ACCA
Paper F9
Financial Management
June 2009
Final Assessment – Answers
© Kaplan Financial Limited, 2008
ANSWER 1
(a) Memo to: Russell Co Main Board
From: Assistant Treasurer
Subject: Alternative Financial Strategies
The present policy is termed a 'matching' financial policy. This attempts to match the maturity of financial liabilities to the lifetime of the assets acquired with this finance. It involves financing long-term assets with long-term finance such as equity or loan stock and financing short-term assets with short-term finance such as trade credit or bank overdrafts. This avoids the potential wastefulness of over-capitalisation whereby short-term assets are purchased with long-term finance, i.e. the company having to service finance not continuously invested in income-earning assets. It also avoids the dangers of under-capitalisation which entails exposure to finance being withdrawn when the company is not easily able to liquidate its assets. In practice, some short-term assets may be regarded as permanent and it may be thought sensible to finance these by long-term finance and the fluctuating remainder by short-term finance.
The proposed policy is an 'aggressive policy' which involves far heavier reliance on short-term finance, thus attempting to minimise long-term financing costs. This requires very careful manipulation of the relationship between payables and receivables (maximising trade payables and minimising receivables), and highly efficient inventory control and cash management. While it may offer financial savings, it exposes the company to the risk of illiquidity and hence possible failure to meet financial obligations. In addition, it involves greater exposure to interest rate risk. The company should be mindful of the inverse relationship between interest rate changes and the value of its assets and liabilities.
Before embarking on such an aggressive policy, the board should consider the following factors:
• How good are we at forecasting cash inflows and outflows? How volatile is our net cash flow? Is there any seasonal pattern evident?
• How efficiently do we manage our cash balances? Do we ever have excessive cash holdings which can be reduced by careful and active management?
• Do we have suitable information systems to provide early warnings of illiquidity?
• Do we have any holdings of marketable securities that can be realised if we run into unexpected liquidity problems?
• How liquid are our non-current assets? Can any of these be converted into cash without unduly disrupting productive operations?
• Do we have any unused long- or short-term credit lines? These may have to be utilised if we meet liquidity problems.
• How will the stock market perceive our switch towards a more aggressive and less liquid financial policy?
security. The main disadvantages of such models is that they ignore the fact that cash flows are to some extent controllable e.g. managers can delay some payments and may be able to encourage receipts.
In practice any experienced cash manager, using a detailed cash budget, should be able to perform better than any cash management model and allow the company to operate using a lower cash balance. The main use of these simple cash management models is to allow us to measure the performance of the cash manager by comparing the results obtained by a 'hands on' expert with those of a simple 'hands off' control model.
(ii) Miller and Orr devised a cash management model that assumes that daily cash flows are random and hence unpredictable. This would result in a pattern of cash flow as shown in the following diagram.
Cash balance
Upper limit
Return point
Lower limit
Time
The treasurer sets upper and lower limits and either transfers cash into the account when the lower limit is reached or transfers cash out by buying marketable securities when the upper limit is reached. The return point determines the amount of cash introduced or withdrawn.
Two questions must be answered:
• How do we decide where to set the limits? This is determined by the variability of daily cash flows, transactions costs and market interest rates. Where variability is great, transactions costs are high and market interest rates are low, the limits will be set far apart. The Miller-Orr formula for setting the limits is:
Range between upper and lower limits =
• Why isn't the return point midway between the two? The Miller-Orr equation for the return point is:
Return point = Lower limit + (Range/3)
By setting the return point below the mid-point between the upper and lower limits the average cash balance on which interest is charged is reduced.
The Baumol and Miller-Orr models are really two extremes. The Baumol model assumes that cash flows are constant whereas the Miller-Orr model assumes they are random and hence completely unpredictable.
(iii) The lower limit should be set at the minimum daily cash balance of $15,000.
The spread can be calculated as:
The upper limit = $15,000 + $26,827 = $41,827
The return point = $15,000 + = $23,942
(c) The advantages of using electronic funds transfer system are:
• Less clerical time and thus cost are involved than in the writing out, signing and posting of a cheque. Also, no postage costs are incurred.
• Electronic transfer reduces the amount of paper work and the likelihood of errors occurring, such as a cheque being made out with words and figures differing or being sent to an incorrect address.
• It is likely to be preferred by a supplier, who may reward their customers who pay by electronic means with longer credit periods, or special offers or other preferential treatment.
MARKING GUIDE
The market values of these sources of funding are as follows:
$m
Equity (10.4m × $0.80) 8.32 Preference shares (4.5m × $0.72) 3.24
Debentures _____ 5.00
Total _____ 16.56
Therefore the company's weighted average cost of capital is:
(b) CAPM would estimate the cost of equity using the equation:
)
R
-)
(E(r
R
)
E(r
i=
f+
β
i m fRf is the risk free rate of return. This could be estimated as the current return offered by irredeemable gilts. This can be looked up in the financial pages of any quality newspaper.
β is the volatility of the company's share price relative to the market. This can either be calculated from recent periods' data or can be read off from pre-calculated figures published by professional organisations. Either method has problems. In calculating
β oneself, the value of β will be different depending on the number of recent periods used in the analysis. If pre-calculated figures are used, one is forced to accept the organisation's choice of period; for example the London Business School calculates β on the basis of monthly returns for the past five years and updates its figures quarterly.
Rm is the return currently available from the equity market. Indices are published such as the FT-Actuaries All Share Index to replicate this return over recent periods of time. Again the choice of period will affect the observed return.
(c) There is no absolute right or wrong answer to the question of whether it is possible to link one source of finance to one segment of a company's activities. Some commentators dismiss the idea immediately, claiming that the company is one entity in law which happens to be financed by a variety of sources of funds. The sources of funds define the sharing out of profits between the shareholders, but their effect is all to support the activities of the business. They argue that it is the projected cash flows that should be looked at from any new investment idea, and that these cash flows should be discounted at the opportunity cost of new capital.
Other commentators disagree, arguing that a particularly large project can certainly be identified with a source of funding raised specifically for the project, and that it is artificial to ignore the relationship between the two.
MARKING GUIDE
Marks
(a) Cost and MV of equity 3
Cost and MV of prefs 2
Cost and MV of debt 2
WACC __ 3
10
(b) Brief explanation 1
Rf, Rm, Beta & how each is obtained __ 6
7
(c) Max 3 marks per explained point 8 __
Total 25__
ANSWER 3
(a) Rights issues tend to reduce the market price of shares because they are sold at a discount to the market price. This is a necessary (but not a sufficient) requirement of a successful rights issue (potential investors still need to be convinced that taking up the rights represents a good investment on their part).
The theoretical ex-rights price is:
New finance required £200m
Issue price (210p less 10%) 189p
Number of new shares (i.e. £200m/£1.89) 105.82m Existing number of shares 1,000.00m
New number of shares 1,105.82m
Existing market value (1,000m × £2.10) £2,100m
Value of new issue £200m
New market value £2,300m
New share price (£2,300/1,105.82) £2.08
The actual market price will be greater than the theoretical ex-rights price if the new money is invested in positive NPV projects, i.e. the money will earn a greater return than the required return for that investment. Thus the market price of the share will only equal the theoretical ex-rights price if the new money earns just the required return for the investment (i.e. the NPV of the investment is zero).
(b) Gearing
Ignoring the overdraft, the gearing ratios will be:
Current Equity finance Debt finance (both types)
Debt 300 300 500
Equity 1,500 1,700 1,500
Gearing 20% 17.6% 33.3%
Alternatively, since it is substantial, you may include the overdraft as follows:
Current Equity finance Debt finance (both types)
Debt 380 380 580
Equity 1,500 1,700 1,500
Gearing 25.3% 22.4% 38.7%
Gearing is currently 20% (or 25.3%). This is relatively low, reflecting the risky nature of current operations.
With a new share issue, gearing will fall to 17.6% (or 22.4%) whereas, with more debt, it will rise to 33.3% (38.7%). Although debt financing is more risky, the gearing is still relatively low.
EPS
EPS is currently 118/1,000 = 11.8p
The projected income statement is (£m)
Ordinary Eurodollar CULS
Operating profit 250 250 250
Interest 40 _______ _______ 54* _______ 56
Profit before tax 210 196 194
Tax 63 _______ _______ 59 _______ 58
Profit after tax 147 137 136
Number of shares _______ 1,106 _______ 1,000 _______ 1,000 EPS 13.3p _______ _______ 13.7p _______ 13.6p
The higher EPS if the company expands using debt may compensate for the higher financial risk borne by the ordinary shareholders. If the Eurodollar bond is used the company will also be exposed to additional foreign exchange risk.
Interest cover – currently 5.2, i.e. 208/40, and changes to:
Ordinary Eurodollar CULS
6.2 4.6 4.5
All look relatively comfortable – reducing the risk regarding financing.
MARKING GUIDE
Marks
(a) Why share price falls 1
TERP calculation 4
When TERP will occur 2 __
7
(b) 4 marks per set of ratios 12
2 marks for discussion on each set of ratios 6 __
18 __
Total 25__
ANSWER 4
(a) (i) The value of a share may be estimated using the dividend valuation model (DVM). This states:
P0 = D0(1 + g)/(re – g). Using the information in the question: D0 = $288,000
'g' is anticipated to be 10%. re = 18%
This gives a total value of 288,000(1 + 0.10)/(0.18 – 0.10) = 3,960,000.
This results in an estimated share price of 3,960/3,000 = $1.32.
A number of factors need to be considered before relying too heavily on this estimate.
(2) The estimate of dividend growth has been based on forecast earnings growth. Dividends may not grow at the same rate as earnings.
(3) The use of the dividend model is always unreliable for small owner managed companies. In such companies dividends paid often have more to do with the financial circumstances of the directors rather than the commercial position of the company.
(ii) An alternative valuation may be found by multiplying EPS by a suitable PE ratio. The latest EPS for Grant & Co is 538/3000 = 17.9 cents. The average PE ratio is 8 .33. This is a PER for quoted companies and Grant & Co is unquoted which usually means that a lower PER is appropriate. The conventional wisdom is that the PER ratio for an unquoted company should be approximately 60 – 70% of that for a similar quoted company. A PER ratio of approximately 5 may be appropriate for valuing an Grant & Co share which means a value of 17.9 × 5 = 90 cents.
The weakness of this valuation is that the adjustment to the PER is entirely arbitrary. We have no way of knowing how Grant & Co compares with average companies in the industry in terms of risk, earnings and dividend growth.
(iii) The final valuation is based on the assets of the business. Since Grant & Co is to continue in business after floatation, the replacement cost of the assets which is usually considered to be the best asset based valuation for valuing the business as a going concern will be used.
$000 Net assets from the balance sheet 2,575
Revaluation of land and buildings: 0.25 × 850 = (213) Revaluation of plant and equipment: 1,500 − 1,350 = 150 Revaluation of stock: 180 − 10 = (170)
_____
Replacement cost of assets 2,342
Number of shares 3,000
_____
Asset based value per share 78 cents
The obvious limitation of this valuation is that it takes no account of the 'goodwill' of the business. As a going concern companies are almost always worth more than the value of their net tangible assets.
(b) Strategies which offer no protection include:
(i) Doing nothing – this is reasonable as long as the risk is not material to the company.
Strategies which offer protection include:
(i) Dealing in own currency – this passes all risk to the other party and is often hard to do in reality.
(ii) Netting/matching – matching foreign currency assets and liabilities can be netted off. Risk only remains on items which cannot be netted off in this way.
(iii) Forward contract – this is an agreement with a bank to buy or sell a certain amount of foreign currency at a certain future date and at a certain rate.
(iv) Money market hedge – this is where a company creates a foreign currency asset or liability by investing or borrowing in the foreign currency in order to match an existing liability or asset in that currency. In this way the risk is extinguished.
(v) Futures – this is where currency futures are bought or sold such that any loss that arises due to foreign exchange rate movements on the actual transaction is matched by a compensating gain on the futures transaction.
(vi) Options – this is where the company has the right but not the obligation to buy or sell a certain amount of foreign currency at a certain future date and at a certain rate.
Of the above strategies only options have the flexibility to allow the company to benefit if there are favourable exchange rate movements. Obtaining this flexibility is costly as a premium is payable by the company in order to obtain an option.
MARKING GUIDE
Marks
(a) Max 3 per value calculation
Max 3 for comments on each valuation Max 14
(b) Brief explanation of strategies offering no protection 3 Brief explanation of strategies offering protection 6 Identification of the strategy offering flexibility __ 2
11 __
