acca f9 fm final assessment answers june09

Final Assessment ACCA Paper F9 Financial Management June 2009 Final Assessment – Answers To gain maximum benefit, not refer to these answers until you have completed the final assessment questions and submitted them for marking KAPLAN PUBLISHING Page of 12 ACCA F9 Financial Management © Kaplan Financial Limited, 2008 All rights reserved No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing Page of 12 KAPLAN PUBLISHING Final Assessment ANSWER (a) Memo to: Russell Co Main Board From: Assistant Treasurer Subject: Alternative Financial Strategies The present policy is termed a 'matching' financial policy This attempts to match the maturity of financial liabilities to the lifetime of the assets acquired with this finance It involves financing long-term assets with long-term finance such as equity or loan stock and financing short-term assets with short-term finance such as trade credit or bank overdrafts This avoids the potential wastefulness of over-capitalisation whereby short-term assets are purchased with long-term finance, i.e the company having to service finance not continuously invested in income-earning assets It also avoids the dangers of under-capitalisation which entails exposure to finance being withdrawn when the company is not easily able to liquidate its assets In practice, some shortterm assets may be regarded as permanent and it may be thought sensible to finance these by long-term finance and the fluctuating remainder by short-term finance The proposed policy is an 'aggressive policy' which involves far heavier reliance on short-term finance, thus attempting to minimise long-term financing costs This requires very careful manipulation of the relationship between payables and receivables (maximising trade payables and minimising receivables), and highly efficient inventory control and cash management While it may offer financial savings, it exposes the company to the risk of illiquidity and hence possible failure to meet financial obligations In addition, it involves greater exposure to interest rate risk The company should be mindful of the inverse relationship between interest rate changes and the value of its assets and liabilities Before embarking on such an aggressive policy, the board should consider the following factors: (b) • How good are we at forecasting cash inflows and outflows? How volatile is our net cash flow? Is there any seasonal pattern evident? • How efficiently we manage our cash balances? Do we ever have excessive cash holdings which can be reduced by careful and active management? • Do we have suitable information systems to provide early warnings of illiquidity? • Do we have any holdings of marketable securities that can be realised if we run into unexpected liquidity problems? • How liquid are our non-current assets? Can any of these be converted into cash without unduly disrupting productive operations? • Do we have any unused long- or short-term credit lines? These may have to be utilised if we meet liquidity problems • How will the stock market perceive our switch towards a more aggressive and less liquid financial policy? (i) Cash management models’ great advantages are that they make management aware of the many variables that affect cash management and the difficult trade off that must be made between liquidity and profitability when deciding how much cash to hold and in which type of deposit or KAPLAN PUBLISHING Page of 12 ACCA F9 Financial Management security The main disadvantages of such models is that they ignore the fact that cash flows are to some extent controllable e.g managers can delay some payments and may be able to encourage receipts In practice any experienced cash manager, using a detailed cash budget, should be able to perform better than any cash management model and allow the company to operate using a lower cash balance The main use of these simple cash management models is to allow us to measure the performance of the cash manager by comparing the results obtained by a 'hands on' expert with those of a simple 'hands off' control model (ii) Miller and Orr devised a cash management model that assumes that daily cash flows are random and hence unpredictable This would result in a pattern of cash flow as shown in the following diagram Cash balance Upper limit Return point Lower limit Time The treasurer sets upper and lower limits and either transfers cash into the account when the lower limit is reached or transfers cash out by buying marketable securities when the upper limit is reached The return point determines the amount of cash introduced or withdrawn Two questions must be answered: • How we decide where to set the limits? This is determined by the variability of daily cash flows, transactions costs and market interest rates Where variability is great, transactions costs are high and market interest rates are low, the limits will be set far apart The Miller-Orr formula for setting the limits is: Range between upper and lower limits = ⎧ Transaction cost × Variance in cash flow ⎫ ⎨ × ⎬ Interest rate ⎭ ⎩4 Page of 12 KAPLAN PUBLISHING Final Assessment • Why isn't the return point midway between the two? The Miller-Orr equation for the return point is: Return point = Lower limit + (Range/3) By setting the return point below the mid-point between the upper and lower limits the average cash balance on which interest is charged is reduced The Baumol and Miller-Orr models are really two extremes The Baumol model assumes that cash flows are constant whereas the Miller-Orr model assumes they are random and hence completely unpredictable (iii) The lower limit should be set at the minimum daily cash balance of $15,000 The spread can be calculated as: The upper limit = $15,000 + $26,827 = $41,827 The return point = $15,000 + (c) = $23,942 The advantages of using electronic funds transfer system are: • Less clerical time and thus cost are involved than in the writing out, signing and posting of a cheque Also, no postage costs are incurred • Electronic transfer reduces the amount of paper work and the likelihood of errors occurring, such as a cheque being made out with words and figures differing or being sent to an incorrect address • It is likely to be preferred by a supplier, who may reward their customers who pay by electronic means with longer credit periods, or special offers or other preferential treatment The only disadvantage of electronic funds transfer to the payer is that funds leave their account at the time of payment If a cheque is made out it takes time in the post and in the clearing system before it is debited to the payers account Thus interest is forgone by the payer on a credit balance (or more interest is paid if an overdraft is maintained) KAPLAN PUBLISHING Page of 12 ACCA F9 Financial Management MARKING GUIDE Marks (a) Rationales – each Factors – each (b) (i) mark per relevant point (ii) Explanation of Miller Orr (1 mark per relevant point) Contrast with Baumol (iii) Lower limit Spread Upper limit Return point 4 1 1 15 (c) mark per explained advantage or disadvantage Total 25 ANSWER (a) Cost of equity Ke = d o (1+ g) + g Pe = + 12% = 17% 80 Cost of preference shares = 9/72 = 12.5% Cost of debentures = 0.65 × 14% = 9.1% The market values of these sources of funding are as follows: Equity Preference shares Debentures Total (10.4m × $0.80) (4.5m × $0.72) $m 8.32 3.24 5.00 _ 16.56 _ Therefore the company's weighted average cost of capital is: ⎛ 8.32 ⎞ ⎛ 3.24 ⎞ ⎛ ⎞ × 17% ⎟ + ⎜ × 12.5% ⎟ + ⎜ × 9.1% ⎟ = 13.73% ⎜ 16.56 16.56 16.56 ⎝ ⎠ ⎝ ⎠ ⎝ ⎠ Page of 12 KAPLAN PUBLISHING Final Assessment (b) CAPM would estimate the cost of equity using the equation: E(ri ) = R f + β i (E(rm ) - R f ) Rf is the risk free rate of return This could be estimated as the current return offered by irredeemable gilts This can be looked up in the financial pages of any quality newspaper β is the volatility of the company's share price relative to the market This can either be calculated from recent periods' data or can be read off from pre-calculated figures published by professional organisations Either method has problems In calculating β oneself, the value of β will be different depending on the number of recent periods used in the analysis If pre-calculated figures are used, one is forced to accept the organisation's choice of period; for example the London Business School calculates β on the basis of monthly returns for the past five years and updates its figures quarterly Rm is the return currently available from the equity market Indices are published such as the FT-Actuaries All Share Index to replicate this return over recent periods of time Again the choice of period will affect the observed return (c) There is no absolute right or wrong answer to the question of whether it is possible to link one source of finance to one segment of a company's activities Some commentators dismiss the idea immediately, claiming that the company is one entity in law which happens to be financed by a variety of sources of funds The sources of funds define the sharing out of profits between the shareholders, but their effect is all to support the activities of the business They argue that it is the projected cash flows that should be looked at from any new investment idea, and that these cash flows should be discounted at the opportunity cost of new capital Other commentators disagree, arguing that a particularly large project can certainly be identified with a source of funding raised specifically for the project, and that it is artificial to ignore the relationship between the two It is probably possible to accept both arguments – that small projects are financed by the general pool of funds available to a company, on which the company pays the weighted average cost of capital; but with large projects it is possible to link the project with a particular source of finance with its own specific cost KAPLAN PUBLISHING Page of 12 ACCA F9 Financial Management MARKING GUIDE Marks (a) Cost and MV of equity Cost and MV of prefs Cost and MV of debt WACC 2 10 (b) Brief explanation Rf, Rm, Beta & how each is obtained (c) Max marks per explained point Total 25 ANSWER (a) Rights issues tend to reduce the market price of shares because they are sold at a discount to the market price This is a necessary (but not a sufficient) requirement of a successful rights issue (potential investors still need to be convinced that taking up the rights represents a good investment on their part) The theoretical ex-rights price is: New finance required Issue price (210p less 10%) Number of new shares (i.e £200m/£1.89) £200m 189p 105.82m Existing number of shares 1,000.00m New number of shares 1,105.82m Existing market value (1,000m × £2.10) Value of new issue New market value New share price (£2,300/1,105.82) £2,100m £200m £2,300m £2.08 The actual market price will be greater than the theoretical ex-rights price if the new money is invested in positive NPV projects, i.e the money will earn a greater return than the required return for that investment Thus the market price of the share will only equal the theoretical ex-rights price if the new money earns just the required return for the investment (i.e the NPV of the investment is zero) However, very often any positive NPV expected for a project will already be reflected in the existing market price of the share Page of 12 KAPLAN PUBLISHING Final Assessment (b) Gearing Ignoring the overdraft, the gearing ratios will be: Current Debt Equity Gearing Equity finance 300 1,500 20% 300 1,700 17.6% Debt finance (both types) 500 1,500 33.3% Alternatively, since it is substantial, you may include the overdraft as follows: Current Debt Equity Gearing Equity finance 380 1,500 25.3% 380 1,700 22.4% Debt finance (both types) 580 1,500 38.7% Gearing is currently 20% (or 25.3%) This is relatively low, reflecting the risky nature of current operations With a new share issue, gearing will fall to 17.6% (or 22.4%) whereas, with more debt, it will rise to 33.3% (38.7%) Although debt financing is more risky, the gearing is still relatively low EPS EPS is currently 118/1,000 = 11.8p The projected income statement is (£m) Ordinary Eurodollar CULS Operating profit Interest 250 40 _ 250 54* _ 250 56 _ Profit before tax Tax 210 63 _ 196 59 _ 194 58 _ Profit after tax Number of shares 147 1,106 _ 137 1,000 _ 136 1,000 _ EPS 13.3p _ 13.7p _ 13.6p _ *The existing Ê40 + ($300m ì 7% ữ 1.50) = £54m KAPLAN PUBLISHING Page of 12 ACCA F9 Financial Management The higher EPS if the company expands using debt may compensate for the higher financial risk borne by the ordinary shareholders If the Eurodollar bond is used the company will also be exposed to additional foreign exchange risk Interest cover – currently 5.2, i.e 208/40, and changes to: Ordinary Eurodollar CULS 6.2 4.6 4.5 All look relatively comfortable – reducing the risk regarding financing MARKING GUIDE Marks (a) Why share price falls TERP calculation When TERP will occur (b) marks per set of ratios marks for discussion on each set of ratios 12 18 Total 25 ANSWER (a) (i) The value of a share may be estimated using the dividend valuation model (DVM) This states: P0 = D0(1 + g)/(re – g) Using the information in the question: D0 = $288,000 'g' is anticipated to be 10% re = 18% This gives a total value of 288,000(1 + 0.10)/(0.18 – 0.10) = 3,960,000 This results in an estimated share price of 3,960/3,000 = $1.32 A number of factors need to be considered before relying too heavily on this estimate (1) Page 10 of 12 The model assumes constant growth in perpetuity which is always unlikely KAPLAN PUBLISHING Final Assessment (ii) (2) The estimate of dividend growth has been based on forecast earnings growth Dividends may not grow at the same rate as earnings (3) The use of the dividend model is always unreliable for small owner managed companies In such companies dividends paid often have more to with the financial circumstances of the directors rather than the commercial position of the company An alternative valuation may be found by multiplying EPS by a suitable PE ratio The latest EPS for Grant & Co is 538/3000 = 17.9 cents The average PE ratio is 33 This is a PER for quoted companies and Grant & Co is unquoted which usually means that a lower PER is appropriate The conventional wisdom is that the PER ratio for an unquoted company should be approximately 60 – 70% of that for a similar quoted company A PER ratio of approximately may be appropriate for valuing an Grant & Co share which means a value of 17.9 × = 90 cents The weakness of this valuation is that the adjustment to the PER is entirely arbitrary We have no way of knowing how Grant & Co compares with average companies in the industry in terms of risk, earnings and dividend growth (iii) The final valuation is based on the assets of the business Since Grant & Co is to continue in business after floatation, the replacement cost of the assets which is usually considered to be the best asset based valuation for valuing the business as a going concern will be used $000 Net assets from the balance sheet Revaluation of land and buildings: 0.25 × 850 = Revaluation of plant and equipment: 1,500 − 1,350 = Revaluation of stock: 180 − 10 = Replacement cost of assets Number of shares Asset based value per share 2,575 (213) 150 (170) _ 2,342 3,000 _ 78 cents The obvious limitation of this valuation is that it takes no account of the 'goodwill' of the business As a going concern companies are almost always worth more than the value of their net tangible assets (b) Strategies which offer no protection include: (i) Doing nothing – this is reasonable as long as the risk is not material to the company (ii) Leading & lagging – this is where a company attempts to benefit from expected exchange rate movements by the timing of its receipts and payments In effect this is low level speculation If exchange rates move differently to what was expected losses will be made KAPLAN PUBLISHING Page 11 of 12 ACCA F9 Financial Management Strategies which offer protection include: (i) Dealing in own currency – this passes all risk to the other party and is often hard to in reality (ii) Netting/matching – matching foreign currency assets and liabilities can be netted off Risk only remains on items which cannot be netted off in this way (iii) Forward contract – this is an agreement with a bank to buy or sell a certain amount of foreign currency at a certain future date and at a certain rate (iv) Money market hedge – this is where a company creates a foreign currency asset or liability by investing or borrowing in the foreign currency in order to match an existing liability or asset in that currency In this way the risk is extinguished (v) Futures – this is where currency futures are bought or sold such that any loss that arises due to foreign exchange rate movements on the actual transaction is matched by a compensating gain on the futures transaction (vi) Options – this is where the company has the right but not the obligation to buy or sell a certain amount of foreign currency at a certain future date and at a certain rate Of the above strategies only options have the flexibility to allow the company to benefit if there are favourable exchange rate movements Obtaining this flexibility is costly as a premium is payable by the company in order to obtain an option MARKING GUIDE Marks (a) (b) Max per value calculation Max for comments on each valuation Brief explanation of strategies offering no protection Brief explanation of strategies offering protection Identification of the strategy offering flexibility Max 14 11 Total Page 12 of 12 25 KAPLAN PUBLISHING .. .ACCA F9 Financial Management © Kaplan Financial Limited, 2008 All rights reserved No part of this... retrieval system, without prior permission from Kaplan Publishing Page of 12 KAPLAN PUBLISHING Final Assessment ANSWER (a) Memo to: Russell Co Main Board From: Assistant Treasurer Subject: Alternative... when deciding how much cash to hold and in which type of deposit or KAPLAN PUBLISHING Page of 12 ACCA F9 Financial Management security The main disadvantages of such models is that they ignore the