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Financial Management

Thursday 4 December 2008

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

Fundamentals Level Skills Module

ALL FOUR questions are compulsory and MUST be attempted


1

Dartig Co is a stock-market listed company that manufactures consumer products and it is planning to expand its
existing business. The investment cost of $5 million will be met by a 1 for 4 rights issue. The current share price of
Dartig Co is $250 per share and the rights issue price will be at a 20% discount to this. The finance director of Dartig
Co expects that the expansion of existing business will allow the average growth rate of earnings per share over the
last four years to be maintained into the foreseeable future.
The earnings per share and dividends paid by Dartig over the last four years are as follows:
Earnings per share (cents)
Dividend per share (cents)

2003
277
128

2004
290
135

2005
290
135

2006
302
145

2007
324
150

Dartig Co has a cost of equity of 10%. The price/earnings ratio of Dartig Co has been approximately constant in recent
years. Ignore issue costs.
Required:
(a) Calculate the theoretical ex rights price per share prior to investing in the proposed business expansion.
(3 marks)
(b) Calculate the expected share price following the proposed business expansion using the price/earnings ratio
method.
(3 marks)
(c) Discuss whether the proposed business expansion is an acceptable use of the finance raised by the rights
issue, and evaluate the expected effect on the wealth of the shareholders of Dartig Co.
(5 marks)
(d) Using the information provided, calculate the ex div share price predicted by the dividend growth model and
discuss briefly why this share price differs from the current market price of Dartig Co.
(6 marks)
(e) At a recent board meeting of Dartig Co, a non-executive director suggested that the companys remuneration
committee should consider scrapping the companys current share option scheme, since executive directors could
be rewarded by the scheme even when they did not perform well. A second non-executive director disagreed,
saying the problem was that even when directors acted in ways which decreased the agency problem, they might
not be rewarded by the share option scheme if the stock market were in decline.
Required:
Explain the nature of the agency problem and discuss the use of share option schemes as a way of reducing
the agency problem in a stock-market listed company such as Dartig Co.
(8 marks)
(25 marks)

The following financial information related to Gorwa Co:

Sales (all on credit)


Cost of sales
Operating profit
Finance costs (interest payments)
Profit before taxation

2007
$000
37,400
34,408

2,992
355

2,637

2006
$000
26,720
23,781

2,939
274

2,665

$000
13,632

$000

2007
$000
Non-current assets
Current assets
Inventory
Trade receivables
Current liabilities
Trade payables
Overdraft
Net current assets
8% Bonds

Capital and reserves


Share capital
Reserves

2006

4,600
4,600

9,200

2,400
2,200

4,600

4,750
3,225

7,975

2,000
1,600

3,600

$000
12,750

1,225

14,857
2,425

12,432

1,000

13,750
2,425

11,325

6,000
6,432

12,432

6,000
5,325

11,325

The average variable overdraft interest rate in each year was 5%. The 8% bonds are redeemable in ten years time.
A factor has offered to take over the administration of trade receivables on a non-recourse basis for an annual fee of
3% of credit sales. The factor will maintain a trade receivables collection period of 30 days and Gorwa Co will save
$100,000 per year in administration costs and $350,000 per year in bad debts. A condition of the factoring
agreement is that the factor would advance 80% of the face value of receivables at an annual interest rate of 7%.
Required:
(a) Discuss, with supporting calculations, the possible effects on Gorwa Co of an increase in interest rates and
advise the company of steps it can take to protect itself against interest rate risk.
(7 marks)
(b) Use the above financial information to discuss, with supporting calculations, whether or not Gorwa Co is
overtrading.
(10 marks)
(c) Evaluate whether the proposal to factor trade receivables is financially acceptable. Assume an average cost
of short-term finance in this part of the question only.
(8 marks)
(25 marks)

[P.T.O.

Rupab Co is a manufacturing company that wishes to evaluate an investment in new production machinery. The
machinery would enable the company to satisfy increasing demand for existing products and the investment is not
expected to lead to any change in the existing level of business risk of Rupab Co.
The machinery will cost $25 million, payable at the start of the first year of operation, and is not expected to have
any scrap value. Annual before-tax net cash flows of $680,000 per year would be generated by the investment in
each of the five years of its expected operating life. These net cash inflows are before taking account of expected
inflation of 3% per year. Initial investment of $240,000 in working capital would also be required, followed by
incremental annual investment to maintain the purchasing power of working capital.
Rupab Co has in issue five million shares with a market value of $381 per share. The equity beta of the company
is 12. The yield on short-term government debt is 45% per year and the equity risk premium is approximately 5%
per year.
The debt finance of Rupab Co consists of bonds with a total book value of $2 million. These bonds pay annual interest
before tax of 7%. The par value and market value of each bond is $100.
Rupab Co pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax-allowable depreciation)
on machinery are on a straight-line basis over the life of the asset.
Required:
(a) Calculate the after-tax weighted average cost of capital of Rupab Co.

(6 marks)

(b) Prepare a forecast of the annual after-tax cash flows of the investment in nominal terms, and calculate and
comment on its net present value.
(8 marks)
(c) Explain how the capital asset pricing model can be used to calculate a project-specific discount rate and
discuss the limitations of using the capital asset pricing model in investment appraisal.
(11 marks)
(25 marks)

Three years ago Boluje Co built a factory in its home country costing $32 million. To finance the construction of the
factory, Boluje Co issued peso-denominated bonds in a foreign country whose currency is the peso. Interest rates at
the time in the foreign country were historically low. The foreign bond issue raised 16 million pesos and the exchange
rate at the time was 500 pesos/$.
Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each year of 61%. The
bonds will be redeemed in five years time at par. The current cost of debt of peso-denominated bonds of similar risk
is 7%.
In addition to domestic sales, Boluje Co exports goods to the foreign country and receives payment for export sales in
pesos. Approximately 40% of production is exported to the foreign country.
The spot exchange rate is 600 pesos/$ and the 12-month forward exchange rate is 607 pesos/$. Boluje Co can
borrow money on a short-term basis at 4% per year in its home currency and it can deposit money at 5% per year
in the foreign country where the foreign bonds were issued. Taxation may be ignored in all calculation parts of this
question.
Required:
(a) Briefly explain the reasons why a company may choose to finance a new investment by an issue of debt
finance.
(7 marks)
(b) Calculate the current total market value (in pesos) of the foreign bonds used to finance the building of the
new factory.
(4 marks)
(c) Assume that Boluje Co has no surplus cash at the present time:
(i)

Explain and illustrate how a money market hedge could protect Boluje Co against exchange rate risk in
relation to the dollar cost of the interest payment to be made in one years time on its foreign bonds.
(4 marks)

(ii) Compare the relative costs of a money market hedge and a forward market hedge.

(2 marks)

(d) Describe other methods, including derivatives, that Boluje Co could use to hedge against exchange rate risk.
(8 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

Ve + Vd 1 T
Ve + Vd 1 T

))

))

The Growth Model

Po =

D0 1 + g

(r

Gordons growth approximation


g = bre
The weighted average cost of capital

V
V
e
d
k 1 T
ke +
WACC =
Ve + Vd d
Ve + Vd

The Fisher formula

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

S1 = S0

(1 + h )
(1 + h )
c

F0 = S0

(1 + i )
(1 + i )
c

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
2
3
4
5

0990
0980
0971
0961
0951

0980
0961
0942
0924
0906

0971
0943
0915
0888
0863

0962
0925
0889
0855
0822

0952
0907
0864
0823
0784

0943
0890
0840
0792
0747

0935
0873
0816
0763
0713

0926
0857
0794
0735
0681

0917
0842
0772
0708
0650

0909
0826
0751
0683
0621

1
2
3
4
5

6
7
8
9
10

0942
0933
0923
0941
0905

0888
0871
0853
0837
0820

0837
0813
0789
0766
0744

0790
0760
0731
0703
0676

0746
0711
0677
0645
0614

0705
0665
0627
0592
0558

0666
0623
0582
0544
0508

0630
0583
0540
0500
0463

0596
0547
0502
0460
0422

0564
0513
0467
0424
0386

6
7
8
9
10

11
12
13
14
15

0896
0887
0879
0870
0861

0804
0788
0773
0758
0743

0722
0701
0681
0661
0642

0650
0625
0601
0577
0555

0585
0557
0530
0505
0481

0527
0497
0469
0442
0417

0475
0444
0415
0388
0362

0429
0397
0368
0340
0315

0388
0356
0326
0299
0275

0305
0319
0290
0263
0239

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0901
0812
0731
0659
0593

0893
0797
0712
0636
0567

0885
0783
0693
0613
0543

0877
0769
0675
0592
0519

0870
0756
0658
0572
0497

0862
0743
0641
0552
0476

0855
0731
0624
0534
0456

0847
0718
0609
0516
0437

0840
0706
0593
0499
0419

0833
0694
0579
0482
0402

1
2
3
4
5

6
7
8
9
10

0535
0482
0434
0391
0352

0507
0452
0404
0361
0322

0480
0425
0376
0333
0295

0456
0400
0351
0308
0270

0432
0376
0327
0284
0247

0410
0354
0305
0263
0227

0390
0333
0285
0243
0208

0370
0314
0266
0225
0191

0352
0296
0249
0209
0176

0335
0279
0233
0194
0162

6
7
8
9
10

11
12
13
14
15

0317
0286
0258
0232
0209

0287
0257
0229
0205
0183

0261
0231
0204
0181
0160

0237
0208
0182
0160
0140

0215
0187
0163
0141
0123

0195
0168
0145
0125
0108

0178
0152
0130
0111
0095

0162
0137
0116
0099
0084

0148
0124
0104
0088
0074

0135
0112
0093
0078
0065

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%

1
2
3
4
5

0990
1970
2941
3902
4853

0980
1942
2884
3808
4713

0971
1913
2829
3717
4580

0962
1886
2775
3630
4452

0952
1859
2723
3546
4329

0943
1833
2673
3465
4212

0935
1808
2624
3387
4100

0926
1783
2577
3312
3993

0917
1759
2531
3240
3890

0909
1736
2487
3170
3791

1
2
3
4
5

6
7
8
9
10

5795
6728
7652
8566
9471

5601
6472
7325
8162
8983

5417
6230
7020
7786
8530

5242
6002
6733
7435
8111

5076
5786
6463
7108
7722

4917
5582
6210
6802
7360

4767
5389
5971
6515
7024

4623
5206
5747
6247
6710

4486
5033
5535
5995
6418

4355
4868
5335
5759
6145

6
7
8
9
10

11
12
13
14
15

1037
1126
1213
1300
1387

9787
1058
1135
1211
1285

9253
9954
1063
1130
1194

8760
9385
9986
1056
1112

8306
8863
9394
9899
1038

7887
8384
8853
9295
9712

7499
7943
8358
8745
9108

7139
7536
7904
8244
8559

6805
7161
7487
7786
8061

6495
6814
7103
7367
7606

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0901
1713
2444
3102
3696

0893
1690
2402
3037
3605

0885
1668
2361
2974
3517

0877
1647
2322
2914
3433

0870
1626
2283
2855
3352

0862
1605
2246
2798
3274

0855
1585
2210
2743
3199

0847
1566
2174
2690
3127

0840
1547
2140
2639
3058

0833
1528
2106
2589
2991

1
2
3
4
5

6
7
8
9
10

4231
4712
5146
5537
5889

4111
4564
4968
5328
5650

3998
4423
4799
5132
5426

3889
4288
4639
4946
5216

3784
4160
4487
4772
5019

3685
4039
4344
4607
4833

3589
3922
4207
4451
4659

3498
3812
4078
4303
4494

3410
3706
3954
4163
4339

3326
3605
3837
4031
4192

6
7
8
9
10

11
12
13
14
15

6207
6492
6750
6982
7191

5938
6194
6424
6628
6811

5687
5918
6122
6302
6462

5453
5660
5842
6002
6142

5234
5421
5583
5724
5847

5029
5197
5342
5468
5575

4836
4988
5118
5229
5324

4656
4793
4910
5008
5092

4486
4611
4715
4802
4876

4327
4439
4533
4611
4675

11
12
13
14
15

End of Question Paper