Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ

CFAP 4 Business Finance Decisions

ST Academy
Certified Finance and Accounting Professional Stage Examination
September 11, 2022
1 Hour 50 Minutes– 60 marks
Additional reading time – 10 minutes

CFAP 4 - Business Finance Decisions (Grand Test 2)

Question 1:
ST Medical plc (STM) is a local company that manufactures a range of medical equipment for
use in hospitals and doctors' surgeries. STM has a year end of 28 February and it has been
trading since 1999.
Extracts from STM's most recent management accounts are shown below:
Income statement for the year ended 28 February 20X4 Rs'000
Profit before interest and taxation 6,512
Debenture interest (516)
Profit before taxation 5,996
Taxation (17%) (1,019)
Profit after taxation 4,977
Dividends (1,493)
Retained profit 3,484

Balance sheet at 28 February 20X4 Rs'000

Ordinary share capital (Rs1 shares) 34,600
Retained earnings 31,384
65,984
6% Redeemable debentures (redeemable 20X9) 8,600
74,584
STM's ordinary shares had a market value of Rs 2.45 each (ex-div) & beta of 0.9 on 28 February
20X4. The return on the market is expected to be 8.6% pa and the risk free rate 2.1% pa.
STM's debentures had a market value of Rs 110 (cum interest) per Rs100 nominal on 28
February 20X4 and they are redeemable at par on 28 February 20X9.
STM's board is now considering diversifying its operations by expanding into a new market. The
average equity beta for companies already operating in this market is 1.9 with an average ratio
of equity to debt (by market values) of 83:17.
This diversification will cost STM approximately Rs25 million. However, there is disagreement
amongst STM's directors as to how the diversification should be funded and whether it should
happen at all. There are three proposals that are being considered:

Proposal 1
STM proceeds with the diversification. It would raise the additional funding required from
equity and debt sources in such a way as to leave its existing equity: debt ratio (by market
values) unchanged following the diversification. The additional debt raised would be in the form
of 8% redeemable debentures issued at par.

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
Proposal 2
STM proceeds with the diversification. It would raise all of the additional funding required in
the form of 8% redeemable debentures issued at par.
Proposal 3
STM does not proceed with the diversification. The funds, raised as in proposal 2, are used
instead to buy back some of its ordinary shares.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.

Required:
a) Ignoring the diversification plans, calculate STM's WACC (weighted average cost of capital)
on 28 February 20X4, using:
i. The Gordon growth model (7 marks)
ii. The CAPM (2 marks)

b) Explain the limitations of the Gordon growth model. (2 marks)

c) Assuming that Proposal 1 is accepted and using the CAPM, calculate the WACC that STM
should use when appraising its diversification plans and explain your reasoning. (6 marks)

d) Assuming that Proposal 2 is accepted, discuss the issues that STM faces when trying to
determine an appropriate WACC for appraising its diversification plans. Your answer should
make reference to relevant theories. (3 marks)
[Total 20 Marks]

Question 2:
Emandaar Ltd (Emandaar) is a large civil engineering company and it has a financial year end of
31 May. Much of Emandaar' work involves long-term contracts for the railway industry. You
work for Emandaar and have been asked for advice by the board on the following problems:
Problem 1
Emandaar is considering a major investment involving five possible projects in the West of
England and South Wales which have been put out to tender. Emandaar' board of directors has
prepared the following estimated cash flows (and resultant net present values at 31 May 20X7)
for the five projects:
Investment Year to Year to Year to
Project Location NPV
on 31/5/X7 31/5/X8 31/5/X9 31/5/Y0
Rs'000 Rs'000 Rs'000 Rs'000 Rs'000
B Bristol -4150 -1290 530 7270 577
C Cardiff -3,870 -1,310 3,130 1,550 -1,309
G Gloucester -6,400 1,770 2,160 3,160 -632
S Swansea -5,000 -2,610 6,450 6,520 2,856
T Tiverton -4,600 1,290 2,870 3,620 1,664
You can assume that the net present values shown in the table above are accurate.

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
Due to financial constraints, the company, if successful with its tenders, would be unable to
take on all five projects. The board is prepared to release Rs8 million for initial investment (on
31 May 20X7) into one or more of the projects, but might increase this figure to Rs9 million if
there are grounds for doing so. An alternative scenario which has been considered would be to
make available sufficient funds to start all five projects in May 20X7, but this would limit the
capital available in the year to 31 May 20X8 to a maximum of only Rs500,000.

Problem 2
Emandaar runs a fleet of vans to support its operations. Currently it replaces those vans every
three years, but the board is not sure whether this is in the company's best interests. Vans cost,
on average, Rs12,400 each. Emandaar' transport manager has prepared the following schedule
of costs and resale values for the vans:
Maintenance and Resale Value
running costs (Rs) (Rs)
In first year of van's life 4,300 After one year 9,800
In second year of van's life 4,800 After two years 7,000
In third year of van's life 5,100 After three years 5,000

Problem 3
About a year ago (March 20X6) Emandaar completed construction of a factory for Sachaa Ltd
(Sachaa). This cost Emandaar Rs720,000 to construct and Sachaa is paying Rs190,000 a year for
eight years.
Emandaar will, therefore, ultimately make a profit of Rs800,000, which gives a return on the
investment of over 100%. When Sachaa sent its first annual instalment last week, it indicated
that rather than make annual payments it would prefer to settle the outstanding balance by
making a one-off payment of Rs925,000 in a year's time (March 20X8). One of Emandaar'
directors is keen on this proposal stating 'I know that this is less than we would receive over the
full eight years, but my calculations show that the internal rate of return would be much
better.'
General information
(1) Emandaar uses a cost of capital of 10% when appraising possible investments.
(2) You should assume that all cash flows take place at the end of the year in question.
(3) All projects are independent.

Required:
a) For Problem 1, assuming that all of the projects are divisible and:
i. Assuming that Emandaar has no capital rationing, advise its directors as to which
projects should be accepted. (1 mark)
ii. Assuming that the directors are prepared to spend a maximum of Rs8 million on 31 May
20X7, advise them as to which projects should be accepted. (2 marks)

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
iii. Assuming that the directors are prepared to make available sufficient funds to start all
five projects on 31 May 20X7, but only Rs500,000 on 31 May 20X8, advise them as to
which projects should be accepted. (4 marks)
b) For Problem 1, assuming that none of the projects are divisible and that the directors are
prepared to spend a maximum of Rs9 million on 31 May 20X7, advise them as to which
projects should be accepted. (3 marks)
c) For Problem 2, advise the directors as to the optimal replacement period for Emandaar'
vans and comment on the limitations of the approach used. (5 marks)
d) For Problem 3, advise the directors as to whether they should accept Sachaa's proposal.
(5 marks)
[Total 20 Marks]
Question 3:
STCo plc (STCo) is a company involved in the production of printing inks used in a wide range of
applications in the food packaging industry. The directors of STCo are currently considering a
Rs2 million investment in new production facilities. At the present time, the company's finance
director is seeking to establish an appropriate cost of capital figure for use in the appraisal of
the proposed investment. Extracts from STCo's most recent financial statements for the year
ended 31 March 20X3 are shown below:

Rs'000
Ordinary share capital (50p shares) 3,200
5% irredeemable preference share capital (50p shares) 1,400
Reserves 7,000
11,600
7% debentures (at nominal value) 1,500
13,100
Current liabilities 3,700
Total equity and liabilities 16,800

Rs'000
Profit before taxation 3,000
Taxation (510)
Preference share dividends (70)
Ordinary share dividends (1,088)

The market prices for the company's shares and debentures on 31 March 20X3 were:
(1) Ordinary shares: Rs1.42 each (cum-div)
(2) 5% irredeemable preference shares: Rs0.20 each (ex-div)
(3) 7% debentures: Rs105.00 (per Rs100 nominal)

The ordinary dividend for the year ended 31 March 20X3 is due to be paid shortly. This is the
first dividend paid since the year ended 31 March 20W9, when the dividend payout ratio was
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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
40% and the earnings per share were Rs0.35. STCo's directors expect future dividends to grow
at the annual growth rate implied by the dividends paid in 20W9 and 20X3. The number of
ordinary shares in issue has not changed since March 20W9.
The annual debenture interest has recently been paid. The 7% debentures are redeemable at
par in 10 years' time.
Shares in the industrial sector in which STCo operates typically have an equity beta of 1.3 with a
debt to equity ratio of 1:1. The risk free rate is 6% pa and the return from the market portfolio
is 14% pa.
The company's finance director has proposed that, if the investment is undertaken, then an
issue of redeemable debentures is used to finance it. However, STCo's Chief Executive has
expressed concerns about the possible use of redeemable debentures. His view is that
increasing the number of debentures issued by the company will increase the company's
gearing dramatically and the increased financial risk associated with this could easily lead to a
fall in the company's share price and, therefore, its market value.
The directors wish to assume a rate of corporation tax of 17% for the foreseeable future.
Required:
a) Calculate (using the dividend growth model) a weighted average cost of capital that could
be used to appraise STCo's proposed investment. (9 marks)
b) Explain the underlying assumptions and any other relevant factors that may mean it is
inappropriate to use the cost of capital figure calculated in requirement a) in the appraisal
of STCo's proposed investment. (3 marks)
c) (i) Estimate STCo's cost of equity using the capital asset pricing model. (2 Marks)
(ii) Explain two key assumptions that would underpin the use of this cost of equity in the
calculation of the weighted average cost of capital. (3 marks)
d) Making reference to relevant theories, comment on the views expressed by STCo's chief
executive. (3 marks)
[Total 20 Marks]

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
Solution Grand Test 2 December 2022
Question 1 Marks Allocation and Solution

Marks Allocation

Part a)
iii. WACC Using The Gordon growth model

(1)
(1)
(1)
(1)
(1)
(1)
(1)
(7) (Total 7 Marks)

iv. WACC Using The Gordon growth model

(0.5)
(1)
(0.5) (Total 2 Marks)

Part b)
limitations of the Gordon growth model. (1 mark for each limitation (Total 2 Marks))

Part c)
(0.5)
(0.5)
(1)
(1)
(1)
(2) (Total 6 Marks)

Part d) Discussion of issues (traditional and M&M) (1 Mark for each point.. Max 3 Marks)

{Total 20 Marks}
SOLUTION Question 1

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
Part a (i)

(Marks distribution mentioned above)

Part a (i)

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
Part b)

Part c)

Part d)

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
Question 2 Marks Allocation and Solution

Marks Allocation

Part a)
i. Reasoning: (0.5) Figures: (0.5) Total 1 Mark
ii. Method and figures: (1.5) Ranking: (0.5) Total 2 Marks
iii. Method: 1 Calculations: 1 Conclusions and reasoning: 2 Total 4 Marks
Total 7 Marks
Part b) Reasoning: 2 Conclusion: 0.5 NPV: 0.5 Total 3 Marks
Part c) Calculations: 3 Limitations: 2 Total 5 Marks
Part d) PV calculations: 3 Conclusion and reasoning: 2 Total 5 Marks

SOLUTION Question 2

Part a (i)

Part a (ii)

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
Part a (iii)

Part b)

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
Part c)

Part d)

Question 3 Marks Allocation and Solution

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy

Marks Allocation
Part a)
(1)
(1)
(1)
(1)
(1)
(1)
(1)
(1)
(1)
(9) Total 9 Marks

Part b) 1 Mark per Point (Max 3 Marks) Total 3 Marks

Part c)
(1)
(0.5)
(0.5)
(3 Marks… 3 Assumtions should be mentioned)
Total 5 Marks

Part d) 1 Mark per Point (Max 3 Marks) Total 3 Marks

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
SOLUTION Question 3
Part a)

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 Grand TEST 2 (Mid Term) December 2022 SAUD TARIQ
CFAP 4 Business Finance Decisions
ST Academy
Part b)

Part c)

Part d)

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