ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing
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Practice questions
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Risk management
43 Interest rate parity 470
44 Foreign exchange 471
45 Money market hedge 471
46 Dunborgen 472
47 FRA 472
48 Swap 473
49 Credit arbitrage 473
50 Currency futures 473
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1 Equity ratios
The following figures have been extracted from the annual accounts of Rainy:
Issued share capital: 1,000,000 ordinary shares of $1 each, fully paid.
Issued debt capital: $250,000 10% debentures.
Reserves
Capital (share premium reserve) $200,000
Accumulated profits $800,000
Profit and distributions
Profit for the year $600,000 (before interest and tax)
Ordinary dividend payments $0.20 per share
The current market price of Rainy’s equity shares is $3.20 each. Its debentures are
priced at$90 per cent. The company’s rate of corporation tax (income tax) is 30%.
Required
Calculate the ratios that are likely to be of interest to an investor or potential
investor in Rainy.
Comment on each.
2 Corporate governance
(a) What is the main purpose of statutory or voluntary codes of corporate
governance?
(b) What are the main problems or issues that a code of corporate governance
might be expected to cover?
3 Cash operating cycle
The working capital (or cash operating) cycle of a business is the length of time
between the payment for purchased materials and the receipt of payment from
selling the goods made with the materials.
The table below gives information extracted from the annual accounts of Entity M
for the past three years.
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Entity M - Extracts from annual account
Year1 Year2 Year3
$ $ $
Inventor
y
:
Rawmaterials 108,000 145,800 180,000
Workin
p
ro
g
ress 75,600 97,200 93,360
Finished
g
oods 86,400 129,600 142,875
Purchases 518,400 702,000 720,000
Costof
g
oodssold 756,000 972,000 1,098,360
Sales 864,000 1,080,000 1,188,000
Tradereceivables 172,800 259,200 297,000
Trade
p
a
y
ables 86,400 105,300 126,000
Required
(a) calculate the length of the working capital cycle (assuming 365 days in the
year); and
(b) list the actions that the management of Entity M might be take to reduce the
length of the cycle.
4 Working capital
DON is a small manufacturing company. Its summarised accounts for the last two
years are presented below:
Balance sheets as at 31
st
March
Year5 Year6
$000 $000 $000 $000
Fixedassets 820 1,000
Currentassets
Inventor
y
340 420
Tradereceivables 360 570
Cash 10 0
–––––––– 710 –––––––– 990
–––––––– ––––––––
Totalassets 1,530 1,990
–––––––– ––––––––
E
q
uit
y
andliabilities
E
q
uit
y
sharesof$0.25 400 400
Accumulated
p
rofits 450 530
–––––––– ––––––––
Totale
q
uit
y
850 930
Medium‐termbankloan 200 200
Currentliabilities
Bankoverdraft 140 250
Trade
p
a
y
ables 280 510
Other
p
a
y
ables 60 100
–––––––– 480 –––––––– 860
–––––––– ––––––––
Totale
q
uit
y
andliabilities 1,530 1,990
–––––––– ––––––––
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Income statements for the year ending 31
st
March:
Year5 Year6
$000 $000
Sales 1,800 2,900
Grossprofit 210 260
Profitbeforetax 120 160
Taxation 30 40
90 120
DON paid dividends of $40,000 each year to the equity shareholders.
Required
Evaluate whether DON is over-trading.
Over-trading is defined as expanding a business quickly with insufficient long-term
finance, and relying excessively on short-term sources of finance. A business entity
is therefore over-trading when it attempts to carry on a growing volume of business
with insufficient working capital
5 Inventory management
KL Games uses wooden boxes as the container for a product that it makes. It has a
requirement for 40 wooden boxes a day, for each of the 250 working days (50
weeks) in each year. The boxes are currently bought in batches of 200 from a local
supplier for $2 each. The cost of ordering the boxes from the local supplier is $65,
regardless of the size of the order.
The annual inventory holding cost is 25% of the inventory value.
Required
(a) Calculate the economic order quantity and the frequency of placing orders.
Calculate the annual saving in costs that would be obtained by using the EOQ
as the order size instead of buying in batches of 200 boxes per order.
(b) Recommend whether or not it is worthwhile to make use of the local
supplier's new quantity discount scheme below.
Orderquantity Discoun
t
boxes
0–999 0%
1,000–4,999 5%
5,000 10%
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6 Trade receivables management
Entity M is reviewing its credit policy. It is estimated that if the period of credit
allowed to customers is reduced to 60 days, there will be a 25% reduction in annual
sales, but bad debts would be reduced by $30,000 each year. It would also be
necessary to spend an extra $20,000 each year on credit control. Entity M has cash
flow difficulties and relies on overdraft finance, for which the interest rate is 9%.
Required
Calculate the effect of these changes on the annual profit. Base your answer on the
level of sales in Year 3, and assume that purchases and inventory would be reduced
in the same proportion as the reduction in sales.
EntityM‐Extractsfromannualaccounts Year3
Inventory $
Rawmaterials 180,000
Workinprogress 93,360
Finishedgoods 142,875
Purchases 720,000
Costofgoodssold 1,098,360
Sales 1,188,000
Tradereceivables 297,000
Tradepayables 126,000
7 Discount and factor
(a) A business entity offers its customers trade credit of 90 days. It is considering
whether to offer a settlement discount of 2% for payment within seven days.
Required
Calculate the cost of offering the discount, as an annual interest cost.
(b) Entity C has monthly sales of $100,000. A factor has offered to take over the
administration of Entity C’s trade receivables, on a non-recourse basis (or
without recourse basis). It would charge a fee of 4% of the value of invoices
processed. If the factor takes over this work, Entity C would save monthly
administration costs of $2,000 and would avoid its bad debts, which are 0.75%
of sales.
Entity C has been informed by the factor that the average collection period
(the time between issuing an invoice and receiving payment from the
customer) will be reduced from 2 months to 1 month.
The factor will also provide finance by lending 80% of the value of unpaid
invoices, charging interest at an annual rate of 8% on the cash that it lends. At
the moment, Entity C finances its trade receivables with bank overdraft
finance at 9% per year interest.
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Required
Calculate the net effect on annual profits of Entity C if the factor took over the
administration of the trade receivables and provided finance on the terms
described above.
8 Baumol and Miller-Orr
(a) Entity X uses a bank account for its daily expenditures. There are no payments
into the account. Instead, whenever the account needs more cash, Entity X
sells a quantity of marketable securities. These currently provide an interest
yield of 5% per year. The cost of selling securities is $60 per transaction,
regardless of the size of the transaction.
Annual payments from the account are $3,000,000.
Required
Use the Baumol cash management model to decide the optimal size of
transaction for selling marketable securities, and the frequency with which
securities will be sold. Assume a 365-day year.
(b) Entity Y uses a bank account for its daily income and expenditures. Each year,
it expects income and expenditure to be $3,000,000. However, daily cash flows
are variable, and the standard deviation of daily cash flows is $2,200. The
annual interest rate is 5%.
If the cash balance goes above a certain level, the entity will buy marketable
securities to earn interest on the surplus cash. If the cash balance reaches a
minimum level, the entity will sell some marketable securities to obtain more
cash. The cost of buying or selling securities is $60 per transaction.
Entity Y uses the Miller-Orr cash management model. It has decided that it
should have a minimum cash balance of $20,000.
Required
Calculate:
(a) the spread between the lower and upper cash limits
(b) the upper cash limit
(c) the return point.
9 Appraisal
A company is considering whether to invest in a new item of equipment costing
$45,000 to make a new product. The product would have a four-year life, and the
estimated cash profits over the four-year period are as follows.
Year $
1 17,000
2 25,000
3 16,000
4 4,000
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The project would also need an investment in working capital of $8,000, from the
beginning of Year 1.
The company uses a discount rate of 11% to evaluate its investments, but has an
additional rule that projects will not be undertaken unless they pay back within
three years.
Required
Calculate the NPV of the project at the discount rate of 11%.
Using the NPV you have calculated at 11%, and the NPV at a discount rate of 15%,
estimate the internal rate of return (IRR) of the project.
Calculate the payback period and state whether the project should be undertaken.
10 Investment appraisal methods
Congo is considering whether to invest in either of two mutually-exclusive
projects, Project 1 and Project 2. Both projects involve the purchase of machinery
with a life of five years.
Project 1: The machine would cost $556,000 and would have a net disposal value
of $56,000 at the end of Year 5. The project would earn annual cash flows
(receipts minus payments) of $200,000.
Project 2: The machine would cost $1,616,000 and would have a net disposal
value of $301,000 at the end of Year 5. The project would earn annual cash flows
(receipts minus payments) of $500,000.
Congo uses the straight-line method of depreciation. Its cost of capital is 15%.
Ignore taxation, inflation and investment in working capital.
Required
(a) For each of the two projects, calculate:
(i) the accounting rate of return ratio, over the project life (average annual
accounting profit as a percentage of the average book value of the
investment, to the nearest one per cent)
(ii) the payback period, to the nearest month
(iii) the net present value, and
(iv) the internal rate of return to the nearest one per cent.
(b) State which project, if any, you would select for acceptance.
Note
At a discount rate of 25%, the following discount factors apply:
Year 5: 0.328.
Years 1 – 5: 2.689.
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11 NPV
A company has a cost of capital of 10%. Calculate the NPV of an investment project
with the following estimated cash flows:
Years Cashfloweachyear
$
0 (70,000)
1 15,000
2–4 12,000
5–10 8,000
State whether the project should be undertaken.
12 DCF and relevant costs
Consolidated Oil wants to explore for oil near the coast of Ruritania. The Ruritanian
government is prepared to grant an exploration licence for a five-year period for a
fee of $300,000 per year. The option to buy the licence must be taken immediately;
otherwise another oil company will be granted the licence.
However if it does take the licence now, Consolidated Oil will not start its
explorations until the beginning of the second year.
To carry out the exploration work, the company will have to buy equipment now.
This would cost $10,400,000, with 50% payable immediately and the other 50%
payable one year later. The company hired a specialist firm to carry out a geological
survey of the area. The survey cost $250,000 and is now due for payment.
The company’s financial accountant has prepared the following projected income
statements. The forecast covers years 2-5 when the oilfield would be operational.
Projected income statements
Year
2 3 4 5
$000 $000 $000 $000 $000 $000 $000 $000
Sales7,4008,3009,8005,800
Minusexpenses:
Wagesandsalaries 550580620520
Materialsand
consumables
340360410370
Licencefee 600300300300
Overheads 220220220220
Depreciation 2,1002,1002,1002,100
Surveycostwrittenoff 250 ‐ ‐ ‐
Interestcharges 650650650650
–––––
4,710
–
––––
4,210
–
––––
4,300
–––––
4,160
–
––––
–
––––
–––––
–
––––
Profit2,6904,0905,5001,640
–
––––
–
––––
–––––
–
––––
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Notes
(i) The licence fee charge in Year 2 includes the payment that would be made at
the beginning of year 1 as well as the payment at the beginning of Year 2. The
licence fee is paid to the Ruritanian government at the beginning of each year.
(ii) The overheads include an annual charge of $120,000 which represents an
apportionment of head office costs. The remainder of the overheads are
directly attributable to the project.
(iii) The survey cost is for the survey that has been carried out by the firm of
specialists.
(iv) The new equipment costing $10,400,000 will be sold at the end of Year 5 for
$2,000,000.
(v) A specialised item of equipment will be needed for the project for a brief
period at the end of year 2. This equipment is currently used by the company
in another long-term project. The manager of the other project has estimated
that he will have to hire machinery at a cost of $150,000 for the period the
cutting tool is on loan.
(vi) The project will require an investment of $650,000 working capital from the
end of the first year to the end of the licence period.
The company has a cost of capital of 10%. Ignore taxation.
Required
Calculate the NPV of the project.
13 Annuities and perpetuities
A company has estimated that its cost of capital is 8.8%. It is deciding whether to
invest in a project that would cost $325,000.
Required
(a) Calculate the NPV if the net cash flows of the project after Year 0 are:
Years 1 – 6: $75,000 per year.
(b) Calculate the NPV if the net cash flows of the project after Year 0 are:
Year $
1 50,000
2–6 75,000
(c) Calculate the NPV if the net cash flows of the project after Year 0 are $50,000
every year in perpetuity.
14 Investment appraisal and tax
JKL is considering whether to invest in the purchase of a new machine costing
$250,000. The machine will have a four-year life and a net disposal value of $100,000
at the end of Year 4.
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In addition, $38,000 of working capital will be required from the start of the project,
increasing to $50,000 at the beginning of the second year. All the working capital
will be recovered at the end of Year 4.
The project is expected to generate extra annual revenues of $200,000 and incur
annual cash operating costs of $80,000 for each year of the project. JKL’s cost of
capital is 10% after tax.
Corporation tax is charged on profits at 35%. Tax is payable in the year following
the year in which the profits occur. There will be a 25% annual writing-down
allowance on capital expenditure, for tax purposes. The tax-allowable depreciation
is calculated by the reducing balance method.
Required
Calculate the NPV of the project and state whether or not it should be undertaken.
15 More investment appraisal and tax
CVB is considering whether to invest in new equipment costing $600,000. The
equipment is expected to have an economic life of five years and will have no
disposal value at the end of Year 5 (and no disposal costs).
CVB’s after-tax cost of capital is 15%. Tax is charged at an annual rate of 35% and is
payable in the year following the year in which the taxable profits arise.
The following forecasts relate to the project under consideration:
$000s
Year 1 2 3 4 5
Salesincome 250 250 300 350 400
Directmaterials 50 55 58 64 70
Directlabour 25 25 30 30 35
Totaldirectcosts 75 75 88 94 105
Depreciation 120 120 120 120 120
There will be tax allowances on the cost of the equipment, calculated at 25% each
year on the reducing balance basis. The first depreciation tax allowance (capital
allowance) would be claimed in year 0 (or very early in year 1).
Assume that:
(1) taxable profits are defined as income minus direct costs and capital allowances
(2) cash profits in each year = sales minus direct costs
Required
Calculate the Net Present Value of the project and recommend whether or not the
project should be undertaken.