FINANCIAL MANAGEMENT

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1 FINANCIAL MANAGEMENT PROFESSIONAL 2 EXAMINATION - AUGUST 2008 NOTES Answer all three questions from Section A. Answer two questions only from Section B. (If you provide answers to more questions than required in Section B, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first two questions to hand will be marked.) FINANCIAL MANAGEMENT TABLES ARE PROVIDED TIME ALLOWED: 3 hours, plus 10 minutes to read the paper. INSTRUCTIONS: During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page. You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted. The Institute of Certified Public Accountants in Ireland, 17 Harcourt Street, Dublin 2.

2 THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND FINANCIAL MANAGEMENT PROFESSIONAL 2 EXAMINATION - AUGUST 2008 Time Allowed: 3 hours, plus 10 minutes to read the paper. Answer all three questions from Section A. Answer two questions only from Section B. SECTION A - ATTEMPT ALL THREE QUESTIONS 1. (a) Ardfield PLC, a client company who produces PVC products, is considering investing in as many as three machines to improve the efficiency of its factory. However, capital renewal funds have been limited by Ardfield PLC s bankers who will only provide 3,500,000 for the renewal. They charge Ardfield PLC 6% on such borrowings. If Ardfield PLC decides not to buy a full machine in its own right, it enjoys an option to share ownership with the machine manufacturers. Ardfield PLC s Management Accountant has researched the financial implications of each machine. Details are summarised as follows: Ardfield PLC - Financial Projections Capital Year 1 Year 2 Year 3 Location Cost ( ) Savings ( ) Savings ( ) Savings ( ) Moulding Equipment 2,000, ,000 1,200,000 0 Extrusion Equipment 4,000,000 2,000,000 1,600,000 1,000,000 Packing Equipment 3,000,000 2,000,000 2,000,000 0 Ignore taxation. REQUIRED: Prepare a briefing note for your client which advises on the following: a) Proposes an optimum capital renewal programme for Ardfield PLC. (10 Marks) b) If a rival banker approached your client and offered unlimited investment funds at a cost of borrowing of 7% should Ardfield PLC accept this proposal? (6 Marks) (b) Sunnycove Limited (Sunnycove), a printing company, is planning to acquire a machine to increase its capacity by 500,000 units per annum, each of which delivers 1 contribution. The machine has an immediate capital cost of 1,000,000 with no expected residual value at the end of its three year life. Capital allowances are given at 30% of cost on a reducing balance basis. Any balancing adjustment is made in the last year of usage of the asset. Sunnycove s cost of capital is 5%. A leasing company has offered Sunnycove the option of leasing the machine at an annual lease cost of 400,000 commencing in year 1. Corporation tax is paid one year in arrears at a rate of 12.5%. REQUIRED: Advise Sunnycove Limited s management on whether they should lease or buy the machine. (9 Marks) [TOTAL: 25 MARKS] Page 1

3 2. It is 5 March Cork PLC is a company which wholesales wines and spirits throughout Ireland. Cork PLC plans to raise finance to fund a strategy to enter the U.K. market. Extracts from Cork PLC s most recent published Balance Sheet are as follows: Cork PLC Balance Sheet Extract As at 29 February s Equity Attributable to Equity Holders 2,000,000 Ordinary 3 each 6,000 10% Preference 2 each 2,000 Other Reserves (Retained Revenue Reserves) 4,000 12,000 Non Current Liabilities 12% Debentures (Redeemable 28/2/2010) 5,000 Notes: Ordinary shares are presently trading at 6.80 cum-div. Preference shares have an ex-div market value of A recent board meeting agreed an ordinary dividend for the year of 0.80c per share. This dividend will be paid on 14 March Cork PLC has announced at a recent meeting with investors that it expects that the average annual rate of growth in dividends will be 20%. Debentures are presently trading at 110% of the value they were issued at. Debenture interest is paid annually. All payments relating to the year end 29/2/2008 have been made in full. Preference dividends are paid annually. Corporation tax of 20% is payable on profits in the year in which profits are reported. REQUIRED: Prepare a brief report for the Board of Cork PLC which: a) Explains the term Weighted Average Cost of Capital (WACC) and how it is calculated. (7 Marks) b) Explains the significance of the WACC for Cork PLC as it considers the manner in which it will raise new funds. (10 Marks) c) Calculates the company s present Weighted Average Cost of Capital. (8 Marks) [Total: 25 Marks] 3. Describe briefly ANY five of the following terms used in financial management: Internal Rate of Return. Earnings Yield. Portfolio Theory. Fundamental Theory of Share Value. Capital Rationing. Market Capitalisation. Beta Factor. [Total: 20 Marks] Page 2

4 SECTION B ATTEMPT TWO QUESTIONS ONLY (If you provide answers to more questions than required in this section, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first two questions to hand will be marked.) 4. Discuss four factors a company is likely to consider in determining its dividend policy. (15 Marks) 5. It is now the 1 November Jamie PLC is a supplier of medical apparatus. The company projects sales of 12 Million for the year ended 31 December Jamie PLC s Board has set a strategic objective to increase sales and reduce costs each year. In order to help achieve these objectives in the year ended 31 December 2008, Jamie PLC s management have put forward the following proposals: Proposal 1 The company s Sales Director has estimated if credit settlement terms were relaxed by offering customers 90 days standard settlement terms, sales would increase by one quarter next year, without the need to reduce prices. Proposal 2 In a bid to achieve the Finance Department s cost reduction target, Jamie PLC s Financial Controller is contemplating replacing the company s Credit Controller, who costs 50,000 annually, and referring potentially bad debts to a factoring agency for collection. The factor has indicated they would charge a fixed annual fee of 20,000 for a with recourse factoring service. Further relevant details are as follows: All sales are on credit with all debtors (except bad debts) fully observing the credit terms of 30 days. Bad debts of 1% of gross sales are currently experienced. The Sales Director expects that this will increase to 5% if credit settlement terms are relaxed and the Credit Controller is replaced by the factoring agency. Jamie PLC s gross profit margin is 25%. Jamie PLC is funded by a bank overdraft which costs 15% per annum. Note: Assume a 360-day year. REQUIRED: Prepare a briefing note for Jamie PLC s Financial Controller which addresses the following issues: Evaluates the profitability implications of the two related proposals (if taken together); and (9 Marks) briefly explains debt factoring setting out the benefits and risks associated therewith. (6 Marks) [Total: 15 Marks] Page 3

5 6. Your client, Horse Limited (Horse), has recently been asked to supply a one off order of 100,000 pre-packed breakfasts to a U.S. airline for its first class passengers. If the airline is satisfied with the quality of the breakfasts, it is likely that it will place a five year contract with Horse Limited to supply 100,000 such breakfasts per month. The initial order will be dispatched to the airline in four months time. It is expected that the airline will pay the $8.00 per breakfast two months after the date it receives the breakfasts. Horse has sourced haddock to be included in the breakfasts in Scotland at a cost of 1.50 sterling per breakfast. Horse Limited has placed the order and has negotiated a three month settlement term with the supplier. If Horse Limited is successful in winning the ongoing contract it plans to source the haddock in the U.S. Horse Limited s management have asked for your advice in relation to foreign currency management. Relevant information is as follows: Exchange Rates Quoted By bank $/ Sterling/ Term Spot $1.46 $ Three Month Forward 2c premium 3c premium 1p discount 1p discount Six Month Forward 4c premium 5c premium 2p discount 3p discount Interest Rates Economy Depositing Borrowing Ireland 4% 8% U.S. 6% 12% U.K. 5% 10% Ignore taxation and transaction costs. REQUIRED: Prepare a briefing note for the management of Horse Limited advising on the following: 1) The euro( ) cost of the sterling ( ) payment to the UK supplier, if the foreign exchange risk is hedged using a forward exchange contract. (3 Marks) 2) The euro( ) value of the US dollar($) receipt if the foreign exchange risk is hedged using a money market hedge. (6 Marks) 3) Explain how netting could be of benefit to Horse Limited in the event that it was successful in winning the tender and in sourcing a U.S. based haddock supplier. (6 Marks) [Total: 15 Marks] END OF PAPER Page 4

6 SUGGESTED SOLUTIONS SOLUTION 1 Briefing Note To: Management, Ardfield PLC From: A.N. Accountant Date: 20th July 2008 Subject: Investment in Equipment THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND FINANCIAL MANAGEMENT PROFESSIONAL 2 EXAMINATION - AUGUST 2008 Introduction This note assesses the financial impact of the three new machines you have been considering purchasing. Findings Two of the machines deliver a positive Net present Value (NPV) and should, if possible be purchased. The moulding machine delivers a negative Net Present Value (NPV) and should not be purchased. Details are summarised as follows: Summary Equipment NPV Moulding Extrusion Packing NPV Calculations Ardfield PLC Moulding Equipment Outlay Year 1 Year 2 Year 3 Cash flows Discount 6% Present Values Net Present Value Extrusion Equipment Outlay Year 1 Year 2 Year 3 Cash flows Discount 6% Present Values Net Present Value Packing Equipment Outlay Year 1 Year 2 Year 3 Cash flows Discount 6% Present Values Net Present Value Capital Rationing Ardfield has only 3.5M available this year to invest in such machinery. Thus, it will not be in a position to purchase both the extruding and packing machines. In which case you must carefully consider how the limited funds available are used. My advice is to invest as follows: Page 6

7 Investment Index Total Investment NPV Equipment Ranking Investment Possible Delivered Packing 1st Extrusion 2nd Total NPV Expected delivering an optimum NPV of 685,600 based on the following profitability indices: Summary Cash Profitability Index Equipment NPV Invested Index Ranking Moulding n/a Extrusion Packing Please note that this will necessarily involve the co-ownership of the extrusion equipment with the manufacturer. Availability of Additional Funding The available funds should be borrowed albeit at a higher cost, as it enables Ardfield PLC to deliver a total NPV of 698,940, an additional 13,340. Investment Total NPV Equipment Investment Delivered Packing Extrusion Total NPV Expected This is because the full availability of funds enables the complete purchase of the extruding equipment. Details are summarised as follows: NPV CALCULATIONS - ARDFIELD PLC Extrusion Equipment Outlay Year 1 Year 2 Year 3 Cash flows Discount 7% Present Values Net Present Value Packing Equipment Outlay Year 1 Year 2 Year 3 Cash flows Discount 7% Present Values Net Present Value Briefing Note To: Management, Sunnycove Limited From: A.N. Accountant Date: 20th June 2008 Subject: Acquisition of printing machine - Financing Options Introduction This note compares the financing options available to you in relation to the acquisition of the printing machine. The two options available are: purchase the machine lease the machine Page 7

8 The following are the financial results of each. Purchase Option The Net Present Value (NPV) of this option is + 306,584. This has been determined as follows: Sunnycove - Purchase Option Year 0 Year 1 Year 2 Year 3 Year 4 Purchase Price Contribution Corporation Tax (Note 1) Net Annual Cash Flows Discount 5% Present Values Net Present Value NOTE 1)CT Computation Year 1 Year 2 Year 3 Year 4 Annual Increased Contribution Capital 30% p.a. RB Balancing Allowance Taxable Profits % CT Payable Lease Option The Net Present Value (NPV) of this option is + 239,901. This has been determined as follows: Sunnycove - Lease Option Year 1 Year 2 Year 3 Year 4 Contribution Lease Payment Corporation Tax (Note 2) Net Annual Cash Flows Discount 5% Present Values Net Present Value NOTE 2)CT Computation Year 1 Year 2 Year 3 Year 4 Annual Increased Contribution Lease Payment Taxable Profits % CT Payable Conclusion Whilst the machine delivers a positive NPV under either financing option, the purchase option is preferable as it delivers an additional 66,683 Net Present Value. Sunnycove Limited - Financing Option Comparison Comparison of Options NPV Purchase Option Lease Option Difference Page 8

9 SOLUTION 2 Report To: Board of Directors, Cork PLC From: Mr A.N.Other, Accountant Date: 24th March 2008 Subject: Cost of Capital & Raising Funds Introduction The purpose of this report is to calculate and explain the meaning of the term Weighted Average Cost of Capital (WACC) and to explain it s relevance to your company as it considers raising finance to fund the U.K. market entry. Weighted Average Cost of Capital (WACC) Cork PLC has three sources of finance namely: Ordinary Shares Preference Shares Debentures In Cork PLC each type of finance has been raised in different proportions as follows: WACC MV % of Funds Ordinary Shares (ex div) % Preference Shares (ex div) % Debentures at MV % Total % and, each has a different cost as follows: WACC % cost of Funds Ordinary Shares (ex div) 36.00% Preference Shares (ex div) 6.25% Debentures at MV 4.53% The WACC represents the overall cost of financing your company. It is calculated by determining the cost of each source of finance and weighting same using the market value of each separate source as weights. As Cork PLC embarks upon the task of raising finance the WACC is of great significance for the following reasons: the WACC can be applied as the discount rate used to appraise the capital investment in the U.K. (and others) to determine whether or not to invest if the finance raised costs less than the present WACC then the overall WACC will be reduced and can improve the company s value/shareholders wealth Cork PLC can consider the cost of all potential sources of finance relative to the present WACC in order to make the financing decision The WACC of Cork PLC is 22.98%. This has been calculated as follows: WACC Note MV % Cost Weighting % Weight Weighted Ordinary Shares (ex div) % 1200/ % 20.87% Preference Shares (ex div) % 320/ % 0.97% Debentures at MV % 5500/ % 1.14% Weighted Average Cost of Capital % 22.98% Note 1) Cost of Equity (Gordon's Growth Model) [.80*(1+.2)/( )] +.2 = 36.00% Page 9

10 Note 2) Cost of Preference Shares Interest Payable/Ex Div. Market value = 20/320 * 100 = 6.25% * 10% = 20 cent dividend per annum. Note 3)Cost of Debentures (IRR Calculation) Year Value Interest Tax Relief Redeem Net C flow 000s 000s 000s 000s 000s % 5% Year Net C flow D factor PV Net Cflow D factor PV 000s 000s 000s 000s Net Present Value Net Present Value IRR (Cost of Debentures) =2%+[237.97/( )]*(5%-2%) = 4.30% Conclusion I hope this report helps you understand the term WACC and it s relevance as you embark upon the task of raising finance to fund your imminent U.K. venture. Page 10

11 SOLUTION 3 Internal Rate of Return This is the discount rate at which an investment proposal delivers a zero/break even net present value (NPV). It is derived using trial and error when selecting discount rates and mathematical interpolation. It is used in investment appraisal to determine whether or not a proposal investment is acceptable or not. Earnings Yield This is a ratio used by investors which calculates the return on an equity share relative to it s market value. It is a percentage measure calculated as follows: EPS / Market Value Per Share * 100 Investors would prefer a higher earnings yield at all times. The earnings yield enables an investor to compare consistently the return from different forms of investment e.g. property, equities, bonds etc. Earnings Yield is often used as an income based model for company valuation. Portfolio Theory Portfolio theory is related to the study of how investment risk and returns vary as we increase the number of investments in a portfolio. Portfolio theory has the following main principles: Investment risk can be reduced by investing in a portfolio of investments rather than a single investment The more investments included in an investment portfolio the more we can diversify away unsystematic risk Portfolio investment cannot eradicate systematic risk The relationship (correlation) between investments in a portfolio impacts on the extent to which unsystematic risk can be diversified away Fundamental Theory of Share Value Fundamental theory of share values states that the market price of a share is the present value of the discounted cashflows i.e. dividends receivable from that share. The dividend growth model enables an investor to determine the current market price of a share. The fundamental theory of share value is often criticised as dividends do not grow smoothly in practice and because the model fails to consider capital gains tax. It can be directly contrasted with Modigliani and Miller s dividend irrelevance theory which suggests that dividend policy is irrelevant to share values. Market Capitalisation Market Capitalisation refers to the total market value of a company. It is calculated by multiplying the market price of shares by the number of shares in issue. Market Capitalisation indicates the size of a company. Beta Factor A Beta Factor is a measure of risk. It measures the systematic risk of an investment relative to the market risk. Beta factors are used by the Capital Asset Pricing Model to predict the required rate of return for an investment/the cost of equity for an organisation. Altman s Z-Scores Professor I Altman researched 66 companies that experienced corporate failure to determine whether or not their failure could have been predicted. His summarised findings known as the Z-Score Model involves the calculation and weighting of five financial ratios. If the result score lies within stated parameters (0 to 1.8), then future corporate failure is likely. The model is used by investors and analysts to inform them of the financial risk associated with potential investments. Page 11

12 SOLUTION 4 Factors a company is likely to consider in determining its dividend policy may include the following: Liquidity Companies that are experiencing cash flow difficulties may decide to retain earnings rather that pay dividends. This should improve cash flow. Growth opportunities Maintaining financial flexibility to enable investment in opportunities Shareholders Expectations Shareholder may have set expectations as to the dividend receivable. Taxation Regime The tax regime that exists may influence dividend policy insofar as it may/may not be advantageous not to distribute dividends in lieu of capital gains. Gearing Retaining earnings may enable a company to avoid raising debt financial and increasing financial gearing related risks. Control Companies may decide to retain profits rather than risk the dilution of control by issuing additional equity shares. Cost of Funds By retaining funds companies may be able to reduce the cost of funding the organisation. Page 12

13 SOLUTION 5 Briefing Note To: Financial Controller, Jamie PLC From: Mr A.N.Hobbs, Management Consultant Date: 14th November 2007 Subject: Debtor Management Introduction The purpose of this report is to evaluate the financial implications of the proposal to relax credit terms and to replace your credit controller with a factoring agency. Present Cost of Debtors At present the cost of debtors is 440,000. It is broken down as follows: Present Position Sales 12,000,000 JAMIE plc Financial Evaluation of Debtors Proposal Bad 1% Gross Sales -240,000 (12,000,000*1%) Cost of Investment in Debtors (Note 1) -150,000 (1,000,000*15%) Cost of credit controller -50,000 Net Cost of Present Debtors -440,000 Note 1)Average Debtor Balances 1,000,000 (12,000,000*30/360) Proposed Cost of Debtors The proposed cost associated with debtors is 420,000. It is broken down as follows: Proposed Position Sales 12,000,000 Sales Increase 25% 3,000,000 Revised Sales Projections 15,000,000 JAMIE plc Financial Evaluation of Debtors Proposal Gross Profit Increase 750,000 Bad 5% Gross Sales -750,000 (15,000,000*5%) Cost of Investment in Debtors (Note 2) -450,000 (2,000,000*15%) Net saving of factoring +30,000 (50,000-20,000) Net Cost of Proposal -420,000 Note 2) Average Debtor Balances 3,000,000 (15,000,000*90/360) This represents an increase of 20,000 increase in profitability. Page 13

14 Factoring Factoring involves the referral of slow paying debtors to a factoring agency. The role of the agency is to ensure that outstanding debts are paid. Factoring can be achieved without recourse whereby the factoring agency bears the risk of non payment. With recourse factoring is where the factoring agency recovers any bad debts from the client. Many factoring agencies provide finance to the client based on the extent of debts outstanding. Benefits of Factoring enables management to concentrate on core business may help reduce bad debts may provide factor finance can reduce costs associated with credit control etc. Risks of factoring may risk of alienating customers can be expensive form of finance Conclusion The proposal to relax credit terms and to replace your credit controller with a factoring agency could be implemented as it will improve profitability by 20,000 per annum. Page 14

15 SOLUTION 6 Briefing Note To: Management Horse Limited From: A.N.Other, Management Advisor Date: 14th April 2008 Subject: Foreign Exchange Risk Management Introduction This note informs you of the cost of managing the foreign currency risks associated with the one-off contract to supply the U.S airline and provides advice as to how foreign exchange risk could be managed if you company is successful winning the tender. Payment to UK supplier. Your UK supplier will need to be paid 150,000 (100,000* 1.5) in three month s time. If you enter into a Forward Exchange contract this will cost you 220,588 = ( / ( ). Payment from US airline. Your US customer will pay $800,000 in six months time. If you hedge the risk of this payment using the money markets the net receipt will be worth 513, in six month s time. Hedge an $800,000 receipt in six month's time. Money Markets Stage 1) Borrow a $dollar amount today which along with the interest thereon will result in a debt of $800,000 in six months time. = $800,000/(1+(.12*6/12)) = $754, Stage 2 )Sell today's $ dollar borrowing to Euros at today's spot rate.=$ /1.50=$503, Stage 3) Deposit converted Euro amount today for six month's to determine its ultimate value at that date. = 503,144.65*(1+(0.04*6/12))= 513, Ongoing Contract If Horse Limited is successful in winning the five year contract to supply breakfasts and sources a reliable supplier of Haddock in the U.S. then it could use netting to manage a certain amount of the foreign currency risk associated with the related dollar transactions. In essence, the company would maintain a U.S. bank account. US dollar receipts from the airline would be paid into this account and payments to the U.S. supplier would be paid there from. This is known as netting of payments and receipts. Only the net amount remitted to Ireland would then be subject to foreign exchange risk which could be hedged using whatever means considered appropriate at that time. Page 15

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