ACCA

Paper F9
Financial Management

June 2015

Revision Mock 2 – Marking Scheme

P. 1
Section A – ALL 20 questions are compulsory and MUST be attempted
Each question is worth 2 marks.

1. D Charging interest is forbidden under Sharia’s law

2. A Although free to raise, using retained earnings as a source of finance (by
withholding a dividend) is not free to use – it is equity finance and requires the
cost of equity to be generated as a return.
3. B The bonus issue would have halved dividend per share, so the comparable
dividend from 4 years ago is 12c × 2 = 24c a share to ascertain growth.
Average annual growth rate: 24c × (1 + g)4 = 34c
g = 0.09 or 9%
34  1.09
Ke   0.09  16.4%
500
4. A The traditional view assumes there is an optimal balance between debt and equity
(there is a ‘U’ shaped weighted average cost of capital (WACC) curve) hence
choosing finance to aim for the optimum suggests the traditional view is adopted.

Modigliani-Miller (no tax) concludes the WACC is unaffected by the finance

decision hence the choice of debt compared to equity is irrelevant.

Modigliani-Miller (with tax) concludes that due to the tax benefits of paying
interest, as much finance as possible should be in the form of debt as increasing
gearing will reduce the WACC. Hence equity would never be chosen.

Residual view / theory is not directly relevant to the capital structure decision.
This term more directly relates to dividend policy.
5. A $2,500,000
Receipt =  $1,274,730
1.9618  0.0006
6. A Statement 1: Increased uncertainty will increase the preference for liquidity, and
will increase required yields into the future.

Statement 2: If the markets feel interest rates are going to rise, the required return
on longer dated bonds will increase in line with these expectations.

Statement 3 is false: this will lead to the curve flattening.

7. D Commercial paper, treasury bills and bankers acceptances do not pay interest.
They are issued at a discount and redeemed at a higher value. A certificate of
deposit does earn and pay interest however.

P. 2
8. B Current receivables = $10 million × (60 / 365) = $1,643,835.
Overdraft interest charge per annum relating to current receivables = $1,643,835
× 10% = $164,383.50 pa
Interest saved when half customers pay cash = 0.5 × $164,383.50 = $82,191.75
pa
Annual cost of the discount = 0.5 × $10 million × 2% = $100,000.
Net cost of offering the early settlement discount = $100,000 – $82,191.75 =
$17,808.25 cost pa
9. A The conversion premium compares the current loan note price with the value
should it be converted ie $125 – (25 × $4.10) = $22.50.
10. B
11. C Only a strong form efficient market reflects privately held information. The
announcement made public on 4 October was reflected in share price two days
earlier on 2 October (possibly due to insider dealing) meaning at that point
privately held information was reflected in share price.
12. C The machines have unequal lives and will be replaced with identical machines
indefinitely hence the choice should be made based on equivalent annual benefit
(EAB).
EAB Machine A = $10,000 / AF1-410% = $10,000 / 3.170 = $3,155 pa
EAB Machine B = $12,200 / AF1-610% = $12,800 / 4.355 = $2,939 pa
Therefore Machine A should be chosen as it offers the highest equivalent annual
benefit.
13. C Statement A describes a contractionary fiscal policy.
Statement B describes an expansionary monetary policy.
Statement C is correct: fiscal policy refers to the balance of taxation and
government spending. In an effort to boost demand, the government would
reduce taxes and increase government spending, net injecting demand into the
economy.
Statement D describes a contractionary monetary policy.
14. D Receivables = (60/360) × $3.6 million = $600,000.
If gross margin = 25% then cost of sales = $3.6million × 75% = $2.7 million
then payables = (90/360) × $2.7m = $675,000
and inventory = ($2.7m /18) = $150,000
Current ratio = (Receivables + inventory + cash) / payables = 2.0
= ($600,000 + $150,000 + cash) / $675,000 = 2
so ($750,000 + cash) = (2 × $675,000) = $1,350,000
Cash = $1,350,000 – $750,000 = $600,000
15. A

P. 3
16. D The retention ratio is 75%. Thus, dividend growth is 75% × 12% = 9%.
The dividend payout for the forthcoming year is 25% × $0·30 = $0·075
Predicted market value per share = [d1/(ke – g)]
= [0·075/(0·12 – 0·09)] = $2·50
17. B As there are different rates of inflation the money approach must be used, i.e. the
cash flows must be inflated at their specific rates and discounted at the money
cost of capital.
By Fisher’s equation: Money cost of capital = 1.1 × 1.08 – 1 = 18.8%
18. D Statement 1 is talking about default by the customers and therefore is part of
credit risk which is an example of financial risk.
Statement 2 refers to purchasing processes, which would be part of process risk.
Statement 3 refers to people risk. Both statements 2 and 3 would fall within
operational risk.
19. D %
Company borrows at LIBOR + 50 b.p. 3.75
Borrowing fixed at 3.63 + 50 b.p. 4.13
Compensation payment to FRA bank 0.38

20. D Statement A is not necessarily correct. Beta factors only measure systematic risk,
not total risk (which also includes specific/unsystematic risk).
Statement B is incorrect. Companies with different Beta factors may face the
same systematic risk factors, only to a differing degree.
Statement C is incorrect. This (assumed) temporary mispricing is unlikely to
affect the Beta factor overall.
Statement D is correct. Beta factors measure the level of systematic risk
associated with a share.

P. 4
Section B – ALL FIVE questions are compulsory and MUST be attempted

Answer 1
(a)
The effect on profit can be calculated as follows:
$000 $000 $000 Marks
Increase in sales
Category A customers (20% × $4m) 800.0
Category B customers (30% × $4m) 1,200.0
Category C customers (50% × $4m) 2,000.0 4,000.0 [1.5]

Increase in variable costs

Materials ($4m/$50 × $10) 800.0
Overheads ($4m/$50 × $5) 400.0 1,200.0 [1]

Increase in marketing costs 1,500.0 [0.5]

Increase in bad debts

Category A customers (1% × $800) 8.0
Category B customers (3% × $1,200) 36.0
Category C customers (5% × $2,000) 100.0 144.0 [1.5]

Increase in financing costs (W1)

Category A customers 6.6
Category B customers 13.2
Category C customers 27.4 47.2 2,891.2 [3]
Net profit 1,108.8 [0.5]
[8]

W1 Financing costs
Customer category A B C
$000 $000 $000 Marks
Increase in sales 800.0 1,200.0 2,000.0

Additional debtors
($800 × 30/365) 65.8
($1,200 × 40/365) 131.5
($2,000 × 50/365) 274.0

P. 5
Interest charges (10%) 6.6 13.2 27.4

(b)
The calculations in (a) above show that profits will increase by approximately $1·1m as a
result of a $4m increase in sales. This return on sales, of approximately 28%, is achieved
despite a marketing campaign which adds a further $1·5m to the total expenses of the
company.

This relatively high return on sales can be explained by the fact that most of the costs of
producing the device are fixed. The contribution per device is $35 per unit (that is, $50
selling price less $15 variable costs) which gives a contribution-to-sales ratio of 70%. Hence,
any additional output will make a significant contribution to profit.
[3 marks]
(c)
A number of policies can be adopted to ensure that credit customers pay on time.
These include the following:
– Issue invoices promptly and ensure that the payment terms are specified on the invoice;
– Send out regular monthly statements and issue reminders when payment is overdue;
– Monitor debtors by producing an ageing analysis of debtors;
– Deal with outstanding queries quickly and efficiently;
– Chase slow payers by letter, e-mail and telephone;
– Ensure that no further credit is given to delinquent debtors.
– Offer financial incentives, such as discounts, to encourage prompt payment.
[1 mark for each point, maximum 4 marks]

P. 6
Answer 2
(a)
EV = (0.3 × 0.50) + (0.5 × 1.40) + (0.2 × 2.0)
= 0.15 + 0.70 + 0.40 = 1.25 (i.e.) $ 1.25m [1]

To determine the NPV of the project, Blackwater must weigh the present value of the costs
incurred i.e. the outlay and the increased production costs, against the benefits in the form of
the two sets of tax reliefs relating to the increased operating costs and to the writing-down
allowance and also the present value of the fines avoided. These are set out in the following
table.

Marks
0 1 2 3 4 5
$m $m $m $m $m $m
Outlay (1.000) [0.5]
EU grant 0.25 [0.5]
FSL’s fee (0.050) [1]
Increase costs (0.315) (0.331) (0.347) (0.365) [1]
Tax saving of costs 0.104 0.109 0.115 0.120 [1]
CA tax benefits 0.083 0.062 0.047 0.035 0.104 [2]
Net cash flows (1.000) (0.032) (0.165) (0.191) (0.215) 0.224
DF @ 12% 1.000 0.893 0.797 0.712 0.636 0.567
PV (1.000) (0.029) (0.132) (0.136) (0.137) 0.127

NPV = (1.307), i.e. ($1.307m) [1]

Year WDV ($) CA ($m) Tax rate Tax benefit

1 1.000 × 25% = 0.25 × 33% = 0.083
2 0.75 × 25% = 0.1875 × 33% = 0.062
3 0.5625 × 25% = 0.141 × 33% = 0.047
4 0.4215 × 25% = 0.1054 × 33% = 0.035
5 0.3161 (bal. allow.) × 33% = 0.104

Since the negative NPV exceeds the expected present value of the fines ($1~250m) over the
same period, it appears that the project is not viable in financial terms (i.e. ) it is cheaper to
risk the fines. [1]

P. 7
(b)
On purely non-financial criteria, it can be suggested that as a regular violator of the
environmental regulation, our company has a moral responsibility to install this equipment,
so long as it does not jeopardise the long-term survival of the company.

But the figures appended suggest that the project is not wealth-creating for Blackwater’s
shareholders as the EV of the fines is less than the expected NPV of the project. However,
this conclusion relies on accepting the validity of the probability distribution, which is
debatable. Not only are the magnitudes of the fines merely estimates, but the probabilities
shown are subjective. Different decision-makers may well arrive at different assessments
which could lead to the opposite decision on financial criteria.

More fundamentally, the use of the expected value principle is only reliable when the
probability distribution approximates to the normal. In this case, it is slightly skewed toward
the lower outcomes. But more significantly, if the distribution itself is examined more closely,
it appears to indicate that there is a 70% chance (0.5 + 0.2) of fines of at least $ 1.4m,
which exceeds the NPV of the costs of the pollution control project. In other words, there is a
70% chance that the project will not be worthwhile. It therefore seems perverse to reject it
on these figures.

Moreover, given that Blackwater is a persistent offender, and that the green lobby is
becoming more influential, there must be a strong likelihood that the level of fines will
increase in the future, suggesting that the data given are under-estimates. Higher expected
fines would further enhance the appeal of the project.

It is also possible that the company may sell more output, perhaps at a higher price, if it is
perceived to be more environmentally friendly and if customers are swayed by this. This
may be less likely for industrial companies although it would create opportunities for self-
publicity on both sides. In addition, there may be more general image effects which may
foster enhanced self-esteem among the workforce, as well as increasing the acceptability of
the company in the local community.

Finally, this may be only a short-term solution. As the operating life of the equipment is only
four years, we will face a further investment decision after this period, although technological
and legal changes may well have altered the situation by then.
[1 mark for each point, maximum 6 marks]

P. 8
Answer 3
(a)
2011 2012 2013 2014
Growth in profit for the period - 25.3% 27.2% 16.5%
Payout ratio 71% 57% 45% -
EPS (cents) 31.0 38.9 49.4 57.6
PE ratio (times) 14.2 13.5 13.0 12.0
DPS (cents) 22 22 22 -
Dividend yield (on opening price) - 5% 4.2% -
Share price growth - 19.3% 22.3% 7.5%
Total shareholder return - 24.3% 26.5% -
[2 marks]

It is clear that VAL Co has recently been through a period of exceptional growth, with the
profit for the period and EPS growing substantially each year.

However, not everything is as positive as it might initially seem. The price earnings ratio has
been falling from a high of 14.2 down to its current level of 12.0. Whilst this may be due to a
decline in share prices more generally, a comparison against AVL Co (a very similar albeit
larger company) shows that this is unlikely; AVL are currently trading on a P/E ratio of 13.5
(250 million × $4.60 ÷ $85 million) which is the level previously seen by VAL Co back in
2012.

Share price growth has fallen significantly in 2014 meaning that if a similar level of dividend
were to be declared in 2014, the total shareholder return would also fall. Dividend yield has
also been falling and does not compare favourably with the level of returns being made on
other equity investments.

Perhaps the biggest cause of this will be the Board’s apparent reluctance to invest in new
projects. For a company to be sat on such a large cash balance does not provide the best
growth potential and does not maximize returns for shareholders. Undoubtedly shareholders
would like to either see the surplus cash invested in positive NPV projects or returned to the
investors by way of higher dividends. For this reason, it would not appear as if VAL Co is
achieving its objective of maximization of shareholder wealth.
[1 mark per relevant comment, maximum 2 marks]

P. 9
(b)
P/E ratio of AVL Co (a suitable proxy co):
EPS – $85m/250m = $0.34
P/E ratio – $4.60/$0.34 = 13.5 times [1 mark]
Value of VAL Co using the P/E ratio of AVL Co:
EPS – $40m/70m = $0.571
Value per share – $0.571 × 13.5 = $7.71
Total company value – $7.71 × 70m = $539.7m [1 mark]

As the current market value of a share is $6.90, the P/E ratio value calculated indicates that
VAL Co may be undervalued by $0.81 ($7.71 – $6.90) per share. As noted above, this
undervaluation is most likely due to the market’s lack of confidence in the investment
decisions being made by the company.

However the P/E value calculated is rather simplistic and a number of other factors should be
considered in addition to those noted in part (a):

VAL Co has achieved market leading growth in recent years and hence it may well have a
better future than AVL Co once it does start investing. Hence the valuation of $7.71 could
itself be an under valuation.

VAL Co is smaller than AVL Co. The market capitalisation of AVL Co is $1,150m (250m ×
$4,60) whilst the market capitalisation of VAL Co is $483m (70m × $6.90). Due to this the
market may view AVL Co as a more stable company than VAL Co in which case a value for
VAL Co based on the P/E ratio of AVL Co may be an over valuation. However, the fact that
the market has previously valued VAL Co based on a higher P/E ratio may suggest this isn’t
the case.

Carrying out a valuation of VAL Co using the P/E ratio of just one other company is
potentially unwise as although AVL Co is said to be very similar, but larger, there are bound
to be other differences. Hence it may be better to use an industry average P/E ratio.

The fact that the market is currently unaware of the new project that VAL Co is considering
will mean that the value of that project is not currently reflected in the market value given the
efficiency of the market. Hence the market value may be an under valuation. If the market
does not know that the company intends to use their cash productively the market may be
marking down the value of VAL Co as it seems to be under utilising its cash resource.
[1 mark for each point, maximum 4 marks]

P. 10
Answer 4
(a)(i)
Share price in 4 years’ time = GBP 3.60 × 1.064 = GBP 4.54
Forecast conversion value = GBP 4.54 × 23 = GBP 104.42 [1 mark]

(a)(ii)
Year Cash flow DF PV DF PV
($) 7% ($) 5% ($)
0 Market value (93.00) 1.000 (93.00) 1.000 (93.00)
1–4 Interest [$3 x (1 – 30%)] 2.1 3.387 7.11 3.546 7.45
4 Redemption value 104.42 0.763 79.67 0.823 85.94
(6.22) 0.39
[2 marks]
The approximate cost of convertible bond is, therefore:
0.39
5%  (7%  5%)  5.12% [1 marks]
0.39  6.22

(a)(iii)
Cost of capital Market value (GBP in GBP
million) million
Share capital Ke = 11.56% (W1) [1 mark] = 280m × GBP 3.60 = 1.008
Preference shares 0.06 = 195m × GBP 1.05 = 204.75
Kp =  5.71% [1 mark]
1.05
Debt Kd = 5.12% ((a)(ii)) 250
1,462.75
[1 mark]
1,008 204.75 250
WACC =  11 .56%   5.71%   5.12% = 9.64%
1,462.75 1,462.75 1,462.75

[1 marks]

W1 Cost of equity
By dividend growth model:
D1 = GBP 0.45 × 50% × 1.05 = GBP 0.23625 per share
0.23625
Ke =  5%  11 .56%
3.6

P. 11
(b)
Treasury is likely to be involved in:
 Determining conversion ratio(s) and coupon interest rate on the instrument.
 Managing the relationship with the investment bank or issuing house supporting the
bond issue.
 Calculating costs of capital and ensuring that new debt will not adversely affect the
value of the company. Ensuring earnings are sufficient to cover interest payments and
maintain dividend levels to preference and ordinary shareholders.
 Preparing all paperwork and a timetable for the issue.
[2 marks]

P. 12
Answer 5
(a)(i)
Shares Loan notes
$m $m
Operating profit (36.0 + 10.0) 46.0 46.0
Loan interest payable (4.0) (7.2)
Profit before taxation 42.0 38.8
Tax (25%) (10.5) (9.7)
Profit for the year 31.5 29.1
[2]
(a)(ii)
Expected EPS
Share issue = $31.5m / 76.0 (W1) = $0.41 [1]

W1 $30m/$0.50 + 40m/($0.50 + $2.0) = 76.0

Loan notes issue = $29.1m / 60.0 = $0.49 [1]

(a)(iii)
Expected level of gearing
50.0
Share issue =  22.8% [1]
(46.0  24.0  99.3  50.0)

50.0  40.0
Loan notes issue =  41.5% [1]
(30  96.9  50  40)

(b)
The calculations in (a) above indicate that expected EPS is higher under the loan notes
option than under the share option. It is also higher than the current earnings per share
figure of 40·0p. This increase in return, however, comes at the cost of higher risk. The
gearing ratio is much higher under the loan notes option than under the share option. It is
also much higher than the current gearing ratio of 33·8%. Nevertheless, the interest cover
ratios suggest that, under both options, operating profits comfortably cover interest
charges. The interest cover ratio is 11·4 times for the share option and 6·4 times for the
loan option. Shareholders must, therefore, consider whether the expected increase in the
level of risk is acceptable for the expected increase in returns.
[2 marks]

P. 13
Under the share option there would be an almost 27% increase in the number of shares in
issue. This is a significant increase and, if existing shareholders are expected to subscribe to
the share issue, will represent a substantial additional investment on their part. If
shareholders, however, are unable or unwilling to participate in the issue, the amount to
be raised will have to come from outside investors. As a consequence, existing
shareholders will suffer a significant dilution in their ownership and control of the
company.
[2 marks]

P. 14