Fundamentals Level Skills Module

Financial Management
Thursday 9 December 2010

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FOUR questions are compulsory and MUST be attempted. Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7 and 8. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

ALL FOUR questions are compulsory and MUST be attempted 1 CJ Co is a profitable company which is financed by equity with a market value of $180 million and by debt with a market value of $45 million. The company is considering two investment projects, as follows. Project A This project is an expansion of existing business costing $35 million, payable at the start of the project, which will increase annual sales by 750,000 units. Information on unit selling price and costs is as follows: Selling price: Selling costs: Variable costs: $200 per unit (current price terms) $004 per unit (current price terms) $080 per unit (current price terms)

Selling price inflation and selling cost inflation are expected to be 5% per year and variable cost inflation is expected to be 4% per year. Additional initial investment in working capital of $250,000 will also be needed and this is expected to increase in line with general inflation. Project B This project is a diversification into a new business area that will cost $4 million. A company that already operates in the new business area, GZ Co, has an equity beta of 15. GZ Co is financed 75% by equity with a market value of $90 million and 25% by debt with a market value of $30 million. Other information CJ Co has a nominal weighted average after-tax cost of capital of 10% and pays profit tax one year in arrears at an annual rate of 30%. The company can claim capital allowances (tax-allowable depreciation) on a 25% reducing balance basis on the initial investment in both projects. Risk-free rate of return: Equity risk premium: General rate of inflation: 4% 6% 45% per year

Directors views on investment appraisal The directors of CJ Co require that all investment projects should be evaluated using either payback period or return on capital employed (accounting rate of return). The target payback period of the company is two years and the target return on capital employed is 20%, which is the current return on capital employed of CJ Co. A project is accepted if it satisfies either of these investment criteria. The directors also require all investment projects to be evaluated over a four-year planning period, ignoring any scrap value or working capital recovery, with a balancing allowance (if any) being claimed at the end of the fourth year of operation. Required: (a) Calculate the net present value of Project A and advise on its acceptability if the project were to be appraised using this method. (12 marks) (b) Critically discuss the directors views on investment appraisal. (c) Calculate a project-specific cost of equity for Project B and explain the stages of your calculation. (6 marks) (25 marks) (7 marks)

The following financial position statement as at 30 November 2010 refers to Nugfer Co, a stock exchange-listed company, which wishes to raise $200m in cash in order to acquire a competitor. $m Assets Non-current assets Current assets Total assets Equity and liabilities Share capital Retained earnings Total equity Non-current liabilities Long-term borrowings Current liabilities Trade payables Short-term borrowings Total current liabilities Total liabilities Total equity and liabilities 100 121 221 100 30 160 190 290 511 $m $m 300 211 511

The recent performance of Nugfer Co in profitability terms is as follows: Year ending 30 November Revenue Operating profit Finance charges (interest) Profit before tax Profit after tax 2007 $m 1226 417 60 357 250 2008 $m 1273 433 62 371 260 2009 $m 1566 501 125 376 263 2010 $m 1893 567 188 379 265

Notes: 1. The long-term borrowings are 6% bonds that are repayable in 2012 2. The short-term borrowings consist of an overdraft at an annual interest rate of 8% 3. The current assets do not include any cash deposits 4. Nugfer Co has not paid any dividends in the last four years 5. The number of ordinary shares issued by the company has not changed in recent years 6. The target company has no debt finance and its forecast profit before interest and tax for 2011 is $28 million Required: (a) Evaluate suitable methods of raising the $200 million required by Nugfer Co, supporting your evaluation with both analysis and critical discussion. (15 marks) (b) Briefly explain the factors that will influence the rate of interest charged on a new issue of bonds. (4 marks) (c) Identify and describe the three forms of efficiency that may be found in a capital market. (6 marks) (25 marks)

[P.T.O.

WQZ Co is considering making the following changes in the area of working capital management: Inventory management It has been suggested that the order size for Product KN5 should be determined using the economic order quantity model (EOQ). WQZ Co forecasts that demand for Product KN5 will be 160,000 units in the coming year and it has traditionally ordered 10% of annual demand per order. The ordering cost is expected to be $400 per order while the holding cost is expected to be $512 per unit per year. A buffer inventory of 5,000 units of Product KN5 will be maintained, whether orders are made by the traditional method or using the economic ordering quantity model. Receivables management WQZ Co could introduce an early settlement discount of 1% for customers who pay within 30 days and at the same time, through improved operational procedures, maintain a maximum average payment period of 60 days for credit customers who do not take the discount. It is expected that 25% of credit customers will take the discount if it were offered. It is expected that administration and operating cost savings of $753,000 per year will be made after improving operational procedures and introducing the early settlement discount. Credit sales of WQZ Co are currently $876 million per year and trade receivables are currently $18 million. Credit sales are not expected to change as a result of the changes in receivables management. The company has a cost of short-term finance of 55% per year. Required: (a) Calculate the cost of the current ordering policy and the change in the costs of inventory management that will arise if the economic order quantity is used to determine the optimum order size for Product KN5. (6 marks) (b) Briefly describe the benefits of a just-in-time (JIT) procurement policy. (5 marks)

(c) Calculate and comment on whether the proposed changes in receivables management will be acceptable. Assuming that only 25% of customers take the early settlement discount, what is the maximum early settlement discount that could be offered? (6 marks) (d) Discuss the factors that should be considered in formulating working capital policy on the management of trade receivables. (8 marks) (25 marks)

The following financial information refers to NN Co: Current statement of financial position $m Assets Non-current assets Current assets Inventory Trade receivables Cash $m $m 101 11 21 10 42 143 50 25 19 94 20 22 7 29 49 143

Total assets Equity and liabilities Ordinary share capital Preference share capital Retained earnings Total equity Non-current liabilities Long-term borrowings Current liabilities Trade payables Other payables Total current liabilities Total liabilities Total equity and liabilities

NN Co has just paid a dividend of 66 cents per share and has a cost of equity of 12%. The dividends of the company have grown in recent years by an average rate of 3% per year. The ordinary shares of the company have a par value of 50 cents per share and an ex div market value of $830 per share. The long-term borrowings of NN Co consist of 7% bonds that are redeemable in six years time at their par value of $100 per bond. The current ex interest market price of the bonds is $10350. The preference shares of NN Co have a nominal value of 50 cents per share and pay an annual dividend of 8%. The ex div market value of the preference shares is 67 cents per share. NN Co pay profit tax at an annual rate of 25% per year Required: (a) Calculate the equity value of NN Co using the following business valuation methods: (i) the dividend growth model; (ii) net asset value. (b) Calculate the after-tax cost of debt of NN Co. (c) Calculate the weighted average after-tax cost of capital of NN Co. (5 marks) (4 marks) (6 marks)

(d) Discuss the factors to be considered in formulating the dividend policy of a stock-exchange listed company. (10 marks) (25 marks)

[P.T.O.

Formulae Sheet Economic order quantity 2C0D CH

MillerOrr Model Return point = Lower limit + ( 1 spread) 3

1

3 transaction cost variance of cash flows 3 Spread = 3 4 interest rate The Capital Asset Pricing Model E ri = Rf + i E rm Rf

()

(( ) )
(

The asset beta formula Vd 1 T Ve a = e + d V + V T V V 1 + 1 T d d e e

))

))

The Growth Model D0 1 + g

Po =

(r

Gordons growth approximation g = bre The weighted average cost of capital V V e d kd 1 T ke + WACC = + V + V V V e d e d

The Fisher formula

(1 + i) = (1 + r ) (1 + h)
Purchasing power parity and interest rate parity S1 = S0

(1 + h ) (1 + h )
c b

F0 = S0

(1 + i ) (1 + i )
c b

Present Value Table Present value of 1 i.e. (1 + r)n Where r = discount rate n = number of periods until payment Discount rate (r) Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1% 0990 0980 0971 0961 0951 0942 0933 0923 0941 0905 0896 0887 0879 0870 0861 2% 0980 0961 0942 0924 0906 0888 0871 0853 0837 0820 0804 0788 0773 0758 0743 3% 0971 0943 0915 0888 0863 0837 0813 0789 0766 0744 0722 0701 0681 0661 0642 4% 0962 0925 0889 0855 0822 0790 0760 0731 0703 0676 0650 0625 0601 0577 0555 5% 0952 0907 0864 0823 0784 0746 0711 0677 0645 0614 0585 0557 0530 0505 0481 6% 0943 0890 0840 0792 0747 0705 0665 0627 0592 0558 0527 0497 0469 0442 0417 7% 0935 0873 0816 0763 0713 0666 0623 0582 0544 0508 0475 0444 0415 0388 0362 8% 0926 0857 0794 0735 0681 0630 0583 0540 0500 0463 0429 0397 0368 0340 0315 9% 0917 0842 0772 0708 0650 0596 0547 0502 0460 0422 0388 0356 0326 0299 0275 10% 0909 0826 0751 0683 0621 0564 0513 0467 0424 0386 0305 0319 0290 0263 0239 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

(n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

11% 0901 0812 0731 0659 0593 0535 0482 0434 0391 0352 0317 0286 0258 0232 0209

12% 0893 0797 0712 0636 0567 0507 0452 0404 0361 0322 0287 0257 0229 0205 0183

13% 0885 0783 0693 0613 0543 0480 0425 0376 0333 0295 0261 0231 0204 0181 0160

14% 0877 0769 0675 0592 0519 0456 0400 0351 0308 0270 0237 0208 0182 0160 0140

15% 0870 0756 0658 0572 0497 0432 0376 0327 0284 0247 0215 0187 0163 0141 0123

16% 0862 0743 0641 0552 0476 0410 0354 0305 0263 0227 0195 0168 0145 0125 0108

17% 0855 0731 0624 0534 0456 0390 0333 0285 0243 0208 0178 0152 0130 0111 0095

18% 0847 0718 0609 0516 0437 0370 0314 0266 0225 0191 0162 0137 0116 0099 0084

19% 0840 0706 0593 0499 0419 0352 0296 0249 0209 0176 0148 0124 0104 0088 0074

20% 0833 0694 0579 0482 0402 0335 0279 0233 0194 0162 0135 0112 0093 0078 0065 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

[P.T.O.

Annuity Table (1 + r)n Present value of an annuity of 1 i.e. 1 r Where r = discount rate n = number of periods Discount rate (r) Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1% 0990 1970 2941 3902 4853 5795 6728 7652 8566 9471 1037 1126 1213 1300 1387 11% 0901 1713 2444 3102 3696 4231 4712 5146 5537 5889 6207 6492 6750 6982 7191 2% 0980 1942 2884 3808 4713 5601 6472 7325 8162 8983 9787 1058 1135 1211 1285 12% 0893 1690 2402 3037 3605 4111 4564 4968 5328 5650 5938 6194 6424 6628 6811 3% 0971 1913 2829 3717 4580 5417 6230 7020 7786 8530 9253 9954 1063 1130 1194 13% 0885 1668 2361 2974 3517 3998 4423 4799 5132 5426 5687 5918 6122 6302 6462 4% 0962 1886 2775 3630 4452 5242 6002 6733 7435 8111 8760 9385 9986 1056 1112 14% 0877 1647 2322 2914 3433 3889 4288 4639 4946 5216 5453 5660 5842 6002 6142 5% 0952 1859 2723 3546 4329 5076 5786 6463 7108 7722 8306 8863 9394 9899 1038 15% 0870 1626 2283 2855 3352 3784 4160 4487 4772 5019 5234 5421 5583 5724 5847 6% 0943 1833 2673 3465 4212 4917 5582 6210 6802 7360 7887 8384 8853 9295 9712 16% 0862 1605 2246 2798 3274 3685 4039 4344 4607 4833 5029 5197 5342 5468 5575 7% 0935 1808 2624 3387 4100 4767 5389 5971 6515 7024 7499 7943 8358 8745 9108 17% 0855 1585 2210 2743 3199 3589 3922 4207 4451 4659 4836 4988 5118 5229 5324 8% 0926 1783 2577 3312 3993 4623 5206 5747 6247 6710 7139 7536 7904 8244 8559 18% 0847 1566 2174 2690 3127 3498 3812 4078 4303 4494 4656 4793 4910 5008 5092 9% 0917 1759 2531 3240 3890 4486 5033 5535 5995 6418 6805 7161 7487 7786 8061 19% 0840 1547 2140 2639 3058 3410 3706 3954 4163 4339 4486 4611 4715 4802 4876 10% 0909 1736 2487 3170 3791 4355 4868 5335 5759 6145 6495 6814 7103 7367 7606 20% 0833 1528 2106 2589 2991 3326 3605 3837 4031 4192 4327 4439 4533 4611 4675 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

End of Question Paper