Financial Management
June 2015
Question Paper / Paper F9
Time allowed
Reading and planning:15 minutes
Writing:3 hours
This paper is divided into two sections:
Section A –ALL TWENTY questions are compulsory and MUST be attempted
Section B –ALL FIVE 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.
Section A – ALL 20 questions are compulsory and MUST be attempted
Each question is worth 2 marks.
1.In Islamic Finance, which of the following is FALSE?
AMudaraba – profits are shared according to a pre-agreed contract. Dividends as such are not paid.
BSukuk – the ‘lender’ maintains ownership of the underlying asset and shares in the risk/rewards of ownership.
CMurabaha – a pre-agreed mark-up is agreed for the convenience of credit.
DCharging interest on murabaha is only acceptable provided all parties agree.
2.Which of the following is NOT an advantage of withholding a dividend as a source of finance?
ARetained profits are a free source of finance
BInvestment plans need less justification
CIssue costs are lower
DIt is quick
3.ABC Co has recently paid a dividend of 34c per share. 4 years ago the dividend was 12c a share. There was a 1 : 1 bonus issue of shares 2 years ago. Current share price is $5 a share.
What is the cost of equity capital for ABC Co?
A38.5%
B16.4%
C17.9%
D6.8%
4.ABC Co’s gearing is slightly above the industry average, so when seeking finance for a new project, ABC Co opts for equity finance.
The capital structure theory they appear to subscribe to is:
ATraditional view
BModigliani-Miller (no tax)
CModigliani-Miller (with tax)
DResidual view
5.The US$/European € spot rate is quoted currently at 1.9612 – 1.9618 $/€. The 3 month forward rate isquoted at $0.0012 – 0.0006 premium in Europe. A Europe company is expecting to receive US$2.5 million in threemonths time and would like to hedge this using a forward contract.
What will be the US$ receipt in 3 months time?
A$1,274,730
B$1,273,950
C$1270,123
D$1,275,510
6.Which of the following could cause the interest yield curve to steepen?
1Increased uncertainty about the future
2Heightened expectations of an increase in interest rates
3The expectation that interest rate decreases will happen earlier than previously thought
A1 and 2 only
B1, 2 and 3
C2 and 3 only
D1 only
7.Which of the following money market instruments would be classed as ‘discount’ instruments as opposed to ‘interest bearing’?
1Commercial paper
2Treasury bills
3Certificate of deposit
4Bankers acceptance
A1 and 2 only
B1, 3 and 4 only
C2, 3 and 4 only
D1, 2 and 4 only
8.ABC Co is considering offering a 2% early settlement discount to its customers. Currently sales are $10million and customers take 60 days to pay. ABC Co estimates half the customers will take up the discountand pay cash. ABC is currently financing working capital using an overdraft on which it pays a 10% charge.Assume 365 days in a year.
What will be the effect of implementing the policy?
ABenefit of $17,808
BCost of $17,808
CBenefit of $82,192
DBenefit of $182,192
9.ABC Co has a 7% convertible loan note in issue, currently priced at $125. It is convertible at any time over the next 5 years into 25 ordinary shares. The share price is currently $4.10
How much is the conversion premium?
A$22.50
B$2.50
C$32.5
D$102.5
10.What type of option would a borrower use to hedge against interest rate rises and when would it be abandoned?
APut option, abandon when rates rise
BPut option, abandon when rates fall
CCall option, abandon when rates rise
DCall option, abandon when rates fall
11.The following relates to a profit warning announcement by ABC Co:
30 SeptemberDiscussion and agreement at Board Level that profits for the year are likely to fall short of expectations.
4 OctoberAnnouncement of the expected shortfall at a press conference.
Share price fell 40% on 2 October.
What does this imply about the efficiency of the capital markets?
AA weak form efficient market
BA semi-strong form efficient market
CA strong form efficient market
DComplete inefficiency in the market
12.A games emporium has one space for a new slot machine. Machine A lasts for 4 years and has a net presentvalue of $10,000. Machine B last for 6 years and has a net present value of $12,800. The emporium has acost of capital of 10%, and intends to indefinitely replace the machine with an identical model goingforwards.
Which machine should the games emporium select and why?
AMachine B as it has the highest net present value.
BMachine A as the average net present value per year is higher.
CMachine A as it offers the highest equivalent annual benefit.
DMachine B as it offers the highest equivalent annual benefit.
13.The government in a country is following an expansionary fiscal policy.
How might this affect many businesses?
AHigher taxes, less government contracts being offered, less subsidies, lower demand.
BLower interest rates, increased availability of credit from banks, higher demand.
CLower taxes, increased government subsidies and contracts being offered, higher demand.
DHigher interest rates, less availability of credit from banks, lower demand.
14.The following information relates to ABC Co.
Current ratio / 2.0Receivables days / 60 days
Annual (360 days) turnover / $3.6 million
Gross margin / 25%
Inventory turnover / 18 times
Payables days / 90 days
What is ABC Co’s positive cash balance?
A$427,500
B$350,000
C$150,000
D$600,000
15.Consider the following statements concerning sources of finance
1.Eurobonds can be denominated in any freely-traded currency and not just in Euros.
2.Junk bonds in the USA and high-yield loan notes in Europe both have high credit risk.
Which of the following combinations (true/false) concerning the above statements is correct?
Statement 1 / Statement 2A / True / True
B / True / False
C / False / True
D / False / False
16.Sinai Co is financed entirely by equity and earnings per share are expected to be $0·30 for the forthcoming year. Thecompany earns a constant return of 12% on its investments and pays a constant dividend payout ratio of 25%.
What is the predicted market value per share?
A$0.36
B$0.63
C$0.83
D$2.50
17.Data of relevance to the evaluation of a particular project are given below.
Cost of capital in real terms / 10% per annumExpected inflation / 8% per annum
Expected increase in the project’s annual cash inflow / 6% per annum
Expected increase in the project’s annual cash outflow / 4% per annum
Which one of the following sets of adjustments will lead to the correct NPV being calculated?
Cash inflow / Cash outflow / Discount percentageA / Unadjusted / Unadjusted / 10.0%
B / 6% p.a. increase / 4% p.a. increase / 18.8%
C / 6% p.a. increase / 4% p.a. increase / 10.0%
D / 8% p.a. increase / 8% p.a. increase / 18.8%
18.The finance director of Mycenae Co made the following statements at a recent meeting.
1.Our credit analysis procedures for new customers need to be evaluated because it seems that the company’s baddebts level is significantly higher than the industrial average.
2.The procedures for selecting and evaluating the preferred suppliers for the company take too long because manyof the steps are repeated. This is having a damaging impact on our relations with suppliers.
3.It seems that recently more of our products have been returned due to poor quality. On investigating this, it seemsthe main reason for this is that staff have not been trained sufficiently on the new factory machinery we installedrecently.
Which combination of the above statements typically relate to operational risk?
A1, 2 and 3
B1 and 2 only
C1 and 3 only
D2 and 3 only
19.Sahara Co wishes to take out a $20 million loan in three months’ time and to fix the interest rate for a nine-monthperiod. A forward rate agreement will be used to hedge interest rate risk and the following rates have been quoted bya bank:
Bid / Offer% / %
3 v 9 / 3.52 / 3.45
3 v 12 / 3.63 / 3.55
Sahara Co can borrow at 50 basis points above LIBOR and, at the fixing date, LIBOR is 3.25%.
What is the rate of interest that Sahara Co will pay to the bank as a result of the forward rate agreement?
A0.20%
B0.27%
C0.30%
D0.38%
20.Company A’s shares have a higher beta factor than Company B’s.
Which of the following is true about Company A?
ATotal risk is higher than Company B
BIt is exposed to more systematic risk factors than Company B
CIts shares are under priced
DIt is exposed to higher levels of systematic risk than Company B
Section B – ALL FIVE questions are compulsory and MUST be attempted
Question 1
BB Ltd produces a tracking device that can be attached to bicycles. The device is designed to help locate thewhereabouts of stolen bicycles and is sold to wholesalers and retailers throughout the US. The following sales andcost data relating to the tracking device has been produced by the company:
Per device$ / $
Selling price / 50.00
Less:
Materials / 10.00
Labour (see Note 1) / 12.00
Overheads (see Note 2) / 15.00 / 37.00
Profit / 13.00
Notes:
1.Labour is a fixed cost.
2.Two-thirds of overhead costs incurred are fixed.
In recent years, sales of the device have been stable at £20 million per year. However, a new chief executive has beenappointed who is determined to increase sales. He commissioned a market research report, which indicates that salescould be increased by 20% if a marketing campaign costing £1·5m per year is undertaken. The company has unusedcapacity within its factory and could easily cope with such an increase in sales.
All sales are on credit and the company divides its customers into three separate categories according to their paymentcharacteristics. The three categories are as follows:
Category / Average collection period(Number of days) / Bad debts
(%)
A / 30 / 1.0
B / 40 / 3.0
C / 50 / 5.0
If the marketing campaign is launched and the increase in sales achieved, 20% of additional sales would be fromCategory A customers, 30% Category B customers and 50% Category C customers. The company would finance anyexpansion in its trade debtors by a bank overdraft, on which it would expect to pay interest at 10% per year.
All workings should be in $000s and should be made to one decimal place.
Required:
(a)What would be the effect of undertaking the marketing campaign on the annual net profits before tax of thecompany, assuming the increase in sales is achieved? (8 marks)
(b)Briefly comment on the results of your finding in (a) above.(3 marks)
(c)Outline steps that a company should take to ensure that credit customers pay on time. (4 marks)
(15 marks)
Question 2
Blackwater plc, a manufacturer of specialty chemicals, has been reported to the anti-pollutionauthorities on several occasions in recent years, and fined substantial amounts for making excessivetoxic discharges into local rivers. Both the environmental lobby and Blackwater’s shareholders demandthat it clean up its operations.
It is estimated that the total fines it may incur over the next four years can be summarised by thefollowing probability distribution (all figures are expressed in present values):
Level of fine / Probability$0.5m / 0.3
$1.4m / 0.5
$2.0m / 0.2
Filta & Strayne Ltd (FSL), a firm of environmental consultants; has advised that new equipment costing$1m can be installed to virtually eliminate illegal discharges. Unlike fines, expenditure on pollutioncontrol equipment is tax-allowable via a 25% capital allowance (reducing balance) and it can be claimed in the year of purchase. The rate ofcorporate tax is 33%, paid with a one-year delay. The equipment will have no resale value after itsexpected five-year working life, but can be in full working order immediately prior to Blackwater’snext financial year.
A European Union Common Pollution Policy grant of 25% of gross expenditure is available, but withpayment delayed by a year. Immediately on receipt of the grant from the EU, Blackwater will pay 20%of the grant to FSL as commission. These transactions have no tax implications for Blackwater.
A disadvantage of the new equipment is that it will raise production costs by $30 per tonne over itsoperating life. Current production is 10,000 tonnes per annum, but expected to grow by 5% per annumcompound. It can be assumed that other production costs and product price are constant over the nextfour years. No change in working capital is envisaged.
Blackwater applies a discount rate of 12% after all taxes to investment projects of this nature. All cashinflows and outflows occur at year ends.
Required:
(a)Calculate the expected net present value of the investment assuming a four-yearoperating period. Briefly comment on your results. (9 marks)
(b)Briefly explain to Blackwater’s management as to the desirability of the project,taking into account both financial and non-financial criteria.
(6 marks)
(15 marks)
Question 3
VAL Co is a listed company with a stated objective of maximisation of shareholder wealth. Ithas 70 million ordinary shares in issue with a par value of $1, has no debt finance andcurrently has nearly $100m in the bank.
Financial information relating to VAL Co for the past three years ending 31 March is asfollows:
2011 / 2012 / 2013 / 2014Profit for the period ($m) / 21.7 / 27.2 / 34.6 / 40.3
Share price / 4.40 / 5.25 / 6.42 / 6.90
Total cash dividend / 15.4 / 15.4 / 15.4 / -
The dividend in respect of the year ending 31 March 2012 has yet to be declared.
VAL Co is considering a major new investment that will be financed using retained earningsand is expected to generate an NPV of $65 million. Information regarding this project hasnot yet been made public.
AVL Co is a very similar but significantly larger company. AVL Co has 250 million ordinaryshares which are currently trading at $4.60. The most recent accounts of AVL Co showed aprofit after tax of $85 million.
Required:
(a)Analyse and discuss whether VAL Co has achieved it stated objective of maximization of shareholder wealth. (4 marks)
(b)Calculate an earnings based value of VAL Co in total and per share and discuss your result. (6 marks)
(10 marks)
Question 4
Assume today is 1 April 2015.
CBA is a manufacturing company, operating in the United Kingdom (UK), whose shares are listed on the main UK stock exchange. The board needs to raise GBP 250 million to fund a number of planned new investments and is considering issuing either a convertible bond or additional shares.
CBA currently has 280 million GBP 1 ordinary shares in issue and today’s share price is GBP 3.60 per share. It also has GBP 195 million (nominal) of undated 6% preference shares. The preference shares each have a nominal value of GBP 1 and are currently quoted at GBP 1.05 per share. CBA currently has no debt.
Financial position prior to new investment or new financing
Earnings per share for the last financial year ended 31 March 2015 are 45 pence per share and the dividend pay-out ratio has been maintained as close as possible to 50% of earnings. Assume that the dividend for the year ended 31 March 2015 has just been paid and was based on 50% of estimated earnings for the year.
The proposed convertible bond
The convertible bond would be issued at a 7% discount to its nominal value and carry a coupon rate of 3% per annum. The bond would be convertible into ordinary shares in 4 years’ time at the ratio of 23 ordinary shares per GBP 100 nominal of the bond.
Forecast position after issuing the convertible bond and making the new investments
Assuming the new investments are undertaken and financed by convertible debt, CBA expects its earnings to grow by 5% per annum for the foreseeable future and to maintain its dividend pay-out ratio at 50%. The share price is expected to rise by 6% per year over the next four year period.
Other information
CBA pays corporate income tax at a rate of 30% on taxable profits and tax is payable at the end of the year in which the taxable profit arises.
CBA has sufficient taxable profits to benefit from any tax relief available.
Required:
(a)Calculate the following values assuming that the proposed convertible bond is issued on 1 April 2015:
(i)The forecast conversion value for the convertible bond in four years’ time.
(1 mark)
(ii)The post-tax cost of debt for the convertible bond based on its yield over the next four years up to and including conversion. (3 marks)
(iii)CBA’s post-tax weighted average cost of capital (WACC). For the purpose of this calculation, assume no change in the market value of the ordinary and preference shares as a result of the convertible bond issue. (4 marks)
(b)Explain the role of CBA’s treasury department in evaluating and implementing the convertible bond issue. (2 marks)
(10 marks)
Question 5
ABC Co operates a chain of children’s clothing stores. The most recent financial statements of the company areset out below:
Statement of financial position as at 30 November 2014
$mASSETS
Non-current assets
Property, plant and equipment / 145.5
Current assets
Inventories / 25.4
Trade receivables / 4.6
Cash at bank / 12.7
42.7
Total assets / 188.2
EQUITY AND LIABILITIES
Equity
Ordinary shares $0.50 / 30.0
Retained earnings / 67.8
97.8
Non-current liabilities
Loan notes / 50.0
Current liabilities
Trade payables / 34.4
Taxation / 6.0
40.4
Total equity and liabilities / 188.2
Income statement for the year ended 30 November 2014
$mRevenues / 362.8
Operating profit / 36.0
Loan interest payable / (4.0)
Profit before taxation / 32.0
Tax (25%) / (8.0)
Profit for the year / 24.0
The company has decided to expand its operations by opening new stores at a cost of $40·0 million. This move isexpected to increase operating profits by $10·0 million per year. To raise the necessary finance, the directors of ABC Co are considering either:
(i)an issue of $0·50 ordinary shares at a premium of $2·0 per share, or
(ii)an issue of $40 million 8% loan notes at their nominal value.
To conserve funds for further expansion, the company will issue no dividends for the foreseeable future.
Required:
(a)For each financing option:
(i)prepare a forecast income statement for the forthcoming year;
(ii)calculate the expected EPS for the forthcoming year;
(iii)calculate the expected level of gearing at the end of the forthcoming year.
(6 marks)
(b)Evaluate each financing option from the prospective of an existing shareholder.
(4 marks)
(10 marks)
Formulae Sheet
1.The Capital Asset Pricing Model /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)