Mock Examination

: ACCA Paper P4

Advanced Financial Management

Session

: June 2014

Prepared by

: Mr Chow Kim Tai

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SAA GLOBAL EDUCATION CENTRE PTE LTD

Company Registration No. 201001206N
111 Somerset Road, TripleOne Somerset #06-01/02
Singapore 238164
Tel: (65) 6733 5731 Fax: (65) 6733 5750
Website: www.saage.edu.sg

Email: studentservices@saage.edu.sg

QUESTION PAPER
Time allowed 3 hours 15 minutes
This paper is divided into two sections
Section A This question is compulsory and MUST be answered
Section B TWO questions ONLY to be answered

Advance Financial
Management

Paper P4
JUNE 2014

Section A - This question is compulsory and MUST be attempted

Question 1

Pursuit Co

Paxis plc will soon announce a takeover bid for Wragger plc, a company in the same
industry. The initial bid will be an all share bid of four Paxis shares for every five Wragger
shares.
The most recent annual data relating to the two companies are shown below:

Sales revenue
Operating costs
Tax allowable depreciation
Earnings before interest and tax
Net interest
Taxable income
Taxation (30%)
After tax income
Dividend
Retained earnings

$000
Paxis
13,333
(8,683)
(1,450)

3,200
(715)

2,485
(746)

1,739
(870)

869

Other information:
Paxis
Annual replacement capital expenditure ($000)
1,600
Expected annual growth rate in sales, operating costs (including
depreciation), replacement investment and dividends for the next
four years
5%
Expected annual growth rate in sales, operating costs (including
depreciation), replacement investment and dividends after four years 4%
Gearing (long term debt/long term debt plus equity by market value) 30%
Market price per share (pence)
298
Number of issued shares (million)
7
Current market cost of fixed interest debt
6%
Equity beta
118
Risk free rate 1
4%
Market return
11%

Wragger
9,400
(5,450)
(1,100)

2,850
(1,660)

1,190
(357)

833
(458)

375
Wragger
1,240

65%
5%
55%
192
8
75%
138

The takeover is expected to result in cost savings in advertising and distribution, reducing
the operating costs (including depreciation) of Paxis from 76% of sales to 70% of sales.
The growth rate of the combined company is expected to be 6% per year for four years,
and 5% per year thereafter. Wraggers debt obligations will be taken over by Paxis. The
corporate tax rate is expected to remain at 30%.
Sales and costs relevant to the decision may be assumed to be in cash terms.

Required
Prepare a report to the board of directors of Paxis plc which cover the following:
(a)

Using free cash flow to the firm analysis for each individual company and
the potential combined company, estimate how much synergy is expected
to be created from the takeover. State clearly any assumptions that you
make.
Note: The weighted average cost of capital of the combined company may be
assumed to be the market weighted average of the current costs of capital of the
individual companies, weighted by the current market value of debt and equity of
the combined company, with the equity of Wragger adjusted for the effect of the
bid price.
(26 marks)

(b)

Discuss the limitations of the above estimates.

(6 marks)

(c)

Discuss the factors that might influence whether the initial bid is likely to
be accepted by the shareholders of Wragger plc.
(4 marks)

(d)

Estimate by how much the bid might be increased without the shareholders
of Paxis suffering a fall in their expected wealth, and discuss whether or
not the directors of Paxis should proceed with the bid.
(5 marks)

(e)

Once the bid is announced, discuss what defences Wragger plc might use
against the bid by Paxis plc.
(5 marks)

Professional marks will be awarded in question 1 for the presentation, structure and clarity of the
answer.
(4 marks)
(50 marks)

Section B - TWO questions only to be answered

Question 2

CNN

(a)

Discuss the advantages and disadvantages of centralised treasury management

for multinational companies.
(6 marks)

(b)

CNN plc is a UK multinational with subsidiaries in Spain, Hong Kong and the USA.
Transactions between companies within the group have historically been in all of the
currencies of the countries where the companies are located and have not been centrally
co-ordinated, with the currency of the transaction varying in each deal. Transactions due
in approximately four months time are shown below. All receipts and payments are in
thousand units of the specified currencies.
Assume that it is now mid-May.

Receipts (read across)

UK
Spain
Hong Kong
USA

UK

100
$HK400
$US430

Payments (read down)

Spain
Hong Kong
210
$HK720

80

120
$HK300

USA
$US110

Exchange rates
Spot
3 months forward
1 year forward

$US/
1.4358 1.4366
1.4285 1.4300
1.4085 1.4100

/
1.6275 1.6292
1.6146 1.6166
1.6033 1.6047

$HK/
11.1987 11.2050
11.1567 11.1602
11.0356 11.0444

Note:
The Hong Kong dollar is pegged against the US dollar.
Interest rates available to CNN and its subsidiaries (annual %)
Borrowing
Investing
UK
6.9
6.0
Spain
5.3
4.5
Hong Kong
n.a.
6.1
USA
6.2
5.4
Philadelphia SE $/ options, 31,250 contracts (cents per pound)
Calls
Puts
July
August
September
July
August
1.42
1.42
2.12
2.67
0.68
1.42
1.43
0.88
1.60
1.79
1.14
1.92
1.44
0.51
1.19
1.42
1.77
2.51

September
2.15
3.12
4.35

Contracts may be assumed to expire at the end of the relevant month.

Required
(i)

The parent company is proposing that inter-company payments should be

settled in sterling via multilateral netting. Demonstrate how this policy
would reduce the number of transactions.
(Foreign exchange spot mid-rates may be used for this purpose.)
(6 marks)

(ii)

If payments were to continue to be made in various currencies, illustrate

three methods by which the UK parent company might hedge its
transaction exposures for the next four months.
Discuss, showing relevant calculations, which method should be selected.
Include in your discussion an evaluation of the circumstances in which
currency options would be the preferred choice.
(Note: CNN plc wishes to minimise the transaction costs of hedging.)
(13 marks)
(25 marks)

Question 3

Fuelit

Fubuki Co, an unlisted company based in Megaera, has been manufacturing electrical parts used
in mobility vehicles for people with disabilities and the elderly, for many years. These parts are
exported to various manufacturers worldwide but at present there are no local manufacturers of
mobility vehicles in Megaera. Retailers in Megaera normally import mobility vehicles and sell
them at an average price of $4,000 each. Fubuki Co wants to manufacture mobility vehicles
locally and believes that it can sell vehicles of equivalent quality locally at a discount of 375% to
the current average retail price.
Although this is a completely new venture for Fubuki Co, it will be in addition to the companys
core business. Fubuki Cos directors expect to develop the project for a period of four years and
then sell it for $16 million to a private equity firm. Megaeras government has been positive about
the venture and has offered Fubuki Co a subsidised loan of up to 80% of the investment funds
required, at a rate of 200 basis points below Fubuki Cos borrowing rate. Currently Fubuki Co can
borrow at 300 basis points above the five-year government debt yield rate.
A feasibility study commissioned by the directors, at a cost of $250,000, has produced the
following information.
1. Initial cost of acquiring suitable premises will be $11 million, and plant and machinery used in
the manufacture will cost $3 million. Acquiring the premises and installing the machinery is a
quick process and manufacturing can commence almost immediately.
2. It is expected that in the first year 1,300 units will be manufactured and sold. Unit sales will
grow by 40% in each of the next two years before falling to an annual growth rate of 5% for the
final year. After the first year the selling price per unit is expected to increase by 3% per year.
3. In the first year, it is estimated that the total direct material, labour and variable overheads
costs will be $1,200 per unit produced. After the first year, the direct costs are expected to
increase by an annual inflation rate of 8%.
4. Annual fixed overhead costs would be $25 million of which 60% are centrally allocated
overheads. The fixed overhead costs will increase by 5% per year after the first year.
5. Fubuki Co will need to make working capital available of 15% of the anticipated sales revenue
for the year, at the beginning of each year. The working capital is expected to be released at the
end of the fourth year when the project is sold.
Fubuki Cos tax rate is 25% per year on taxable profits. Tax is payable in the same year as when
the profits are earned. Tax allowable depreciation is available on the plant and machinery on a
straight-line basis. It is anticipated that the value attributable to the plant and machinery after four
years is $400,000 of the price at which the project is sold. No tax allowable depreciation is
available on the premises.
Fubuki Co uses 8% as its discount rate for new projects but feels that this rate may not be
appropriate for this new type of investment. It intends to raise the full amount of funds through
debt finance and take advantage of the governments offer of a subsidised loan. Issue costs are
4% of the gross finance required. It can be assumed that the debt capacity available to the
company is equivalent to the actual amount of debt finance raised for the project.
Although no other companies produce mobility vehicles in Megaera, Haizum Co, a listed
company, produces electrical-powered vehicles using similar technology to that required for the
mobility vehicles. Haizum Cos cost of equity is estimated to be 14% and it pays tax at 28%.
Haizum Co has 15 million shares in issue trading at $253 each and $40 million bonds trading at
$9488 per $100. The five-year government debt yield is currently estimated at 45% and the
market risk premium at 4%.

Required:
(a) Evaluate, on financial grounds, whether Fubuki Co should proceed with the project.
(17 marks)
(b) Discuss the appropriateness of the evaluation method used and explain any
assumptions made in part (a) above.
(8 marks)
(25 marks)

Question 4

Toutplut

The managers of Toutplut Co were surprised at a recent newspaper article which suggested that
the companys performance in the last two years had been poor. The CEO commented that
turnover had increased by nearly 17% and pre-tax profit by 25% between the last two financial
years, and that the company compared well with others in the same industry.
$ million
Profit and loss account extracts for the year
2000
2001
Turnover
326
380
Pre-tax accounting profit 1
Taxation
Profit after tax
Dividends
Retained earnings

Fixed assets
Net current assets
Financed by:
Shareholders funds
Medium and long-term bank loans

67
23
---44
15
---29

84
29
---55
18
---37

Balance sheet extracts for the year ending

2000
2001
120
156
130
160
250
316
195
155
250

236
180
316

1 After deduction of the economic depreciation of the companys fixed assets. This is also the
depreciation used for tax purposes.
Other information:
(i)
Toutplut had non-capitalised leases valued at $10 million in each year 1999-2001.
(ii)
Balance Sheet capital employed at the end of 1999 was $223 million.
(iii)
The companys pre-tax cost of debt was estimated to be 9% in 2000, and 10% in 2001.
(iv)
The companys cost of equity was estimated to be 15% in 2000 and 17% in 2001.
(v)
The target capital structure is 60% equity, 40% debt.
(vi)
The effective tax rate was 35% in both 2000 and 2001.
(vii)
Economic depreciation was $30 million in 2000 and $35 million in 2001.
(viii)
Other non-cash expenses were $10 million per year in both 2000 and 2001.
(ix)
Interest expense was $4 million in 2000 and $6 million in 2001.
Required
(a)

Estimate the Economic Value Added (EVA) for Toutplut Inc for both 2000 and 2001.
State clearly any assumptions that you make.
Comment upon the performance of the company.
(7 marks)

(b)

Explain the relationship between economic value added and net present value.
(2 marks)
Briefly discuss the advantages and disadvantages of EVA.
(6 marks)

(c)

Toutplut has subsidiaries in three countries Umgaba, Mazila and Bettuna.

The subsidiary in Umgaba manufactures specialist components, which may then

be assembled and sold in either Mazila or Bettuna.

Production and sales volume may each be assumed to be 400,000 units per year
no matter where the assembly and sales take place.

Manufacturing costs in Umgaba are $16 per unit and fixed costs (for the normal
range of production) $18 million.

Assembly costs in Mazila are $9 per unit, and in Bettuna $75 per unit. Fixed
costs are $700,000 and $900,000 respectively.

The unit sales price in Mazila is $40 and in Bettuna $37.

Corporate taxes on profits are at the rate of 40% in Umgaba, 25% in Mazila, 32%
in Bettuna, and 30% in the UK. No tax credits are available in these three
countries for any losses made.

Tax allowable import duties of 10% are payable on all goods imported into
Mazila.

A withholding tax of 15% is deducted from all dividends remitted from Umgaba.

Toutplut expects about 60% of profits from each subsidiary to be remitted direct
to the UK each year.

Cost and price data in all countries is shown in US dollars.

Required
(d)

Evaluate and explain

(i)

Wheter the transfer price from Umgaba should be based upon fixed cost
plus variable cost, or fixed cost plus variable cost plus a mark up of 30%;

(ii)

Whether assembly should take place in Mazila or Bettuna.

(10 marks)
(25 marks)

- END OF QUESTION PAPER -