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Professional Level Options Module

Paper P4
Advanced Financial
Management
September/December 2016 Sample Questions

Time allowed: 3 hours 15 minutes

This question paper is divided into two sections:

Section A This ONE question is compulsory and MUST be attempted


Section B TWO questions ONLY to be attempted

Formulae and tables are on pages 812.

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

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

The Association of
Chartered Certified
Accountants
Section A This ONE question is compulsory and MUST be attempted

1 Morada Co is involved in offering bespoke travel services and maintenance services. In addition to owning a few
hotels, it has built strong relationships with companies in the hospitality industry all over the world. It has a good
reputation of offering unique, high quality holiday packages at reasonable costs for its clients. The strong relationships
have also enabled it to offer repair and maintenance services to a number of hotel chains and cruise ship companies.
Following a long discussion at a meeting of the board of directors (BoD) about the future strategic direction which
Morada Co should follow, three directors continued to discuss one particular issue over dinner. In the meeting, the
BoD had expressed concern that Morada Co was exposed to excessive risk and therefore its cost of capital was too
high. The BoD feared that several good projects had been rejected over the previous two years, because they did not
meet Morada Cos high cost of capital threshold. Each director put forward a proposal, which they then discussed in
turn. At the conclusion of the dinner, the directors decided to ask for a written report on the proposals put forward by
the first director and the second director, before taking all three proposals to the BoD for further discussion.
First directors proposal
The first director is of the opinion that Morada Co should reduce its debt in order to mitigate its risk and therefore
reduce its cost of capital. He proposes that the company should sell its repair and maintenance services business unit
and focus just on offering bespoke travel services and hotel accommodation. In the sale, the book value of non-current
assets will reduce by 30% and the book value of current liabilities will reduce by 10%. It is thought that the
non-current assets can be sold for an after-tax profit of 15%.
The first director suggests that the funds arising from the sale of the repair and maintenance services business unit
and cash resources should be used to pay off 80% of the long-term debt. It is estimated that as a result of this,
Morada Cos credit rating will improve from Baa2 to A2.
Second directors proposal
The second director is of the opinion that risk diversification is the best way to reduce Morada Cos risk and therefore
reduce its cost of capital. He proposes that the company raise additional funds using debt finance and then create a
new strategic business unit. This business unit will focus on construction of new commercial properties.
The second director suggests that $70 million should be borrowed and used to invest in purchasing non-current assets
for the construction business unit. The new debt will be issued in the form of four-year redeemable bonds paying an
annual coupon of 62%. It is estimated that if this amount of debt is raised, then Morada Cos credit rating will worsen
to Ca3 from Baa2. Current liabilities are estimated to increase to $28 million.
Third directors proposal
The third director is of the opinion that Morada Co does not need to undertake the proposals suggested by the first
director and the second director just to reduce the companys risk profile. She feels that the above proposals require
a fundamental change in corporate strategy and should be considered in terms of more than just tools to manage risk.
Instead, she proposes that a risk management system should be set up to appraise Morada Cos current risk profile,
considering each type of business risk and financial risk within the company, and taking appropriate action to manage
the risk where it is deemed necessary.
Morada Co, extracts from the forecast financial position for the coming year
$000
Non-current assets 280,000
Current assets 48,000

Total assets 328,000

Equity and liabilities
Share capital (40c/share) 50,000
Retained earnings 137,000

Total equity 187,000

Non-current liabilities (62% redeemable bonds) 120,000
Current liabilities 21,000

Total liabilities 141,000

Total liabilities and equity capital 328,000

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Other financial information
Morada Cos forecast after-tax earnings for the coming year are expected to be $28 million. It is estimated that the
company will make a 9% return after-tax on any new investment in non-current assets, and will suffer a 9% decrease
in after-tax earnings on any reduction in investment in non-current assets.
Morada Cos current share price is $288 per share. According to the companys finance division, it is very difficult
to predict how the share price will react to either the proposal made by the first director or the proposal made by the
second director. Therefore it has been assumed that the share price will not change following either proposal.
The finance division has further assumed that the proportion of the book value of non-current assets invested in each
business unit gives a fair representation of the size of each business unit within Morada Co.
Morada Cos equity beta is estimated at 12, while the asset beta of the repairs and maintenance services business
unit is estimated to be 065. The relevant equity beta for the new, larger company including the construction unit
relevant to the second directors proposals has been estimated as 121.
The bonds are redeemable in four years time at face value. For the purposes of estimating the cost of capital, it can
be assumed that debt beta is zero. However, the four-year credit spread over the risk free rate of return is 60 basis
points for A2 rated bonds, 90 basis points for Baa2 rated bonds and 240 basis points for Ca3 rated bonds.
A tax rate of 20% is applicable to all companies. The current risk free rate of return is estimated to be 38% and the
market risk premium is estimated to be 7%.

Required:
(a) Explain how business risk and financial risk are related; and how risk mitigation and risk diversification can
form part of a companys risk management strategy. (6 marks)

(b) Prepare a report for the board of directors of Morada Co which:


(i) Estimates Morada Cos cost of equity and cost of capital, based on market value of equity and debt,
before any changes and then after implementing the proposals put forward by the first and by the second
directors; (17 marks)
(ii) Estimates the impact of the first and second directors proposals on Morada Cos forecast after-tax
earnings and forecast financial position for the coming year; and (7 marks)
(iii) Discusses the impact on Morada Co of the changes proposed by the first and second directors and
recommends whether or not either proposal should be accepted. The discussion should include an
explanation of any assumptions made in the estimates in (b)(i) and (b)(ii) above. (9 marks)
Professional marks will be awarded in part (b) for the format, structure and presentation of the report.
(4 marks)

(c) Discuss the possible reasons for the third directors proposal that a risk management system should consider
each risk, before taking appropriate action. (7 marks)

(50 marks)

3 [P.T.O.
Section B TWO questions ONLY to be attempted

2 Fernhurst Co is a manufacturer of mobile communications technology. It is about to launch a new communications


device, the Milland, which its directors believe is both more technologically advanced and easier to use than devices
currently offered by its rivals.
Investment in the Milland
The Milland will require a major investment in facilities. Fernhurst Cos directors believe that this can take place very
quickly and production be started almost immediately.
Fernhurst Co expects to sell 132,500 units of the Milland in its first year. Sales volume is expected to increase by
20% in Year 2 and 30% in Year 3, and then be the same in Year 4 as Year 3, as the product reaches the end of its
useful life. The initial selling price in Year 1 is expected to be $100 per unit, before increasing with the rate of inflation
annually.
The variable cost of each unit is expected to be $4368 in year 1, rising by the rate of inflation in subsequent years
annually. Fixed costs are expected to be $900,000 in Year 1, rising by the rate of inflation in subsequent years
annually.
The initial investment in non-current assets is expected to be $16,000,000. Fernhurst Co will also need to make an
immediate investment of $1,025,000 in working capital. The working capital will be increased annually at the start
of each of Years 2 to 4 by the inflation rate and is fully recoverable at the end of the projects life. Fernhurst Co will
also incur one-off marketing expenditure of $1,500,000 post inflation after the launch of the Milland. The marketing
expenditure can be assumed to be made at the end of Year 1 and be a tax allowable expense.
Fernhurst Co pays company tax on profits at an annual rate of 25%. Tax is payable in the year that the tax liability
arises. Tax allowable depreciation is available at 20% on the investment in non-current assets on a reducing balance
basis. A balancing adjustment will be available in Year 4. The realisable value of the investment at the end of Year 4
is expected to be zero.
The expected annual rate of inflation in the country in which Fernhurst Co is located is 4% in Year 1 and 5% in
Years 2 to 4.
The applicable cost of capital for this investment appraisal is 11%.
Other calculations
Fernhurst Cos finance director has indicated that besides needing a net present value calculation based on this data
for the next board meeting, he also needs to know the figure for the projects duration, to indicate to the board how
returns from the project will be spread over time.
Failure of launch of the Milland
The finance director would also like some simple analysis based on the possibility that the marketing expenditure is
not effective and the launch fails, as he feels that the products price may be too high. He has suggested that there
is a 15% chance that the Milland will have negative net cash flows for Year 1 of $1,000,000 or more. He would like
to know by what percentage the selling price could be reduced or increased to result in the investment having a zero
net present value, assuming demand remained the same.
Assessment of new products
Fernhurst Cos last board meeting discussed another possible new product, the Racton, and the finance director
presented a range of financial data relating to this product, including the results of net present value and payback
evaluations. One of the non-executive directors, who is not a qualified accountant, stated that he found it difficult to
see the significance of the different items of financial data. His understanding was that Fernhurst Co merely had to
ensure that the investment had a positive net present value and shareholders were bound to be satisfied with it, as it
would maximise their wealth in the long term. The finance director commented that, in reality, some shareholders
looked at the performance of the investments which Fernhurst Co made over the short term, whereas some were more
concerned with the longer term. The financial data he presented to board meetings included both short and long-term
measures.

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Required:
(a) Evaluate the financial acceptability of the investment in the Milland and, calculate and comment on the
investments duration. (15 marks)

(b) Calculate the % change in the selling price required for the investment to have a zero net present value, and
discuss the significance of your results. (5 marks)

(c) Discuss the non-executive directors understanding of net present value and explain the importance of other
measures in providing data about an investments short and long-term performance. (5 marks)

(25 marks)

5 [P.T.O.
3 Chithurst Co gained a stock exchange listing five years ago. At the time of the listing, members of the family who
founded the company owned 75% of the shares, but now they only hold just over 50%. The number of shares in
issue has remained unchanged since Chithurst Co was listed. Chithurst Cos directors have continued the policy of
paying a constant dividend per share each year which the company had before it was listed. However, investors who
are not family members have become increasingly critical of this policy, saying that there is no clear rationale for it.
They would prefer to see steady dividend growth, reflecting the increase in profitability of Chithurst Co since its listing.
The finance director of Chithurst Co has provided its board with details of Chithurst Cos dividends and investment
expenditure, compared with two other similar-sized companies in the same sector, Eartham Co and Iping Co. Each
company has a 31 December year end.
Chithurst Co Eartham Co Iping Co
Profit for Dividend New Profit for Dividend New Profit for Dividend New
year after paid investment year after paid investment year after paid investment
interest expenditure interest expenditure interest expenditure
and tax and tax and tax
$m $m $m $m $m $m $m $m $m
2012 77 33 18 95 38 30 75 35 37
2013 80 33 29 (10) 15 15 88 17 64
2014 94 33 23 110 44 42 118 39 75
2015 97 33 21 120 48 29 132 42 84
Other financial information relating to the three companies is as follows:
Chithurst Co Eartham Co Iping Co
Cost of equity 11% 14% 12%
Market capitalisation $m 608 1,042 1,164
Increase in share price in last 12 months 1% 5% 10%
Chithurst Cos finance director has estimated the costs of equity for all three companies.
None of the three companies has taken out significant new debt finance since 2011.

Required:
(a) Discuss the benefits and drawbacks of the dividend policies which the three companies appear to have
adopted. Provide relevant calculations to support your discussion.
Note: Up to 5 marks are available for the calculations. (15 marks)

(b) Discuss how the market capitalisation of the three companies compares with your valuations calculated using
the dividend valuation model. Use the data provided to calculate valuations based on growth rates for the
most recent year and for the last three years.
Note: Up to 5 marks are available for the calculations. (10 marks)

(25 marks)

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4 Pault Co is currently undertaking a major programme of product development. Pault Co has made a significant
investment in plant and machinery for this programme. Over the next couple of years, Pault Co has also budgeted for
significant development and launch costs for a number of new products, although its finance director believes there
is some uncertainty with these budgeted figures, as they will depend upon competitor activity amongst other matters.
Pault Co issued floating rate loan notes, with a face value of $400 million, to fund the investment in plant and
machinery. The loan notes are redeemable in ten years time. The interest on the loan notes is payable annually and
is based on the spot yield curve, plus 50 basis points.
Pault Cos finance director has recently completed a review of the companys overall financing strategy. His review has
highlighted expectations that interest rates will increase over the next few years, although the predictions of financial
experts in the media differ significantly.
The finance director is concerned about the exposure Pault Co has to increases in interest rates through the loan notes.
He has therefore discussed with Millbridge Bank the possibility of taking out a four-year interest rate swap. The
proposed terms are that Pault Co would pay Millbridge Bank interest based on an equivalent fixed annual rate of
4847%. In return, Pault Co would receive from Millbridge Bank a variable amount based on the forward rates
calculated from the annual spot yield curve rate at the time of payment minus 20 basis points. Payments and receipts
would be made annually, with the first one in a years time. Millbridge Bank would charge an annual fee of 25 basis
points if Pault Co enters the swap.
The current annual spot yield curve rates are as follows:
Year One Two Three Four
Rate 370% 425% 470% 510%
A number of concerns were raised at the recent board meeting when the swap arrangement was discussed.
Pault Cos chairman wondered what the value of the swap arrangement to Pault Co was, and whether the value
would change over time.
One of Pault Cos non-executive directors objected to the arrangement, saying that in his opinion the interest rate
which Pault Co would pay and the bank charges were too high. Pault Co ought to stick with its floating rate
commitment. Investors would be critical if, at the end of four years, Pault Co had paid higher costs under the
swap than it would have done had it left the loan unhedged.

Required:
(a) (i) Using the current annual spot yield curve rates as the basis for estimating forward rates, calculate the
amounts Pault Co expects to pay or receive each year under the swap (excluding the fee of 25 basis
points). (6 marks)
(ii) Calculate Pault Cos interest payment liability for Year 1 if the yield curve rate is 45% or 29%, and
comment on your results. (6 marks)

(b) Advise the chairman on the current value of the swap to Pault Co and the factors which would change the
value of the swap. (4 marks)

(c) Discuss the disadvantages and advantages to Pault Co of not undertaking a swap and being liable to pay
interest at floating rates. (9 marks)

(25 marks)

7 [P.T.O.
Formulae

Modigliani and Miller Proposition 2 (with tax)

Vd
k e = kie + (1 T)(kie k d )
Ve

The Capital Asset Pricing Model

E(ri ) = R f + i (E(rm ) Rf )

The asset beta formula

Ve V (1 T)
d
a = e + d
(Ve + Vd (1 T)) (Ve + Vd (1 T))

The Growth Model

Do (1 + g)
Po =
(re g)

Gordons growth approximation


g = bre

The weighted average cost of capital

V V
e d
WACC = k + k (1 T)
Ve + Vd e Ve + Vd d

The Fisher formula


(1 + i) = (1 + r)(1+h)

Purchasing power parity and interest rate parity

(1+hc ) (1+ic )
S1 = S0 x F0 = S0 x
(1+hb ) (1+ib )

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Modified Internal Rate of Return

1
PV n
MIRR = R 1 + re 1
PVI
( )

The Black-Scholes option pricing model

c = PaN(d1) PeN(d2 )e rt

Where:

ln(Pa / Pe ) + (r+0.5s2 )t
d1 =
s t

d2 = d1 s t

The Put Call Parity relationship

p = c Pa + Pe e rt

9 [P.T.O.
Present Value Table

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


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

Discount rate (r)


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

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

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

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

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

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

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

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

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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%

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

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

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

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

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

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

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

11 [P.T.O.
Standard normal distribution table

000 001 002 003 004 005 006 007 008 009
00 00000 00040 00080 00120 00160 00199 00239 00279 00319 00359
01 00398 00438 00478 00517 00557 00596 00636 00675 00714 00753
02 00793 00832 00871 00910 00948 00987 01026 01064 01103 01141
03 01179 01217 01255 01293 01331 01368 01406 01443 01480 01517
04 01554 01591 01628 01664 01700 01736 01772 01808 01844 01879

05 01915 01950 01985 02019 02054 02088 02123 02157 02190 02224
06 02257 02291 02324 02357 02389 02422 02454 02486 02517 02549
07 02580 02611 02642 02673 02704 02734 02764 02794 02823 02852
08 02881 02910 02939 02967 02995 03023 03051 03078 03106 03133
09 03159 03186 03212 03238 03264 03289 03315 03340 03365 03389

10 03413 03438 03461 03485 03508 03531 03554 03577 03599 03621
11 03643 03665 03686 03708 03729 03749 03770 03790 03810 03830
12 03849 03869 03888 03907 03925 03944 03962 03980 03997 04015
13 04032 04049 04066 04082 04099 04115 04131 04147 04162 04177
14 04192 04207 04222 04236 04251 04265 04279 04292 04306 04319

15 04332 04345 04357 04370 04382 04394 04406 04418 04429 04441
16 04452 04463 04474 04484 04495 04505 04515 04525 04535 04545
17 04554 04564 04573 04582 04591 04599 04608 04616 04625 04633
18 04641 04649 04656 04664 04671 04678 04686 04693 04699 04706
19 04713 04719 04726 04732 04738 04744 04750 04756 04761 04767

20 04772 04778 04783 04788 04793 04798 04803 04808 04812 04817
21 04821 04826 04830 04834 04838 04842 04846 04850 04854 04857
22 04861 04864 04868 04871 04875 04878 04881 04884 04887 04890
23 04893 04896 04898 04901 04904 04906 04909 04911 04913 04916
24 04918 04920 04922 04925 04927 04929 04931 04932 04934 04936

25 04938 04940 04941 04943 04945 04946 04948 04949 04951 04952
26 04953 04955 04956 04957 04959 04960 04961 04962 04963 04964
27 04965 04966 04967 04968 04969 04970 04971 04972 04973 04974
28 04974 04975 04976 04977 04977 04978 04979 04979 04980 04981
29 04981 04982 04982 04983 04984 04984 04985 04985 04986 04986

30 04987 04987 04987 04988 04988 04989 04989 04989 04990 04990

This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes model
of option pricing. If di > 0, add 05 to the relevant number above. If di < 0, subtract the relevant number above from 05.

End of Question Paper

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