Contribution 787 1,368 1, Taxable cash flow 682 1,253 1, Tax liabilities (205) (376) (506) (257)

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3 Fundamentals Level Skills Module, Paper F9 Financial Management June 2012 Answers 1 (a) Calculation of net present value (NPV) As nominal after-tax cash flows are to be discounted, the nominal after-tax weighted average cost of capital of 7% must be used. Year \$000 \$000 \$000 \$000 \$000 Sales revenue 1,300 2,466 3,622 2,018 Variable costs (513) (1,098) (1,809) (1,035) Contribution 787 1,368 1, Fixed costs (105) (115) (125) (125) Taxable cash flow 682 1,253 1, Tax liabilities (205) (376) (506) (257) CA tax benefits After-tax cash flow 682 1,161 1, (97) Scrap value 100 Net cash flow 682 1,161 1, (97) Discount at 7% Present values 638 1,014 1, (69) \$000 Present value of cash inflows 3,115 Cost of machine (1,500) NPV 1,615 Project 1 has a positive NPV of \$1,615,000 and so it is financially acceptable to Ridag Co. However, the discount rate used here is the current weighted average after-tax cost of capital. As this is a recently-developed product, it may be appropriate to use a project-specific discount rate that reflects the risk of the new product launch. Workings Sales revenue Year Selling price (\$/unit) Inflated selling price (\$/unit) Sales volume (units/year) 50,000 95, ,000 75,000 Sales revenue (\$/year) 1,300,000 2,466,200 3,621,800 2,018,250 Variable cost Year Variable cost (\$/unit) Inflated variable cost (\$/unit) Sales volume (units/year) 50,000 95, ,000 75,000 Variable costs (\$/year) 512,500 1,098,200 1,808,800 1,035,000 Capital allowance tax benefits Year Capital allowance Tax benefit Year benefit received 1 1,500,000 x 0 25 = \$375, ,000 x 0 3 = \$112, ,125,000 x 0 25 = \$281, ,250 x 0 3 = \$84, ,750 x 0 25 = \$210, ,938 x 0 3 = \$63, \$532,812* 532,812 x 0 3 = \$159,844 5 *843, , ,000 = \$532,812 13

4 Alternative calculation of net cash flow Year \$000 \$000 \$000 \$000 \$000 Taxable cash flow 682 1,253 1, Capital allowances (375) (281) (211) (533) Taxable profit , Taxation (92) (292) (443) (98) After-tax profit ,185 (118) (98) Add back allowances After-tax cash flow 682 1,161 1, (98) Scrap value 100 Net cash flow 682 1,161 1, (98) Discount at 7% Present values 638 1,014 1, (70) There are slight differences due to rounding. (b) Calculation of equivalent annual cost for machine 1 Since taxation and capital allowances are to be ignored, and where relevant all information relating to project 2 has already been adjusted to include future inflation, the correct discount rate to use here is the nominal before-tax weighted average cost of capital of 12%. Year Maintenance costs (\$) (25,000) (29,000) (32,000) (35,000) Investment and scrap (\$) (200,000) 25,000 Net cash flow (\$) (200,000) (25,000) (29,000) (32,000) (10,000) Discount at 12% Present values (200,000) (22,325) (23,113) (22,784) (6,360) Present value of cash flows \$274,582 Cumulative present value factor Equivalent annual cost = 274,582/3 037 = \$90,412 Calculation of equivalent annual cost for machine 2 Year Maintenance costs (\$) (15,000) (20,000) (25,000) Investment and scrap (\$) (225,000) 50,000 Net cash flow (\$) (225,000) (15,000) (20,000) 25,000 Discount at 12% Present values (225,000) (13,395) (15,940) 17,800 Present value of cash flows \$236,535 Cumulative present value factor Equivalent annual cost = 236,535/2 402 = \$98,474 The machine with the lowest equivalent annual cost should be purchased and calculation shows this to be Machine 1. If the present value of future cash flows had been considered alone, Machine 2 (cost of \$236,535) would have been preferred to Machine 1 (cost of \$274,582). However, the lives of the two machines are different and the equivalent annual cost method allows this to be taken into consideration. (c) Within the context of investment appraisal, risk relates to the variability of returns and so it can be quantified, for example by forecasting the probabilities related to future cash flows. From this point of view, risk can be differentiated from uncertainty, which cannot be quantified. Uncertainty can be said to increase with project life, while risk increases with the variability of returns. It is commonly said that risk can be included in the investment appraisal process by using sensitivity analysis, which determines the effect on project net present value of a change in individual project variables. The analysis highlights the project variable to which the project net present value is most sensitive in relative terms. However, since sensitivity analysis changes only one variable at a time, it ignores interrelationships between project variables. While sensitivity analysis can indicate the key or critical variable, it does not indicate the likelihood of a change in the future value of this variable, i.e. sensitivity analysis does not indicate the probability of a change in the future value of the key or critical variable. For this reason, given the earlier comments on risk and uncertainty, it can be said that sensitivity analysis is not a method of including risk in the investment appraisal process. 14

6 Net profit margin 100 x 4,067/14,525 = 28% 100 x 3,735/10,375 = 36% Current ratio 5,349/4,365 = 1 2 times 2,826/1,887 = 1 5 times Quick ratio 3,200/4,365 = 0 7 times 1,734/1,887 = 0 9 times Inventory days 365 x 2,149/10,458 = 75 days 365 x 1,092/6,640 = 60 days Receivables days 365 x 3,200/14,525 = 80 days 365 x 1,734/10,375 = 61 days Payables days 365 x 2,865/10,458 = 100 days 365 x 1,637/6,640 = 90 days Net working capital 5,349 4,365 = \$984,000 2,826 1,887 = \$939,000 Sales/net working capital 14,525/984 = 15 times 10,375/939 = 11 times (b) (c) Working capital investment policy is concerned with the level of investment in current assets, with one company being compared with another. Working capital financing policy is concerned with the relative proportions of short-term and long-term finance used by a company. While working capital investment policy is therefore assessed on an inter-company comparative basis, assessment of working capital financing policy involves analysis of financial information for one company alone. Working capital financing policy uses an analysis of current assets into permanent current assets and fluctuating current assets. Working capital investment policy does not require this analysis. Permanent current assets represent the core level of investment in current assets that supports a given level of business activity. Fluctuating current assets represent the changes in the level of current assets that arise through, for example, the unpredictability of business operations, such as the level of trade receivables increasing due to some customers paying late or the level of inventory increasing due to demand being less than predicted. Working capital financing policy relies on the matching principle, which is not used by working capital investment policy. The matching principle holds that long-term assets should be financed from a long-term source of finance. Non-current assets and permanent current assets should therefore be financed from a long-term source, such as equity finance or bond finance, while fluctuating current assets should be financed from a short-term source, such as an overdraft or a short-term bank loan. Both working capital investment policy and working capital financing policy use the terms conservative, moderate and aggressive. In investment policy, the terms are used to indicate the comparative level of investment in current assets on an inter-company basis. One company has a more aggressive approach compared to another company if it has a lower level of investment in current assets, and vice versa for a conservative approach to working capital investment policy. In working capital financing policy, the terms are used to indicate the way in which fluctuating current assets and permanent current assets are matched to short-term and long-term finance sources. An aggressive financing policy means that fluctuating current assets and a portion of permanent current assets are financed from a short-term finance source. A conservative financing policy means that permanent current assets and a portion of fluctuating current assets are financed from a long-term source. An aggressive financing policy will be more profitable than a conservative financing policy because short-term finance is cheaper than long-term finance, as indicated for debt finance by the normal yield curve (term structure of interest rates). However, an aggressive financing policy will be riskier than a conservative financing policy because short-term finance is riskier than long-term finance. For example, an overdraft is repayable on demand, while a short-term loan may be renewed on less favourable terms than an existing loan. Provided interest payments are made, however, long-term debt will not lead to any pressure on a company and equity finance is permanent capital. Overall, therefore, it can be said that while working capital investment policy and working capital financing policy use similar terminology, the two policies are very different in terms of their meaning and application. It is even possible, for example, for a company to have a conservative working capital investment policy while following an aggressive working capital financing policy. Calculation of upper limit The upper limit is the sum of the lower limit and the spread. If we use the minimum cash balance as the lower limit, the upper limit = 200, ,000 = \$275,000 Calculation of return point The return point is the sum of the lower limit and one-third of the spread. Return point = 200,000 + (75,000/3) = 200, ,000 = \$225,000 Use in managing cash balances The Miller-Orr model provides decision rules about when to invest surplus cash (if a cash balance increases to a high level), and about when to sell short-term investments (if a cash balance falls to a low level). By using these decision rules, the cash balance is kept between the upper and lower limits set by the Miller-Orr model. When the cash balance reaches the upper limit, \$50,000 is invested in short-term securities. This is equal to the upper limit minus the return point (\$275,000 \$225,000). When the cash balance falls to the lower limit, short-term securities worth \$25,000 are sold for cash. This is equal to the return point minus the lower limit (\$225,000 \$200,000). 16

8 sharing profits with the Islamic bank that provided the finance and which was acting as the owner of capital. The Islamic bank would not interfere in the management of the business and this is what would be expected if Zigto Co were to finance the business expansion using debt such as a bank loan. However, while interest on debt is likely to be at a fixed rate, the mudaraba contract would require a sharing of profit in the agreed proportions. (d) (e) Forward exchange contract Zigto Co needs to use the six-month forward exchange rate to hedge its six-month euro receipt. Dollar value in six months time = 500,000/1 990 = \$251,256 Money market hedge The six-month euro receipt is a future asset and needs to be hedged by a future euro liability. Zigto Co needs to borrow sufficient euros now so that in six months time the debt is equal to 500,000. The six month euro borrowing rate is 2 5% (5%/2). Euros borrowed now = 500,000/1 025 = 487,805 Dollar value of this euro debt = 487,805/2 000 = \$243,903 The six-month dollar deposit rate is 2% (4%/2) Future value of these dollars placed on deposit = 243,903 x 1 02 = \$248,781 The forward contract gives the higher value and hence is preferred to the money market hedge. Expected (future) spot exchange rate Using purchasing power parity, the expected (future) spot exchange rate can be calculated from the relative inflation rates, i.e. expected spot rate = 2 00 x (1 03/1 045) = per \$. The change in the spot rate over time can therefore, according to purchasing power parity, be related to relative inflation rates. This expected spot rate can be compared with the current twelve-month forward rate of per \$ Relationship between the expected (future) spot rate and the current forward rate The twelve-month forward exchange rate is a rate currently offered in the forward exchange market and a company can lock into this rate using a forward exchange contract. Forward rates are set using interest rate parity, i.e. by relative interest rates between two countries. If there were equilibrium between relative inflation rates and relative interest rates between two countries, the expected spot rate and the current forward rate would be the same. This is referred to as expectations theory. In practice, purchasing power parity tends to hold over long periods of time, and the existence of short-term disequilibrium leading to a difference between the expected spot rate and the current forward rate is not unusual. 4 (a) Price/earnings ratio valuation The value of the company using this valuation method is found by multiplying future earnings by a price/earnings ratio. Using the earnings of Corhig Co in Year 1 and the price/earnings ratio of similar listed companies gives a value of 3,000,000 x 5 = \$15,000,000. Using the current average price/earnings ratio of similar listed companies as the basis for the valuation rests on two questionable assumptions. First, in terms of similarity, the valuation assumes similar business operations, similar capital structures, similar earnings growth prospects, and so on. In reality, no two companies are identical. Second, in terms of using an average price/earnings ratio, this may derive from companies that are large and small, successful and failing, low-geared and high-geared, and domestic or international in terms of markets served. The calculated company value therefore has a large degree of uncertainty attached to it. The earnings figure used in the valuation does not include expected earnings growth. If average forecast earnings over the next three years are used (\$3 63 million), the price/earning ratio value increases by 21% to \$18 15 million (3 63 x 5). Although earnings growth beyond the third year is still ignored, \$18 15 million is likely to be a better estimate of the value of the company than \$15 million because it recognises that earnings are expected to increase by almost 50% in the next three years. (b) Value of company using the dividend valuation model The current cost of equity using the capital asset pricing model = 4 + (1 6 x 5) = 12% Since a dividend will not be paid in Year 1, the dividend growth model cannot be applied straight away. However, dividends after Year 3 are expected to grow at a constant annual rate of 3% per year and so the dividend growth model can be applied to these dividends. The present value of these dividends is a Year 3 present value, which will need discounting back to year 0. The market value of the company can then be found by adding this to the present value of the forecast dividends in Years 2 and 3. PV of year 2 dividend = 500,000/ = \$398,597 PV of year 3 dividend = 1,000,000/ = \$711,780 18

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11 Fundamentals Level Skills Module, Paper F9 Financial Management June 2012 Marking Scheme Marks 1 (a) Sales revenue 2 Variable costs 1 Fixed costs 0 5 Tax liabilities 1 Balancing allowance 1 Capital allowance tax benefits 2 Timing of taxation benefits and liabilities 1 Scrap value 0 5 Initial investment 0 5 Using correct discount rate 0 5 Net present value 1 Comment on financial acceptability 1 (b) Equivalent annual cost of Machine 1 2 Equivalent annual cost of Machine 2 2 Discussion of which machine to purchase 2 Marks 12 6 (c) Explanation of risk and uncertainty 1 Discussion of sensitivity analysis 2 3 Discussion of probability analysis 2 3 Other relevant discussion 1 2 Maximum (a) Rapid increase in revenue 1 2 Increase in trade receivables days 2 3 Decrease in profitability 2 3 Rapid increase in current assets 2 3 Increased dependence on short-term finance 2 3 Decrease in liquidity 2 3 Conclusion as regards overtrading 1 Maximum 12 (b) Working capital investment policy 3 4 Working capital financing policy 5 6 Maximum 9 (c) Calculation of upper limit 1 Calculation of return point 1 Explanation of use in managing cash balances

12 Marks Marks 3 (a) Causes of conflict between objectives 2 3 Reasons for less conflict in SMEs 1 2 Maximum 4 (b) Factors to consider when choosing source of debt 4 5 Factors considered by providers of finance 4 5 Maximum 8 (c) Nature of a mudaraba contract 3 Financing business expansion using mudaraba 2 (d) Calculated value of a forward exchange contract 1 Calculated value of a money market hedge 3 Comment on hedge to select 1 (e) Calculation of one-year future spot rate 1 Link between future spot rate and forward rate (a) Price/earnings value using year 1 earnings 1 Price/earnings value using average earnings 1 Discussion of variables 2 (b) Calculation of current cost of equity using CAPM 1 PV of year 2 dividends 0 5 PV of year 3 dividends 0 5 Year 3 DGM value 2 Year 0 PV of year 3 DGM value 1 Company value using dividend valuation model 1 (c) After-tax cost of debt 1 After-tax WACC 1 Revised cost of equity using CAPM 1 Revisied after-tax cost of debt 1 Revised after-tax WACC 1 Comment on change in WACC (d) Nature of business risk 1 2 Assessment of business risk 1 2 Nature of financial risk 1 2 Assessment of financial risk 1 2 Nature of systematic risk 1 2 Assessment of systematic risk 1 2 Maximum

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