ACCA REVISION MOCK 2

Financial Management

June 2012
Question Paper

Time allowed
Reading and planning: 15 minutes
Paper F9
Writing: 3 hours

ALL FOUR questions are compulsory and MUST be attempted.

DO NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.

P. 1
P. 2
ALL FOUR questions are compulsory and MUST be attempted

Question 1

The US manufacturer of footwear, Willow Ltd, is considering a major investment in a new

product area, novelty umbrellas. It hopes that these products will become fashion icons. The
following information has been collected:
 The project will have a limited life of 11 years.
 The initial investment in plant and machinery will be $1 million and a marketing budget
of $200,000 will be allocated to the first year.
 The net cash flows before depreciation of plant and machinery and before marketing
expenditure for each umbrella will be $1.
 The products will be introduced both in the UK and in France.
 The marketing costs in Years 2 to 11 will be $50,000 per annum.
 If the product catches the imagination of the consumer in both countries then sales in
the first year are anticipated at 1 million umbrellas.
 If the fashion press ignore the new products in one country but become enthusiastic in
the other the sales will be 700,000 umbrellas in Year 1.
 If the marketing launch is unsuccessful in both countries, first year sales will be 200,000
umbrellas.

The probability of each of these events occurring is:

 1m sales: 0.3
 0.7m sales: 0.4
 0.2m sales: 0.3

If the first year is a success in both countries then two possibilities are envisaged:
1. Sales levels are maintained at 1 million units per annum for the next 10 years –
probability 0.3.
2. The product is seen as a temporary fad and sales fall to 100,000 units for the remaining
10 years – probability 0.7.

If success is achieved in only one country in the first year then for the remaining 10 years
there is:
1. a 0.4 probability of maintaining the annual sales at 700,000 units; and
2. a 0.6 probability of sales immediately falling to 50,000 units per year.

If the marketing launch is unsuccessful in both countries then production will cease after the

P. 3
first year. The plant and machinery will have no alternative use once installed and will have
no scrap value. The annual cash flows and marketing costs will be payable at each year end.

Assume:
 Cost of capital: 10%.
 No inflation or taxation.

Required:

(a) Calculate the expected NPV for the project and comment your result. (13 marks)

(b) Calculate the standard deviation for the project. (4 marks)

(c) Discuss the weaknesses of the ENPV approach for decision-making purposes.
(3 marks)
(d) Discuss the particular investment appraisal problems created by the existence of
high rates of inflation. (5 marks)
(Total 25 marks)

P. 4
Question 2

Redskins plc is a holding company owning shares in various subsidiary companies. Its
directors are currently considering several projects to increase the range of the business
activities undertaken by Redskins plc and its subsidiaries. The directors would like to use
discounted cash flow techniques in their evaluation of these projects but as yet no weighted
average cost of capital has been calculated.

Redskins plc has an authorised share capital of 10 million 25c ordinary shares, of which 8
million have been issued. The current ex-dividend market price per ordinary share is $1.10. A
dividend of 10c per share has been paid recently. The company’s project analyst has
calculated that 18% is the most appropriate cost of equity capital. Extracts from the latest
balance sheets for both the group and the holding company are given below.

Redskins and Subs Redskins

$000 $000
Issued share capital 2,000 2,000
Share premium 1,960 1,960
Reserves 3,745 708
Shareholders funds 7,705 4,668

Minority interest 895 -

3% irredeemable debts 1,400 -

9% debentures 1,500 1,500
6% bonds 2,000 2,000
Bank loans 1,540 600
6,440 4,100

All debt interest is payable annually and all the current year’s payments will be made shortly.
The current cum-interest market prices for $100 nominal value are $31.60 and $103.26 for the
3% and 9% debentures respectively. Both the 9% debentures and the 6% bonds are
redeemable at par in ten years’ time. The 6% bonds are not traded on the open market but the
analyst estimates that its actual pre-tax cost is 10% per annum. The bank loans bear interest at
2% above base rate (which is currently 11%) and are repayable in six years. The effective
corporation tax rate of Redskins plc is 30%.

P. 5
Required:

(a) Calculate the effective after-tax weighted average cost of capital as required by the
directors. (8 marks)

(b) Discuss the problem that are encountered in the estimation of a company’s WACC
when
(i) bank overdrafts, and
(ii) convertible bonds
(6 marks)

(c) What are the two classification of risk that organizations face in relation to their
cash flows and/or cost of capital? (4 marks)

(d) Discuss whether the dividend growth model or the capital asset pricing model
offers the better estimate of the cost of equity of a company. (7 marks)
(Total 25 marks)

P. 6
Question 3

Dyer Ltd manufactures a variety of products using a standardised process which takes one
month to complete. Each production batch is started at the beginning of a month and is
transferred to finished goods at the beginning of the next month. The cost structure, based on
current selling prices, is as follows.
$ $
Sales price 100
Variable costs
Raw materials 30
Other variable costs 40
Total variable costs – used for inventory valuation (70)
Contribution 30

Activity levels are constant throughout the year and annual sales, all of which are made on
credit, are $2.4 million. Dyer is now planning to increase sales volume by 50% and unit sales
price by 10%. Such expansion would not alter the fixed costs of $50,000 per month, which
includes monthly depreciation of plant at $10,000. Similarly, raw materials and other variable
costs per unit would not alter as a result of the price rise.

In order to facilitate the envisaged increases, several changes would be required in the long
term. The relevant points are as follows.
1. The average credit period allowed to customers will increase to 70 days.
2. Suppliers will continue to be paid on strictly monthly terms.
3. Raw material inventory held will continue to be sufficient for one month’s production.
4. Inventory of finished goods held will increase to one month’s output or sales volume.
5. There will be no change in the production period and “other variable costs” will
continue to be paid for in the month of production.
6. The current end of month working capital position is as follows.
$000 $000
Raw materials 60
Work in progress 140
Finished goods 70
270
Accounts receivables 200
470
Accounts payable (60)

P. 7
 Net working capital – excluding cash 410
Compliance with the long-term changes required by the expansion will be spread over several
months. The relevant points concerning the transitional arrangements are as follows.
7. The cash balance anticipated for the end of May is $80,000.
8. Up to and including June all sales will be made on one month’s credit. From July all
sales will be on the transitional credit terms which will mean

60% of sales will take two months’ credit

40% of sales will take three months’ credit.

9. The sales price increase will occur with effect from the sales in August.
10. Production will increase by 50% with effect from production in July; raw material
purchases made in June will reflect this.
11. Sales volume will increase by 50% from sales in October.

Required:

(a) Show the long-term increase in annual profit and long-term working capital
requirements as a result of the plans for expansion and the price increase. (Costs of
financing the extra working capital requirements may be ignored.) (6 marks)

(b) Produce a monthly cash forecast for June to December, the first seven months of
the transitional period. (10 marks)

(c) Using your findings from (a) and (b) above, make brief comments to the
management of Dyer Ltd on the major factors concerning the financial aspects of
the expansion which should be brought to their attention. (4 marks)

Assume that there are 360 days in a year and that each month contains 30 days.

(d) At the year end, Dyer Ltd has an overdraft of $1m. Interest at a rate of 10% per
annum is being charged on the overdraft.

The directors are concerned at the size of the overdraft and ask the finance
manager to take steps to reduce the figure. Additionally, the directors suspect that
improvements could be made within the working capital cycle.

P. 8
Sales during the year were $5m, with cost of sales at $3m. The following working
capital ratios at the year ended had been calculated.
Accounts receivable collection period 3 months
Inventory holding period 4 months
Accounts payable period 2 months

At present cash sales represent 10% of turnover, and 20% of all trade purchases
were cash on delivery (COD).

The finance manager feels that the working capital ratios could be improved to

Accounts receivable collection period 2 months

Inventory holding period 3 months
Accounts payable period 2.5 months

Additionally, no further COD purchases will be made. Cash sales will continue to
represent 10% of sales.

After negotiations with the bank it was agreed that $200,000 of the overdraft could
be converted to a fixed loan on which 7% interest would be charged per year. The
loan comes into effect on 1 January next year.

Required:

Assuming that the current levels of sales and cost of sales are repeated next year
and that any improvements in working capital will give rise to a whole year of
interest charge saved, calculate the total amount of interest saved solely as a result
of the financial manager’s proposed improvements.
(5 marks)
(Total 25 marks)

P. 9
Question 4

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):

$000
Authorised share capital, 50c each 20,000

Issued share capital, 50c each 2,500

Reserves 4,000
10% debentures (2014) 2,000
Bank overdraft (secured) 2,000
10,500

Other information:
Turnover 55,000
Profit after interest and tax 3,000
Interest paid 200
Dividends paid and proposed 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).

Required:

(a) Calculate and comment briefly on the company’s current capital gearing.
(3 marks)

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;

(b) By issuing ordinary shares at $2 each. (4 marks)

(c) By issuing 5% convertible loan stock, convertible in 2014. The conversion ratio is

P. 10
 40 shares per $100 of loan stock. (6 marks)
(d) By issuing 7.5% undated debentures. (3 marks)
(You should ignore issue costs in your answers to parts (b) to (d).

It assumes that the 7.5% undated debentures mentioned above is in floating rate, the company
wants to hedge using a one-year Forward Rate Agreement (FRA). The relevant rate is also set
at 7.5%.

Required:

(e) Explain how FRA works and state the advantages of FRA. (4 marks)
(f) Calculate the result of the FRA and the effective loan rate if the one-year FRA
benchmark rate has moved to:
(i) 6.5%;
(ii) 9.5%
(5 marks)
(Total 25 marks)

P. 11
 Formulae Sheet

1. The Capital Asset Pricing Model R j  R f   ( Rm  R f )

 Ve   Vd (1  T ) 
2. The asset beta formula a   e    d 
 Ve  Vd (1  T )    Ve  Vd (1  T )  
d 0 (1  g )
3. The growth model P0 
(k e  g )
4. Gordon’s growth approximation g  bre

5. The weighted average cost of  Ve   Vd 

WACC =  ke    k d (1  T )
capital  Ve  V d   Ve  V d 

6. The Fisher formula (1+ i) = (1+ r)(1+ h)

1  hc 
7. Purchasing power parity S1  S 0 
1  hb 

1  i c 
8. Interest rate parity F0  S 0 
 1  ib 

2C 0 D
9. Economic order quantity =
CH

Return point = Lower limit + (1/3 x spread)

10. Miller-Orr model 1

 3 transaction cos t  var iance of cash flow  3
3   
4 int erest rate 

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