Mock Examination : ACCA Paper P4

Advanced Financial Management

Session : June 2011

Set by : Mr Chow Kim Tai

Your Lecturer
‰ Mr Chow Kim Tai

Your Mailing Address : ______________________________________

______________________________________

Your Contact Number : ______________________________________

I wish to have my script marked by my lecturer and

‰ collect the marked script at the SAA-GE Reception Counter
‰ have the marked script returned to me by mail

(Please submit your script latest by 6th May 2011 for marking)

SAA GLOBAL EDUCATION CENTRE PTE LTD

Company Registration No. 201001206N
20 Aljunied Road, #01-04, CPA House,
Singapore 389805
Tel: (65) 6744 9700 Fax: (65) 6744 9796

Website: www.saa.org.sg Email: acca@saa.org.sg

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

PART 3

Advance Financial
Management

JUNE2011

1
Section A - BOTH questions are compulsory and MUST be attempted

Question 1 CNN

(a) Discuss the advantages and disadvantages of centralised treasury management

for multinational companies. (6 marks)

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

Assume that it is now mid-May.

Payments (read down)

Receipts (read across) UK Spain Hong Kong USA
UK – €210 $HK720 $US110
Spain £100 – €80 –
Hong Kong $HK400 – – –
USA $US430 €120 $HK300 –

Exchange rates
$US/£ €/£ $HK/£
Spot 1.4358 – 1.4366 1.6275 – 1.6292 11.1987 – 11.2050
3 months forward 1.4285 – 1.4300 1.6146 – 1.6166 11.1567 – 11.1602
1 year forward 1.4085 – 1.4100 1.6033 – 1.6047 11.0356 – 11.0444

Note:
The Hong Kong dollar is pegged against the US dollar.

Interest rates available to CNN and its subsidiaries (annual %)

Borrowing Investing
UK 6.9 6.0
Spain 5.3 4.5
Hong Kong n.a. 6.1
USA 6.2 5.4

Philadelphia SE $/£ options, £31,250 contracts (cents per pound)

Calls Puts
July August September July August September
1.42 1.42 2.12 2.67 0.68 1.42 2.15
1.43 0.88 1.60 1.79 1.14 1.92 3.12
1.44 0.51 1.19 1.42 1.77 2.51 4.35

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

Required

(i) The parent company is proposing that inter-company payments should be

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

2
 (ii) If payments were to continue to be made in various currencies, illustrate
three methods by which the UK parent company might hedge its
transaction exposures for the next four months.

Discuss, showing relevant calculations, which method should be selected.

Include in your discussion an evaluation of the circumstances in which
currency options would be the preferred choice.

(Note: CNN plc wishes to minimise the transaction costs of hedging.)

(15 marks)

(c) Ignore result of part (b)(ii), illustrate and discuss the possible outcomes of forward
market and currency options hedges for the dollar exposure if possible exchange
rates in four months’ time are either:

(i) $1.4280 – $1.4295/£

or (ii) $1.4400 – $1.4425/£. (8 marks)
(35 marks)

3
Question 2 Fuelit

Fuelit plc is an electricity supplier in the UK. The company has historically generated the majority
of its electricity using a coal fuelled power station but as a result of the closure of many coal
mines and depleted coal resources is now considering what type of new power station to invest
in. The alternatives are a gas fuelled power station or a new type of efficient nuclear power
station.

Both types of power station are expected to generate annual revenues at current prices of £800
million. The expected operating life of both types of power station is 25 years.

Financial estimates:
£ million
Gas Nuclear
Building costs 600 3,300
Annual running costs (at current prices):
Labour costs 75 20
Gas purchases 500 -
Nuclear fuel purchases - 10
Sales and marketing expenses 40 40
Customer relations 5 20
Interest expense 51 330
Other cash outlays 5 25
Accounting depreciation 24 132

Other information:
(i) Whichever power station is selected, electricity generation is scheduled to commence in
three years time.
(ii) If gas is used most of the workers at the existing coal fired station can be transferred to
the new power station. After tax redundancy costs are expected to total £4 million in year
four. If nuclear power is selected fewer workers will be required and after tax redundancy
costs will total £36 million also in year 4.
(iii) Both projects would be financed by Eurobond issues denominated in Euros. The gas
powered station would require a bond issue at 8.5% per year; the bond for the nuclear
project would have a debt beta of 0.58.
(iv) Costs of building the new power station would be payable in two equal installments in
one and two years’ time.
(v) The existing coal fired power station would need to be demolished at a cost of £10
million in three years time.
(vi) The company’s equity beta is expected to be 0.7 if the gas station is chosen and 1.4 if
the nuclear station is chosen. Gearing (debt to equity plus debt) is expected to be 35%
with gas and 60% with nuclear fuel.
(vii) The risk free rate is 4.5% per year and the market return is 14% per year. Inflation is
currently 3% per year in the UK.
(viii) Corporate tax is at the rate of 30% per year payable in the year that the liability arises.
(ix) Tax allowable depreciation is at a rate of 10% per year on a straight line basis.
(x) At the end of the twenty-five years of operations the gas plant is expected to cost £25
million (after tax) to demolish and clean up the site. Costs of decommissioning the
nuclear plant are much less certain and could be anything between £500 million and
£1000 million (after tax) depending upon what form of disposal is available for nuclear
waste.

4
Required

(a) Estimate the expected NPV of EACH of the investment in a gas fuelled power
station and investment in a nuclear fuelled power station.
State clearly any assumption that you make.
(20 marks)
(b) Discuss other information that might assist the decision process. (7 marks)

(c) Explain the significance of the existence of real options to the capital investment
decision and briefly discuss examples of real options that might be significant in
the power station decision process. (8 marks)
(35 marks)

5
Section B - TWO questions only to be answered

Question 3 Miller

Miller plc produces garden tools in its factories in East Anglia and the South East of England. It
has a large export market in South East Asia that it services by exporting from its British factories.
The availability of low cost real estate and a plentiful supply of relatively cheap labour have
caused the directors of Miller plc to consider setting up a manufacturing subsidiary in Thailand.
Miller evaluates investment opportunities using the NPV rule but some dispute has arisen over
the correct discount rate to use in evaluating the Thai project.

Miller plc is quoted on London’s AIM. It has an equity beta value of 1.25. The current annual
return on UK Treasury Bills is 5% and the expected return on the FT All-Share Index is 14%. Both
figures are after 25% UK corporation tax payable 12 months in arrears. The project would be
financed partly with a Euro15m five year floating rate 6urocurrency loan arranged through the
company’s bank at an interest rate of LIBOR +1%. Miller plc has a debt equity ratio, using market
values, of 25%. Miller has discovered that the main Thai manufacturer of similar products has an
equity beta of 1.4 and a debt to equity ratio (market values) of 50%.

Exchange rates
Spot €1.5950/£
6 months forward €1.5751/£

€ LIBOR is currently 5%.

Corporation tax in Thailand 40%.

Required

Advise the directors of Miller plc as to the discount rate they should use in the evaluation
of the Thai investment (15 marks)

6
Question 4 Toutplut

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

Pre-tax accounting profit 1 67 84

Taxation 23 29
---- ----
Profit after tax 44 55
Dividends 15 18
---- ----
Retained earnings 29 37

Balance sheet extracts for the year ending

2000 2001
Fixed assets 120 156
Net current assets 130 160
250 316
Financed by:
Shareholders’ funds 195 236
Medium and long-term bank loans 155 180
250 316

1 After deduction of the economic depreciation of the company’s fixed assets. This is also the
depreciation used for tax purposes.

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

Required

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

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

7
Question 5 Transfer Pricing

Shegdor plc, a UK based multinational company, has subsidiaries in three countries – Umgaba,
Mazila and Bettuna.

– The subsidiary in Umgaba manufactures specialist components, which may then

be assembled and sold in either Mazila or Bettuna.

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

– Manufacturing costs in Umgaba are $16 per unit and fixed costs (for the normal
range of production) $1·8 million.

– Assembly costs in Mazila are $9 per unit, and in Bettuna $7·5 per unit. Fixed
costs are $700,000 and $900,000 respectively.

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

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

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

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

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

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

Required

(a) Evaluate and explain

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

(ii) Whether assembly should take place in Mazila or Bettuna.

(10 marks)

(b) Comment upon the likely attitude of the governments of each of the four countries
towards the transfer price and assembly location selected in b (i) and b (ii) above.
(5 marks)
(15 marks)

- END OF QUESTION PAPER -