ACCA

Paper P4 Advanced Financial Management

Tuition Mock Examination June 2012 Answer Guide
Health Warning! How to pass Attempt the mock examination under exam conditions BEFORE looking at these suggested answers. Then constructively compare your answer, identifying the points you made well and identifying those not so well made. If you got basics wrong then re-revise by rewriting them out until you get them correct. Simply read or audit the answers congratulating yourself that you would have answered the questions as per the suggested answers.

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 Interactive World Wide Ltd, April 2012 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Interactive World Wide Ltd, April 2012.

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Question 1

Tutorial help and key points

Marking scheme Marks (a) Discussion Report format Selection of project based on NPV 2 marks each for other relevant factors discussed Up to a maximum of 8 marks Calculations Garden Tool Cost of equity Cost of debt WACC Sales Labour cost Material cost Tax Tax savings on allowable depreciation NPV 1 1 8 _______ Max 10

2 2 1 1 1 1 1 2 1 _______ Max 10 2 1 1 1 1 1 2 1 1 _______ Max 10

Jack process Cost of equity WACC Direct labour cost saved Redundancy cost + training cost Maintenance cost Tax Tax savings on allowable depreciation Disposal of machinery NPV

(b) Stating the daughter statement was correct Explanation of real options Examples of real options 1 2 2 _______ Max 5

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(a) To: From: Date: Subject: Proposed acquisition of new jack machines or the expansion of garden tool production. The report is about the decision to purchase the new machines or to expand garden tool production. From the financial perspective the two alternatives were compared on the basis of their respective net present values. The project with the highest net present value would be the one that would maximise our shareholders wealth. The expansion of the garden tools production produced net present value of 281.4m whilst the purchase of the new machines for jack production produced net present value of 38.3 million. On this basis the expansion of the garden tools production produces the highest net present value and should be the best alternative to consider. However, before making the final decision the following factors should also be considered: The cost of capital used to discount the cash flows of each alternative might not reflect the true cost of capital. For the jack product, the cost of capital was estimated based on the difference between the equity beta of the company as whole and that of the garden production. The beta for the garden production was estimated using the beta from other companies producing tools on the assumption that the business risk is the same for all the companies. This may not necessarily be the case. The new machines would make 50 employees redundant and this may have adverse effects on the motivation of other employees. Future development in the markets of both the garden tools and the jack should be considered. You should consider which of these two alternatives have the potential future development. The appraisal covers a period of five years. The cash flows beyond five years should also be considered. Real options o Another important consideration should be the effect of the decision on your competitors and market share. You were concerned that failure to invest in the new jack manufacturing process might lead to the company losing significant market share in the jack market if competitors were able to reduce their prices in real terms as a result of introducing the new process. Additional working capital requirement should also be considered. The jack production will not lead increase in production and may not need extra injection of working capital. However, the expansion of the garden tools will require production of an additional 70,000 units and the company may need extra working capital to finance the increase in activity.

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In relation to the above point, the 70,000 additional units from garden tools would be sold at the same price. This may not be achieved as increase in output may require you to reduce price to encourage demand.

From the financial perspective, both projects produce positive net present value and would be worth to undertake all the two projects as they are not mutually exclusive. However, this may require additional cost and is also subject to availability of finance.

Financial and non-financial factors should be considered before taking the final decision. Consultant Appendix Net present value of new jack process Year 0 000 1 000 271.6 (354) (15) 0 _____ (369) 2 000 287.9 3 000 305.2 4 000 323.5 5 000 342.9 6 000

Dirct labour saved Redundancy costs Training cost Maintenance cost

Tax Tax saved on allowable depreciation Machines cost (535) Disposal of machine 0 _____ (904) Discount factor 16% Present value Net present value 1 _____ (904) 38.3

46.8 _____ 224.8 92.2 66.9

48.7 _____ 239.2 (56.2) 16.7

50.6 _____ 254.6 (59.8) 12.5

52.6 _____ 270.9 (63.6) 9.4

54.7 _____ 288.2 (67.7) 7.1

(72) 11.2

125 _____ 508.9 0.862 _____ 438.9

0 _____ 199.7 0.743 _____ 148.4

0 _____ 207.3 0.641 _____ 132.9

0 _____ 216.7 0.552 _____ 119.6

40 _____ 267.6 0.476 _____ 127.4

0 _____ (60.8) 0.41 _____ (24.9)

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Net present value of garden tool production Year 0 000 1 000 573.3 244.9 178.1 _____ 150.3 25 0 _____ 175.3 0.893 _____ 156.5 2 000 602 259.6 188.8 _____ 153.6 37.6 6.2 0 _____ 122.2 0.797 _____ 97.4 3 000 632.1 275.1 200.1 _____ 156.9 38.4 4.7 0 _____ 123.2 0.712 _____ 87.7 4 000 663.7 291.6 212.1 _____ 160 39.2 3.5 0 _____ 124.3 0.636 _____ 79.1 5 000 696.8 309.1 224.8 _____ 162.9 40 2.6 14 _____ 139.5 0.567 _____ 79.1 6 000

Sales Labour cost Material cost Tax Tax saved on allowable depreciation Equipment (200) _____ (200) Discount factor 12% Present value Net present value Workings (1) Direct labour saved 1 _____ (200) 281.4

0 _____ 0 40.7 4.4 0 _____ (36.3) 0.507 _____ (18.4)

Year 1

25% x (1.8 + 2.3) x 250 x 1.06 = 271.6

Then increase with 1.06 factor for the subsequent years. (2) Maintenance cost

Year 1 = 45 x 1.04 = 46.8 Inflate this by 1.04 for the subsequent years. (3) (4) The head office and apportioned overheads as well as the interest costs are irrelevant Tax savings on capital allowances Jack production Year 1 2 3 4 5 535 267.5 200.6 150.5 112.9 Capital allowance 267.5 66.9 50.2 37.6 28.2 Tax saved 66.9 16.7 12.5 9.4 7.1

Balancing allowance assuming it is available in year 6 84.7 40 = 44.7 x 25% = 11.2

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(5)

Tax savings on capital allowances garden production Year 1 2 3 4 5 200 100 75 56.2 42.2 Capital allowance 100 25 18.7 14.1 10.5 Tax saved 25 6.2 4.7 3.5 2.6

Balancing allowance assuming it is available in year 6 31.7 14 = 17.7 x 25% = 4.4 Assuming tax savings on capital/depreciation allowances start from year 1, allowances are claimed at the beginning of the year. (6) Cost of capital/discount factor

The cost of capital used should reflect the systematic risk that goes with each investment and as such the current WACC cannot be used as the discount factor. The specific cost of capital for each alternative can be estimated as follows: Garden tools The proxy beta will be the equity beta of other tools producers. This is equal to 1.4 (given in question). Ungear the proxy beta to measure the asset beta Ba = Be (E/E + D(1-t)) as debt is assumed to be risk free = 0.8

Ba = 1.4 (50/50 +50(0.75)

Regear to reflect the method DDPs financing. Market value of debt = 400 + 125/100 x 1,000 = 1,650 Market value of equity = 700/0.25 x 1.62 = 4,536 Ba = Be (E/E + D(1-t)) 0.8 = Be (4,536/4,536 +1,650(0.75) Be = 1.018

Using CAPM calculate the cost of equity Ke = 7% +1.018(14% - 7%) = 14.126%

Cost of debt The cost of debt may be estimated as the internal rate of return or can be assumed at the risk free rate as debt is assumed to be risk free. Using internal rate of return the cost of debt can be calculated as: Year Item Cash flow (125) 11.25 100 DF(7%) PV DF(10%) PV

0 current MV 1-10 interest 10 redemption value

1 7.024 0.508

(125) 79.02 50.8 ______ 4.82 ______

1 6.145 0.368

(125) 69.13 36.8 ______ (19.07) ______

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Cost of capital

7% +

4.82 4.82 + 19.07

x (10%-7%)

= 7.61% Calculate WACC WACC = 14.126% (4536/6186) + 7.6% (1650/6186) = 12.385 SAY 12% Jack production The overall equity beta of the DDP plc is 1.3. Given garden tools equity beta of 1.018 and 60% of the value of the company, the equity beta of jack production can be estimated at: 1.018 x 60% + equity beta of jack x 40% = 1.3 Equity beta of jack = 1,723 Cost of equity using CAPM Ke = 7% + 1.723(14% -7%) = 19.06% =16.00%

WACC = 19.06% (4536/6186) + 7.6% (1650/6186) (b)

The managing directors daughter is correct that the net present value does not consider any future options arising from investment decisions. Such options could lead to additional net present values and could influence the decision process. The valuation of the options from capital investments that might occur in several years time is however difficult, even though the Black-scholes model could be adopted for such valuations. For most companies it is important to have an awareness of the nature of the possible options that might exist, and to use this qualitative information in the decision process.

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Question 2

Tutorial help and key points

Marking scheme Marks (a) Forward contract 5 months forward rate Net payment Money market Amount to invest Converted amount in sterling Total cost of borrowing Futures contract Sell December contract Basis Lock in rate Number of contracts Options December put option Number of contracts (1/2 mark for each exercise price) Premium (1/2 mark for each exercise price) Under/over hedge Overall outcome (1 mark for each exercise price) Conclusion 1 1

1 1 1

1 1 2 1

1 1.5 1.5 1 3 2 _______ Max 20

(b) Exchange rate Sterling value of $4.2 million Present value Relevant discussion on ways to manage economic exposure 1 1 1 2 _______ Max 5

(a) Report on how the five-month currency risk should be hedged. Asters plc is a UK based company and will have no currency exposure on sterling payments and receipts. Therefore, only the net dollar receipts and payments should be hedged. From the information given in the question Asters plc may hedge the net dollar exposure using forward contract, money market hedge, futures and options.

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Forward contract Interpolation of the three month and one year forward rates for buying dollars will be needed to calculate the five month forward rate. This may be estimated as: 3 month rate 1 year rate Difference 1.9066 1.8901 0.0165

Assuming the rate decline in a linear manner; 5 month forward rate = 1.9066 - (0.0165 x 2/9) = Forward contact will fix the payment at: $1.9029

$1,150,000 1.9029

604,341

Money market hedge With money market hedge involving payment of dollars, the company should borrow an appropriate amount in pounds sterling today convert it immediately at the spot rate to dollars, place it on deposit account and repay the loan plus its interest on the due date. How much will be borrowed depends on how much is to be invested in order to get the amount of the exposure. Asters plc should buy dollars now and put them into a deposit account for 5 months in order to get $1,150,000. = $1,150,000 / (1+ (0.02 x 5/12) = $1,140,496 Convert pounds sterling into $1,140,496 at the spot rate =1,140,496/1.9156 = 595,373 This means the company has to borrow 595,373 in the UK for 5 months at an interest rate of 5.5%. The total amount payable in sterling is: 595,373 x (1 + (0.055 x 5/12) == 609,017 The effective lock in rate = 1,150,000 / 609,017 = $1.8883 This is more expensive than the forward contract. Futures What contract: The appropriate contract will be the contract that matures immediately after the transaction date 1st November. This is the December contract, which matures at the end of December. Sell: Asters plc should sell December sterling futures. Basis Spot rate Future price (December) Basis 1.9156 1.8986 0.017_

Assuming the basis will decline in a linear manner over the seven months, then the expected basis in five month =

0.017

2 7

0.0486

Therefore the expected lock-in futures rate may be estimated by: 18986 + 000486 = 19035 representing a total payment of 604,150 (1,150,000/1.9035).
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This is more favourable than the forward market. However, futures contracts are standardized and there may over or under hedge. For example, the number of contract is:

604,150 = 62,500

967 contracts

Also currency futures require margin payments and there exist basis risk. Options What date contract - The appropriate contract will be the contract that matures at the nearest date after the transaction date: this is the December contract. Put option. Since the contract size is denominated in pounds sterling, the company will need to sell pounds for dollars, therefore it needs to buy a put option to get the right to sell pounds. No of contracts (a) Exercise Price 1.8800 1.9000 1.9200 (b) $ c=(b/a) (d) Contract size 31,250 31,250 31,250 e=(c/d) Number of Contracts

1,150,000 1,150,000 1,150,000

611,702 605,263 598,958

19.57 = 19 - Under hedged 19.37 = 19 - Under hedged 19.17 = 19 - Under hedged

Premium payment 1.8800= 31,250 x 19 contracts x 2.96cent = $17,575 at spot rate of 1.9156 = 9,175 1.9000= 31,250 x 19 contracts x 4.34cent = $25,769 at spot rate of 1.9156 = 13,452 1.9200= 31,250 x 19 contracts x 6.55cent = $38,891 at spot rate of 1.9156 = 20,302 Under hedge (using forward contract) 1.8800 = 1.8800 x 31,250 x19 = $1,116,250 $1,150,000 = $37,750 at forward rate of 1.9029 = 17,736 1.9000 = 1.9000 x 31,250 x19 = $1,128,125 $1,150,000 = $21,875 at forward rate of 1.9029 = 11,496 1.9200 = 1.9200 x 31,250 x 19 = $1,140,000 $1,150,000 = $10,000 at forward rate of 1.9029 = 5,255 Overall outcome Basic cost = 31250 x 19 contracts = 593,750 Exercise price 18800 19000 19200 Basic cost () Premium Underhedged at forward Total

593,750 593,750 593,750

9,175 13,452 20,302

17,736 11,496 5,255

620,661 618,698 619,307

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The option is more expensive than the other hedging methods. However, should the dollar weaken more than the relative strike price the company could let the option lapse in order to take advantage of the market exchange rate. (b) The estimated effect on market value can be calculated as: Exchange Rate $/ Spot 1 year 2 3 4 5 19156 18581 18024 17483 16959 16450 value of $42m 2,192,525 2,260,374 2,330,226 2,402,334 2,476,561 2,553,191 difference DF (11%) PV of difference 0 61,132 111,813 153,370 187,180 213,875 ________ 727,370 ________

0 67,849 137,701 209,809 284,036 360,666

1 0901 0812 0731 0659 0593

The present value of future cash flows is expected to decrease as the dollar appreciates in value. This will therefore reduce the market value of the company by 727,370. Economic exposure (also called operating or competitive exposure or strategic exposure) measures the changes in the present value of the firm resulting from any changes in the future operating cash flows of the firm caused by an unexpected changes in exchange rates. The change in value depends on future sale volume, price, and costs. Economic exposure may be managed through international diversification whereby the company can diversify production, supply of its products and finance. For example if it had established production plants worldwide and bought its components worldwide it is unlikely that the currencies of all its operations would revalue at the same time, so that a loss in some may be compensated by gain from the others. Asters plc may also manage the economic exposure through natural hedge by borrowing funds in the USA, and use cash flows in USA to pay interest and principal.

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Question 3

Tutorial help and key points

Marking scheme Marks (a) 2 marks case for, 3 marks case against (b) (i) (ii) (iii) (c) 1 mark per point (maximum 4 marks) 4 ___ 20 2 marks for current share price 2 marks current share price, 2 marks share exchange 2 marks profit for the year, 3 marks predicted share price 5

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(a) Diversification may be used to help a business reduce its overall risk. At a point when one particular industry is thriving, another may be in difficulties. Thus, by operating in more than one industry, it may be possible to achieve less volatility in overall sales and profits. Furthermore, a diversified business may be in a stronger position to survive a downturn in one of the industries in which it has invested. Diversification, however, may not enhance shareholder value. It can be a costly exercise as a premium often has to be paid in order to acquire another business (as is the case in this question). The key issue is whether diversification by a business will provide any benefits to shareholders that the shareholders themselves cannot achieve. It may well be cheaper and simpler for a shareholder to hold a diversified portfolio of shares than for a business to acquire another. (b) (i) Earnings per share (EPS) of ASOP Co EPS = $125/50m = $250 Current market value per share of ASOP Co: = P/E ratio x EPS = 8 x $250 = $200

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(ii)

Earnings per share (EPS) of WXP Co EPS = $240m/80m = $30 Current market value = P/E ratio x EPS = 20 x $30 = $600 Offer price = [$200 + (20% x $200)] = $240 Number of shares to be issued by WXP Co for 1 share in ASOP Co = $240/$600 = 04 WXP Co will offer 2 shares for every 5 shares held in ASOP Co. This means, (50m x 2/5) = 20m new shares must be issued.

(iii)

The profit for the year following a successful takeover will be: Profit (after tax) of WXP Co Profit (after tax) of ASOP Co Savings after tax $m 2400 1250 400 _____ 4050 _____

Number of shares in issue following takeover (80m + 20m) = 100m EPS following takeover = $405m/100m = $405 Market value per share = P/E ratio x EPS = {[200 (15% x 200)] x $405} = $6885 (c) For the shareholders of ASOP Co a cash offer may have the following advantages and disadvantages: Advantages: Certainty: A cash payment will mean that the amount received will be certain and clearly understood. Transaction costs: Cash will be received from the disposal of the shares without any transaction costs being incurred. (Although there will be transaction costs if the shareholders decide to re-invest the amounts received in shares.) Disadvantages Taxation: The receipt of cash may lead to a tax on the gains from the share disposal.

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Investment opportunity: Shareholders will have no stake in the merged company and so will forfeit the opportunity to benefit from any future income and capital growth.

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Question 4

Tutorial help and key points

Marking scheme Marks (a) 2 or 3 marks per well discussed point related to possible impact Contents of a code of ethics Max 6 8 ___ 14

(b) For each of the two scenarios 1 or 2 marks for explaining conflict 1 or 2 marks for discussing the resolution

Max 6

(a) An ethical code that is formally written and made available both within the organisation and publicly could have a number of internal and external benefits. The main external benefit would be that an ethical code made available publicly could increase the reputation of the company. Expectations that corporations should behave as responsible businesses are increasing. Corporate social responsibility has been framed such that a company has responsibilities that are wider than just going for profit maximisation. A company that behaves in an acceptable ethical manner and does so to a set of prescribed ethical standards is likely to enhance its image and reputation. Ethical standards should be written to address the needs of the companys stakeholders and this in turn would be beneficial to shareholder value in the long term. The second significant external benefit of an ethical code would demonstrate the companys intention to exercise its power responsibly. This would lessen the burden of regulation and thus give the company more flexibility in its operations. For this to be effective, all the major companies in the industry must buy into the idea. A company going out on its own is unlikely to prevent or mitigate the pressure for formal regulation. An internal benefit of an ethical code would be to provide managers with a framework to which they should operate. It would help managers plan their activities to take account of what the organisation expects in terms of meeting the expectations of the various stakeholder groups. This in turn would help managers (and other employees) match their personal code of ethics to that of the companys. Related to the above, an ethical code would also provide managers and employees with a yardstick to measure the extent to which they are following the required corporate social responsibility. It may provide a basis for resolving conflicts of interest between stakeholder groups and help to provide justification for resolving

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conflicts in a prescribed manner. It may also enable managers to think in innovative ways in order to resolve conflicts of interest. However, Ansoft Co needs to ensure that the managers and other employees do not just pay lip service to the ethical code. In order for the ethical code to be accepted and become pervasive within the organisation, significant amounts of money, time and effort must be devoted to it. It is possible that an ethical code which is not acted upon could damage the companys reputation much more than having no code at all. A code of ethics could possibly contain details on the following areas: (b) Both the issues result in conflicts of interest between different stakeholders. The first issue results in conflict because changing to more environmentally friendly tyres may have a negative impact on the local manufacturer of the tyres and possibly on its employees. On the one hand, Ansoft Co would be fulfilling its ethical code in protecting and preserving the environment. On the other hand, it may be responsible for curtailing the business of a supplier, and the question may be asked whether this was treating the supplier fairly. Added to that, there is a third issue of the environmental impact of importing the tyres from North America. The ethical code may provide guidelines to the manager on how to prioritise if the conflict cannot be resolved. She may consider what would impact on the loss of reputation the least. Then there is the question as to what stance an ethical company might take. The ethical code may also encourage the manager to think of a new alternative. For example, would it be possible to ask the local manufacturer to produce and supply the environmentally friendly tyres? Or could both kinds of tyres be kept in stock and this would give the customers more choice. The manager would need to assess the extra costs and benefits involved, and engage in discussing the issue with the local manufacturer. With the second issue the conflict is not immediately apparent because there is little direct evidence to suggest that the chemical is definitely harmful. Furthermore, the company has been complying with the health and safety regulations. However, it needs to decide whether employees should be informed of the potential danger and also make them aware that the evidence to date is inconclusive or, because there is little evidence so far, to not say anything. Compliance with the ethical code, and its guidelines that employees should be protected, may make the Ansoft Cos directors take the view of informing the employees concerned. They could then explore several options, for example, are there alternative lubricants which do not contain the chemical. Or could the
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Dealing with shareholders, customers, suppliers, employees and other stakeholder groups fairly. How conflicts of interest may be avoided and resolved. Maintaining confidentiality. How business will be conducted to protect and preserve the environment. How the organisation may help develop the community. Compliance with regulation and the law. Protecting the assets of a company and using them properly. Encouraging the reporting of illegal and unethical behaviour.

employees be provided with protective gloves and implements to administer the lubricants without direct contact. Such action may demonstrate the companys desire to be seen as a caring employer and receive positive press coverage, and the press may recommend the company as a good place to work. (Note: other approaches to answering both parts of this question would be acceptable.)

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Question 5

Tutorial help and key points

Marking scheme Marks (a) Benefits of interest rate swap Problems of interest rate swap 4-5 3-4 _______ Max 8

(b) Arbitrage savings of 0.5% Arbitrage savings of 25,000 KFPs after tax savings BBB companys after tax savings Conclusion 2 1 1 1 1 _______ Max 6

(c) Six month interest savings of 75,000 Discount factor (1/2 mark for each six month factor) Present value Conclusion 1 3 1 1 _______ Max 6

(a) Interest rate swaps have several uses including: (i) (ii) (iii) (iv) Long-term hedging against interest rate movements as swaps may be arranged for periods of several years. The ability to obtain finance at a cheaper cost than would be possible by borrowing directly in the relevant market. The opportunity to effectively restructure a companys capital profile without physically redeeming debt. Access to capital markets in which it is impossible to borrow directly, for example because the borrower is relatively unknown in the market or has a relatively low credit rating.

The risks faced by KFP and the bank include: (i) Default risk by the counterparty to the swap. If the counterparty is a bank this risk will normally be very small. A bank would face larger counterparty default risk, especially from counterparties such as the BBB company with a relatively low credit rating.

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(ii)

Market or position risk. This is the risk that market interest rate will change such that the company undertaking the swap would have been better off, with hindsight, if it had not undertaken the swap. Banks often undertake a warehousing function in swap transactions. The size and/or maturity of the transactions desired by each counterparty to the bank often do not match. In such cases the bank faces gap or mismatch risk which it will normally hedge in the futures or other markets.

(iii)

(b) Fixed rate KFP BBB company Difference 625% 725% ______ 100% Floating rate LIBOR + 075% LIBOR + 125% ______________ 050%

There is a potential 050% arbitrage saving from undertaking the swap. On a 50 million swap this is 250,000 per year. KFP plc would require 60% of any saving, or 150,000 annually (105,000 after tax). The BBB company would receive 100,000 annually (70,000 after tax). The bank would charge each party 120,000 per year. After tax this is a cost of 84,000 each. This would leave a net loss of 14,000 for the BBB rated counterparty company. The swap is not potentially beneficial to all parties, unless the savings are shared equally. (c) KFP plc will pay floating rate interest as a result of the swap. If KFP plc receives 60% of the arbitrage savings, it will save 05% (060) on its interest rates relative to borrowing directly in the floating rate market, and effectively pay LIBOR + 045%,or 570% at current interest rates. If LIBOR moves to 575% in six months time, KFP plc will then pay 620% floating rate interest for the remaining period of the swap. Interest savings in each six month periods are 50 million x 030% x 05 = 75,000 If the money market is efficient, the relevant discount rate will be the prevailing interest rate paid by KFP plc. Period: 06 months 6 months1 year 1 year18 months 18 months2 years 2 years30 months 30 months3 years Total present values Savings 75,000 75,000 75,000 75,000 75,000 75,000 Discount factor Present value () 0972 0942 0913 0887 0860 0835 (57%) (62%) (62%) (62%) (62%) (62%) 72,900 70,650 68,475 66,525 64,500 62,625 _______ 405,675

The interest rate swap is estimated to produce interest rate savings with a present value of 405,675 relative to borrowing floating rate directly. The swap would be beneficial, even after deducting the fee of 120,000 per year.

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With hindsight lower interest costs would have been available by borrowing at 625% in the fixed rate market.

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