Financial Management
December 2013
Question Paper / Paper F9
Time allowed
Reading and planning: 15 minutes
Writing: 3 hours
ALL FOUR questions are compulsory and MUST be attempted.
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.
ALL FOUR questions are compulsory and MUST be attempted
Question 1
Widget Co is a listed group which operates a number of manufacturing facilities within its home country. Widget Co has $700 million funds available for capital investment in new product lines in the current year. Most products have a very limited life cycle. Four possible projects have been identified, each of which can be started without delay.
Initial calculations for these projects are shown below:
Project / Initial investment / Net annual cash inflows after initial investment / Project term (years) / PV of cash flows arising after the initial investment / NPV$m / $m / $m / $m
A / 100 / 151.2 / 1 / 135 / 35
B / 150 / 82.3 / 4 / 250 / 100
C / 300 / 242.6 / 2 / 410 / 110
D / 350 / 124.0 / 6 / 510 / 160
Notes:
1. The projects are non-divisible and each project can only be undertaken once.
2. Apart from the initial investment, annual cash flows are assumed to arise at the end of the year.
3. A discount rate of 12% has been used throughout.
4. Ignore taxation.
Required:
(a) Prioritise the project according to each of the following measures:
(i) Net present value (NPV)
(ii) Profitability index (PI)
(iii) Payback (undiscounted)
(5 marks)
(b) Explain the strengths and weaknesses of each of the prioritization methods used in (a) above as the basis for making investment decisions in the context of capital rationing for non-divisible projects. (9 marks)
(c) Advise what combination of projects maximizes shareholders’ wealth within a maximum total initial investment of $700 million. (3 marks)
(d) Explain how the optimal combination of projects would need to reassessed under EACH of the following circumstances:
(i) ‘Soft’ rather than ‘hard’ single period capital rationing applies.
(ii) The same level of capital rationing and range of projects is expected in the following year.
(8 marks)
(Total 25 marks)
Question 2
PPT is a private manufacturing company. The company owns patents for certain luxury skin care products which it manufactures and sells to the wholesale market. It is also actively involved in research and development (R&D) of new products. PPT has a pre-tax cost of debt of 3.0% and gearing (debt/debt + equity) of 40%, based on its best estimate of the market values of debt and equity.
PPT is currently considering a number of different possible investment projects, proposed by both the R&D and manufacturing departments.
When evaluating proposed investments, PPT has previously always used a discount rate of 10% to discount expected future cash flows. However, the new Financial Director (FD) has challenged this and has suggested that the company should derive a weighted cost of capital (WACC) using the capital asset pricing model (CAPM). This WACC could then be used as the discount rate in future investment appraisal decisions. The Managing Director (MD) has asked the FD to justify this proposal and to calculate a more appropriate WACC for PPT.
The FD of PPT has identified a company, TT, which operates in the same industry. TT has an equity beta of 2.4 and gearing (debt/debt + equity) of 30% based on market values.
Additional information:
l The long term market risk premium can be assumed to be 4.0%.
l The risk free rate is 1.0%.
l Corporate income tax is charged at 35%.
l Debt betas for both PPT and TT can be assumed to be zero.
Required:
(a) Calculate a WACC for PPT using TT’s beta. (6 marks)
(b) Explain:
(i) the difference between systematic and unsystematic risk. (6 marks)
(ii) the theoretical relationship between components shown by the CAPM formula. (4 marks)
(c) Discuss the view that issuing traded bonds will decrease the weighted average cost of capital and thereby increase the market value of the company. (9 marks)
(Total 25 marks)
Question 3
Thorne Co operates an office furniture business that generated sales revenues of $80 million during the year ended 31 December 2011. The office furniture market is expected to be stagnant for the foreseeable future and so sales revenues for the company for the forthcoming year are forecast to remain the same as in the previous year, assuming that no changes are made to the terms of trade.
All sales are on credit and the terms of trade include the requirement that payment for goods is due one month after sale. A recent analysis of trade receivables, however, shows that, on average, customers take two months to pay. Although the company does not currently offer its customers a discount for prompt payment, the board of directors is considering a change in policy in an effort to improve the average collection period for receivables.
The marketing department believes that, by offering a 2.5% discount for customers who pay within one month, 75% of existing customers will pay at the end of one month in order to receive the discount. The remaining 25%, however, are likely to pay at the end of two months. A change in discount policy is likely to prove popular with customers and will bring the company’s terms of trade into line with those of its competitors. This change is also forecast to generate new customers, all of which are likely to take advantage of the new discount policy. The marketing director, who is a long-time advocate of offering discounts for prompt payment, has suggested that these new customers are likely to generate an additional $10 million of sales revenue during the forthcoming year.
The following forecasts for the forthcoming year have been made and are not affected by the proposed change in the terms of trade:
(i) a gross profit margin on sales revenues of 45%.
(ii) variable overheads will be 20% of sales.
(iii) fixed overheads will be $4.8 million.
(iv) variable and fixed overheads will be paid in the month in which incurred.
(v) sales and cost of sales will accrue evenly over the year.
(vi) three months’ credit (based on the cost of sales) will be taken from trade payables.
The company intends to hold four months’ inventory at all times and to have a cash balance at the year end of $0.3 million.
Ignore taxation.
Required:
(a) Calculate the forecast net profit of Thorne Co for the forthcoming year, based on the assumption that:
(i) the proposed discount policy is not adopted; and
(ii) the proposed discount policy is adopted.
(5 marks)
(b) Calculate the investment in working capital at the end of the forthcoming year, based on the assumption that:
(i) the proposed discount policy is not adopted; and
(ii) the proposed discount policy is adopted.
(6 marks)
(c) Discuss your calculations in answer to parts (a) and (b) above and state whether the proposed discount policy should be adopted. (4 marks)
(d) Explain why very Small to Medium-size Enterprises (SMEs) might face problems in obtaining appropriate sources of finance and suggest potential sources of finance for very new SMEs excluding sources from capital markets. (10 marks)
(Total 25 marks)
Question 4
NV Co, a quoted company whose home currency is the dollar, has cash balances of $23 million set aside for strategic acquisitions. The Board has suggested the purchase of S Co, a company based in the same industry but in a different country, whose home currency is the peso.
S Co is a subsidiary within a larger group (P Co) who are looking to dispose of S Co in order to focus on their core activities. P Co considers the subsidiary to be worth 500 million pesos in total.
In the last financial year, S Co reported earnings after tax of 50 million pesos. The Board of NV Co feel that after acquiring S Co, the following would occur:
• A number of employees would be made redundant in order to eliminate the duplication of roles. This would save an estimated 4 million pesos before tax
• Further synergistic benefits will arise through bulk purchasing and the co-ordination of research programmes. These are estimated at 6 million pesos before tax
The corporation tax rate in S Co’s home country is 25%.
Other relevant data:
P Co earnings yield / 10%NV Co earnings yield / 12.5%
Average P/E of companies recently taken over in the industry, based upon the offer price / 9
Since NV Co does not currently have sufficient funds to cover the entire asking price immediately, the balance remaining, after the full use of the current cash reserves, will take the form of a loan from P Co, repayable in one year’s time. As part of the agreement, interest will be charged on this loan at a rate of 4%, payable every six months.
The following further information is available:
Per $Spot rate: / pesos 12.500 – pesos 12.588
Six-month forward rate: / pesos 12.606 – pesos 12.692
Interest rates that can be used by NV Co:
Borrow / DepositPeso interest rates: / 9.1% per year / 7.4% per year
Dollar interest rates: / 5.5% per year / 3.7% per year
Required:
(a) Comment on whether the 500 million peso valuation of S Co appears reasonable, based on the information provided. (8 marks)
(b) Calculate the value of loan, in pesos, that will be repayable in one year’s time, together with the interest payment due after 6 and 12 months. (2 marks)
(c) Calculate whether a forward market hedge or a money market hedge should be used to hedge the interest payment in six months’ time. Assume that NV Co would need to borrow any cash it uses in hedging exchange rate risk. (6 marks)
(d) Discuss the reasons why different bonds of the same company might have different costs of debt. (9 marks)
(Total 25 marks)
Formulae Sheet
2. The asset beta formula /
3. The growth model /
4. Gordon’s growth approximation /
5. The weighted average cost of capital / WACC =
6. The Fisher formula / (1+ i) = (1+ r)(1+ h)
7. Purchasing power parity /
8. Interest rate parity /
9. Economic order quantity / =
10. Miller-Orr model / Return point = Lower limit + (1/3 × spread)
P. 1