AFM Mock C - Answers S22

ACCA
AFM
Advanced Financial Management

September 2022
Mock C – Answers
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A F M : AD VAN CED FINANCIA L MANAGEMEN T
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2 K A P LA N P UB L I S H I N G
MO CK C A NSWER S
1 GRIMALDI CO
(a) Acquisition and organic growth
The two most common methods by which a company can grow are acquisition and
organic growth.
Acquisition is when one company takes over another, and organic growth is when a
company sets up a new business from scratch.
The relative advantages of the two methods are:
Advantages of acquisition (disadvantages of organic growth)
• Acquisition generally leads to quicker growth, since the new business is already
set up and fully functioning. This may be important if economies of scale are
significant.
• After an acquisition, the integration of two businesses can lead to an exchange
of ideas and methods which can help to make both businesses more efficient.
• Acquisition helps to avoid the risk of failure which is always associated with
setting up a new business.
• Acquisition can eliminate a competitor from the market place, thus reducing the
risk attached to future earnings.
• When one firm acquires another, synergies (value gains) are often achieved, so
that the combined firm is worth more than the two firms individually. For
example, there could be savings in marketing costs if a design company and a
printing company decide to target customers together rather than
independently. These savings will lead to value gains for the combined firm’s
shareholders.
Disadvantages of acquisition (advantages of organic growth)
• Organic growth is usually cheaper than acquisition – when a business is
acquired, a premium often has to be paid to cover the intangible assets (e.g.
goodwill, brand) of the target company.
• Organic growth avoids the culture clashes which often arise if a business is
acquired and the two firms are integrated.
• Organic growth can be planned very carefully to fit in exactly with the company’s
objectives. Sometimes when a new business is acquired, it may have some
operations in different regions or industries which the acquiring company did
not plan to enter.
(b) REPORT
To: The Directors, Grimaldi Co
From: An Advisor
Date: Today
Subject: The proposed diversification into the design industry
Introduction
I have presented below some valuation calculations for Manin Co, together with an
explanation of different payment methods, and an overview of
dividend/financing/investment policies.
KAPLAN P UBLI S H I N G 3
(i) Valuation of Manin Co

I have presented my calculations of the valuation of Manin Co in the attached
Appendix. Based on the information presented on the Manin website, the
valuation is $24.6m using the P/E method and $22m using the present value
method.
Assumptions underpinning the calculations
• Given forecasts and estimated growth rates have been assumed to be
reasonable.
• EBIT has been taken as a starting point for the estimate of cash flows.
Apart from depreciation (which has been added back) it has been
assumed that the EBIT figure represents cash received by Manin.
• Accounting depreciation has been assumed to be equal to tax
depreciation. Hence, the depreciation has been added back as a non cash
item AFTER the tax charge has been calculated.
• Manin’s debt finance has been assumed to be risk free
• The expected investor return in the design industry of 12% has been
assumed to be a suitable discount rate for the Manin cash flows: this
assumes that Manin’s level of risk (and hence expected investor return) is
comparable to the industry as a whole.
• The industry P/E of 15 has been applied to the Manin profit figure: this
assumes that the investor expectations for Manin are in line with industry
average.
Reservations about the calculations
• The calculations are based on very little analysis of the detailed position
of Manin. The due diligence work might reveal more information which
would cause us to revise our estimates.
• Manin is a relatively small, unquoted company. It is debatable whether
the industry average P/E and investor return figures given are applicable
to such a company. Generally such information is derived from quoted
companies, which are much bigger and more attractive to investors. A
non-marketability discount should probably be applied to the industry
quoted figures, but it is difficult to estimate the size of this until after more
detailed analysis has been performed.
• In the present value method, the value of the first 4 years of cash flows is
$6.05m, and the value of the growing perpetuity from year 5 onwards is
$21.25m i.e. the bulk of the value is derived from the more distant cash
flows, where any estimates are likely to be less accurate.
Conclusion on valuation – the suggested offer for Manin Co
If the acquisition of Manin is to go ahead, detailed due diligence work will need
to be performed before a final bid can be made.
However, based on the given information, the value of Manin would appear to
be somewhere between $22m and $24.6m. These valuations may well be quite
high given that they are based on industry average figures for P/E and investor
returns, so it is suggested that the initial offer should be somewhere below these
values.
MO CK C A NSWER S
An offer of, say, $15m might well be a suitable opening bid. If this offer is
rejected as being too low, Grimaldi should be prepared to increase the bid to
round about $20m if necessary.
(ii) The method of payment in the acquisition
The process by which one company acquires another can indeed be complex
and time consuming. The terms of the offer and the method of payment used
are particularly important, since an inappropriate choice of method could see
the target company shareholders refusing to sell their shares.
There are three main methods of paying for a target company’s shares: cash,
share for share exchange, or earn-out.
Cash offer
A cash offer is the simplest for the target company’s shareholders to understand
– they are offered a fixed cash sum for their shares, which they can spend
immediately, as long as they first settle any capital gains tax liability. This gives
the target company shareholders an exit route from the company. Given that
Manin is unquoted, this may well be important to Manin’s shareholders since
no ready market exists for the shares elsewhere. From Grimaldi’s point of view,
the cash would need to be raised and paid out straight away. This might cause
liquidity problems, or gearing problems if the money has to be borrowed.
Share for share exchange
In a share for share exchange, Grimaldi would issue some new shares and give
them to the Manin shareholders in exchange for their Manin shares. This
enables the target company shareholders to maintain a stake in the company,
but the value of the offer might be difficult for them to assess (especially in this
case, where both Grimaldi and Manin are unquoted companies so their shares
will have no readily available market value). Grimaldi would now not need to
find the cash in the short term, so may prefer this method.
Earn-out
In an earn-out, Grimaldi would pay some of the consideration straight away, but
would delay the balance and only pay it if certain targets were met in the years
after the acquisition.
This would give a measure of security to Grimaldi, who would pass some of the
financial risk associated with the purchase of Manin on to the Manin
shareholders.
Earn-outs normally work best when the target company is an owner-managed
business, so that the owners are incentivised to carry on working for the
enlarged business after the acquisition and to strive towards targets to ensure
they maximise the consideration payable. The idea is that this should benefit the
acquiring company too, since it will help to ensure that the acquisition is
successful.
A combination of methods
As an alternative to any of the three options mentioned above, a combination
of the methods can sometimes be used. For example, if some of Manin’s
shareholders would prefer the certainty of a cash offer, but some would prefer
to maintain an interest in the business through a share for share exchange, a
choice of cash or shares could be offered.
(iii) Dividend policy, investment policy and financing policy

The Financial Manager has expressed concern that Grimaldi might not be able
to satisfy its existing shareholders’ needs if the directors spend too much time
and money on the Manin takeover, and this diverts funds from the dividends
payable.
He is right to be concerned about the shareholders’ needs – in theory the
primary objective of any company is to maximise the wealth of its shareholders.
However, paying dividends to shareholders is not the only way to improve
shareholder wealth.
Shareholder wealth is increased if the company invests in positive Net Present
Value ('NPV') projects, so arguably the firm’s investment policy should be just as
important to the Financial Manager and the shareholders as the dividend policy.
It is important to understand the links between the company’s dividend,
investment and financing policies.
Investment policy
Companies should always aim to invest in projects which increase shareholder
wealth, i.e. those which have a positive NPV when discounted at the firm’s cost
of capital. In the case of Grimaldi Co, this would mean that the investment in
Manin should only be undertaken if the NPV of the potential investment is
positive.
Financing policy
In order to fund the acquisition of Manin, it is likely that Grimaldi would have to
raise some finance. This is likely to affect the firm’s cost of capital – theoretically,
Modigliani and Miller proved that raising debt finance reduces cost of capital,
whereas raising equity finance increases the cost of capital. In practice, it is
generally accepted that a balance of debt and equity finance is likely to lead to
a minimum cost of capital. The key point is that the cost of capital is used in
investment appraisal, so clearly the financing policy of the firm is linked to the
investment policy – a low cost of capital will generally lead to higher NPVs, and
greater shareholder wealth.
Dividend policy
In theory, shareholders should be indifferent between receiving returns in the
form of dividends or capital gains – as long as the firm has an investment policy
which chooses positive NPV projects, the shareholders’ wealth will increase.
However, it is clear from the Financial Manager’s comments that the Grimaldi
shareholders expect to see a growing level of dividends each year. This is known
as the 'clientele effect' – investors will be attracted to a company by its dividend
policy, because it suits their particular circumstances.
For example, they may have a preference for dividends ahead of capital gains
for tax purposes, or in the case of Grimaldi (an unquoted company) because they
would find it difficult to sell their shares to realise any capital gain.
Changing this established dividend policy in practice might upset the
shareholders and cause them to consider selling their shares.
MO CK C A NSWER S
Suggested approach to dividend/investment/financing policy for Grimaldi

If it can be shown that the acquisition of Manin is a positive NPV investment,
Grimaldi should go ahead with the takeover.
When financing the takeover, the impact of the new source of finance on the
cost of capital should be considered carefully – if possible, raising the new
finance should move Grimaldi to a lower cost of capital position.
Grimaldi should try to maintain the current dividend policy if possible, to keep
shareholders happy. However, if the policy needs to be changed in the short
term to release funds for the new investment, careful communication with
shareholders will hopefully enable them to see that the new investment will in
fact benefit them in the longer term.
Overall report conclusion
If Manin Co’s shareholders will accept a bid of between $15m and $20m, and if
it is considered that the purchase of Manin Co at this price will be a positive NPV
investment, the acquisition should go ahead. A choice of consideration options
(perhaps cash and share exchange) could be offered to encourage the Manin
shareholders to dispose of their shares.
Appendix: Valuation calculations
Price Earnings (P/E) method
Value = Maintainable earnings × P/E ratio
where the maintainable earnings figure is an estimate of base level future post
tax earnings, and the P/E ratio is an industry average figure since no specific P/E
ratio exists for Manin. (N.B. This assumes that the industry average is
appropriate to Manin’s circumstances.)
Here, the year 1 post tax profits are forecast to be:
$m
EBIT (per given forecast) 2.55
Interest (4% × $5m) (0.20)
Tax 30% × (2.55 – 0.20) (0.71)
–––––
Profit after tax 1.64
–––––
So, value = $1.64m × 15 = $24.6m
Often, the industry average P/E ratio is taken from similar quoted companies,
whose quoted shares tend to be more marketable and attractive to investors
than those of an unquoted company like Manin.
Consequently, a discount for non-marketability is often applied when valuing
non-quoted company shares. The size of the discount varies depending on how
different the non-quoted company is from its comparable quoted companies.
We are not given enough information here to enable us to estimate the size of
any necessary discount, but be aware that this P/E derived value may well be a
little high as it currently stands.
Present value of future cash flows method

$m Yr 1 Yr 2 Yr 3 Yr 4
EBIT 2.55 3.43 4.09 5.00
Tax (30%) (0.77) (1.03) (1.23) (1.50)
Add: depreciation 0.50 0.52 0.54 0.56
Less: Capex (0.75) (0.77) (0.79) (0.81)
Less: Working capital investment (0.30) (0.31) (0.32) (0.33)
–––––– –––––– –––––– ––––––
Free Cash Flow 1.23 1.84 2.29 2.92
–––––– –––––– –––––– ––––––
Discount factors (12%) 0.893 0.797 0.712 0.636
–––––– –––––– –––––– ––––––
Present value 1.10 1.47 1.63 1.85
–––––– –––––– –––––– ––––––
Net present value (years 1 – 4) = $6.05m
2.92 × 1.03
Net present value (years 5 – perpetuity) = × 0.636 = $21.25m
0.12 – 0.03
Total net present value = $6.05m + $21.25m = $27.30m
This total NPV value represents the total capital value of the business, i.e. the
value of the equity and the debt finance. To find the equity value, we need to
deduct the current market value of the debt finance from this total.
Market value of debt finance can be found as the present value of investor
receipts, discounted at the risk free rate of return (N.B. This assumes that the
Manin bond is risk free.), i.e.
MV = (4% × £5m) × AF 1 – 3 (5%) + (£5m × 1.10) × DF3 (5%) = £5.30m
So the value of the Manin equity is $27.30m – $5.30m = $22m
MO CK C A NSWER S
Marking scheme
Marks
(a) One mark per well explained point Max 6
(b)(i) P/E method– profit after tax 1
– PAT × P/E ratio 1
– non-marketability discount discussion 1
NPV method – EBIT and tax 1
– Depreciation 1
– Capital expenditure 1
– Working capital investment 1
– Year 1 – 4 value (at 12%) 1
– Year 5 – onwards value (at 12%) 2
– Total value (D + E) 1
– Deduct value of debt to give equity value 1
Assumptions Max 3
Reservations Max 3
Conclusion – logical offer based on calculated figures Max 2
––––
Total part (b)(i) Maximum 18
––––
(ii) Payment methods – cash Max 3
– share for share Max 3
– earn-out Max 2
– a combination 1
––––
Total part (b)(ii) Maximum 7
––––
(iii) Key objective – maximise shareholder wealth 1

Investment policy Max 2
Financing policy Max 2
Dividend policy Max 2
Links, and application to Grimaldi Max 3
––––
Total part (b)(iii) Maximum 9
––––
Professional skills marks (see below) 10
––––
Total 50
––––
Professional skills
Communication
General report format and structure (use of headings/sub-headings and an
introduction)
Style, language and clarity (appropriate layout and tone of report response,
presentation of calculations, appropriate use of the tools)
Effectiveness of communication (answer is relevant, specific rather than general and
focused to the requirement)
Analysis and Evaluation
Appropriate use of the data to determine suitable calculations
Appropriate use of the data to support discussion and draw appropriate conclusions
Demonstration of reasoned judgement when considering key matters for this specific
company
Demonstration of ability to consider relevant factors applicable to this specific scenario
Scepticism
Effective challenge of information and assumptions supplied and, techniques carried
out to support any decision
Demonstration of the ability to probe into the reasons for issues and problems,
including the identification of missing information or additional information, which
would alter the decision reached
Commercial acumen
Effective use of examples and/or calculations from the scenario information and other
practical considerations related to the context to illustrate points being made
Recognition of external constraints and opportunities as necessary
Maximum 10 marks
MO CK C A NSWER S
2 MAUREEN AND BARRIE

(a) How lenders set their interest rates
The main determinant of the interest rate charged by a bank to a borrower is the
assessment of the credit risk of the borrower. Large banks may undertake their own
credit risk assessment, or they may use the analysis of a credit assessment agency such
as Moody’s or Standard and Poor’s. Here Maureen Co has been assessed as having an
AA Credit Rating, which suggests that the bank views Maureen Co as a low risk client.
Determining credit risk
The credit rating agencies and banks have traditionally assessed credit risk by analysing
a company’s financial statements (ratio analysis). However, these accounting-based
methods are often criticised for being too simplistic.
Hence, more sophisticated methods, known as 'structural models' have been
developed in recent years. These models use statistical methods (such as normal
distribution theory) to analyse the riskiness of a firm’s assets and cash generation, and
to calculate the likelihood of a firm defaulting on its interest and/or capital
repayments.
Credit spread
Once the firm’s credit risk has been assessed, the lender will quote an interest rate to
the firm which will be made up of two elements; a base rate plus a credit spread. The
credit spread will be low for highly regarded companies which are assessed as being
low risk investments. The greater the credit risk of a firm, the higher the credit spread
will be, and hence the higher the rate of interest it will have to pay. The credit spread
is calculated by the lender using probability theory: the greater the probability of
default, the higher the credit spread will be.
Application to Maureen Co
Maureen Co’s credit rating is AA, and the bank has assessed the appropriate credit
spread to be 65 basis points (0.65%). Hence, with a base rate of 5.25%, the quoted
interest rate on the loan becomes 5.90%.
(b) Key features of the three hedging methods
Both the forward rate agreement ('FRA') and the futures contract will enable the
company to fix its interest rate on the borrowing. If interest rates are predicted to rise,
this may well be an attractive proposition.
However, it is worth mentioning that FRAs and futures contracts are very inflexible
arrangements. For example, if an expected rise in interest rates does not materialise,
the company may end up fixed to a borrowing rate which is higher than the rate
available on the open market. In this case, an option would be much more attractive,
since the company would be able to let the option lapse and borrow at the cheaper
prevailing rate.
Both FRAs and futures contracts are relatively cheap hedging methods compared to
options, where an expensive premium is paid at the time the hedge is set up.
FRAs
FRAs are Over The Counter ('OTC') instruments, which means that they are provided
by banks and can be tailored to a firm’s particular circumstances. Under an FRA, the
firm borrows at the standard market rate, and then any difference between this rate
and the FRA fixed rate is paid to, or received from, the bank as necessary. An example
of this is presented below.
Futures contracts
Futures contracts are standardised derivative products which are traded on
exchanges. The fact that they are standardised means that they cannot necessarily be
tailored specifically to a firm’s specific requirements. N.B. However, in this case (see
calculations below for details) four contracts can be used to cover the borrowing
exactly. As a consequence, futures hedges are not always completely efficient, so the
results of futures and FRA hedges will not necessarily be the same.
Options contracts
Options can be OTC instruments or exchange traded. In this case it appears that the
options quoted are traded options – we are presented with a table showing premia at
various exercise prices for standard sized $1 million contracts. A premium is paid when
the option is set up, and then the holder of the option can decide later whether to
exercise the option or to let it lapse. The calculations below show how options can be
used in this case.
Calculations – likely hedge outcomes
FRA:
For a borrowing which starts in 3 months and finishes 4 months later, the 3 – 7 FRA
would be used. The higher rate quoted (5.55%) is the rate applicable to borrowings.
Hence the effect of the FRA would be to fix Barrie Co’s interest rate to 8.15% (5.55% +
2.60%). If the base rate were to be 6% at the end of December, the cash flows to Barrie
would be:
Interest payable (at the standard 2.60% above base rate) = 8.60% × $3m × 4/12 = $86,000
FRA: Compensation due: (6.00% – 5.55%) × $3m × 4/12 = $4,500
Net interest payable (86,000 – 4,500) = $81,500
Futures contract:
To use futures contracts, the hedge needs to be set up in advance by addressing 3 key
questions:
1 Initially buy or sell futures? Borrowing →sell futures to set up the hedge
2 How many contracts? To cover $3 million for 4 months, with standard $1 million
3 month contracts, we need 4 contracts.
3 Which expiry date? Here, the December contracts match the transaction date
exactly.
i.e. contact the exchange immediately, and arrange to sell 4 December contracts, at
the initial futures price of 94.55.
MO CK C A NSWER S
If the base rate is 6% on 31 December, the December futures price should theoretically
be 94.00 (100 – the expected rate at the end of December), so the cash flows for Barrie
Co will be:
Transaction:
Interest payable (at 2.60% above base rate) = 8.60% × $3m × 4/12 = $86,000
Futures market:
Initially: Sell 94.55
Closing out: Buy 94.00
Gain 0.55% × amount covered i.e. 4 (contracts) = $5,500
× $1m × 3/12
Net interest payable (86,000 – 5,500) = $80,500
Options contract:
To use options contracts, the hedge needs to be set up in advance by addressing 4 key
questions:
1 Do we need call or put options? Borrowing →sell futures to set up the hedge, so
PUT options (options to SELL) are needed
2 How many contracts? To cover $3 million for 4 months, with standard $1 million
3 month contracts, we need 4 contracts.
3 Which expiry date? Here, the December contracts match the transaction date
exactly.
4 Which exercise price should be used? Let’s find the cheapest alternative,
including the cost of the premium:
Implied Premium cost Total cost
borrowing rate (Dec Put)
94.50 5.50% 1.80 7.30%
94.00 6.00% 1.39 7.39%
93.50 6.50% 0.92 7.42%
Note that the cheapest overall cost corresponds to the 94.50 exercise price, so
94.50 options should be chosen.
Summary
Contact the exchange immediately, and arrange to buy 4 December put options, with
an exercise price of 94.50. The premium payable immediately will be
1.80% × 4 × $1m × 3/12 = $18,000
As above, if the base rate is 6% on 31 December, the December futures price should
theoretically be 94.00 (100- the expected rate at the end of December), so the cash
flows for Barrie Co will be:
Transaction:
Interest payable (at the standard 2.60% above base rate)
= 8.60% × $3m × 4/12 = $86,000
Futures/options market:
Exercise options, since interest rates have risen and we are borrowing money:
Initially: Sell (put options) 94.55
Closing out: Buy 94.00
Gain 0.50% × amount covered = $5,000
Net interest payable (86,000 – 5,000) i.e. 4 (contracts) × $1m × 3/12 = $81,000
Marking scheme
Marks
(a) Link to credit risk 1
Explanation of AA rating 1
Methods of determining credit risk 3
Explanation of credit spread 1
–––
Total part (a) Maximum 5
–––
(b) Features of FRA 2
Features of futures 2
Features of options 2
FRA calculation 2
Futures calculation 3
Options calculation 4
–––
Total part (b) Maximum 15
–––
–––
Total 25
–––
Professional skills marks

Appraisal of information objectively to make a hedging recommendation
Commercial acumen
Effective use of examples and/or practical considerations related to the context to
illustrate points being made relating to setting interest rates and hedging the
transaction
Maximum 5 marks
MO CK C A NSWER S
3 HAWLEY CO
(a) The main advantage of the financing package is that it would allow the buy-out to go
ahead, and the MBO team to have control of the organisation with ownership of 80%
of the equity, whilst only contributing 11% of the required capital.
The effectiveness of control, however, depends upon the MBO team remaining a
cohesive voting group. If less than 50% of shares are to be held by the key senior
management group, control is less secure.
A disadvantage of achieving control with a small percentage of the required capital is
that capital gearing will be extremely high. Even in comparison to other management
buy-outs an initial debt to equity ratio of 600% ($30 million debt to $5 million equity)
is unusually high. It is understandable that EPP Bank, as the major risk bearer of debt,
has imposed a covenant that seeks to reduce capital gearing over the next four years.
VC Co is offering unsecured mezzanine finance. This is very high risk debt and a
premium of 5% over secured debt is not unusual. $2 million of the debt is repayable
each year during the five year period, which may result in cash flow problems for AIR
Co, or necessitate the company seeking further finance.
If the warrants are exercised, up to 1 million new shares would be issued raising
$1 million in new capital. The ownership structure following the exercise of all the
warrants would be approximately 73% for the MBO team, 18% for Hawley Co and
9% for VC Co, which still maintains control for the MBO team (albeit with less than the
75% of voting rights needed to pass a special resolution in general meetings).
(b) The projected income statements for the airport are detailed below:
Year 1 2 3 4
Landing fees 14,700 15,435 16,207 17,017
Other turnover 9,030 9,482 9,956 10,453
––––––– ––––––– ––––––– –––––––
23,730 24,917 26,163 27,470
––––––– ––––––– ––––––– –––––––
Labour 5,460 5,733 6,020 6,321
Consumables 3,990 4,190 4,399 4,619
Central services 3,000 3,150 3,308 3,473
Other expenses 3,675 3,859 4,052 4,254
Interest (W1) 4,400 4,040 3,680 3,320
––––––– ––––––– ––––––– –––––––
20,525 20,972 21,459 21,987
––––––– ––––––– ––––––– –––––––
Taxable profit 3,205 3,945 4,704 5,483
Taxation (33%) 1,058 1,302 1,552 1,809
Dividend 0 0 0 0
––––––– ––––––– ––––––– –––––––
Retained earnings 2,147 2,643 3,152 3,674
––––––– ––––––– ––––––– –––––––
(W1) Interest
Interest in year 1 = (13% × $20m) + (18% × $10m) = $4.400m
Interest in year 2 = (13% × $20m) + (18% × $8m) = $4.040m etc.
Notes and assumptions
1 Landing fees, other turnover, labour, consumables and other expenses continue
as at the last income statement, increased by 5% per year.
2 It is assumed that the central services of Hawley Co continue to be used. Hawley
Co is a major shareholder and has a vested interest in providing efficient services
and marketing.
3 No dividend is assumed to be paid during the first four years.
4 The data is based upon a projected funding requirement of $35 million. This
does not allow for working capital requirements, which could increase gearing
and interest costs significantly.
5 If the interest cap is purchased, this will require immediate finance of $800,000
which gives protection against interest rates of 15% or higher. Whether the cap
is used depends upon expectations of future interest rate levels. For the
purposes of these calculations, the interest rate on the floating rate loan is
assumed not to change, and therefore it has been assumed that the cap will not
be purchased.
MO CK C A NSWER S
Assuming no further borrowing, share issues or revaluation of assets during the

next four years, the book value of gearing is expected to move to approximately:
Year 1 2 3 4
Debt (W2) 28 26 24 22
Equity (W3) 7.15 9.79 12.94 16.61
% 392 266 185 132
(W2) Debt
Debt is $30 million at the beginning and then it reduces by $2m per year as the
VC Co mezzanine debt is repaid in equal instalments.
(W3) Equity
Immediately after the MBO, book value of equity is $5m ($4m from the
directors/employees and $1m from Hawley Co). Then, the book value of equity
increases by the value of retained profit each year.
i.e. end of year 1 value = $5m + $2.147m = $7.147m
end of year 2 value = $7.147m + $2.643m = $9,790m etc.
Summary of findings
If the warrants are exercised this will result in an extra $1m equity capital, but this will
still leave expected gearing significantly above 100%. This estimate is based upon the
assumption that no dividends are paid for four years, which may not be acceptable to
all managers and employees in the buy-out.
The covenant is likely to be breached in four years’ time.
(c) The covenant gives EPP Bank the right to recall the loan but there is no certainty that
it will do so. If interest payments and any other conditions of the loan are being met,
the bank may not exercise its call option on the loan, especially as the loan is secured
against the land and buildings of the airport. If the covenant is believed to be a
significant problem, action that AIR Co might take includes:
(i) Investigate the possibility of obtaining alternative finance in four years’ time if
the loan is recalled. This could include a stock market listing.
(ii) Renegotiate the covenant to allow a longer period e.g. six years, for the 100%
gearing to be achieved, or for a higher gearing ratio to be permitted.
(iii) If further expansion is planned during the next four years, attempt to finance
such expansion with equity. This might include a runway extension to allow
long-haul flights which could significantly increase airport revenue.
(iv) Improve profitability and hence increase shareholders' equity through increased
retentions. Cost savings might be possible in comparison with current
performance e.g., AIR Co might be able to provide central services at a lower
cost than would be charged by Hawley Co.
Marking scheme
Marks
(a) Advantages (1 mark per sensible point) 4
Disadvantages (1 mark per sensible point) 4
–––
Total part (a) Maximum 7
–––
(b) Profit forecasts (1 mark each for revenue, costs, interest and tax) 4
Assumptions (1 mark per sensible point) 3
Gearing calculations, and conclusion 3
–––
Total part (b) Maximum 9
–––
(c) Suggested actions (1 mark per sensible point) 4
–––
Total part (c) Maximum 4
–––
–––
Total Maximum 25
–––
Professional skills marks
Appraisal of information objectively to make a recommendation on preferred payment
method
Scepticism
Effective challenge and critical assessment of the information and assumptions
provided
Commercial acumen
Effective use of examples and/or practical considerations related to the context to
illustrate points being made
Maximum 5 marks
MO CK C A NSWER S

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AFM Mock C - Answers S22

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ACCA

Advanced Financial Management

To gain maximum benefit, do not refer to these answers until you

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(i) Valuation of Manin Co

(iii) Dividend policy, investment policy and financing policy

Suggested approach to dividend/investment/financing policy for Grimaldi

Present value of future cash flows method

(iii) Key objective – maximise shareholder wealth 1

2 MAUREEN AND BARRIE

Professional skills marks

Assuming no further borrowing, share issues or revaluation of assets during the

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