Financial management paper f9 revision question bankF9FM RQB qs d08

REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Question COMPANY OBJECTIVES Justify and criticise the usual assumption made in financial management literature that the objective of a company is to maximise the wealth of the shareholders (Do not consider how this wealth is to be measured) Outline other goals that companies claim to follow, and explain why these might be adopted in preference to the maximisation of shareholder wealth (20 marks) Question NON-FINANCIAL OBJECTIVES What non-financial objectives might organisations have? In your answer, identify any stakeholder group that may have a non-financial interest (12 marks) Question STAKEHOLDERS Private sector companies have multiple stakeholders who are likely to have divergent interests Required: (a) Identify five stakeholder groups and briefly discuss their financial and other objectives (12 marks) (b) Examine the extent to which good corporate governance procedures can help manage the problems arising from the divergent interests of multiple stakeholder groups in private sector companies in the UK (13 marks) (25 marks) Question NOT-FOR-PROFIT Discuss the nature of the financial objectives that may be set in a not-for-profit organisation such as a charity or a hospital (8 marks) Question TAGNA Tagna is a medium-sized company that manufactures luxury goods for several well-known chain stores In real terms, the company has experienced only a small growth in turnover in recent years, but it has managed to maintain a constant, if low, level of reported profits by careful control of costs It has paid a constant nominal (money terms) dividend for several years and its managing director has publicly stated that the primary objective of the company is to increase the wealth of shareholders Tagna is financed as follows: Overdraft 10 year fixed interest bank loan Share capital and reserves $m 1·0 2·0 4·5 ––– 7·5 ––– FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Tagna has the agreement of its existing shareholders to make a new issue of shares on the stock market but has been informed by its bank that current circumstances are unsuitable The bank has stated that if new shares were to be issued now they would be significantly under-priced by the stock market, causing Tagna to issue many more shares than necessary in order to raise the amount of finance it requires The bank recommends that the company waits for at least six months before issuing new shares, by which time it expects the stock market to have become strong-form efficient The financial press has reported that it expects the Central Bank to make a substantial increase in interest rate in the near future in response to rapidly increasing consumer demand and a sharp rise in inflation The financial press has also reported that the rapid increase in consumer demand has been associated with an increase in consumer credit to record levels Required: (a) Discuss the meaning and significance of the different forms of market efficiency (weak, semi-strong and strong) and comment on the recommendation of the bank that Tagna waits for six months before issuing new shares on the stock market (9 marks) (b) On the assumption that the Central Bank makes a substantial interest rate increase, discuss the possible consequences for Tagna in the following areas: (i) (ii) (iii) (c) sales; operating costs; and, earnings (profit after tax) (10 marks) Explain and compare the public sector objective of “value for money” and the private sector objective of “maximisation of shareholder wealth” (6 marks) (25 marks) Question MONOPOLY An important element in the economic and financial management environment of companies is the regulation of markets to discourage monopoly Required: Outline the economic problems caused by monopoly and explain the role of government in maintaining competition between companies (9 marks) Question EFFICIENT MARKET HYPOTHESIS Explain the meaning of the term “Efficient Market Hypothesis” and discuss the implications for a company if the stock market on which it is listed has been found to be semi-strong form efficient (9 marks) REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Question BURLEY PLC (a) Burley plc, a manufacturer of building products, mainly supplies the wholesale trade It has recently suffered falling demand due to economic recession, and thus has spare capacity It now perceives an opportunity to produce designer ceramic tiles for the home improvement market It has already paid $0.5m for development expenditure, market research and a feasibility study The analysis reveals scope for selling 150,000 boxes per annum over a five-year period at an initial price of $20 per box Estimated operating costs, largely based on experience, are as follows: Cost per box of tiles ($) (at today’s prices): Material cost Direct labour Variable overhead Fixed overhead (allocated) Distribution, etc 8.00 2.00 1.50 1.50 2.00 Production can take place in existing facilities although initial re-design and set-up costs would be $2m after allowing for all relevant tax reliefs Returns from the project would be taxed at 33% Burley’s shareholders require a nominal return of 14% per annum, which includes allowance for generally-expected inflation of 5.5% per annum It can be assumed that all operating cash flows will inflate at 5.5% Required: Assess the financial desirability of this venture, finding both the Net Present Value and the Internal Rate of Return (to the nearest 1%) offered by the project Note: Assume no tax delay (7 marks) (b) Briefly explain the purpose of sensitivity analysis in relation to project appraisal, indicating the drawbacks with this procedure (6 marks) (c) Determine the values of (i) (ii) price volume at which the project’s NPV becomes zero Discuss your results, suggesting appropriate management action (7 marks) (20 marks) FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Question DEIGHTON PLC You are the chief accountant of Deighton plc, which manufactures a wide range of building and plumbing fittings It has recently taken over a smaller unquoted competitor, Linton Ltd Deighton is currently checking through various documents at Linton’s head office, including a number of investment appraisals One of these, a recently rejected application involving an outlay on equipment of $900,000, is reproduced below It was rejected because it failed to offer Linton’s target return on investment of 25% (average profit to-initial investment outlay) Closer inspection reveals several errors in the appraisal Evaluation of profitability of proposed project NT17 (all values in nominal terms) Item ($000) Sales Materials Direct labour Overheads Interest Depreciation Profit pre-tax Tax at 33% Post-tax profit Outlay Inventory Equipment Market research 1,400 (400) (400) (100) (120) (225) 155 (51) 104 1,600 (450) (450) (100) (120) (225) 255 (84) 171 1,800 (500) (500) (100) (120) (225) 355 (117) 238 1,000 (250) (250) (100) (120) (225) 55 (18) 37 (100) (900) (200) _ (1,200) _ Rate of return = Average profit 138 = 11.5% = 1,200 Investment You discover the following further details: (1) Linton’s policy was to finance both working capital and fixed investment by a bank overdraft A 12% interest rate applied at the time of the evaluation (2) A 25% writing down allowance (WDA) on a reducing balance basis is offered for new investment Linton’s profits are sufficient to utilise fully this allowance throughout the project (3) Corporate tax is paid a year in arrears (4) Of the overhead charge, about half reflects absorption of existing overhead costs (5) The market research was actually undertaken to investigate two proposals, the other project also having been rejected The total bill for all this research has already been paid (6) Deighton itself requires a nominal return on new projects of 20% after taxes, is currently ungeared and has no plans to use any debt finance in the future REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Required: Write a report to the finance director in which you: (a) Identify the mistakes made in Linton’s evaluation (b) Restate the investment appraisal in terms of the post-tax net present value to Deighton, recommending whether the project should be undertaken or not (10 marks) (10 marks) (20 marks) Question 10 BLACKWATER PLC Blackwater plc, a manufacturer of speciality chemicals, has been reported to the anti-pollution authorities on several occasions in recent years, and fined substantial amounts for making excessive toxic discharges into local rivers Both the environmental lobby and Blackwater’s shareholders demand that it clean up its operations It is estimated that the total fines it may incur over the next four years can be summarised by the following probability distribution (all figures are expressed in present values): Level of fine $0.5m $1.4m $2.0m Probability 0.3 0.5 0.2 Filta & Strayne Ltd (FSL), a firm of environmental consultants; has advised that new equipment costing $1m can be installed to virtually eliminate illegal discharges Unlike fines, expenditure on pollution control equipment is tax-allowable via a 25% writing-down allowance (reducing balance) The rate of corporate tax is 33%, paid with a one-year delay The equipment will have no resale value after its expected four-year working life, but can be in full working order immediately prior to Blackwater’s next financial year A European Union Common Pollution Policy grant of 25% of gross expenditure is available, but with payment delayed by a year Immediately on receipt of the grant from the EU, Blackwater will pay 20% of the grant to FSL as commission These transactions have no tax implications for Blackwater A disadvantage of the new equipment is that it will raise production costs by $30 per tonne over its operating life Current production is 10,000 tonnes per annum, but expected to grow by 5% per annum compound It can be assumed that other production costs and product price are constant over the next four years No change in working capital is envisaged Blackwater applies a discount rate of 12% after all taxes to investment projects of this nature All cash inflows and outflows occur at year ends Required: (a) Calculate the expected net present value of the investment assuming a four-year operating period Briefly comment on your results (12 marks) (b) Write a memorandum to Blackwater’s management as to the desirability of the project, taking into account both financial and non-financial criteria (8 marks) (20 marks) FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Question 11 ARR AND PAYBACK (a) Explain and illustrate (using simple numerical examples) the Accounting Rate of Return and Payback approaches to investment appraisal, paying particular attention to the limitations of each approach (6 marks) (b) (i) Explain the differences between NPV and IRR as methods of Discounted Cash Flow analysis (6 marks) (ii) A company with a cost of capital of 14% is trying to determine the optimal replacement cycle for the laptop computers used by its sales team The following information is relevant to the decision: The cost of each laptop is $2,400 Maintenance costs are payable at the end of each full year of ownership, but not in the year of replacement e.g if the laptop is owned for two years, then the maintenance cost is payable at the end of year Interval between Replacement (years) Trade-in Value ($) Maintenance cost ($) 1200 800 300 Zero 75 (payable at end of Year 1) 150 (payable at end of Year 2) Required: Ignoring taxation, calculate the equivalent annual cost of the three different replacement cycles, and recommend which should be adopted What other factors should the company take into account when determining the optimal cycle? (8 marks) (20 marks) Question 12 LEAMINGER PLC Leaminger plc has decided it must replace its major turbine machine on 31 December 2002 The machine is essential to the operations of the company The company is, however, considering whether to purchase the machine outright or to use lease financing Purchasing the machine outright The machine is expected to cost $360,000 if it is purchased outright, payable on 31 December 2002 After four years the company expects new technology to make the machine redundant and it will be sold on 31 December 2006 generating proceeds of $20,000 Capital allowances for tax purposes are available on the cost of the machine at the rate of 25% per annum reducing balance A full year’s allowance is given in the year of acquisition but no writing down allowance is available in the year of disposal The difference between the proceeds and the tax written down value in the year of disposal is allowable or chargeable for tax as appropriate Leasing The company has approached its bank with a view to arranging a lease to finance the machine acquisition The bank has offered two options with respect to leasing which are as follows: Contract length (years) Annual rental First rent payable Finance Lease $135,000 31 December 2003 Operating Lease $140,000 31 December 2002 REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) General For both the purchasing and the finance lease option, maintenance costs of $15,000 per year are payable at the end of each year All lease rentals (for both finance and operating options) can be assumed to be allowable for tax purposes in full in the year of payment Assume that tax is payable one year after the end of the accounting year in which the transaction occurs For the operating lease only, contracts are renewable annually at the discretion of either party Leaminger plc has adequate taxable profits to relieve all its costs The rate of corporation tax can be assumed to be 30% The company’s accounting year-end is 31 December The company’s annual after tax cost of capital is 10% Required: (a) Calculate the net present value at 31 December 2002, using the after tax cost of capital, for (i) purchasing the machine outright; (ii) using the finance lease to acquire the machine; and (iii) using the operating lease to acquire the machine Recommend the optimal method (b) (12 marks) Assume now that the company is facing capital rationing up until 30 December 2003 when it expects to make a share issue During this time the most marginal investment project, which is perfectly divisible, requires an outlay of $500,000 and would generate a net present value of $100,000 Investment in the turbine would reduce funds available for this project Investments cannot be delayed Calculate the revised net present values of the three options for the turbine given capital rationing Advise whether your recommendation in (a) would change (5 marks) (c) As their business advisor, prepare a report for the directors of Leaminger plc that assesses the issues that need to be considered in acquiring the turbine with respect to capital rationing (8 marks) (25 marks) Question 13 BASRIL PLC Basril plc is reviewing investment proposals that have been submitted by divisional managers The investment funds of the company are limited to $800,000 in the current year Details of three possible investments, none of which can be delayed, are given below Project An investment of $300,000 in work station assessments Each assessment would be on an individual employee basis and would lead to savings in labour costs from increased efficiency and from reduced absenteeism due to work-related illness Savings in labour costs from these assessments in money terms are expected to be as follows: Year Cash flows ($000) 85 90 95 100 95 Project An investment of $450,000 in individual workstations for staff that is expected to reduce administration costs by $140,800 per annum in money terms for the next five years FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Project An investment of $400,000 in new ticket machines Net cash savings of $120,000 per annum are expected in current price terms and these are expected to increase by 3·6% per annum due to inflation during the five-year life of the machines Basril plc has a money cost of capital of 12% and taxation should be ignored Required: (a) Determine the best way for Basril plc to invest the available funds and calculate the resultant NPV: (i) on the assumption that each of the three projects is divisible; (ii) on the assumption that none of the projects are divisible (10 marks) (b) Explain how the NPV investment appraisal method is applied in situations where capital is rationed (3 marks) (c) Discuss the reasons why capital rationing may arise (d) Discuss the meaning of the term “relevant cash flows” in the context of investment appraisal, giving examples to illustrate your discussion (5 marks) (7 marks) (25 marks) Question 14 LKL PLC LKL plc is a manufacturer of sports equipment and is proposing to start project VZ, a new product line This project would be for the four years from the start of year 19X1 to the end of 19X4 There would be no production of the new product after 19X4 You have recently joined the company’s accounting and finance team and have been provided with the following information relating to the project: Capital expenditure A feasibility study costing $45,000 was completed and paid for last year This study recommended that the company buy new plant and machinery costing $1,640,000 to be paid for at the start of the project The machinery and plant would be depreciated at 20% of cost per annum and sold during year 19X5 for $242,000 receivable at the end of 19X5 As a result of the proposed project it was also recommended that an old machine be sold for cash at the start of the project for its book value of $16,000 This machine had been scheduled to be sold for cash at the end of 19X2 for its book value of $12,000 REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Other data relating to the new product line: 19X1 $000 1,000 84 Sales Receivables (at the year end) Lost contribution on existing products 30 Purchases 400 Payables (at the year end) 80 Payments to sub-contractors, 60 including prepayments of Net tax payable associated with this project 96 Fixed overheads and advertising: With new line 1,330 Without new line 1,200 19X2 $000 1,300 115 19X3 $000 1,500 140 19X4 $000 1,800 160 40 500 100 90 10 40 580 110 80 36 620 120 80 142 174 275 1,100 1,000 990 900 900 800 Notes − − − − − The year-end receivables and payables are received and paid in the following year The net tax payable has taken into account the effect of any capital allowances There is a one year time-lag in the payment of tax The company’s cost of capital is a constant 10% per annum It can be assumed that operating cash flows occur at the year end Apart from the data and information supplied there are no other financial implications after 19X4 Labour costs From the start of the project, three employees currently working in another department and earning $12,000 each would be transferred to work on the new product line, and an employee currently earning $20,000 would be promoted to work on the new line at a salary of $30,000 per annum The effect of the transfer of employees from the other department to the project is included in the lost contribution figures given above As a direct result of introducing the new product line, four employees in another department currently earning $10,000 each would have to be made redundant at the end of 19X1 and paid redundancy pay of $I5,500 each at the end of 19X2 Agreement had been reached with the trade unions for wages and salaries to be increased by 5% each year from the start of 19X2 Material costs Material XNT which is already in inventory, and for which the company has no other use, cost the company $6,400 last year, and can be used in the manufacture of the new product If it is not used the company would have to dispose of it at a cost to the company of $2,000 in 19X1 Material XPZ is also in inventory and will be used on the new line It cost the company $11,500 some years ago The company has no other use for it, but could sell it on the open market for $3,000 in 19X1 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Required: (a) Prepare and present a cash flow budget for project VZ, for the period 19X1 to 19X5 and calculate the net present value of the project (14 marks) (b) Write a short report for the board of directors which: (c) (i) explains why certain figures which were provided in (a) were excluded from your cash flow budget, and (ii) advises them on whether or not the project should be undertaken, and lists other factors which would also need to be considered (7 marks) LKL needs to raise $5 million to finance project VZ, and other new projects The proposed investment of the $5 million is expected to yield pre-tax profits of $2 million per annum Earnings on existing investments are expected to remain at their current level From the data supplied below: Statement of Financial Position (extract from last year): Authorised share capital Ordinary shares of 50c each $000 20,000 _ Issued ordinary share capital, Shares of 50c each Reserves 10% Debentures (19X4) Bank Overdraft (secured) 2,500 4,000 2,000 2,000 _ 10,500 _ Other information: Turnover Net profit after interest and tax Interest paid Dividends paid and proposed $000 55,000 3,000 200 800 The 50c ordinary shares are currently quoted at $2.25 per share: The company’s tax rate is 33% The average gearing percentage for the industry in which the company operates is 35% (computed as debt as a percentage of debt plus equity, based on book values, and excluding bank overdrafts) (i) Calculate and comment briefly on the company’s current capital gearing Discuss briefly the effect on gearing and EPS at the end of the first full year following the new investment if the $5 million new finance is raised in each of the following ways; (ii) By issuing ordinary shares at $2 each (iii) By issuing 5% convertible loan stock, convertible in 19X4 The conversion ratio is 40 shares per $ 100 of loan stock (iv) By issuing 7.5% undated debentures (You should ignore issue costs in your answers to parts (ii) – (iv)) (14 marks) (35 marks) 10 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Required: (a) Prepare a monthly cash budget for the period from January to April 2006 Your budget must clearly indicate each item of income and expenditure, and the opening and closing monthly cash balances (10 marks) (b) Discuss the factors to be considered by Thorne Co when planning ways to invest any cash surplus forecast by its cash budgets (5 marks) (c) Discuss the advantages and disadvantages to Thorne Co of using overdraft finance to fund any cash shortages forecast by its cash budgets (5 marks) (d) Explain how the Baumol model can be employed to reduce the costs of cash management and discuss whether the Baumol cash management model may be of assistance to Thorne Co for this purpose (5 marks) (25 marks) Question 46 MERTON PLC The following financial information relates to Merton plc, a supplier of photographic equipment and film services to the film industry Income Statement for years ended 30 April Turnover Cost of sales Operating expenses Operating profit Interest Profit before tax Taxation Profit after tax Dividends Share price at 30 April: 48 2006 $m 160·0 120·0 ––––– 40·0 30·0 ––––– 10·0 3·6 ––––– 6·4 1·9 ––––– 4·5 1·5 ––––– 3·0 ––––– $2·70 2005 $m 145·0 105·3 ––––– 39·7 26·0 ––––– 13·7 3·3 ––––– 10·4 3·1 ––––– 7·3 1·7 ––––– 5·6 ––––– $5·11 2004 $m 132·0 95·7 ––––– 36·3 23·5 ––––– 12·8 3·3 ––––– 9·5 2·8 ––––– 6·7 1·6 ––––– 5·1 ––––– $4·69 REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Statement of Financial Position as at 30 April Fixed assets Current assets Inventory Receivables Cash Current liabilities Trade payables Overdraft Net current assets Total assets less current liabilities Long-term liabilities 10% debentures 2008 8% debentures 2013 Capital and reserves Ordinary shares (50 cents par) Reserves $m 2006 $m $m 45 $m 36 41 ––– 78 17 ––– 25 ––– 13 25 ––– 2005 $m $m 35 32 24 16 ––– 72 11 ––– 53 ––– 98 38 ––– 60 ––– 10 50 ––– 60 ––– 12 ––– 13 25 ––– 60 ––– 95 38 ––– 57 ––– 10 47 ––– 57 ––– Notes: All sales are on credit Merton currently pays interest on its overdraft at an annual rate of 4%, although this rate is variable Shareholders of Merton plc have been alarmed by the company’s recent announcement that it intends to cut the total dividend for the year The announcement, which was released on June 2006, also said that Merton plc is considering expanding into the retail camera market, as a result of which it expects future share price growth and dividend growth to be at least 8% per year Following the announcement, the company’s share price fell from $2·70 to $2·45 (on an ex dividend basis) where it has remained The Board of Merton plc has not announced how it plans to finance the proposed expansion into the retail camera market, but it believes that the additional capital needed would be at least $19 million It also believes that the expansion will generate an after-tax return of 9% per year The newly-appointed Finance Director has suggested a rights issue to finance the proposed expansion, but he is concerned that the recent fall in the company’s share price may cause many shareholders to decide against taking up their rights Merton plc has not issued any new shares for the last three years The Finance Director believes that a rights issue would be a for rights issue at a 20% discount to the current share price The rights issue would be underwritten by the issuing house for a fee of $300,000 49 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK The Finance Director decided when taking up his appointment that substantial improvement was needed in the area of working capital management and asked the factoring subsidiary of a major bank to provide a quotation for non-recourse factoring The factor has indicated that it would require an annual fee of 0·5% of sales It would advance Merton plc 80% of the face value of sales at an interest rate 1% above the current overdraft rate It expects the average time taken by customers to pay to fall immediately to 75 days, with a reduction to no more than the average for the sector within two years The Finance Director has also been assured that bad debts, currently standing at $500,000 per year, would fall by 80% Savings in current administration costs of Merton plc of $100,000 per year would be achieved as a result of factoring The Finance Director has collected the following average data for the media sector: Return on capital employed Gross profit margin Net profit margin Interest cover Gearing (debt/equity using book values) 12% 25% 8% times 50% Inventory days Receivables days Payables days Current ratio Quick ratio 100 days 60 days 50 days 3·5 times 2·5 times Required: (a) Using appropriate ratios and financial analysis, comment on: (i) the view of the Finance Director that substantial improvement is needed in the area of working capital management of Merton plc; (10 marks) (ii) the recent financial performance of Merton plc from a shareholder perspective Clearly identify any issues that you consider should be brought to the attention of the ordinary shareholders (15 marks) (b) Determine whether the factoring company’s offer can be recommended on financial grounds Assume a working year of 365 days and base your analysis on financial information for 2006 (8 marks) (c) Calculate the theoretical ex rights price per share and the net funds to be raised by the rights issue, and determine and discuss the likely effect of the proposed expansion on: (i) (ii) the current share price of Merton plc; the gearing of the company Assume that the price–earnings ratio of Merton plc remains unchanged at 12 times (11 marks) (d) Calculate the ex dividend share price predicted by the dividend growth model and discuss the company’s view that share price growth of at least 8% per year would result from expanding into the retail camera market Assume a cost of equity capital of 11% per year (6 marks) (50 marks) 50 REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Question 47 ARG CO (a) Included in the receivables of ARG Co is an expected receipt of $500,000 in three months’ time The following exchange rates are available: Spot Three months forward $/£ 1·7642 – 1·7962 1·7855 – 1·8174 Explain why ARG Co might wish to hedge its expected three-month dollar receipt using the forward market and calculate the sterling value arising from a forward market hedge (4 marks) (b) Discuss how bills of exchange can be used to reduce the risk associated with the overseas receivables of ARG Co (4 marks) (8 marks) Question 48 VERTID LTD In an attempt to recover from the economic recession, Vertid Ltd, a company employing 30 workers in the UK Midlands, is starting to trade with two foreign countries, Werland and Thodia Competitively priced components have been purchased from Werland, with payment of 3,000,000 Werland francs due in three months time Goods have been sold to Thodia and receipts of 3,500,000 Thodian pesos are due to be received in six months time The managing director of Vertid is concerned that the company cannot afford to lose money on the two deals, as the company’s poor cash flow situation has been the subject of recent discussions with the company’s bank Vertid’s overdraft is currently approaching its agreed limit, and the bank has indicated that it is unlikely that the overdraft facility will be increased in the near future The managing director asked his sales manager for a brief report discussing the likely foreign exchange risk to be faced when trading with Werland and Thodia The sales manager has stated that there is likely to be substantial foreign exchange risk in trading with Werland, but little risk in trading with Thodia, whose currency is directly linked to the US dollar The US dollar in recent months has been quite stable relative to sterling: Exchange rates Spot market 290 – 294 Werland francs per £ 1.4640 – 1.4690 $US per £ 220 – 228 Thodian pesos per $US Forward market $US per £ months forward 0.98 – 1.15 cents dis months forward 1.70 – 1.86 cents dis No forward market exists for the Werland franc or Thodian peso 51 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Current inflation rates United Kingdom US Werland Thodia 3% 6% 12% 20% Current annual interest rates that are available to Vertid £ sterling $US Werland francs Thodian pesos Investing 4.5% 6% 12.5% 15% Borrowing 10% 12% – – OTC European currency call options are available for Werland francs at a premium of 25 francs per £ with an exercise price of 300 francs per £ and a three month maturity date The managing director of Vertid wishes to develop a strategy for: (i) (ii) protecting against any form of risk that these deals involve; financing the overseas trade deals Required: You have been asked as a consultant to: (a) Explain whether or not the views of the sales manager regarding exchange risk are likely to be correct (9 marks) (b) Prepare a report discussing how the managers of Vertid might protect the company against all of the risks of each of the foreign deals Relevant calculations should support your report (25 marks) (c) Outline what alternatives might be available to Vertid Ltd to finance the two trade deals (6 marks) (40 marks) Question 49 GITLOR At a luncheon meeting the managing director of Gitlor plc has told two of his colleagues, who hold senior executive positions in different companies, that he has recently obtained from his bank forecasts of exchange rates in one year’s time His two colleagues also work for companies that are heavily engaged in international trade, and both agree to obtain their own forecasts The following week the three again meet for lunch and compare the forecasts made by their banks These forecasts are shown below: $ per Euro £ per Euro Yen per $ $ per £ Bank 0·76 0·56 120 1·36 Bank 0·84 0·64 140 1·31 Bank 1·00 0·65 140 1·54 Current spot rates 0·88 0·62 125 1·42 US UK Euro bloc Japan Annual inflation rates 3% 2% 3% (1%) Annual short-term interest rates 3·25% 4·75% 4·18% 0·01% The three senior executives are puzzled by this information 52 REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Required: Prepare a report discussing and analysing the above information, and explaining why the banks’ forecasts might differ Your analysis should include calculations based upon inflation rates and interest rates Discuss in the report the mechanisms influencing future exchange rates and whether or not it is possible to accurately forecast such future exchange rates, and if so under what circumstances (15 marks) Question 50 INTEREST RATE MANAGEMENT (a) Discuss the advantages of hedging with interest rate caps and collars (b) Explain the possible benefits to a company of undertaking an interest rate swap (4 marks) (6 marks) (10 marks) Question 51 ENDESS LTD An entrepreneur wishes to undertake a buy-in of Endess Ltd The entrepreneur will have 60% ownership of the share capital and other investors, (including some existing management) 40% Endess’ accountant has recently read the valuation chapter in a finance textbook and suggests two valuations using methods in the book Method This is the average of: (i) the realisable value of the net assets of the company; (ii) the estimated maintainable profits of the company capitalised at a rate of 16% Maintainable profits are to be based upon the average pre-tax profit of the last two years Method This requires an agreed “normal” pre-tax rate of return, in this case 15%, to be applied to the realisable value of net assets to establish “normal” profits These profits are then compared with the expected average annual pre-tax profits over the next two years If expected profits are higher, this difference is regarded as Economic Value Added (EVA®) and the price to be paid will be the net assets price plus three years of EVA® 53 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Endess has supplied the following data from the last two years: Income Statements year ending 31 March 20X2 $000 1,940 1,410 _ 20X3 $000 2,175 1,550 _ Gross profit Distribution costs Administrative expenses Interest payable 530 85 120 84 _ 625 100 140 78 _ Profit before tax Taxation 241 70 _ 307 92 _ Profit after tax 171 _ 215 _ Turnover Cost of goods sold Statements of Financial Position as at 31 March Fixed assets Land and buildings Plant and equipment (net) Current assets Inventory Receivables Cash Current liabilities Trade payables Overdraft Tax payable Financed by Ordinary shares (25 cents) Reserves Term loan (five years) 54 $000 20X2 $000 $000 20X3 $000 340 580 _ 340 540 _ 920 880 410 570 20 _ 560 785 15 _ 1,000 340 250 50 _ 1,360 430 320 110 _ 640 _ 860 _ 1,280 _ 1,380 _ 300 630 _ 300 730 _ 930 350 _ 1,030 350 _ 1,280 _ 1,380 _ REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Additional information (i) Profit before tax is expected to grow at approximately 10% per year (ii) The existing directors who own 95% of the shares declared dividends of $115,000 in the latest financial year, and $71,000 in 20X2 (iii) The average earnings yield of AIM listed companies in the same industry as Endess is 12% per year, and average earnings per share 20 cents (iv) The value of freehold land and buildings (never revalued) has fallen by 25% since purchased due to the recession (v) The entrepreneur hopes to be able to pay off all of the company’s existing loans (vi) Endess’ cost of equity is estimated to be 18% (vii) The replacement cost of plant and equipment is $600,000 but its current realisable value is $450,000 (viii) $75,000 of inventory is obsolete and could only be sold for $3,000 as scrap Required: (a) Estimate the purchase price of Endess Ltd using each of these two methods (b) Acting as an adviser to the entrepreneur, prepare a short report discussing the advantages and disadvantages of each of these two methods (4 marks) (c) Prepare, and critically discuss two additional valuations of Endess for your client, and give a reasoned recommendation as to what value the entrepreneur should be prepared to pay (7 marks) Question 52 NICK NASOM CARS (6 marks) (17 marks) Alf Tighs is the managing director of Sutcha and Sutcha plc, a large advertising company As well as having entrepreneurial skills in advertising, Alf is also a car enthusiast In particular he has a passion for old Italian sports cars and it is this passion that has resulted in a business opportunity for the firm At a recent party Alf discovered that Nick Nasom, drummer with the famous rock group Plink Void, owned a garage that imported Italian sports cars Furthermore, Nick was keen to sell the business to give more time for writing rock operas Alf feels that this is an opportunity not to be missed and that Sutcha and Sutcha should buy the garage Summary financial statements are as follows 55 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Statement of Financial Position as at 31 December 20X6 Fixed assets Freehold garage (NBV) Pumps, desks, etc (NBV) Inventory of Italian sports cars (at cost) Shares in British Car Auctions Ltd (at cost) Other net current assets Bank loan $000 Note 100 —— 108 200 10 27 —— 345 (50) —— 295 —— Income statement for the year ended 31 December 20X6 Gross profit on garage (excluding car sales) Profit on disposal of cars Dividends received from BCA Interest payable Notes $000 40 100 (8) —— 133 —— Note (1) The freehold garage is currently worth $150,000 or could be leased for approximately $15,000 per annum (2) Other fixed assets have a net realisable value of $2,000 (3) The current inventory of sports cars comprises two vehicles (i) (ii) 1963 Masoringhi 365 1970 Ferrati Beano 246 – cost $120,000 – cost $80,000 Both models are extremely rare so it is difficult to estimate current value The last time a Masoringhi sold was three years ago for $200,000 Unfortunately the classic car market has been depressed since then As for the Ferrati Beano, prices reached $500,000 five years ago but a similar car fetched $130,000 at an auction six months ago (4) The BAC Ltd shares are currently valued at $25,000 (5) The profit on car disposals relates to six cars which Nick sold to rock musician friends over the last year In fact the majority of purchases and sales occur with music industry colleagues 56 REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Like most garages dealing with old sports cars, Nick’s firm is unquoted Some P/E ratios for large firms in the car industry are given below Company P/E Volvo Evans Halshaw Lex Service Kwik-Fit (Sutcha and Sutcha 13 17 16 20) Market capitalisation $m 4,000 136 332 287 Business Car manufacturer Car dealer and garage services Car dealer and garage services Exhausts, suspensions, tyres, etc Required: Calculate the value of the garage business using the following techniques (i) (ii) (iii) Net book value of assets less liabilities Net realisable value of assets less liabilities Applying a suitable P/E ratio to the earnings of the business For each technique detail any reservations you have with the figures used (15 marks) Question 53 ASSOCIATED INTERNATIONAL SUPPLIES LTD The following are summary financial statements for Associated International Supplies Ltd Fixed Assets Current Assets Current Liabilities Long Term Liabilities Total Capital and Reserves 1994 $000 115 650 513 42 210 210 1999 $000 410 1,000 982 158 270 270 Sales Cost of sales, expenses and interest Profit before tax Tax and distributions Retained earnings 1994 $000 1,200 1,102 98 33 65 1999 $000 3,010 2,860 150 133 17 Notes: Cost of sales was $530,000 for 1994 and $1,330,000 for 1999 Receivables are 50% of current assets and trade payables are 25% of current liabilities for both years 57 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Required: (a) You are a consultant advising Associated International Supplies Ltd Using suitable financial ratios, and paying particular attention to growth and liquidity, write a report on the significant changes faced by the company since 1994 The report should also comment on the capacity of the company to continue trading, together with any other factors considered appropriate An appendix to the report should be used to outline your calculations (b) (17 marks) Explain and evaluate the sources of finance available to small businesses for fixed assets (8 marks) (25 marks) 58 REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) ACCA Pilot Paper – Questions ALL FOUR questions are compulsory and MUST be attempted 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 Statement of Financial Position for the last year $000 7,000 (500) –––––– 6,500 (1,950) –––––– 4,550 –––––– $000 Non-current assets Current assets Total assets 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 5,000 22,500 –––––– 5,000 2,500 –––––– $000 20,000 20,000 –––––– 40,000 –––––– 27,500 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 existing loan notes are secured on the 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 59 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Required: (a) Calculate the current weighted average cost of capital of Droxfol Co (9 marks) (b) Discuss whether financial management theory suggests that Droxfol Co can reduce its weighted average cost of capital to a minimum level (8 marks) (c) 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) (iii) interest coverage ratio; financial gearing; earnings per share Assume that the dividend growth rate of 4% is unchanged (8 marks) (25 marks) Nedwen Co is a UK-based company which has the following expected transactions One month: One month: Three months: Expected receipt of $240,000 Expected payment of $140,000 Expected receipts of $300,000 The finance manager has collected the following information: Spot rate ($ per £): One month forward rate ($ per £): Three months forward rate ($ per £): 1.7820 ± 0.0002 1.7829 ± 0.0003 1.7846 ± 0.0004 Money market rates for Nedwen Co: One year sterling interest rate: One year dollar interest rate: Borrowing 4.9% 5.4% Deposit 4.6 5.1 Assume that it is now May Required: (a) Discuss the differences between transaction risk, translation risk and economic risk (6 marks) (b) Explain how inflation rates can be used to forecast exchange rates (c) Calculate the expected sterling receipts in one month and in three months using the forward market (3 marks) (d) Calculate the expected sterling receipts in three months using a money-market hedge and recommend whether a forward market hedge or a money market hedge should be used (5 marks) (e) Discuss how sterling currency futures contracts could be used to hedge the three-month dollar receipt (5 marks) (6 marks) (25 marks) 60 REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9) Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit, although customers on average take ten days more than this to pay Contribution represents 60% of sales and the company currently has no bad debts Accounts receivable are financed by an overdraft at an annual interest rate of 7% Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days and to extend the maximum credit offered to 60 days The company expects that these changes will increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of turnover The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay Required: (a) Evaluate whether the proposed changes in credit policy will increase the profitability of Ulnad Co (6 marks) (b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of $7,500 The average cost to the company of making deposits or selling investments is $18 per transaction and the standard deviation of its cash flows was $1,000 per day during the last year The average interest rate on investments is 5.11% Determine the spread, the upper limit and the return point for the cash account of Renpec Co using the Miller-Orr model and explain the relevance of these values for the cash management of the company (6 marks) (c) Identify and explain the key areas of accounts receivable management (6 marks) (d) Discuss the key factors to be considered when formulating a working capital funding policy (7 marks) (25 marks) 61 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Trecor Co plans to buy a new machine to meet expected demand for a new product, Product T This machine will cost $250,000 and last for four years, at the end of which time it will be sold for $5,000 Trecor Co expects demand for Product T to be as follows: Year Demand (units) 35,000 40,000 50,000 25,000 The selling price for Product T is expected to be $12.00 per unit and the variable cost of production is expected to be $7.80 per unit Incremental annual fixed production overheads of $25,000 per year will be incurred Selling price and costs are all in current price terms Selling price and costs are expected to increase as follows: Selling price of Product T: Variable cost of production: Fixed production overheads: Increase 3% per year 4% per year 6% per year Other information Trecor Co has a real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in arrears It can claim capital allowances on a 25% reducing balance basis General inflation is expected to be 5% per year The machine will be bought on the first day of a financial year Trecor Co has a target return on capital employed of 20% Depreciation is charged on a straight-line basis over the life of an asset Required: (a) Calculate the net present value of buying the new machine and comment on your findings (work to the nearest $1,000) (13 marks) (b) Calculate the before-tax return on capital employed (accounting rate of return) based on the average investment and comment on your findings (5 marks) (c) Discuss the strengths and weaknesses of internal rate of return in appraising capital investments (7 marks) (25 marks) 62 ... Blackwater’s management as to the desirability of the project, taking into account both financial and non -financial criteria (8 marks) (20 marks) FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Question. .. analysis of the current financial position and recent financial performance of the company (16 marks) (45 marks) 21 FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Question 22 AGD CO AGD Co... zero Discuss your results, suggesting appropriate management action (7 marks) (20 marks) FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK Question DEIGHTON PLC You are the chief accountant