Financial Management

Thursday 5 June 2008

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

Burse Co wishes to calculate its weighted average cost of capital and the following information relates to the company
at the current time:
Number of ordinary shares
Book value of 7% convertible debt
Book value of 8% bank loan

20 million
$29 million
$2 million

Market price of ordinary shares

Market value of convertible debt

$550 per share

$10711 per $100 bond

Equity beta of Burse Co

Risk-free rate of return
Equity risk premium

12
47%
65%

Rate of taxation

30%

Burse Co expects share prices to rise in the future at an average rate of 6% per year. The convertible debt can be
redeemed at par in eight years time, or converted in six years time into 15 shares of Burse Co per $100 bond.
Required:
(a) Calculate the market value weighted average cost of capital of Burse Co. State clearly any assumptions that
you make.
(12 marks)
(b) Discuss the circumstances under which the weighted average cost of capital can be used in investment
appraisal.
(6 marks)
(c) 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)
(25 marks)

THP Co is planning to buy CRX Co, a company in the same business sector, and is considering paying cash for the
shares of the company. The cash would be raised by THP Co through a 1 for 3 rights issue at a 20% discount to its
current share price.
The purchase price of the 1 million issued shares of CRX Co would be equal to the rights issue funds raised, less
issue costs of $320,000. Earnings per share of CRX Co at the time of acquisition would be 448c per share. As a
result of acquiring CRX Co, THP Co expects to gain annual after-tax savings of $96,000.
THP Co maintains a payout ratio of 50% and earnings per share are currently 64c per share. Dividend growth of 5%
per year is expected for the foreseeable future and the company has a cost of equity of 12% per year.
Information from THP Cos statement of financial position:
Equity and liabilities
Shares ($1 par value)
Reserves
Non-current liabilities
8% loan notes
Current liabilities
Total equity and liabilities

$000
3,000
4,300

7,300
5,000
2,200

14,500

Required:
(a) Calculate the current ex dividend share price of THP Co and the current market capitalisation of THP Co
using the dividend growth model.
(4 marks)
(b) Assuming the rights issue takes place and ignoring the proposed use of the funds raised, calculate:
(i)
(ii)
(iii)
(iv)

the
the
the
the

rights issue price per share;

cash raised;
theoretical ex rights price per share; and
market capitalisation of THP Co.

(5 marks)

(c) Using the price/earnings ratio method, calculate the share price and market capitalisation of CRX Co before
the acquisition.
(3 marks)
(d) Assuming a semi-strong form efficient capital market, calculate and comment on the post acquisition market
capitalisation of THP Co in the following circumstances:
(i) THP Co does not announce the expected annual after-tax savings; and
(ii) the expected after-tax savings are made public.

(5 marks)

(e) Discuss the factors that THP Co should consider, in its circumstances, in choosing between equity finance
and debt finance as a source of finance from which to make a cash offer for CRX Co.
(8 marks)
(25 marks)

[P.T.O.

FLG Co has annual credit sales of $42 million and cost of sales of $189 million. Current assets consist of inventory
and accounts receivable. Current liabilities consist of accounts payable and an overdraft with an average interest rate
of 7% per year. The company gives two months credit to its customers and is allowed, on average, one months credit
by trade suppliers. It has an operating cycle of three months.
Other relevant information:
Current ratio of FLG Co
Cost of long-term finance of FLG Co

14
11%

Required:
(a) Discuss the key factors which determine the level of investment in current assets.

(6 marks)

(b) Discuss the ways in which factoring and invoice discounting can assist in the management of accounts
receivable.
(6 marks)
(c) Calculate the size of the overdraft of FLG Co, the net working capital of the company and the total cost of
financing its current assets.
(6 marks)
(d) FLG Co wishes to minimise its inventory costs. Annual demand for a raw material costing $12 per unit is 60,000
units per year. Inventory management costs for this raw material are as follows:
Ordering cost:
Holding cost:

$6 per order
$05 per unit per year

The supplier of this raw material has offered a bulk purchase discount of 1% for orders of 10,000 units or more.
If bulk purchase orders are made regularly, it is expected that annual holding cost for this raw material will
increase to $2 per unit per year.
Required:
(i)

Calculate the total cost of inventory for the raw material when using the economic order quantity.
(4 marks)

(ii) Determine whether accepting the discount offered by the supplier will minimise the total cost of
inventory for the raw material.
(3 marks)
(25 marks)

SC Co is evaluating the purchase of a new machine to produce product P, which has a short product life-cycle due
to rapidly changing technology. The machine is expected to cost $1 million. Production and sales of product P are
forecast to be as follows:
Year
Production and sales (units/year)

1
35,000

2
53,000

3
75,000

4
36,000

The selling price of product P (in current price terms) will be $20 per unit, while the variable cost of the product (in
current price terms) will be $12 per unit. Selling price inflation is expected to be 4% per year and variable cost
inflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC Co has spare capacity
in both space and labour terms.
Producing and selling product P will call for increased investment in working capital. Analysis of historical levels of
working capital within SC Co indicates that at the start of each year, investment in working capital for product P will
need to be 7% of sales revenue for that year.
SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by capital
allowances on machinery (tax-allowable depreciation), which SC Co can claim on a straight-line basis over the
four-year life of the proposed investment. The new machine is expected to have no scrap value at the end of the
four-year period.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.
Required:
(a) Calculate the net present value of the proposed investment in product P.
(b) Calculate the internal rate of return of the proposed investment in product P.

(12 marks)
(3 marks)

(c) Advise on the acceptability of the proposed investment in product P and discuss the limitations of the
evaluations you have carried out.
(5 marks)
(d) Discuss how the net present value method of investment appraisal contributes towards the objective of
maximising the wealth of shareholders.
(5 marks)
(25 marks)

[P.T.O.

Formulae Sheet
Economic order quantity
2C0D

CH

Miller Orr 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
V
e
d
k 1 T
ke +
WACC =
Ve + Vd d
Ve + Vd

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