Fundamentals Level Skills Module

Time allowed
Reading and planning: 15 minutes
Writing: 3 hours
ALL FOUR questions are compulsory and MUST be attempted.
Formulae Sheet, Present Value and Annuity Tables are on
pages 7, 8 and 9.
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.
P
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9
Financial Management
Thursday 9 June 2011
The Association of Chartered Certified Accountants
ALL FOUR questions are compulsory and MUST be attempted
1 BRT Co has developed a new confectionery line that can be sold for $500 per box and that is expected to have
continuing popularity for many years. The Finance Director has proposed that investment in the new product should
be evaluated over a four-year time-horizon, even though sales would continue after the fourth year, on the grounds
that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both
in current price terms) will depend on sales volume, as follows.
Sales volume (boxes) less than 1 million 119 million 229 million 339 million
Variable cost ($ per box) 280 300 300 305
Total fixed costs ($) 1 million 18 million 28 million 38 million
Forecast sales volumes are as follows.
Year 1 2 3 4
Demand (boxes) 07 million 16 million 21 million 30 million
The production equipment for the new confectionery line would cost $2 million and an additional initial investment
of $750,000 would be needed for working capital. Capital allowances (tax-allowable depreciation) on a 25%
reducing balance basis could be claimed on the cost of equipment. Profit tax of 30% per year will be payable one
year in arrears. A balancing allowance would be claimed in the fourth year of operation.
The average general level of inflation is expected to be 3% per year and selling price, variable costs, fixed costs and
working capital would all experience inflation of this level. BRT Co uses a nominal after-tax cost of capital of 12% to
appraise new investment projects.
Required:
(a) Assuming that production only lasts for four years, calculate the net present value of investing in the new
product using a nominal terms approach and advise on its financial acceptability (work to the nearest
$1,000). (13 marks)
(b) Comment briefly on the proposal to use a four-year time horizon, and calculate and discuss a value that could
be placed on after-tax cash flows arising after the fourth year of operation, using a perpetuity approach.
Assume, for this part of the question only, that before-tax cash flows and profit tax are constant from year
five onwards, and that capital allowances and working capital can be ignored. (5 marks)
(c) Discuss THREE ways of incorporating risk into the investment appraisal process. (7 marks)
(25 marks)
2
2 The finance director of AQR Co has heard that the market value of the company will increase if the weighted average
cost of capital of the company is decreased. The company, which is listed on a stock exchange, has 100 million
shares in issue and the current ex div ordinary share price is $250 per share. AQR Co also has in issue bonds with
a book value of $60 million and their current ex interest market price is $104 per $100 bond. The current after-tax
cost of debt of AQR Co is 7% and the tax rate is 30%.
The recent dividends per share of the company are as follows.
Year 2006 2007 2008 2009 2010
Dividend per share (cents) 1938 2020 2041 2102 2180
The finance director proposes to decrease the weighted average cost of capital of AQR Co, and hence increase its
market value, by issuing $40 million of bonds at their par value of $100 per bond. These bonds would pay annual
interest of 8% before tax and would be redeemed at a 5% premium to par after 10 years.
Required:
(a) Calculate the market value after-tax weighted average cost of capital of AQR Co in the following
circumstances:
(i) before the new issue of bonds takes place;
(ii) after the new issue of bonds takes place.
Comment on your findings. (12 marks)
(b) Identify and discuss briefly the factors that influence the market value of traded bonds. (5 marks)
(c) Discuss the directors view that issuing traded bonds will decrease the weighted average cost of capital of
AQR Co and thereby increase the market value of the company. (8 marks)
(25 marks)
3 [P.T.O.
3 The following financial information relates to YNM Co, which has a cost of equity of 12%. Assume that it is now
31 March 2011 and that the ordinary share price of YNM Co is $417 per share. YNM Co has been experiencing
trading difficulties due to a continuing depressed level of economic activity:
Income statement information for recent years ending 31 March
2009 2010 2011
$m $m $m
Profit before interest and tax 293 266 253
Finance charges (interest) 48 53 55

Profit before tax 245 213 198
Taxation expense 73 64 59

Profit for the period 172 149 139

Statement of financial position information as at 31 March 2011
$m $m
Ordinary shares, par value $1 190
Retained earnings 885

Total equity 1075

8% bonds, redeemable in two years time 500

Total equity and non-current liabilities 1575

Note: the statement of financial position takes no account of any dividend to be paid. The ordinary share capital of
YNM Co has not changed during the period under consideration and the 8% bonds were issued in 1998.
Dividend and share price information
2008 2009 2010
Total cash dividend paid ($m) 95 95
Share price at end of year ($/share) 594 510 459
Average data on companies similar to YNM Co:
Interest coverage ratio 10 times
Long-term debt/equity (book value basis) 40%
Financial objective of YNM Co
YNM Co has a declared objective of maximising shareholder wealth.
Dividend decision
YNM Co is considering two alternative dividend choices for the year ending 31 March 2011:
(1) To pay the same total cash dividend as in 2010
(2) To pay no dividend at all for the year ending 31 March 2011
Financing decision
YNM Co is also considering raising $50 million of new debt finance to support existing business operations.
4
Required:
(a) Analyse and discuss the recent financial performance and the current financial position of YNM Co,
commenting on:
(i) achievement of the objective of maximising shareholder wealth;
(ii) the two dividend choices;
(iii) the proposal to raise $50 million of new debt finance. (13 marks)
(b) Discuss the following sources of finance that could be suitable for YNM Co, in its current position, to meet
its need for $50m to support existing business operations:
(i) equity finance;
(ii) sale and leaseback. (6 marks)
(c) Explain the nature of a scrip (share) dividend and discuss the advantages and disadvantages to a company
of using scrip dividends to reward shareholders. (6 marks)
(25 marks)
5 [P.T.O.
4 (a) ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when peso
interest rates were relatively cheap compared to dollar interest rates. Economic difficulties have now increased
peso interest rates while dollar interest rates have remained relatively stable. ZPS Co must pay interest of
5,000,000 pesos in six months time. The following information is available.
Per $
Spot rate: pesos 12500 pesos 12582
Six-month forward rate: pesos 12805 pesos 12889
Interest rates that can be used by ZPS Co:
Borrow Deposit
Peso interest rates: 100% per year 75% per year
Dollar interest rates: 45% per year 35% per year
Required:
(i) Explain briefly the relationships between;
(1) exchange rates and interest rates;
(2) exchange rates and inflation rates. (5 marks)
(ii) Calculate whether a forward market hedge or a money market hedge should be used to hedge the
interest payment of 5 million pesos in six months time. Assume that ZPS Co would need to borrow any
cash it uses in hedging exchange rate risk. (6 marks)
(b) ZPS Co places monthly orders with a supplier for 10,000 components that are used in its manufacturing
processes. Annual demand is 120,000 components. The current terms are payment in full within 90 days,
which ZPS Co meets, and the cost per component is $750. The cost of ordering is $200 per order, while the
cost of holding components in inventory is $100 per component per year.
The supplier has offered either a discount of 05% for payment in full within 30 days, or a discount of 36% on
orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding components
in inventory would increase to $220 per component per year due to the need for a larger storage facility.
Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 45% per year.
Required:
(i) Discuss the factors that influence the formulation of working capital policy; (7 marks)
(ii) Calculate if ZPS Co will benefit financially by accepting the offer of:
(1) the early settlement discount;
(2) the bulk purchase discount. (7 marks)
(25 marks)
6
7 [P.T.O.
Formulae Sheet
Economic order quantity
MillerOrr Model
The Capital Asset Pricing Model
The asset beta formula
The Growth Model
Gordons growth approximation
The weighted average cost of capital
The Fisher formula
Purchasing power parity and interest rate parity
=
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Return point = Lower limit + (
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8
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 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 0980 0961 0943 0925 0907 0890 0873 0857 0842 0826 2
3 0971 0942 0915 0889 0864 0840 0816 0794 0772 0751 3
4 0961 0924 0888 0855 0823 0792 0763 0735 0708 0683 4
5 0951 0906 0863 0822 0784 0747 0713 0681 0650 0621 5
6 0942 0888 0837 0790 0746 0705 0666 0630 0596 0564 6
7 0933 0871 0813 0760 0711 0665 0623 0583 0547 0513 7
8 0923 0853 0789 0731 0677 0627 0582 0540 0502 0467 8
9 0941 0837 0766 0703 0645 0592 0544 0500 0460 0424 9
10 0905 0820 0744 0676 0614 0558 0508 0463 0422 0386 10
11 0896 0804 0722 0650 0585 0527 0475 0429 0388 0305 11
12 0887 0788 0701 0625 0557 0497 0444 0397 0356 0319 12
13 0879 0773 0681 0601 0530 0469 0415 0368 0326 0290 13
14 0870 0758 0661 0577 0505 0442 0388 0340 0299 0263 14
15 0861 0743 0642 0555 0481 0417 0362 0315 0275 0239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 0812 0797 0783 0769 0756 0743 0731 0718 0706 0694 2
3 0731 0712 0693 0675 0658 0641 0624 0609 0593 0579 3
4 0659 0636 0613 0592 0572 0552 0534 0516 0499 0482 4
5 0593 0567 0543 0519 0497 0476 0456 0437 0419 0402 5
6 0535 0507 0480 0456 0432 0410 0390 0370 0352 0335 6
7 0482 0452 0425 0400 0376 0354 0333 0314 0296 0279 7
8 0434 0404 0376 0351 0327 0305 0285 0266 0249 0233 8
9 0391 0361 0333 0308 0284 0263 0243 0225 0209 0194 9
10 0352 0322 0295 0270 0247 0227 0208 0191 0176 0162 10
11 0317 0287 0261 0237 0215 0195 0178 0162 0148 0135 11
12 0286 0257 0231 0208 0187 0168 0152 0137 0124 0112 12
13 0258 0229 0204 0182 0163 0145 0130 0116 0104 0093 13
14 0232 0205 0181 0160 0141 0125 0111 0099 0088 0078 14
15 0209 0183 0160 0140 0123 0108 0095 0084 0074 0065 15
9
Annuity Table
Present value of an annuity of 1 i.e.
Where r = discount rate
n = number of periods
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1
2 1970 1942 1913 1886 1859 1833 1808 1783 1759 1736 2
3 2941 2884 2829 2775 2723 2673 2624 2577 2531 2487 3
4 3902 3808 3717 3630 3546 3465 3387 3312 3240 3170 4
5 4853 4713 4580 4452 4329 4212 4100 3993 3890 3791 5
6 5795 5601 5417 5242 5076 4917 4767 4623 4486 4355 6
7 6728 6472 6230 6002 5786 5582 5389 5206 5033 4868 7
8 7652 7325 7020 6733 6463 6210 5971 5747 5535 5335 8
9 8566 8162 7786 7435 7108 6802 6515 6247 5995 5759 9
10 9471 8983 8530 8111 7722 7360 7024 6710 6418 6145 10
11 1037 9787 9253 8760 8306 7887 7499 7139 6805 6495 11
12 1126 1058 9954 9385 8863 8384 7943 7536 7161 6814 12
13 1213 1135 1063 9986 9394 8853 8358 7904 7487 7103 13
14 1300 1211 1130 1056 9899 9295 8745 8244 7786 7367 14
15 1387 1285 1194 1112 1038 9712 9108 8559 8061 7606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1
2 1713 1690 1668 1647 1626 1605 1585 1566 1547 1528 2
3 2444 2402 2361 2322 2283 2246 2210 2174 2140 2106 3
4 3102 3037 2974 2914 2855 2798 2743 2690 2639 2589 4
5 3696 3605 3517 3433 3352 3274 3199 3127 3058 2991 5
6 4231 4111 3998 3889 3784 3685 3589 3498 3410 3326 6
7 4712 4564 4423 4288 4160 4039 3922 3812 3706 3605 7
8 5146 4968 4799 4639 4487 4344 4207 4078 3954 3837 8
9 5537 5328 5132 4946 4772 4607 4451 4303 4163 4031 9
10 5889 5650 5426 5216 5019 4833 4659 4494 4339 4192 10
11 6207 5938 5687 5453 5234 5029 4836 4656 4486 4327 11
12 6492 6194 5918 5660 5421 5197 4988 4793 4611 4439 12
13 6750 6424 6122 5842 5583 5342 5118 4910 4715 4533 13
14 6982 6628 6302 6002 5724 5468 5229 5008 4802 4611 14
15 7191 6811 6462 6142 5847 5575 5324 5092 4876 4675 15
1 (1 + r)
n

r
End of Question Paper