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2 Fundamentals Level Skills Module, Paper F9 Financial Management December 2013 Answers 1 (a) Calculating the net present value of the investment project using a nominal terms approach requires the discounting of nominal (money terms) cash flows using a nominal discount rate, which is given as 12%. 5 \$000 \$000 \$000 \$000 \$000 Sales revenue 1, , , , Costs (523 50) (1,096 21) (2,869 33) (2,102 93) Net revenue , , , Tax payable (235 58) (516 32) (1,511 56) (1,002 20) CA tax benefits After-tax cash flow , , , (749 07) Working capital (150 86) (509 06) Project cash flow , , , (749 07) Discount at 12% Present values , , (424 72) \$000 PV of future cash flows 6, Initial investment (2,000 00) Working capital (130 88) NPV 3, The net present value is \$3,947,220 and so the investment project is financially acceptable. Workings Sales revenue (\$000) 1,250 2,570 6,890 4,530 Inflated sales revenue (\$000) 1, , , , Costs (\$000) 500 1,000 2,500 1,750 Inflated costs (\$000) , , , Inflated sales revenue (\$000) 1, , , , Working capital (\$000) Incremental (\$000) (130 88) (150 86) (509 06) Capital allowance (\$000) Tax benefit (\$000) (b) Calculating the net present value of the investment project using a real terms approach requires discounting real terms cash flows with a real discount rate. Real terms cash flows are found by deflating nominal cash flows by the general rate of inflation. Since only the general rate of inflation is available, the real terms operating cash flows are those given in the question. The nominal discount rate is 12% and the general rate of inflation is 4 7%. The real discount rate is therefore 7% (1 12/1 047). 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 , , , Tax payable (225 00) (471 00) (1,317 00) (834 00) CA tax benefits After-tax cash flow , , , (580 87) Working capital (132 00) (432 00) Project cash flow , , , (580 87) Discount at 7% Present values , , (414 16) 11

3 \$000 PV of future cash flows 6, Initial investment (2,000 00) Working capital (125 00) NPV 3, 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. Working Sales revenue (\$000) 1,250 2,570 6,890 4,530 Working capital (\$000) Incremental (\$000) (125) (132) (432) 236 Examiner s note An alternative approach is to deflate the nominal project cash flows from part (a) by 4.7% per year to give real terms project cash flows, before discounting by the real discount rate of 7%. 5 \$000 \$000 \$000 \$000 \$000 Project cash flow , , , (749.07) Deflate at 4.7% , , , (595.37) Discount at 7% Present values , , (424.50) \$000 PV of future cash flows 6, Initial investment (2,000.00) Working capital (130.88) NPV 3, (c) 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. 12

4 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. 2 (a) Cost of equity of Card Co using DGM The average dividend growth rate in recent years is 4%: (62 0/55 1) = = 0 04 or 4% per year Using the dividend growth model: K e = [(62 x 1 04)/716] = = 0 13 or 13% (b) (c) (d) (e) The dividend growth model calculates the apparent cost of equity in the capital market, provided that the current market price of the share, the current dividend and the future dividend growth rate are known. While the current market price and the current dividend are readily available, it is very difficult to find an accurate value for the future dividend growth rate. A common approach to finding the future dividend growth rate is to calculate the average historic dividend growth rate and then to assume that the future dividend growth rate will be similar. There is no reason why this assumption should be true. The capital asset pricing model tends to be preferred to the dividend growth model as a way of calculating the cost of equity as it has a sound theoretical basis, relating the cost of equity or required return of well-diversified shareholders to the systematic risk they face through owning the shares of a company. However, finding suitable values for the variables used by the capital asset pricing model (risk-free rate of return, equity beta and equity risk premium) can be difficult. Cost of debt of Card Co The annual after-tax interest payment is 8 5 x (1 0 3) = \$5 95 per bond Using linear interpolation: Year Cash flow \$ 5% DF PV (\$) 6% DF PV (\$) 0 Market price (103 42) (103 42) (103 42) 1 5 Interest Redemption (3 66) After-tax cost of debt = 5 + [((6 5) x 0 74)/( )] = = 5 17% Market values \$000 Equity: 8m x 7 16 = 57,280 Bonds: 5m x /100 = 5,171 Total value of Card Co 62,451 WACC calculation WACC of Card Co = [(12 x 57,280) + (5 17 x 5,171)]/62,451 = 11 4% First, the proxy company equity beta must be ungeared: Asset beta = (1 038 x 0 75)/( (0 25 x 0 7)) = The asset beta must then be regeared to reflect the financial risk of Card Co: Equity beta = x (57,280 + (5,171 x 0 7))/57,280 = Project-specific cost of equity = 4 + (0 895 x 5) = 8 5% 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. 13

7 and demand differs between markets for loans of different maturity. If demand for long-term loans is greater than the supply, for example, because of a high public sector borrowing requirement, interest rates in the long-term loan market will increase to restore equilibrium between demand and supply. Differing interest rates between markets for loans of different maturity can also explain why the yield curve may not be smooth, but kinked. Fiscal policy Governments may use fiscal policy to support the achievement of economic objectives. For example, the government or central bank may act to increase short-term interest rates in order to reduce inflation. This can result in short-term interest rates being higher than long-term interest rates, an effect which can be compounded if there is a decrease in the anticipated inflation reflected in long-term interest rates. 16

8 Fundamentals Level Skills Module, Paper F9 Financial Management December 2013 Marking Scheme Marks 1 (a) Inflated sales revenue 1 Inflated costs 1 Tax liability 1 Capital allowance, years 1 to 3 1 Balancing allowance, year 4 1 Capital allowance tax benefits 1 Timing of tax liabilities and benefits 1 Incremental working capital investment 1 Recovery of working capital 1 Market research omitted as sunk cost 1 Calculation of nominal terms NPV 1 Comment on financial acceptability 1 Marks 12 (b) Calculation of real cost of capital 2 Real terms net revenue 1 Real terms after-tax cash flow 1 Real terms working capital investment and recovery 1 Calculation of real terms NPV 1 Comment on financial acceptability 1 2 Maximum 7 (c) Managerial reward schemes 3 5 Regulatory requirements 3 4 Other relevant discussion 1 2 Maximum (a) Calculation of historic dividend growth rate 1 Calculation of cost of equity using DGM 2 3 (b) Dividend growth model discussion 2 3 Capital asset pricing model discussion 2 3 Maximum 5 (c) After-tax interest payment 1 Setting up linear interpolation calculation 1 Calculation of after-tax cost of debt 1 Calculation of market value of equity 0 5 Calculation of market value of debt 0 5 Calculation of WACC 1 (d) Ungearing proxy company equity beta 1 Regearing asset beta 1 Project-specific cost of equity using CAPM (e) Traditional view of capital structure 1 2 Miller and Modigliani views of capital structure 3 4 Market imperfections view of capital structure 2 3 Other relevant discussion 1 2 Maximum

9 Marks 3 (a) (i) Current ordering cost 1 Buffer inventory 0 5 Average inventory 0 5 Holding cost 0 5 Total cost 0 5 Marks (ii) Economic order quantity 1 EOQ order cost 1 Holding cost 0 5 Total cost (iii) Saving from EOQ ordering policy 1 3 (b) Current trade payables 1 Trade payables after discount 1 Increase in finance costs 1 Value of discount 1 Net value of discount offer 1 5 (c) Invoice discounting 2 3 Factoring 3 4 Maximum 6 (d) Objectives of working capital management 3 4 Role of working capital management 3 4 Maximum (a) Timing of lease payments 1 Present value of cost of leasing 1 Present value of maintenance costs 1 Present value of salvage value 1 Present value of cost of borrowing 2 Evaluation of financing choice 1 Explanation of evaluation of financing method 3 10 (b) Attractions of leasing as short-term finance source 2 3 Attractions of leasing as long-term finance source 2 3 Maximum 5 (c) Explanation of interest (riba) 1 2 Explanation of returns on Islamic financial instruments 3 4 Maximum 5 (d) Liquidity preference theory 1 2 Expectations theory 1 2 Market segmentation theory 1 2 Fiscal policy 1 2 Maximum

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