Financial Management

Friday 6 December 2013

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

Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future cash flows of an
investment project with an expected life of four years, as follows:
Year
Sales revenue ($000)
Costs ($000)

1
1,250
500

2
2,570
1,000

3
6,890
2,500

4
4,530
1,750

These forecast cash flows are before taking account of general inflation of 47% per year. The capital cost of the
investment project, payable at the start of the first year, will be $2,000,000. The investment project will have zero
scrap value at the end of the fourth year. The level of working capital investment at the start of each year is expected
to be 10% of the sales revenue in that year.
Capital allowances would be available on the capital cost of the investment project on a 25% reducing balance basis.
Darn Co pays tax on profits at an annual rate of 30% per year, with tax being paid one year in arrears. Darn Co has
a nominal (money terms) after-tax cost of capital of 12% per year.
Required:
(a) Calculate the net present value of the investment project in nominal terms and comment on its financial
acceptability.
(12 marks)
(b) Calculate the net present value of the investment project in real terms and comment on its financial
acceptability.
(7 marks)
(c) Explain ways in which the directors of Darn Co can be encouraged to achieve the objective of maximisation
of shareholder wealth.
(6 marks)
(25 marks)

Card Co has in issue 8 million shares with an ex dividend market value of $716 per share. A dividend of 62 cents
per share for 2013 has just been paid. The pattern of recent dividends is as follows:
Year
Dividends per share (cents)

2010
551

2011
579

2012
591

2013
620

Card Co also has in issue 85% bonds redeemable in five years time with a total nominal value of $5 million. The
market value of each $100 bond is $10342. Redemption will be at nominal value.
Card Co is planning to invest a significant amount of money into a joint venture in a new business area. It has
identified a proxy company with a similar business risk to the joint venture. The proxy company has an equity beta
of 1038 and is financed 75% by equity and 25% by debt, on a market value basis.
The current risk-free rate of return is 4% and the average equity risk premium is 5%. Card Co pays profit tax at a rate
of 30% per year and has an equity beta of 16.
Required:
(a) Calculate the cost of equity of Card Co using the dividend growth model.

(3 marks)

(b) Discuss whether the dividend growth model or the capital asset pricing model should be used to calculate
the cost of equity.
(5 marks)
(c) Calculate the weighted average after-tax cost of capital of Card Co using a cost of equity of 12%.
(5 marks)
(d) Calculate a project-specific cost of equity for Card Co for the planned joint venture.

(4 marks)

(e) Discuss whether changing the capital structure of a company can lead to a reduction in its cost of capital
and hence to an increase in the value of the company.
(8 marks)
(25 marks)

[P.T.O.

Plot Co sells both Product P and Product Q, with sales of both products occurring evenly throughout the year.
Product P
The annual demand for Product P is 300,000 units and an order for new inventory is placed each month. Each order
costs $267 to place. The cost of holding Product P in inventory is 10 cents per unit per year. Buffer inventory equal
to 40% of one months sales is maintained.
Product Q
The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per unit on
60 days credit. The supplier has offered an early settlement discount of 1% for settlement of invoices within 30 days.
Other information
Plot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365 days in each
year.
Required:
(a) Calculate the following values for Product P:
(i)

The total cost of the current ordering policy;

(ii) The total cost of an ordering policy using the economic order quantity;
(iii) The net cost or saving of introducing an ordering policy using the economic order quantity.

(3 marks)
(3 marks)
(1 mark)

(b) Calculate the net value in dollars to Plot Co of accepting the early settlement discount for Product Q.
(5 marks)
(c) Discuss how invoice discounting and factoring can aid the management of trade receivables.

(6 marks)

(d) Identify the objectives of working capital management and discuss the central role of working capital
management in financial management.
(7 marks)
(25 marks)

Spot Co is considering how to finance the acquisition of a machine costing $750,000 with an operating life of five
years. There are two financing options.
Option 1
The machine could be leased for an annual lease payment of $155,000 per year, payable at the start of each year.
Option 2
The machine could be bought for $750,000 using a bank loan charging interest at an annual rate of 7% per year.
At the end of five years, the machine would have a scrap value of 10% of the purchase price. If the machine is bought,
maintenance costs of $20,000 per year would be incurred.
Taxation must be ignored.
Required:
(a) Evaluate whether Spot Co should use leasing or borrowing as a source of finance, explaining the evaluation
method which you use.
(10 marks)
(b) Discuss the attractions of leasing as a source of both short-term and long-term finance.

(5 marks)

(c) In Islamic finance, explain briefly the concept of riba (interest) and how returns are made by Islamic financial
instruments.
(5 marks)
(d) Discuss briefly the reasons why interest rates may differ between loans of different maturity.

(5 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 = R f + i E rm Rf

The asset beta formula

Vd 1 T
Ve

a =
e +
d

V
+
V
1

T
V
+
V
1

T
d
d
e
e

))

))

The Growth Model

Po =

D0 1 + g

(r

Gordons growth approximation

g = bre
The weighted average cost of capital
V

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

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
0914
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

0350
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

10368
11255
12134
13004
13865

9787
10575
11348
12106
12849

9253
9954
10635
11296
11938

8760
9385
9986
10563
11118

8306
8863
9394
9899
10380

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