F9 Revision Mock Answers

ACCA

Paper F9

Financial Management December 2012

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, 2012

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REVISION MOCK: ANSWERS

KAPLAN PUBLISHING 3

1 LUCA FOODS

Key answer tips

Tackling this question requires a methodical and logical approach. The requirements must be attempted in the order given. It is an excellent test of your understanding on the key investment appraisal topic. The highlighted words are key phrases that markers are looking for.

(a)

Tutor’s top tips:

A careful read of the question is essential. For example, the inflation increases only occur from the second year, whilst fixed costs do not inflate. Furthermore, as the investment is in training costs, no capital allowances are to be received.

With so many calculations, be careful to layout your workings neatly and cross reference fully where applicable.

0 1 2 3 4 5 $000 $000 $000 $000 $000 $000 Sales revenue 1,800 3,672 4,682 5,253 5,845 Ingredients (800) (1,696) (2,247) (2,620) (3,030) Labour (400) (880) (1,200) (1,430) (1,680) Fixed costs (100)

––––––(100)

––––––(100)

–––––– (100)

–––––– (100)

–––––– Taxable cash flow 500 996 1,135 1,103 1,035 Tax liabilities @ 30%

(150) (299) (340) (331) (311)

Investment (1,500) Working capital (500)

–––––– –––––– ––––––

––––––

–––––– 500

–––––– Net cash flow (2,000) 350 697 794 772 1,225 DF @ 12% Factor 1.000

–––––– 0.893

––––––0.797

––––––0.712

–––––– 0.635

–––––– 0.567 ––––––

Discounted CF (2,000) 313 556 565 490 694 –––––– Net present value 618

The project has a positive NPV, which will increase both the value of the business and the wealth of shareholders, therefore it should be accepted.


4 KAPLAN PUBLISHING

Workings 0 1 2 3 4 5 Unit volume 000's 400 800 1,000 1,100 1,200Inflated selling price @ 2% ($ / unit) 4.50 4.59 4.68 4.78 4.87

Sales revenue ($000)

1,800

3,672

4,682

5,253

5,845 Inflated ingredients cost @ 6% ($ / unit)

2.00

2.12

2.25

2.38

2.52

Ingredients cost ($000)

800

1,696

2,247

2,620

3,030

Inflated labour cost ($ / unit) 1.00 1.10 1.20 1.30 1.40

Labour costs ($000)

400

880

1,200

1,430

1,680

(b) Internal rate of return

Tutor’s top tips:

Don’t forget, the IRR formula is not supplied in the exam so you will need to memorise it.

0 1 2 3 4 5 $000 $000 $000 $000 $000 $000 Net cash flow (2,000) 350 697 794 772 1,225DF@ 20% 1

–––––– 0.833

––––––0.694

––––––0.579

–––––– 0.482

–––––– 0.402

––––––Discounted cash flow

(2,000) 292 484 460 372 492––––––

Net present value 100

IRR = 12 + [(618 / (618 – 100)) × (20 – 12)] = 21.54%

The project is acceptable as the IRR is significantly higher than both the existing cost of capital of 12% and the minimum 15% limit set by the managing director.

Tutorial note:

20% is not the only possible discount factor to use here; any value over 12% is acceptable. The IRR may differ slightly, but should not be significantly different if alternative values are used.


KAPLAN PUBLISHING 5

(c) Discounted payback Year Net

discounted cash flow

Cumulative cash flow

$000 $000 0 (2,000) (2,000) 1 313 (1,687) 2 556 (1,131) 3 565 (566) 4 490 (76) 5 694 618

Discounted payback period = 4 years + (76 ÷ 694) × 12 months = 4 years 1 month

The project fails to meet the deadline of 2 years set by the CEO, and should therefore be rejected. However this fails to consider the entire life of the project or the fact that the project will increase shareholder wealth. This should therefore be discussed further with the CEO as it appears that he is perhaps being over cautious.

(d)

Tutor’s top tips:

This part of the question requires you to demonstrate the impact inflation has on the profitability of the target product across the intended life.

Inflation can have a dual impact upon the proposed opportunity. Primarily increases in the selling price will derive additional revenue for the company. It is projected that the price per unit will inflate by 2% each year, resulting in a selling price of $4.87 by year 5.

However the rate of inflation is in fact much higher for the costs incurred. Ingredients rise by 6% per annum, whilst the labour costs will rise on average by 8.8% per annum ($1.40 ÷ $1.00)¼.

This will result in an increase in cost of $0.92 per unit (($2.52 + $1.40) – ($2.00 + $1.00) whilst additional revenue will only increase by $0.37. The contribution per unit will fall from $1.50 in year 1 (33% of selling price) to $0.95 in year 5 (19% of selling price).

The above analysis explains the concerns of the CEO, and demonstrates why he insists on early payback to ensure the project does not subsequently operate at a loss in those later years.


6 KAPLAN PUBLISHING

Marking scheme (a) Sales revenue Ingredients Labour Fixed costs Tax Working capital Present value of cash flows (@ 12%) NPV Comment (b) NPV at alternative rate IRR Comment (c) Discounted payback Comment that it fails to meet target set by CEO Further comment (d) 2 marks for calculation and comment regarding revenue 2 marks for calculation and comment regarding costs

2 marks for impact upon contribution per unit and CEO concerns

Total

2 2 2 1 1 1 1 1 1

–––– 1 1 1

–––– 2 1 1

–––– 2 2 2

––––

Marks

12

3

4

6

–––– 25

––––

2 HARRY’S MOTORS

Key answer tips

Although preparing a cash budget is a fairly mechanical process, it’s easy to get overwhelmed by the numbers. Care is needed to ensure you manage your time properly and don’t miss out of some of the easier ‘learn and churn’ marks later in the question.

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

(a)

Tutor’s top tips:

The key to quickly and efficiently preparing a cash budget is a methodical approach using well structured workings.

The vast majority of questions will be laid out in a user friendly way; the examiner isn’t trying to trick you.

Work your way through the information provided, at all times working out the impact that piece of information will have on cash.


KAPLAN PUBLISHING 7

Jan Feb March April Cash inflows $000 $000 $000 $000 Paid in month (20%) 300 380 340 350 Paid in arrears (80%) 1,000 1,080 1,160 1,200

––––– ––––– ––––– ––––– Total cash inflow 1,300 1,460 1,500 1,550 Cash outflows Cost of sales (1,080) (1,160) (1,200) (1,520) Sales team salary (18) (18) (18) (18) Sales commission (30) (38) (34) (35) Fixed overheads (35) (35) (35) (35) Franchise fee (100) Tax liability (250)

––––– Net cash flow 137 209 113 (308) Opening balance (250) (113) 96 209

––––– ––––– ––––– ––––– Closing balance (113) 96 209 (99)

The projected cash balance at the end of April is negative, and as such will result in action being undertaken by the bank which will threaten the future of the business.

Workings Oct Nov Dec Jan Feb Mar Apr Sales units 25 27 29 30 38 34 35

$000 $000 $000 $000 $000 $000 $000 Sales revenue @ $50k p.u. 1,250 1,350 1,450 1,500 1,900 1,700 1,750 20% paid in month 250 270 290 300 380 340 350 80% paid after 3 months 1,000 1,080 1,160 1,200 Variable cost of car (@ 80%) (1,000) (1,080) (1,160) (1,200) (1,520) (1,360) (1,400)Paid after 2 months (1,000) (1,080) (1,160) (1,200) (1,520)Commission (25) (27) (29) (30) (38) (34) (35)

(b)

Tutor’s top tips:

You should be able to cut-down significantly on the work required for this part of the requirement by using the numbers you’ve already calculated in part (a). Focus your time on the things that are changing as this will be where the majority of the marks are available.


8 KAPLAN PUBLISHING

Jan Feb March April Cash inflows $000 $000 $000 $000 Paid in month (20%) 300 380 340 350 Paid in arrears (80%) 1,000 2,280 2,680 1,360

––––– ––––– ––––– ––––– Total cash inflow 1,300 2,660 3,020 1,710 Cash outflows Cost of sales (1,080) (1,160) (1,200) (1,520) Sales team salary (18) (18) (18) (18) Sales commission (30) (38) (34) (35) Fixed overheads (40) (40) (40) (40) Franchise fee (100) Tax liability (250)

––––– Net cash flow 132 1,404 1,628 (153) Opening balance (250) (118) 1,286 2,914

––––– ––––– ––––– ––––– Closing balance (118) 1,286 2,914 2,761

The acceleration of the outstanding debts will dramatically improve the situation, with a positive cash balance of $2,761k at the end of April. This will prevent the company from facing the threat of liquidation.

Workings Oct Nov Dec Jan Feb Mar Apr Sales units 25 27 29 30 38 34 35

$000 $000 $000 $000 $000 $000 $000 Sales revenue @ $50k p.u. 1,250 1,350 1,450 1,500 1,900 1,700 1,750 20% paid in month 250 270 290 300 380 340 350 80% paid after 3 months (pre Jan) 1,000 1,080 1,160 80% paid after 1 month (post Jan) 1,200 1,520 1,360 Variable cost of car (@ 80%) (1,000) (1,080) (1,160) (1,200) (1,520) (1,360) (1,400)Paid after 2 months (1,000) (1,080) (1,160) (1,200) (1,520)Commission (25) (27) (29) (30) (38) (34) (35)

(c) When using a third party to collect debts on the company’s behalf, there is a risk that the promises made in regards to collecting within the agreed timeframes may not be met. To circumvent this situation, perhaps the monthly fee could be could be linked to achieving this target.

Further the third party may take an aggressive approach with customers which could upset them, and subsequently impair the ability to generate future sales due to a poor reputation.


KAPLAN PUBLISHING 9

Alternatives measures that are available to improve the cash position include

(1) Seek to extend suppliers credit terms, perhaps paying the supplier after 3 months as opposed to 2.

(2) Reduce the annual franchise fee by seeking to pay in monthly instalments

(3) Enter into negotiations to pay the $250,000 tax liability over a longer period.

(d) Small company’s such as HM have limited access to the equity and debt markets, thus there is a need to be self sufficient. Regular cash requirements could be classified as:

• Transaction, the need to meet regular commitments such as the monthly payroll,

• Precaution, the need to hold cash in order to service a reduction in trading activities, and

• Speculation, to take advantage of emerging opportunities, such as increased marketing when competitors collapsed.

Marking scheme (a) Cash paid in month Amount paid in arrears Variable cost of sales Sales team salary Sales team commission Fixed overheads Franchise fee Tax liability Net cash flow in month Closing balance Comment (b) Amount in arrears Fixed overheads / factor fee Comment (c) 1 mark for each problem noted 1 mark for each alternative measures

(d) 1 mark access to finance 3 marks for transaction / precaution / speculation Total

1 2 1 1 1 1

0.5 0.5 1 1 2

––––

2 1 1

––––

2 3

––––

1 3

––––

Marks

12

4

5

4 ––––

25 ––––


10 KAPLAN PUBLISHING

3 NV CO

Key answer tips

This is a tricky question drawing together two lesser examined areas of the syllabus: business valuations and risk management. Working in pesos for much of the question may cause some confusion but is preferable to doing lots of conversion to dollars.

Parts (d) & (e) offer the easiest chance to pick up marks and are independent of the rest of the question; these should therefore be attempted first.

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

(a) Valuation of S Co

An assessment can be made of the reasonableness of the valuation using the P/E ratio method. This requires an assessment of future maintainable earnings, together with an appropriate P/E ratio.

Maintainable earnings Pesos (m) Current earnings after tax 50 Redundancies (4m × (1 – 0.25)) 3 Synergistic gains (6m × (1 – 0.25)) 4.5 –––– Future Maintainable earnings 57.5

Appropriate P/E ratio

The P/E ratio of similar acquisitions in the industry (9) may provide the best unbiased assessment of an appropriate P/E ratio.

Using the earnings yield data for both NV Co and P Co, we can calculate their respective P/E ratios:

PE ratio = Yield Earnings

1

NV Co = 1 ÷ 0.125 = 8

P Co = 1 ÷ 0.10 = 10

Assessment of valuation

From P Co’s perspective, assuming the company saw no change in its P/E ratio following the market’s reaction to the disposal, it would expect a fall in value of

10 × 50 million pesos = 500 million pesos

This would therefore be deemed an appropriate valuation from their perspective and the amount suggested appears reasonable.

From NV Co’s perspective, again assuming there was no change in the company’s P/E ratio following the acquisition, it would expect an increase in value of:

8 × 57.5 million pesos = 460 million pesos

This would suggest that NV Co is paying too much for S Co.


KAPLAN PUBLISHING 11

Based on the recent acquisitions within this industry, S Co would be valued at:

9 × 57.5 million pesos = 517.5 million pesos.

Based on this valuation, there is scope for NV Co to realise additional shareholder wealth from the acquisition, but only if the market considers the future growth prospects of the combined company to be better than before. That the average P/E of recent acquisitions is greater than NV’s current P/E suggests this would be likely.

Tutor’s top tips:

Don’t forget that the consideration of different perspectives will often be key to any discussion on valuation.

(b) NV Co has $23m of cash available now.

This would be translated at the spot rate of 12.5 pesos / $ giving 287.5 million pesos

Based on an acquisition price of 500 million pesos, the loan value will be:

500 million – 287.5 million = 212.5 million pesos.

At a six monthly interest rate of 4%, this will result in interest payments of:

212.5 million × 0.04 = 8.5 million pesos every six months.

(c) The costs of the two exchange rate hedges need to be compared at the same point in time, e.g. in six months’ time.

Forward market hedge

Interest payment = 8.5 million pesos

Six-month forward rate for buying pesos = 12.606 pesos per $

Dollar cost of peso interest using forward market = 8,500,000 / 12.606 = $674,282

Money market hedge

NV Co has an 8.5 million peso liability in six months and so needs to create an 8.5 million peso asset at the same point in time. The six-month peso deposit rate is 7.4%/2 = 3.7%. The quantity of pesos to be deposited now is therefore 8,500,000 / 1.037 = 8,196,721 pesos.

The quantity of dollars needed to purchase these pesos is 8,196,721/12.500 = $655,738 and NV Co would borrow this quantity of dollars now. The six-month dollar borrowing rate = 5.5%/2 = 2.75% and so in six month’s time the debt will be $655,738 × 1.0275 = $673,771. This is the dollar cost of the peso interest using the money market hedge.

Comparing the $674,282 cost of the forward market hedge, with the $673,771 cost using a money market hedge, we can see the money market hedge is fractionally cheaper by $511. It is possible that the Treasurer may view this as an insignificant amount given the additional certainty that would by achieved by a forward market hedge.



(d) Methods of hedging interest rate risk include:

(i) Forward rate agreements (FRAs)

A forward rate agreement (FRA) is a contract by which two parties agree on the interest rate to be paid during a future period. The principal amount is agreed, but not exchanged, and the contract is settled in cash. Risk exposure to differences in interest rates can therefore be eliminated for the principal amount.

Note that the FRA does not include the borrowing of the principal amount; this must be arranged as a separate contract. The FRA is purely a contract based on interest rates during a future period. If NV Co entered into an FRA at say 6%, this would involve the bank paying the company if interest rates rose above 6% during the period, while the company would pay the bank if interest rates were below 6% during the period. Either way, the interest cost payable by NV Co over the period would become a net 6%, whatever the actual rate during the period happened to be.

(ii) Interest rate futures

An interest rate futures contract gives the holder the right to buy or sell a specific financial instrument at a specific price at a given future date. The idea is to establish a hedge between the futures position and the underlying cash instrument so that if, for example, the company finds itself paying more interest on its cash borrowings then it should be compensated by its future becoming more valuable.

(iii) Interest rate options

An interest rate options contract gives the right, but not the obligation, to buy/sell a specified financial instrument paying a fixed rate of interest at a specified price and future date. Futures exchanges, such as LIFFE, deal in option contracts in standard amounts of a selection of financial instruments, at standard strike prices and expiry dates. Alternatively over-the-counter (OTC) options can be specifically arranged by a bank.

The advantage of interest rate options over FRAs and futures is that, if there are favourable movements in the underlying market, the option need not be exercised and the company is free to enjoy the upside potential of the situation.

The disadvantage of interest rate options is the significant premium payable to buy the contract. This cost should be compared with the expected benefits of the cover provided.

(e) The term ‘return’ refers to the financial rewards gained as a result of making an investment. An investor or a company expects a particular return when making an investment.

Risk can be defined as the possibility that the actual return may be different from the expected return. Investment risk therefore arises because returns are variable and uncertain.

A key concept within financial management is that an investor or company will only take on more risk if a higher return is offered in compensation. As the possibility of the actual return being different from expected return increases, investors will demand a higher expected return.



In this scenario, P Co is switching between an investment in the equity of a company (S Co) for a return in the debt finance of the same company. As the owner of S Co, P Co faces a great deal of risk, and would therefore be looking for a higher level of expected return as compensation.

In contrast, by providing a loan to the new owners of S Co, P Co are given greater certainty over the returns they will gain (in the form of interest at a fixed rate). This allows them to lower their expected returns as they will face less investment risk.

Marking scheme Marks (a) Adjustments to maintainable earnings 2 New maintainable earnings figure 0.5 P/E for P Co & NV Co 1 Amended ME × relevant P/Es 1.5 Discussion (1 mark per point) 2 Conclusion 1

–––

8 (b) Cash balance translated at spot rate 1 Value of loan 0.5 Value of interest payments 0.5

–––

2 (c) Dollar cost of forward market hedge 1 Calculation of six-month interest hedges 1 Use of correct spot rate 1 Dollar cost of money market hedge 2 Comparison of cost of hedges 1

–––

6 (d) Up to 2 marks per method identified and explained 5 (e) 1 mark per relevant point adequately discussed 4

–– Total 25

––



4 MILY CO

Key answer tips

This question is a good reflection of the style you can expect on the day. It is also an excellent example of how different areas of the syllabus can be brought together in one question. Here we see cost of capital being seamlessly covered alongside sources of finance and financial ratios.

(a) Market values

Market value of equity = 2m ÷ $0.50 × $4 = $16m

Market value of debt = $4.5m ÷ 100 × $162 = $7.29m

Total market value of all finance = $16m + $7.29m = $23.29m

Current cost of equity using DVM and working in totals:

P0 = $16m (from above)

D0 = $1.8m (from question)

g = 4% (from question)

re = ((1.8 × 1.04) / 16) + 0.04

re = 15.7%

Cost of debt

MV = $162 (from question)

Interest (I) = $100 × 12% = $12 per annum

Kd (1 – T) = ($12 × (1 – 0.3) / 162

Kd (1 – T) =5.2%

Therefore the current WACC is:

(15.7% × 16/23.29) + (5.2% × 7.29/23.29) = 12.4%

(b) Rights issue price = 4.00 × 0.85 = $3.40

(i) Theoretical ex rights price = ((5 × 4.00) + 3.40)/6 = $3.90

(ii) Value of rights per existing share = (3.90 – 3.40)/5 = 10c



(c)

Tutor’s top tips:

The earnings per share of Mily will be impacted by the change in financing in two ways:

− A change in the earnings due to lower interest payments (following the redemption of some of the existing debentures)

− Total earnings will be spread over a greater number of shares as a result of the rights issues

The second of these is easy to spot. The first is a little harder and is easily overlooked without careful consideration of the implications of these changes.

Current share price = $4.00 (from question)

Earnings per share = 100 × (4.00/15.24) = 26.25c

Number of ordinary shares = 2m/0.5 = 4m shares

Earnings of Mily = 4m × 0.2625 = $1.05m

New shares issued = 4m/5 = 0.8m

Funds raised from rights issue = 0.8m × $4.00 × 0.85 = $2.72m

Funds raised less issue costs = 2.72m – 0.22m = $2.5m

Debenture interest saved = 2.5m ÷ $162 × 100 × 0.12 = $0.185m

Revised profit after tax = 1.05m + ($0.185m × 0.7) = $1.18m

Tutorial note:

When adjusting for the reduced interest, don’t forget that interest is tax deductible.

Shares in issue = 4m + 0.8m = 4.8

Revised earnings per share = 100 × ($1.18m/4.8) = 24.58c

(d)

Tutor’s top tips:

Since the TERP does not reflect the reduced interest charge and the P/E valuation does, we would expect the P/E valuation to be higher.

Assuming the price/earnings ratio remains constant, the share price expected after redeeming part of the debentures will fall to $3.75 per share (24.58 × 15.24). Since this is less than the theoretical ex rights share price of $3.90, using the funds raised by the rights issue to redeem part of the debentures results in a capital loss of 15c per share. The proposal to use the rights issue funds to redeem part of the debentures therefore results in a reduction in shareholder wealth.



(e)

Tutor’s top tips:

Take your lead from the question and ensure you cover the impact on the debt/equity ratio and interest cover.

Gearing

The current debt/equity ratio using market values is:

Debt/equity ratio = 100 × $7.29m ÷ $16m = 46%

This is above the sector average of 35% and is likely to be of concern to shareholders.

The $2.5m of funds raised will be used to redeem some of the existing debentures. Assuming the market value of each debenture is unchanged, the total market value will fall to:

$7.29m – $2.5m = $4.79m

Market value of equity will increase to:

4.8m × $3.75 = $18m

A substantial reduction in gearing will therefore occur if the rights issue is used to redeem some of the debentures:

Debt/equity ratio = 100 × $4.79m ÷ $18m = 26.6%

The debt/equity ratio falls to less than the sector average, signalling a decrease in financial risk. The debt/equity ratio would fall further if increased retained profits were included in the calculation.

A rights issue will be an attractive source of finance to Mily Co as it will reduce the gearing of the company.

Interest cover

Existing interest cover:

Interest = $4.5m × 12% = $0.54m

Earnings (profit after tax) = $1.05m (from above)

Profit before interest and tax = $1.05 ÷ 0.7 + $0.54m = $2.04m

Interest cover = $2.04m ÷ $0.54m = 3.8 times

Revised interest cover:

Nominal value of remaining debentures = $4.5m – ($2.5m ÷ $162 × $100) = $2.96m

Revised interest = $2.96m × 12% = $0.36m

PBIT will be unchanged at $2.04m

Interest cover = $2.04m ÷ $0.36m = 5.7 times

Interest cover will therefore move from 3.8 times, which is below the sector average of 5 times, to 5.7 times, which is marginally better than the sector average. Interest cover might also increase if the funds raised are invested in profitable projects.



Other factors

A rights issue will also be attractive to Mily Co since it will make it more likely that the company can raise further debt finance in the future, possibly at a lower interest rate due to its lower financial risk.

It should be noted that a decrease in gearing is likely to increase the average cost of the finance used by Mily Co, since a greater proportion of relatively more expensive equity finance will be used compared to relatively cheaper debt. This will increase the discount rate used by the company and decrease the net present value of any expected future cash flows.

Marking scheme Marks (a) Market value of equity 1 Market value of debt 1 Cost of equity 1 Cost of debt 1 Weighted average cost of capital 2

––

6 (b) Theoretical ex rights price per share 2 Value of rights per existing share 1

––

3 (c) Current earnings per share 1 Current earnings 1 Funds raised via rights issue 1 Interest saved by redeeming debentures 1 Revised earnings 1 Revised earnings per share 1

––

6 (d) Expected share price after redeeming debentures 1 Comparison with theoretical ex rights price 1 Discussion and conclusion 1

––

3 (e) Effect of rights issue on debt/equity ratio 3 Effects of rights issue on interest cover 3 Discussion and link to Mily Co 3

––

Max 7 ––

Total 25 ––

F9 Revision Mock Answers

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