ACCA

Tuition Examination September 2021 – June 2022 exams

Financial Management (FM)

Answers

© First Intuition Ltd, 2021

 2 Tuition exam answers ACCA FM

Section A

1
True False
It is solely concerned with long term financing decisions  
It assumes that the primary objective of a commercial organisation
 
is to maximise shareholder wealth
It necessarily involves risk management  

Financial management is concerned with financing, investment and dividend decisions

2  Increasing profit by reducing research and development costs incurred

This is likely to improve short term results at the expense of long term success

3  3 and 4 only
Agency problems arise when managers are not acting in the best interests of the shareholders.
For example by using finance which is better for them but which may not maximise the
shareholders wealth, or by not protecting the shareholders investments adequately by taking
unnecessary or uncontrolled risks to boost profits and performance and possibly bonuses.

4
$ 0.98

EPS = ($2.5 – 0.2 – 0.8 – 0.03)/1.5 = $0.98

Earnings available to ordinary shareholders are profits after deducting loan interest, tax and
preference dividends (6% × $500,000 = $30,000)

5
Monetary policy Fiscal policy
Reduce personal tax rates  
Increase spending on social security benefits  
Reduce interest rates  
Increase government investment in national  
infrastructure

6  2 only
Imports will become more expensive if a currency depreciates as foreign goods will cost more in
terms of the domestic currency
ACCA FM Tuition exam answers 3

7  Liquidity and profitability

8
True False
If the cost of capital is 10% the project will have a negative NPV and
 
is unacceptable
The discounted payback period will be more than 2.5 years  

An investment project which has an IRR of 12% will have a positive NPV at 10%.
Discounting the cashflows will reduce their present value and increase the time it takes to
payback the investment

9  11.4%
Average annual profit = 35,000 less depreciation of 22,500 ((200,000-20,000)/8) = $12,500
Average investment = ½(200,000 + 20,000) = 110,000
ROCE = 12,500/110,000 = 11.4%

10  $66,500
If the projects are indivisible they can only be done in full or not at all.
Project combination Investment Total NPV
$ $
A+B+D 150,000 $66,500
A+C 130,000 $61,500
C+D 105,000 $53,000

11 Replace every 5 years at an equivalent annual cost of $ 15,969

Replacement cycle: 3 years 5 years
$ $
PV of total costs over the lifecycle 40,805 60,540
AF at 10% 2.487 3.791
EAC $16,407 $15,969

12  $1,225,000
MV Druid = 10 × $350k = $3.5m
MV Druid and Henge = 9 × (350+150+25) = 9 × $525 = $4.725m
Increase in value = $1,225,000
4 Tuition exam answers ACCA FM

13  £309,885
Appropriate 6 month forward rate = $1.60+ 0.0135 = $1.6135
Cost = $500,000/1.6135 = £309,885
Don’t forget you need to add the discount. This may seem illogical but a discount means the
dollar is expected to depreciate against the £ and so the £ will be worth more in 6 months’ time.

14  1 and 3 only
Smoothing is where a company finances itself by using more fixed rate debt, thus smoothing out
increases and decreases in interest rates.
Matching is where a company has investments and loans of the same value earning and paying
the same rate of interest. Thus if interest rates change, the effects self-cancel.

15  $10,000
$5,000,000 x (5%-4.7%) x (8/12) = $10,000

Marking guide Marks

1–15 Two marks per question 30
ACCA FM Tuition exam answers 5

Section B

EXAMINER’S COMMENTS
This called for the calculation of the value of the target company using the PER
(price/earnings ratio) method and the dividend growth model (DGM). These were not
complicated calculations, although it was necessary to assume with the DGM that the
dividend growth rate was the same as the earnings per share growth rate given in the
question. This was a reasonable assumption, as the earnings per share growth rate and the
dividend payout ratio had both been constant for several years.
Even though the question gave both the earnings per share (EPS) of the target company and
an instruction to use the PER provided, some candidates made life difficult for themselves by
doing something other than multiplying the earnings per share by the PER. The most
common error was using the retained earnings of the target company instead of the EPS
provided. Another common error was trying to calculate a PER value, rather than using the
one given.
Many candidates had difficulty in calculating the dividend per share for use in the DGM.
Since the target company EPS and payout ratio were provided in the question, this can only
be explained by a lack of understanding of the payout ratio.

16
$ 64 million

Earnings per share of NGN = 80c per share

Price/earnings ratio of KFP Co = 8
Share price of NGN = 80 × 8 = 640c or $6.40
Number of ordinary shares of NGN = 5m/0.5 = 10 million shares
Value of NGN = 6.40 × 10m = $64 million

17  $50.2 million
EPS= 80c and there is a pay-out ratio of 45%
Dividend per share of NGN = 80c × 0.45 = 36c per share
Since the payout ratio has been maintained for several years, recent earnings growth is the
same as recent dividend growth, i.e. 4.5%. Assuming that this dividend growth continues in the
future, the future dividend growth rate will be 4.5%.
Share price from dividend growth model = (36 × 1.045)/ (0.12 – 0.045) = 502c or $5.02
Value of NGN = 5.02 × 10m = $50.2 million

18  $19.2 million
Market value = 5% x $20m x 4.212 (AF 6%, 5years) + $20m x 0.747 (DF 6%, 5 years) = $19.152m
6 Tuition exam answers ACCA FM

19  Weak form efficient

20
True False
According to Modigliani and Miller with tax, the company’s cost of  
debt will fall as its gearing increases
Under traditional theory the WACC should decrease if the existing  
gearing level is sub-optimal

According to Modigliani and Miller with tax, the company’s WACC will fall as its gearing
increases. Its cost of debt will be constant.

21  $10,000
Current average collection period = 30 + 10 = 40 days
Current accounts receivable = 6m × 40/365 = $657,534
Average collection period under new policy = (0.3 × 15) + (0.7 × 60) = 46.5 days
New level of credit sales = $6.3 million
Accounts receivable after policy change = 6.3 × 46.5/365 = $802,603
Increase in financing cost = (802,603 – 657,534) × 0.07 = $10,155

22  $28,000
Cost of discount = 6.3m × 0.015 × 0.3 =$28,350

23
$ 13757

Daily interest rate = 5.11/365 = 0.014% per day

Variance of cash flows = 1,000 × 1,000 = $1,000,000 per day
Transaction cost = $18 per transaction
Spread = 3 × ((0.75 × transaction cost × variance)/interest rate1/3
= 3 × ((0.75 × 18 × 1,000,000)/0.00014)1/3 = 3 × 4,585.7 = $13,757

24  Neither 1 nor 2
An aggressive funding policy is likely to be attractive to risk seeking managers
A conservative funding policy will reduce profitability as long term finance is more expensive

25  It will have a negative effect on the cash operating cycle

 It will increase the accounts receivable days
Increasing credit offered will increase the cash operating cycle (a negative impact), accounts
receivable days and the risk of bad debts but may help the company to win more customers
from competitors
ACCA FM Tuition exam answers 7

26  13%
The average dividend growth rate in recent years is 4%:
(62·0/55·1)0·333 – 1 = 1·040 – 1 = 0·04 or 4% per year
Using the dividend growth model:
Ke = 0·04 + [(62 × 1·04)/716] = 0·04 + 0·09 = 0·13 or 13%

27
5.8 %

The annual after-tax interest payment is 8·5 × (1 – 0·3) = $5·95 per bond
Each $100 bond has a market value of $103.42
If the interest is valued as a perpetuity, $103.42 = $5.95 / Kd
Hence, Kd = $5.95 / $103.42 = 5.75%

28
0.895

First, the proxy company equity beta must be ungeared:

Asset beta = (1·038 × 0·75)/(0·75 + (0·25 × 0·7)) = 0·842
The asset beta must then be regeared to reflect the financial risk of Cardot Co:
Equity beta = 0·842 × (57,280 + (5,171 × 0·7))/57,280 = 0·895

29  All of the above

30
Statement Capital structure theory
The value of a company is unaffected by its capital Modigliani and Miller theory without
structure tax
The optimal capital structure is achieved by gearing
Modigliani and Miller theory with tax
up as much as possible
At high levels of gearing the risk of bankruptcy
Traditional theory
increases and the cost of debt rises

Modigliani and Miller concluded in their first theory, in the absence of tax, that the weighted
average cost of capital, and hence the value of a company, is unaffected by its capital structure.
Once tax is considered, Modigliani and Miller concluded that the weighted average cost of
capital will reduce as gearing is increased and the optimal position is for the company to gear up
as much as possible.
Traditional theory believed that at high levels of gearing the cost of debt would rise due to
increased risk of bankruptcy.
Marking guide Marks
16–30 Two marks per question 30
 8 Tuition exam answers ACCA FM

Part C

1 DUO CO
EXAMINER’S COMMENTS: PART (a)
Part (a) of this question asked candidates to calculate the net present value (NPV) of buying a
new machine and to advise on its acceptability. Many candidates gained very high marks here.
Common errors (where there were errors) included:
 Failing to calculate correctly the weighted average cost of capital of the investing
company (for example, using the before-tax rather than the after-tax cost of debt in the
calculation)
 Failing to use incremental demand as the production volume of the new machine
 Failing to recognise the cap on production in Year 4 compared to demand
 Failing to lag tax liability by one year; including scrap value or tax benefits of capital
allowances with taxable income; incorrect calculation of balancing allowance; treating
initial investment as a Year 1 rather than a Year 0 cash flow; and using annuity factors
rather than discount factors in calculating NPV.
A number of candidates lost straightforward marks by failing to comment on the calculated
NPV, or by simply saying ‘accept’ without referring to the NPV decision rule. The reason for
accepting an investment project must be clearly explained.

EXAM SMART
Unless explicitly told otherwise, always round to the nearest whole percentage.

(a) Net present value evaluation of investment

After-tax weighted average cost of capital = (11 × 0.8) + (8.6 × (1 – 0.3) × 0.2) = 10%
Time 0 1 2 3 4 5
$000 $000 $000 $000 $000 $000
Contribution 440 550 660 660
Fixed costs (240) (260) (280) (300)
Taxable cash flow 200 290 380 360
Taxation (60) (87) (114) (108)
Initial investment (800)
Scrap value 30
CA tax benefits 60 45 34 92
Net cash flows (800) 200 290 338 310 (16)
Discount at 10% 1.000 0.909 0.826 0.751 0.683 0.621
Present values (800) 182 240 254 212 (10)

Thus the net present value is $78,000

The net present value is positive and so the investment is financially acceptable. However,
demand becomes greater than production capacity in the fourth year of operation and so
further investment in new machinery may be needed after three years. The new machine will
ACCA FM Tuition exam answers 9

itself need replacing after four years if production capacity is to be maintained at an increased
level. It may be necessary to include these expansion and replacement considerations for a
more complete appraisal of the proposed investment.
A more complete appraisal of the investment could address issues such as the assumption of
constant selling price and variable cost per kilogram and the absence of any consideration of
inflation, the linear increase in fixed costs of production over time and the linear increase in
demand over time. If these issues are not addressed, the appraisal of investing in the new
machine is likely to possess a significant degree of uncertainty.
Workings
Annual contribution
Year 1 2 3 4
Excess demand (kg/yr) 400,000 500,000 600,000 700,000
New machine output (kg/yr) 400,000 500,000 600,000 600,000
Contribution ($/kg) 1.1 1.1 1.1 1.1
Contribution ($/yr) 440,000 550,000 660,000 660,000

Capital allowance (CA) tax benefits

Capital
Year allowance Tax benefit
($) ($)
1 200,000 (800,000 x 0·25) 60,000 (0·3 x 200,000)
2 150,000 (600,000 x 0·25) 45,000 (0·3 x 150,000)
3 112,500 (450,000 x 0·25) 33,750 (0·3 x 112,500)
462,500
30,000 (scrap value)
492,500
4 307,500 (by difference) 92,250 (0·3 x 307,500)
800,000

EXAMINER’S COMMENTS: PART (b)

In part (b) candidates were asked to calculate the internal rate of return (IRR) of buying the
new machine and to advise on its acceptability. Many candidates gained full marks here.
Some candidates lost marks through the incorrect application of linear interpolation in calculating
IRR (for example, adding instead of subtracting values, or multiplying instead of adding).
Some candidates said that both a positive NPV and a negative NPV were needed in order to
calculate IRR, when in fact two positive values can be used (resulting in extrapolation, but
the extrapolation calculation is identical in structure to an interpolation calculation).
A number of candidates lost a straightforward mark by not commenting on their calculated IRR.
Some candidates confused IRR with accounting rate of return (ARR) and, as a result, gained
no credit.

EXAM SMART
The IRR formula is not given in the exam and must be learnt.
10 T u i t i o n e x a m a n s w e r s ACCA FM

(b) Internal rate of return evaluation of investment

Time 0 1 2 3 4 5
$000 $000 $000 $000 $000
After-tax cash flows (800) 200 290 338 310 (16)
Discount at 20% 1.000 0.833 0.694 0.579 0.482 0.402
Present values (800) 167 201 196 149 (6)

Thus net present value is $(93,000) (i.e. (800) + 167 + 201 + 196 + 149 + (6))
Internal rate of return = 10 + [(78/(78 + 93)) × (20 – 10)] = 10 + 4·6 = 14.6%
The investment is financially acceptable since the internal rate of return is greater than the cost
of capital used for investment appraisal purposes. However, the appraisal suffers from the
limitations discussed in connection with net present value appraisal in part (a).

EXAMINER’S COMMENTS: PART (c)

Candidates were asked in part (c) to explain the difference between risk and uncertainty in
the context of investment appraisal.
Many candidates were not able to explain the difference between risk and uncertainty in
investment appraisal, offering answers that were founded on interpretations of the words
‘risk’ and ‘uncertainty’, or which discussed the various kinds of risk to be found in financial
management. The key point is to recognise that risk can be quantified (probabilities can be
assigned and outcomes can be predicted) while uncertainty cannot be quantified.

(c) Risk refers to the situation where probabilities can be assigned to a range of expected outcomes
arising from an investment project and the likelihood of each outcome occurring can therefore
be quantified. Uncertainty refers to the situation where probabilities cannot be assigned to
expected outcomes.

EXAM SMART
Quantification is the key difference between risk and uncertainty.

Investment project risk therefore increases with increasing variability of returns, while
uncertainty increases with increasing project life. The two terms are often used interchangeably
in financial management, but the distinction between them is a useful one.
Marking guide Marks
(a) After-tax weighted average cost of capital 2
Annual contribution 2
Fixed costs 1
Taxation 1
Capital allowance tax benefits 3
Scrap value 1
Discount factors 1
Net present value 1
Comment 1 to 2
Max 13
ACCA FM Tuition exam answers 11

Marking guide Marks

(b) Net present value calculation 1
Internal rate of return calculation 2
Comment 1 to 2
Max 4
(c) Risk and uncertainty Max 3
Maximum marks available 20

2 NG CO
EXAMINER’S COMMENTS: PART (a)
Part (a) required candidates to calculate the theoretical ex-rights price per share for a new
equity issue. The question stated that the rights issue needed to provide €6.5 million. Since
the issue was in dollars and the exchange rate was 1.3000 €/$, the rights issue needed to
raise $5 million. Since issue costs were $312,000 the rights issue needed to raise
$5.312 million. The rights issue price was $3.32 per share meaning that 1.6 million shares
needed to be issued.
The errors that candidates made here are instructive for students who are studying the
Financial Management Paper, such as: not converting euros into dollars; using the exchange
rate incorrectly, so that the dollar amount was greater than the euro amount; being unable
to calculate the number of new shares to be issued and assuming a form for the rights issue
(such as a 1-for-1 issue); ignoring issue costs; and using a rights issue to raise all of the
finance needed, even though the question said that 50% of funding was through debt.

(a) Amount of equity finance to be invested in euros = 13m/2 = €6.5 million

Amount of equity to be invested in dollars = 6.5m/1.3000 = $5 million
The amount of equity finance to be raised in dollars = 5m + 0.312m = $5.312m
Rights issue price = 4.00 × 0·83 = $3.32 per share
Number of new shares issued = 5.312m/3.32 = 1.6 million shares
Current number of ordinary shares in issue = $100m/4.00 = 25 million shares
Total number of shares after the rights issue = 25m + 1.6m = 26.6 million shares
Theoretical ex-rights price = ((25m × 4) + (1.6m × 3.32) – 0.312m)/26.6m = 105m/26.6m = $3.95
per share

EXAMINER’S COMMENTS: PART (b)

Many candidates ignored the 20% return on investment before interest and tax and
discussed the position of the company after the rights issue; many were also unable to
calculate the current earnings per share of the company, even though the question gave its
current price/earnings ratio and its current share price.
In order to make progress in answering the question, candidates needed to calculate the
earnings per share after the new funds had been raised, taking into account the return on
the new funds raised. This evaluation could be calculated in euros or in dollars, provided that
the revised earnings per share was expressed in the home currency of the company, which
was dollars. Once the revised earnings per share had been calculated, multiplying by the
price/earnings ratio gave the revised share price.
12 T u i t i o n e x a m a n s w e r s ACCA FM

The poor standard of answers here (in general) shows that candidates need to study the
suggested answer with care and reflect on the areas where their own answers ran into
difficulty.

(b)
(i) Effect on earnings per share
Current EPS = 100 × 4.00/10 = 40 cents per share
(Alternatively, current profit after tax = 100m/10 = $10 million
Current EPS = 100 × 10m/25m = 40 cents per share)
Increase in profit before interest and tax = 13m × 0.2 = €2,600,000
Dollar increase in profit before interest and tax = 2,600,000/1.3000 = $2 million
$000
Increase in profit before interest and tax 2,000
Increase in interest = 6.5m × 0.08 = 0.52m/1.3000 = 400
Increase in profit before tax 1,600
Taxation = 1.6m × 0.3 = 480
Increase in profit after tax 1,120
Current profit after tax = 100m/10 = 10,000
Revised profit after tax 11,120

Alternatively, using euros:

€000
Increase in profit before interest and tax = 13m × 0.2 = 2,600
Increase in interest = 6.5m × 0.08 = 520
Increase in profit before tax 2,080
Taxation = 2.08m × 0.3 = 624
Increase in profit after tax 1,456

$000
Increase in dollar profit after tax = 1.456m/1.300 = 1,120
Current profit after tax = 100m/10 = 10,000
Revised profit after tax 11,120

Revised EPS = 100 × 11.12m/26.6m = 41.8 cents/share

(ii) Effect on shareholder wealth
Expected share price using PER method = (41.8 × 10)/100 = $4.18 per share
This should be compared to the theoretical ex-rights price per share in order to evaluate
any change in shareholder wealth.
The investment produces a capital gain of 22 cents per share ($4.18 – $3.96)
In the absence of any information about dividend payments, it appears that the
investment will increase the wealth of shareholders.
(c) Cost
Debt holders take on less risk investing in a company than shareholders as the interest is
guaranteed and paid before the discretionary dividends and debt holders are paid first if the
company is wound up. They also often have security over the debt which increases their priority
for a pay out when the company is wound up. As a result the debt holders require less return on
the debt than shareholders do on the equity, making debt cheaper for the company to service
than equity.
ACCA FM Tuition exam answers 13

In addition, interest on debt is tax deductible but dividends are not. Therefore, although the
interest rate on NG Co’s bond is 8% per year they will save 30% tax on this payment. This
amounts to €156,000 of tax saved each year (€6.5 million x 8% x 30%). This makes debt even
cheaper for a company to service than equity.
Debt also has lower issue costs than equity, although a rights issue as proposed by NG Co is a
cheaper way of obtaining equity finance than a public issue of shares.
Cash flows
Debt will require regular payments of interest, in the case of NG Co €260,000 every six months
(€6.5 million x 8% x 0.5). With the rights issue shares the directors of NG Co have discretion over
when and how much dividends to pay. This gives them more flexibility over the payments.
However, if the project delivers the expected 20% return in profits before interest each year
then sufficient cash will be generated to pay the interest on the debt.
Dilution of control/covenants
As the equity will be raised by a rights issue there will be no dilution of control for the existing
shareholders from the raising of the new equity or debt.
Debt often has restrictive covenants attached which can affect management’s decision making
once the loan is outstanding.
Currency
The debt will be raised in euros which matches the currency of the investment. The euro returns
from the investment will be able to be used to make the euro interest payments. This helps to
reduce NG Co’s foreign currency risk from the project. Translation risk will be reduced by
offsetting the value of the investment with the value of the loan (as they both need to be re-
translated into dollars at each balance sheet date). Transaction risk will be reduced by using
euro returns to pay euro interest reducing the exposure to the moving exchange rate.
The rights issue will raise funds in dollars. This does not help to offset any foreign currency risk
faced by NG Co on the project.
Matching
The investment and both financing methods are long term and do match each other.
Current position
No information is provided on NG Co’s current position on financial gearing and interest cover.
NG Co Director’s should consider whether their weighted average cost of capital is at an optimal
level currently, and what impact this change in their financial gearing might have on the overall
cost of their funding.

EXAM SMART
The question asks you to discuss the factors in the financing decision of NG Co. Think broadly
of the factors that a company needs to consider when deciding whether to use debt or equity
finance, and tailor to the scenario as closely as possible.
14 T u i t i o n e x a m a n s w e r s ACCA FM

Marking guide Marks

(a) Amount of equity finance to be raised in dollars 1
Rights issue price 1
Theoretical ex-rights price 2
Max 4
(b) Current EPS 1
Increase in PBIT from investment 1
Interest on bond issue 1
Revised dollar profit after tax 2
Revised EPS 1
Revised share price using PER method 1
Comment on effect on shareholder wealth 1 to 3
Max 8
(c) Servicing cost 1 to 2
Issue cost 1
Cash flows 1 to 2
Dilution of control/covenants 1 to 2
Currency 1 to 2
Matching 1
Current position 1
Max 8
Maximum marks available 20