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Fundamentals Level Skills Module

Financial Management
Friday 7 December 2012

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FOUR questions are compulsory and MUST be attempted. Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7 and 8. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

ALL FOUR questions are compulsory and MUST be attempted 1 BQK Co, a house-building company, plans to build 100 houses on a development site over the next four years. The purchase cost of the development site is $4,000,000, payable at the start of the first year of construction. Two types of house will be built, with annual sales of each house expected to be as follows: Year Number of small houses sold: Number of large houses sold: 1 15 7 2 20 8 3 15 15 4 5 15

Houses are built in the year of sale. Each customer finances the purchase of a home by taking out a long-term personal loan from their bank. Financial information relating to each type of house is as follows: Selling price: Variable cost of construction: Small house $200,000 $100,000 Large house $350,000 $200,000

Selling prices and variable cost of construction are in current price terms, before allowing for selling price inflation of 3% per year and variable cost of construction inflation of 45% per year. Fixed infrastructure costs of $1,500,000 per year in current price terms would be incurred. These would not relate to any specific house, but would be for the provision of new roads, gardens, drainage and utilities. Infrastructure cost inflation is expected to be 2% per year. BQK Co pays profit tax one year in arrears at an annual rate of 30%. The company can claim capital allowances on the purchase cost of the development site on a straight-line basis over the four years of construction. BQK Co has a real after-tax cost of capital of 9% per year and a nominal after-tax cost of capital of 12% per year. New investments are required by the company to have a before-tax return on capital employed (accounting rate of return) on an average investment basis of 20% per year. Required: (a) Calculate the net present value of the proposed investment and comment on its financial acceptability. Work to the nearest $1,000. (13 marks) (b) Calculate the before-tax return on capital employed (accounting rate of return) of the proposed investment on an average investment basis and discuss briefly its financial acceptability. (5 marks) (c) Discuss the effect of a substantial rise in interest rates on the financing cost of BQK Co and its customers, and on the capital investment appraisal decision-making process of BQK Co. (7 marks) (25 marks)

KXP Co is an e-business which trades solely over the internet. In the last year the company had sales of $15 million. All sales were on 30 days credit to commercial customers. Extracts from the companys most recent statement of financial position relating to working capital are as follows: Trade receivables Trade payables Overdraft $000 2,466 2,220 3,000

In order to encourage customers to pay on time, KXP Co proposes introducing an early settlement discount of 1% for payment within 30 days, while increasing its normal credit period to 45 days. It is expected that, on average, 50% of customers will take the discount and pay within 30 days, 30% of customers will pay after 45 days, and 20% of customers will not change their current paying behaviour. KXP Co currently orders 15,000 units per month of Product Z, demand for which is constant. There is only one supplier of Product Z and the cost of Product Z purchases over the last year was $540,000. The supplier has offered a 2% discount for orders of Product Z of 30,000 units or more. Each order costs KXP Co $150 to place and the holding cost is 24 cents per unit per year. KXP Co has an overdraft facility charging interest of 6% per year. Required: (a) Calculate the net benefit or cost of the proposed changes in trade receivables policy and comment on your findings. (6 marks) (b) Calculate whether the bulk purchase discount offered by the supplier is financially acceptable and comment on the assumptions made by your calculation. (6 marks) (c) Identify and discuss the factors to be considered in determining the optimum level of cash to be held by a company. (5 marks) (d) Discuss the factors to be considered in formulating a trade receivables management policy. (8 marks) (25 marks)

[P.T.O.

The statement of financial position of BKB Co provides the following information: $m Equity finance Ordinary shares ($1 nominal value) Reserves Non-current liabilities 7% Convertible bonds ($100 nominal value) 5% Preference shares ($1 nominal value) Current liabilities Trade payables Overdraft Total liabilities 25 15 20 10 10 15 $m

40

30

25 95

BKB Co has an equity beta of 12 and the ex-dividend market value of the companys equity is $125 million. The ex-interest market value of the convertible bonds is $21 million and the ex-dividend market value of the preference shares is $625 million. The convertible bonds of BKB Co have a conversion ratio of 19 ordinary shares per bond. The conversion date and redemption date are both on the same date in five years time. The current ordinary share price of BKB Co is expected to increase by 4% per year for the foreseeable future. The overdraft has a variable interest rate which is currently 6% per year and BKB Co expects this to increase in the near future. The overdraft has not changed in size over the last financial year, although one year ago the overdraft interest rate was 4% per year. The companys bank will not allow the overdraft to increase from its current level. The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. BKB Co pays profit tax at an annual rate of 30% per year. Required: (a) Calculate the market value after-tax weighted average cost of capital of BKB Co, explaining clearly any assumptions you make. (12 marks) (b) Discuss why market value weighted average cost of capital is preferred to book value weighted average cost of capital when making investment decisions. (4 marks) (c) Comment on the interest rate risk faced by BKB Co and discuss briefly how this risk can be managed. (5 marks) (d) Discuss the attractions to a company of convertible debt compared to a bank loan of a similar maturity as a source of finance. (4 marks) (25 marks)

GWW Co is a listed company which is seen as a potential target for acquisition by financial analysts. The value of the company has therefore been a matter of public debate in recent weeks and the following financial information is available: Year Profit after tax ($m) Total dividends ($m) 2009 85 50 2010 89 52 2011 97 56 2012 101 60

Statement of financial position information for 2012 $m Non-current assets Current assets Inventory Trade receivables Total assets Equity finance Ordinary shares Reserves Non-current liabilities 8% bonds Current liabilities Total liabilities $m 910

38 45

83 993

200 472

672 250 71 993

The shares of GWW Co have a nominal (par) value of 50c per share and a market value of $400 per share. The cost of equity of the company is 9% per year. The business sector of GWW Co has an average price/earnings ratio of 17 times. The 8% bonds are redeemable at nominal (par) value of $100 per bond in seven years time and the before-tax cost of debt of GWW Co is 6% per year. The expected net realisable values of the non-current assets and the inventory are $860m and $42m, respectively. In the event of liquidation, only 80% of the trade receivables are expected to be collectible. Required: (a) Calculate the value of GWW Co using the following methods: (i) (ii) (iii) (iv) market capitalisation (equity market value); net asset value (liquidation basis); price/earnings ratio method using the business sector average price/earnings ratio; dividend growth model using: (1) the average historic dividend growth rate; (2) Gordons growth model (the bre model). The total marks will be split equally between each part. (10 marks)

(b) Discuss the relative merits of the valuation methods in part (a) above in determining a purchase price for GWW Co. (8 marks) (c) Calculate the following values for GWW Co: (i) the before-tax market value of the bonds of GWW Co; (ii) debt/equity ratio (book value basis); (iii) debt/equity ratio (market value basis). Discuss the usefulness of the debt/equity ratio in assessing the financial risk of GWW Co. The total marks will be split equally between each part. (7 marks) (25 marks) 5 [P.T.O.

Formulae Sheet Economic order quantity 2C0D Ch

MillerOrr Model Return point = Lower limit + ( 1 spread) 3


1

3 transaction cost variance of cash flows 3 Spread = 3 4 interest rate The Capital Asset Pricing Model E ri = Rf + i E rm Rf

()

(( ) )
(

The asset beta formula Vd 1 T Ve + a = e d Ve + Vd 1 T Ve + Vd 1 T

))

))

The Growth Model D0 1 + g

Po =

(r

Gordons growth approximation g = bre The weighted average cost of capital V V e d ke + k 1 T WACC = Ve + Vd Ve + Vd d

The Fisher formula

(1 + i) = (1 + r ) (1 + h)
Purchasing power parity and interest rate parity S1 = S0

(1 + h ) (1 + h )
c b

F0 = S0

(1 + i ) (1 + i )
c b

Present Value Table Present value of 1 i.e. (1 + r)n Where r = discount rate n = number of periods until payment Discount rate (r) Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1% 0990 0980 0971 0961 0951 0942 0933 0923 0914 0905 0896 0887 0879 0870 0861 2% 0980 0961 0942 0924 0906 0888 0871 0853 0837 0820 0804 0788 0773 0758 0743 3% 0971 0943 0915 0888 0863 0837 0813 0789 0766 0744 0722 0701 0681 0661 0642 4% 0962 0925 0889 0855 0822 0790 0760 0731 0703 0676 0650 0625 0601 0577 0555 5% 0952 0907 0864 0823 0784 0746 0711 0677 0645 0614 0585 0557 0530 0505 0481 6% 0943 0890 0840 0792 0747 0705 0665 0627 0592 0558 0527 0497 0469 0442 0417 7% 0935 0873 0816 0763 0713 0666 0623 0582 0544 0508 0475 0444 0415 0388 0362 8% 0926 0857 0794 0735 0681 0630 0583 0540 0500 0463 0429 0397 0368 0340 0315 9% 0917 0842 0772 0708 0650 0596 0547 0502 0460 0422 0388 0356 0326 0299 0275 10% 0909 0826 0751 0683 0621 0564 0513 0467 0424 0386 0350 0319 0290 0263 0239 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

(n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

11% 0901 0812 0731 0659 0593 0535 0482 0434 0391 0352 0317 0286 0258 0232 0209

12% 0893 0797 0712 0636 0567 0507 0452 0404 0361 0322 0287 0257 0229 0205 0183

13% 0885 0783 0693 0613 0543 0480 0425 0376 0333 0295 0261 0231 0204 0181 0160

14% 0877 0769 0675 0592 0519 0456 0400 0351 0308 0270 0237 0208 0182 0160 0140

15% 0870 0756 0658 0572 0497 0432 0376 0327 0284 0247 0215 0187 0163 0141 0123

16% 0862 0743 0641 0552 0476 0410 0354 0305 0263 0227 0195 0168 0145 0125 0108

17% 0855 0731 0624 0534 0456 0390 0333 0285 0243 0208 0178 0152 0130 0111 0095

18% 0847 0718 0609 0516 0437 0370 0314 0266 0225 0191 0162 0137 0116 0099 0084

19% 0840 0706 0593 0499 0419 0352 0296 0249 0209 0176 0148 0124 0104 0088 0074

20% 0833 0694 0579 0482 0402 0335 0279 0233 0194 0162 0135 0112 0093 0078 0065 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

[P.T.O.

Annuity Table
n Present value of an annuity of 1 i.e. 1 (1 + r) r

Where

r = discount rate n = number of periods Discount rate (r)

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1% 0990 1970 2941 3902 4853 5795 6728 7652 8566 9471 10368 11255 12134 13004 13865 11% 0901 1713 2444 3102 3696 4231 4712 5146 5537 5889 6207 6492 6750 6982 7191

2% 0980 1942 2884 3808 4713 5601 6472 7325 8162 8983 9787 10575 11348 12106 12849 12% 0893 1690 2402 3037 3605 4111 4564 4968 5328 5650 5938 6194 6424 6628 6811

3% 0971 1913 2829 3717 4580 5417 6230 7020 7786 8530 9253 9954 10635 11296 11938 13% 0885 1668 2361 2974 3517 3998 4423 4799 5132 5426 5687 5918 6122 6302 6462

4% 0962 1886 2775 3630 4452 5242 6002 6733 7435 8111 8760 9385 9986 10563 11118 14% 0877 1647 2322 2914 3433 3889 4288 4639 4946 5216 5453 5660 5842 6002 6142

5% 0952 1859 2723 3546 4329 5076 5786 6463 7108 7722 8306 8863 9394 9899 10380 15% 0870 1626 2283 2855 3352 3784 4160 4487 4772 5019 5234 5421 5583 5724 5847

6% 0943 1833 2673 3465 4212 4917 5582 6210 6802 7360 7887 8384 8853 9295 9712 16% 0862 1605 2246 2798 3274 3685 4039 4344 4607 4833 5029 5197 5342 5468 5575

7% 0935 1808 2624 3387 4100 4767 5389 5971 6515 7024 7499 7943 8358 8745 9108 17% 0855 1585 2210 2743 3199 3589 3922 4207 4451 4659 4836 4988 5118 5229 5324

8% 0926 1783 2577 3312 3993 4623 5206 5747 6247 6710 7139 7536 7904 8244 8559 18% 0847 1566 2174 2690 3127 3498 3812 4078 4303 4494 4656 4793 4910 5008 5092

9% 0917 1759 2531 3240 3890 4486 5033 5535 5995 6418 6805 7161 7487 7786 8061 19% 0840 1547 2140 2639 3058 3410 3706 3954 4163 4339 4486 4611 4715 4802 4876

10% 0909 1736 2487 3170 3791 4355 4868 5335 5759 6145 6495 6814 7103 7367 7606 20% 0833 1528 2106 2589 2991 3326 3605 3837 4031 4192 4327 4439 4533 4611 4675 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

End of Question Paper

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