancetax-allowable depreciation on the purchase price of the new machine. The company has a real after-tax weightedaverage cost of capital of 6% and a nominal after-tax weighted average cost of capital of 11%.

Required:

(a) Using a nominal terms net present value approach, evaluate whether purchasing the new machine isfinancially acceptable. (10 marks)

(b) Discuss the reasons why investment finance may be limited, even when a company has attractive investmentopportunities available to it. (5 marks)

(15 marks)

5 [P.T.O.

6Formulae Sheet

Economic order quantity

MillerOrr Model

The Capital Asset Pricing Model

The asset beta formula

The Growth Model

Gordons growth approximation

The weighted average cost of capital

The Fisher formula

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7 [P.T.O.

Present Value Table

Present value of 1 i.e. (1 + r)n

Where r = discount rate n = number of periods until payment

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1 2 0980 0961 0943 0925 0907 0890 0873 0857 0842 0826 2 3 0971 0942 0915 0889 0864 0840 0816 0794 0772 0751 3 4 0961 0924 0888 0855 0823 0792 0763 0735 0708 0683 4 5 0951 0906 0863 0822 0784 0747 0713 0681 0650 0621 5

6 0942 0888 0837 0790 0746 0705 0666 0630 0596 0564 6 7 0933 0871 0813 0760 0711 0665 0623 0583 0547 0513 7 8 0923 0853 0789 0731 0677 0627 0582 0540 0502 0467 8 9 0914 0837 0766 0703 0645 0592 0544 0500 0460 0424 9 10 0905 0820 0744 0676 0614 0558 0508 0463 0422 0386 10

11 0896 0804 0722 0650 0585 0527 0475 0429 0388 0350 11 12 0887 0788 0701 0625 0557 0497 0444 0397 0356 0319 12 13 0879 0773 0681 0601 0530 0469 0415 0368 0326 0290 13 14 0870 0758 0661 0577 0505 0442 0388 0340 0299 0263 14 15 0861 0743 0642 0555 0481 0417 0362 0315 0275 0239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1 2 0812 0797 0783 0769 0756 0743 0731 0718 0706 0694 2 3 0731 0712 0693 0675 0658 0641 0624 0609 0593 0579 3 4 0659 0636 0613 0592 0572 0552 0534 0516 0499 0482 4 5 0593 0567 0543 0519 0497 0476 0456 0437 0419 0402 5

6 0535 0507 0480 0456 0432 0410 0390 0370 0352 0335 6 7 0482 0452 0425 0400 0376 0354 0333 0314 0296 0279 7 8 0434 0404 0376 0351 0327 0305 0285 0266 0249 0233 8 9 0391 0361 0333 0308 0284 0263 0243 0225 0209 0194 9 10 0352 0322 0295 0270 0247 0227 0208 0191 0176 0162 10

11 0317 0287 0261 0237 0215 0195 0178 0162 0148 0135 11 12 0286 0257 0231 0208 0187 0168 0152 0137 0124 0112 12 13 0258 0229 0204 0182 0163 0145 0130 0116 0104 0093 13 14 0232 0205 0181 0160 0141 0125 0111 0099 0088 0078 14 15 0209 0183 0160 0140 0123 0108 0095 0084 0074 0065 15

8

Annuity Table

Present value of an annuity of 1 i.e.

Where r = discount rate n = number of periods

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1 2 1970 1942 1913 1886 1859 1833 1808 1783 1759 1736 2 3 2941 2884 2829 2775 2723 2673 2624 2577 2531 2487 3 4 3902 3808 3717 3630 3546 3465 3387 3312 3240 3170 4 5 4853 4713 4580 4452 4329 4212 4100 3993 3890 3791 5

6 5795 5601 5417 5242 5076 4917 4767 4623 4486 4355 6 7 6728 6472 6230 6002 5786 5582 5389 5206 5033 4868 7 8 7652 7325 7020 6733 6463 6210 5971 5747 5535 5335 8 9 8566 8162 7786 7435 7108 6802 6515 6247 5995 5759 9 10 9471 8983 8530 8111 7722 7360 7024 6710 6418 6145 10

11 10368 9787 9253 8760 8306 7887 7499 7139 6805 6495 11 12 11255 10575 9954 9385 8863 8384 7943 7536 7161 6814 12 13 12134 11348 10635 9986 9394 8853 8358 7904 7487 7103 13 14 13004 12106 11296 10563 9899 9295 8745 8244 7786 7367 14 15 13865 12849 11938 11118 10380 9712 9108 8559 8061 7606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1 2 1713 1690 1668 1647 1626 1605 1585 1566 1547 1528 2 3 2444 2402 2361 2322 2283 2246 2210 2174 2140 2106 3 4 3102 3037 2974 2914 2855 2798 2743 2690 2639 2589 4 5 3696 3605 3517 3433 3352 3274 3199 3127 3058 2991 5

6 4231 4111 3998 3889 3784 3685 3589 3498 3410 3326 6 7 4712 4564 4423 4288 4160 4039 3922 3812 3706 3605 7 8 5146 4968 4799 4639 4487 4344 4207 4078 3954 3837 8 9 5537 5328 5132 4946 4772 4607 4451 4303 4163 4031 9 10 5889 5650 5426 5216 5019 4833 4659 4494 4339 4192 10

11 6207 5938 5687 5453 5234 5029 4836 4656 4486 4327 11 12 6492 6194 5918 5660 5421 5197 4988 4793 4611 4439 12 13 6750 6424 6122 5842 5583 5342 5118 4910 4715 4533 13 14 6982 6628 6302 6002 5724 5468 5229 5008 4802 4611 14 15 7191 6811 6462 6142 5847 5575 5324 5092 4876 4675 15

1 (1 + r)nr

End of Question Paper