Financial Management (FM)

Solution Pack
S. No Question ACCA Exam Paper Topics Covered

1 Dusty Co Sep/Dec 2019 Working Capital Management

2 Dink Co Sep/Dec 2019 Investment Appraisal (Lease Vs Buy)
3 Corfe Co Mar/Jun 2019 Estimating the cost of capital
4 Pinks Co Mar/Jun 2019 Investment Appraisal
5 Melanie Co Sep/Dec 2018 Investment Appraisal
6 Oscar Co Sep/Dec 2018 Working Capital Management
7 Tin Co Mar/Jun 2018 Sources of Finance
8 Copper Co Mar/Jun 2018 Investment Appraisal
9 Tufa Co Sep/Dec 2017 Sources of Finance and WACC
10 Pelta Co Sep/Dec 2017 Investment Appraisal
11 Pangli Co Mar/Jun 2017 Working Capital Management
12 Vyxyn Co Mar/Jun 2017 Risk, Uncertainty and Investment Appraisal
13 Nesud Co Sep 2016 Working Capital Management
14 Hebac Co Sep 2016 Investment Appraisal and CAPM
15 Cargo Co Mar/Jun 2016 Overtrading
16 Palm Co Mar/Jun 2016 Interest Rate Hedging
17 Plot Dec 2013 Working Capital Management
18 Darn Dec 2013 Investment Appraisal
19 Card Dec 2013 Cost of Equity
20 GWW Dec 2014 Business Valuations
21 TGA June 2013 Working Capital and Risk Management
22 Wobnig June 2012 Working Capital Management
23 Spot Dec 2013 Investment Appraisal
24 Close Dec 2011 WACC and Business Valuations
25 PV Co Dec 2014 Investment Appraisal
26 DD Co Dec 2014 Sources of Finance
 DUSTY CO

Part (a)(i) Annual holding and ordering costs of the current inventory management system

Current order = 1,500,000/12 = 125,000 units per order

Average inventory = 125,000/2 = 62,500 units
Current holding cost = 62,500 x 0·21 = $13,125 per year
Current ordering cost = 12 x 252 = $3,024 per year
Current total inventory management cost = $13,125 + $3,024 = $16,149 per year

Part (a)(ii) Financial effect of adopting EOQ model

EOQ = (2 x 252 x 1,500,000/0·21)0·5 = 60,000 units/order

Number of orders = 1,500,000/60,000 = 25 orders per year
Average inventory = 60,000/2 = 30,000 units
Holding cost = 30,000 x 0·21 = $6,300 per year
Ordering cost = 25 x 252 = $6,300 per year
EOQ total inventory management cost = $6,300 + $6,300 = $12,600 per year
Reduction in total inventory management cost = $16,149 – $12,600 = $3,549 per year
Reduction in average inventory = (62,500 – 30,000) x 14 = $455,000
The overdraft will decrease by the same amount.
Finance cost saving = 455,000 x 0·03 = $13,650 per year
Overall saving = $3,549 + $13,650 = $17,199

Part (a)(iii) Financial effect of accepting the bulk order discount

Number of orders = 1,500,000/250,000 = 6 orders per year

Average inventory = 250,000/2 = 125,000 units
Holding cost = 125,000 x 0·21 = $26,250 per year
Ordering cost = 6 x 252 = $1,512 per year
Total inventory management cost = $26,250 + $1,512 = $27,762 per year
Increase in total inventory management cost = $27,762 – $16,149 = $11,613 per year
Increase in value of average inventory = (125,000 x 14) – (62,500 x 13·93) = $879,375
The overdraft will increase by the same amount.
Finance cost increase = 879,375 x 0·03 = $26,381 per year
Bulk order discount = 1,500,000 x 14 x 0·005 = $105,000 per year
Overall saving = $105,000 – $11,613 – $26,381 = $67,006

Part (a)(iv) Recommendation

Availing the bulk order discount saves $67,006, while the EOQ approach saves $17,199. The bulk order
discount is recommended as it leads to the greater cost saving.
Part (b) Key factors in determining working capital funding strategies

Permanent and fluctuating current assets

It is important to distinguish between permanent and fluctuating current assets. Permanent current
assets represent the core level of current assets needed to support normal levels of business activity, for
example, the level of trade receivables associated with the normal level of credit sales.

Business activity will be subject to unexpected variations, however, such as some customers being late
in settling their accounts, leading to unexpected variations in current assets. These can be termed
fluctuating current assets.

Relative cost and risk of short-term and long-term finance

The relative cost of short-term and long-term finance is another key factor. Long-term debt finance is
more expensive than short-term debt finance. If agreement terms are adhered to, and interest is paid
when due, long-term debt finance is a secure form of low-risk finance.

While short-term debt finance is lower cost than long-term debt finance, it is higher risk. For example, an
overdraft is technically repayable on demand.

Matching principle

Another key factor is the matching principle, which states that the maturity of assets should be reflected
in the maturity of the finance used to support them. Short-term finance should be used for fluctuating
current assets, while long-term finance should be used for permanent current assets and non-current
assets.

Relative costs and benefits of different funding policies

A matching funding policy would use long-term finance for permanent current assets and non-current
assets, and short-term finance for fluctuating current assets.

A conservative funding policy would use long-term finance for permanent current assets, non-current
assets and some of the fluctuating current assets, with short-term finance being used for the remaining
fluctuating current assets.

An aggressive funding policy would use long-term finance for the non-current assets and part of the
permanent current assets, and short-term finance for fluctuating current assets and the balance of the
permanent current assets.

A conservative funding policy, using relatively more long-term finance, would be lower in risk but lower in
profitability.

An aggressive funding policy, using relatively more short-term finance, would be higher in risk but higher
in profitability.

A matching funding policy would balance risk and profitability, avoiding the extremes of a conservative or
an aggressive funding policy.

Other key factors

Managerial attitudes to risk can lead to a company preferring one working capital funding policy over
another, for example, a risk-averse managerial team might prefer a conservative working capital funding
policy. Organisational size can be an important factor in relation to, for example, access to different
forms of finance in support of a favoured working capital funding policy.
 DINK CO

Part (a)(i) PV of cost of borrowing to buy:

After-tax cost of borrowing = 8·6 x (1 – 0·3) = 8·6 x 0·7 = 6%

Year 0 1 2 3 4 5

Purchase (750,000)

Residual value 50,000

Service costs (23,000) (23,000) (23,000) (23,000)

TAD benefit 56,250 42,188 31,641 79,922

Service tax benefits 6,900 6,900 6,900 6,900

Net cash flow (750,000) (23,000) 40,150 26,088 65,541 86,822

Discount at 6% 1 0·943 0.890 0.840 0.792 0.747

Present values (750,000) (21,689) 35,734 21,914 51,908 64,856

NPV $597,777

Working: TAD Benefit

Year 0 1 2 3 4 5

Purchase (750,000)

TAD 187,500 140,625 105,469 266,406*

30% TAD benefit 56,250 42,188 31,641 79,922

*750,000 – 187,500 – 140,625 – 105,469 – 50,000 = $266,406

Part (a)(ii) PV of cost of leasing:

Year 0 1 2 3 4 5

Lease rentals (200,000) (200,000) (200,000) (200,000)

Tax benefits 60,000 60,000 60,000 60,000

Net cash flow (200,000) (200,000) (140,000) (140,000) 60,000 60,000

Discount at 6% 1 0·943 0.890 0.840 0.792 0.747

Present values (200,000) (188,600) (124,600) (117,600) 47,520 44,820

NPV $538,460
Part (a)(iii) Recommendation:

Financial benefit of leasing = $597,777 – $538,460 = $59,317

Leasing the new machine is recommended as the option which is more attractive in financial terms to
Dink Co.

Part (b)(i) Reasons why investment capital may be rationed:

Companies experience capital rationing and are limited in the amount of investment finance available.
Hard capital rationing is due to external factors, while soft capital rationing is due to internal factors or
management decisions.

Reasons for hard capital may be general. For example, the availability of new finance may be limited
because share prices are depressed on the stock market or because of government-imposed restrictions
on bank lending.

Reasons for hard capital rationing may be company-specific. For example, a company may not be able
to raise new debt finance if banks or investors see the company as being too risky to lend to.

Reasons for soft capital rationing include managerial aversion to issuing new equity, for example, a
company may want to avoid potential dilution of its EPS or avoid the possibility of becoming a takeover
target.

Soft capital rationing could also arise because managers wish to finance new investment from retained
earnings rather than a sudden increase in size which might result from undertaking all investments with a
positive net present value.

Lastly, a reason for soft capital rationing may be that managers want investment projects to compete for
funds, in the belief that this will result in the acceptance of stronger, more robust investment projects.

Part (b)(ii) Ways in which Dink Co’s external capital rationing might be overcome:

Business angel financing can be used to overcome external capital rationing. This informal source of
finance is from wealthy individuals or groups of investors who invest directly in the company and who are
prepared to take higher risks in the hope of higher returns.

Crowdfunding could be considered whereby many investors provide finance for a business venture, for
example, via an internet-based platform.

Dink Co might be entitled to grant aid from a government, national or regional source which could be
linked to a specific business area or to economic regeneration in a specified geographical area.

Dink Co could also consider a joint venture as a way of decreasing the need for additional finance,
depending on the nature of its business and its business plans, and whether the directors of Dink Co are
prepared to sacrifice some control to the joint venture partner.
 CORFE CO
(a) ke = 3.5% + (1.25  6.8%) = 12.00%
kpref = (0.06  0.75)/0.64 = 7.03%
Loan notes
After tax interest payment 8%  (1-0.2) = 6.4%
Nominal value of loan notes 100.00
Market value of loan notes 103.50
Time to redemption (years) 5
Redemption premium (%) 10

Year $ 5% DF PV ($) 10% DF PV ($)

0 MV (103.50) 1.000 (103.50) 1.000 (103.50)
1-5 Interest 6.40 4.329 27.71 3.791 24.26
5 Redeem 110.00 0.784 86.24 0.621 68.31
10.45 10.93

IRR = 5 + ((10-5)  (10.45/(10.45 + 10.93))) = 7.44%

This figure can also be used for the cost of debt of the bank loan.
Market values and WACC calculation
BV Nominal MV MV Cost MV 
Cost
($m) ($m) (%) (%)
Equity shares 15 1.00 6.10 91.50 12.00 1,098.0
Preference shares 6 0.75 0.64 5.12 7.03 35.99
Loan notes 8 100 103.50 8.28 7.44 61.60
Bank loan 5 5.00 7.44 37.20
109.90 1,232.79
(b) Director A claims there is $29m cash reserve available for the investment. This is not correct, the
$29m relates of all Corfe Co’s assets; only $4m of this is cash. Some of this could be used for
investments, but some will also need to be held for the day-to-day operations of the company.
Corfe Co’s current ratio of 2.86 (=20/7) indicates that reducing working capital could release
additional cash. This could be achieved by:
 Delaying payments to suppliers, and strengthening credit control procedures but this could
damage customer and supplier relationships; and
 Implementing just-in-time inventory control, but this creates a risk of being unable to fulfil
orders
It is therefore unlikely that reserves could be used for the investment, as suggested by Director A.
Director B suggests selling the headquarters for $20m to fund the investment. He is correct that
this would raise most of the funds that are needed and that it would reduce ongoing property
management costs. However, there are problems to consider:
 Once sold, future benefits are lost, eg loans can no longer be secured against it so overall
borrowing capacity is lowered.
 Rental costs would increase, offsetting the saving property management costs
 One-off costs, such as costs of relocating staff
 Head office staff may now be dispersed across several locations, or are based in a less-
effective locations and so reducing internal synergies and efficiencies
Director C suggests reducing dividends over the next three years. Last year’s dividend of $13.5m
is high compared with total reserves ($29k), so if this amount was available to pay, reducing it would
fund the investment. However:
 Shareholders will not be happy with a cut in dividends
 May signal to the shareholders that there are problems in the company
 May withdraw their support as a result
 The dividend policy would be brought into question if a one-off high dividend payment has
been made, particularly as doing so is inconsistent with the investment strategy the directors
are following
 PINKS CO
(a) (i) Nominal terms appraisal of the investment project
Year 1 2 3 4
$’000 $’000 $’000 $’000
Sales revenue 39,375 58,765 85,087 32,089
Variable cost (22,047) (31,185) (41,328) (17,923)
Contribution 17,328 27,580 43,759 14,166
Fixed costs (3,180) (3,483) (3,811) (3,787)
Cash flows before tax 14,148 24,097 39,948 10,379
Tax at 26% (3,679) (6,265) (10,387) (2,699)
TAD benefits 1,300 975 731 2,194
Cash flows after tax 11,769 18,807 30,292 9,874
Discount at 12% 0.893 0.797 0.712 0.636
Present values 10,510 14,989 21,568 6,280

$’000
Sum of all PVs of future cash 53,347
flows
Initial investment 20,000
NPV 33,347

Workings
Year 1 2 3 4
Selling price ($/unit) 125 130 140 120
Inflated by 5%/year 131.25 143.33 162.07 145.86
Sales volume (units/year) 3000,000 410,000 525,000 220,000
Sales revenue ($’000/year) 39,375 58,765 85,087 32,089

Variable cost ($/unit) 71 71 71 71

Inflated by 3.5% per year 73.49 76.06 78.72 81.47
Sales volume (units/year) 300,000 410,000 525,000 220,000
Variable cost ($’000/year) 22,047 31,185 41,328 17,923

Fixed costs ($’000/year) 3,000 3,100 3,200 3,000

Inflated by 6% per year 3,180 3,483 3,811 3,787

TAD ($’000) 5,000 3,750 2,813 8,437

TAD benefits ($’000) 1,300 975 731 2,194
(ii) Real terms appraisal of the investment project
Year 1 2 3 4
$’000 $’000 $’000 $’000
Nominal cash flows before tax 14,148 24,097 39,948 10,379
Real cash flows before tax 13,643 22,408 35,823 8,975
Tax at 26% (3,547) (5,826) (9,314) (2,334)
TAD benefits 1,300 975 731 2,194
Cash flows after tax 11,396 17,557 27,240 8,835
Discount at 8% 0.926 0.857 0.794 0.735
Present values 10,553 15,046 21,629 6,494

(b) Tutorial note: only four suggestions were asked for. More are provided here for tuition purposes
Managers can be encouraged to achieve stakeholder objectives by:
Offering share option schemes. This aligns the goals of managers with those of shareholders as
the managers themselves will have a stake in the company. This aids goal congruence, however it
can lead to short-termism as managers focus on achieving the highest profits in the current year.
Incentivising with performance related pay so that a proportion of the manager’s pay will be
conditional upon meeting a particular target. Again, care should be taken in selecting targets to
ensure the manager focuses on the long-term success of the organisation and not only on meeting
the specific target.
Applying corporate governance codes of best practice to ensure the organisation operates in
line with best practice in key areas of corporate goverance, such as remuneration, risk
management, internal controls and doing so. By complying with best practice, stakeholder
objectives are more likely to be achieved.
Complying with stock exchange listing regulation. This encourages price-sensitive information
to be disclosed and to reduce the information gap between managers and stakeholders. More
informed stakeholders can better determine the extent to which their objectives are being met, and
thus encourages managers to work harder to meet those objectives.
Monitoring the decisions and performance of managers, for example by auditing the financial
statements.
 MELANIE CO
Part (a)(i) Lease v Buy

If Melanie Co chooses to lease as opposed to (borrow and) buy, relevant cash flows would be as follows:

$ T0 T1 T2 T3
Initial investment saved 160,000
Scrap proceeds foregone (40,000)

Maintenance costs saved 8,000 8,000 8,000

Lease costs – in advance (55,000) (55,000) (55,000) _______
Net cash flow 105,000 (47,000) (47,000) (32,000)
8% discount factor 1 0.926 0.857 0.794
Present value
105,000 (43,522) (40,279) (25,408)
(cash flow x discount factor)

Net Present value of leasing as opposed to buying (=the sum of the present values) = $(4,209).

Leasing as opposed to buying has a negative NPV so this should NOT be undertaken – the company
should purchase the asset.

Note: The loan being taken out and repaid is a financing flow and is not a relevant cashflow. The interest
costs associated with the loan are part of the discount rate so do not need to also be included as a cash
outflow.

Part (a)(ii) Equivalent Annual Costs

3 year cycle

Discount factor
$ Present value
10%
T0 Initial cost (160,000) 1 (160,000)
T1-3 Maintenance costs (8,000) 2.487* (19,896)
T3 Scrap proceeds 40,000 0.751 30,040
(149,856)

The EAC = (149,856) / 2.487* = £(60,256) i.e. an equivalent annual cost of £60,256 per annum.

*3 year annuity factor

4 year cycle

Discount factor
$ Present value
10%
T0 Initial cost (160,000) 1 (160,000)
T1-4 Maintenance costs (12,000) 3.170* (38,040)
T3 Scrap proceeds 11,000 0.683 7,513
(190,827)

The EAC = (190,827) / 3.170* = £(60,103) i.e. an equivalent annual cost of £60,103 per annum.
*4 year annuity factor

Based on the above, the 4 year cycle has a marginally lower equivalent annual cost so the machine
should be replaced every four years.

Part (b) NPV v IRR

NPV may be considered superior to IRR for a number of reasons:

NPV gives a direct measure of the impact on shareholder wealth – If it is assumed that the objective
is to maximise shareholder wealth, NPV measures that impact in financial terms directly.

NPV can be used to compare projects: IRR is a relative measure. For example, one project may have
a higher IRR than another, but because it is small it doesn’t create as much wealth for the shareholders.

There is only one NPV: with non-conventional cash flows (for example, an initial outflow, years of
inflows then a large outflow at the end) there may be several IRRs, confusing the decision rule for IRR.
The decision rule with NPV is clear: if the NPV is positive, accept the project as to do so will increase
shareholder wealth.

The IRR uses an unrealistic ‘reinvestment assumption.’ The IRR assumes cash flows earned early
on in the project are reinvested to earn the IRR. There is no reason to suppose that is likely to be the
case. When cash flows are earned, they are taken elsewhere and spent/invested by the business on
other things.
 OSCAR CO
Part (a) - Costs and benefits of the factoring options

Option 1

Costs
Factor fee - $28m x 0.5% (140,000)
Benefits
Admin saving 30,000
Reduction in overdraft interest:
Current receivables 5,370,000
New receivables: (30/365) x $28m (2,301,369)
Reduction in receivables: 3,068,631
@ 7% overdraft interest rate 214,804
Net benefit of option 1 104,804

Option 2

Costs
Factor fee - $28m x 1.5% (420,000)
Additional finance charge on advance: (36,822)
80% x 2,301,370 (new receivables – see option 1 above) x
(9%-7%)

Benefits
Admin saving 30,000
Reduction in overdraft interest:
Bad debt saving – $28m x 2% 560,000
Saving due to reduction in receivables: 214,804
$3,068,631 (see option 1 above) x 7%
Net benefit of option 2 347,982

As the net benefit of option 2 is considerably larger than for option 1, Option 2 is the preferred choice.
That said, either option is better than the current situation.

Part (b) - Benefits of using a factor

Expertise: Factors will have specialist knowledge and skills to improve recovery times and reduce bad
debts

Frees up management time: Oscar Co Management can focus on their business rather than risk being
distracted by collection issues

Access to finance for a growing business: As revenue and receivables grow, the factor as a source of
finance also grows as the factor advance in option 2 is related to the size of the receivables ledger.

Bad debt insurance: The risk of bad debts is removed in a non-recourse arrangement (option 2), thus
saving Oscar co the 2% bad debt expense they suffer currently.
Liquidity management – it provides a source of finance which may well be welcome as fast growing
businesses like Oscar often suffer from cash flow difficulties.

Cost savings – Due to the factor’s size they may well be able to administer debt collection much for
efficiently than Oscar Co can on its own, bringing costs down.

Part (c) - Factors affecting the level of working capital

Industry norms: terms of trade are often standardized in industry, for example customer may routinely
be offered 30 days credit in Oscar’s industry. Than being the case, Oscar would probably not want to
offer shorter terms to customers as they may lose business. Equally, the nature of the business will
affect the inventory levels. A service business for example will carry very little.

The risk attitude of management: A risk averse management team may prefer to have plenty of
working capital – for example to reduce the risk of stock-outs, or giving customers plenty of time to pay
to maintain relationships. However, this requires financing. A more aggressive policy would be to reduce
inventory levels, collect from customers promptly and extend credit taken from suppliers. This would
reduce the money tied up in working capital but may strain relationships with customers and suppliers.

The size of the business: The amount of working capital required is relevant to the size of business. A
large supermarket chain for example will naturally require significantly more working capital than an
individual one-off supermarket.
 TIN CO
Part (a) – 14 Marks = 25 minutes

(i) Theoretical ex-rights price

TERPS ($/share) = (Current value of equity + Proceeds of rights issues) ÷ No. of shares after rights
issue

= [(4 × $5) + ((1 – 20%) × $5)] ÷ 5 = 4·83

(ii) Revised EPS assuming equity financed

Revised EPS (calculated in 000s) = Revised earnings ÷ Revised number of shares

= $1,249 (W) ÷ (2,500 + 500) = 0.42

(iii) Revised EPS assuming debt financed

Revised EPS = Revised earnings ÷ Number of shares (unchanged)

= $1,124 (W) ÷ 2,500 = 0.45

WORKINGS
(ii) Equity (iii) Debt
financed financed
$000 $000
Increased PBIT (1,597 × 120%) 1,916 1,916
Finance costs (315) (475) (315 + 8% × $200)
––––– –––––
Revised profit before tax 1,601 1,441
Taxation at 22% (352) (317)
––––– –––––
Revised profit after tax 1,249 1,124
––––– –––––

(iv) Revised share prices ($/share)

Using equity (12·5 × 0·42) 5·25

Using debt (12·5 × 0·45) 5·63

(v) Discussion

At 56·3%, current gearing is less than the industry average of 60·5%. Using equity finance, would
further reduce gearing to 45·1%. Using debt finance, would increase gearing to 84·4%, well above the
industry average.

Equity finance would increase interest cover, which looks much safer than if interest cover were to fall to
4 times, using debt finance, which is clearly riskier.

However, debt finance, though riskier, may be the more attractive as the increase in share price will be
50% more (0·63 ÷ 0·42 = 150%).
WORKINGS

Current Equity Debt

finance finance

Gearing (D/E using BV) 4,500 ÷ 4,500 ÷ (4,500 + 2,000) ÷

(2,500 + 5,488) (7,988 + 2,000) 7,988
= 56·3% = 45·1% = 81·4%

Interest cover 1,597 ÷ 315 1,916 ÷ 315 1,916 ÷ 475

= 5·1 times = 6·1 times = 4·0 times

Increase in share price ($) 5·25 - 4·83 = 0·42 5·63 - 5 = 0·63

Part (b) – 6 marks = 11 minutes

Alternative Islamic finance sources (only TWO asked for)

A mudaraba contract which is between a two partners, is the Islamic instrument that is closest to equity
finance and hence a rights issue. A bank provides the capital to a customer which provides the business
expertise to manage the investment. Profits generated are apportioned between the partners as agreed
in the contract and losses are borne by the bank alone, up to the amount of capital provided.

Sukuk is the closest equivalent to a loan note issue (debt finance). However, as interest (riba) is
prohibited under Sharia law, the sukuk holders’ return is a share of the income generated by an
underlying tangible asset. Ownership of this asset must therefore pass to the sukuk holders. Sukuk
holders also share something in common with equity investors as their risks and rewards of ownership
include variable rather than fixed returns.

Ijara, which is similar to lease finance, might be an alternative to a loan note issue, depending on the
nature of the planned business expansion. The provider of the finance, the lessor, allows the customer
the use of a tangible asset in exchange for regular rental payments. Ownership of the leased asset may
be transferred from the lessor to the lessee at the end of the lease period.
 COPPER CO
Part (a) – 12 Marks = 21½ minutes

(i) Mean (expected) NPV of the proposed investment

PV Yr 1 CF PV Yr 2 CF
Probability Probability Total PV Joint probability Total PV
(W) (W)
$000 A $000 B $000 JP = A x B x JP
893 0.1 1,594 0.3 2,487 0.03 74.6
893 0.1 2,392 0.6 3,285 0.06 197.1
893 0.1 3,985 0.1 4,878 0.01 48.8
1,786 0.5 1,594 0.3 3,380 0.15 507.0
1,786 0.5 2,392 0.6 4,178 0.3 1,253.4
1,786 0.5 3,985 0.1 5,771 0.05 288.6
2,679 0.4 1,594 0.3 4,273 0.12 512.8
2,679 0.4 2,392 0.6 5,071 0.24 1,217.0
2,679 0.4 3,985 0.1 6,664 0.04 266.6
Check: 1 4,365.8

Expected PV of the proposed investment ($000) 4,366

Investment (3,500)
–––––
Expected NPV 866
–––––

WORKING

Year 1 CF PV @ 12% Year 2 CF PV @ 12%

1,000 893 2,000 1,594
2,000 1,786 3,000 2,392
3,000 2,679 5,000 3,986

(ii) Probability of the investment having a negative NPV

NPV is negative when total PV is less than 3,500 (i.e. when Yr 1 CF is 1,000 and Yr 2 CF is 2,000 or
3,000 and when CF n both years is 2,000.) The sum of the joint probabilities of these outcomes is 24%
(i.e. 0.03 + 0.06 + 0.15).

(iii) NPV of the most likely outcome

The most likely outcome is the outcome with the highest joint probability which is 30%.

The NPV ($000) = 4,178 – 3,500 = 678

(iv) Comment on financial acceptability of proposed investment

Based on the expected NPV, which is positive, the proposed investment appears to be is financially
acceptable. However, this average NPV is not a possible outcome because the proposed investment is
 a one-off decision. Although the NPV of the most likely outcome is also positive, there is only a 30%
chance of this and there is a 24% chance that the investment will not be worthwhile. Therefore, whether
the proposed investment is financially acceptable will depend on Copper Co’s directors’ attitude to risk.

Part (b) – 8 marks = 14½ minutes

Methods of adjusting for risk and uncertainty in investments appraisal (only TWO asked for)

(i) Simulation is a technique which can be used to evaluate an investment project where there is a
relationship between two or variables and a probability distribution can be associated with each
variable. Random numbers are assigned to the possible values of each project variable to reflect
its probability distribution. Random numbers are then generated to provide outcomes from which
a mean (expected) value can be calculated.

A probability distribution of a mean (expected) NPV can therefore be derived from the results of
repeated simulations. The project risk can be assessed using the standard deviation of the
expected NPV, the most likely outcome and the probability of a negative NPV.

(ii) Adjusted payback usually refers to discounted payback which is the period of time that it takes
for the discounted returns from an investment to recover the initial investment. The adjustment
for risk is reflected in the discount rate used.

If risk and uncertainty are considered to be the same, as uncertainty (risk) increases, the
payback period will be reduced to place more emphasis on the earlier, more certain, cash flows.
As uncertainty (risk) falls, the payback period will be increased and so place less emphasis on
the earliest cash flows.

(iii) A risk-adjusted discount rates incorporates the risk associated with an investment project by
including a risk premium over the risk-free rate of return. The risk premium can be subjective, for
example, recognising that a new venture is inherently riskier than expanding existing operations.

The risk premium can be determined using the capital asset pricing model to find a project-
specific discount rate to be used in investment appraisal. The investment’s business risk is
found by ungearing the equity beta of a proxy company, which is then regeared to reflect the
financial risk of the investing company. The project-specific equity beta can then be used as the
project-specific discount rate.
 TUFA CO
Part (a) – 11 Marks = 21.5 minutes

Calculate the after-tax weighted average cost of capital of Tufa Co on a market value basis.

Long term Debt Capital

$10M at 7%
$100 nominal Value
$102.34 Market Price
4 Years until redemption
5% Premium on redemption
30% Tax Rate

Year Item $ 5% DF PV ($) 6% DF PV ($)

0 MV (102.34) 1.000 (102.34) 1.000 (102.34)
1–4 Interest 4.9 3.546 17.38 3.465 16.98
4 Redeem 105.00 0.823 86.42 0.792 83.16

1.45 (2.20)

IRR (%) (5 + (1.45/(1.45 + 2.20))) = 5.40

Cost of bank loan (%) 5.40
Market values and WACC calculation

BV ($000) Nominal MV MV ($000) Cost (%) WACC

Ordinary shares 12,000 0.50 7.07 169,680 11.7 10.67
Preference shares 5,000 0.50 0.31 3,100 8.06 0.13
Loan notes 10,000 100.00 102.34 10,234 5.40 0.30
Bank loan 3,000 3,000 5.40 0.09

186,014 11.19

Part (b) – 3 Marks = 5.5 min

It is appropriate to use the current WACC to appraise and evaluate current projects that reflect the
current risk factors of Tufa Co. The current WACC is based on the current debt and equity costs and
once they are unchanged then it is suitable to use the current WACC to guide decision making. The
current WACC indicates that project must produce a return of at least 11.19% to produce the return
needed by investors and to meet debt cost.
Part (c) – 6 Marks = 11 min

THREE advantages to Tufa Co of using convertible loan notes as a source of long-term finance.

● Convertible loans offer flexibility to Tufa the company can convert the loan notes to shares avoiding
depleting cash reserves that repayment of the loan would cause.

● Converting loan stock into shares reduces the companies gearing which could be a good thing for
Tufa as it is highly geared.

● Convertible loans tend to be cheaper and have fixed interest rates, so Tufa can take advantage of
lower fixed interest rates.
 PELTA CO
Part (a) – 9 Marks = 17.50 min

(i) Present Value of future cash flows is €35,485,320 less €25,000,000 initial investment is a positive
NPV of €10,485,000.
(ii) The discounted Payback period is 2.7 years

Part (b)

The project produces a positive NPV therefore it is financially acceptable as the companies cost of
capital and risk margins are met and it is generating wealth and in turn growth for the company. The
NPV is substantial at over €10 million. The payback period of the project is longer than the company
allows however the NPV is a better measure as it incorporates risk and cost of finance, and since the
NPV is positive it is acceptable.

Part (c)

The directors only evaluate projects over four years meaning that some projects that generate wealth in
the long term are ruled out. This is a limited view however shows the emphasis the directors place on
cash flows. Given the short payback period and short time frame of four years. Cash flows although
important do not tell the full story and very profitable projects may be sacrificed due to this short-term
cash centric attitude.

The assumed terminal value has no foundation and is just an estimation. Assuming end values can
result in unreliable financial results. For example, the terminal value of a real estate investment project
vs the terminal value of a perishable goods project is very different yet in this situation they are both
given the same value.
 PANGLI CO
Part (a)

(i) Cash Conversion Cycle = Days Inventory Outstanding + Days Receivables Outstanding – Days
Payables Outstanding

Days Inventory Outstanding = (Inventory / Cost of Sales) x 360 = (455,000/ (3,500,000* 60%)) 360 = 78
days

Days Receivables Outstanding = (408,350/3,500,000) x 360 = 42 days

Days payables outstanding =186,700/(3,500,000 x 60%) x 360 = 32 days

Cash Conversion Cycle = 78+42-32 = 88 Days

(ii)

Details $
Overdraft at 1 Jan 240,250
Interest 70,000
Operating Cash Outflow 146,500
Cash Received from November sales (40% of $270,875) (108,350)
Cash Received from December sales (60% of $300,000) (180,000)
Cash to suppliers (186,700 @ 70%) 130,690
Total 299,090

Expected Overdraft $299,090

(iii) Current ratios at start of Jan 2017

Current Assets / Current Liabilities

Current Assets = 455,000+408,350 = 863,350

Current Liabilities = 186,700+240,250= 426,950

863,350/426,950= 2

Current Ratio at the end of Jan

Current assets
Inventory = 455,000+52,250= 507,250

Trade Receivables

At 1 Jan 408,350
40% of November paid (108,350)
60% of December paid (180,000)
Jan sales 350,000
Total 470,000
Trade Payables

At 1 Jan 186,700
Payment of 70% of trade payables (130,690)
Jan 20x7 Credit purchases 250,000
Total 306,010

Over draft calculated in part (ii) is $299,090

(507,250+470,000)/(306,010+299,090)= 1.61

Part (b)

1. Before any new measures are implemented Pangli needs to look at its debtors list and identify
exactly who owes them money and start chasing that list down starting with the oldest debt first. This
process could identify bad debt and unpaying customers who have been taking advantage of the
companies’ lax credit terms.

2. Offer discounts for early payment of invoices – Although the company would be reducing the sales it
would be saving on overdraft interest.

3. Review the credit terms offered to customers- 40% of customers are taking up to 60 days to pay, this
is well over the current credit terms. It is advisable that the company reviews which customers get
customer credit.

4. Invoice discounting – By selling the trade receivables – particularly late payers to an invoice
discounting company Pangli can receive its cash before the customers pay, however this does cost a
fee.

5. Actively implement credit control activities. Currently 40% of customers who pay late are likely not
being chased. If Pangli implemented credit control steps as soon as the sale is made it would reduce
slow payers. Sending out statements and final notices would be part of this process.
 VYXYN CO
Part (a)

Risk in investment terms can be quantified and a probability given. For example, there is a 45%
probability that the variable cost per unit will be $10.8 that verses a 20% chance at $14.70 shows us it’s
more likely that the unit price will be $10.80. The risk increases when there are more possible outcomes.
Uncertainty cannot be quantified so it is not possible to decide the likelihood of different returns.
Uncertainty increases with the length of a project.

Part (b)

See calculation in excel:

The project will result in a positive NPV of $2.8million using a cost of capital of 10% this shows that the
project will generate wealth for the company. If the actual cost f capital is 7% the project will be even
more profitable.

The variable cost has a risk of ranging between 10.8 and 14.7 and the likelihood is that it will be closer to
10.8 than 14.7. However, for the calculation I used the mean based on the probability getting a blended
figure. It is advisable to run this calculation again using the higher variable cost to see what impact this
has on the NPV. If it is a negative one than the project is dependent on the variable costs remaining low
and the likelihood of this must be investigated.

Part (c)

Risk must always be appraised in the investment process as it is always present. It can be appraised
using a sensitivity analysis.

A sensitivity analysis – investigate how changes in each project variable can affect the NPV. For
example, if the sales price drops by $1 what impact will it have on the NPV? This analysis identifies the
most sensitive parts of the project, which variable needs the smallest amount of change to become a
negative NPV and then these factors need to be controlled. This analysis doesn’t look at the probability
of something occurring only the sensitivity of the project.

The risk of the project must be decided – a less risky project will require a lower return than a high-risk
project where all the capital could be lost. This risk must then be incorporated into the cost of capital or
discount factor. For example, if Vyxyn are considering a project totally outside their normal business
there is additional risk and therefore may increase the risk factor in the WACC and therefore assess
projects using a 15% WACC instead of a 10%.
 NESUD CO
Part (a)

Payment within 0 days = 0.5% discount

Purchases = $1.5 million at 0.5% = $7,500 discount
Extra Costs $500 per year.
Trade Payables before discount = 1500000 x 60/360 = 250,000
Trade Payables after discount = 1500000 x 30/360 = 125000
Difference 125,000 financed at 4%= 5000

$7,500 – 500 – 5000 = $2,000

Overall saving will be $2,000
Nasud should accept the early payment discount as the savings will be $2,000 per year.

Part (b)

Cost of placing order = $248.44

12 orders per year therefore cost is= $2,981 per annum
Holding cost = $1.06 per unit per year
Cost $5 per unit = 480k units per year, 40k per month
Average holding cost = (40,000/2) x 1.06 = $21,200 per year
$2.4 million sales per year = $200k per month

Current cost = Holding $21,200 + Order $2,981 = $24,181

The EOQ = (2 x 248.44 x 480,000/1.06)^0.5 = 15,000 units

Usage is 480k units per year so 32 orders per year

32 orders at 248.44 = $7,950.08
Storage = 15,000/2 = 7,500 x 1.06 = $7,950

Total = $15,900

Cost reduction if EOQ is adopted = $24,181 – $15,900 = $8,281

Adopting the EOQ would save Nesud $8,281 per year and therefore it should be adopted.

Part (c)

1% of credit sales resulting in bad debt is costing $450,000. A 1% bad debt rate is not very high however
it is costing the company a lot.

Nesud needs to implement a strict credit control policy and tackle is late paying customers by refusing
credit to all late payers. Refusal of credit would reduce the bad debt cost as they will be unable to run up
credit after the 40 days has past. By implementing credit control where invoices and statements are sent
in a timely manner then customers are more likely to pay on time.

The current credit terms customers are receiving should be reviewed and the credit worthiness of each
client considered. Customers that have not paid in the past should not be offered credit and new
customers should not be offered credit until they have proved their ability to pay. Nasuds credit terms
should also be brought into line with the industry norm if they are shorter than their current terms.

Discounts could be offered to early payers – the discounts offered should be less than the current cost to
maintain the overdraft therefore Nesud will be reducing financing cost.
An invoice discounting service can be used to eliminate bad debt as invoices can be sold at a discount to
invoice discounting companies.
 HEBAC CO
Part (a)

The project results in a positive NPV therefore the project should be accepted.

Part (b)

The Capital Asset Pricing Model will assist Hebac Co by looking at the systematic risk and the reward on
a project by project basis. This project is outside Hebacs current operations and is therefore riskier and
the current WACC should not be used as it only reflects the current risk and cost of current operations.
Hebac should use the CAPM method to calculate a discount rate of this individual project which will
incorporate the increased risk and therefore the increased returns expected. As this project is riskier
investors will expect a higher reward resulting in a higher cost of capital.
 CARGO CO
Current Ratio of Crago Co
In 20x5
4500/4300 = 1.04

In 20x4 = 3,100/2,100 =1.48

The current ratio has reduced since 20x4 however the company can still meet its short term liabilities.

Quick Ratio
20X5 = 2,000/4300 = 0.465
20x4= 1,000/2,100 = 0.476

This shows a slight reduction on the previous year.

The company can still meet its short-term liabilities however its liquidity ratios have declined and below
the industry average and the company is demonstrating signs of over trading.

Sales have increased by 43% as these are credit it will take time to receive the cash this is putting
pressure on the working capital of the company.

The increase on reliance on short term debt shows the impact of the growth of the company with the
overdraft almost doubling.

However, care must be taken as if the company increases its short-term liabilities it will be over trading.
The company highly geared compared to the industry average and it is advisable to reduce the reliance
on short term credit to increase the liquidity of the company.

Over trading can be overcome by reducing reliance on short term debt and replacing it with long term
debt, for example the over-draft could be partially replaced with a long-term loan of $2million. This would
improve the short-term liquidity of the company.
 PALM CO
Part (a)

An interest payment of 30 million pesos is needed in six months’ time. The current dollar cost of this is
30/58.335 = $514,271. In six months’ time the dollar cost will be 30/56.585 =$530,176. This is an
increase of $15,905.

The increase in the interest cost is a risk and needs to be managed, this can be hedged in the following
ways:

A forward market hedge agreement with a financial institution agreeing and fixing the exchange rate of
the pesos in six months’ time to the expected 56.58 rate. This eliminates uncertainty that the rate will go
up however if the rate decreases Plam co will lose out on the benefits.

As the company has no cash reserves Pesos cannot be bought now however a money market hedge
using a loan in dollars could be used.

The best option is to use the forward market hedge.

Part (b)

Interest Rate risk faced by Plam Co:

Variable vs fixed interest rates – As interest rates are expected to fall the cost of capital will reduce. The
company has circa $32 million debt and $20 million is fixed rate meaning that the lowering of interest
rates will not affect most of its debt meaning Plam could become uncompetitive given that it could be
paying high fixed rate interest.
 PLOT CO
Part (a)

Part (a) is concerned with inventory management of Product P, specifically the cost of the ordering
policy. The costs may include:

● The order cost;

● The holding cost;
The purchase cost. The purchase cost will only change if the question has quantity discounts. Otherwise,
purchase costs can be ignored.

As you read through the question, you should highlight key numbers or aspects and annotate any
thoughts that are relevant in the context of the requirements just analysed.

Product P is the subject of part a. The total order cost is calculated as follows:

Total order cost = Co x No. of orders

Finally, the holding cost where there is a buffer inventory is calculated as follows:

Holding cost = (Q/2) + B

i) Cost of current ordering policy

Here we need to calculate the buffer inventory, the number of orders placed, and the quantity ordered
on each order:

Monthly order = monthly demand = 300,000/12 = 25,000 units

Buffer inventory = 25,000 x 0.4 = 10,000 units

Holding cost = Ch x [(Q/2) + B] = 0.1 x [(25,000 / 2) + 10,000] = $2,250 per year

Ordering cost = Co x orders placed = 12 x 267 = $3,204 per year

Total cost = Holding cost + Ordering cost = $2,250 + $3,204 = $5,454

ii) Cost of ordering policy using economic order quantity (EOQ)

EOQ = √[(2 x Ordering cost x Annual demand) / Cost of holding an item per year]

EOQ = ((2 x 267 x 300,000)/0.10)0.5 = 40,025 or 40,000 units per order

Number of orders per year = 300,000/40,000 = 7·5 orders per year

Holding cost = 30,000 x 0·1 = $3,000 per year

Ordering cost = 7·5 x 267 = $2,003

Total cost = Holding cost + Ordering cost = $3,000 + $2,003 = $5,003

iii) Saving from introducing EOQ ordering policy = 5,454 – 5,003 = $451 per year
Part (b)

Part (b) is concerned with an early settlement discount on Product Q. The question is likely to require a
comparison of the purchase costs saved and the effect of paying out funds more quickly.

Product Q is the subject of part b. As predicted, we will need to compare the benefit of the lower price,
i.e., a 1% reduction, to the cost of paying 30 days sooner.

Effectively there are three elements to the calculation in part b:

● The reduction in the purchase price;

● The financing cost of paying the account more quickly;
● The net cost or benefit, i.e., the difference between the first 2 aspects.

Value of discount = 456,000 x 0·01 = $4,560

Financing cost = Reduction in accounts payable x finance cost of 5%

Reduction in payables = Current payables - New payables

Reduction in payables = ($456,000 x 60 days / 365) - (99% x $456,000 x 30 days / 365) = $37,854
Increase in financing cost = 37,854 x 0·05 = $1,893

Net value of offer of discount = 4,560 – 1,893 = $2,667

Part (c)

Part (c) asks you to discuss, i.e., think from different perspectives, how invoice discounting & factoring
can aid management of trade receivables, the process of getting in the money owed to you by your
customers as quickly and efficiently as possible.

Parts (c) will be answered from our syllabus knowledge.

Invoice discounting involves selling sales invoices to a third party and has the advantages of receiving
money more quickly, freeing up debt collection resource and also it can be used on an ad hoc basis to
assist with short term liquidity problems.

Factoring is a more formal arrangement whereby a company outsources its credit control function. This
provides access to expertise in this area this may reduce administrative cost and effort. It should also
ensure that credit is granted more wisely making the debt collection process easier and reduce the cost
of bad debts.

Part (d)

Part (d) asks you to identify the objectives, that’s state what they are, of working capital management
and discuss the central role of working capital management in financial management which includes
investment, dividend, and financing decisions.

Parts (d) will be answered from our syllabus knowledge.

The objectives are working capital management are to balance the conflicting needs of profitability
(helped by holding high levels) and liquidity (supported by holding low levels of working capital to avoid
tying up too much cash).

Working capital impacts, to a greater or lesser degree, on all 3 of the Financial Management
Decisions and so is central to Financial Management generally. Looking at each of these in turn:
● Investments - the amount invested in working capital can have a direct impact of the attractiveness
of a company to its customers, eg with high inventory levels we can offer fast delivery or wide
choice.
● Financing - the working capital investment will need to be financed, however, management of
suppliers can itself provide a source of short term finance in terms of the credit period obtained;
finally
● Dividends - companies can only pay dividends if they have the cash to do so and if they have
sufficient levels of retained profits. As discussed above, both aspects are directly affected by
working capital management
 DARN CO
a) NPV proforma:

Calculating the net present value of the investment project using a nominal terms approach requires the
discounting of nominal (including inflation) cash flows using a nominal discount rate, which is given as
12%.

Number of columns Number of rows

- Column “0” for initial investment - Revenues, costs and tax implications
- One column for each year of project’s life - Capital expenditure, residual value and tax allowance
- Extra column for tax paid in arrears - Working capital section
- Discounting section

Note: For the project to be financially acceptable, the NPV must give a positive value.

Darn has already undertaken market research and so this is a sunk cost and will not feature in your
NPV. You may want to state this as a note in your answer.

- The numbers in the question exclude inflation at 4.7%. The numbers will be used as they are in part
b, but must be inflated in part a;
- Initial spend is $2 million and the resale value is zero. These will be shown in the Capital
Expenditure section;
- Working Capital is 10% of sales and the incremental movement will be shown in the third section;
- Capital Allowances are available at 25% reducing balance and will be included in the Capex section.
The same numbers will go in parts a & b;
- Profits (in the first section) are taxed at 30% and paid one year in arrears (so we will need a column
5);
- Finally, the nominal cost of capital (ie including inflation) is 12%. This is the discount factor for part a
but will need to be adjusted to a real cost of capital for part b. The adjustment is made using the
Fisher formula:

(1 + i) = (1 + r) (1 + h)

Key elements:

- The tax charge is offset by a column;

- All of the workings are referenced;
- Inflation is 4.7% per annum so there is a cumulative effect;
- The working capital cash flow is only the incremental movement from one year to the next;
- The sunk cost is not relevant and has not been included;
- It is emphasised that the NPV is positive.

Finally, the requirement asks you to comment on the financial acceptability of the project so make sure
you interpret the NPV calculated. As long as your answer is consistent with your numbers, you will earn
a mark for this comment.
Solution:

Year 1 2 3 4 5
$000 $000 $000 $000 $000
Sales revenue 1,308.75 2,817.26 7,907.87 5,443.58
Costs (523.50) (1,096.21) (2,869.33) (2,102.93)
Net revenue 785.25 1,721.05 5,038.54 3,340.65
Tax payable (235.58) (516.32) (1,511.56) (1,002.20)
CA tax benefits 150.00 112.50 84.38 253.13
After-tax cash flow 785.25 1,635.47 4,634.72 1,913.47 (749.07)
Working capital (150.86) (509.06) 246.43 544.36
Project cash flow 634.39 1,126.41 4,881.15 2,457.83 (749.07)
Discount at 12% 0.893 0.797 0.712 0.636 0.567
Present values 566.51 897.75 3,475.38 1,563.18 (424.72)

$000
PV of future cash flows 6,078.10
Initial investment (2,000.00)
Working capital (130.88)
NPV 3,947.22

The net present value is $3,947,220 and so the investment project is financially acceptable.

Workings

Year 1 2 3 4
Sales revenue ($000) 1,250 2,570 6,890 4,530
Inflated sales revenue ($000) 1,308.75 2,817.26 7,907.87 5,443.58
Year 1 2 3 4
Costs ($000) 500 1,000 2,500 1,750
Inflated costs ($000) 523.50 1,096.21 2,869.33 2,102.93
Year 1 2 3 4
Inflated sales revenue ($000) 1,308.75 2,817.26 7,907.87 5,443.58
Working capital ($000) 130.88 281.73 790.79 544.36
Incremental ($000) (130.88) (150.86) (509.06) 246.43
Year 1 2 3 4
Capital allowance ($000) 500.00 375.00 281.25 843.75
Tax benefit ($000) 150.00 112.50 84.38 253.13
 b) The pro-forma is identical to that used in part a. The sales and costs are now shown excluding
inflation and this has a knock on effect on the profit and therefore the tax. It also impacts the working
capital requirements as these are linked to the sales value. The Initial capital expenditure and
capital allowances are exactly the same as part a.

The important element in part b is that we must be consistent between the cash flows and the
discount factor in terms of inflation. In other words, if (as in part a) the cash flows are inflated then
so must the discount factor be. If however, as in part b, the cash flows exclude inflation, a real or
current discount factor must be used rather than the 12% nominal rate used in part a. As mentioned
previously, the fisher formula (given in the exam) is used to derive the appropriate rate:

(1 + i) = (1 + r) (1 + h)

The inflated rate is 12%, the inflation rate is 4.7% so the real rate is calculated as follows:

(1 + r) = (1 + i) / (1 + h) = 1.12 / 1.047 = 1.07 = 7%

Year 1 2 3 4 5
$000 $000 $000 $000 $000
Sales revenue 1,250 2,570 6,890 4,530
Costs (500) (1,000) (2,500) (1,750)
Net revenue 750.00 1,570.00 4,390.00 2,780.00

Tax payable (225.00) (471.00) (1,317.00) (834.00)

CA tax benefits 150.00 112.50 84.38 253.13
After-tax cash flow 750.00 1,495.00 4,031.50 1,547.38 (580.87)
Working capital (132.00) (432.00) 236.00 453.00
Project cash flow 618.00 1,063.00 4,267.5 2,000.38 (580.87)
Discount at 7% 0.935 0.873 0.816 0.763 0.713
Present values 577.83 928.00 3,482.28 1,526.29 (414.16)

$000
PV of future cash flows 6,100.24
Initial investment (2,000.00)
Working capital (125.00)
NPV 3,975.24

The net present value is $3,975,240 and so the investment project is financially acceptable. The
difference between the nominal terms NPV ($3,947,220) and the real terms NPV is due primarily to two
factors. First, the tax benefits from capital allowances are not affected by inflation and so will have
different present values due to the change in discount rate. Second, the working capital cash flows are
timed differently to the sales income on which they depend, and so their inflation effects are timed
differently to the related inflation effects in the discount rate.
Year 1 2 3 4
Sales revenue ($000) 1,250 2,570 6,890 4,530
Working capital ($000) 125 257 689 453
Incremental ($000) (125) (132) (432) 236

c)

Your answer is likely to fall into 2 broad areas:

1) Using regulation to “force” directors to focus on maximising shareholder wealth, e.g. by

incorporating strong Corporate Governance, and ensuring that legislation (eg stock market rules) is
adhered to; or
2) Ensuring that reward systems “incentivise” them to do so by ensuring that they benefit by ensuring
that shareholders benefit. Solutions may refer to performance related pay or share options.

Solution:

The directors of Darn Co can be encouraged to achieve the objective of maximising shareholder wealth
through managerial reward schemes and through regulatory requirements.

Managerial reward schemes

As agents of the company’s shareholders, the directors of Darn Co may not always act in ways which
increase the wealth of shareholders, a phenomenon called the agency problem. They can be
encouraged to increase or maximise shareholder wealth by managerial reward schemes such as
performance-related pay and share option schemes. Through these methods, the goals of shareholders
and directors may increase in congruence.

Performance-related pay links part of the remuneration of directors to some aspect of corporate
performance, such as levels of profit or earnings per share. One problem here is that it is difficult to
choose an aspect of corporate performance which is not influenced by the actions of the directors,
leading to the possibility of managers influencing corporate affairs for their own benefit rather than the
benefit of shareholders, for example, focusing on short-term performance while neglecting the longer
term.

Share option schemes bring the goals of shareholders and directors closer together to the extent that
directors become shareholders themselves. Share options allow directors to purchase shares at a
specified price on a specified future date, encouraging them to make decisions which exert an upward
pressure on share prices. Unfortunately, a general increase in share prices can lead to directors being
rewarded for poor performance, while a general decrease in share prices can lead to managers not
being rewarded for good performance. However, share option schemes can lead to a culture of
performance improvement and so can bring continuing benefit to stakeholders.

Regulatory requirements

Regulatory requirements can be imposed through corporate governance codes of best practice and
stock market listing regulations.

Corporate governance codes of best practice, such as the UK Corporate Governance Code, seek to
reduce corporate risk and increase corporate accountability. Responsibility is placed on directors to
identify, assess and manage risk within an organisation. An independent perspective is brought to
directors’ decisions by appointing non-executive directors to create a balanced board of directors, and by
appointing non-executive directors to remuneration committees and audit committees.
Stock exchange listing regulations can place obligations on directors to manage companies in ways
which support the achievement of objectives such as the maximisation of shareholder wealth. For
example, listing regulations may require companies to publish regular financial reports, to provide
detailed information on directorial rewards and to publish detailed reports on corporate governance and
corporate social responsibility.
 CARD CO
a) D1 can be calculated as follows:

D1 = D0 (1 + g)

Dividends have grown from 55.1 cents 3 years ago to 62.0 cents today and the annual growth can
be calculated as follows:

(62.0/55.1)0.333 – 1 = 1.040 – 1 = 0.04 or 4% per year

We now have all of the numbers required and these can be inserted into the formula:

Ke = 0.04 + [(62 x 1.04) / 716] = 0.04 + 0.09 = 0.13 or 13%

b) The dividend approach assesses the share price as the present value of estimated dividend receipts
and a difficulty is identifying what the dividend growth rate will be.

For the CAPM model, we may describe it as being based around the Systematic risk of the share
but that estimating numbers such as market rate & risk free rate may be problematic.

Whilst there are drawbacks to both, the CAPM is a more widely used technique.

Note: We can write out our answer by turning each bullet into a sentence and joining the sentences
together. Other relevant points could also have been made here.

c) Card is financed by equity shares and redeemable bonds and for each of these we need a cost and
a market value:

Description Equity Debt

Cost 12%
Market value 57,280 5,171
Total 62,451

Market values $000

Equity: 8m x 7.16 = 57,280
Bonds: 5m x 103.42/100 = 5,171

The major calculation here is to use an IRR approach to estimate the cost of debt. You should set
up your IRR from the perspective of an investor buying 1 bond today, i.e., having an outflow at time
0 of $103.42:

Time Cash Details DF @ 5% PV DF @ 7% PV

0 103.42 Market value 1 (103.42) 1 (103.42)
1-5 5.95* Interest 4.329 25.76 4.10 24.40
5 100 Redemption 0.784 78.40 0.713 71.30
0.74 (7.72)

*The annual after-tax interest payment is 8.5 x (1 – 0.3) = $5.95 per bond
 Finally, the 2 NPVs and discount factors are put into the IRR formula to estimate the percentage at
which the NPV would be zero:

Kd = 5 + (0.74 / (0.74 + 7.72) x 2) = 5.17%

WACC = Cost of equity x proportion of equity + Cost of debt x proportion of debt

WACC = [(12% x 57,280) + (5.17% x 5,171)]/62,451 = 11.4%

d) The asset beta formula:

Note: In the absence of any details, βd is assumed to be zero.

First, the proxy company equity beta must be ungeared:

Asset beta = (1.038 x 0.75) / (0.75 + (0.25 x 0.7)) = 0.842

The asset beta must then be regeared to reflect the financial risk of Card Co:

Equity beta = 0.842 x (57,280 + (5,171 x 0.7)) / 57,280 = 0.895

Project-specific cost of equity = 4 + (0.895 x 5) = 8.5%

e) In theory, the amount paid for stocks and shares by investors will be an amount that allows them to
make the return they are looking for, i.e., the present value of future receipts. If they are willing to
accept a lower return, they can pay a higher price, thereby increasing the company value.

The value of a company can be expressed as the present value of its future cash flows, discounted
at its weighted average cost of capital (WACC). The value of a company can therefore theoretically
be maximised by minimising its WACC. If the WACC depends on the capital structure of a company,
i.e. on the balance between debt and equity, then the minimum WACC will arise when the capital
structure is optimal.

The idea of an optimal capital structure has been debated for many years. The traditional view of
capital structure suggests that the WACC decreases as debt is introduced at low levels of gearing,
before reaching a minimum and then increasing as the cost of equity responds to increasing
financial risk.

Miller and Modigliani originally argued that the WACC is independent of a company’s capital
structure, depending only on its business risk rather than on its financial risk. This suggestion that it
is not possible to minimise the WACC, and hence that it is not possible to maximise the value of a
company by selecting a particular capital structure, depends on the assumption of a perfect capital
market with no corporate taxation.

However, real world capital markets are not perfect and companies pay taxes on profit. Since
interest is a tax-allowable deduction in calculating taxable profit, debt is a tax-efficient source of
finance and replacing equity with debt will decrease the WACC of a company. In the real world,
therefore, increasing gearing will decrease the WACC of a company and hence increase its value.

At high levels of gearing, the WACC of a company will increase due, for example, to increasing
bankruptcy risk. Therefore, it can be argued that use of debt in a company’s capital structure
 GWW CO
TGA Co, a multinational company, has annual credit sales of $5·4 million and related cost of sales are
$2·16 million. Approximately half of all credit sales are exports to a European country, which are invoiced
in euros. Financial information relating to TGA Co is as follows:

a)

i) Market capitalisation of GWW Co

Market capitalisation = Market value of shares x Number of shares

Number of shares = Total value of shares / Nominal value of share = $20m / $0.5 = 40m

Market capitalisation = 40m x $4 = $160m

ii) Net asset value (liquidation basis)

Here we need to think what the value of the business would be should the company be winding down
and liquidating its assets and repaying its liabilities. In other words, there will be no value associated with
the going concern of the enterprise. If GWW would be closing down, the assets would be valued as
follows:

Assets
Non-current assets $86m
Inventory $4.2m
Receivables (80% of $4.5m) $3.6m
Liabilities
Bonds (at par) ($25m)
Current liabilities ($7.1m)
Net assets $61.7m

iii) Price/earnings ratio value

This method uses the earnings of the company or a comparable company to estimate its value:

Price/earnings ratio value = Latest earnings x PE ratio of similar company (or group of companies)

Sector average PE ratio = 17

Profit after tax (2012) = $10.1m

Price/earnings ratio value = $10.1m x 17 = $171.7m

iv) 1) Dividend growth model value (using historic dividend growth rate)

The Dividend growth model estimates the value of a share by assuming that dividends will continue
to grow based on historic growth rate.

P = D0 (1+g) / (ke - g)

Using the historic growth method, g would be best calculated with the geometric average as follows:
 g = [(6m / 5m) ⅓ -1] x 100 = 6.27%

P = 6m (1.0627) / (0.09 - 0.067) = $234m

2) Dividend growth model value (using Gordon’s growth model)

g=bxr

Dividend payout = $6m / $10.1m x 100 = 59.4%

Retention rate = 100% - 59.4% = 40.6%

Return on equity = $10.1m / $67.2m x 100 = 15%

Dividend growth = 0.15 x 0.406 = 6.09%

P = $6m (1.0609) / (0.09 - 0.0609) = $219m

b)

It is important to remember that GWW is a listed company and a potential acquisition target. This means
that potential buyers, as well as shareholders, may be in the process of negotiating the purchase price
acceptable to both parties.

Market capitalisation

Market capitalisation gives a view on what shareholders could get for their shares at a given point in
time. It is important to remember that the share price will fluctuate with any new information surrounding
the company or events that might affect it. Shareholders will expect a purchase price that will be at very
least the market value, otherwise why would they agree to sell their shares. Finally, market capitalisation
serves as a valuable benchmark when cross checking valuations calculated with other methods.

Net asset value

This is an asset based valuation method whereas the P/E and the Dividend valuation method are income
based. This means that the net asset basis assumes the value of the firm is in its assets whereas the
second two methods look at the value of future earnings. The Net assets method can be useful if the
company is winding down and the assets are being liquidated. In other words, there is no value
associated with the going concern of the business. It represents simply what shareholders could expect
in return for selling the assets and repaying the liabilities. The Net asset value tends to be lower than the
other methods but higher and more realistic than looking at the book values.

Dividend growth model

This method tends not to give a value of what is being sold but indicates to shareholders what they will
be foregoing. In other words, they will be forgoing the value of their future dividends that they will no
longer receive should they decide to sell their shares. This method is often used as a benchmark as well
to shareholders but this time representing the minimum value that they would be likely to accept.

Price/earnings ratio method

This method is the most widely used and usually considered the most appropriate in a potential takeover
situation. This is because it is generally accepted that a company’s future earnings is where the value in
a firm lies. A P/E ratio indicates how much investors would be willing to pay for a company’s earnings.
Using the sector average of $17 suggests that investors are on average willing to pay $17 for each dollar
of future earnings. The higher the P/E ratio, the higher the market considers the growth prospects to be.
 The sector average P/E may not be suitable here though as Gww may not represent an average
company in the sector in which case adjustments can be made to P/E to reflect this.

c)

i) Calculation of market value of bond

The market value of a bond is an estimation of what a potential investor would be willing to pay for that
bond today. An investor would pay not more than the present value of the cash flows that he or she
would receive from the bond. And that would be the interest on the redemption value.

The redemption value at 7 years time = $100 discounted at 6% = $100 x 0.665 = $66.5

Interest over 7 years = $8 per year discounted at 6% (annuity factor should be used) = $8 x 5.582 =
$44.66

Market value of bond = $44.66 + $66.50 = $111.16

ii) Debt/equity ratio (book value basis)

D/E = 100 x $25m / $67.2m = 37.2%

iii) Debt/equity ratio (market value basis)

Nominal value of bond = $100

Market value of bond = $111.16

Market value = 111.6% of the book value

Market value of debt = $25m x 111.6/100 = $27.8m

A second way of working out the market value of the bond is to calculate how many bonds are in issue
and to multiply it by the market price:

Nominal value of bond = $100

Total number of bonds in issue = $25m / $100 = 250,000 bonds

Total market value of bonds = 250,000 x $111.16 = $27.8m

We know that the share price is $4 and we know that there are 40m of shares in issue. So the market
value of all shares equals:

Market value of shares = $4 x 40m = $160m

Note: Although we included the reserves figure in the book value D/E calculation, we do not include
reserves in the equity value here because the share price that we have used in calculating the market
value of the equity ($4) already incorporates the presence of these reserves. The total market value of
the equity is, therefore, just a $160m.

D/E = 100 x 27.8/160.0 = 17.4%

iv) Debt/equity ratio and assessing financial risk

Financial risk can be defined as the potential variability in earnings that a company faces as the debt in
its capital structure increases. In other words, as debt increases, financial risk will also increase.
Usefulness of D/E in assessing financial risk:

- It gives the investor an idea of the proportion of debt within the firm;
- To be more meaningful, this ratio needs to be compared to other companies within the same
industry;
- Potential purchasers should also calculate the interest cover ratio to see how easily GWW can meet
its interest payments.
 TGA CO
a)

i) The current operating cycle is the sum of the current inventory days and trade receivables days,
less the current trade payables days.

Following the change in the working capital policy, the days are given and so the cycle can be
calculated as follows:

Operating cycle after policy changes = 50 + 62 - 45 = 67 days

Inventory 473.4
Current inventory days = x 365 = x 365 = 80 days
CoS 2,160

Receivables 1,331.5
Current receivables days = x 365 = x 365 = 90 days
Sales 5,400

Payables 177.5
Current payables days = x 365 = x 365 = 30 days
CoS 2,160

Current operating cycle = 80 + 90 - 30 = 140 days

Accordingly, the proposed policy change will significantly reduce the number of days that cash is
tied up in working capital from 140 to 67 days.

ii) The current ratio expresses the current assets as a multiple of the current liabilities and is a
measure of the company’s ability to meet its short term obligations.

At present, the current ratio is 1,804,900/1,504,100 = 1.20 times.

To get to the figure after the policy change you will need to use the days given in the question to
estimate the dollar values. You will use the reverse of the procedure adopted above.

Revised inventory = 2,160,000 x 50/365 =$295,890

Revised trade receivables = 5,400,000 x 62/365 = $917,260

Revised trade payables = $2,160,000 x 45/365 = $266,301

Now, you are told that net working capital will remain at $300,800 so total current liabilities must be
the total current assets $1,213,150 - $300,800 = $912,350

You have just calculated that payables are 266.3 so the overdraft must be the balancing figure:

Revised overdraft level = $912,350 - $266,301 = $646,049

Revised current ratio = 1,213,150/912,350 = 1.33 times

 This represents a slight increase on the current position indicating that TGA is in a better position to
meet short term obligations following the policy change.

iii) The finance cost saving arises from the decrease in the overdraft from $1,326,600 to $646,049, a
reduction of $680,551, with a saving of 5% per year or $34,028 per year.

b) There are broadly 3 aspects to a trade receivables policy:

1) Who will credit be granted to and how much? This is referred to as credit analysis. A company will
need to assess the credit-worthiness of existing and potential customers. This may be undertaken
internally either by considering trading history or by analysing available information, e.g., published
accounts. Alternatively, a company may seek references from third parties or use the services of a
credit agency. This should be an ongoing process as circumstances may change over time.

2) How will the system be managed to minimise the risks of incurring bad debts? This is called credit
control. Having granted credit, a company will need to ensure that agreed terms are adhered to and
that checks to identify variances are operating appropriately. This may include:

- The content and timing of accurate invoices;

- The timing of statements;
- The checking of customer credit limits before goods are shipped etc.

This will also include the reports that should be produced to allow management to monitor
performance.

3) The debt collection process itself. The company should ensure that there are appropriate “triggers”
within the system so that in the event of late payments, necessary actions are implemented without
delay. For example, on the day money is due, a telephone call is placed with the customer to check
on the whereabouts of the payment. Other actions may include letters, visits, legal action, etc.

c) There are 3 categories of risk:

1. Transaction risk - the risk that exchange rates will move between the time that a foreign currency
transaction is agreed and the point at which the transaction is completed and accounts are settled.
This could result in a transaction being less profitable than anticipated when expressed in the
company's domestic currency;
2. Translation risk - the risk that overseas assets and liabilities will appear to have changed in value
merely due to the rate at which they are translated for incorporation into the domestic accounts.
Whilst this is not a cash movement, it will still impact of the value of the company and, therefore, on
the wealth of shareholders;
3. Economic risk - the risk that the amounts received from an overseas project, expressed in the
domestic currency of the company, will change due to a change in the exchange rate over time.
This could result in a project that was believed to be profitable becoming unprofitable even though it
performed according to expectations in terms of the foreign currency.

d)
Income from forward market hedge = 500,000/1.687 = $296,384

Under the money market hedge, an amount of euros will be borrowed today so that they can be
converted to $ today at spot. The euro receipt in 3 months will then be used to pay off the loan.

Three-month euro borrowing rate = 9/4 = 2.25%

 Euros borrowed now = 500,000/1.0225 = €488,998

Dollar value of this borrowing = 488,998/1.675 = $291,939

Three-month dollar deposit rate = 4/4 = 1%

Dollar income on this deposited sum = 291,939 x 1.01 = $294,858

The forward contract produces a higher dollar receipt and so is preferred on financial grounds.

COMMENTS:
The requirement in Part a states, for the change in working capital policy, calculate the change in the
operating cycle, the effect on the current ratio and the finance cost saving. There are a number of key
aspects here:

1. You will need to identify from the scenario what the current working capital policy is and how it will
change;
2. You are asked to calculate the change in and this will require you to perform calculations both pre
and post the change. You will need to identify what numbers are given in the scenario; and
3. Have a clear plan of attack to ensure there is a logic to your approach;
4. There are 3 different calculations: operating cycle (also known as the cash operating cycle or
working capital cycle); current ratio and finance cost saving;
5. This is a lot of calculations, confirming the initial assumption that there are only 1 or 2 marks for the
comment.

The requirement of Part b is to discuss the key elements of a trade receivables management policy.
Think about the components of the policy as this will help you structure your answer and assist you in
identifying how you will “use” your 7 points across the whole question.

The requirement in Part c asks you to explain the different types of foreign currency risk faced by a
multinational company. Think about how many different types there are and then allocate the points
required across each type. If you know the official terms for each type then you should state them,
however, make sure you explain each type rather than just identifying them.

The requirement in Part d is to calculate the dollar income from a forward hedge and a money market
hedge and indicate which hedge would be financially preferred. You will need to identify the currency
receipt, exchange rates, and interest rates when you read through the scenario.

You should read through the scenario, highlighting relevant numbers and annotating relevant comments
onto the face of the question paper. The following information is all relevant to Part a:

● Credit sales (used to calculate receivable days) are $5.4m;

● Cost of sales (used to calculate inventory and payable days) are $2.16m;
● Current figures for current assets and liabilities are provided as 1,804.9 & 1,504.1 thousand dollars
respectively;
● The change to working capital policy will not change the sales or COS quoted above or the net
working capital of $300.8k. This figure will enable you to calculate the overdraft as a balancing figure
once inventory, receivables, and payables are known. The overdraft is needed to assess the finance
cost saving;
● Working capital days post policy change are provided;
● Finally, you are provided with dollar interest rates (borrowing and deposit) which may also be
 relevant in Part d.

The additional information provided later in the question is required for Part d:

● There is a € receipt in 3 months;

● Forward and spot rates are 1.687 and 1.675 respectively;
● € borrowing rates are 9% per annum.
 WOBNIG CO
In Part a you are given a substantial amount of financial information and the first requirement is to
establish whether Wobnig Co is overtrading.

The first thing that you could do is to give a brief explanation of what overtrading means and how it can
be identified.

So what is overtrading?

An overtrading (also called undercapitalisation) happens when a company’s sales become more than the
working capital in place can cope with. Put more formally, overtrading is transacting more than the firm’s
working capital can sustain.

If the working capital is strained, then cash flow will be under pressure and the company may not be able
to do things like paying its suppliers or its staff. This will eventually lead to the collapse of the business.
So even though sales are strong, the underlying working capital has to be available to run the day to day
operation of the business.

With regards to overtrading, the first thing you will need to analyse is:

1) The change in revenues alongside the receivables and profitability. These need to be looked at in
relation to one another and you should ask yourself:

- How much have revenues increased?

- Have the receivables days increased disproportionately?
- Has profitability improved in line with revenues? If not has the cost of sales increased and/or the
sales price decreased?

Revenue has increased by 40%, from $10,375,000 to $14,525,000, while long-term finance has
increased by only 4.7% ($16,268,000/$15,541,000).

Trade receivables have increased by 85% ($3,200,000/$1,734,000).

Trade receivables days have increased from 61 days to 80 days, an increase of 31%:

Accounts receivables days = (AR / sales) x 365

2011: (3,200 / 14,525) x 365 = 80 days

2010: (1,734 / 10,375) x 365 = 61 days

Receivables days increase: (80-61) / 61 = 31%

The net profit margin of Wobnig Co has decreased from 36% in 2010 to 28% in 2011:

Net profit margin = net profit / sales

2011: (4,067 / 14,524) = 28%

2010: (3,735 / 10,375) = 36%

This significant increase in receivables suggests that either Wobnig is offering more generous
payment terms than previously, or that it is struggling to get customers to pay. This is further
evidenced by the increase in receivables days from 61, which was in line with the industry average
of 60 days, to 80 days. Either way, the increase in accounts receivable is putting a strain on the
 cash flow - the net profit margin has decreased from 36% to 28%, despite the revenue increase.
This could be due to either a decrease in sales price or an increase in the cost of sales.

2) Other elements that make up the net current assets. We have already considered accounts
receivables, so that leaves inventory, accounts payable as well as any cash or overdraft:

- Has inventory increased?

- What is the cash situation? If there is an overdraft, has it increased?
- What has happened to accounts payable over the last year?
- How has the working capital and the sales to net working capital ratio changed?

Inventory:

Increase in inventory: (2,149 - 1,092) / 1,092 = 97%

Inventory days = (Inventory / COS) x 365

2011: (2,149 / 10,458) x 365 = 75 days

2010: (1,092 / 6,640) x 365 = 60 days

Inventory days increase: (75-60) / 60 = 25%

Accounts payable:

Increase in accounts payable: (2,865 - 1,637) / 1,637 = 75%

Accounts payable days = (Accounts payable /COS) x 365

2011: (2,865 / 10,458) x 365 = 100 days

2010: (1,637 / 6,640) x 365 = 90 days

Accounts payable days increase = (100-90) / 90 = 11%

Overdraft:

Increase in overdraft: (1,500 - 250) / 250 = 500%

Net working capital:

Net working capital = Current assets - current liabilities

2011: 5,349 - 4,365 = 984

2010: 2,826 - 1,887 = 939

Sales to net working capital = sales / working capital

2011: 14,525 / 984 = 15 times

2010: 10,375 / 939 = 11 times

Increase = (15-11)/11 = 36%

The above tells us that:

- There is a significant increase in inventory, this suggests that Wobnig may be planning to increase
sales in the near future.
- The 2010 inventory days were already above the industry average (60 v 55) but have further
increased by 25% in 2011. This means that Wobnig are holding onto inventory for longer, which will
put a strain on the short term cash flow
- Accounts payable have increased by 97% but accounts payable days have increased by only 11%.
This is longer than the industry average, suggesting that Wobnig may be relying on this source of
finance by delaying payment to creditors
- The company’s overdraft has increased by 500%; this is significant and demonstrates that Wobnig
are indeed relying on short term finance
- The sales to net working capital ratio has also increased by 36% - this also indicates an increased
reliance on short term finance.

3) Current ratio and the quick ratio.

Current ratio = current assets / current liabilities

2011: 5,349 / 4,365 = 1.2 times

2010: 2,826 / 1,887 = 1.5 times

Quick ratio = (Current assets - inventory) / current liabilities

2011: 3,200 / 4,365 = 0.7 times

2010: 1,734 / 1,887 = 0.9 times

Both the current ratio at 1.2 times and the quick ratio at 0.9 times were lower than the industry
averages of 1.7 times and 1.1 times in 2010 and have fallen even further in 2011 to 1.2 times and
0.7 times.

These are definite indications that liquidity is problematic for Wobnig and that it has a weaker
liquidity position that expected for the industry.

Our analysis, which demonstrates a longer cash operating cycle (increased accounts receivable
days, increased inventory days) and an increased reliance on short term funding suggests that
Wobnig is in a position of overtrading. In other words, it seems that the available working capital is
not enough to keep up with the rapidly increasing sales.

b) Working capital investment and working capital financing sound the same but do in fact differ in their
meaning.

The first part of your answer to this question could then be to explain the two policies:

1) Working capital investment policy refers to the level of investment in net current assets within a
company. For example, a company with a high level of accounts receivables and inventory and low
accounts payables has a higher investment in working capital than a company that has low levels of
receivables and inventory;
2) Working capital financing policy is concerned with the mix of short term and long term financing that
is used to fund the net current assets. For example, a company could use only an overdraft to
finance its current assets while another may use some long term finance as well.

This could then lead you to cover one of the main differences between the two policies:
● To analyse working capital investment policy, and determine whether the level of investment is high
or low, we would tend to compare with other similar companies within the same industry;
● Working capital financing policy looks only at the company concerned and the mix of long term /
short term financing within it.

To help determine the best type of funding to source, working capital financing policy would also be
concerned with how the current assets are split into permanent current assets and fluctuating
current assets:

● Permanent current assets are the minimum amount of current assets that a firm will have. For
example, there will always be a certain amount of accounts receivable and inventory;
● Fluctuating current assets represent the increase in current assets as a result of seasonality. For
example, if sales increase, accounts receivable will increase too.

Whether each of these types of current assets are funded with short term financing, such as an
overdraft, or long term financing, such as a long term bank loan, bonds, or equity, will depend on
whether the company adopts a conservative, moderate, or aggressive working capital financing
policy.

A conservative working capital financing policy means that:

- The permanent current assets will be funded with long term finance, which is more expensive than
short term financing;
- The fluctuating current assets will also in part be funded by long term finance with the rest funded by
short term financing.

The long term financing is less risky than short term financing, such as an overdraft, which is
repayable on demand. Long term finance is more expensive than short term finance as the lending
is over a longer period of time and therefore more risky for the lender.

An aggressive working capital financing policy, on the other hand, means that:

● The fluctuating current assets will all be funded by short term finance;
● The permanent current assets will be funded partly with short term finance, which is cheaper than
long term financing and partly by long term funding.

An aggressive working capital financing policy will be more profitable than a conservative one,
however, it is also more risky as the short term finance is repayable on demand.

In working capital financing policy, the terms conservative / moderate / aggressive are used to
establish how the permanent and fluctuating assets are matched to short term and long term
sources of finance. Working capital investment policy also uses the terms conservative / moderate /
aggressive but simply to establish the level of investment in net current assets relative to other
comparable companies.

We might say that one company has a more aggressive approach to working capital investment
than another if they have a relatively low level of net current assets compared to other companies
within the industry.

The matching principle is also an important consideration within working capital financing policy.
This principle suggests that long term assets should be financed from long term sources of finance
and that current assets should be financed with short term sources of finance. This ties in with what
we said before about permanent and fluctuating current assets:
- The longer term or permanent current assets will tend to be financed with long term sources of
finance;
- The short term fluctuating assets will tend to be financed with short term sources of finance.

The matching principle is not used by working capital investment policy but only to working capital
financing policy.

c) The Miller-Orr model is used for setting the target cash balance within a firm and shows how the
cash balance fluctuates over time:

The lower limit is the minimum level that the firm would ideally let its cash balance fall to. Any lower and
they risk not being able to support the day to day operations of the business. In this situation, we know
that the lower limit is $200,000.

The firm will also not want the cash balance to go above the upper limit, as any cash above the upper
limit could be invested elsewhere, longer term for a greater return.

The return point is the target cash balance. When the cash balance reaches either the lower limit or the
upper limit, securities will be sold or cash invested to bring the balance back to the return point.

Finally, the spread refers to the difference between the upper and lower limits.

The first item you are asked to calculate is the return point. The return point is found by applying the
following formula:

Return point = Lower limit + (⅓ spread)

We know that the lower limit is $200,000 and the spread is $75,000. Therefore:

Return point = 200,000 + (75,000/3) = 200,000 + 25,000 = $225,000

The second item you are asked to calculate is the upper limit. No formula is given for this, but you can
work out that it will be the minimum level plus the spread, both of which you know.

The upper limit = 200,000 + 75,000 = $275,000

If Wobnig’s cash balance falls to $200,000, then the treasury department will sell short term securities
worth $25,000. This will bring the cash balance to the return point of $225,000. If the cash balance
reaches the upper limit of $275,000, Wobnig will invest $50,000 cash in short term securities. This will
bring the cash balance back to the return point of $225,000.

Application of the Miller-Orr model theoretically ensures that the cash balance is kept between the upper
and lower limits. This helps maintain the optimum cash balance to support the working capital
requirements of the firm, which will fluctuate on a day to day basis.
 SPOT CO
a) There are two possible approaches to part a and either way is acceptable in this question. Both
approaches will be covered here.

Part a - 1st approach

In this approach, we need to identify the present value of the costs of each method by discounting the
cash flows at the cost of debt (remember we are ignoring tax). We will then choose the option with the
lowest net present value.

Leasing

The leasing option is quite straightforward. There are 5 annual payments of $155,000 starting at time
zero and ending at time 4, i.e., an annuity of $155,000. We look up the discount factor from the annuity
table as the intersect of 7% (the cost of debt) and 4 periods (the time of the final payment) and get 3.387.
Remember though, the table assumes the first payment is in 1 year’s time. In other words, the factor
ignores the amount paid immediately, at time 0 and so to take account of this we add 1 to the discount
factor to get 4.387 (the discount factor at time 0 is always 1).

Present value of cost of leasing = 155,000 x 4·387= $679,985

Borrowing

You could use a standard NPV layout or, given that there are only a few items, it is probably easier and
quicker to identify the PV of each item separately.

The cost of the machine is $750,000 and given that it is spent immediately, the discount factor is 1 and
so the present value is $750,000.

The scrap proceeds are 10% of the cost, $75,000 and will be received in 5 year’s time so we multiply by
a discount of 0.713 (the intersect of 7% and 5 periods from the present value table):

Scrap proceeds = $75,000 x 0.713 = $53,475

Finally, the maintenance costs are a $20,000 annuity from time 1 - time 5 and so the PV is calculated as
follows:

Maintenance PV = $20,000 x 4.100 (7%, 5 periods from annuity table) = $82,000

Present value of cost of borrowing = 750,000 + 82,000 – 53,475 = $778,525

Note: There is no need to include interest on the loan as this is already included in the discount factor.

Comparing the two options, it can be seen that leasing is cheaper by $98,540 and so, on financial
grounds would be the preferred option.

Part a - 2nd approach

An alternative approach to part a involves comparing the two options together in a single NPV. In other
words to look at the effect of leasing as opposed to purchasing.

Initially, you should consider the effect of not purchasing. In other words, if you lease you would not need
to purchase the machine outright.
Description 0 1 2 3 4 5
Save outlay 750,000
Save maintenance 20,000 20,000 20,000 20,000 20,000
Lose scrap value (75,000)
Lease premium (155,000) (155,000) (155,000) (155,000) (155,000)
Cash flow 595,000 (135,000) (135,000) (135,000) (135,000) (55,000)
DF @ 7% 1 0.935 0.873 0.816 0.763 0.713
Present value 595,000 (126,225) (117,855) (110,610) (103,005) (39,215)
NPV 98,540

You would usually interpret a positive NPV as demonstrating that the project was financially viable. Be
careful, that is not what we are determining here but rather whether leasing is financially viable, i.e.,
cheaper than purchasing outright. The fact that the NPV is positive shows that the leasing is indeed
cheaper.

You will notice that the answer that it is $98,540 cheaper is the same as the conclusion drawn in the first
approach. You should also note, however, that using this second approach, you do not know the actual
cost of either option, simply that leasing is $98,540 cheaper. Accordingly, whilst either approach is fine
here, if a question required you to state the cost of the individual options, you would need to use the first
approach.

Irrespective of the approach used, remember there are 2 or 3 marks for explaining your approach, i.e.,
comparing the present value of the cost of the 2 options.

b) Attractions of short term (operating) leases might include:

● Avoids the risk of assets becoming outdated and obsolete and is especially relevant to high tech
assets;
● Enables companies to obtain the use of specialist equipment for a short period without the
inconvenience of having to buy it, use it, and resell it;
● Maintenance is often included in the lease contract effectively giving the lessee access to
specialist maintenance;
● A disadvantage of operating leases is that they can be expensive.
Note: Remember that the question asks for attractions so no marks would be earned for making
the point here.

Attractions of long term (finance) leases might include:

● It enables common assets, e.g. company cars, to be obtained more cheaply by using the buying
power of the lessor;
● The lessee can get the benefits of capital allowances via the lessor in circumstances when they
would not be able to claim the allowances themselves due to low taxable profits.

Finally, it is the case that leases of either type are usually more available than loans.

c) Your points may include:

● Interest is an amount added onto a loan to reimburse the lender for giving up liquidity;
● Under Islamic Finance, interest or Riba is seen as immoral;
● The predetermined rate of interest, which takes no account of the performance of the project
 funded, is seen as unfair;
● Riba is also determined to be earning money from money rather than from business endeavour;
● Islamic Finance products are based on sharing of the risks and rewards of the business activity;
● For example, a mudaraba contract is a contract between a party that provides finance and a
party that manages the business. The contract will determine how profits are shared, however,
losses will be borne by the finance provider.

d) The final part is effectively asking for a technical explanation of the yield curve and so whilst the
general principles still apply, your answer will probably include the following:

Liquidity Preference Theory

People like to hold money and so will need to be compensated for giving this up for longer periods

Expectation Theory

Interest rates agreed on loans will reflect expectations of future rates. If the expectation is of rates
rising in the future, longer term loans will be more expensive

Market Segmentation Theory

The different rates reflect the different sections of the financial markets that are used depending on
the term of the loan and the levels of supply and demand in each

Note, it is not essential that you use the exact names of the theories as long as you can describe
them.

COMMENTS:
The first requirement of the Part a asks you to evaluate whether Spot should use leasing or borrowing as
a source of finance.

Potentially there could be non-financial aspects, e.g., leasing may impose restrictions on how we use or
adapt the asset, however, it is most likely to be a financial comparison, i.e., which method is cheaper.
This will usually require you to compare the present value of the two cash flows using the post tax cost of
debt as the discount factor. When you read through the scenario you will need to identify the relevant
costs associated with each approach.

The second part of the question asks you to explain the evaluation method which you use. Although you
would often expect to allocate marks equally between the sub-requirements, a question that asks you to
explain the approach to your calculations is unlikely to be worth more than 2 or 3 marks.

The remaining three parts of this question are wordy and, as with any wordy questions, there are a
number of potential answers that would earn marks. There are, however, some general principles that
must be applied.

1. Make sure your points are factually correct, you will obviously not gain marks if something is wrong;
2. Make sure your points answer the question set;
3. Limit yourself to the number of points required to earn the available marks. By all means, add an
extra 1 or 2 points but certainly not an extra 4 or 5 as this simply wastes time;
4. Make sure you answer all parts of the question and in particular look out for the word and in a
question.

As you read through the question you should highlight numbers or facts that are relevant on the face of
the exam paper.

Spot has already decided to buy a machine (the acquisition decision is made) for $750,000 with a life of
5 years and is considering two financing options:

Option 1 is the leasing option with lease payments in advance of $155,000 pa. Given that it is a 5-year
lease, these will be made annually from Time 0 to Time 4 (remember payments are in advance).

Option 2 is the purchasing option, funded by a loan at 7%. This gives us the cost of debt that the
discount factor for both options will be based upon. We are also told that the machine has a scrap value
equal to 10% of the purchase price (10% of $750,000 is $75,000) and that maintenance costs of $20,000
pa would be incurred if the machine is purchased outright.

Finally, we are told to ignore taxation. Accordingly, we don't need to consider:

● Tax relief on the lease premiums or the maintenance expense;

● Tax allowances on the capital expenditure; or
● Adjusting the cost of debt to post tax.
 CLOSE CO
a)

i) Net asset valuation

There was no mention of realisable values so we simply need to take the relevant numbers from the
Statement of Financial Position.

Value = $720m (Assets) - $70m (Current liabilities) - $160m (Non-current liabilities) = $490m

Alternatively:

Share Capital + Reserves = $490m

ii) Dividend growth model

Value = D1 / (Ke - g)

D1 = D0 x (1 + g)

Value = [D0 x (1 + g)] / (Ke - g)

Value of company = (40m x 1.04)/(0.1 - 0.04) = $693m

iii) Earnings yield method

This method calculates the present value of the earnings. If you assume the earnings will continue for
ever, i.e. is a perpetuity, then the present value is calculated as follows:

Value = Earnings x 1 / Yield

Value of company = 66·6m/0·11 = $605m

Alternatively, you were told in the question that earnings are expected to grow at 5% and you calculate
the PV of a growing perpetuity as follows:

Value = Earnings x (1 + growth) / (Yield - growth) = (66·6m x 1·05)/(0·11 - 0·05) = $1,166m

b)

- This approach is more appropriate as a way of valuing a minority shareholding;

- Dividends are only one aspect of the return received by shareholders, share price growth being the
other;
- Further, companies that don’t pay a dividend would be valued at zero by this method;
- Calculating the cost of equity is very difficult in practice, especially for unlisted company’s;
- Estimating and agreeing the dividend growth rate is also difficult;
- Even if the growth rate can be estimated, dividends are unlikely to grow at a constant rate;
- The model would calculate a negative value if the growth rate is higher than the cost of equity.

c) The following approach should be adopted:

1) Identify the sources of finance. From the Statement of Financial Position, you can see that Close
has 80m equity shares, a 6% bank loan, and 8% bonds.
2) For each source calculate the market value. The equity shares are valued at $8.50 so 80m are
worth $680m. The bank loan does not have a market value (it cannot be sold) so we simply use the
loan amount $40m. The market value of a bond will be calculated as the present value of the cash
receipts discounted at the cost of debt.

Holders of bonds will receive interest at 8% for the next 6 years, so:

Present value of future interest = ($100 x 8% x 4·767) = $38·14

Present value of future principal payment = (100 x 0·666) = $66·60

Ex interest bond value = 38·14 + 66·60 = $104·74 per bond

Market value of bonds = 120m x (104·74/100) = $125·7 million

Total value of company = 680m + 125·7m + 40m = $845·7m

3) For each source calculate the cost. The cost of equity of 10% and The cost of debt of 7% are
both given in the question. The cost of the bank loan is simply the interest rate of 6%. Remember
that Close will get tax relief on the interest of both the loan and the debt. It is entirely up to you
whether you show the figures here as net of tax or whether you make the adjustment.

4) Combine all of the information into the WACC formula given in the exam:

WACC = (Ke x MVe / MV) + (Kd x (1 - t) x MVd / MV) + (KL x (1 - t) x MVL / MV)

WACC = (10 x 680 / 845.7) + (7 x 0.7 x 125.7 / 845.7) + (6 x 0.7 x 40 / 845.7) = 9%

d)

1. The circumstances under which the WACC can be used as a discount factor in investment
appraisal:

- The discount factor should reflect the return required given the risks;
- Risks include both financial risk (linked to debt levels) and business risk (linked to the industry);
- The WACC reflects the risks of the current business and so can only be used to assess a proposed
investment if it won’t change the risks of the underlying business;
- For this to be the case, it is most likely to only be relevant on relatively small projects.

2. Briefly indicate alternative approaches that could be adopted instead:

- The WACC is not appropriate if the project risks are different to the those of the underlying
business;
- If the Company is moving into a new area, i.e. changing the business risk, a project specific cost of
capital that could be used, based around the business risk of a similar company already in the
project’s area.
- If the financial risk is changing, a marginal cost of capital, i.e. linked to the new finance could be
used.
 COMMENTS:
In Part a) we are asked to calculate a value for Close Co using 3 different techniques:

- Part i), requires the net asset value method, i.e. the assets minus liabilities. Alternatively, equity
share capital plus reserves would get us to the same point. We will need to identify whether we just
use values from the Statement of Financial Position or whether there are realisable values quoted
that we will need to adjust for;
- Part ii), requires the dividend growth model, the formula for which is provided in the exam. We will
need information on dividends, cost of equity and growth rates;
- Part iii), requires the earnings yield method, i.e. the present value of earnings discounted at the
required yield. We will need to identify earnings and the required yield when we read through the
scenario.

Part b) is a wordy requirement asking you to discuss the weaknesses of the dividend growth model. This
emphasises the importance of understanding where different approaches can be used and any
limitations or assumptions upon which they are built as well as the mechanics of the calculations.

Part c) asks you to calculate the weighted average cost of capital using market values for the weighting.
When calculating a WACC, you should adopt the following approach:

2) Identify the sources of finance - don’t just assume there are two of them;
3) For each source calculate the market value;
4) For each source calculate the cost;
5) Combine all of the information into the WACC formula given in the exam.

There are 2 components in Part d) and it is important that you cover both. Firstly, discuss the
circumstances under which the WACC can be used as a discount rate. Remember that the WACC
attempts to reflect the return required by investors given the risks they face. Secondly, what are the
alternatives if the WACC is not appropriate. Notice you are only asked to briefly indicate so avoid writing
too much on this aspect.

You should read through the question, highlighting relevant aspects and annotating the paper as
appropriate:

- The question starts with figures for earnings of $66.6m (required in part a - iii) and dividends of
$40.0m (part a - ii);
- You are then provided with a Statement of Financial Position. This will enable you to identify assets
and liabilities (part a - i) and sources of finance (part c).

Reading through the paragraph that follows, you can extract:

- Dividend growth rate is 4% (part a - ii);

- Earnings Yield is 11% (part a - iii);
- Cost of equity is 10% (part a - ii & part c);
- Cost of debt is 7% (part c);
- Tax rate is 30% (part c);
- Share price is $8.50 (part c).
 PV CO
Part (a)
Part (b)

The investment proposal has a positive net present value (NPV) of $366,722 and is therefore financially
acceptable. The results of the other investment appraisal methods do not alter this financial acceptability,
as the NPV decision rule will always offer the correct investment advice.

The internal rate of return (IRR) method also recommends accepting the investment proposal, since the
IRR of 18·2% is greater than the 10% return required by PV Co. If the advice offered by the IRR method
differed from that offered by the NPV method, the advice offered by the NPV method would be preferred.

The calculated return on capital employed of 25% is less than the target return of 30%, but as indicated
earlier, the investment proposal is financially acceptable as it has a positive NPV. The reason why PV
Co has a target return on capital employed of 30% should be investigated. This may be an out-of-date
hurdle rate which has not been updated for changed economic circumstances.

Part (c)

As a large listed company, PV Co’s primary financial objective is assumed to be the maximisation of
shareholder wealth. In order to pursue this objective, PV Co should undertake projects, such as this one,
which have a positive NPV and generate additional value for shareholders.

However, not all of PV Co’s stakeholders have the same objectives and the acceptance of this project
may create conflict between the different objectives. Due to Product W33 being produced using an
automated production process, it will not meet employees’ objectives of continuity or security in their
employment. It could also mean employees will be paid less than they currently earn. If this move is part
of a longer-term move away from manual processes, it could also conflict with government objectives of
having a low rate of unemployment.

The additional noise created by the production of Product W33 will affect the local community and may
conflict with objectives relating to healthy living. This may also conflict with objectives from environmental
pressure groups and government standards on noise levels as well.
 DD CO
SOLUTION

(a) (i) Dividend growth rate = 100 x ((52/50) – 1) = 100 x (1·04 – 1) = 4% per year
Share price using DGM = (50 x 1·04)/(0·124 – 0·04) = 52/0·84 = 619c or $6·19
(ii) Number of ordinary shares = 25 million
Market value of equity = 25m x 6·19 = $154·75 million
Market value of Bond A issue = 20m x 95·08/100 = $19·016m
Market value of Bond B issue = 10m x 102·01/100 = $10·201m
Market value of debt = $29·217m
Market value of capital employed = 154·75m + 29·217m =
$183·967m Capital gearing = 100 x 29·217/183·967 = 15·9%
(iii) WACC = ((12·4 x 154·75) + (9·83 x 19·016) + (7·82 x 10·201))/183·967 = 11·9%

(b) Miller and Modigliani showed that, in a perfect capital market, the value of a company depended
on its investment decisions alone, and not on its dividend or financing decisions. In such a
market, a change in dividend policy by DD Co would not affect its share price or its market
capitalisation. Miller and Modigliani showed that the value of a company was maximised if it
invested in all projects with a positive net present value (its optimal investment schedule). The
company could pay any level of dividend and if it had insufficient finance, make up the shortfall
by issuing new equity. Since investors had perfect information, they were indifferent between
dividends and capital gains. Shareholders who were unhappy with the level of dividend declared
by a company could gain a ‘home-made dividend’ by selling some of their shares. This was
possible since there are no transaction costs in a perfect capital market.
Against this view are several arguments for a link between dividend policy and share prices. For
example, it has been argued that investors prefer certain dividends now rather than uncertain
capital gains in the future (the ‘bird-in-the-hand’ argument).
It has also been argued that real-world capital markets are not perfect, but semi-strong form
efficient. Since perfect information is therefore not available, it is possible for information
asymmetry to exist between shareholders and the managers of a company. Dividend
announcements may give new information to shareholders and as a result, in a semi-strong form
efficient market, share prices may change. The size and direction of the share price change will
depend on the difference between the dividend announcement and the expectations of
shareholders. This is referred to as the ‘signalling properties of dividends’.
It has been found that shareholders are attracted to particular companies as a result of being
satisfied by their dividend policies. This is referred to as the ‘clientele effect’. A company with an
established dividend policy is therefore likely to have an established dividend clientele. The
existence of this dividend clientele implies that the share price may change if there is a change in
the dividend policy of the company, as shareholders sell their shares in order to reinvest in
another company with a more satisfactory dividend policy. In a perfect capital market, the
existence of dividend clienteles is irrelevant, since substituting one company for another will not
incur any transaction costs. Since real-world capital markets are not perfect, however, the
existence of dividend clienteles suggests that if DD Co changes its dividend policy, its share
price could be affected.