Financial management paper f9 monitoring tests F9FM mock1 as d08

Mock Financial Management F9FM-Mock1-Z08-A Answers & Marking Scheme Accountancy Tuition Centre Ltd ATC INTERNATIONAL AMBER (a) The expected number of passengers using the service is dependent upon the demand at each particular exchange rate At 1·52 Euro/£ expected demand At 1·54 Euro/£ expected demand At 1·65 Euro/£ expected demand = = = = = = (0·33·)(500 + 460 + 420) 460 (0·33·) (550 + 520 + 450) 506·67 (0·33·) (600 + 580 +500) 560 = = = = (0·2) (460) + (0.5) (506·67) + (0·3) (560) 92 + 253·33 + 168 513·3 per train 1026·7 per day The expected demand is thus: (b) WORKINGS 45% of passengers use the catering service, spending $4.50 per head on average Two trains are run daily, for 360 days per year This gives: Annual Revenue Costs Direct material Labour Year = = = 0.45(513.3) ($4.5) (2) (360) £748,440 £748,440/360 = £2,079 per day = = (0·55) (£748,440) £411,642 = = (0·1)(£748,440) £74,844 Rising by 5% per year, this gives: Year Year Year Year £78,586 £82,516 £86,641 £90,973 Variable overhead = = Purchase and insurance = = Less savings (0·12) (£748,440) £89,813 0·05 (£748,440) £37,422 (£21,000) _ £16,422 _  Accountancy Tuition Centre (International Holdings) Ltd 2008 Contract cost per year = (250)(360) = £90,000 Gross catering receipts are less than an average of £2,200 per day, therefore the 5% commission does not apply Contribution from the current service: Contribution £246,985 per year Cash Flows: In House Option Year Sales Variable costs Contribution Labour costs Purchase & insurance Asset purchase/disposal Net cash flow Discount Factor at 12% PRESENT VALUE 748,440 748,440 748,440 748,440 748,440 (501,455) (501,455) (501,455) (501,455) (501,455) 246,985 246,985 246,985 246,985 246,985 (74,844) (78,586) (82,516) (86,641) (90,973) (37,422) (37,422) (37,422) (37,422) (37,422) (500,000) 280,000 134,719 (369,023) 127,047 122,922 398,590 0·893 0·797 0·712 0·636 0·567 120,304 (294,111) 90,457 78,178 226,000 NET PRESENT VALUE = £220,828 Cash Flows: Contract Out Option Year Contract Fee Asset sale Fixed Costs Net Cash flow Discount Factor Present Value 650,000 (90,000) (90,000) (90,000) (90,000) (90,000) (16,422) (16,422) (16,422) (16,422) (16,422) 650,000 (106,422) (106,422) (106,422) (106,422) (106,422) 1·0 0·893 0·797 0·712 0·636 0·567 650,000 (95,035) (84,818) (75,772) (67,684) (60,341) NET PRESENT VALUE = £266,350 This option thus offers an NPV which is £45,522 greater than the in-house option Alternative Solution Differential cash flows: contracting out versus in-house provision Year Asset purchase/Sale 650,000 500,000 Lost contribution (246,985) (246,985) (246,985) (246,985) Fixed costs savings 95,844 99,586 103,516 107,641 Contract fee (90,000) (90,000) (90,000) (90,000) Net cash flow 650,000 (241,141) 262,601 (233,469) (229,344) Discount Factor 1·0 0·893 0·797 0·712 0·636 Present Value 650,000 (215,339) 209,293 (166,230) (145,863) (280,000) (246,985) 111,973 (90,000) (505,012) 0·567 (286,342) NET PRESENT VALUE = £45,519 Contracting out the catering service is thus the preferred alternative and it is recommended that Amber plc accept the tender from the outside supplier  Accountancy Tuition Centre (International Holdings) Ltd 2008 (c) The primary limitation of making demand forecasts lies in the fact that they are forecasts and hence their reliability is unknown Most forecasts are based upon a mix of historic information and expectations in relation to relevant influential variables For example, the exchange rate forecasts, where the highest probability is attached to a rate of 1·54Euro/£, is likely to be based on the statistical pattern of historic exchange rates (including the standard deviation) such that 1·54 Euro/£ constitutes the most frequently observed rate This does not, however, necessarily mean that the rate will be similar in the future – history does not always repeat itself Another limitation relates to the nature of the data being forecast Weather forecasts are notoriously unreliable because nature is such an uncontrollable force Even if the UK weather has been hot, on average, for the past five years does not imply that this will be the case in the future The factors which dictate the weather are uncontrollable and consequently to a large degree unpredictable The forecast also runs into problems because it seeks to link two unrelated variables The state of the weather is totally independent of the exchange rate, and vice versa, and they can only be linked in the way suggested by the table if the range of alternative observations is restricted This is ultimately a distortion of a reality which is far more complex (d) There are numerous non-financial factors which may be relevant to a decision to contract out, and the type of factors are likely to be dependent upon the process/service which is the subject of the decision Amongst the most important of the non-financial considerations will be the impact of any decision on the company’s competitive position For example, in the case of Amber plc, if the on train catering facility is sufficiently high class, it may attract new clientele to use their trains, thereby giving Amber plc a competitive advantage The opposite may also be the case In other words, the strategic impact of a decision needs to be taken into account, in addition to the directly measurable financial effects Another factor which needs to be taken into account is the question of management control of service quality Once a service moves “out of house” the only control mechanism which rests with the purchasing company may be a variety of penalties, the extreme one being termination of the contract If the service remains inside the company, it may be easier to change things in response to changing customer needs In other words, contracting out may be linked to a reduction in the level of management control Staff morale may be affected by contracting out, and any such effects need to be carefully considered Staff in departments which remain in-house may begin to feel threatened and view their service as the next on the “hit list” for external contracting It is important for managers to help allay such fears, and make clear the criteria on which any future outsourcing decisions will be based Other non-financial factors which may be useful to consider include: environmental effects, such as changes in food packaging policies; the terms of any contract for outside supply, and the willingness of the supplier to respond to changes in market demand as and when necessary; the capabilities of the business to manage the external supply process If a large number of contracts are in place, this can possibly become a logistical headache  Accountancy Tuition Centre (International Holdings) Ltd 2008 KESWICK PLC (a) Trade payables (i) Significance in working capital cycle For many firms, trade payables – suppliers of goods and services – represent the major component of current liabilities, the amounts owed by the company which have to be repaid within the next accounting period Together with current assets – cash, inventory and receivables – current liabilities determine the firm’s net working capital position i.e., the net sum it invests in working capital Different suppliers will operate different credit periods, but the average trade credit period in days can be calculated as follows: Trade payables/Credit purchases × 365 Sometimes, it is expressed in terms of total purchases and sometimes in terms of overall cost of sales The length of the trade credit period depends partly on competitive relationships among suppliers and partly on the firm’s own working capital policy The trade credit period is an important element in a company’s cash conversion cycle – the length of time between a firm making payment for its purchases of materials and labour and receiving payment for its sales The time period over which net current assets have to be financed depends not only on policy towards suppliers but also on receivables management and inventory control policy: Cash conversion cycle = [Receivables days + inventory period] – [trade credit period] (ii) Dangers of over-reliance on trade credit In effect, because trade credit represents temporary borrowing from suppliers until invoices are paid, it becomes an important method of financing the firm’s investment in current assets Firms may be tempted to view trade payables as a cheap source of finance, especially as in the UK at least, it is currently interest-free Having a receivables’ collection period shorter than the trade collection period may be taken as a sign of efficient working capital management However, trade credit is not free By delaying payment of accounts due, the company may be passing up valuable discounts, thus effectively increasing the cost of goods sold Excessive delay in the settlement of invoices can undermine the existence of the business in a number of ways Existing suppliers may be unwilling to extend more credit until existing accounts are settled, they may begin to attach a lower priority to future orders placed, they may raise prices in the future or simply not supply at all In addition, if the firm acquires a reputation among the business community as a bad payer, its relationships with other suppliers may be soured (b) Analysis of potential arrangement with supplier At present the working capital cycle is: Receivables days: Inventory days: Payables days: $0.4m/$10m $0.7m/$8m $1.5m/$8m × × × 365 = 15 days 365 = 32 days (cost of sales = $10m – $2m) 365 = (68 days) Total  Accountancy Tuition Centre (International Holdings) Ltd 2008 (21 days) Clearly, Keswick is exceptionally efficient in its use of working capital The proposed arrangement would shorten payables days in relation to half of cost of sales to 15 days The effect is to lower the average to: (ẵ ì 68 days) + (ẵ ì 15 days) = 41.5 days Overall, this will increase cycle time to: [15 + 32 – 41.5 days] i.e., to 5.5 days Interest cover At present, interest cover (earnings before interest and tax divided by interest) is: $2m/$0.5m = 4.0 times, which appears safe The advanced payment will raise interest costs but will generate savings via the discount The discount applies to half of cost of sales, i.e., ẵ ì $8m ì 5% = $0.2m The EBIT will increase accordingly The net advanced payment of ($4m – $0.2m) = $3.8m will have to be financed for an extra (68 – 15) days, generating interest costs of: [$3.8m × 12% × 53/365] = $66,214 The interest cover slightly declines to: [$2.0m + $0.2m]/[$0.50m + $0.066m] = 3.89 times Profit after tax, ROE and EPS The “before” and “after” income statements appear thus: Sales Cost of sales $m $m No discount With discount 10.000 10.000 (8.000) (7.800) Earnings before interest and tax Interest 2.000 (0.500) 2.200 (0.566) Taxable profit Tax at 33% 1.500 (0.495) 1.634 (0.539) Profit after tax 1.005 1.095 ROE EPS 1.005m = 50.3% 2m 1.005m = = 25.1c 1m × = 1.095m = 54.8% 2m 1.095m = 27.4c 4m The proposal appears beneficial to Keswick in terms of the effect on profitability measures i.e.; EBIT, PAT, EPS, and ROE However, it does have a slightly harmful effect on its interest cover It also lengthens its working capital cycle and turns it into a net demander of working capital This suggests an increase in its capital gearing  Accountancy Tuition Centre (International Holdings) Ltd 2008 Before the adjustment, gearing at book values (overdraft/shareholder’s funds) was: $3.0m/$2m = 150% The overdraft will increase by: ($3.8m × 53/365] = $0.55m Ignoring the beneficial effect on equity, gearing after the adjustment becomes: $3.55m/$2m = 178% This looks rather dangerous, considering the short-term nature of much of the debt, and Keswick’s low liquidity Perhaps Keswick should reconsider its policy regarding long-term borrowing, although whether prospective lenders would oblige is probably doubtful PLANKERS LTD (a) (i) Cash brought forward at January 2009: Building programme investment Minimum cash balance requirement $m 8·48 (12·00) 1·00 _ Additional loan required at January 2009: 4·52 _ Projected income statement for the year to 31 December 2009: $m 1·980 0·900 1·037 0·043 0·013 0·030 EBIT before depreciation Extra depreciation Interest charges PBT Tax PAT Cash available in PAT: PBT Add back depreciation Tax 0·043 0·900 (0·013) _ 0·930 (4·52 + 7) × 0·09 = 1·037  Accountancy Tuition Centre (International Holdings) Ltd 2008 (ii) Check on cash balances at 31 December 2009: Cash ledger Brought forward January 2009 Cash retentions Additional loan financing Building programme expenditure Carried forward balance 31 December 2009 DR $m 8·48 0·93 4·52 CR $m 12·00 1·93 The conditions of the loan and the other targets can then be checked: Interest cover: (1·98–0·9)/1·037: EPS: (PAT/4m): 1·041 times 0·75c Clearly, only the cash balance target is met (iii) Options: (1) Delay the building programme until sufficient funds are available from cash retentions; (2) Re-negotiate the terms of the long term loan; (3) Pay out less dividends; (4) Leasing; (5) Raise further equity capital; (6) Sell assets; (7) Reduce working capital investments; (8) Combinations of the above (iv) The only condition satisfied is that relating to the minimum cash balance Both the interest cover and the EPS conditions are breached The scale of the building programme suggests that options 1, 3, 4, and are very unlikely to provide sufficient additional capital Extending the loan facilities in option would likely make worse the interest cover and EPS figures The only viable option appears to be an equity issue  Accountancy Tuition Centre (International Holdings) Ltd 2008 (b) Responding to various stakeholder groups If a company has a single objective in terms of maximising profitability then it is only responding to one stakeholder group, namely shareholders However, companies can no longer fail to respond to the interests and concerns of a wider range of groups, particularly with respect to those who may have a non-financial interest in the organisation Stakeholder groups with a non financial interest can therefore generate for companies non financial objectives and place constraints on their operations to the extent that the company is prepared to respond to such groups Various stakeholder groupings can emerge The following represents examples of likely groups, their non financial objectives and/or the constraints they may place on a business: Stakeholder Employees Community Customers Suppliers Government Trade bodies Objective Employee welfare Responding to community concerns Product or service levels Good trading relationships Protecting the consumer Protecting professional reputation Constraints Maximum hours worked Limits on activities Minimum quality standards Minimum standards on products or services Minimum standards on products or services The difficulties associated with managing organisations with multiple objectives To the extent that an organisation faces a range of stakeholders, then they also face multiple objectives This would not particularly be a problem if the multiple objectives were congruent, but they normally are not There are a number of difficulties: Multiple stakeholders imply multiple objectives To the extent that they conflict then compromises must be made This will lead potentially to opportunity costs in that maximisation of profitability will potentially be reduced Responding to stakeholders other than shareholders involves costs, either in management time or in directly responding to their needs Some objectives are not clearly defined e.g what is actually meant by “protecting the consumer”? It will therefore not always be clear to the organisation that they have met the needs of all of their stakeholders Some of the objectives may actually be conflicting where compromise is not possible Prioritisation and ranking will then have to take place Questions then arise as to who is the most important stakeholder or what ranking should be assigned? New stakeholder groups often emerge This can create a problem of longer term strategic management in that plans can be diverted if new pressures arise For example, environmental issues were not so important 20 years ago Management of the organisation becomes complex when multiple objectives have to be satisfied Each managerial decision is likely to face many constraints  Accountancy Tuition Centre (International Holdings) Ltd 2008 BUNTAM PLC Report to Private Clients: Subject: Traded Investments Author: A.N Accountant (a) Traded investments The term “traded investment” refers to the purchase of an investment asset, which is traded in the financial markets Examples include government and company bonds, ordinary shares, preference shares, warrants, and options or futures contracts The range of such investments is therefore wide, and it is important to recognise that each type of investment has unique characteristics in terms of its cost, rate of return and risk All of these factors must be taken into account when selecting an investment The price of bonds and shares will vary, depending upon economic conditions and the financial performance of the individual companies Interest rates directly affect the price of gilt-edged stock and corporate bonds, such that as interest rates rise, the price of bonds falls This represents a capital risk to the investor, who cannot be certain of the price at which the bond can be sold This uncertainty is counter-balanced by the fact that such investments offer a fixed rate of return If an investor buys, for example, 10% Treasury Stock 2001, at a price of $105, he/she can be certain that the interest payable is $10 per bond, equal to a return of 10/105, or 9.5% gross This interest is payable annually (usually in two instalments) until the date of maturity of the bond, when the bond is redeemed for the nominal value of $100 The return earned on bonds will generally, though not always, be higher than that available through interest bearing deposit accounts Ordinary shares present a much riskier form of investment, particularly for private individuals, who may incur high charges for the purchase and sale of shares The price of ordinary shares varies daily, depending on factors within the market in general, and also specific to the company An investor may earn a return via dividends and/or capital gains The amount of dividends receivable is dependent, amongst other things, upon the profits of the company, and hence is not predictable with certainty Individual share prices are definitely not predictable with any level of certainty Consequently, investment in ordinary shares is relatively risky, but may offer good returns, which historically have been shown on average to be higher than the returns on bonds The purchase of derivatives, such as futures or options, as a way of investing in traded securities, may be highly risky unless they are covered trades The potentially very high returns from such investments reflect the associated high risk In conclusion, when comparing the different traded investments, it is essential that the composition of the investment portfolio matches both the liquidity and risk needs of each individual investor (b) Meanings and relevance (i) Gross dividend At the end of the financial year, companies will announce the profits or losses that they have earned, and a figure for net profit after tax A company can choose either to pay any profit out in dividends or to re-invest it in the business Dividends are paid out per share, and so the more shares that you own in a business, the more dividend income that you will receive Using the example of Buntam plc, the figures indicate a gross dividend yield of 5% This means that the dividend paid equals 5% of the share price, or eight cents, in this case The term gross means that this is the dividend paid before tax The equivalent calculation for Zellus plc means that the dividend yield of 3.33% is equivalent to a gross dividend payment of nine cents  Accountancy Tuition Centre (International Holdings) Ltd 2008 10 If an individual shareholder in Buntam plc pays tax at 20% on investment income then he will collect a net dividend of 6.40 cents per share The company pays this basic rate of tax to the government as an advance payment of its corporation tax liability, when it pays out its dividends, and so investors receive the dividend after deduction of the basic tax payable The gross dividend figure is of relevance to an investor as it facilitates direct comparison of the dividend figure and dividend yield paid out by different companies, as well as comparison with interest yields on fixed return investments The tax liability is determined by the individual circumstances of each investor, and so its inclusion would serve only to confuse any comparative analysis The dividend figure is also relevant to an investment decision because it is a way of earning income from investments, as opposed to capital gains, which can only be realised when the investment is sold (ii) Earning per share Earnings per share (EPS) is calculated as profit attributable to equity divided by the number of shares in issue and ranking for dividends EPS thus represents what is available to be paid out as dividends Clearly, therefore, if the number of shares in issue remains fixed, the EPS will rise as the net profit attributable to equity increase The value of EPS can be calculated by dividing the share price by the P/E ratio For Buntam this means EPS equals eight cents In other words, the earnings per share is equal to the gross dividend payable For Zellus, the EPS is equal to 18 cents (270/15), which compares with a gross dividend of nine cents On first sight, therefore, it is tempting to view Zellus as a better investment because its EPS is higher On the other hand, an investor has to pay 270 cents per share to get earning of 18 cents, compared with 160 cents to get earning of eight cents The EPS figure is of limited value on its own; it needs to be judged in conjunction with the share price, and hence the P/E ratio (iii) Dividend cover Dividend cover measures the relationship between earnings per share and net dividends per share The higher the level of dividends (for any given level of EPS) the lower will be the level of profit retained and re-invested within the business This can have an effect on the balance of returns available to an equity investor The returns from investing in shares may take the form of either income i.e dividends, which are paid twice yearly or capital gain/loss which is earned when the shares are sold Some investors may prefer one type of return to the other, often for tax reasons Dividend cover is measured as follows: Earnings per share (net)/dividend per share (net) Using the example of Zellus plc, the net EPS is 18 cents The gross dividend is nine cents, and so if tax is payable at 20%, then the net dividend equals 7.2 cents Using the formula, dividend cover equals 18/7.2, which gives a dividend cover of 2.5 In other words, Zellus’ earnings are sufficient for the company to be able to pay out dividends at a rate 2.5 times their current level By comparison, Buntam has an EPS of eight cents and a net dividend per share of 6.4 cents, giving a dividend cover of just 1.25 Investors need to understand the relationship between dividend cover and investment returns As a general rule, the greater the level of retention (and dividend cover), the greater the likelihood that a share will yield capital gain rather than income  Accountancy Tuition Centre (International Holdings) Ltd 2008 11 From the examples given above, it would thus appear for Buntam plc (paying out almost all their earnings as dividends), there is limited scope for capital growth in the share price By contrast, Zellus has a relatively high dividend cover, and so the reinvestment of profits should generate capital gains As with all investor ratios, dividend cover has to be interpreted with caution, and alongside a number of other measures (c) Estimating the market value of a share The dividend growth model suggests a method whereby share values can be estimated from information on the required return on equity and the expected dividend payable The theory suggests that the value of a share is equivalent to the discounted value of the future dividend stream, where the discount rate is determined by the return required by the investor For example, if I decide that an investment is very risky; the result may be that I require a return of 20%, and the dividend flows will be discounted at this rate In this way, the price that an investor places on a share is a reflection of his perceived risk re that investment together with his dividend expectations Using Crazy Games plc as an example, the formula for share valuation under the dividend growth model is as follows: Market value of share = D1 R -G Where D1 = Next year’s dividend R = Investor’s required return on the equity G = Growth rate of the dividends From the figures given relating to Crazy Games plc, G = 16.36% i.e 5.5 / − R = 20% D1 = 5.5 (1.1636) = 6.40 cents 6.40 Market value = 0.2 − 0.1636 Market value = 175.8 cents This means that to buy 1,000 shares in Crazy Games would cost $1,758 It is important to note that the model bases share prices on dividend growth rates even though, as in this case, there is often a significant difference between the rate of growth of dividends and that of earnings  Accountancy Tuition Centre (International Holdings) Ltd 2008 12 (d) Shape of the yield curve Gross yield To redemtion (%) 5 10 15 Years to maturity 20 The yield curve clearly shows that as the years to maturity increase, the yield earned on the gilt investment falls The shape of the curve drawn above is contrary to that which would be expected from liquidity preference theory Theory suggests that investors require increasing levels of compensation as the time to maturity lengthens – the curve drawn above shows the exact opposite The reason for the difference between the theoretical and the observed shape of the curve is market expectations The market believes that over the long term interest rates will fall, and the effect of market expectations is currently greater than the effects of liquidity preference The slope of the yield curve shows not only how much an investor can expect as investment returns, but also the cost of debt finance to the government  Accountancy Tuition Centre (International Holdings) Ltd 2008 13 Marking Scheme AMBER (a) Calculation of expected number of passengers (b) In house: Revenue Variable costs Labour costs Purchase/insurance Acquisition/disposal NPV Subcontract: Fee Asset disposal Fixed costs NPV 2 1 1 1 12 (c) One mark per point (d) Two marks per explained factor KESWICK (a) (i) Definition of working capital cycle Relevance of trade payables ––– 25 ––– (ii) Two marks per explained risk (b) Two marks per ratio calculated before/after change Conclusion 12  Accountancy Tuition Centre (International Holdings) Ltd 2008 14 14 ––– 25 ––– FLANKERS (a) (i) EBIT Depreciation Interest Tax PAT 1 1 (ii) One mark per condition/target (iii) One mark per option suggested (iv) Half mark per option analysed Recommendation (b) 2½ ½ (i) One mark per stakeholder (ii) One mark per point 5 ––– 25 ––– PRIVATE CLIENTS (a) One mark per factor (b) Four marks per area 12 (c) Explanation of valuation theory Calculation of share value Graph of yield curve Explanation of inverted yield curve 2 (d) ––– 25 –––  Accountancy Tuition Centre (International Holdings) Ltd 2008 15 ... Contribution £246,985 per year Cash Flows: In House Option Year Sales Variable costs Contribution Labour costs Purchase & insurance Asset purchase/disposal Net cash flow Discount Factor at 12%... The primary limitation of making demand forecasts lies in the fact that they are forecasts and hence their reliability is unknown Most forecasts are based upon a mix of historic information and... the data being forecast Weather forecasts are notoriously unreliable because nature is such an uncontrollable force Even if the UK weather has been hot, on average, for the past five years does