ACCA Paper F9 Financial Management December 2013 ... - Kaplan

ACCA Paper F9 Financial Management December 2013

Revision Mock – Answers To gain maximum benefit, do not refer to these answers until you have completed the revision mock questions and submitted them for marking.

PAPER F9: FINANCIAL MANAGEMENT

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REVISION MOCK ANSWERS

1

MAX CO

Key answer tips Part (a) presents a fairly unusual way of testing the NPV calculation. A well-rehearsed student will be able to manage the equivalent annual cost workings without too much thought. Part (b) required fairly detailed application of the optimum replacement cycle theory. Candidates without a true understanding of the concept will have struggled here so if you did, it is well worth spending some time going through the marking guide for this part of the question. Part (c) was standard fare in terms of testing the limitations of the calculations previously carried out. Part (d) and (e) can provide a few easy marks which are not applied to the scenario. The highlighted words in the written sections are key phrases that markers are looking for. (a)

Optimum economic life of asset as at May 20X3 Time

Cash

DF

$000 4 year cycle

PV $000

0

Buy

(350)

1

(350)

1

Run

(50)

0.909

(45)

2

Run

(110)

0.827

(91)

3

Run

(170)

0.751

(128)

4

Run

(230)

0.683

(157)

4

Sale

30

0.683

20 (751)

EAC = (751) / 3.17 = (236.91) Time

Cash

DF

$’000 5 year cycle

PV $’000

0

Buy

(350)

1

(350)

1

Run

(50)

0.909

(45)

2

Run

(110)

0.827

(91)

3

Run

(170)

0.751

(128)

4

Run

(230)

0.683

(157)

5

Run

(290)

0.621

(180) (951)

EAC = (951) / 3.791 = (250.86) Four year cycle is the cheapest. KAPLAN PUBLISHING

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(b)

(i)

Effect of increased purchase price The optimum economic life of a machine is a balance between the purchase cost and repairs and maintenance costs. Replacing more often results in more purchase cost and less repairs cost. Replacing less often results in less purchase cost and more repairs cost. If the purchase price were to increase relative to the cost of repairs, then this would shift the balance so that replacing less often would become more efficient. Therefore, an increase in the cost of the machine would lengthen the economic cycle.

(ii)

Effect of increased cost of capital Later cash flows are effectively reduced by the discount factor to determine the annual equivalent. An increase in the company’s cost of capital will result in these cash flows being reduced still further i.e. the later running and repair costs will be less significant relative to the capital cost. Therefore an increase in the cost of capital would lengthen the economic life of the machine.

(c)

Tutor’s top tips:

To gain a good mark, candidates will need to fully develop their answer, rather than merely listing unexplained points. Limitations of the replacement analysis performed The analysis carried out assumes that a firm is continually replacing like with like, and therefore determines a once-and-for-all optimal replacement cycle. In practice, this is unlikely to be valid due to: •

• •

• • •

(d)

Changing technology, which can quickly make machines obsolete and shorten replacement cycles. This means that one asset is not being replaced by one exactly similar. Inflation, which by altering the cost structure of assets means that the optimal replacement cycle can vary over time. If inflation affects all variables equally it is best excluded from the analysis by discounting real cash flows at a real interest rate – the optimal replacement cycle will remain valid. Differential inflation rates mean that the optimal replacement cycle varies over time. The effects of taxation (ignored in the analysis but they could be incorporated). The fact that production is unlikely to continue in perpetuity.

The motives for holding cash are: Transactions motive – to pay the normal day to day transactions of the company including payments to suppliers for instance. Investment motive – to pay for investment in new plant and machinery for instance.

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Precautionary motive – to pay for unexpected needs that may arise at any time. Payments to hire a spare machine to replace one which is having to be repaired for example. Finance motive – to make payments to providers of finance such as debt lenders. A speculative motive is also sometimes mentioned. This is where funds are held in order to be able to rapidly take advantage of opportunities which may arise. (e)

When faced with cash flow shortages, a company may consider one or more of a number of possible remedies: • • • • • • • • •

Postpone non-essential capital expenditure. Offer discounts for early payment by debtors. Chase overdue accounts. Use the services of a factor. Use invoice discounting. Sell any cash investments. Delay payment to creditors. Reschedule loan repayment. Reduce dividend payments (this, though, could be taken as a sign of financial weakness). Marking scheme Marks

(a)

Optimum replacement cycle 4 year

3.5

5 year

3.5

Conclusion

1 –––– 8

(b)

Effect of increased price/ discount rate Discussion of cost of machine

2

Discussion of cost of capital

2 –––– 4

(c)

Limitations – 0.5 marks per point raised briefly, 1 mark per point adequately discussed

(d)

2 marks per well explained motive

(e)

1 mark per briefly explained reasonable suggestion

3

5

5 –––– Total

25 ––––

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2

BIG BALLOON ENTERTAINMENT

Key answer tips This question is an effective discriminator as candidates have to use their calculations to conclude whether an equity or debt issue would be preferable. A good candidate will use the results from parts (a) and (b) as the basis for their discussion in part (c). Part (d) provides an opportunity to use your knowledge on Islamic Finance but you must remember to apply it to the scenario at every opportunity. As long as you are confident in your knowledge of Miller and Modigliani’s capital structure theories, part (e) should provide a nice opportunity to pick up some easy marks. The highlighted words are key phrases that markers are looking for. (a)

Tutor’s top tips: With good knowledge of basic formulae, this is a straight-forward requirement. Theoretical ex rights price (TERP) Current number of shares in circulation = $1m/$0.50 = 2m Current market capitalisation = 2m × $8 = $16m Rights issue price = $8 × 75% = $6 Number of new shares issued = 2m/4 = 500,000 TERP = ($16m + $3m)/(2m + 0.5m) = $7.60

Tutor’s top tips: Remember to make comparisons between the value of debt and equity, based on each option for funding. Do not just state the new increased values. (b)

Impact upon debt / equity ratio Current balance of debt to equity = $2m/$2.75m = 73% Balance of debt to equity following the rights issue = $2m/$5.75m = 35% (assumes $3m of equity introduced) Balance of debt to equity following issue of the loan note = $5m/$2.75m = 182% (Assumes $3m of debt introduced)

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The current debt to equity ratio is significantly higher than the industry average, which suggests that BBE has high financial risk, during a time when the retail sector is struggling. The rights issue would significantly reduce the ratio to 35% thus reducing financial risk, which is perhaps advisable as the business risk is about to increase due to the diversification. Online music is highly competitive and price sensitive. To issue a new loan note is certainly not a wise idea, as this will increase the ratio to 182% and raises concern as to whether the company could survive if trading conditions deteriorated. The loan note will increase interest payments by $0.24m per annum. Alternative sources of finance The company currently has a very high amount of debt as indicated by the high gearing ratio, thus debt should not be considered any further. External sources The company has suggested a rights issue, which would only seek investment from existing shareholders. An alternative would be to offer new shares to the wider market, whilst this is more time consuming and expensive, it has the potential to raise a greater amount of funds. A wealthy individual who is seeking to invest in a project, rather than have cash, would be ideal as they would be willing to take a risk in exchange for a higher than average return. A venture capitalist would also be willing to provide funds, however they would want a large say in the operations of the business and may dictate future policy. Internal sources The company currently has a very large overdraft, which indicates that there is insufficient cash to finance the project, however if the company currently pays a dividend, perhaps this could be deferred to reinvest. The current assets appear to be exceptionally high, thus a reduction programme, i.e. moving inventory to JIT, outsourcing receivables to external organisations, could release cash to invest. Perhaps the payables could be extended for the same reason. Sale and leaseback of non-current assets may also generate funds required, however this would very much depend on the realisable value of the assets. (d)

Islamic Finance is an option that is increasing in popularity. Essentially the business would find a partner to invest in return for a share of future profits that are generated. The central principle of Islamic finance is that making money out of money is not acceptable, i.e. interest is prohibited. This avoids the company taking on a high level of financial risk as they will not be obligated to make annual interest payments. Islamic finance, is a partnership between one party that brings finance or capital into the contract and another party that brings business expertise and personal effort into the contract. The first party is called the owner of capital, while the second party is called the agent, who runs or manages the business. A contract would specify how profit from the business is shared proportionately between the two parties. Any loss, however, is borne by the owner of capital, and not by the agent managing the business.

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(e)

There is a clear relationship between the capital structure of a business and the weighted average cost of capital (WACC). As relatively cheap debt is introduced, in theory the WACC should reduce, which in turn will increase the market value of the company. The market value can be expressed as the present value of future corporate cash flows, discounted by the WACC. However, as noted in an earlier discussion, increasing gearing will increase financial risk and may lead to an increase in the cost of equity, offsetting the effect of the cheaper debt. Traditional view of capital structure In the traditional view of capital structure, there is a non-linear relationship between the cost of equity and financial risk, as measured by gearing. Equity investors are indifferent to the addition of small amounts of debt, so as a company gears up by replacing expensive equity with cheaper debt, the WACC initially decreases. Debt is cheaper than equity because of the relative positions of the two sources of finance in the creditor hierarchy (the traditional view of capital structure ignores taxation). As equity investors start to respond to increasing financial risk, however, the cost of equity begins to increase until a point is reached where WACC ceases to fall. This corresponds to an optimal capital structure, since at this point WACC is at a minimum and hence the market value of the company is at a maximum. After this point, the WACC starts to increase as the company continues to gear up, rising more quickly at very high levels of gearing due to the appearance of bankruptcy risk. Under the traditional view, issuing debt will decrease WACC, depending on the position of the company relative to its optimal capital structure. Miller and Modigliani Miller and Modigliani showed that in a perfect capital market without corporate taxation, the replacement of expensive equity with cheaper debt did not lead to a decrease in the WACC, since the effect of adding in cheaper debt was exactly offset by the increase in the cost of equity, which had a linear relationship with financial risk, as represented by gearing. This meant that the market value of the company was independent of its capital structure (financial risk) and depended only on its business operations (business risk). In their second paper on capital structure Miller and Modigliani showed that, if taxation were allowed (so that the after-tax cost of debt was considered, rather than the before-tax cost of debt), replacing equity with debt led to a linear decrease in the WACC, because of the tax shield on profits gained by interest payments being an allowable deduction in calculating tax liability. Under this contribution to capital structure theory, gearing up as much as possible would maximise the market value of the company and thus issuing debt would decrease the WACC of BBE. Pecking order theory In practice it has been noticed that companies do not appear to base their financing decisions on the objective of achieving an optimal capital structure, but rather have a preference for sources of finance in the order of retained earnings, bank loans, ordinary debt, convertible debt and equity. A number of reasons have been suggested for this ‘pecking order’.

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Marking scheme Marks (a)

Current Shares In Circulation Current Market Capitalisation New Shares Issued Issue Price TERP Calculation

0.5 0.5 0.5 0.5 1 ––––

(b)

Current Debt / Equity Proposed Debt / Equity

1 2 ––––

(c)

Acceptability of Proposed Finance Alternative External Sources – 1 mark for each well explained option Alternative Internal Sources – 1 mark for each well explained option

3

3 2 3 3 –––– 8 (d)

Explain Islamic Finance – 1 mark for each valid point

(e)

Introduction To Capital Structure Theory Traditional Theory M&M No Tax / With Tax

4 4

Total

3

1 3 3 –––– 7 –––– 25 ––––

KINGSGATE CO

Key answer tips Part (a) is a fairly unusual requirement asking for two alternative calculations of the weighted average cost of capital. The calculations were not tricky but candidates will need to be comfortable with both methods, not only for the calculations but also for the required discussion. Essential knowledge for a good answer to part (b) is that a major diversification into a new industry is likely to involve a different level of systematic risk from that of the company’s existing investment portfolio. With use of the formula provided a good attempt should be made here. Parts (c) and (d) are stand alone parts of the question and can provided some easy marks for the well-rehearsed candidate. The highlighted words in the written sections are key phrases that markers are looking for.

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(a)

(i)

Dividend valuation model If we assume a constant growth in dividends, we may estimate the cost of equity by using: Ke

=

Do(1 + g) +g Po

where:

= $2.14m/10m shares = 21.4c

D0

P0 = 321c g

= 11%

Therefore: Ke

= (21.4c × 1.11 / 321c) + 0.11 = 0.184, or 18.4%

Kd(1-t) As the question tells us to assume that 'corporate debt is risk-free', we can therefore assume that the cost of debt equals the risk free rate: Kd (1-t) = 12% × (1 – 0.30) = 8.4 % The weighted average cost of capital (WACC): =

Ke ×

WACC

=

18.4% ×

= (ii)

D E + Kd(1 − t) × E+D E+D

WACC

2 3

+ 8.4% ×

1 3

15.07%

Capital asset pricing model Ke

= Rf + β × [Rm − Rf]

β

= 1.4

Rf

= 12%

Rm

= 16%

Therefore: Ke

= 12% + 1.40 x [16% − 12%] = 17.6%

Kd

= 8.4% as in part (i)

WACC

= 17.6% ×

2 3

+ 8.4% ×

1 3

= 14.53% The cost of equity may be estimated using either the dividend valuation model or the capital asset pricing model. In theory the two models should provide the same estimate of the cost of equity. In many instances, because of market imperfections and problems in the estimation of an appropriate growth rate in the dividend valuation model, the two models often give different results. CAPM is normally considered to be the better alternative. However, this model also has theoretical weaknesses and there may be problems in obtaining data to input into the model.

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(b)

A major diversification into a new industry is likely to involve a different level of systematic risk from that of the company’s existing investment portfolio. In these circumstances a project specific discount rate should be estimated, and the company’s weighted average cost of capital is not appropriate. The β equity of the industry is 1.50. βa =

Ve βe ( Ve + Vd (1 - T ))

+

Vd (1 - T ) βd ( Ve + Vd (1 - T ))

As β debt is 0.

3 +0 3 + 1(1 − 0.30)

β asset

= 1.50 ×

β asset

(= β equity for an ungeared project) = 1.23

Adjustment for the company’s gearing level may be achieved by ‘re-gearing’ the β asset.

Asset beta

= Equity beta ×

Ve ( Ve + Vd (1 - T ))

2 2 + 1(1 − 0.30)

1.23

= Equity beta ×

Equity beta

= 1.23/0.74 = 1.66

Project E(r equity) = 12 + 1.66 x (16 − 12) = 18.64%

(c)

All treasury management activities are concerned with managing the liquidity of a business, the importance of which to the survival and growth of a business cannot be over-emphasised. The functions carried out by the treasurer have always existed, but have been absorbed historically within other finance functions. A number of reasons may be identified for the modern development of separate treasury departments: Size and internationalisation of companies: those factors add to both the scale and the complexity of the treasury functions. Size and internationalisation of currency, debt and security markets: these make the operations of raising finance, handling transactions in multiple currencies and investing, much more complex. Sophistication of business practice: this process has been aided by modern communications, and as a result the treasurer is expected to take advantage of opportunities for making profits or minimising costs which did not exist a few years ago. For these reasons, most large international companies have moved towards setting up separate treasury departments.

(d)

The benefits brought about by the intermediation role of the banking sector include: (i)

Provides a market where lenders and borrowers are brought together.

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(ii)

Risk reduction – a lender’s funds are spread over many borrowers.

(iii)

Aggregation – small deposits can be added together to enable the banks to lend large amounts.

(iv)

Maturity transformation – a series of short term deposits can be used to enable the bank to lend in the longer term.

(v)

The banking sector provides information and advice to both lenders and borrowers.

ACCA marking scheme Marks (a)

Dividend valuation model to calculate ke Cost of debt WACC CAPM calculation of Ke WACC Comments

2 1 1 2 2 2 –––– 10

(b)

Calculation of beta asset Calculation of beta equity CAPM calculation of Ke

(c)

1 mark per relevant point adequately discussed

(d)

Maximum 1.5 marks per well explained role

2 2 1 –––– 5 3

Total

4

7 –––– 25 ––––

HULSTA CO

Key answer tips This question gives a good opportunity to pick up some easy marks providing you have a reasonable understanding of the theory underpinning foreign exchange risk. It is heavily weighted towards discursive elements, with some minor calculations; to score higher marks make sure you go into sufficient depth when tackling the discursive elements. The highlighted words in the written sections are key phrases that markers are looking for. (a)

Invoicing in sterling would produce a sterling receipt of: $1.4m/1.8970 = £738,007 Invoice in dollars using a forward market hedge would produce a sterling receipt of: $1.4m/1.8860 = £742,312 The forward rate is calculated as 1.8970 – 0.011 = 1.8860

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(b)

Option 1 The advantage here is that all foreign exchange transaction risk is transferred to the US firm. However, there must be doubt as to whether this would be acceptable to the US firm – this is described as a competitive market and Hulsta is moving into it for the first time. Whether or not this policy could be implemented by Hulsta would depend on the relative bargaining power of the two firms. If the US firm has alternative sources of supply, then this option is unlikely to be achievable in practice. Option 2 With a forward contract, Hulsta is able to eliminate all foreign exchange transaction risk, but this means that whilst potential losses are avoided, potential gains from favourable currency movements are also foregone. Whether Hulsta’s management considers this to be an acceptable price to pay for certainty concerning the sterling receipt will be the key factor here. Once a forward contract is entered into it is binding, which can also create problems if the US firm fail to honour its payment commitment in six months’ time. Hulsta would still have to sell $ under the forward contract – this would have to be done at the prevailing spot rate and, depending on the rate at the time, could involve Hulsta in a loss. Option 1 produces the lower sterling receipt and is probably not feasible for the reasons stated above. The forward contract produces the higher sterling receipt so is probably the preferred option.

(c)

Effectively, a futures contract works like a bet. If a company expects a foreign currency receipt at some point in the future, it will lose out if the foreign currency depreciates relative to sterling. Using a futures contract, the company ‘bets’ that the foreign currency will depreciate. If it does, the win on the bet cancels out the loss on the transaction i.e. the gain on the futures contract will offset the loss suffered on the open market. If the foreign currency appreciates, the gain on the transaction covers the loss on the bet. Ultimately, futures contracts ensure a no win/ no loss position. A futures contract is like a forward exchange contract in that the company’s position is fixed by the rate of exchange in the futures contract and it is a binding contract. A futures contract differs from a forward exchange contract in a number of ways. Futures can be traded on futures exchanges. The contract which guarantees the price (known as the futures contract) is separated from the transaction itself, allowing the contracts to be easily traded. Settlement takes place in three-monthly cycles (March, June, September or December) i.e. a company can buy or sell September futures, December futures and so on. Futures are standardised contracts for standardised amounts. Only whole number multiples of the standard contract size can be bought or sold. The price of a currency futures contract is the exchange rate for the currencies specified in the contract. Because each contract is for a standard amount and with a fixed maturity date, unlike with a forward exchange contract, they rarely cover the exact foreign currency exposure.

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(c)

Forecasts of exchange rates using interest rate differentials are not likely to be accurate. Reasons for this include: •

Even if the interest differential remains constant the International Fisher Effect (IFE) is an unbiased, not accurate, predictor of future exchange rates. The interest rate differential may change during the next two years. Exchange rates may not be in equilibrium at the current time. The IFE predicts movements from an equilibrium position. Factors other than interest rates influence exchange rates, including government intervention in foreign exchange markets, inflation rates etc.

• • •

This is demonstrated by the fact that the banks are all forecasting different rates none of which are exactly in line with the forecast using IFE. (d)

Tutor’s top tips: This discursive part of the requirement is worth remembering is as it gives a chance to pick up a few non-applied knowledge marks. Exchange rate fluctuations primarily occur due to fluctuations in currency supply and demand. Demand comes from individuals, firms and government who want to buy a currency and supply comes from those who want to sell it. Supply and demand for currencies are, in turn, influenced by: (i)

The rate of inflation, compared with the rate of inflation in other countries

(ii)

Interest rates, compared with interest rates in other countries

(iii)

The balance of payments

(iv)

Sentiment of foreign market participants regarding economic prospects

(v)

Speculation

(vi)

Government policy on intervention to influence exchange rate Marking scheme Marks

(a)

Calculation of sterling receipt Forward rate Calculation of forward market sterling receipt

1 1 1 –––

(b)

Option 1 Option 2 Conclusion

2.5 2.5 1 –––

(c) (d) (e)

1 mark per relevant point adequately discussed 1 mark per relevant point adequately discussed 1 mark per relevant point adequately discussed

3

Total

14

6 7 3 6 ––– 25 –––

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