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Financial Management

Thursday 10 June 2010

Time allowed
Reading and planning:
Writing:

15 minutes
3 hours

ALL FOUR questions are compulsory and MUST be attempted.


Formulae Sheet, Present Value and Annuity Tables are on pages 6, 7
and 8.
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.
This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level Skills Module

ALL FOUR questions are compulsory and MUST be attempted


1

ZSE Co is concerned about exceeding its overdraft limit of $2 million in the next two periods. It has been experiencing
considerable volatility in cash ows in recent periods because of trading difculties experienced by its customers, who
have often settled their accounts after the agreed credit period of 60 days. ZSE has also experienced an increase in bad
debts due to a small number of customers going into liquidation.
The company has prepared the following forecasts of net cash ows for the next two periods, together with their
associated probabilities, in an attempt to anticipate liquidity and nancing problems. These probabilities have been
produced by a computer model which simulates a number of possible future economic scenarios. The computer model
has been built with the aid of a rm of nancial consultants.
Period 1 cash flow
$000
8,000
4,000
(2,000)

Probability
10%
60%
30%

Period 2 cash flow


$000
7,000
3,000
(9,000)

Probability
30%
50%
20%

ZSE Co expects to be overdrawn at the start of period 1 by $500,000.


Required:
(a) Calculate the following values:
(i)
(ii)
(iii)
(iv)

the
the
the
the

expected value of the period 1 closing balance;


expected value of the period 2 closing balance;
probability of a negative cash balance at the end of period 2;
probability of exceeding the overdraft limit at the end of period 2.

Discuss whether the above analysis can assist the company in managing its cash flows.

(13 marks)

(b) Identify and discuss the factors to be considered in formulating a trade receivables management policy for
ZSE Co.
(8 marks)
(c) Discuss whether profitability or liquidity is the primary objective of working capital management. (4 marks)
(25 marks)

YGV Co is a listed company selling computer software. Its profit before interest and tax has fallen from $5 million to
$1 million in the last year and its current financial position is as follows:
$000
Non-current assets
Property, plant and equipment
Intangible assets
Current assets
Inventory
Trade receivables

$000

3,000
8,500

11,500

4,100
11,100

15,200

26,700

Total assets
Current liabilities
Trade payables
Overdraft
Equity
Ordinary shares
Reserves

5,200
4,500

9,700

10,000
7,000

17,000

26,700

YGV Co has been advised by its bank that the current overdraft limit of $45 million will be reduced to $500,000
in two months time. The finance director of YGV Co has been unable to find another bank willing to offer alternative
overdraft facilities and is planning to issue bonds on the stock market in order to finance the reduction of the overdraft.
The bonds would be issued at their par value of $100 per bond and would pay interest of 9% per year, payable at the
end of each year. The bonds would be redeemable at a 10% premium to their par value after 10 years. The finance
director hopes to raise $4 million from the bond issue.
The ordinary shares of YGV Co have a par value of $100 per share and a current market value of $410 per share.
The cost of equity of YGV Co is 12% per year and the current interest rate on the overdraft is 5% per year. Taxation is
at an annual rate of 30%.
Other financial information:
Average gearing of sector (debt/equity, market value basis):
Average interest coverage ratio of sector:

10%
8 times

Required:
(a) Calculate the aftertax cost of debt of the 9% bonds.

(4 marks)

(b) Calculate and comment on the effect of the bond issue on the weighted average cost of capital of YGV Co,
clearly stating any assumptions that you make.
(5 marks)
(c) Calculate the effect of using the bond issue to finance the reduction in the overdraft on:
(i) the interest coverage ratio;
(ii) gearing.

(4 marks)

(d) Evaluate the proposal to use the bond issue to finance the reduction in the overdraft and discuss alternative
sources of finance that could be considered by YGV Co, given its current financial position.
(12 marks)
(25 marks)

[P.T.O.

The following draft appraisal of a proposed investment project has been prepared for the nance director of OKM Co by
a trainee accountant. The project is consistent with the current business operations of OKM Co.
Year
Sales (units/yr)
Contribution
Fixed costs
Depreciation
Interest payments
Taxable prot
Taxation
Prot after tax
Scrap value
Aftertax cash ows
Discount at 10%
Present values

1
250,000
$000
1,330
(530)
(438)
(200)

162

2
400,000

3
500,000

162

$000
2,128
(562)
(438)
(200)

928
(49)

879

$000
2,660
(596)
(437)
(200)

1,427
(278)

1,149

162
0909

147

879
0826

726

1,149
0751

863

4
250,000
$000
1,330
(631)
(437)
(200)

62
(428)

(366)
250

(116)
0683

(79)

5
$000

(19)

(19)
(19)
0621

(12)

Net present value = 1,645,000 2,000,000 = ($355,000) so reject the project.


The following information was included with the draft investment appraisal:
1.
2.
3.
4.
5.

The initial investment is $2 million


Selling price: $12/unit (current price terms), selling price ination is 5% per year
Variable cost: $7/unit (current price terms), variable cost ination is 4% per year
Fixed overhead costs: $500,000/year (current price terms), xed cost ination is 6% per year
$200,000/year of the xed costs are development costs that have already been incurred and are being recovered
by an annual charge to the project
6. Investment nancing is by a $2 million loan at a xed interest rate of 10% per year
7. OKM Co can claim 25% reducing balance capital allowances on this investment and pays taxation one year in
arrears at a rate of 30% per year
8. The scrap value of machinery at the end of the four-year project is $250,000
9. The real weighted average cost of capital of OKM Co is 7% per year
10. The general rate of ination is expected to be 47% per year
Required:
(a) Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.
(5 marks)
(b) Prepare a revised calculation of the net present value of the proposed investment project and comment on the
projects acceptability.
(12 marks)
(c) Discuss the problems faced when undertaking investment appraisal in the following areas and comment on
how these problems can be overcome:
(i) assets with replacement cycles of different lengths;
(ii) an investment project has several internal rates of return;
(iii) the business risk of an investment project is significantly different from the business risk of current
operations.
(8 marks)
(25 marks)

A shareholder of QSX Co is concerned about the recent performance of the company and has collected the following
nancial information.
Year to 31 May
Turnover
Earnings per share
Dividend per share
Closing ex dividend share price
Return on equity predicted by CAPM

2009
$68m
589c
400c
$648
8%

2008
$68m
642c
385c
$835
12%

2007
$66m
617c
370c
$740

One of the items discussed at a recent board meeting of QSX Co was the dividend payment for 2010. The nance
director proposed that, in order to conserve cash within the company, no dividend would be paid in 2010, 2011
and 2012. It was expected that improved economic conditions at the end of this three-year period would make it
possible to pay a dividend of 70c per share in 2013. The nance director expects that an annual dividend increase of
3% per year in subsequent years could be maintained.
The current cost of equity of QSX Co is 10% per year.
Assume that dividends are paid at the end of each year.
Required:
(a) Calculate the dividend yield, capital gain and total shareholder return for 2008 and 2009, and briefly discuss
your findings with respect to:
(i) the returns predicted by the capital asset pricing model (CAPM);
(ii) the other financial information provided.

(10 marks)

(b) Calculate and comment on the share price of QSX Co using the dividend growth model in the following
circumstances:
(i) based on the historical information provided;
(ii) if the proposed change in dividend policy is implemented.

(7 marks)

(c) Discuss the relationship between investment decisions, dividend decisions and financing decisions in the
context of financial management, illustrating your discussion with examples where appropriate.
(8 marks)
(25 marks)

[P.T.O.

Formulae Sheet
Economic order quantity
2C0D

CH

MillerOrr Model
Return point = Lower limit + (

1
spread)
3
1

3 transaction cost variance of cash flows 3

Spread = 3 4

interest rate

The Capital Asset Pricing Model

(( ) )

()

E ri = Rf + i E rm Rf

The asset beta formula

Vd 1 T
Ve

a =
e +
d

V
+
V
T
V
V
1

+
1

T
d
d
e
e

))

))

The Growth Model

Po =

D0 1 + g

(r

Gordons growth approximation


g = bre
The weighted average cost of capital
V

e
d
ke +
k 1 T
WACC =
Ve + Vd
Ve + Vd d

The Fisher formula

(1 + i) = (1 + r ) (1 + h)
Purchasing power parity and interest rate parity

S1 = S0

(1 + h )
(1 + h )
c

F0 = S0

(1 + i )
(1 + i )
c

Present Value Table


Present value of 1 i.e. (1 + r)n
Where

r = discount rate
n = number of periods until payment
Discount rate (r)

Periods
(n)

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0990
0980
0971
0961
0951

0980
0961
0942
0924
0906

0971
0943
0915
0888
0863

0962
0925
0889
0855
0822

0952
0907
0864
0823
0784

0943
0890
0840
0792
0747

0935
0873
0816
0763
0713

0926
0857
0794
0735
0681

0917
0842
0772
0708
0650

0909
0826
0751
0683
0621

1
2
3
4
5

6
7
8
9
10

0942
0933
0923
0941
0905

0888
0871
0853
0837
0820

0837
0813
0789
0766
0744

0790
0760
0731
0703
0676

0746
0711
0677
0645
0614

0705
0665
0627
0592
0558

0666
0623
0582
0544
0508

0630
0583
0540
0500
0463

0596
0547
0502
0460
0422

0564
0513
0467
0424
0386

6
7
8
9
10

11
12
13
14
15

0896
0887
0879
0870
0861

0804
0788
0773
0758
0743

0722
0701
0681
0661
0642

0650
0625
0601
0577
0555

0585
0557
0530
0505
0481

0527
0497
0469
0442
0417

0475
0444
0415
0388
0362

0429
0397
0368
0340
0315

0388
0356
0326
0299
0275

0305
0319
0290
0263
0239

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0901
0812
0731
0659
0593

0893
0797
0712
0636
0567

0885
0783
0693
0613
0543

0877
0769
0675
0592
0519

0870
0756
0658
0572
0497

0862
0743
0641
0552
0476

0855
0731
0624
0534
0456

0847
0718
0609
0516
0437

0840
0706
0593
0499
0419

0833
0694
0579
0482
0402

1
2
3
4
5

6
7
8
9
10

0535
0482
0434
0391
0352

0507
0452
0404
0361
0322

0480
0425
0376
0333
0295

0456
0400
0351
0308
0270

0432
0376
0327
0284
0247

0410
0354
0305
0263
0227

0390
0333
0285
0243
0208

0370
0314
0266
0225
0191

0352
0296
0249
0209
0176

0335
0279
0233
0194
0162

6
7
8
9
10

11
12
13
14
15

0317
0286
0258
0232
0209

0287
0257
0229
0205
0183

0261
0231
0204
0181
0160

0237
0208
0182
0160
0140

0215
0187
0163
0141
0123

0195
0168
0145
0125
0108

0178
0152
0130
0111
0095

0162
0137
0116
0099
0084

0148
0124
0104
0088
0074

0135
0112
0093
0078
0065

11
12
13
14
15

[P.T.O.

Annuity Table
(1 + r)n
Present value of an annuity of 1 i.e. 1
r
Where

r = discount rate
n = number of periods
Discount rate (r)

Periods
(n)

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0990
1970
2941
3902
4853

0980
1942
2884
3808
4713

0971
1913
2829
3717
4580

0962
1886
2775
3630
4452

0952
1859
2723
3546
4329

0943
1833
2673
3465
4212

0935
1808
2624
3387
4100

0926
1783
2577
3312
3993

0917
1759
2531
3240
3890

0909
1736
2487
3170
3791

1
2
3
4
5

6
7
8
9
10

5795
6728
7652
8566
9471

5601
6472
7325
8162
8983

5417
6230
7020
7786
8530

5242
6002
6733
7435
8111

5076
5786
6463
7108
7722

4917
5582
6210
6802
7360

4767
5389
5971
6515
7024

4623
5206
5747
6247
6710

4486
5033
5535
5995
6418

4355
4868
5335
5759
6145

6
7
8
9
10

11
12
13
14
15

1037
1126
1213
1300
1387

9787
1058
1135
1211
1285

9253
9954
1063
1130
1194

8760
9385
9986
1056
1112

8306
8863
9394
9899
1038

7887
8384
8853
9295
9712

7499
7943
8358
8745
9108

7139
7536
7904
8244
8559

6805
7161
7487
7786
8061

6495
6814
7103
7367
7606

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0901
1713
2444
3102
3696

0893
1690
2402
3037
3605

0885
1668
2361
2974
3517

0877
1647
2322
2914
3433

0870
1626
2283
2855
3352

0862
1605
2246
2798
3274

0855
1585
2210
2743
3199

0847
1566
2174
2690
3127

0840
1547
2140
2639
3058

0833
1528
2106
2589
2991

1
2
3
4
5

6
7
8
9
10

4231
4712
5146
5537
5889

4111
4564
4968
5328
5650

3998
4423
4799
5132
5426

3889
4288
4639
4946
5216

3784
4160
4487
4772
5019

3685
4039
4344
4607
4833

3589
3922
4207
4451
4659

3498
3812
4078
4303
4494

3410
3706
3954
4163
4339

3326
3605
3837
4031
4192

6
7
8
9
10

11
12
13
14
15

6207
6492
6750
6982
7191

5938
6194
6424
6628
6811

5687
5918
6122
6302
6462

5453
5660
5842
6002
6142

5234
5421
5583
5724
5847

5029
5197
5342
5468
5575

4836
4988
5118
5229
5324

4656
4793
4910
5008
5092

4486
4611
4715
4802
4876

4327
4439
4533
4611
4675

11
12
13
14
15

End of Question Paper

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