You are on page 1of 41

Practice Questions and Answers

MAIN PAGE

Tony Surridge Online Limited, 2013

Paper F9: Financial Management


CONTENTS

FORMULAE

www.TonySurridge.co.uk

PRESENT VALUE

ANNUITY

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

FORMULAE

PRESENT VALUE

ANNUITY

ACCA Paper F9: FINANCIAL MANAGEMENT


Diagnostic Tests - Questions and Answers
Published by Tony Surridge Online Limited in 2013

Copyright Tony Surridge Online Limited


Part of the Tony Surridge +AddVance study materials range

Tony Surridge Online Limited


www.tonysurridge.co.uk

This E-book is sold subject to the condition that no part of it shall be reproduced, transmitted, or freely
distributed, in any form by any means, electronic, photocopying, recording or otherwise, without the prior
permission in writing of Tony Surridge Online Limited. This book is not to be used for commercial use. It
is sold on the understanding that a private individual has bought it for individual personal use, and
prohibits purchase by any company or organisation entity (limited or otherwise) or sole trader or
partnership. Such entities must contact technical@tonysurridge.co.uk separately to purchase a multi-user
license.

Tony Surridge Online Limited is grateful to the Association of Chartered Certified Accountants
(ACCA) and the Chartered Institute of Management Accountants (CIMA) for permission to
reproduce past examination questions. The suggested solutions in the exam answer bank have
been prepared by Tony Surridge Online Ltd, unless otherwise stated.

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

No snowflake in an avalanche ever feels responsible.


Voltaire

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

PRESENT VALUE

FORMULAE

ANNUITY

+AddVance Study Material

Data Map

ACCA Paper F9
Financial Management (FM)
Practice Questions & Answers

Copyright Statement
Environmental Notice
Contents
For the ladies only
Electronic links Icons within this E-book
Test your knowledge now!

Syllabus
The structure of the syllabus
Intellectual levels
Learning hours
Guide to exam structure
Guide to examination assessment
Aim
Main capabilities
Relational diagram of main capabilities
Rational
Detailed syllabus
Approach to examining the syllabus

Study guide
A. Financial management function
B. Financial management environment
C. Working capital management
D. Investment appraisal
E. Business finance
F. Cost of capital
G. Business valuations
H. Risk management

Tools
PV table
Annuity table
Formulae sheet
Symbols and notations
Diagnostic Test Topics
1. Financial management function
2. Financial analysis
3. Financial management environment
4. Working capital Management
5. Cash management
6. Capital investment appraisal
7. Nature and role of financial markets and institutions
8. Business finance
9. Cost of capital
10. Business and asset valuation
11. Risk management

Only Topic 5 is activated for this free sample

Past Exam Questions and Answers


Additional study text
Islamic finance
Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Tony Surridge +AddVance Study Materials


ACCA F9 Diagnostic Tests Practice Questions and Answers

Contents
Screen
Tutorial

Syllabus classification
Questions

Answers

Tutorial 1

Financial management function

24

27

Tutorial 2

Financial analysis

31

39

Tutorial 3

Financial management environment

53

57

Tutorial 4

Working capital Management

68

79

Tutorial 5

Cash management

97

106

Tutorial 6

Capital investment appraisal

120

132

Tutorial 7

Nature and role of financial markets and


institutions

159

164

Tutorial 8

Business finance

177

195

Tutorial 9

Cost of capital

231

239

Tutorial 10

Business and asset valuation

254

261

Tutorial 11

Risk management

272

290

Text

Islamic finance

329

Past Exam Questions and Answers

354

Trust in Allah, but tie your camel first.


Arabic proverb

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

ACCA Paper F9
Financial Management

Diagnostic Test:

Cash management
Questions

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Question 1
What are the FOUR main responsibilities of the finance manager?
(4 marks)

Question 2
Strategic financial management in a company is concerned with
THREE key decisions. What are they?
(3 marks)

Question 3
List FIVE responsibilities of a 'Cash manager' working in a large
company.
(5 marks)

Question 4
Write a formula which describes liquidity?

(1 mark)

Question 5
List FOUR categories of revenue expenses.

(4 marks)

Question 6
List the FOUR main business motives for holding cash.

(4 marks)

Question 7
One model used for forecasting cash is the 'Receipts and Payments Forecast'. List the SIX stages
involved in this model.
(6 marks)

Question 8
Give THREE possible reasons for surplus cash.

(3 marks)

Question 9
When the cash forecast shows surplus funds, plans are needed for putting them to use. List EIGHT
factors to be considered before investing these funds.
(8 marks)

A
A
A
A

A
A

Question 10
Different investments bring different yields. List
A
THREE main factors that influence the level of
yield.
(3 marks)

Question 11

List FIVE short-term investments that a company


might make with temporary cash surpluses. (5 marks)

Question 12
In addition to deciding how much cash to hold in total and where spare cash should be invested, a
company must decide upon the proportion held as liquid cash. List FOUR factors which influence this
decision.
(4 marks)

Question 13
One model for determining the optimal cash balance is the 'economic quantity' model ('Baumol'
model). State the equation which makes up this model.
(2 marks)

www.TonySurridge.co.uk

Tony Surridge Online Limited, 2013

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Question 14

XYZ Company has a high investment of some $12m in short-term securities, which currently earn an
average return of 5.4% per annum, or 0.45 percent for a one-month period (i). The company's finance
director estimates a cash need of $2,000,000 (P) over a onemonth period where the cash is expected to be dispersed at a
constant rate. The transaction fee (T) each time money is
withdrawn from the short-term securities is $200.
Calculate, by using the Baumol model:
(a) the optimal transaction size (withdrawal lot size) (Q);
(2 marks)
(b) the average cash balance; and
(1 mark)
(c) the number of transactions which the company should
make during the month.
(1 mark)

Brush up your knowledge by


working through small
questions. Large questions
are made up of small parts

Question 15
D Company expects to have a steady demand for cash for the next year amounting to $800,000. The
transaction cost associated with selling marketable securities or borrowing each time the firm needs to
replenish its cash balances is $100. The company's opportunity interest rate is 8 percent per year.

Required:
(i)

Calculate D Company's optimum transaction size (in $s).

(2 marks)

(ii)

Calculate the approximate number of transactions made each year, and their total cost.
(1 mark)

(iii)

Suppose the company's opportunity interest rate increases from 8 percent to 10 percent. Calculate
the revised optimum transaction size, and the total cost of transactions over the next year.
(2 marks)

(iv)

Now suppose transaction costs increase from $100 to $150 but the interest rate remains 8 percent.
Calculate the revised optimum transaction size, and the total cost of transactions over the year.
(2 marks)
The following formula should be used:

2 x P x T
i
Where : Q = optimal amount of funds to transfer to the firm' s cash account
P = total amount of net new cash needed for transactions over the specified period
T = fixed costs per transaction of selling securities or borrowing
i = opportunity cost of holding cash (rate of return foregone on marketable securities)
Q =

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

FORMULAE

PRESENT VALUE

ANNUITY

Question 16

FOR YOUR INTEREST ONLY: NOT EXAMINABLE. This question will help you understand the daily
variance that is used in the Miller-Orr model.
The last 50 day period had been analysed to determine the cash balance positions for XYZ Company.
The analysis showed the following pattern of cash balances (to the nearest $2,000):
Days
5
10
20
8
7
50

$
12,000
14,000
18,000
22,000
24,000

You are required to calculate:


(a)

the probability distribution for the cash position over the 50-day period;

(2 marks)

(b)

the 'expected' (arithmetic mean) cash balance for any day;

(2 marks)

(c)

the daily variance of cash flows.

(2 marks)

(d)

the standard deviation of cash per day.

(1 mark)

For parts (c) and (d) you are to use the following formula:

p x - x

Where :

)2

= standard deviation of the daily cash balance


= square root

p
x

= probability of the actual cash balance


= actual cash balance

= arithmetric mean daily cash balance

Calculations are to be to the nearest $1.

Question 17

Describe how the Miller-Orr model attempts to provide an approach to cash management
(2 marks)

Question 18
The Miller-Orr model is based on a 'return point'. State the formula by which the return point is
calculated.
(1 mark)

Question 19
State the formula for the 'spread' of daily cash (used in the Miller-Orr model).

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

(2 marks)

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Question 20
Using the logic of Miller-Orr state the formula for the upper limit of daily cash.

(1 mark)

Question 21
Data is provided for XYZ Company which use the Miller-Orr cash model for treasury purposes.
-

The company's policy is to operate with a minimum cash balance of $8,000.


The fixed transaction cost for buying and selling securities is $12.
The opportunity interest rate on short-term securities is 0.028 per cent per day.
The companys daily cash variance is $14,393,600, equivalent to a standard deviation of $3,794.

You are required to calculate:


(a)
(b)

the company's upper limit of daily cash balance;


the cash 'return point;

(3 marks)
(1 mark)

which can then be used as a decision rule by the company's treasury management.

Question 22
Briefly describe the steps necessary to use the Miller-Orr model.

(3 marks)

A
A

Question 23
A companys cash forecast shows a serious cash deficit, even though the company has a good profit
forecast. List FIVE ways that plans may be implemented to improve the future cash flow.
(5 marks)

Question 24
Antro Company is thinking of purchasing new plant and machinery. With this new plant and
machinery, the company expects sales to increase from $16,000,000 to $20,000,000.

Management know that the company's assets, debtors and accrued expenses vary directly with sales. The
company's after-tax profit margin on sales is 8 percent, and management plans to pay 40 percent of its aftertax earnings in dividends. The company's current statement of financial position is given below.
Statement of Financial Position
Current assets
Non-current assets
Total assets

$'000
6,000
24,000
30,000

Accounts payable
Accrued expenses
Long-term debt
Ordinary share capital
Retained earnings
Total liabilities and net worth

8,000
2,000
6,000
4,000
10,000
30,000

You are required to prepare an estimated statement of financial position for the year after acquiring the
new plant and machinery and to determine the additional funds needed by the company by the end of that
year.
(4 marks)

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

10

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Question 25

The following sales budget is given for Saspong Company for the second quarter of 2013.

Sales budget

April
$90,000

May
$100,000

June
$120,000

Total
$310,000

Credit sales are collected as follows: 70 percent in month of sale, 20 percent in month following sale, 8
percent in second month following sale, and 2 percent bad debts. The accounts receivable balance at the
beginning of the second quarter is $36,000, of which $7,200 represents uncollected February sales, and
$28,800 represents uncollected March sales.
You are required to:
(a) calculate the total sales for February and March 2013.

(3 marks)

(b) calculate the budgeted cash receipts from sales for April, May and June 2013. Without prejudice to
your answer at (a), assume February sales equal $80,000 and March sales equal $100,000.
(4 marks)

Question 26

A
The treasurer of Ernhar Company plans for the company to have a cash balance of $182,000 on
1st June. Sales during June are estimated at $1,800,000. May sales amounted to $1,200,000 and April
sales amounted to $1,000,000. Cash payments for June have been budgeted at $1,160,000. Cash
collections have been estimated as follows: 60 percent of the sales for the month to be collected during the
month, 30 percent of the sales for the preceding month to be collected during the month, and 8 percent of
the sales for the second preceding month to be collected during the month.
The treasurer plans to accelerate collections by allowing a 2 percent discount for prompt payment. With
the discount policy, she expects to collect 70 percent of the current sales and will permit the discount
reduction on these collections. Sales of the preceding month will be collected to the extent of 15 percent
with no discount allowed, and 10 percent of the sales of the second month will be collected with no discount
allowed. This pattern of collection can be expected in subsequent months. During the transitional month
of June, collections may run somewhat higher. However, the treasurer prefers to estimate collections on
the basis of the new patterns so that estimates will be somewhat conservative.
You are required to:
(a) estimate cash collections (receipts) for June and the cash balance at 30th June under the present policy;
(3 marks)
(b) estimate cash collections for June and the cash balance at 30th June according to the new policy
allowing discounts; and
(3 marks)
(c) Advise the company whether the discount policy is economically worthwhile.

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

(1 mark)

11

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

FORMULAE

PRESENT VALUE

ANNUITY

Question 27

Elizabeth Stores wants to estimate cash payments (disbursements) for cash budgeting purposes for the first
3 months of 2013 from the data given below.
(i)

Cost of merchandise sold, estimated


2012:
2013:

December
January
February
March

$450,000
$500,000
$560,000
$420,000

The cost of merchandise is to be paid for as follows: 35 percent in the month of sale and 65 percent in
the following month.
(ii) Wages for each month are estimated as follows:
2012:
2013:

December
January
February
March

$46,000
$52,000
$62,000
$50,000

All wages are paid as incurred.


(iii) Other expenses are to be paid every other month at the amount of $640 per month. The first payment
is to be made in February.
(iv) Six months' rent and insurance amounting to a total of $19,400 is to be paid in January.
(v) Corporation tax of $25,000 is to be paid in March.
(vi) Depreciation on equipment has been estimated at $15,000 for the year.
(vii) New equipment costing $100,000 is to be acquired in February, with a down payment of $8,000
required at the date of purchase. The balance is to be paid in April using a 6%, 2-year loan
negotiated with the bank. Repayment is by monthly payments of capital plus interest.
(viii) Other operating expenses have been estimated at $4,500 per month, which are to be paid each
month.
You are required to prepare a cash payments budget for each of the first 3 months of 2013. (7 marks)

Question 28
Companies experience cash flow problems (deficit cash) for various reasons. List FIVE reasons.
(5 marks)

Question 29
Define the term 'float' (as it relates to cash management practice).

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

(1 mark)

12

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Question 30
Describe THREE reasons why there may be a lengthy float.

(3 marks)

Question 31
Describe SIX ways the float could be reduced.

(6 marks)

- END -

End of the Diagnostic Test


based on Cash management

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

13

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

ACCA Paper F9
Financial Management

Diagnostic Test:

Cash management
Answer Guides

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

14

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Answer to Question 1

The work of financial management includes the following.


1.
2.
3.
4.

The maintenance and production of statutory accounts.


The provision of management accounting and management accounting information services.
Treasury management and strategic financial decisions.
Internal audit (probably reporting to the 'Audit Committee')

Click and bounce


back to the question
screen

Bouncing cheque!

Answer to Question 2
1.
2.
3.

How funds should be invested.


How to obtain such funds.
Dividend policy.

Answer to Question 3
1.
2.
3.
4.
5.

Cash budgeting; daily, weekly, monthly, quarterly, annually and possibly longer term.
Cashier's duties of making transactions payments to suppliers and paying wages, etc.
Banking receipts.
The management of short-term marketable securities (e.g. investing short-term surplus funds).
Advising senior management of forecast cash deficit balances and advising on ways to deal
with this problem.

Answer to Question 4
Liquidity = Cash + Current account + Sight deposits + Short-term securities
(cheque account)

Answer to Question 5
1.
2.
3.
4.

Material inputs
Labour wages
Direct expenses
Overhead expenses

When the going gets tough, the tough get going.


Kennedy family motto

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

15

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

PRESENT VALUE

FORMULAE

ANNUITY

Answer to Question 6
1.
2.
3.
4.

Transactions motive.
Finance motive - repay loans, finance acquisition of assets.
Precautionary motive - a cushion to meet unplanned spending.
Speculation motive - to take advantage of short-term investment opportunities.

Answer to Question 7
1.
2.
3.
4.
5.
6.

Decide the budget period.


Forecast sales for the budget period (usually month by month).
Estimate ALL cash receipts (time lag to convert receivables to cash, and other cash receipts).
Estimate ALL cash payments (supplies of raw materials, and other purchases and payments).
Compute net cash flow per period within the budget period (often monthly).
Develop a cash summary.

Answer to Question 8
1.
2.
3.

Over funding.
A reduction in operating assets (the sale of assets).
A surplus of retained earnings over the increase in net assets employed.

Answer to Question 9
Factors to consider are:
1. the amount of funds available;
2. the period for which funds are available;
3. alternative yields that can be obtained;
4. expectation of future interest rates;
5. risk that unexpected liquidity will be required;
6. tax considerations (different investment have different tax implications);
7. risk and return from the investment; and
8. does the company have outstanding borrowings that could be repaid early
(from the cash available).

Answer to Question 10
1. Risk.
2. Term.
3. Marketability (or realisability)
Note:
The lower the risk, the lower the yield (and vice versa).
The longer the term, the higher the yield (and vice versa).
Investments which cannot be realised (sold) quickly offer higher yields than those which can.

Answer to Question 11
1.
2.
3.
4.
5.

Reduce its bank overdraft.


Invest in deposit account(s) (retail bank or investment [merchant] bank).
Invest in term deposit(s), probably linked to 'Certificate of Deposit'.
Buy government or local authority loans/securities, such as Treasury bills (TBs).
Invest in other money-market instruments, such as Certificates of deposit (CDs).

Every path has its puddle.

English proverb

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

16

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

FORMULAE

PRESENT VALUE

ANNUITY

Answer to Question 12
Four factors which influence the decision are:
1.

the rate of interest earned from short-term investments (a higher rate will mean a greater cost of
keeping money in a current account);
the cost of transferring money between the short-term investments and the current account (a higher
cost will mean that more money should be kept in the current account so that less frequent transfers
are required);
the uncertainty of cash requirement (if there is a great volatility in daily cash flows then more money
will be needed in the current account);
the consequence of running out of liquid resources (if these are serious then more liquid
cash should be held).

2.

3.
4.

Answer to Question 13
2 x P x T
i
Where : Q = optimal amount of funds to transfer to the firm' s cash account
P = total amount of net new cash needed for transactions over the specified period
Q =

T = fixed costs per transaction of selling securities or borrowing


i = opportunity cost of holding cash (rate of return foregone on marketable securities)

Answer to Question 14

(a) Optimum transaction size


Q =

2 x $2,000,000 x $200
0.0045*

= 0.45/100 = 0.0045

= $421,637

(b) Average cash balance


$421,637/2 = $210,819
(c) Number of transactions
$2,000,000/$421,637 = 5

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

17

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Answer to Question 15

The following formula should be used:


2 x P x T
i
Where : Q = optimal amount of funds to transfer to the firm' s cash account
P = total amount of net new cash needed for transactions over the specified period
T = fixed costs per transaction of selling securities or borrowing
i = opportunity cost of holding cash (rate of return foregone on marketable securities)
Q =

(i)

D Company's optimal transaction size


2 x $800,000 x $100
0.08
= $44,722

Q =

(ii) Number of transactions made each year


No of T = P/Q = $800,000/44,722 = approx. 18 transactions
Total transaction cost = 18 x $100 = $1,800
(iii) Revised optimal cash balance: interest rate at 10%
2 x $800,000 x $100
0.1
= $40,000

Q =

$800,000
x $100
Cost of transactions :
$40,000
= $2,000

(iv) Revised optimal cash balance: transaction cost at $150

2 x $800,000 x $150
0.08
= $54,773

Q =

$800,000
x $150
Cost of transactions :
$54,773
= $2,191

To a certain extent, a little blindness is necessary when you undertake a risk.


Bill Gates
Microsoft founder

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

18

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

PRESENT VALUE

FORMULAE

ANNUITY

Answer to Question 16

(a) The probability distribution is as follows:


$
p
* 5/50 = 0.1
12,000
0.10*
(i.e. 5/50)
14,000
0.20
(i.e. 10/50)
18,000
0.40
(i.e. 20/50)
22,000
0.16
(i.e. 8/50)
24,000
0.14
(i.e. 7/50)
1.00
Workings for (b), (c) and (d):
x
12,000
14,000
18,000
22,000
24,000

p
0.10
0.20
0.40
0.16
0.14
1.00

xp
1,200
2,800
7,200
3,520
3,360
x = 18,080

(x x )
(6,080)
(4,080)
( 80)
3,920
5,920

(x x )

p xx
36,966,400
3,696,640
16,646,400
3,329,280
6,400
2,560
15,366,400
2,458,624
35,046,400
4,906,496
Daily variance = 14,393,600

(b) The 'expected' cash balance for any day is $18,080.


(c) The daily variance of cash flows is $14,393,600.
(d) The standard deviation of cash per day is:

Variance =

$14,393,600 = $3,793.8898, say $3,794

Note: The standard deviation () is not required in the Miller-Orr model, but it is worth remembering that the
variance is 2 (i.e. in this case $3,7942 = $14,393,600) if the examiner gets you to calculate it this way.

HELP

If you need help


understanding what a
variance is then click here.

Slow and steady wins the race.


Aesop, c. 620 560 B.C.
The Hare and the Tortoise

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

19

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

Answer to Question 17

ANNUITY

The Miller-Orr model is a stochastic model for cash management where uncertainty exists for cash
payments and receipts. In other words there is irregularity of cash payments. The Miller-Orr model places
an upper and lower limit for cash balances. When the upper limit is reached a transfer of cash to
marketable securities or other suitable investments is made. When the lower limit is reached a transfer
from securities to cash occurs. In both cases the investment/withdrawal will bring the cash balance to a
'return point'. A transaction will not occur as long as the cash balance falls between the upper and lower
limits.

Answer to Question 18

Return point = Minimum limit + Spread


(Stated in the Formulae Sheet which is issued in the exam.)

Answer to Question 19

transaction cost x daily variance of cash


Spread = 3 0.75 x
daily interest

1
flows 3

Note: For ease of using your calculator treat as 0.3333(recurring).


(This formula is stated in the Formula Sheet which is issued in the exam.

Answer to Question 20

Upper limit = Minimum limit + Spread

Answer to Question 21

transaction cost x daily variance of cash flows 3



(a) Spread = 3 0.75 x
daily interest

$12 x $14,393,600 3
= 3 0.75 x
* 0.028/100 = 0.00028

0.00028*

= $23,203

Hence:
Upper limit = $8,000 + $23,203
= $31,203
(b) Return point = $8,000 + 1/3($23,203)
= $15,734

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

20

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

PRESENT VALUE

FORMULAE

ANNUITY

Answer to Question 22

The steps involves in using the Miller-Orr model are as follows.


1.

The minimum level of cash is set, as a policy. This may be zero, or it may be set at some safety
margin above zero.

2.

The variance of cash flows is estimated. This can be calculated by using sample observations for a
number of days past.

3.

Estimate/determine both the opportunity interest rate and the fixed transaction cost for each sale or
purchase of securities.

4.

Compute the 'spread' between the upper and minimum levels and use it to calculate the 'return point'
and the upper level.

5.

Implement the limits strategy. When the upper limit is reached invest enough funds in short-term
securities to bring the cash level to the 'return point'. When the minimum level is reached draw
sufficient funds from short-term securities to bring the cash balance to the 'return point'.

Answer to Question 23
1.
2.
3.
4.
5.

Delay selected payments.


Reduce or cancel selected discretionary purchase payments.
Fund forecast capital purchases from other sources, such as leases where applicable.
Liquidate short-term marketable securities or other short-term assets.
Reduce working capital investment (shorten the working capital cycle).

Answer to Question 24

Antro Company
Estimated Financial Position (at end of first year)
Present level

% of sales

Projected level
(based on sales of $20m)

Non-current assets
Current assets:
Current liabilities:
accounts payable
accrued expenses
Net assets employed

$m
24
6
(8)
(2)
20

150.0
37.5
50.0
12.5

$m
30.0
7.5
(10.0)
( 2.5)
25.0

Continued on
the next
screen

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

21

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

PRESENT VALUE

FORMULAE

ANNUITY

Answer to Question 24 (continued)

Antro Company
Estimated Financial Position (at end of first year) continued
Present level

% of sales

Projected level
(based on sales of $20m)

$m
Capital represented by:
Long term debt
Ordinary share capital:
issued capital
retained earnings
Total funds provided
Additional funds required
Total funds required

$m

n.a.

4
10
20

n.a.
n.a.

6.0
4.0
10.96 (note 1)
20.96
4.04
25.00

Note 1
Retained earnings
$m
1.60
0.64
0.96
10.00
10.96

Profit for the period ($20m x 0.08)


Less dividends, this period ($1.6m x 0.4)
To retained earnings
Add brought forward retained earnings
Retained earnings balance
CONCLUSION: The additional funds required are $4,040,000.

Answer to Question 25
(a)

February March April


February sales (100% - 70% - 20%) = 10% (of sales) = $7,200
February sales =

$7,200
= $72,000
10%

March
April
March sales (100% - 70%) = 30% (of sales) = $28,800
$28,800
March sales =
= $96,000
30%

(b) Cash collections

February
March
April

May
June

($80,000 x 0.08)
($100,000 x 0.2)
($100,000 x 0.08)
($90,000 x 0.7)
($90,000 x 0.2)
($90,000 x 0.08)
($100,000 x 0.7)
($100,000 x 0.2)
($120,000 x 0.7)

April
$
6,400
20,000

June
$

8,000
63,000
18,000
7,200
70,000

89,400

Tony Surridge Online Limited, 2013

May
$

96,000

www.TonySurridge.co.uk

20,000
84,000
111,200

22

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

FORMULAE

PRESENT VALUE

ANNUITY

Answer to Question 26
(a) and (b)

Opening balance at 1st June


Collections:
from June sales
from May sales
from April sales
Total cash available
Less cash payments
Balance at 30th June

(a)
Cash collection
under the present policy
$
182,000
1,080,000
360,000
80,000
1,702,000
1,160,000
542,000

(b)
Cash collection
under the discount policy
$
182,000

($1,800,000 x 0.6)
($1,200,000 x 0.3)
($1,000,000 x 0.08)

1,234,800
180,000
100,000
1,696,800
1,160,000
536,800

(note 1)
($1,200,000 x 0.15)
($1,000,000 x 0.10)

Note 1
$1,800,000 x 0.7 x 0.98 = $1,234,800
(c) No, the policy is not economically worthwhile, since, under the discount policy, the 30th June cash
balance will be smaller. It seems that the discount will not increase the level of sales and will
cause an increase in bad debts from 2% to 5%.

Answer to Question 27

Elizabeth Stores
Cash Payments Budget
for 3 months January - March 2013

Payments for variable materials:


35% current month
65% preceding month
Total payments for variable materials
Wages
Other expenses
Rent and insurance
Corporation tax
Equipment, down payment
Other operating expenses
Total payments

January
$'000

February
$'000

March
$'000

Total
$'000

175.0
292.5
467.5
52.0

196.00
325.00
521.00
62.00
0.64

147.0
364.0
511.0
50.0

518.00
981.50
1,499.50
164.00
0.64
19.40
25.00
8.00
13.50
1,730.04

19.4
25.0
4.5
543.4

8.00
4.50
596.14

4.5
590.5

Notes: 1. Depreciation does not affect cash flow.


2. The bank loan is not taken out until April 2013.

HELP

Tony Surridge Online Limited, 2013

If you need help following


the payment pattern for
variable materials then
click here.

www.TonySurridge.co.uk

23

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Answer to Question 28
Companies experience cash flow problems for the following reasons.
1.
2.
3.
4.
5.

The company is continually trading at a loss.


Because the company is growing and needs to increase its working capital and acquire more fixed
assets.
When a business has seasonal or cyclical sales, and for example needs to build inventory for a period
before a sales period.
In a period of inflation the company will need ever-increasing amounts of cash to replace used-up and
worn-out assets.
When the company needs to spend money on one-off items of expenditure, such as the redemption of
a loan.

Answer to Question 29

Float describes the amount of money tied up (usually in the form of cheques) between the time when
a payment is initiated (for example when a receivable posts a cheque) and the time when the funds become
available for use in the recipient's bank account. It includes the amount of transactions (cheques, etc.) in
transit between banks and not yet credited.

Answer to Question 30
Reasons why there may be a lengthy float include:
1.
2.
3.

The time taken by a bank to clear a cheque (clearance delay).


Transmission delay (such as the period of time the money is held in the postal system, which is
longer for overseas post.)
Delay in the recipient banking the payments received (lodgement delay).

Answer to Question 31
There are several measures that could be taken to reduce the float.

1.

The recipient could ensure that the lodgement delay is kept to a minimum. (For example by
presenting cheques to the bank on day of receipt.)

2.

For regular payment, standing orders or direct debits might be used.

3.

In certain circumstances bank cards or credit cards may be used to receive payments.

4.

BACS (Bankers' Automated Clearing Services Company) is a banking service which provides for
the computerised transfer of funds between banks (e.g. the payer's bank and the recipient's bank).
The payer (customer) is required to supply a disk to BACS, which contains details of payments, and
payment will then be made in two days.

5.

CHAPS (Clearing House Automated Payments System) is a computerised service for banks to make
same-day clearances between each other. Each member bank of CHAPS can allow its corporate
customers to make immediate transfer of funds through CHAPS. However, there is a large
minimum size of payment using CHAPS.

6.

The recipient might, in some cases, arrange to collect cheques from the payer's premises.
This is only practicable if the payer is local.

- END -

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

24

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

PRESENT VALUE

FORMULAE

ANNUITY

Score sheet:
Diagnostic Test: Cash management
Question
number

Marks
available

Score

Question
number

Marks
available

21

22

23

24

25

26

27

28

10

29

11

30

12

31

13

128

14

Total
score

15

16

17

18

19

20

Score

Total score b/fwd

Percentage (%)

Total score c/fwd

91 128 marks

Tony Surridge Online Limited, 2013

65 90marks

www.TonySurridge.co.uk

0 64 marks

25

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Measure of dispersion: VARIANCE


The extent of dispersion of a given value is reflected in the extent of its deviation from the average (mean)
value of all the items. Take the following two examples:
Example 1
Value Deviation Deviation2

Example 2
Value Deviation Deviation2

from average

4
6
5
15

-1
+1
0

from average

1
1
0
2/2 = 1
Variance = 1

The average is 5 (15/3)

11
3
1
15

+6
-2
-4

36
4
16
56/2 = 28

Variance = 28

The average is also 5 (15/3)

The averages are the same but the dispersions are different. By virtue of the definition of the mean the sum of
the deviations will be zero (e.g. in Example 1, - 1 + +1), but if we square the deviations (as shown in the third
column of each example), because all the squared items will be positive, the sum will be non-zero. If this sum
is divided by one less than the number of items, i.e. 2 in both examples (the reason for this is not discussed
here) a representative measure of dispersion is obtained. This is known as the variance and its square root is
known as the standard deviation. Although not strictly the full picture, it does give us as idea of what a
variance is. The calculations are slightly different when probabilities are involved, as in the case of XYZ
Company. It is worth remembering that variances can have very high values.

Return

If two line on a graph cross, it must be important.


Ernest F.Cooke
University of Baltimore
Remark to a student, February 1985

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

26

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

FORMULAE

PRESENT VALUE

ANNUITY

Payments for variable materials.


Lets produce a matrix to see the pattern of payments:
Month that variable material
(merchandise) is used

Cost of materials
$000

December
January
February
March

450
500
560
420

Month of payment
January
February
$000
$000
(x 0.65) 292.5
(x 0.35) 175.0

467.5

(x 0.65) 325
(x 0.35) 196

521

March
$000

(x 0.65) 364
(x 0.35) 147

511

Return

How often have I said to you that when you have eliminated the
impossible, whatever remains, however improbable, must be the truth.
Sherlock Holmes
Arthur Conan Doyle, 1859 - 1930

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

27

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Past Exam
Questions and Answers

ACCA Paper F9
Performance Management
Scroll through the screens

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

28

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Pages

Contents: Exam-status Questions 1 of 5

Question

Answer

360

361

366

367

371

372

377

378

380

381

387

388

393

395

402

403

407

408

412

413

Droxfol Co: Pilot Paper


Calculation of current weighted cost of capital, interest coverage ratio,
financial gearing, earnings per share.

Nedwen Co: Pilot Paper


Discussion of different foreign exchange exposures, use of the purchasing
power parity method of forecasting exchange rates, calculations using the
forward market and also a money-market hedge and discussion of hedging
methods.

Ulnad Co: Pilot Paper


Evaluation of proposed early settlement discount, the use of the Miller-Orr
cash model, key areas of accounts receivable management and working
capital funding policy.
Trecor Co: Pilot Paper
Calculation of net present value (NPV) and accounting rate of return (ARR).
Discussion of strengths and weaknesses of internal rate of return (IRR)

Phobis Co: December 2007


Calculation of (a) value of a company using P/E ratio and dividend growth
models and (b) two values of a convertible bond. Difference between weak,
semi-strong and strong forms of stock market efficiency.

Duo Co: December 2007


Calculation of (a) NPV with a need to also calculate WACC, and (b) IRR.
Discussion - difference between risk and uncertainty and the use of (a)
sensitivity analysis and probability analysis.

Echo Co: December 2007


Analysis and discussion re three proposals concerning (a) increasing dividend,
(b) a bond issue and (c) a rights issue. Discussion - attractions of operating
leasing as a source of finance.

PKA Co: December 2007


Discussion objectives of working capital management. Calculation of the
cost of the current ordering policy and saving that could be made by using the
EOQ model. Evaluation of a money market hedge, a forward market hedge
and a lead payment.

Burse Co: June 2008


Calculation of market value WACC and statement of assumptions. Discussion
of circumstances under which the WACC can be used. Comparison between
the dividend growth model and the asset pricing model.

THP Co: June 2008


Calculation of value using the dividend growth model. Calculations re a rights
issue. Calculation of value using the P/E ratio method. Implications of the
above results in a semi-efficient capital market. Choice of equity or debt
finance.

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

29

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Pages

Contents: Exam-status Questions 2 of 5

Question

Answer

FLG Co: June 2008


Discussion re (a) level of current assets and (b) factoring and invoice
discounting. Calculation size of overdraft, net working capital and the cost of
financing the current assets. Calculation (a) the total cost of inventory when
using the EOQ and (b) whether to accept a bulk purchase discount.

418

419

SC Co: June 2008


Calculation of (a) NPV (with inflation) and (b) IRR. Discussion on (a) results of
above and (b) evaluation of the use of NPV.

423

424

430

431

436

438

443

444

Boluje Co: December 2008


Reasons why a company may issue debt finance. Calculation of the total
market value of foreign bonds (valued in an overseas currency). Explanation
and illustration of a market hedge and comparison of a money market hedge
and a forward market hedge. Description of other hedging techniques
including derivatives.

448

449

KFP Co: June 2009


Calculation of (a) WACC, (b) total value of a target company using (i) the P/E
ratio model, and (ii) the dividend growth model. Discussion of the relationship
between capital structure and the WACC, and its implications for KFP.

454

455

PV Co: June 2009


Identification of key stages in the capital investment decision-making process.
Calculation of NPV, IRR, ARR and discounted payback period. Discussion on
whether the investment proposal is financially acceptable.

458

459

HGR Co: June 2009


Discussion re the working capital financing strategy. Calculation/comments of
the bank balance in two situations. Discussion on how risks arising from
granting credit to foreign customers can be managed and reduced.

464

465

JJG Co: June 2009


Evaluation of finance performance (using ratio analysis). Calculation/
comments concerning a rights issue. Discussion on the relative merits of (i) a
rights issue, (ii) a placing and (iii) an issue of bonds.

471

472

Dartig Co: December 2008


Calculation of (a) theoretical ex rights price and (b) share price using the P/E
ratio method. Discussion on the use of a rights issue and calculation of a
share price using the dividend growth model. Explanation of the nature of the
agency problem and the use of share option schemes.

Gorwa Co: December 2008


Discussion/calculation of the effects of an increase in interest rates. Analysis
of whether the company is overtrading. Evaluation of a proposal to factor
trade receivables.
Rupab Co: December 2008
Calculation of (a) the WACC and (b) NPV (with inflation). Explanation of how
the CAPM can be used to calculate a project-specific discount rate and
discussion of the limitations of the CAPM.

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

30

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Pages

Contents: Exam-status Questions 3 of 5

Question

Answer

476

477

481

482

490

491

495

497

501

502

506

508

513

515

525

526

ASOP Co: December 2009


Calculation/discussion re lease or buy decision. Calculation of NPV (including
inflation). Discussion/illustration of the use of equivalent annual cost/benefit.
Discussion on how an optimal investment schedule can be formulated when
capital is rationed and projects are (i) divisible and (ii) non-divisible.

DD Co: December 2009


Calculation of cost of debt. Discussion on costs of debt. Calculation (i) cost of
equity (using the CAPM), (ii) share price (using the dividend growth model),
(iii) capital gearing and (iv) market WACC. Discussion on whether a change
in dividend policy will affect share price.

NG Co: December 2009


Calculation of theoretical ex right price. Evaluation of the effect of an overseas
investment on (i) earnings per share, and (ii) the wealth of the shareholders.
Explanation of the difference between transaction risk and translation risk.
Identification/calculation that illustrates two hedging methods.

APX Co: December 2009


Discussion on the role of financial intermediaries. Preparation of financial
statements: (i) an income statement, and (ii) a statement of financial position.
Analysis/discussion of (i) the working capital financing policy and (ii) forecast
financial performance in terms of working capital management.

ZSE Co: June 2010


Calculation/discussion of (i) expected values, (ii) the probability of a negative
cash balance and (iii) the probability of exceeding the overdraft limit.
Discussion of (i) factors to be considered in formulating a trade receivable
management policy and (ii) whether profitability or liquidity is the primary
objective of working capital management.

YGV Co: June 2010


Calculation of (i) after-tax cost of debt, (ii) the effect of a bond issue on the
WACC and (iii) the effect of using the bond issue on (1) the interest coverage
ratio and (2) gearing. Evaluation of the proposal to use the bond issue with
discussion of alternative sources of finance.

OKM Co: June 2010


Identification of any errors in a prepared investment appraisal and the
preparation of a revised NPV. Discussion of problems faced when
undertaking investment appraisal and how these problems are overcome in
three situations.

QSX Co: June 2010


Calculation of dividend yield, capital gain and total shareholder return with
respect to the CAPM and the other financial information provided. Calculation/
commentary on the share price using the dividend growth model in
circumstances (i) based on the historical information, and (ii) if the proposed
change in dividend policy is implemented. Discussion on the relationship
between investment decisions, dividend decisions and financing decisions.

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

31

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Pages

Contents: Exam-status Questions 4 of 5

Question

Answer

530

531

536

538

542

543

547

549

552

553

558

559

564

566

572

573

582

583

CJ Co: December 2010


Calculation/discussion of NPV (with inflation). Critical discussion re directors
view (as stated). Calculation of a project-specific cost of equity and
explanation of the calculation.

Nugfer Co: December 2010


Evaluation of suitable financing methods (using stated figures) supporting the
evaluation with analysis/critical discussion. Explanation of factors that will
influence the rate of interest charged on a new issue of bonds. Identification
of three forms of efficiency found in a capital market.

WQZ Co: December 2010


Calculation of the cost of the current ordering policy and the change in the
costs of inventory that will arise if the economic order quantity is used.
Description of benefits of JIT procurement. Calculation on (i) whether
proposed changes in receivables management will be acceptable and (ii)
acceptance of an early settlement discount.

NN Co: December 2010


Calculation of equity value using (i) the dividend growth model and (ii) net
asset value. Calculation of (i) the after-tax cost of debt and (ii) the WACC.
Discussion of the factors to be considered in formulating the dividend policy.

BRT Co: June 2011


Calculation of NPV (with inflation). Calculation of an after-tax cash flow value,
using a perpetuity approach. Discussion of three ways of incorporating risk
into the investment appraisal process.

AQR: June 2011


Calculation/discussion of WACC (i) before the new issue of bonds, and (ii)
after the new issue of bonds. Identification/discussion of factors that influence
the market value of traded bonds. Discussion of the view that issuing traded
bonds will decrease the WACC and thereby increase corporate value.

YNM Co: June 2011


Analysis/discussion of financial performance. Discussion of sources of finance
in terms of (i) equity finance and (ii) sale and leaseback. Explanation of the
nature of a scrip (share) dividend and discussion of its advantages and
disadvantages.

ZPS Co: June 2011


Explanation of relationships between (i) exchange rates and interest rates,
and (ii) exchange rates and inflation rates. Calculation/discussion of (i) a
forward market hedge and (ii) a money market hedge. Discussion of factors
that influence the formulation of working capital policy. Calculation of whether
the company will benefit financially by accepting the offer of (i) the early
settlement discount and (ii) the bulk purchase discount.

Warden Co: December 2011


Calculation of (i) NPV and (ii) IRR. Explanation of sensitivity analysis in the
context of investment appraisal. Calculation of the sensitivity of the
investment. Discussion on the nature and causes of the problem of capital
rationing and how this problem can be overcome.

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

32

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Pages

Contents: Exam-status Questions 5 of 5

Question

Answer

591

593

596

598

603

604

609

610

615

617

621

622

626

627

Bold Co: December 2011


Explanation/discussion of (i) cash operating cycle, (ii) relationship between
the cash operating cycle and the level of investment in working capital.
Calculation of the cash operating cycle. Calculation of the value of a factors
offer (i) on a with-recourse basis and (ii) on a non-recourse basis.
Commentary on the financial acceptability of the factors offer and possible
benefits of the company factoring its trade receivables.

Close Co: December 2011


Calculation of corporate value using (i) net asset value method, (ii) dividend
growth model and (iii) earnings yield method. Discussion on the weaknesses
of the dividend growth model as a way of valuing a company. Calculation of
the WACC. Discussion of circumstances under which the WACC can be used
as a discount rate in investment appraisal.
Bar Co: December 2011
Calculation of theoretical ex rights price per share following a rights issue.
Calculation/discussion on the policy of buying back bonds. Calculation/
discussion of the effect of the company using the cash raised by the rights
issue to buy back bonds on the financial risk as measured by (i) its interest
coverage ratio and (ii) its book value to equity value. Comparison of the
financial objectives of a stock exchange listed company and the financial
objectives of a not-for-profit organisation.

Ridag Co: June 2012


Calculation/commentary of NPV. Calculation/discussion of equivalent annual
costs. Critical discussion of the use of sensitivity analysis and probability
analysis as ways of including risk in the investment appraisal process.

Wobnig Co: June 2012


Evaluation on whether the company is overtrading. Critical discussion on the
similarities and differences between working capital in two areas: (i) working
capital investment and (ii) working capital financing. Calculation of the MillerOrr upper limit and return point and explanation of how these would be used to
manage the cash balances,

Zigto Co: June 2012


Discussion on the reasons why small and medium-sized entities might
experience less conflict between the objectives of shareholders and directors
than large listed companies. Discussion of the factors that the company
should consider when choosing a source of debt finance and the factors that
may be considered by providers of finance. Explanation of the nature of a
mudaraba contract. Calculation whether a forward exchange contract or a
money market hedge would be financially preferred. Calculation of the oneyear (future) spot rate predicted by purchasing power parity theory and an
explanation of the relationship between the expected spot rate and the current
forward exchange rate.

Corhig Co: June 2012


Estimation/discussion of value using the P/E ratio method. Calculation of the
current cost and, using this value, the value of the company using the dividend
valuation model. Calculation of the current WACC and the WACC following
the new debt issue and commentary on the difference between the two values.
Discussion re (i) business risk, (ii) financial risk and (iii) systematic risk.
Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

33

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Droxfol Co: Question


A Calculation of current weighted cost of capital, interest coverage ratio, financial gearing,
earnings per share.
Droxfol Co is a listed company that plans to spend $10m on expanding its existing business. It has
been suggested that the money could be raised by issuing 9% loan notes redeemable in ten years
time. Current financial information on Droxfol Co is as follows.
Income statement information for the last year
Profit before interest and tax
Interest
Profit before tax
Tax
Profit for the period
Balance sheet for the last year
Non-current assets
Current assets
Total assets
Equity and liabilities
Ordinary shares, par value $1
Retained earnings
Total equity
10% loan notes
9% preference shares, par value $1
Total non-current liabilities
Current liabilities
Total equity and liabilities

$000
7,000
(500)
6,500
(1,950)
4,550
$000

$000
20,000
20,000
40,000

5,000
22,500
27,500
5,000
2,500
7,500
5,000
40,000

The current ex div ordinary share price is $4.50 per share. An ordinary dividend of 35 cents per share
has just been paid and dividends are expected to increase by 4% per year for the foreseeable future.
The current ex div preference share price is 76.2 cents. The loan notes are secured on the existing
non-current assets of Droxfol Co and are redeemable at par in eight years time. They have a current
ex interest market price of $105 per $100 loan note. Droxfol Co pays tax on profits at an annual rate of
30%.
The expansion of business is expected to increase profit before interest and tax by 12% in the first
year. Droxfol Co has no overdraft.
Average sector ratios:
Financial gearing:
45% (prior charge capital divided by equity capital on a book value basis)
Interest coverage ratio: 12 times
Required:
(a)
Calculate the current weighted average cost of capital of Droxfol Co.
(b)

(c)

(9 marks)

Discuss whether financial management theory suggests that Droxfol Co can reduce its weighted
average cost
of capital to a minimum level.
(8 marks)

Evaluate and comment on the effects, after one year, of the loan note issue and the expansion
of business on the following ratios:
(i)

interest coverage ratio;

(ii)

financial gearing;

(iii)

earnings per share.

Assume that the dividend growth rate of 4% is unchanged.


Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

(8 marks)
(25 marks)

A
34

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Droxfol Co: Answer


A Calculation of current weighted cost of capital, interest coverage ratio, financial gearing,
earnings per share.
(a)

Calculation of weighted average cost of capital (WACC)


Market values
Step 1: requity

Step 2: rpreference

Use of dividend growth model

D (1 + g )
re = 0
+ g
P0
=

P0 =

dp

rp =

dp

35 x 1.04
+ 0.04
450

= 12.08%

rp

P0
9
76.2

= 11.81%
Step 3: debt
Trial and error approach
Year
0
18
8

Cash flow
$
market value
(105)
interest (10 x 0.7) 7
redemption
100

1st trial
10% DF
1.000
5.335
0.467

PV ($)
(105.00)
37.34
46.70
(20.96)

2nd trial
5% DF
1.000
6.463
0.677

PV ($)
(105.00)
45.24
67.70
7.94

7.94

%
rd = 5% +
x (10 - 5)
20.96 + 7.94
= 6.37%
Thus:
Step 4: Market values and WACC
Market value of equity = 5m x 4.50 =
Market value of preference shares = 2.5m x .0762 =
Market value of 10% loan notes = 5m x (105/ 100) =
Total market value = 22.5m + 1.905m + 5.25m =

$22.5 million
$1.905 million
$5.25 million
$29.655 million

WACC =
[(12.08% x 22.5) + (11.81% x 1.905) + (6.37% x 5.25)]/ 29.655 = 11.05%

(b)

Droxfol Co has long-term finance provided by ordinary shares, preference shares and loan
notes. The rate of return required by each source of finance depends on its risk from an investor
point of view, with equity (ordinary shares) being seen as the most risky and debt (in this case
loan notes) seen as the least risky. Ignoring taxation, the weighted average cost of capital
(WACC) would therefore be expected to decrease as equity is replaced by debt, since debt is
cheaper than equity, i.e. the cost of debt is less than the cost of equity.

Q
Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

35

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

PRESENT VALUE

FORMULAE

ANNUITY

Q
However, financial risk increases as equity is replaced by debt and so the cost of equity will
increase as a company gears up, offsetting the effect of cheaper debt. At low and moderate
levels of gearing, the before-tax cost of debt will be constant, but it will increase at high levels of
gearing due to the possibility of bankruptcy. At high levels of gearing, the cost of equity will
increase to reflect bankruptcy risk in addition to financial risk.
In the traditional view of capital structure, ordinary shareholders are relatively indifferent to the
addition of small amounts of debt in terms of increasing financial risk and so the WACC falls as
a company gears up. As gearing up continues, the cost of equity increases to include a financial
risk premium and the WACC reaches a minimum value. Beyond this minimum point, the WACC
increases due to the effect of increasing financial risk on the cost of equity and, at higher levels
of gearing, due to the effect of increasing bankruptcy risk on both the cost of equity and the cost
of debt. On this traditional view, therefore, Droxfol Co can gear up using debt and reduce its
WACC to a minimum, at which point its market value (the present value of future corporate cash
flows) will be maximised. (For a diagram showing the traditional view click two screens on.)
In contrast to the traditional view, continuing to ignore taxation but assuming a perfect capital
market, Miller and Modigliani demonstrated that the WACC remained constant as a company
geared up, with the increase in the cost of equity due to financial risk exactly balancing the
decrease in the WACC caused by the lower before-tax cost of debt. Since in a prefect capital
market the possibility of bankruptcy risk does not arise, the WACC is constant at all gearing
levels and the market value of the company is also constant. Miller and Modigliani showed,
therefore, that the market value of a company depends on its business risk alone, and not on its
financial risk. On this view, therefore, Droxfol Co cannot reduce its WACC to a minimum. (For a
diagram showing the M&M view click three screens on.)
When corporate tax was admitted into the analysis of Miller and Modigliani, a different picture
emerged. The interest payments on debt reduced tax liability, which meant that the WACC fell
as gearing increased, due to the tax shield given to profits. On this view, Droxfol Co could
reduce its WACC to a minimum by taking on as much debt as possible.
However, a perfect capital market is not available in the real world and at high levels of gearing
the tax shield offered by interest payments is more than offset by the effects of bankruptcy risk
and other costs associated with the need to service large amounts of debt. Droxfol Co should
therefore be able to reduce its WACC by gearing up, although it may be difficult to determine
whether it has reached a capital structure giving a minimum WACC.
Aide-mmoire:
What is a perfect market?
Any market in which assets are priced with total efficiency. In a perfect capital market,
there are no possibilities for arbitrage. (Arbitrage is the simultaneous buying and selling
of a security at two different prices in two different markets, resulting in profits without
risk.)
End of Aide-mmoire
(c)

(i)

Interest coverage ratio


Current interest coverage ratio
Increased profit before interest and tax
Increased interest payment
Interest coverage ratio after one year

=
=
=
=

7,000/ 500 = 14 times


7,000 x 1.12 = $7.84m
(10m x 0.09) + 0.5m = $1.4m
7.84/ 1.4 = 5.6 times

The current interest coverage of Droxfol Co is higher than the sector average and can be
regarded as quiet safe. Following the new loan note issue, however, interest coverage is
less than half of the sector average, perhaps indicating that Droxfol Co may not find it
easy to meet its interest payments.

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

Q
36

Practice Questions and Answers


MAIN PAGE

(ii)

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Financial gearing
This ratio is defined here as prior charge capital/equity share capital on a book value
basis
Current financial gearing
Ordinary dividend after one year
Total preference dividend

= 100 x (5,000 + 2,500)/ (5,000 + 22,500) = 27%


= 0.35 x 5m x 1.04 = $1.82 million
= 2,500 x 0.09 = $225,000

Income statement after one year


$000
Profit before interest and tax
Interest
Profit before tax
Income tax expense
Profit for the period
Preference dividends
Ordinary dividends

$000
7,840
(1,400)
6,440
(1,932)
4,508

225
1,820
(2,045)
2,463

Retained earnings

Financial gearing after one year = 100 x (15,000 + 2,500)/ (5,000 + 22,500 + 2,463)
= 58%
The current financial gearing of Droxfol Co is 40% ((45-27)/45) less (in relative terms)
than the sector average and after the new loan note issue it is 29% ((58-45)/45) more (in
relative terms). This level of financial gearing may be a cause of concern for investors and
the stock market. Continued annual growth of 12%, however, will reduce financial gearing
over time.
(iii)

Earnings per share


Current earnings per share
Earnings per share after one year

= (4,550 - 225)/5,000 = 86.5 cents


= (4,508 - 225)/5,000 = 85.7 cents

Earnings per share is seen as a key accounting ratio by investors and the stock market,
and the decrease will not be welcomed. However, the decrease is quiet small and future
growth in earnings should quickly eliminate it.
The analysis indicates that an issue of new debt has a negative effect on the companys
financial position, at least initially. There are further difficulties in considering a new issue
of debt. The existing non-current assets are security for the existing 10% loan notes and
may not available for securing new debt, which would then need to be secured on any
new noncurrent assets purchased. These are likely to be lower in value than the new debt
and so there may be insufficient security for a new loan note issue. Redemption or
refinancing would also pose a problem, with Droxfol Co needing to redeem or refinance
$10 million of debt after both eight years and ten years. Ten years may therefore be too
short a maturity for the new debt issue.
An equity issue should be considered and compared to an issue of debt. This could be in
the form of a rights issue or an issue to new equity investors.

Q
Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

37

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

Traditional model of capital structure

Cost of capital

Ke

WACC

Kd

0
m

Level of gearing

The shape of the graph can be explained as follows:


1. Starting from a zero gearing level (left side of the x axis), as debt is progressively
introduced into the capital structure (and the gearing increases), the cost of debt, kd,
at first remains unchanged.
2. Initially, borrowing additional debt on a low geared basis will not be regarded by
shareholders as an additional risk and they will not expect an increased return, ke.
3. Because the return expected by debt providers is less than that expected by
shareholders, the effect on the WACC is that it falls initially as new debt is
introduced. This reflects the benefit of taking on lower cost debt.
4. The cost of equity, ke, can be seen to increase as the level of financial gearing
increases. This is because, in the traditionalists view, as the level of gearing
increases, the level of financial risk to which the shareholders are exposed also
increases. Consequently they will expect higher returns.
5. Beyond a certain point the cost of debt also begins to rise. This is because the
providers of debt now also perceive a greater financial risk and therefore expect a
higher return.
6. The effect on the WACC is that it falls initially until its curve eventually reaches a
minimum point, m in the graph, and then begins to increase when the cost of equity
and the cost of debt begin to rise.
7. The graph, and its logic, would suggest that there is a optimum capital structure.
Note: remember that the expected return expected by an investor, r, also represents the
firms cost of capital, k.
Figure 14.3: Traditional model of capital structure

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

Q
38

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

PRESENT VALUE

FORMULAE

ANNUITY

M&Ms Proposition II

Cost of capital

Ke

WACC
Kd

0
Risk-free debt

Risky debt

Level
of gearing

The shape of the graph can be explained as follows:


1. Starting from a zero gearing level (left side of the x axis), as debt is progressively
introduced into the capital structure (and the gearing increases), the cost of debt, kd, at
first remains unchanged.
2. The cost of equity, ke, can be seen to increase as new debt is introduced and the level of
financial gearing increases. This is because according to the M&M view, as the level of
gearing increases, the level of financial risk to which the shareholders are exposed also
increases. Consequently they will expect higher returns.
3. Because the return expected by debt providers is less than that expected by shareholders, but
at the same time the expected return of shareholders rises, the effect on the WACC is that it
remains constant.
4. Beyond a certain point the cost of debt also begins to rise. This is because theproviders of
debt now also perceive a greater financial risk and therefore expect a higher return. However
because the risk associated with the firms assets is increasingly being transferred from the
shareholders to the debt providers, the rise in the expected returns of the equity holders
becomes progressively less.
6. The effect on the WACC is that it remains constant.
7. The graph, and its logic, would suggest that there is not an a optimum capital structure.
Note: remember that the expected return expected by an investor, r, also represents the firms
cost of capital, k.

M&Ms Proposition 11

Q
Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

39

Practice Questions and Answers


MAIN PAGE

Paper F9: Financial Management


CONTENTS

FORMULAE

PRESENT VALUE

ANNUITY

We hope you enjoyed our free sample, and found it useful.


For the FULL WORKING version, buy it NOW, online at...

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

40

Practice Questions and Answers

Paper F9: Financial Management


CONTENTS

MAIN PAGE

FORMULAE

PRESENT VALUE

ANNUITY

Sorry... But that link will not work in this free sample copy.
To buy the full version, complete with all links, and even more Diagnostic Tests covering 11 topics
for your ACCA F9 Revision and 44 Past Exam Questions and Answers , please go to

www.TonySurridge.co.uk

Dedicated to the Accountancy and Finance Profession

Tony Surridge Online Limited, 2013

www.TonySurridge.co.uk

41

You might also like