A BIG THANKS TO

FOR THIS MOCK

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ACCA MOCK
Advanced Financial Management
AFM

Time allowed
3 hours and 15 minutes
This question paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be
attempted
Section B – BOTH questions are compulsory and MUST be
attempted

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MOCK EXAM – ANSWERS

1. Entertainment Co.
Report on Proposed Investment in Wildlife Park
This report considers whether or not Entertainment Co should proceed with the
investment in the wildlife park. It begins by estimating the cost of capital that
Entertainment Co should be using in the evaluation of the proposed project. It then
includes a financial appraisal of the investment based on the available financial
information. A critical appraisal of the figures used in the financial analysis is also
included. Lastly, the report discusses the non-financial aspects which Entertainment
Co should consider before making the final decision to invest in the wildlife park.
(a) Cost of Capital for Wildlife Park Project
Entertainment Co cannot use the current cost of capital to evaluate the proposed
project. This is because the nature of the proposed business is different from the
nature of the current business. The cost of capital should reflect the risk of the
investment being undertaken. Therefore, the cost of capital should be estimated
using the risk bet of Panda Co.
Step 1 – Ungearing Panda Co’s Beta
Equity = $500 x 2 = $1,000
Debt = $400 / $100 x $90 = 360
Assuming that the debt is virtually risk free, ungeared beta can be calculated as:

Step 2 – Regearing Beta

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Step 3 – Cost of Equity and Cost of Debt
The cost of equity can be calculated using the capital asset pricing model.
Ke = Rf + Be (Rm – Rf)
Ke = 4% + 1.80 (8%)
Ke = 18.4%
The cost of debt, as given in the scenario, is 5.5%.
Step 4 – Weighted Average Cost of Capital
WACC = Cost of equity x Weightage of Equity + Post tax cost of debt = Weightage
of Debt
WACC = 18.4% x 60% + 5.5% x (1 – 30%) x 40%
WACC = 12.5%
12% is used in the answer as the discount rate. 12.5% or 13% are equally
acceptable.
(b) Financial Acceptability of the Project
The financial acceptability of the project can be determined using the net present
value method. The net present value of the proposed project is as follows;
Year 0 1 2 3 4 5 6 7
Receipts: $m $m $m $m $m $m $m $m
Admission 102.21 106.30 110.55 114.97 119.57
Food and drinks 13.63 14.17 14.74 15.33 15.94
Gifts 27.26 $28.35 29.48 30.66 31.89
Golf course 4.00 4.80 4.80 4.80 4.80

Total receipts 147.10 153.62 159.57 165.76 172.20

Expenses:
Maintenance (20.00) (15.00) (15.00) (15.00) (15.00)
Labour (32.45) (33.75) (35.10) (36.50) (37.96)
Capital allowances (62.50) (46.88) (35.16) (26.37)
Total expenses (114.95) (95.63) (85.26) (77.87) (52.96)
32.15 57.99 74.32 87.89 119.24
Taxation (30%) (9.64) (17.40) (22.29) (26.37) (35.77)
22.50 40.60 52.02 61.53 83.47
Add: Capital allowances 62.50 46.88 35.16 26.37
Initial cost (250.00) (250.00)
Realisable value 50.00
Working capital (41.60) (1.66) (1.73) (1.80) (1.87) (1.95) 50.61
Net cash flow (250.00) (291.60) 83.34 85.75 85.38 86.02 131.52 50.61
Discount factor (12%) 1 0.893 0.797 0.712 0.636 0.567 0.507 0.452
Present values (250.00) (260.36) 66.44 61.03 54.26 48.81 66.63 22.89

Net present value (190.28)

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The net present value of the investment has turned out to be (190.28 million). Based
on the financial analysis, the project does not appear to create any value for the
shareholders.
Notes and Workings
Year 2 Receipts

The park will be constructed in one year from now. Therefore, receipts will start from
year 2. Except golf course member, all receipts have to be inflated based on the 4%
inflation rate.
Admissions = 18,000 x 350 x 15 x (1.04)2 = $102.21 million
Food and drinks = 18,000 x 350 x 2 x (1.04)2 = $13.63 million
Gifts = 18,000 x 350 x 4 x (1.04)2 = $27.26 million
Golf course membership = 8,000 x 2500 x 0.2 = $4 million
The golf course membership will only include the share of Entertainment Co. The
expenses and income of the third party are irrelevant. Receipts for the remaining
years will calculated on the same principle.

Capital allowances
It is assumed that the capital allowances are available with one-year lag. It is further
assumed that allowances will be used against other taxable cash flows of
Entertainment Co in the ski resort business.
Year Written down value Capital allowance (25%) Available in
1 250 62.5 Year 2
2 187.5 46.88 Year 3
3 140.62 35.16 Year 4
4 105.47 26.37 Year 5

The will be no balancing allowance or charge as the realisable value has been
estimated on after-tax basis.
Market Research
Market research is a sunk cost.
Cleaning Costs
The savings in cleaning costs do not represent cash flows. Therefore, they do not
have to be separately added.
The benefit is already realised as no cash outflow is included in relation to
advertising costs.

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Apportioned Overheads
The apportioned overheads are not relevant cash flows.

(c) Appraisal of Figures used in Financial Evaluation

The financial projections used in the investment appraisal are simply estimates.
They are subject to considerable inaccuracy. Any change in the financial figures can
virtually change the outcome of the project. Many of the figures used in performing
the financial evaluation appear to be unreasonable. They should be reinvestigated
in order to create a more reliable forecast.

Inflation Rate
The forecast assumes a constant rate of inflation for all inflows and outflows in the
next five years. There can be different inflation rate for each component included in
the financial evaluation. Similarly, the inflation rate is unlikely to remain constant
for the next five years.

Visitors per Day

The entire receipts from admissions, gifts, food and drinks depend on the number
of visitors per day. The current analysis assumes constant number of visitors each
day for a period of five years. This appears very unrealistic. The number of visitors
will remain variable throughout the year, depending upon the season and weather.
Similarly, if the park becomes a popular place of attraction, the number of visitors
can increase drastically in the next five years. Ideally, sensitivity or simulation
analysis should be performed to use a range of values in order to ascertain the
value of the investment.

Constant Admission Price

The forecast assumes a constant admission price throughout the five years. The
admission price may have to be changed during the peak seasons. Similarly, the
price will also change in the next five years based on the performance of the park.

Tax Rates
Taxes have a major impact on the outcome of a project. Tax rates are unlikely
remain constant for a period of five years. A better approach would be to estimate a
range of tax rates and apply each of them to understand the different possible
outcomes.
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Realisable Value and Project Life

The realisable value at the end of year five is subjective. This will change depending
upon the economical conditions at the end of the project life. Similarly, the project
life may turn out to be different from five years. This will affect the outcome of the
appraisal process. Also, Year 5 realisable value is asset value and not the value of
the business as a going concern. The going concern value will be very different from
the value of the asset. This can directly affect the decision to opt for the
investment.

Discount Rate
The business has used Panda Co’s equity beta to calculate its own cost of equity.
The business risk of Panda Co and Entertainment Co may significantly differ. This
will make the existing cost of capital unrealistic. Similarly, the gearing of the
business will not remain constant for the next five years. Any change in the gearing
will change the discount rate. For instance, if Entertainment Co uses a higher
proportion of debt, the cost of capital can turn out to be lower than expected.

(d) Non-financial Aspects

The decision to invest in a major project must be based on both the financial and
the non-financial information. The entry into a separate line of the business
qualifies as a major decision. Therefore, apart from considering the net present
value of the project, Entertainment Co should also consider the strategy fit of the
investment and its own future plans to make the final decision.
The strategic importance of the project must be considered in the first place.
Entertainment Co successfully runs a chain of ski resorts. It should consider
whether the future of the business lies in its core ski resort business. It is true that
the ski resort business is seasonal. If this is the case, the diversification into a new
business may be the only solution for Entertainment Co.
Entertainment Co needs to consider if the investment in the current park will lead
to other opportunities in the future. If so, the benefit of such options should also be
incorporated in the current decision. The business may be willing to bear some
losses in order to understand the operations of a wildlife park. These losses can
allow the business with considerable experience to open further wildlife parks in
more profitable areas. If this is the case, Entertainment Co should proceed with the
project regardless of the financial losses.

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The business also needs to consider the amount of competition and the probable
reaction of the competitors in the industry. There are a number of laws and
regulations to consider in the wildlife industry. Providing unsafe or inadequate
conditions in the wildlife park can lead to lawsuits and penalties. Similarly, there
has been a cause of concern for looking after the animals in the wildlife parks. The
public is demanding freedom for the wildlife and the provision of natural facilities
for promoting the wildlife. If any unpleasant incident occurs in the wildlife park, it
can bring bad publicity not only to the wildlife business but also to the ski resort
business.
Entertainment Co should also consider its own expertise in managing the wildlife
park. The business is experienced in managing the ski-resorts. However, different
set of skills are required in the wildlife park. Not all species survive in the different
climatic conditions and these factors must be taken into account before making the
ultimate decision.

Conclusion
The net present value of the investment has turned out to be (190.28 million).
Based on the financial analysis, the project does not appear to create any value for
the shareholders. However, this financial estimate can significantly change with the
changes in inflation rate, number of visitors, taxation rate, realisable value and
capital structure. Apart from these financial considerations, the business should
also consider non-financial factors such as strategic fit of the investment and future
opportunities before making the final decision.

Report prepared by:

Date:

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2. Pledge Co
(a) Borrowing Cost
Pledge Co needs to borrow $50 million a period of (10 months – 4 months) = 6
months.
Borrowing cost at current rate of 3.5% + 0.9% = $50,000,000 x (6/12) x 4·4% =
$1,100,000
Borrowing cost at increased rate of 3.5% + 0.9% + 0.8% = $50,000,000 x 6/12 x 5·2%
= $1,300,000
Additional cost due to increase = $1,300,000 - $1,100,000 = $200,000
(b) Financial Implications of Hedging Techniques
The financial impact of using interest rate futures, options on interest rate futures
and collar on options to hedge the risk is as follows:
Using Interest Rate Futures
In order to hedge against the rise in interest rates, Pledge Co needs to take a short
position.
Number of contracts = (Loan amount / Contract size) x (Loan period / Underlying rate
period)
Number of contracts = ($50,000,000/ $1,000,000) x (6/3)
Number of contracts = 100 contracts
Basis = 100 - Spot rate - Futures price
Basis = 100 – 3.5 – 95.70
Basis = 0·80
Unexpired basis = 2/6 x 0.80 = 0.27
(Basis risk is the difference between the futures price and the current ‘cash market’
price of the underlying security.
If LIBOR increases by 80 basis points to 4.3%:
Expected futures price = 100 – 4·3 – 0·27 = 95·43
Gain on futures = (95·70 – 95·43) x $25 x 100 = $67,500
The gain made on futures will reduce the additional cost of Pledge Co by;
Net additional cost = $200,000 – $67,500
Net additional cost = $132,500

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Using Options on Futures

Pledge Co needs to buy put options to hedge against the risk of increase in the
interest rates.
Number of contracts = (Loan amount / Contract size) x (Loan period / Underlying
rate period)
Number of contracts = ($50,000,000/ $1,000,000) x (6/3)
Number of contracts = 100 contracts
Two different options, with strike price of 95.50 and 96.00, are available in the
market.
If strike price of 95.80 is selected:
The exercise price of 95.80 is favourable than 95.43. Therefore, the option will be
exercised.
Gain in basis points = 95.80 – 95.43 = 37 basis points
Gain on options = $25 x 100 x 37
Gain on options = $92,500
Premium on put option = 31·5 x $25 x 100
Premium on put option = $78,750
Net benefit of option = $92,500 - $78,750
Net benefit of option = $13,750
Net additional cost = $200,000 - $13,750
Net additional cost = $186,250
If strike price of 96.20 is selected:
The exercise price of 96.20 is favourable than 95.43. Therefore, option will be
exercised.
Gain in basis points = 96.20 – 95.43 = 77 basis points
Gain on options = $25 x 100 x 77
Gain on options = $195,200
Premium on put option = 74·2 x $25 x 100
Premium on put option = $185,500
Net benefit of option = $195,200 - $185,500
Net benefit of option = $9,700
Net additional cost = $200,000 – $9,700
Net additional cost = $190,300

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(c) Advise for Hedging

If the interest rates increase by 80 basis points, the overall interest cost for the
business will increase by $200,000. If Pledge Co uses interest rate futures to hedge
this risk, the additional cost will be reduced to $132,500. If the business uses options
on futures at the strike price of 95.80, the additional cost will be reduced to
$186,250. If interest rate options, with the strike price of 96.20 are used, the
additional cost will be reduced to $190,300. Based on the detailed calculations, the
futures hedge would reduce the additional cost by the greatest amount. However, it
is important to note that options provide greater flexibility. If the interest rates do
not increase, or actually decrease, the business can simply allow the option to lapse.

(d) Problems of Using Interest Rate Futures

The following problems are usually encountered in using futures contracts to hedge
the interest rate risk:
• Futures contracts are only available in fixed sized contracts. The sum to be hedged
is not always equal to a whole number of contracts. This leaves a fractional amount
unhedged. This, however, can be hedged using other hedging techniques.
• Futures contracts only expire in certain months. The month of borrowing or
deposit is not always exactly aligned with the contract expiry date. Therefore, a
perfect hedge is not always possible.
• An initial as well as a daily margin based on fluctuations must be paid in the
futures contracts. Therefore, companies with poor liquidity often prefer other types
of hedging techniques.
• Future contracts are usually closed before expiry. Given the difference between the
two dates, futures contracts expose the holder to basis risk. This also prevents
perfect hedging.
• Futures contracts are usually complex and good training is required to manage the
risks based on these contracts. As evident from the history, poor decision making can
result in disaster for the company.

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3. Radar Co
(a) Assessment of Option Price
The Black-Sholes option pricing model can be used to illustrate if the price of the
option offered by the bank is fair. The value of a put option can be found first by
estimating the value of a call option and then using the putcall parity theorem to
find the value of the put option.
Current share price = 400 cents
Exercise price = 380 cents
Risk free rate = 5% = 0.05
Volatility = 14% = 0.14
Relevant period = 6 months = 0.5
Call price = PaN(d1) – PeN(d2)e-rt
In order to use this equation, we first need to determine the value of d1 and d2 d1
= {ln(Pa/Pe)+(r+0.5s2)t} / (s√t)
d1 = {ln(400/380)+(0.05+0.5x0.142)x0.5} / (0.14√0.5) d1 = 0.8201
d2 = d1 - s√t d2 = 0.8201 - 0.14√0.5 d2 = 0.7211
N(d1) = 0.5 + 0.2939 = 0.7939 N(d2) = 0.5 + 0.2648 = 0.7648
The call price can now be calculated by inputting this information into call price
equation.
Call price = PaN(d1) – PeN(d2)e-rt
Call price = 400 x 0.7939 – 380 x 0.7648 x e-0.05 x 0.5
Call price = 317.56 - 283.44
Call price = 34.12 cents
The value of the put option can now be estimated using the put-call parity theorem.
P = C – Pa + Pe x e-rt
P = 34.12 – 400 + 380 x e-(0.05 x 0.5)
P = 4.73 cents
Fair price of option = Price of option x Number of shares
Fair price of option = 4.73 cents x 6,000,000
Fair price of option = $283,800
The option price of $450,000 offered by the bank is considerably higher than the
fair price as pre Black-Scholes model.

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(b) Factors to Consider

Radar Co should consider the following factors before making the decision to
purchase the option:
• The option is only valid for a six-month period. If Radar Co wishes to protect
against the long-term risk, other strategies will be required.
• The option involves a premium which has to be paid regardless of the actual
benefit. Radar Co should carefully consider whether the shares in Satellite Co are
likely to fall beyond the certain level.
• The business may want to hedge the entire portfolio instead of a specific
investment. The bank may offer a better price for the entire portfolio.
• There can be tax implications for gains made on the options.
• There can be cheaper alternates to over-the-counter option. The collar options of
stock index futures should also be considered.

(c) Limitations of Black-Scholes Model

• Black-Scholes model is theoretical and not a perfect estimator of options prices. It
does not consider all the market conditions that can affect the option price.
• Black-Scholes model can only be used to price European options. It cannot be
used for American options which could be exercised before expiry.
• The model assumes past volatility to continue in the future period. This
assumption is unrealistic.
• The model assumes constant risk-free rate. The risk-free rate can change in the
future which can significantly affect the option price.
• The model assumes constant dividends. This is unrealistic as dividends tend to
vary.

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