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STUDY QUESTION BANK

December 2014June 2015 Edition

ACCAPaper F9 | FINANCIAL MANAGEMENT

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2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved. (i)

ACCA

PAPER F9

FINANCIAL MANAGEMENT

STUDY QUESTION BANK

For Examinations to June 2015

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STUDY QUESTION BANK FINANCIAL MANAGEMENT (F9)

2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved. (iii)

CONTENTS Question Page Answer Marks

MULTIPLE CHOICE QUESTIONS 1 The Financial Management Function 1 1001 10 2 The Financial Management Environment 1 1001 10 3 Investment Decisions 2 1001 12 4 Discounted Cash Flow Techniques 3 1002 20 5 Relevant Cash Flows 5 1003 20 6 Applications of DCF Techniques 8 1005 10 7 Project Appraisal under Risk 9 1006 10 8 Equity Finance 10 1007 10 9 Debt Finance 11 1007 10 10 Security Valuation and Cost of Capital 12 1008 20 11 Weighted Average Cost of Capital and Gearing 14 1009 16 12 Capital Asset Pricing Model 17 1010 12 13 Working Capital Management 19 1010 14 14 Inventory Management 20 1011 10 15 Cash Management 21 1012 10 16 Management of Accounts Receivable and Payable 22 1012 12 17 Risk Management 24 1013 12 18 Business Valuation and Ratio Analysis 25 1014 20 THE FINANCIAL MANAGEMENT FUNCTION 1 Private and public sector objectives 28 1015 10 THE FINANCIAL MANAGEMENT ENVIRONMENT 2 Capital market efficiency 28 1016 10 3 Corporate governance 28 1017 10 INVESTMENT DECISIONS 4 Elvira Co 28 1018 12 DISCOUNTED CASH FLOW TECHNIQUES 5 Khan Co 29 1019 18 6 Discounted cash flow 30 1022 30 7 Gerrard 31 1024 12 8 Despatch Co 31 1024 4 9 Carter Co 31 1025 13 RELEVANT CASH FLOWS FOR DISCOUNTED CASH FLOW TECHNIQUES 10 Blackwater Co (ACCA D97) 32 1026 20 11 ARG Co (ACCA D04) 33 1027 31 12 BFD Co (ACCA D05) 36 1030 45 Sa

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FINANCIAL MANAGEMENT (F9) STUDY QUESTION BANK

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Question Name or subject Page Answer Marks

APPLICATIONS OF DISCOUNTED CASH FLOW TECHNIQUES 13 Sticky Fingers Co 38 1034 13 14 Taleb Co 38 1036 10 15 Stan Beldark 39 1037 10 16 Armstrong Co 40 1038 20 17 Sassone Co (ACCA D04) 41 1040 38 PROJECT APPRAISAL UNDER RISK 18 Sensitivity analysis 43 1043 10 EQUITY FINANCE 19 Moorgate Co 43 1044 25 20 Greiner Co 44 1046 12 DEBT FINANCE 21 Mr Fidelio 44 1048 10 22 Equity and debt issues (ACCA D03) 45 1049 16 23 Hendil Co (ACCA D06) 45 1051 50 SECURITY VALUATION AND THE COST OF CAPITAL 24 Cost of capital 47 1056 15 25 Kelly Co 48 1058 20 WEIGHTED AVERAGE COST OF CAPITAL AND GEARING 26 Redskins Co 49 1061 20 27 Berlan Co 50 1064 15 CAPITAL ASSET PRICING MODEL 28 Crestlee Co (ACCA D92) 51 1066 25 29 Wemere (ACCA J90) 52 1068 20 30 Guidance manual 53 1071 30 WORKING CAPITAL MANAGEMENT 31 Mugwump Co 56 1073 10 32 Dire Co 57 1074 6 INVENTORY MANAGEMENT

33 Wagtail Co 57 1075 10 34 Tipex Co 58 1076 10 CASH MANAGEMENT 35 Mr Colorado 58 1077 20

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2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved. (v)


MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE 36 Worral Co 59 1079 20 37 Moore Co 61 1081 12 38 Frantic Co 61 1083 50 39 Merton Co (ACCA J06) 63 1088 50 RISK MANAGEMENT 40 Fourx Co 66 1094 10 41 Storace Co 66 1095 16 42 Three small companies (ACCA J93) 67 1097 12 43 Vertid (ACCA J95) 68 1098 40 44 Omnitown Co (ACCA D91) 69 1101 10 BUSINESS VALUATION AND RATIO ANALYSIS 45 British Industrial Group 69 1102 30 46 Twello Co 71 1107 25 47 Salween 74 1109 12 FURTHER PRACTICE QUESTIONS

THE FINANCIAL MANAGEMENT FUNCTION

48 Non-financial objectives (ACCA D01) 76 1111 10 49 Stakeholders (ACCA D02) 76 1112 10 50 Corporate governance (ACCA D02) 76 1113 10 51 RZP Co (ACCA J05) 76 1114 10 52 GGG Co (ACCA J09) 77 1117 10 53 Management remuneration (ACCA J05) 77 1118 10 THE FINANCIAL MANAGEMENT ENVIRONMENT 54 Monopoly (ACCA D03) 78 1120 8 INVESTMENT DECISIONS 55 ARR and Payback (ACCA J00) 78 1120 10 DISCOUNTED CASH FLOW TECHNIQUES 56 Charm Co (ACCA J06) 78 1123 15 57 Investment appraisal methods (ACCA J06) 79 1124 10 58 Duo (ACCA D07) 79 1126 15 59 SC Co (ACCA J08) 79 1128 15 60 NPV and shareholder wealth (ACCA J08) 80 1139 5 Sa

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(vi) 2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved.


APPLICATIONS OF DISCOUNTED CASH FLOW TECHNIQUES 61 Bread Products 80 1130 10 62 Leaminger Co (ACCA D02) 81 1131 15 63 Capital rationing 82 1133 10 64 AGD Co (ACCA D05) 82 1134 15 65 Single and multi-period rationing (ACCA D06) 82 1136 10 PROJECT APPRAISAL UNDER RISK 66 Risk and uncertainty (ACCA D04) 82 1137 5 67 Umunat Co (ACCA D04) 83 1137 15 EQUITY FINANCE AND DEBT FINANCE 68 Arwin (ACCA J04) 84 1139 15 69 Tirwen Co (ACCA D04) 85 1141 15 70 Echo (ACCA D07) 86 1142 10 71 Echo Echo (ACCA D07) 87 1144 10 72 JJG Co (ACCA J09) 88 1145 15 73 NG Co (ACCA D09) 88 1146 15 74 Debt issue (ACCA D08) 89 1148 15 COST OF CAPITAL AND GEARING 75 Dangers of high gearing (ACCA J04) 89 1149 10 76 Oxfield Co 89 1150 15 77 YGV Co (ACCA J10) 90 1152 15 78 Close Co (ACCA D11) 91 1154 15 CAPITAL ASSET PRICING MODEL 79 Burse Co (ACCA J08) 92 1155 15 80 Rupab Co (ACCA D08) 92 1157 15 WORKING CAPITAL MANAGEMENT 81 Cash operating cycle (ACCA J04) 93 1158 10 82 Level of current assets (ACCA J09) 93 1159 10 83 Associated International Supplies 93 1160 15 84 Anjo Co (ACCA D06) 94 1163 15 INVENTORY MANAGEMENT 85 TNG Co (ACCA J05) 95 1164 15 CASH MANAGEMENT 86 Thorne Co (ACCA D05) 96 1165 15 87 Optimal cash level (ACCA D06) 96 1166 8 88 ZSE Co (ACCA J10) 96 1167 15

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2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved. (vii)


MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE 89 Factoring and discounting (ACCA J09) 97 1169 6 90 Overseas receivables (ACCA J09) 97 1170 8 91 Gorla (ACCA D08) 97 1171 15 RISK MANAGEMENT 92 Interest rate management (ACCA J01) 98 1172 10 93 Gitlor (ACCA D02) 99 1173 10 BUSINESS VALUATION 94 Tundra (ACCA J03) 99 1174 8 95 NGN (ACCA J09) 99 1174 6 96 Phobis Co (ACCA D07) 100 1175 10 97 THP Co (ACCA J08) 100 1176 15 98 Dartig Co (ACCA D08) 101 1177 15

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STUDY MULTIPLE CHOICE QUESTION BANK FINANCIAL MANAGEMENT (F9)

2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved. 1

1 The Financial Management Function

1.1 Which of the following is NEVER consistent with the objective of maximising shareholder wealth?

A Following corporate social responsibility B Increasing sales levels C Satisficing D Paying dividends

1.2 In which of the following principal/agent relationships is the principal named second?

A Shareholders and managers B Customers and the company C Shareholders and debt-holders D Employers and employees

1.3 Which of the following is a sign that a company is failing to maximise shareholder wealth?

A Management has challenging performance bonuses B Investment decisions are evaluated on the basis of their net present value C The company has not diversified its operations D Financing of the company is via equity finance alone

1.4 Which of the following are not usually considered to be agency costs?

A Costs associated with giving share options to managers B Costs of monitoring managers C Costs of obtaining a listing on the stock exchange D Costs of divergent behaviour by managers

1.5 Which of the following is LEAST likely to solve the agency problem between shareholders and managers?

A Giving managers profit-related rewards B Using external auditors to gauge company performance C Writing restrictive covenants into bond contracts D Monitoring managers actions

2 The Financial Management Environment

2.1 Which of the following statements about interest rates is/are true?

(1) In a period of high inflation, one would expect nominal interest rates to be higher than in a period of low inflation.

(2) Overdraft interest rates will normally increase in direct proportion to the balance outstanding.

A 1 only B 2 only C Both 1 and 2 D Neither 1 nor 2

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FINANCIAL MANAGEMENT (F9) STUDY MULTIPLE CHOICE QUESTION BANK

2 2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved.

2.2 Freely fluctuating exchange rates perform which of the following functions?

A They tend to correct a lack of equilibrium between imports and exports B They make imports cheaper and exports more expensive C They impose constraints on the domestic economy D They eliminate the need for foreign currency hedging

2.3 Which of the following investments is not acceptable as a way for companies to invest short-term cash surpluses?

A Bank deposit account B Ordinary shares C Certificates of deposit D Treasury bills

2.4 Supply side policy is designed for what purpose?

A To raise the level of aggregate monetary demand in the economy B To manage the money supply in the economy C To improve the ability of the economy to produce goods and services D To reduce unemployment by limiting the supply of labour

2.5 Which ONE of the following government policies would NOT tend to raise national income over time?

A Increased expenditure on the economic infrastructure B Tax cuts to encourage higher demand from consumers C Policies to encourage the training of labour D Financial incentives to encourage personal saving

3 Investment Decisions

3.1 Which investment appraisal method is generally considered the best model for long-range decision making?

A Payback B Accounting rate of return C Internal rate of return D Net present value

3.2 Which of the following statements concerning the payback method is correct?

A It does not consider the time value of money B It is the time required to recover the investment and earn a profit C It is a measure of how profitable one investment project is compared to another D It is reliable for project selection decisions

3.3 In considering the payback period for three projects, Fly Co gathered the following data about cash flows:

Year 1 Year 2 Year 3 Year 4 Year 5 $ $ $ $ $ Project A (10,000) 3,000 3,000 3,000 3,000 Project B (25,000) 15,000 15,000 (10,000) 15,000 Project C (10,000) 5,000 5,000

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Which of the projects will achieve payback within three years?

A Projects A, B, and C B Projects B and C only C Project B only D Projects A and C only

3.4 Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?

A Accounting rate of return B Payback period C Internal rate of return D Profitability index

3.5 A company wants to know how many years it will take before the accumulated cash flows from an investment equal the initial investment cost, without taking the time value of money into account.

Which of the following methods should be used?

A Payback period B Discounted payback period C Internal rate of return D Net present value

3.6 In making capital budgeting decisions, management may consider factors that are broader than relevant costs alone.

Which one of the following factors is LEAST likely to be considered a non-financial or qualitative factor?

A Increase in manufacturing flexibility B Improved corporate image C Reduced waste and product reworking D Reduction in new product development time

4 Discounted Cash Flow Techniques

4.1 Which of the following limitations is common to the calculations of payback period, discounted payback, internal rate of return and net present value?

A They do not consider the time value of money B They require multiple trial and error calculations C They require knowledge of a companys cost of capital D They rely on the forecasting of future data

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4.2 Salem Co is considering a project that produces annual net cash inflows of $420,000 for Years 1 through 5 and a net cash inflow of $100,000 in Year 6. The project will require an initial investment of $1,800,000. Salems cost of capital is 10%.

What is the net present value for this project to the nearest $100?

A $83,000 B ($108,200) C ($151,400) D ($442,000)

4.3 A company is considering purchasing a machine that costs $100,000 and has a $20,000 scrap value. The machine will produce annual operating cash inflows of $25,000 each year and has a six-year life. The company uses a discount rate of 10%.

What is the net present value of the machine?

A ($2,405) B $8,875 C $20,155 D $28,875

4.4 An investment in a new product will require an initial outlay of $20,000. The cash inflow from the project will be $4,000 a year for the next six years.

Using an 8% discount rate what is the net present value of the investment?

A ($4,876) B ($1,508) C ($29) D $1,508

4.5 Which of the following phrases defines the internal rate of return on a project?

A The number of years it takes to recover the investment B The discount rate at which the net present value of the project equals zero C The discount rate at which the net present value of the project equals one D The weighted-average cost of capital used to finance the project

4.6 If a project has a required rate of return of 6%, which of the following statements is correct?

A The NPV will be positive if the IRR is equal to 5% B The project will be rejected if the IRR is equal to 7% C The NPV will be negative if the IRR is greater than 6% D The project will be accepted if the IRR is greater than 6%

4.7 Which of the following statements is true if the net present value of a project is negative $4,000 and the required rate of return is 5%?

A The projects IRR is less than 5% B The required rate of return is lower than the IRR C The NPV assumes cash flows are reinvested at the IRR D The NPV would be positive if the IRR was equal to 5%

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4.8 Which of the following items describes a weakness of the internal rate of return (IRR) method?

A IRR is can only be estimated using a financial calculator or spreadsheet

B Cash flows from the investment are assumed to be reinvested at the IRR

C The IRR calculation ignores the time value of money

D The IRR calculation ignores project cash flows occurring after the initial investment is recovered

4.9 A firm is contemplating investing $10,000 on 31 December 20X1 to earn a single sum of

$12,100 receivable on 1 January 20X4.

What is the internal rate of return of this investment?

A 6.5% B 7.0% C 10.0% D 10.5%

4.10 Consider the following graph.

NPV

Discount rate0 15%

Project X

Project Y

Which ONE of the following statements is true?

A Project Y has a higher internal rate of return than project X B At discount rate of less than 15%, project Y is preferred to project X C Project X is preferred to project Y irrespective of discount rate D Project Y is preferred to project X irrespective of discount rate

5 Relevant Cash Flows

5.1 Gunning Industries is considering investment in a new machine which has a five year life. The investment in the new machine would also require an immediate increase in working capital of $35,000. Gunning is subject to a 40% corporate tax rate and has a 10% weighted average cost of capital

What is the overall discounted cash flow effect on Gunning Industries working capital investment over the life of the new machine?

A ($7,959) B ($10,680) C ($13,265) D ($35,000)

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5.2 Moore Co is considering the acquisition of a new machine costing $105,000. It is estimated that the machine will have a 10-year life and scrap value of $5,000. Over its life the machine is expected to produce 2,000 units each year with a sales price per unit of $500 and combined material and labour costs of $450 per unit. Capital allowances are available on a straight-line basis on cost over five years. Moore has a 40% tax rate and tax is paid in the year of returns.

What is the post-tax cash flow for the tenth year of the project?

A $81,000 B $68,400 C $63,000 D $60,000

5.3 Which one of the following will normally affect a projects net present value?

A Estimated scrap value of the asset B Net book value of the asset C Amount of annual depreciation on the asset D Amoun of head office costs recharged to the project

5.4 What is a capital allowance?

A A government grant B A reduction in taxable proft C Depreciation expense D Impairment to an assets value

5.5 Carter Co paid $1,000,000 for land three years ago. Carter estimates that it could sell the land today for $1,200,000. If the land is not sold, Carter plans to develop the land at an initial cost of $1,500,000. Carter estimates the net operating cash inflow during the first year following development would be $500,000.

What is Carters opportunity cost of the development?

A $1,500,000 B $1,200,000 C $1,000,000 D $500,000

5.6 A firm is considering investment in new labour-saving equipment costing $1 million. The current wage rate is $5 per hour but the firm expects this to increase by 5% each year into the foreseeable future. The equipment is expected to save 20,000 labour hours per year.

The companys nominal (money) cost of capital is 15.5%.

What (to the nearest $000) is the present value of the savings over a ten year planning period?

A $385,000 B $558,000 C $615,000 D $676,000

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5.7 Oze Co uses the net present value approach in evaluating projects. Data for a particular project are given below.

% per year Cost of capital in real terms 10 General inflation rate 5 Annual cash inflow (CI) from the project is expected to increase by 6 Annual cash outlay (CO) on the project is expected to increase by 4

Which one of the following sets of adjustments will lead to the correct NPV being calculated?

A CI and CO to be increased by 5% each year and discounted by 15% each year

B CI to be increased by 6% each year, CO to be increased by 4% each year and both discounted by 15% each year

C CI to be increased by 6% each year, CO to be increased by 4% each year and both discounted by 15.5% each year

D CI and CO to be unadjusted and discounted by 10% each year

5.8 Paisley Co plans to purchase a machine costing $13,500. The machine will save labour costs of $7,000 in the first year. Labour rates in the second year will increase by 10%. The general rate of inflation is 8% and the companys real cost of capital is estimated at 12%.

The machine has a two year life with an estimated scrap value of $5,000.

What is the NPV (to the nearest $10) of the proposed investment?

A $550 B $770 C $970 D $1,150

5.9 Net present value as used in investment decision-making is based on which ONE of the following?

A Net income B Earnings before interest, taxes and depreciation C Earnings before interest and taxes D Cash flows

5.10 A firm expects to receive annual cash flows of $75,000 per year in current price terms for a period of five years. The cash flows will inflate at 4% and the firms nominal cost of capital is 10%.

What is the present value of the expected cash flows (to the nearest $1,000)?

A $318,000 B $375,000 C $284,000 D $296,000

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6 Applications of DCF Techniques

6.1 The profitability index is a variation of which of the following capital budgeting models?

A Internal rate of return B Return on investment C Net present value D Discounted payback

6.2 Progress Co has the following non-divisible projects available:

Project PV Cash outflows PV Cash inflows Profitability index $ $ 1 200,000 300,000 1.50 2 450,000 725,000 1.61 3 350,000 425,000 1.21 4 900,000 1,300,000 1.44 5 600,000 1,000,000 1.67 Assuming the company has $1,000,000 to invest in capital projects, which combination of projects should Progress Co accept?

A 1 and 5 only B 2 and 4 only C 3 and 5 only D 1, 2 and 3 only

6.3 A company should accept all positive NPV projects when which of the following conditions is true?

A The company has extremely limited resources for capital investment B The company has excess cash on its statement of financial position C The company has virtually unlimited resources for capital investment D The company currently has limited resources for capital investment but is planning

to issue new equity

6.4 A company will lease new machinery. The lease term is five years and lease payments of $10,000 will be made annually in advance.

What is the present value of the lease payments using a discount rate of 10%?

A $4,170 B $6,209 C $37,910 D $41,700

6.5 Which one of the following is a possible formula for calculating the profitability index of a project?

A Subtract actual net income from the minimum required return in dollars

B Divide the present value of the annual cash inflows by the original cash invested in the project

C Divide the initial investment for the project by the net annual cash inflow

D Multiply net profit margin by asset turnover

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7 Project Appraisal under Risk

7.1 Dough Co has decided to increase its daily muffin purchases by 100 boxes. A box of muffins costs $2 and sells for $3 in normal shops. Any boxes not sold in normal shops are sold through Doughs economy shop for $1. Dough estimates the following probabilities to selling additional boxes:

Normal Economy shop sales shop sales Probability 60 40 0.6 100 0 0.4 What is the expected value of Doughs decision to buy 100 additional boxes of muffins?

A $28 B $40 C $52 D $68

7.2 Blane Co purchases a new machine for $340,000. The machine is expected to increase annual cash flows by $110,000 per year for the next four years. The appropriate discount rate is 4%.

Using the discounted payback period method, approximately how many years will it take for Blane to recover its investment?

A 3.09 years B 3.16 years C 3.37 years D 3.58 years

7.3 A supplier offered Wyatt Co $25,000 compensation for losses resulting from faulty raw materials. Alternately, a lawyer offered to represent Wyatt in a lawsuit against the supplier for a $12,000 minimum fee and 50% of any award over $35,000. Possible court awards with their associated probabilities are:

Award Probability $75,000 0.6 $0 0.4 Compared to accepting the suppliers offer, what is the expected value for Wyatt of taking the matter to court?

A $4,000 loss B $18,200 gain C $21,000 gain D $38,000 gain

7.4 Dallara runs an office sandwich delivery service. He orders sandwiches at the start of each day for 45 cents each and takes them round to local offices where he sells them for 75 cents. Any unsold sandwiches are thrown away. Possible levels of daily demand are as follows:

Demand Probability 50 0.2 60 0.3 70 0.4 80 0.1

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How many sandwiches should be ordered each day to maximise long-term profit?

A 50 B 60 C 64 D 70

7.5 The annual sales volume and the contribution per unit of a new product are uncertain. Estimates for these two variables are as follows:

Sales volume Probability Contribution Probability (units) 80,000 0.1 $2.00 0.5 75,000 0.6 $1.50 0.5 50,000 0.3 The sales volume and contribution per unit can be assumed to be independent.

If the annual fixed costs are $130,000, what is the probability that the company will make a loss?

A 0.30 B 0.50 C 0.65 D 1.00

8 Equity Finance

8.1 A firms current share price is $4. The company then makes a 2 for 3 rights issue at an issue price of $2.

What is the theoretical ex-rights price?

A $250 B $280 C $300 D $320

8.2 A company makes a rights issue and the following prices apply:

Current share price $10 Rights issue price $6 Theoretical ex-rights price $9 What were the terms of the rights issue?

A 1 for 3 B 3 for 1 C 1 for 4 D 4 for 1

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8.3 What effect would making a scrip issue of shares have?

A Decreases the debt/equity ratio of the company B Decreases earnings per share C Increases individual shareholder wealth D Increases the market price of the share

8.4 Sutton Co has announced a 1 for 3 rights issue at $2 per share. The current share price is $3.04.

What is the theoretical value of one right per existing share?

A $0.26 B $0.35 C $0.78 D $1.04

8.5 A company, whose shares currently sell at $75 each, plans to make a rights issue of one share at $60 for every four existing shares.

What is the theoretical ex-rights price of the shares after the issue?

A $75.00 B $72.00 C $67.50 D $63.00

9 Debt Finance

9.1 For what reason would a firm issue convertible debt?

A It is cheaper to service than ordinary debt B Sales and earnings are expected to fall over the next few years C If conversion takes place, it will not change the firms financial gearing ratio D If conversion takes place, it will generate additional finance for the firm

9.2 A company is evaluating the advantages and disadvantages of short-term and long-term financing options.

Which of the following two characteristics are usually true?

Short-term financing Long-term financing A Lower rollover risk Lower cost B Higher rollover risk Higher cost C Lower rollover risk Higher cost D Higher rollover risk Lower cost

9.3 Which of the following best describes the term coupon rate as applied to bonds?

A The annual interest paid on the face value of the bond

B The annual interest divided by the current market price of the bond

C The total return on a bond, taking into account capital repayment as well as interest payments

D The annual interest paid on the market price of the bond

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9.4 Which one of the following best describes a participating preference share?

A A preference share which has the right to be converted into ordinary shares at some future date

B A preference share which entitles to the holder to a guaranteed minimum dividend with the possibility of an additional amount

C A preference share which carries forward the right to dividends, if unpaid, from one year to the next

D A preference share which entitles the shareholder to a fixed rate of dividend

9.5 Which of the following are reasons why a company may prefer debt financing to equity financing?

(1) Debt, unlike equity finance, will not need to be secured against assets (2) Debt can be raised for finite time periods (3) Debt finance can be raised more quickly than equity finance (4) Interest payments are tax-deductible

A 1, 2 and 3 only B 2, 3 and 4 only C 1, 3 and 4 only D 1, 2 and 4 only

10 Security Valuation and Cost of Capital

10.1 Davis wants to buy shares of Epoch Co.

If Davis uses a zero growth model, a required rate of return of 20% and an annual dividend of $10, what is Epochs share price?

A $2 B $20 C $50 D $100

10.2 If Brewer Cos bonds have a yield to maturity (gross redemption yield) of 8%, why would the companys cost of debt be lower?

A Market interest rates have increased B Additional debt can be issued more cheaply that the original debt C Interest is deductible for tax purposes D There is a mixture of old and new debt

10.3 Which capital structure theory suggests that the weighted average cost of capital (WACC) will initially decrease, reach a minimum and then increase?

A Pecking order theory B The traditional trade-off view C Modigliani and Miller without tax D Modigliani and Miller with tax

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10.4 Which one of a firms sources of new capital usually has the lowest after-tax cost?

A Retained earnings B Bonds C Preference shares D Ordinary shares

10.5 The capital structure of a firm includes bonds with a coupon rate of 12% and a yield to maturity (gross redemption yield) of 14%. The corporate tax rate is 30%.

What is the firms net cost of debt?

A 8.4% B 9.8% C 12.0% D 14.0%

10.6 The shares of Fargo Co are selling for $85. The dividend after one year is expected to be $4.25 and is expected to then grow at a rate of 7%. The corporate tax rate is 30%.

What is the firms cost of equity?

A 5.0% B 8.4% C 12.0% D 12.35%

10.7 A firm distributes 80% of its earnings. The return on its projects is 15%. the firms market capitalisation is $1.5 million and most recent net income is $125,000.


A 9.6% B 9.9% C 18.7% D 19.5%

10.8 Quinton Cos most recent income statement is as follows: $000

Profit before tax 500 Taxation (100) Net income 400 Dividends on ordinary shares (300) Retained profit 100

Net assets in the statement of financial position were $4,500,000.

What is the annual dividend growth rate computed using Gordons growth approximation?

A 3.70% B 2.96% C 2.78% D 2.22%

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10.9 A company has 15% coupon $100 nominal value bonds in issue. Investors currently require a gross redemption yield (yield to maturity) of 12% on bonds of this class of risk.

If the corporation tax rate is 35% what is the cost of the bonds to the company?

A 7.80% B 9.00% C 9.75% D 11.25%

10.10 The following data relate to an unquoted company:

Dividend (just paid) $180,000 Payout ratio 40% Return on investments 15% Cost of equity 20%

What is the theoretical market value of equity (to the nearest $000)?

A $900,000 B $1,363,000 C $1,636,000 D $1,784,000

11 Weighted Average Cost of Capital and Gearing

11.1 DQZ Telecom has the following combination of debt and equity finance:

Bonds with a market value of $15 million. Ordinary shares with a market capitalisation of $35 million. The expected return on the equity market is 11%. Treasury bills are currently yielding 5%. The equity beta for DQZ is estimated to be 0.80 and its bonds have a yield to maturity of 7%. The tax rate is 30%.

What is the weighted average cost of capital?

A 9.80% B 9.17% C 8.96% D 8.33%

11.2 ABC Co had debt with a market value of $1 million and an after-tax cost of debt of 8%. ABC also had equity with a market value of $2 million and a cost of equity of 9%.

What is ABCs weighted-average cost of capital?

A 8.0% B 8.5% C 8.7% D 9.0%

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11.3 Which ONE of the following factors might cause a firm to increase the debt in its financial structure?

A An increase in the corporate tax rate B Increased economic uncertainty C An increase in the price/earnings ratio D A decrease in the interest cover ratio

11.4 What is the weighted average cost of capital?

A The rate of return on assets that covers the costs associated with the funds employed

B The minimum rate a firm must earn on high-risk projects

C The cost of the firms equity capital at which the market value of the firm will remain unchanged

D The maximum rate of return on assets

11.5 Youngsten Electric has the following capital structure:

8% $1 preference shares. There are 10 million preference shares in issue, each trading at $1.30.

30 million ordinary shares with an equity beta of 1.45 and market price of $2.50 per share.

The risk-free rate is 3%, the market risk premium is 5% and corporate tax rate 30%.

What is Youngstens weighted average cost of capital?

A 10.3% B 9.6% C 9.9% D 6.2%

11.6 Bryan Co has 10 million ordinary shares in issue with a market price of 155 cents cum-div. An annual dividend of 9 cents is just about to be paid. Annual dividends have been growing at a steady rate of 6% each year. The companys other major source of funds is a bank loan of $7 million which has a pre-tax cost of 8%.

If Bryan Co pays corporation tax at a rate of 33%, what is its post-tax weighted average cost of capital?

A 8.17% B 8.50% C 11.06% D 10.21%

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11.7 One of the following diagrams is consistent with the traditional view of capital structure, where ke refers to the cost of equity and k refers to the weighted average cost of capital:

Cost Cost

Cost Cost

Diagram A

Diagram DDiagram C

Diagram B

k

k

k

k

k

k

k

ke e

ee

gearing gearing

gearinggearing Which diagram is correct?

A Diagram A B Diagram B C Diagram C D Diagram D

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11.8 One of the following diagrams is consistent with Modigliani and Millers model of capital structure ignoring corporate tax, where ke refers to the cost of equity and k refers to the weighted average cost of capital:

Cost Cost

Debt value/ Equity value


Cost Cost

Diagram A

Diagram D Diagram C

Diagram B

k k

k k

k k

k k

e e

e e



Which diagram is correct?

A Diagram A B Diagram B C Diagram C D Diagram D

12 Capital Asset Pricing Model

12.1 Which of the following statements about risk is/are true?

(1) In order to reduce the risk of a portfolio, the returns on its securities must be negatively correlated.

(2) A risk-averse investor will always seek to minimise risk.

A 1 only B 2 only C Both 1 and 2 D Neither 1 nor 2

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12.2 Capital investments require balancing risk and return. Managers have a responsibility to ensure that the investments that they make increase shareholder value.

Managers have met that responsibility if the return on the capital investment meets which ONE of the following conditions?

A It exceeds the rate of return associated with the firms beta factor B It is less than the rate of return associated with the firms beta factor C It is greater than the risk-free rate of return D It is less than the risk-free rate of return

12.3 The equity market is expected to earn 12%. Treasury bills are currently yielding 5%. The equity beta of DQZ Co is estimated to be 0.60 and the firm has a tax rate of 40%.

What is DQZs cost of equity?

A 5.5% B 9.2% C 10.0% D 12.2%

12.4 A firm has an equity beta of 1.25 and a debt beta of 0.20. The equity market premium is 8% and the risk-free rate is 6%. The tax rate is 30%.


A 8.5% B 11.2% C 14% D 16.0%

12.5 Assume that a firms equity beta is 0.90, the risk-free rate is 2.75% and the market return is 5.50%.

What is the cost of retained earnings using the capital asset pricing model?

A 5.25% B 5.50% C 7.70% D 8.25%

12.6 What correlation between returns on shares held will best reduce risk?

A Perfect positive correlation B No correlation C Perfect negative correlation D Weak correlation

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13 Working Capital Management

13.1 Which of the following transactions would increase the current ratio and decrease net profit?

A Tax due from the previous year is paid B A long-term bond is redeemed C A scrip dividend is paid D Land is sold for less than the net book value

13.2 Which of the following ratios would most likely be used by management to evaluate short-term liquidity?

A Return on total assets B Sales to cash C Accounts receivable turnover D Acid test (quick) ratio

13.3 Which of the following items are included in the calculation of the cash conversion cycle (working capital cycle)?

(1) Inventory conversion period (2) Payables payment period (3) Receivables collection period (4) Settlement discount period A 1, 2 and 3 only B 2, 3 and 4 only C 1, 3 and 4 only D 1, 2 and 4 only

13.4 The cash conversion cycle of an organisation would shorten under which of the following combinations of changes?

Inventory Receivables Payables conversion period collection period payment period A Increase Increase Increase B Decrease Decrease Increase C Increase Decrease Decrease D Decrease Decrease Decrease

13.5 Which ONE of the following situations will produce the most favourable operating cycle?

Inventory Receivable Payable conversion period collection period deferral period A Short Short Short B Long Long Short C Short Short Long D Long Short Long

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13.6 What is the operating cycle of company Z given the following?

Inventory days 30 days Days sales outstanding 38 days Trade payables days 44 days A 112 days B 68 days C 36 days D 24 days

13.7 A company has a current ratio of 2. Due to having significant surplus cash balances, it has decided to pay its trade payables after 30 days in future, rather than after 50 days as it has in the past.

What will be the effect of this change on the companys current ratio and its cash operating cycle?

Current ratio Cash operating cycle A Increase Increase B Increase Decrease C Decrease Increase D Decrease Decrease

14 Inventory Management

14.1 Spotech Cos budgeted sales and budgeted cost of sales for the coming year are $212,000,000 and $132,500,000 respectively. Short-term interest rates are expected to average 5%.

If Spotech could increase inventory turnover from its current 8 times per year to 10 times per year, its expected cost savings in the current year would be:

A $81,812 B $165,625 C $250,000 D $331,250

14.2 Which one of the following would tend to increase the amount of inventory that a company holds?

A Cost of holding inventory decreases B Variability of sales decreases C Cost of running out of inventory decreases D Lead time decreases

14.3 Stewart Co uses the Economic Order Quantity (EOQ) model for inventory management.

A decrease in which ONE of the following variables would increase the EOQ?

A Cost per order B Level of buffer stock C Holding cost D Quantity demanded

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14.4 An increase in which ONE of the following should cause management to reduce the average inventory?

A The cost of placing an order B The cost of holding inventory C The annual demand for the product D The lead time needed to acquire inventory

14.5 Lyle Cos inventory reorder level is 500 units, the lead time is three weeks, and the sales volume is estimated at 50 units per week.

Lyle has established which of the following amounts as its safety stock?

A 150 B 350 C 500 D 650

15 Cash Management

15.1 Average daily cash outflows are $3 million for Evans Co. A new cash management system can add two days to the cash payments schedule. Evans can earn 10% per annum on surplus funds.

What is the maximum amount that Evans should be willing to pay each year for this cash management system?

A $3,000,000 B $1,500,000 C $600,000 D $150,000

15.2 Each day a company sends cheques to suppliers totalling $10,000 and receives cheques from customers totalling $10,000. It takes five days for the cheques sent to suppliers to be deducted from the companys account but only four days for the deposits to clear.

Based on this information what is the companys bank balance?

A $(10,000) B $0 C $10,000 D $25,000

15.3 The following items were extracted from a companys budget for next month:

$ Purchases on credit 360,000 Expected decrease in inventory over the month 12,000 Expected increase in trade payables over the month 15,000

What is the budgeted payment to trade payables for the month?

A $333,000 B $345,000 C $357,000 D $375,000

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15.4 A company commenced business on 1 April. Sales in April were $20,000, but this is expected to increase at 2% a month. Credit sales amount to 60% of total sales.

The credit period allowed is one month. Bad debts are expected to be 3% of credit sales, but other customers pay on time. Cash sales represent the other 40% of sales.

How much cash is expected to be received in May?

A $19,560 B $19,640 C $19,800 D $20,160

15.5 Which of the following would most likely be considered a disadvantage for a company to maintain high levels of cash?

A Holding cash ensures liquidity

B Occasionally, the company has an opportunity to buy inventory at a substantially reduced price

C Investor dissatisfaction with the firms asset allocation

D The ability to cope with unexpected events

16 Management of Accounts Receivable and Payable

16.1 A factor has offering the following arrangement to Dino Co which has annual sales of $1,500,000 and an average receivables period of one month:

The factor will advance 80% of the face value of receivables at a 10% annual interest rate and charge a fee of 2% on turnover. Dino Co estimates that the firm would save $24,000 in administration expenses over the year.

What is the annual net cost of factoring?

A $12,000 B $14,800 C $16,000 D $20,000

16.2 Jackson Distributors sells to retail stores on credit terms of 2% discount for settlement within 10 days or full payment within 30 days. Daily sales average 150 units at a price of $300 each.

Assuming that all sales are on credit and 60% of customers take the discount and pay on day 10 while the rest of the customers pay on day 30, the amount of Jacksons accounts receivable is:

A $990,000 B $900,000 C $810,000 D $450,000

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16.3 Foster Co is considering implementing a new cash collection system at a cost of $80,000 per year. Annual sales are $90 million and the new system will reduce collection time by three days.

If Foster can invest surplus funds at 8% per annum, what is the net gain/ (loss) from implementing the new system? Assume a 360-day year.

A Net gain of $60,000 per year B Net loss of ($20,000) per year C Net loss of ($60,000) per year D Net loss of ($140,000) per year

16.4 The following information has been extracted from a companys financial records:

Opening Closing balance balance $ $ Cash 3,900 3,000 Cash equivalents 3,800 4,400 Accounts receivable 14,600 12,900 Total current assets 22,300 20,300 Revenues 103,200 Expenses 20,430 Net income 82,770 What is the companys receivable turnover ratio?

A 6.0 B 7.1 C 7.5 D 8.0

16.5 What does invoice discounting normally involve?

A Offering a cash discount for early settlement of invoices B Selling all invoices to a finance house who takes over administration of the

receivables ledger C Receiving a cash advance from a finance house based on a percentage of face value

of selected invoices D Writing off an invoice, partly or in total, as a bad debt

16.6 When accounts receivable are sold to a debt factoring company, which of the following is LEAST likely?

A Cash will be received sooner than if receivables were not sold B The accounts receivable will be sold above their face value C The debt factoring company will make a profit on the service provided D Working capital will decrease

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17 Risk Management

17.1 In relation to the term structure of interest rates what is an inversed yield curve?

A Upward sloping B Downward sloping C U-shaped D Horizontal

17.2 Atlas Worldwide Industries conducts business in a number of different countries and is trying to evaluate its economic exposure to long-term exchange rate trends.

Which of the following statements is NOT correct?

A Atlas will suffer an economic loss if it has net cash outflows in a foreign currency and the foreign currency appreciates

B Atlas will enjoy an economic gain if it has net cash outflows of a foreign currency and the foreign currency depreciates

C Atlas will suffer an economic loss if it has net cash inflows of a foreign currency and the foreign currency appreciates

D Atlas will suffer an economic loss if it has net cash inflows of a foreign currency and the foreign currency depreciates

17.3 Universal Industries limits its operations to exports to foreign countries.

Which ONE of the following statements about Universals exposures to exchange rate risk is correct?

A Universal is subject to potential transaction, economic and translation exposures to exchange rate risk

B Universal is subject to potential transaction and economic exposures to exchange rate risk

C Universal is subject to economic and translation exposures to exchange rate risk

D Universal is subject to transaction and translation exposures to exchange rate risk

17.4 What is the effect on a US-based company when a foreign competitors currency becomes weaker compared to the US dollar?

A The foreign company will have an advantage in the US market B The foreign company will be disadvantaged in the US market C The fluctuation has no effect on the US companys sales or cost of goods sold D It is better for the US company when the value of the US dollar strengthens

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17.5 Solway International is a US-based firm which is due to receive 10,000 in 60 days from a UK customer. The current exchange rate is $1.30 per 1. Solway has purchased a put option to sell 10,000 in 60 days for $1.25 per 1, and has paid a premium of $0.005 per 1.

If 60 days from now the spot exchange rate is $1.20, what will be the net benefit for Solway International compared to not hedging?

A $0 B $450 C $500 D $550

17.6 Teseo Co, a UK-based firm, borrowed $120,000 in dollars and one year later repaid $132,000 in dollars. When the loan was taken the exchange rate was $1.50 per 1, and when the loan was repaid the rate was $1.25 per 1.

What was the effective annual cost of the loan in terms of the pounds sterling received and paid by Teseo Co?

A 8.3% income B 10.0% expense C 24.2% expense D 32.0% expense

18 Business Valuation and Ratio Analysis

18.1 Which of the following ratios would be used to evaluate a companys profitability?

A Current ratio B Inventory turnover ratio C Debt to total assets ratio D Gross margin ratio

18.2 Green Co, a financial investment-consulting firm, was engaged by Maple Co to provide technical support for making investment decisions. Maple, a manufacturer of ceramic tiles, was in the process of buying Bay Co, its main competitor.

Greens financial analyst made an independent detailed analysis of Bays average collection period to determine which of the following?

A Financing B Return on equity C Liquidity D Operating profitability

18.3 Which ONE of the following statements about a company with high operating gearing is true?

A A change in sales will have a relatively small impact on profits B The company has a relatively high proportion of debt finance C The company will have higher risk and increased potential return D The company will have lower risk and decreased potential return

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18.4 Coldwell is using the dividend valuation model with a constant growth rate to estimate the value of an ordinary share.

Which of the following assumptions is Coldwell making?

A The discount rate will grow at a constant rate B Dividends will grow at a rate higher than the cost of equity C The share price will grow at the same rate as the dividend D The share price will grow at the same amount as the dividend

18.5 What does a high price/earnings (P/E) ratio indicate to investors?

A Earnings have growth potential B Earnings have peaked and will remain flat C Earnings have peaked and will likely fall D The company is undervalued

18.6 Which of the following describes the situation where investors overemphasise their abilities to evaluate securities?

A Excessive optimism B Overconfidence C Confirmation bias D Herd mentality

18.7 Harbor Co had sales of $1,500,000 an asset turnover ratio of 2 and a return on investment of 6%.

What was Harbors total assets and operating profit?

Assets Operating profit A $500,000 $30,000 B $750,000 $45,000 C $750,000 $90,000 D $3,000,000 $90,000

18.8 A firm designs its cost structure to include a higher degree of operating fixed costs than variable costs by electing to pay salaries instead of commissions.

The firm is magnifying the impact of each additional sales dollar using which concept?

A Operating gearing B Fixed gearing C Financial gearing D Combined gearing

18.9 Which ONE of the following statements concerning operating gearing is true?

A Above the breakeven point, a company with lower operating gearing will increase profits with less additional sales than a company with higher operating gearing.

B A company that riases debt to finance its operations is increasing its operating gearing.

C A company with high operating gearing is less profitable than another company with the same amount of sales and lower operating gearing.

D A company with relatively high fixed operating costs has high operating gearing.

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18.10 Which ONE of the following would be implied by an increase in a companys operating gearing ratio?

A The company has a greater proportion of costs that are variable B The company has profits which are more sensitive to changes in sales volume C The company is more profitable D The company is less risky

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Answer 1 PRIVATE AND PUBLIC SECTOR OBJECTIVES

(a) Financial objectives

(i) State owned enterprise

(1) The overall objective is commonly to fulfil a social need.

(2) Because of problems of measuring attainment of social needs the government usually sets specific targets in accounting terms.

(3) Examples include target returns on capital employed, requirement to be self-financing, cash or budget limits.

(ii) Private sector

(1) The firm has more freedom to determine its own objectives.

(2) A capital market quotation will mean that return to shareholders becomes an important objective.

(3) Traditionally financial management sees firms as attempting to maximise shareholder wealth. Note that other objectives may exist, e.g. social responsibilities, and the concept of satisficing various parties are important.

(b) Strategic and operational decisions

The major change in emphasis will be that decisions will now have to be made on a largely commercial basis. Profit and share price considerations will become paramount. The following are examples of where significant changes might occur:

Financing decisions. The firm will have to compete for a wide range of sources of finance. Choices between various types of finance will now have to be made, e.g. debt versus equity.

Dividend decision. The firm will now have to consider its policy on dividend payments to shareholders.

Investment decision. Commercial rather than social considerations will become of major importance. Diversifications into other products and markets will now be possible. Expansion by merger and takeover can also be considered.

Threat of takeover. If the government completely relinquishes its ownership it is possible that the firm could be subject to takeover bids.

Other areas. Pricing, marketing, staffing, etc. will now be largely free of government constraints. Sa

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Answer 2 CAPITAL MARKET EFFICIENCY

The efficient market hypothesis is often considered in terms of three levels of market efficiency:

(1) Weak-form efficiency; (2) Semi-strong form efficiency; and (3) Strong-form efficiency. The accuracy of the statement in the question depends in part upon which form of market efficiency is being considered. The first sentence states that all shares prices are correct at all times. If correct means that prices reflect true values (the true value being an equilibrium price which incorporates all relevant information that exists at a particular point in time), then strong-form efficiency does suggest that prices are always correct. Weak and semi-strong prices are not likely to be correct as they do not fully consider all information (e.g. semi-strong efficiency does not include inside information). It might be argued that even strong-form efficiency does not lead to correct prices at all times as, although an efficient market will react quickly to new relevant information, the reaction is not instant and there will be a short period of time when prices are not correct.

The second sentence in the statement suggests that prices move randomly when new information is publicly announced. Share prices do not move randomly when new information is announced. Prices may follow a random walk in that successive price changes are independent of each other. However, prices will move to reflect accurately any new relevant information that is announced, moving up when favourable information is announced, and down with unfavourable information. If strong-form efficiency exists, prices might not move at all when new information is publicly announced, as the market will already be aware of the information prior to public announcement and will have already reacted to the information.

Information from published accounts is only one possible determinant of share price movement. Others include the announcement of investment plans, dividend announcements, government changes in monetary and fiscal policies, inflation levels, exchange rates, and many more.

Fundamental and technical analysts play an important role in producing market efficiency. An efficient market requires competition among a large numb of analysts to achieve correct share prices, and the information disseminated by analysts (through their companies) helps to fulfil one of the requirements of market efficiency (i.e. that information is widely and cheaply available).

An efficient market implies that there is no way for investors or analysts to achieve consistently superior rates of return. This does not say that analysts cannot accurately predict future share prices. By pure chance some analysts will accurately predict share prices. However, the implication is that analysts will not be able to do so consistently. The same argument may be used for corporate financial managers. If, however, the market is only semi-strong efficient, then it is possible that financial managers, having inside information, would be able to produce a superior estimate of the future share price of their own companies and that, if analysts have access to inside information, they could earn superior returns. Sa

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Answer 3 CORPORATE GOVERNANCE

(a) Factors influencing the development of corporate governance codes

There are a variety of factors that have led to the introduction of the various codes of corporate governance. These include: a trend towards global investment; there have been a number of well publicised financial collapses; there are concerns about the standards of financial reporting; additionally there are concerns about potential insider dealing; concerns about institutions being run in the interests of their directors and executives rather than their shareholders and concerns about accountability to other stakeholders.

(b) Impact of codes on corporate governance

The Cadbury report introduced a variety of recommendations aimed at improvements in corporate governance systems, such as at least three non-executive directors, importance that the board of directors meet on a regular basis, it suggested a split in the roles of chairman and chief executive. Additionally the annual report should include a statement about the organisations ability to continue as a going concern and to report on the effectiveness of its internal controls. In the Greenbury report the two main recommendations were on the need for a remuneration committee responsible for setting remuneration for senior executives and for reporting of the remuneration policy and directors remuneration.

The recommendations of the Hempel report included: identifying a senior non-executive director; the establishment of a remuneration committee and at the AGM shareholders should have the opportunity to vote separately on each issue rather than bundled proposals with related papers being sent to shareholders 20 working days before the AGM. There were also recommendations on Accountability and audit including stressing the importance of the audit committee. The Hempel committee also recommended a single combined set of recommendations that became the Combined Code. The Combined Code amends and combines recommendations from the Cadbury, Greenbury and Hempel committees and calls for such things as the: division of board responsibilities; separation of role of chairman and chief executive; one third of the board to be non-executive directors; the directors report in the annual statement to include a statement about the organisations ability to continue as a going concern and to report on the effectiveness of its internal controls; encourages dialogue between the companys board and its shareholders and that directors should maintain a sound system of internal control and review the system of controls at least annually.

The Turnbull report: main elements of which concerned the need for a robust system of internal control to safeguard the shareholders investment and the companys assets and management should review control systems at least annually. Also risk management is the collective responsibility of the board of directors and the risks facing the business should be regularly evaluated and managed. OECD principles in the areas of the rights of shareholders, the equitable treatment of shareholders, the role of stakeholders, disclosure and transparency and the responsibilities of the board.

Each of the above have contributed to increasing the awareness of the importance of corporate governance systems and led to some improvements; however, some issues remain unresolved. Sa

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Answer 4 ELVIRA CO

(a) Payback period

A $100,000/$40,000 = 2.5 years (or 3 years, if cash flows arise at year end) B After 4 years net position is $120,000-$40,000 = $80,000 negative. Payback = 4 years + $80,000/$200,000 = 4.4 years C After one year cash $50,000 negative. Payback = 1 + $50,000/$80,000 = 1.6 years (b) Accounting rate of return

A Total profit = total inflow total depreciation = 160 - (100-10) = 70 Average profit = 70/4 = 17.5 Average investment = (cost + residual value)/2 = (100+10)/2 = 55 ARR = 17.5/55 = 31.8% B 40.0% C 27.3% (c) Net present value at 15%

A $100,000 + ($40,000 2.855) + ($10,000 0.572) = $19,920 B $120,000 + ($10,000 2.855) + ($212,000 0.497) = $13,914 C $150,000 + ($100,000 0.870) + ($95,000 0.756) = $8,820 (d) Internal rate of return

NPV at 20% A $100,000 + $40,000 2.589 + $10,000 0.482 = $8,380 B $120,000 + $10,000 2.589 + $212,000 0.402 = $8,886 C $150,000 + $100,000 0.833 + $95,000 0.694 = $770 IRR

A 380,8920,19920,1915 (20 15) = 24%

B 886,8914,13914,1315 (20 15) = 18%

C 770820,8820,815 (20 15) = 20%

Summary A B C Preferred Payback (years) 3 5 2 C ARR (%) 32 40 27 B NPV ($000) 20 14 9 A IRR (%) 24 18 20 A

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Answer 5 KHAN CO

(a) NPV and IRR calculations

Promotion method NPV IRR $ % Alternative 1 + 3,100 5 or 50 Alternative 2 + 3,470 23 WORKINGS Alternative 1

(i) Net present value Cash 20% Present flow discount value $000 factor $000 Year 0 (100.0) 1.000 (100.00) Year 1 255.0 0.833 212.41 Year 2 (157.5) 0.694 (109.31) Net present value 3.10

(ii) Internal rate of return

At 20% cost of capital the NPV is positive suggesting the IRR is above 20%. Trial and error shows that IRR = 50% (-100 + 255/1,5 157.5/1.52 = 0)

However this project does not have a conventional cash flow structure (i.e. there is a cash

outflow at the end of its life). In this situation the project may have two IRRs. These can be found by setting up and solving a quadratic equation.

Tutorial note: you would not be asked to solve a quadratic equation in the exam. The proof below is provided for reference only

100 + 255 (1 + r)-1 157.5 (1 + r)-2 = 0

Multiply each side of the equation by (1 + r)2 100 (1 + r)2 255 (1 + r) + 157.5 = 0

Using the quadratic formula: x = 2a

4ac) (b b 2

(1 + r) = 1002

157.5) 100 (4 (255 255 2

= 200

45 255

So (1 + r) = + 1.05 r = 0.05 or 5% or (1 + r) = + 1.50 r = 0.50 or 50% Thus Alternative 1 has two internal rates of return: 5% and 50%.

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Alternative 2 (i) Net present value

Cash 20% Present flow discount value $000 factor $000 Year 0 (50) 1.000 (50.00) Year 1 0 0.833 0 Year 2 42 0.694 29.15 Year 3 42 0.579 24.32 Net present value 3.47


The internal rate of return is estimated using linear interpolation. Using a 20% discount rate (see above), the cash flow has an NPV of $3,470. Using a 25% discount rate, the NPV of the cash flow is as follows:

Cash 25% Present flow discount value $000 factor $000 Year 0 (50) 1.000 (50.00) Year 1 0 0.800 0 Year 2 42 0.640 26.88 Year 3 42 0.512 21.50 Net present value (1.62)

Therefore, the IRR (the discount rate that reduces net present value to zero) lies

between 20% and 25%.

IRR 0. 620,1470,3470,320 (0.25 0.2) = 0.234

The internal rate of return is approximately 23%.

(b) Choice of project

The net present value calculations indicate that Alternative 2 is more favourable and should be undertaken. It has the larger positive net present value and should therefore add the greater extra amount to shareholders wealth; although it should be noted that there is relatively little difference between the NPV of the two alternatives.

However, it would be unwise to make the final decision solely on the basis of these calculations without investigating the risk attached to each alternative and the marketing and manpower factors that may be involved. For example, the heavy advertising characteristic of alternative 1 may have a beneficial impact on the companys other products, or the widespread use of agents with this alternative may benefit the promotion of other products imported by Khan.

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In terms of the risk aspects, it may be judged that novelty products generally are high risk short-lived undertakings and that alternative 1, which promotes the product for only a single year, may be a less risky approach than alternative 2, which appears to extend the life by a further one or two years.

In addition, there are many other considerations which may be relevant to the decision, such as whether the promotion of this particular novelty product will adversely affect other products sold by the company.

The internal rates of return of the two alternatives have been ignored in formulating the decision advice for two main reasons. The first is that alternative 1 has two internal rates of return, one above, the other below, the required rate. This conflicting investment advice clearly indicates that the use of internal rates of return is an unreliable tool.

The second reason for rejecting the IRR approach is that it assumes that the surplus cash flows generated by a project can be reinvested into other projects which generate the same IRR. This is unlikely to be true in practice.

(c) Comments on Mr Courts views

(i) Payback method

The payback method of investment appraisal is relatively quick and simple to operate and understand. It calculates how quickly a projects outlay is recovered from its operating cash flows. However setting a maximum acceptable payback period is subjective.

Payback can also be criticised for not taking into account the time value of money although discounted payback can be calculated. The major weakness of payback period is its failure to consider cash flows that occur after payback is reached.

However, payback can act as a useful guide when liquidity is a problem for a company and the speed of a projects return is of prime importance.

(ii) Investment appraisal and reported profits

Most investment opportunities undertaken by firms have returns whose generation covers a relatively long time period (several years). It is one of the tasks of published accounts (and particularly the income statement) to cut up this continuous stream of wealth generation into a series of time periods (i.e. the accounting year).

It is certainly a powerful argument that, as well as undertaking NPV calculations, management should also consider the implications for the published accounts of any investment opportunity especially if the projects are of a substantial size. For instance, if a particular project had a healthy positive NPV but its acceptance would have an adverse effect on the published financial accounts, although it would be unwise for the project to be rejected on these grounds alone, management should make efforts to ensure that its investment plans are fully communicated to and understood by the shareholders.

In this case the comment has been made earlier that, although Alternative 2 is the more favoured on the basis of its net present value, there is really little difference between the NPVs of the two alternatives. If the acceptance of Alternative 2 would have a substantial and adverse effect on the companys reported profits, this may well be a legitimate reason in these circumstances to review the NPV decision.

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Answer 6 DISCOUNTED CASH FLOW

(a) (i) Alternative machines

Year 8% Factor Machine 1 PV Machine 2 PV $ $ $ $

0 1 (10,000) (10,000) (9,000) (9,000) 1 0.926 1,000 926 1,200 1,111 2 0.857 1,600 1,371 1,500 1,286 3 0.794 2,500 1,985 3,500 2,779 4 0.735 2,500 1,838 2,000 1,470 5 0.681 2,500 1,702 2,000 1,362 6 0.630 1,500 945 2,000 1,260 7 0.583 2,500 1,458 225 268

Since both projects have positive NPVs either machine is a good investment. However, the NPV for machine 2 is slightly higher and this machine should therefore be preferred.

(ii) Comment on results

Since the difference between the two figures is marginal it may be prudent to carry out a sensitivity analysis on the result.

The cash flow figures are estimates for several years ahead. A small change in any of these figures could affect the result to such an extent that machine 1 might be the better investment.

Changes could even lead to the projects having negative NPVs since the values are only small positive figures. Investments with negative NPVs should be rejected.

(b) Production decision

Time Cash 7% factor PV $ $

1 (40,000) 0.935 (37,400) 2 29 2,000 12.278 (W) 0.935 22,686

Negative NPV (14,714)

Therefore, the firm should not produce the device.

WORKING

= 0.07

)07.01(1 29 = 12.278 Samp

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(c) Investment in crusher


0 (6,000) 1 (6,000) 3 1,200 1/0.12 1.690 = 6.643 7,972

Positive NPV 1,972

Therefore, the crusher should be purchased.

Alternatively

Time Cash Time Cash $ $

3 1,200 is the same as 1 1,200 212.11

Therefore, PV of perpetuity = $1,200 212.11

12.01 = $7,972

Therefore, NPV of project = $6,000 + $7,972 = $1,972

(d) IRR

IRR of perpetuity = investment Initial

inflow annual Equal 100 = 5,000475 100 = 9.5%

Since the internal rate of return is greater than the return which J can obtain elsewhere, he would be advised to invest in the scheme.

(e) (i) IRR

Time Cash flow 10% Factor 10% NPV 7% Factor 7% NPV $ $ $

0 (10,000) 1 (10,000) 1 (10,000) 1 (10,000) 0.909 (9,090) 0.935 (9,350) 2 & 3 4,000 1.577 6,308 1.689 6,756 4 11 3,000 4.008 (W1) 12,024 4.875 (W2) 14,625 (758) 2,031

WORKINGS

(1) @10% DF111 DF13 = 6.495 2.487 = 4.008 (2) @7% = 7.499 2.624 = 4.875

IRR = 7% + 2 0312 031 758

,,

(10 7) % = 7% + 2.18% ~ 9%

Since the IRR of this project is less than the required rate of return, it should not be undertaken. Therefore, the ball and crane should not be bought.

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(ii) Alternative methods

An alternative approach to this problem would be to discount the cash flows at 10%. Since the project has a negative NPV at 10% (the desired rate of return), the project would not be accepted.

Answer 7 GERRARD

(a) (b) NPV and IRR

Net Year end Machinery Receipts Paper Salary cash flow $000

0 (50) + (8) = (58.0) 1 (25) + 30 + (8) + (0.5) = (3.5) 2 30 + (8) + (0.5) = 21.5 3 30 + (8) + (0.5) = 21.5 4 30 + (8) + (0.5) = 21.5 5 30 + (0.5) = 29.5

Year end Net Discount PV Discount PV cash flow factors 12% factors 14% $000 $000 $000

0 (58.0) 1.000 (58.00) 1.000 (58.00) 1 (3.5) 0.893 (3.13) 0.877 (3.07) 2 21.5 0.797 17.14 0.769 16.53 3 21.5 0.712 15.31 0.675 14.51 4 21.5 0.636 13.67 0.592 12.73 5 29.5 0.567 16.73 0.519 15.31 NPV = 1.72 NPV = (1.99)

(c) Comment on results

In view of the projects positive NPV at 12%, expansion is (just) worthwhile.

The IRR of the project is approximately 13% (i.e. half way between 12 & 14%) or

IRR = 12% + 172172 199

.. . (14 12) % = 12.9%

This gain indicates that the project is worthwhile.

Answer 8 DESPATCH CO


0 (12,000) 1 (12,000) 1 10 2,000 5.216 10,432 10 500 0.27 135 (1,433) As the NPV is negative at 14% the company should not undertake this project.

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Answer 9 CARTER CO

(a) (i) Net present value

Time Cash flow 10% factor Present value $ $ 0 (32,000) 1 (32,000) 1 15 5,000 7.606 38,030 Positive NPV 6,030

In view of the positive NPV the project should be undertaken.


The internal rate of return is calculated by finding a 15 year cumulative discount factor as follows:

15 year factor @ IRR = flowcash Annual

Investment = 000,5000,32

= 6.4

Therefore, IRR = 13%

The project should be undertaken as the IRR exceeds the cost of borrowing (10%).

(b) (i) Book value of $2,000

This information does not affect the NPV as a book value is not a cash flow.

(ii) Reduced project duration to ten years

Revised NPV calculation: 10% Present Time Cash flow factor value

$ $

0 Net investments (32,000) 1 (32,000) 1 10 Net savings 5,000 6.145 30,725

Negative NPV (1,275)

The reduction in the project duration means that it is no longer worthwhile.

(iii) Changes in allocation and apportionment

This information does not affect the NPV as allocation and apportionment are arbitrary. The cash flows are unchanged.

(iv) Revised scrap values

With the existing equipment having a scrap value of $2,000 in 15 years time, if the project is undertaken this $2,000 in year 15 will be forgone. The NPV will therefore be reduced be reduced by the present value of $2,000 discounted for 15 years.

NPV = $6,030 ($2,000 0.239) = $5,552 The project will still be accepted though the NPV is reduced.

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Answer 10 BLACKWATER CO

(a) Expected NPV

Expected value of fines = (0.3 0.50) + (0.5 1.40) + (0.2 2.0) = 0.15 + 0.70 + 0.40 = $1.25m

Tutorial note: there is no need to discount the fines as they were stated in the question in present value terms.

To determine the overall NPV of the project, Blackwater must compare the present value of the costs incurred to the expected value of the fines avoided.

Year Item ($m) 0 1 2 3 4 5 Outlay (1.000) EU grant 0.250 FSLs fee (0.050) Increased operating costs (0.315) (0.331) (0.347) (0.365) Tax saving at 33% 0.104 0.109 0.115 0.120 WDA 0.250 0.188 0.141 0.105 0.316 Tax saving at 33% 0.083 0.062 0.047 0.035 0.104 Net cash flows (1.000) (0.032) (0.165) (0.191) (0.215) 0.224 Discount factor at 12% 1.000 0.893 0.797 0.712 0.636 0.567 PV (1.000) (0.029) (0.132) (0.136) (0.137) 0.127 PV = ($1.307m) Tutorial notes: as the equipment will be purchased on the last day of a financial year i.e. on the date of a tax computation, the initial WDA can be claimed instantly. This WDA of 1m25% = 0.25 is not a cash flow but will save cash tax of 0.25 33% = 0.083 one year later. WDAs are then claimed on a reducing balance basis at the end of the first three years of operating the equipment, At the end of the fourth year the brought forward tax written down value of 1 - 0.25 0.188 0.141 0.105 = 0.316 is compared to the scrap value (zero) and written off as a balancing allowance, saving tax of 0.316 33% = 0,104 one year later. Overall NPV = ($1.307m) - $1.25m = ($0.057) It appears that the project is not viable in financial terms.

(b) Memorandum

Memo to: Blackwater Co management. Subject: Proposed Pollution Control Project. From: Financial consultant. Date: Black Monday.

On purely non-financial criteria, it can be suggested that as a regular violator of the environmental regulation, our company has a moral responsibility to install this equipment, so long as it does not jeopardise the long-term survival of the company. Sa

mple



But the figures appended suggest that the project is not wealth-creating for Blackwaters shareholders as the EV of the fines is less than the expected NPV of the project. However, this conclusion relies on accepting the validity of the probability distribution, which is debatable. Not only are the magnitudes of the fines merely estimates, but the probabilities shown are subjective. Different decision-makers may well arrive at different assessments which could lead to the opposite decision on financial criteria.

More fundamentally, the use of the expected value principle is only reliable when the probability distribution approximates to the normal. In this case, it is slightly skewed toward the lower outcomes. But more significantly, if the distribution itself is examined more closely, it appears to indicate that there is a 70% chance (0.5 + 0.2) of fines of at least $1 4m, which exceeds the NPV of the costs of the pollution control project. In other words, there is a 70% chance that the project will be worthwhile. It therefore seems perverse to reject it on these figures.

Moreover, given that Blackwater is a persistent offender, and that the green lobby is becoming more influential, there must be a strong likelihood that the level of fines will increase in the future, suggesting that the data given are under-estimates. Higher expected fines would further enhance the appeal of the project.

It is also possible that the company may sell more output, perhaps at a higher price, if it is perceived to be more environmentally friendly and if customers are swayed by this. This may be less likely for industrial companies although it would create opportunities for self-publicity on both sides. In addition, there may be more general image effects which may foster enhanced self-esteem among the workforce, as well as increasing the acceptability of the company in the local community.

It is even possible that the companys share price may benefit from managers of ethical investment funds deciding to include Blackwater in their portfolios.

Finally, this may be only a short-term solution. As the operating life of the equipment is only four years, we will face a further investment decision after this period, although technological and legal changes may well have altered the situation by then.

Answer 11 ARG CO

(a) NPV calculation for Alpha and Beta

Year 1 2 3 4 $ $ $ $ Sales revenue 3,585,000 6,769,675 6,339,000 1,958,775 Material cost (1,395,000) (2,634,225) (2,466,750) (761,925) Fixed costs (1,000,000) (1,050,000) (1,102,500) (1,157,625) Advertising (500,000) (200,000) (200,000) Taxable profit 690,000 2,885,450 2,569,750 39,225 Taxation (172,500) (721,362) (642,438) (9,806) WDA tax benefit 250,000 Fixed asset sale 1,200,000 WC recovery 1,000,000 Net cash flow 767,500 2,164,088 1,927,312 2,229,419 Discount factors 0885 0783 0693 0613 Present values 679,237 1,694,481 1,335,626 1,366,634

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$ Sum of present values 5,075,978 Initial investment 3,000,000 Net present value 2,075,978 The positive NPV indicates that the investment is financially acceptable.

WORKINGS

Alpha sales revenue

Year 1 2 3 4 Sellin

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