ACCA REVISION MOCK 3

Financial Management

December 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.

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ALL FOUR questions are compulsory and MUST be attempted

Question 1

Widget Co is a listed group which operates a number of manufacturing facilities within its
home country. Widget Co has $700 million funds available for capital investment in new
product lines in the current year. Most products have a very limited life cycle. Four possible
projects have been identified, each of which can be started without delay.

Initial calculations for these projects are shown below:

Project Initial Net annual cash Project term PV of cash flows NPV
investment inflows after (years) arising after the
initial investment initial investment
$m $m $m $m
A 100 151.2 1 135 35
B 150 82.3 4 250 100
C 300 242.6 2 410 110
D 350 124.0 6 510 160

Notes:
1. The projects are non-divisible and each project can only be undertaken once.
2. Apart from the initial investment, annual cash flows are assumed to arise at the end of
the year.
3. A discount rate of 12% has been used throughout.
4. Ignore taxation.

Required:

(a) Prioritise the project according to each of the following measures:

(i) Net present value (NPV)
(ii) Profitability index (PI)
(iii) Payback (undiscounted)
(5 marks)
(b) Explain the strengths and weaknesses of each of the prioritization methods used in
(a) above as the basis for making investment decisions in the context of capital
rationing for non-divisible projects. (9 marks)

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(c) Advise what combination of projects maximizes shareholders’ wealth within a
maximum total initial investment of $700 million. (3 marks)
(d) Explain how the optimal combination of projects would need to reassessed under
EACH of the following circumstances:
(i) ‘Soft’ rather than ‘hard’ single period capital rationing applies.
(ii) The same level of capital rationing and range of projects is expected in the
following year.
(8 marks)
(Total 25 marks)

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Question 2

Sky Ltd is a stock-market listed manufacturing company that is seeking additional finance of
$5 million to undertake a new project. The finance director of Sky Ltd is currently
considering whether to raise the capital via debt or equity finance.

The capital structure of the company (before the new finance has been raised) is as follows:

$m $m
Equity
Ordinary shares (par value 50c per share) 10
Reserves 30
40
Non-current liabilities
Bond A (par value $100) 10
Bank loan 5
15
55

Other relevant financial information:

Ordinary share price (cum div basis) $4.69
Earnings per share 40c
Proposed payout ratio 60%
Return on capital employed 15%
Taxation rate 30%

Bond A will be redeemed at par in five year’s time and pays a fixed annual interest of 9%.
Alternatively, each bond may be converted on that date into 20 ordinary shares of the
company. The current bond price of Sky Ltd is $120.

The bank loan is repayable in two years’ time. It is a floating rate loan at LIBOR + 1%.
LIBOR is currently at 3%.

Some initial enquiries made by the finance director have indicated that further fixed rate debt
finance could be raised at an annual post-tax cost of 7%. Floating rate debt finance could be
obtained for LIBOR + 2%. Market experts are divided over the expectations of future interest
rates with some expecting rates to remain steady for the foreseeable future and others

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predicting an increasing up to 4%.

Required:

(a) Calculate the cost of equity of Sky Ltd. (4 marks)

(b) Calculate the after-tax cost of bond A of Sky Ltd. (5 marks)

(c) Calculate the weighted average after-tax cost of capital of Sky Ltd. (4 marks)

(d) Evaluate the impact on the weighted average cost of capital of raising the new
finance via:
(i) Equity
(ii) Fixed rate debt.
State any assumptions that you make. (4 marks)

(e) Discuss the factors affecting the choice between fixed and floating rate debt and
describe two methods of hedging interest rate risk that may be appropriate for Sky
Ltd. (8 marks)
(Total 25 marks)

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Question 3

Thorne Co operates an office furniture business that generated sales revenues of $80 million
during the year ended 31 December 2011. The office furniture market is expected to be
stagnant for the foreseeable future and so sales revenues for the company for the forthcoming
year are forecast to remain the same as in the previous year, assuming that no changes are
made to the terms of trade.

All sales are on credit and the terms of trade include the requirement that payment for goods
is due one month after sale. A recent analysis of trade receivables, however, shows that, on
average, customers take two months to pay. Although the company does not currently offer its
customers a discount for prompt payment, the board of directors is considering a change in
policy in an effort to improve the average collection period for receivables.

The marketing department believes that, by offering a 2.5% discount for customers who pay
within one month, 75% of existing customers will pay at the end of one month in order to
receive the discount. The remaining 25%, however, are likely to pay at the end of two months.
A change in discount policy is likely to prove popular with customers and will bring the
company’s terms of trade into line with those of its competitors. This change is also forecast
to generate new customers, all of which are likely to take advantage of the new discount
policy. The marketing director, who is a long-time advocate of offering discounts for prompt
payment, has suggested that these new customers are likely to generate an additional $10
million of sales revenue during the forthcoming year.

The following forecasts for the forthcoming year have been made and are not affected by the
proposed change in the terms of trade:

(i) a gross profit margin on sales revenues of 45%.

(ii) variable overheads will be 20% of sales.
(iii) fixed overheads will be $4.8 million.
(iv) variable and fixed overheads will be paid in the month in which incurred.
(v) sales and cost of sales will accrue evenly over the year.
(vi) three months’ credit (based on the cost of sales) will be taken from trade payables.

The company intends to hold four months’ inventory at all times and to have a cash balance at
the year end of $0.3 million.

Ignore taxation.

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Required:

(a) Calculate the forecast net profit of Thorne Co for the forthcoming year, based on
the assumption that:
(i) the proposed discount policy is not adopted; and
(ii) the proposed discount policy is adopted.
(5 marks)

(b) Calculate the investment in working capital at the end of the forthcoming year,
based on the assumption that:
(i) the proposed discount policy is not adopted; and
(ii) the proposed discount policy is adopted.
(6 marks)

(c) Discuss your calculations in answer to parts (a) and (b) above and state whether
the proposed discount policy should be adopted. (4 marks)

(d) Explain why very Small to Medium-size Enterprises (SMEs) might face problems
in obtaining appropriate sources of finance and suggest potential sources of finance
for very new SMEs excluding sources from capital markets. (10 marks)

(Total 25 marks)

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Question 4

Since moving to the West as a student accountant, a Middle‐Eastern entrepreneur has

successfully developed a diversified portfolio of interests. He is currently considering the
purchase of a privately owned chain of supermarkets using debt finance and has obtained the
following information about the supermarket company:

Turnover $23 million

Profit before tax $7 million
Shareholders’ funds $16.2 million (per the latest statement of financial position)

However the net realisable value of the company is only considered to be $11.7m. This is
because the business leases its premises and hence the shareholders’ funds are largely made
up of the fixtures and fittings of the supermarkets. These fixtures and fittings have to be
renewed on a regular basis to continue to attract customers but would have a limited resale
value if the business was no longer a going concern.

The existing owner of the business currently pays himself a salary of $250,000 per annum.
This is far in excess of the remuneration required for such a post. It is estimated that a
commercial remuneration would be approximately $90,000.

Other relevant information is as follows:

Corporate tax rate 28%

Average price earnings ratio for listed supermarket operators 10.6
Range of price earnings ratio for listed supermarket operators 6.4 – 15.2

Mr Jaizy is keen that the finance to be used for the acquisition should be structured under
Islamic Finance principles.

Required:

(a) Calculate a value of the supermarket chain using the price earnings based method.
(5 marks)
(b) Discuss the relevance of the value calculated to negotiations regarding the
proposed acquisition. Compare this with the relevance of the asset values provided.
(9 marks)
(c) Define other valuation methods that could be used to calculate a value for the

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 chain of supermarkets and briefly discuss some of their limitations in this
circumstances. (6 marks)
(d) Discuss how the desire to use Islamic finance principles may impact on the
acquisition and its funding. Briefly outline a suitable source of Islamic finance
that Mr Jaizy may consider. (5 marks)
(Total 25 marks)

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 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 WACC =  Ve   Vd 

 ke    k d (1  T )
capital Ve  Vd  Ve  Vd 

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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