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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
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Contents
Screen
Tutorial
Syllabus classification
Questions
Answers
Tutorial 1
24
27
Tutorial 2
Financial analysis
31
39
Tutorial 3
53
57
Tutorial 4
68
79
Tutorial 5
Cash management
97
106
Tutorial 6
120
132
Tutorial 7
159
164
Tutorial 8
Business finance
177
195
Tutorial 9
Cost of capital
231
239
Tutorial 10
254
261
Tutorial 11
Risk management
272
290
Text
Islamic finance
329
354
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ACCA Paper F9
Financial Management
Diagnostic Test:
Cash management
Questions
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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
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)
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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)
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)
(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 =
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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
the probability distribution for the cash position over the 50-day period;
(2 marks)
(b)
(2 marks)
(c)
(2 marks)
(d)
(1 mark)
For parts (c) and (d) you are to use the following formula:
p x - x
Where :
)2
p
x
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).
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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.
-
(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)
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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.
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(1 mark)
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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)
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
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).
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(1 mark)
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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 -
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ACCA Paper F9
Financial Management
Diagnostic Test:
Cash management
Answer Guides
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Answer to Question 1
Bouncing cheque!
Answer to Question 2
1.
2.
3.
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
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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.
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.
English proverb
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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 =
Answer to Question 14
2 x $2,000,000 x $200
0.0045*
= 0.45/100 = 0.0045
= $421,637
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Answer to Question 15
(i)
Q =
Q =
$800,000
x $100
Cost of transactions :
$40,000
= $2,000
2 x $800,000 x $150
0.08
= $54,773
Q =
$800,000
x $150
Cost of transactions :
$54,773
= $2,191
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Answer to Question 16
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
Variance =
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
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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
Answer to Question 19
1
flows 3
Answer to Question 20
Answer to Question 21
$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
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Answer to Question 22
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.
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
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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
Answer to Question 25
(a)
$7,200
= $72,000
10%
March
April
March sales (100% - 70%) = 30% (of sales) = $28,800
$28,800
March sales =
= $96,000
30%
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
May
$
96,000
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20,000
84,000
111,200
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Answer to Question 26
(a) and (b)
(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
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
HELP
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Answer to Question 28
Companies experience cash flow problems for the following reasons.
1.
2.
3.
4.
5.
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.
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.
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 -
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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
Percentage (%)
91 128 marks
65 90marks
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Example 2
Value Deviation Deviation2
from average
4
6
5
15
-1
+1
0
from average
1
1
0
2/2 = 1
Variance = 1
11
3
1
15
+6
-2
-4
36
4
16
56/2 = 28
Variance = 28
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
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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
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FORMULAE
PRESENT VALUE
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Past Exam
Questions and Answers
ACCA Paper F9
Performance Management
Scroll through the screens
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360
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476
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530
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591
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603
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609
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615
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621
622
626
627
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$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)
(ii)
financial gearing;
(iii)
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(25 marks)
A
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Step 2: rpreference
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
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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)
=
=
=
=
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.
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Q
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(ii)
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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
$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 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.
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Cost of capital
Ke
WACC
Kd
0
m
Level of gearing
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M&Ms Proposition II
Cost of capital
Ke
WACC
Kd
0
Risk-free debt
Risky debt
Level
of gearing
M&Ms Proposition 11
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