ACCA FINAL ASSESSMENT
Financial
Management
JUNE 2009
QUESTION PAPER
Do not open this paper until instructed by the supervisor
Time allowed
Reading and planning 15 minutes; Writing 3 hours
All FOUR questions are compulsory and MUST be attempted
Mathematical Tables and Formulae are on pages 3, 4 and 5
MATHEMATICAL TABLES AND FORMULAE
TABLES
Present value table
Present value of 1 i.e. (1 + r)-n where r = discount rate
n = number of periods until payment
Periods Discount rates (r)
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
Annuity table
Present value of an annuity of 1 i.e. r
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
_______________________________________________________________________________________
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
FORMULAE
Economic order quantity = H
The Capital Asset Pricing Model
E(r)j = Rf + βj (E(rm) – Rf)
The Growth Model
P0 =
Gordon’s growth approximation
g = bre
The weighted average cost of capital
WACC =
The Fisher Formula
(1 + i) = (1 + r) (1 + h)
Purchasing power parity and interest rate parity
All FOUR questions are compulsory and MUST be attempted
QUESTION 1
(a) The Treasurer of Russell Co is contemplating a change in financial policy. At present, Russell's balance sheet shows that non-current assets are of equal magnitude to the amount of long-term debt and equity financing. It is proposed to take advantage of a recent fall in interest rates by replacing the long-term debt capital with an overdraft. In addition, the Treasurer wants to speed up receivables collection by offering early payment discounts to customers and to slow down the rate of payment to suppliers.
Required:
As his assistant, you are required to write a brief memorandum to other board members explaining the rationales of the old and new policies and pinpointing the factors to be considered in making such a switch of policy. (5 marks)
(b) The Treasurer is also reviewing her cash management procedures. She plans to introduce the use of cash management models and has asked you to investigate their applicability to the company. The following information is available:
• The company has agreed with its bank that it will maintain a minimum daily cash balance of $15,000. Severe financial penalties will apply if this balance is not maintained.
• A forecast of daily cash movements for the next twelve months shows a standard deviation of daily cash flows of $3,000.
• The daily interest rate is at present 0.0236% and this is not expected to change in the foreseeable future.
• The transaction cost for each sale or purchase is $25.
Required:
As her assistant advise the Treasurer on:
(i) The advantages and disadvantages of cash management models over more traditional methods of cash forecasting. (4 marks)
(ii) Explain the Miller Orr model for cash management and contrast it with the
Baumol model. (5 marks)
(iii) Using the information given above, calculate the spread, upper limit and
return point applicable to Russell Co. (6 marks)
QUESTION 2
The following is an extract from the balance sheet of Leisure International Co at 30 June 20X7:
$000
Ordinary shares of 50c each 5,200
Reserves 4,850
9% preference shares of $1 each 4,500
14% irredeemable debentures ______ 5,000
Total long-term funds ______ 19,550
The ordinary shares are quoted at 80c ex-div. Assume that the market estimate of the next ordinary dividend is 4c, growing thereafter at 12% per annum indefinitely. The preference shares, which are irredeemable, are quoted at 72c and the debentures are quoted at par. Corporation tax is 35%.
Required:
(a) Use the relevant data above to estimate the company's weighted average cost of capital (WACC), i.e. the return required by the providers of the three types of capital,
using the respective market values as weighting factors. (10 marks)
(b) Explain how the capital asset pricing model would be used as an alternative method of estimating the cost of equity, indicating what information would be required and
how it would be obtained. (7 marks)
(c) Assume that the debentures have recently been issued specifically to fund the company's expansion programme under which a number of projects are being considered. It has been suggested at a project appraisal meeting that, because these projects are to be financed by the debentures, the cut-off rate for project acceptance should be the after-tax interest rate on the debentures rather than the WACC.
Comment on this suggestion. (8 marks)
QUESTION 3
Borrows plc is a UK based company and has decided to embark upon a new investment strategy. Traditionally a mining company operating coal, silver, gold and other mines throughout the world, it has now decided to use its expertise to move into international oil exploration with a view to setting up joint ventures to exploit any oilfields it discovers. The company feels that it requires another £200 million finance to support new operations for the next eight years, and it has identified three possible sources:
(1) An issue of ordinary shares. The company proposes to make a rights issue at a 10% discount to the current market price.
(2) An issue of a ten-year 7% $300 million Eurodollar bond (secured).
(3) A sale of 8% convertible unsecured loan stock of £100 each. Each of these can be converted by holders at any time into 40 ordinary shares. Any outstanding stocks will be redeemed at par in five years’ time.
The balance sheet for Borrows at 31 March 20X7 is as follows:
£m £m
Non-current assets 1,400
Current assets 600
Less: Current liabilities* (200)___
Net current assets _____ 400
1,800
Less: Non-current liabilities:
10% debentures _____ (300)
Net assets _____ 1,500
Capital and reserves
Issued ordinary shares (50p par) 500
Reserves _____ 1,000
_____ 1,500
*Current liabilities include £80 million overdraft.
The current market price per share is 210p, and price per debenture £90 per cent. The current exchange rate of £1=$1.50 is expected to be maintained in the medium term.
The income statement (year-end 31 March 20X7) for the company is:
£m
Operating profit* 208
− Interest 40 ___
Required:
(a) Explain why a rights issue generally results in a fall in the market price of shares. Calculate the theoretical ex-rights price of the share if the issue is undertaken. Under what circumstances would you expect the share price to actually go to this price? Ignore issue costs in this question. (7 marks)
(b) Discuss the financial implications of all three options by calculating the following accounting ratios:
(i) gearing (book value of debt/book value of equity) (ii) earnings per share
(iii) interest cover. (18 marks)
(Total: 25 marks)
QUESTION 4
(a) The current managing director John Grant formed Grant and Co 12 years ago. He is now thinking about retirement and would like to release part of his investment in the company. Some of the other board members are also reaching retirement age and they would like to convert at least part of their shareholdings into cash. The company also needs to raise approximately $1 million to finance a major new investment opportunity, which the board believes could contribute further to the long-term success of the company. The board is now considering floatation on the Alternative Investment Market (AIM) as a way of achieving the twin objectives of raising additional finance and releasing part of the board’s equity investment. The intention is that the directors will sell 25% of their existing shareholding and issue new shares to raise the $1 million of new finance required. The plans are still very much at a preliminary stage.
The following summarised financial data applies to Grant and Co:
20X7 20X8
$000 $000
Profit after tax 427 538
Non-current assets:
Land and buildings 850 850
Plant and equipment (net) _____ 1,450 _____ 1,350
2,300 2,200
Current assets:
Inventory 1,025 1,400
Total net assets 2,325 2,575
Additional information
(i) Profit before tax is expected to grow at approximately 10% per year. Dividend growth is expected to be in line with this growth in earnings.
(ii) The existing directors, who own 95% of the shares, declared dividends of $288,000 in the latest financial year.
(iii)
(iii) The average price earnings ratio of AIM listed companies in the same industry as Grant is 8.33, and average earnings per share is 20 cents.
(iv) The value of freehold land and buildings (never revalued) has fallen by 25% since purchased due to a recession.
(v) Grant’s cost of equity is estimated to be 18%.
(vi) The replacement cost of plant and equipment is $1,500,000 but its current realisable value is $1,125,000.
(vii) $180,000 of inventory is obsolete and could only be sold for $10,000 as scrap.
Required:
Estimate the value of a share in Grant and Co using:
(i) the dividend valuation model (ii) a suitable PE ratio
(iii) an asset based value.
Comment on the reliability of your estimates. (14 marks)
(b) Required:
