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PAPER F9FINANCIAL MANAGEMENT

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ACCA F9 Financial Management Mock Exam December 2010

This material is © protected and is licensed by Kevin J Kelly to Opentuition.com 1

Solution 1 Cost of Capital and Investment Appraisal

Before attempting this question you are advised to have carefully revised the following chapters of the OpenTuition.com Course Notes

Chapter 6 Management of Working Capital (4) - Cash Chapter 7 Investment Appraisal

Chapter 8 Relevant Cash Flows for DCF Chapter 11 Sources of Finance - Equity Chapter 12 Sources of Finance – Debt

Chapter 14 The Valuation of Securities – theoretical approach Chapter 15 The Valuation of Securities – practical issues

Chapter 16 The Cost of Capital Chapter 17 When (and when not!) to use the WACC for Investment Appraisal

Solution 1 a) Calculate the after-tax weighted average cost of capital of Orihuela SA (6 marks) *Tutors Note: Firstly, let’s recap on the procedure (Answer Plan) to follow in the exam … so that you produce an answer with a well structured layout that the marker can easily follow. WACC procedure may be summarised under the following headings. You will then only need to decide on which components of the following structure will be relevant to answering our specific exam question. WACC states: Ko = Ke (%) + Kdat (%) Approach / Procedure in the EXAM

Ke DVM (Growth or no Growth in Dividends?)

P/E model CAPM NPV # 1

Kdat Redeemable => IRR => NPV # 2 Interpolate

IRRedeemable => IRR => CI (1-t) / MV

Weightings Preferably Market Values *Tutors Note: Looking at our question it is easily apparent that in our answer we will need to calculate Ke (the cost of equity) by reference to a suitable Dividend Valuation Model (DVM.. in this case Gordon’s Dividend Growth Formula) and the Kdat (the cost of redeemable debt AFTER TAX) by reference to first principles, using IRR.



Ke - Cost of Equity Gordon’s formula states that Ke = Do (1+g) + g Pe *Tutors Note: “Just Paid” = Do = $53, Current MPS = $18, Growth = g = 0.06 Filling in the blanks we get: Ke = 3.0 (1+.06) + .06 18 Ke = 23.67% KDAT - Cost of Redeemable Debt *Tutors Note: We calculate Kdat from first principles - based on examination of the Relevant Cash Flows (Relevant Costs) associated with the bond. These c/f’s may be summarized as follows

Calculation of NPV @ say 5% Table of Relevant Cash Flows

To t1 t2!!!.> t10 Cost (MV) (93) Coupon Interest (1-t) 4.2 4.2……..> 4.2 Redemption @par 100 Redemption premium 10% 10 Net Cash Flows (93) 4.2 4.2……. 114.20 Df @5% 1 0.952 0.907 …. 0.614 P.V. (93) 4.0 3.81 ……. 70.12 NPV = 6.97 *Tutors Note: Within the strict time constraints of the exam it would be a little time consuming to work out the NPV in this “normal” fashion. Clearly, it would be more efficient to use the Cumulative Discount Tables (or Annuity Factor Tables) to work out the Present Value of the constant CI cash flow ($4.20) between years 1 & 10 as follows: KDAT - Cost of Redeemable Debt

Calculation of NPV @ say 5% Summary of Relevant Cash Flows PV Cost To (93) x 1.00 (Real Cost) (93) CI after tax t1 to t10 4.20 x 7.722 (AF for 10 yrs) 32.43 Redemption t10 110 x .614 (df for yr 10) 67.54 NPV + 6.97



*Tutors Note: The 2nd approach to calculating the NPV is much faster in this instance. Therefore, I will derive the 2nd NPV in this way also. Calculation of NPV @ say 10% Summary of Relevant Cash Flows PV Cost To (93) x 1.00 (Real Cost) (93) CI after tax t1 to t10 4.20 x 6.145 (AF for 10 yrs) 25.81 Redemption t10 110 x .386 (df for yr 10) 42.46 NPV - 24.73 NPV = (24.73) *Tutors Note: We can now proceed to INTERPOLATE in order to estimate the Cost of Capital (df) that gives us a breakeven NPV … => the Kdat (of Redeemable Debt). *Tutors Note: The Formula for the IRR is either: NL IRR ! L + (H – L) X NL + NH

- or if you prefer - Difference in Pos. NPV IRR ! Pos. Coc + Coc X Sum of NPV’s Where: L = Lower rate of Interest H = Higher rate of Interest NL = NPV @ Lower rate of Interest HL = NPV @ Higher rate of Interest Interpolate 6.97 Kdat = IRR ! 5% + 5% x 31.70 ! 6.10% Weightings (based on Market Values) Market # ‘000 MPU Value % [E] Equity 1,500 18.00 27,000 85.31 [D] Debt 5,000 93% 4,650 14.69 [V] Value 31,650 100% WACC states: Ko = Ke (%) + Kdat (%) *Tutors Note: Now, filling in the blanks in the formula we get: ! Ko = 23.67(.8531) + 6.10(.1469) ! 21.09%



Solution 1 contd., (b) Advise the MD of Orihuela SA, with reasons, whether or not you believe the investment appears worthwhile. (6 marks) *Tutors Note: Questions of this nature, which question the economic value of investments (whether or not they are worthwhile) require you ALWAYS (unless you are instructed otherwise) to calculate the NPV of the investments. The DECISION CRITERION is then to choose the investment with the highest NPV. Why is this? The answer is simple, NPV is THEORETICALLY, the superior decision making technique.

Calculation of NPV

Based on examination of the Relevant Cash Flows (Relevant Costs)

Table of Relevant Cash Flows - 000’s - t0 t1 t2 t3 t4 t5 t6 Cash from Operations: Operating cash flows 710 745.5 782.8 821.9 863 Tax - Payable (213) (223.6) (234.8) (246.6) (258.9) - Saved on CA’s (W1) 225 168.7 126.6 94.9 248.8 Other Relevant Cash Flows: Cost (3,000) Scrap Value 120 Working Capital (W2) (390) (19.50) (20.5) (21.5) (22.5) 474 Net Cash Flow (3,390) 690.5 737 706.4 691.2 1305.3 (10.1) d.f @21%(W3) 1.0 .826 .683 .564 .466 .385 .319 P.V. (3,390) 570.3 503.4 398.4 322.1 502.5 (3.2) NPV = (1,096) Negative REJECT (W1) Calculation of Tax Relief on Capital Allowances Tax Year WDV CA Relief Timing 1 3,000 750 225 t2 2 2,250 562.5 168.75 t3 3 1,687.5 421.9 126.57 t4 4 1,265.6 316.4 94.92 t5 5 949.2 *829.2 248.76 t6 Total Entitlement 2,880 x 30% 864



* Calculation of Balancing Allowance / Charge Tax WDV of 949.2 – Sale Proceeds of 120 = Balancing Allowance of 829.2 (W2) Calculation of annual Incremental Working Capital requirement Beginning Opening Annual Year Balance Increment Timing 1 390 (390) t0 2 409.5 (19.5) t1 3 429.975 (20.475) t2 4 451.474 (21.499) t3 5 474.047 (22.573) t4 End of year 5 Repayment 474.047 t5 (W3) Calculation of an appropriate df (Discount Factor) to use in the evaluation Assumption: that 21.09%, the WACC calculated in part (a) rounded to 21%, is the correct average cost of capital (df) to use in this instance. This assumption is based on the assertion that the new investment will have the same Business Risk (same Industry) and will be financed in the same way (the same Financial Risk / same Financing mix of capital, D:E) as the company’s existing operations. Consequently, it is considered appropriate to use the existing company WACC. If both of these conditions were not met then a project specific WACC would have to be calculated using CAPM Advise the MD, with reasons, whether or not you believe the investment appears worthwhile. Purely on financial grounds I would advise the MD not to proceed with the proposed investment. The principle reason is that, in THEORY, proceeding with the proposed investment will result in an immediate DECREASE in shareholders wealth in the amount of $1,096,000. This advice however ignores consideration of a range of non-financial and/or qualitative factors which will necessarily be an important part of the strategic decision making process of the MD and the board of Orihuela Plc in this instance. *Tutors Note: Refer to the points listed under part ( c) below for further information on non-financial/qualitative factors.



Solution 1 contd., (c) Advise the Managing Director on what factors he should consider before deciding on a “correct” buying price to pay for the target company. (3 marks) *Tutors Note: It is important to appreciate, when considering what price the predator company should pay for the target company, that questions about “correct price” are like trying to consider “how long is a piece of string”! There are many practical considerations to take into a/c, each varying in importance depending on the circumstances or motivations surrounding the takeover discussions. There are financial considerations (valuation methods, funding issues, stock market & share price reaction, synergies,…) as well as non-financial considerations (strategic, managerial, operational issues,…) to take into a/c. Suffice it to say that every minute aspect of the business and the industry in which it operates in are likely to be considered. …… Thus following on from this logic you should now be able to appreciate that there is NO SUCH THING as a “correct buying price” – in the final analysis it will depend on the negotiation skills of the people involved and sitting around the table! Having said all this an acceptable answer for 3 marks might look like this: (i) Range of Prices - Valuation methods There are several possible valuation models available, each of which have different underlying assumptions and thus each model will produce a different BUYING PRICE. For example, there are;

• Dividend valuation models • Price / Earnings models • Discounted Cash Flow Models • Net Asset based models

The Net Assets or Balance Sheet approaches are often quite useful in these types of negotiations; the Net Realizable Value basis can provide a useful MINIMUM PRICE and the Net Replacement Cost basis can provide a useful MAXIMUM PRICE….around which the negotiations can take place. The other bases (P/E, DVM and DCF models) tend to provide prices which lie between the two extremities of the price range provided by the NRV and NRC. As I have stated above, the FINAL or “correct” buying price will be a matter of judgment and will very much depend on the negotiation skills of the people involved in the discussions. *Tutors Note: To recap: EQUITY valuation models include:

• Dividend valuation models • Price / Earnings models • Discounted Cash Flow Models • Net Asset (Balance Sheet) based models providing valuations based on:

N.B.V ! Little use N.R.V ! Min. (Seller) N.R.C ! Max. (Buyer)



(ii) Other Financial considerations Costs (accountants, legal, brokers, underwriting), Goodwill, stock market reaction, EPS, Share Price, Funding arrangements, (iii) Other Non-Financial considerations Strategic (rapid growth, acquire expertise, diversification, enhance EPS), Managerial & Operational…. Solution 1 contd., (d) (i) Calculate the theoretical ex-rights price of an ordinary share. (2 marks) Theoretical ex-rights price per ordnary share. Shares Price MV Existing (original) holding 4 2.80 11.20 Rights Issue 1 2.20 2.20 13.40 TERP => 13.40/5 = $2.68 *Tutors Note: => this implies that the value of the rights are $2.68 -$2.20 = $0.48 for every 4 shares held or new share acquired. (d) (ii) How will the wealth of an investor holding 10,000 ordinary shares in Murcia Plc be affected by the rights issue if they take up their rights to buy new shares or decline the option to do so. (3 marks) Expected effect on Wealth of Shareholders - Wealth - $ 10,000 shares Before $ Current position (as above) 4 x 2.80 = 11.20 28,000 Take up Rights New position 5 x 2.68 = 13.40 Cost of new share 1 x 2.20 = (2.20) Wealth 11.20 28,000 Before = 11.20 After = 11.20 No Change in Wealth of the Shareholder Decline Rights Issue offer but sells rights New value of existing sh/holding 4 x 2.68 = 10.72 Proceeds from sale of rights 1 x 0.48 = 0.48 Wealth 11.20 28,000 Before = 11.20 After = 11.20 No Change in Wealth of the Shareholder



Decline Rights Issue offer and does nothing (does not sell rights) New value of existing sh/holding 4 x 2.68 = 10.72 26,800 Before = 11.20 After = 10.72 Wealth of the Shareholder has Decreased *Tutors Note: => this implies that the Wealth of the shareholder has decreased by the value of the rights that have not been taken up ($2.68 -$2.20 = $0.48). On 10,000 shares this is a fall in wealth of 2,500 shares x $0.48 = $1,200. To recap: In THEORY, the only way the investor can lose is if he IGNORES the rights issue offer and neglects to SELL the rights. Consequently, in THEORY, there is NO EFFECT on the wealth of the shareholder whether he decides to take up the rights and/or sells the rights. But, from the point of view of retaining some influence within the company however, the decision whether to invest in the rights or not would be an important one. Solution 1 contd., (e) Explain what you understand by the term “Funding Gap” and suggest remedies

that an SME (small or medium sized enterprise) finding itself in this position might consider. (5 marks)

*Tutors Note: Given the economic climate that exists within the UK and Europe at present, it would be unwise not to be prepared for a question that refers to the current“Liquidity Crisis”, “Banking Crisis” or “Credit Crisis”. More than ever before, if companies are to survive these harsh economic times it is imperative that they operate sound principles of working capital management – note specifically that from a practical point of view good Cash Management involves knowing not only how to raise more money and/or spend less money but also importantly an understanding of the variety of Sources of Finance available through the EQUITY Markets, BOND Markets, MONEY MARKETS and central and regional Government/European initiatives. As a corollary, part (e) should be an important part of your THEORY preparations for the forthcoming December 2010 examination. For this reason I am providing you with a solution that goes WAY BEYOND what might be expected in the exam for 5 marks but nevertheless I hope that you find this summary of Sources of Finance generally useful and that it helps to “bring together” what is an otherwise potentially expansive part of the syllabus. The FUNDING GAP ... facing SME’s



Funding Gap…. arises when the SME wants to expand beyond its existing Funding Capacity and finds that it is unable to access suitable Debt and/or Equity Finance to do so.

• For investments below £500,000 most SME’s can access an informal funding network of their friends, families and business angels. Once companies require funding above £2m they are usually quite established and therefore perceived as lower risk and therefore are more likely to be able to secure funding from institutional investors.

• The gap between these two finance situations is known as the Funding Gap. Maturity Gap……arises because LT loans are easier to raise than MT or ST loans.

• LT loans can be secured against Personal Property and/or other assets via Mortgages.

• Banks are basically unwilling to lend further without a corresponding increase in SECURITY

Equity Gap…..arises out of the difficulty associated with obtaining additional Equity Finance beyond the Initial equity finance injected by the Owners and/or BUSINESS ANGELS… many assets are intangible. Compounding the Funding Gap difficulties being faced by SME’s are also the following: Security Lack of suitable assets available to PLEDGE as security on Bank Borrowings - Fixed and/or Floating Charges on assets Size Usually SME is un-quoted…..a draw back to raising D and E Un-quoted (normally the SME is unquoted)

• Greater difficulty in raising finance thru a Rights Issue or a Placing …. often family and friends will be exhausted (as well as financially!) from the SME.

• Other external Investors are difficult to attract because of greater perceived Systematic Financial Risk and Systematic Business Risk

Track Record Young Entrepreneurial companies often have no or limited borrowing history / track record. Competitive Market Place for Finance Large quoted companies, government all competing for a limited pool of deposits. Lack of Financial Expertise Deficit of knowledge in identifying and raising suitable sources of finance Risk

• Both D and E Investors consider SME’s more risky investments • High Failure rate of start-ups and SME’s



Uncertainty No or Poor Credit Rating with Credit Rating Agencies or the Banks themselves. Lack of adequate MIS or FIS Detailed Accounting Records, Fixed Asset Registers (re; Fixed or Floating Charges), Projections, Budgets, Business Plans, suitably Qualified Directors with Financial Skills (ACCA qualified accountants) Exit Route

• A problem for Equity Investors as the company is usually Un-quoted. • If company tries to buy back its own shares this can often just exacerbate C/F

problems

Potential Sources of Finance for SME’s ….. REMEDIAL ACTION Equity (E) Debt (D) Government Aid

Share Issues R.E’s ST LT Owners Div Policy B/Overdraft Loans (SFLGS) Business Angels Operating Lease Finance Lease RI (Rights Issue) Factoring Mortgage Loans Private Placing Invoice Discounting MezanineFinance Venture Capital Commercial Paper Franchise Finance (see definition in OT Course Notes) Trade Credit Sale & Lease back Flotation (IPO on AIM or maybe Official List) Euro-Currency Loans After Flotation could lead to: Working Capital mgt Preference Shares - Offer for Sale -by Tender Cash Operating Cycle Public Debt - Offer for Sale -@ Fixed Price Debentures - if SME is quoted Scrip Dividends Redeemable Debentures Irredeemable Debentures Convertible Debentures Debentures with Warrants Zero Coupon Bonds Deep Discount Bonds Junk Bonds - SFLGS



- Govt Grants - Govt.Loans - Govt. Tax Incentives - E.C.F’s (Enterprise Capital Funds) Government Aid The assistance available, in order to encourage Loans and/or Equity Investment into SME’s, is very Country Specific …. the various schemes available in the UK can differ to the variety and extent of the schemes available in Ireland, Spain, Germany, etc., Considering the UK situation.., the main points to consider are: SFLGS - Definition. .. The Small Firms Loan Guarantee Scheme is designed to help Small Firms get a loan from the bank…..especially when they lack the SECURITY the Bank ordinarily needs. - Under the scheme, the bank can lend up to £250,000 without SECURITY over PERSONAL assets or a PERSONAL GUARANTEE being required of the borrower. - All available BUSINESS assets must be used as security if required by the bank. - The Government will guarantee 75% of the Loan. - A PREMIUM of 2% is payable on the guaranteed part of the loan. GRANTS - Definition…a CAPITAL or REVENUE Grant is a sum of money given to an individual or business for a specific project or purpose. The Grant usually covers only part of the total costs involved. - Grants to help with Business Development are available from a variety of sources such as the following sources:

• Government • European Union • Regional Development Agencies • Business Link • Local Authorities • Charitable Organisations

- Grants are awarded on the basis of:

• Business Activity • Specific Industry Sector (e.g. Technology) • Geographical Area (e.g. areas in need of economic Regeneration or Regional

Development) - Examples of various Government Grant schemes:

• RSA – REGIONAL SELECTIVE ASSISTENCE SCHEME • RIG – REGIONAL INNOVATION GRANTS • ENTERPRISE GRANTS



- Examples of various Government Loan schemes: • SFLGS – SMALL FIRMS LOAN GUARANTEE SCHEME • STFL – SMALL FIRMS TRAINING LOANS • EIB – EUROPEAN INVESTMENT BANK • EIF – EUROPEAN INVESTMENT FUND

- Examples of various Government Tax Incentive schemes:

• EIS – ENTERPRISE INVESTMENT SCHEME • VCT – VENTURE CAPITAL TRUSTS • EMPLOYEE SHARE INCENTIVE SCHEMES • DECREASING CORPORATION TAX THRESHOLD • INCREASING SALES TAX THRESHOLD • ECF - ENTERPRISE CAPITAL FUNDS

- Definition…ECFs were launched in the UK in 2005. ECF’s are designed to be commercial funds, investing a combination of private and public money/funds in high-growth businesses. - Each ECF will be able to make Equity investments of up to 2 million into eligible SMEs that have genuine growth potential but whose funding needs are not currently met. Further Points to remember on the …“Equity” Sources of Finance mentioned above Business Angels High net worth individuals who invest in Start-Ups and Development Stage of SMEs Usually have very good knowledge / expertise of INDUSTRY ( BUSINESS RISK ) they are buying into…..do you watch ‘Dragons Den” ? ! RI The key points to remember with Rights Issues are: Voting Rights remain Unchanged / RIs are at Directors Discretion / Rarely Fails / Cheaper / Pre-emption Rights VC Definition…Venture Capital is the provision of Risk Finance to young Entrepreneurial Companies on a 5 – 7 year investment time horizon. Consider the following points in Choosing between Sources (E -v- D) Finance

• Amount of Finance (Loan or Equity) required • Cost (Interest Rates – Fixed or Floating - versus Dividends) • Term Structure of Interest Rates (The Yield Curve) • Duration / Maturity / Redemption • Gearing / Capital Structure (Optimal balance reached?) • Accessibility • Control • Dividend Policy • Memorandum and Articles of Association • Debt Covenants



Solution 2 Working Capital Management & Financial Analysis


Chapter 3 Management of Working Capital (1) Chapter 4 Management of Working Capital (2) - Inventory

Chapter 5 Management of Working Capital (3) – Receivables & Payables Chapter 6 Management of Working Capital (4) - Cash

Chapter 11 Sources of Finance - Equity Chapter 12 Sources of Finance - Debt

Chapter 13 Capital Structure and Financial Ratios Chapter 18 Cost of Capital – the Effect of Changes in Gearing

Solution 2 (a) Comment on why you think the bank has refused the additional loan facility requested and advise on what remedial action you think might be available. (13 marks) Tutor’s note: a discussion on the working capital financing policy, capital structure and the financial performance of UK Plc is required here Firstly, a quick Tutorial on Ratios FINANCIAL ANALYSIS: SOME BASIC EXAMPLES Ratios are potentially useful in financial analysis since they help summarize extensive amounts of data in a meaningful format. Ratios may be grouped into 5 broad categories:

1. Profitability } Return on Capital employed (ROCE) + Return on Equity (ROI) 2. Liquidity 3. Working Capital 4. Capital Structure 5. Investor Ratios Tutor’s note: There is no universal agreement on the definitions of the ratios to use here. Different textbooks/professors utilize alternative measures and even use alternative grouping schemes. For the purposes of ACCA F9 this classification is fine.



Remember

1. Be Selective……. Choose to calculate /use those ratios that will help you to answer what you want to know:

1. How well is the Company managed?

2. How well is the Working Capital managed? 3. How is the company financed? 4. How good is the company’s Liquidity?

5. How good an Investment is the company?

2. Individual Ratios are of little use…... Look at the (a) TREND over time

and/or (b) inter-company comparisons within the SAME INDUSTRY and/or (c) BUDGETS.

3. Look at trends over time in terms of …….. 1. E.P.S. 2. Dividends 3. Sales

4. Do not forget to adjust for INFLATION

5. Look out for OVER-TRADING ….. a successful company with insufficient

investment in w/c (under-capitalized for Working Capital).

Symptoms:

1) HIGH ROCE 2) POOR Liquidity Ratios 3) POOR Creditors day ratio

6. Working Capital Management can be assessed by an analysis of the Cash

Operating Cycle

+ Debtors + Trade Debtors * 365 = x days Annual Credit Sales + Stocks + Raw Material Stocks *365 = x days

Annual Purchases

+ Work in Progress *365 = x days Cost of Sales



+ Finished Goods Stocks *365 = x days Cost of Sales

- Creditors - Trade Creditors *365 = (x days) Annual Purchases

………… Length of Cash Operating (W/C) Cycle X

……….

7. If a company Requires Finance consider: ! Equity ! Debt - rem: Loan Guarantee Scheme ! Factoring / Invoice Discounting ! Better Debtors Control ! Better Stock management ! Take more Credit from supplier ! Sale and lease-back of Free Hold property ! Sale of Investments and / or Assets ! “Management-Buyout” …. Sell–off one of your divisions for cash.

Finally, remember that in a Financial Analysis (ratio analysis) question you can expect the marks for the CALCULATIONS and the marks for COMMENTS to be broadly evenly split. In other words, expect a MAXIMUM of 50% of the marks for the calculations….. You have been warned! Tutor’s note: For those of you who find answering exam questions on Financial Analysis difficult can I suggest that you Study and Learn the following TEMPLATE and I hope you will thus find that your understanding and approach to answering questions on Financial Analysis improves accordingly. Use this template approach to practice ALL previous ACCA F9 questions on Financial Analysis so far examined. Financial Analysis TEMPLATE for UK Plc

Ratio

Calculation

Latest

Year 2010

Previous

Year 2009

Ind Avg

Turnover

Turnover ($m) 4,980 4,530 Turnover growth (% pa.) 4,980/4,530 10% Geometric average growth n" MRY/EY

Profitability

Profit before interest and



tax ($m) 565 PBIT growth (% pa.) Geometric average growth (%) "

ROCE PBIT/Net Assets 565/2,180 26% Net Profit Margin PBIT/Sales 565/4,980 11.3% n/a n/a 9% Fixed Asset Turnover Sales/Fixed Assets 4,980/900 5.5 x 4,530/820 5.52 Gross Profit Margin Sales–Cost of Sales

Sales

Liquidity

Current Ratio 2:1 Current Assets / Current Liabilities

2,900/2,060 1.41:1 1,965/1,620 1.21:1

Quick Ratio 1:1 (Acid Test)

Cash & Near Cash / Current Liabilities

1,300/2,060 0.63:1 970/1,620 0.60:1

1.0

Working Capital

Growth in Debtors (% pa.) 1,300/970 34% Growth in Stocks (% pa.) 1,600/995 61% Growth in Creditors (%pa) 1,150/805 43% Day Ratios

(x 365)

Debtors Collection Trade Debtors/ Sales 1,300/4,980 95 days 970/4,530 78 ds Stock Holding period Stock/Cost of Sales Trade Credit allowed Trade Creditors/COS Cash Operating Cycle

Turnover Ratios

(x Times)

Debtors T/o Sales/Trade Debtors 4,980/1,300 3.8 x 4,530/970 4.67 Stock T/o Cost of Sales/Stock Creditors T/o COS/Trade Creditors Stock Market Ratios

# of Ordinary Shares 2,000 Share price (cents) 180 Share price growth (% pa) Geometric average growth (%) "

Earnings ($m) 225 EPS (cents) EAT/ # of Shares 225/2000 11.25 EPS growth (% pa.) Geometric average growth (%) "

PE Ratio MPS/EPS 1.80/11.25 16.0 n/a n/a 20



Dividends ($m) 75 DPS (cents) Divs/ # of Shares 75/2000 3.75 DPS growth (% pa.) Geometric average growth (%) "

Dividend Yield Gross DPS/MPS ROI EAT/Sholders Funds 225/865 27.6% TSR – Total Shareholders Return

Increase in SP + DPS / Opening SP

Capital Structure

@ Book Values Ordinary Share Capital Reserves Shareholders Funds 815 665 Debt (Fixed / Var) 1,000 +365 1,000 Capital Employed 2,180 1,665 Gearing Ratio (BV) Debt/Equity 1,365/815 167% 1,000/665 1.50 0.60 @ Market Values MV of Equity 1.80 x 2,000 3,600 MV Debt Assume BV 1,365 Gearing Ratio (MV) Debt/Equity 1,365/3,600 38% Interest Cost (Fixed / Var) 220 Interest Cover Ratio PBIT/Interest Liabs 565/220 2.57 6 x Dividend Cover Ratio EAT/Dividends 225/75 3.0 n/a n/a 4 x Additional Observations Investment Income

25

Return on Investment 25/440 5.7% * Debt / Equity = L.T Debt +Bank o/d + Preference Capital / Shareholders Funds

(Equity Capital + ALL the reserves) ** Geometric Growth = n" mry / ey where, MRY = most recent year EY = earliest year N = # of periods of growth Tutor’s note: It may on first observation appear that I have not performed sufficient calculations to undertake my review but here-in-lies a common trap and source of failure in the exam with this type of question. All too often students fail to MANAGE their available time between the written commentary and the calculations themselves. As you will now see, I have performed more than sufficient calculations to make a reasonable commentary.



Bank’s Refusal – a Critical Review On the basis of the above preliminary financial analysis of the figures it is not surprising that the bankers do not wish to provide further financing. UK Co’s ratios show up serious shortcomings in the overall financial management of the company and especially the management of its working capital. Business Performance & Working Capital Management: During the latest year turnover increased by 10% and the overall ROCE (return on capital employed) appears healthy at 26%. However, on closer inspection debtors are seen to have increased by 34% and stocks by 61%, respectively. Debtors and Stocks need examination and control. Based on the turnover levels disclosed they should have increased by less than $200,000($1,965 x 10%), the actual increase was $935,000! This is a dangerous misuse of working capital which may result in obsolescence and / or bad debts. Clearly, questions need to be asked here as to why w/c performance is so far out of sink with business performance. This would not appear to be acceptable and the inherent risk has clearly disturbed the bank. Trade creditors increased by 43% providing partial funding. But it must be asked at what cost to customer goodwill and future business performance. This aspect of w/c management needs further investigation. The Current Ratio (1.41:1) has deteriorated over the year and the Quick Ratio especially is well below the Industry Average of 1:1. Clearly, the company’s Bankers are going to require explanations from management concerning the Liquidity of the company. Turning our attention to the Capital Structure of the business raises even more concerns. For example, the Debt:Equity financing mix based on Book Values is 167% for the current year versus an average for the Industry of just 60%. This level of Financial Gearing compared with the rest of the Industry is likely to have been a major concern for the company’s bankers. Financial Gearing Ratios help to highlight the level of Financial Risk or exposure faced by the company’s bankers (and shareholders). Operating Gearing levels for the company, as reflected in the Interest Cover ratio of 2.57, do not compare well when compared to the Industry Average Interest Cover of 6.0. Thus clearly from even just a cursory Financial Analysis, as above, there are going to be serious questions asked by the company’s bankers. Bank’s Refusal – a Positive Review Shareholders are likely to feel quite encouraged by the company’s recent increase in turnover and accompanying profit margins. ROCE appears quite healthy at 26% for the year. Net profit margin has come in at 11% as compared to the Industry Average of 9%



and again this is likely to be viewed favorably by the shareholders and bankers alike. However, as mentioned above, the Net Profit margin has the potential to be higher with improved financial management and a better funding balance between debt and equity. But, and it is a big but, the heavy incidence at present of fixed interest payments exposes the company to a sharp downturn in Net Profits, EPS and Dividend Cover. A return to the previous year’s stock and debtor levels will further improve the balance sheet and profitability. A full review of purchasing policy and sales terms / credit control should be undertaken to ensure this result. As soon as possible the bank should be informed that additional equity funding is being arranged. The level of financial risk, which is clearly giving rise to so much concern, will fall immediately as a result. The bank must be persuaded that these unsatisfactory ratios occur despite the fact that profitability before interest and tax stands at 26% and that the Net Profit margin being earned by the company is better than the industry average @ 11.3% (9%). That is, that this operationally profitable firm’s problems are mainly due to a poor financial / trading structure, which is now being rectified. The bank’s continued support is necessary to achieve this objective. Conclusion A planned approach to improve the financial profile of UK Plc is urgently needed. UK Plc seems to rely too much on loans and overdraft finance to fund operations. More equity is needed to improve the balance sheet to acceptable levels. As a corollary, I would advise the company to immediately proceed to sell off its investments which will reduce the need for external financing and should result in net interest savings well in excess of the 5.6% dividend received last year Solution 2 contd.,on next page



Solution 2 contd., (b) (i) Calculate the costs of placing orders, holding stocks and the total stock costs pa if

either 60 or 100 orders are placed during the year (4 marks) Calculating “Total Stock Costs pa”…… a TEMPLATE approach Tutor’s note: Calculating the “Total Stock Costs pa” is based on an examination of the Total Order Costs + Total Holding Costs pa Where, TC = Oc + Hc + Pc => Compare “Total Annual Stock Costs” for each Order Quantity/Size (Include PC only if DISCOUNTS are offered) - Order Quantity - Annual Demand 60,000 [ OC ] Order Cost No. of Orders pa.* 60 100 * Annual Demand / Order Size Order Size - units 1,000 600 Cost per Order 95 95 Total Re-Order Cost pa 5,700 9,500 [ HC ] Holding Cost Average Stock Holding * 1,000/2 600/2 * Order Size / 2 Average Stock Held (units) 500 300 Cost of holding one unit of stock pa 3.50 3.50 Purchase Price pu 6.00 6.00 Average Stock Value 3,000 1,800 Total Stock Holding Cost pa 1,750 1,050 [ PC ] Purchase Cost Demand 60,000 60,000 Purchase Cost PU 6.00 6.0 Total Purchase Cost 360,000 360,000 * [ TC ] Total Stock Costs pa. 7,450 10,550 * Tutor’s note: as Total Purchase Costs pa are the same for all Order Sizes => ignore Remember: You include the purchase costs (PC) in the analysis only if DISCOUNTS are offered. DECISION Choose Option 1 Cheapest Order Size Because of the high ordering costs relative to the holding costs, it is better to order larger batches less frequently.



Tutor’s note: Many students appear to have difficulty understanding the assumptions underlying the calculation of Total Stock Cost pa. For those of you who find answering exam questions on this component of W/C confusing can I suggest that you Study and Learn the above TEMPLATE approach to laying out your answer and dealing in turn with each of the two assumed components; OC and HC. (bring PC into the analysis only if the question includes DISCOUNTS on bulk order sizes). I hope you will then find that your understanding and approach to answering questions on stocks improves. Then go on to use the template to practice further questions on the analysis of Stock Costs and Order Quantities.

(b) (ii) Estimate the optimal stock quantity to order using the economic order quantity model (EOQ) and calculate the ensuing Total Stock Costs pa (3 marks)

EOQ model states that EOQ = " 2.Co.D Ch

= " 2 x 95 x 60,000 3.50

EOQ = " 3,257,143 = 1,805 The Economic Order Quantity would be a batch size of 1,805. In practice the company might choose a batch level of 1,800 units. Using the Economic Order Quantity to estimate the minimum Total Stock Cost pa. [ OC ] Order Cost Economic Order size (units) = 1,805 No of orders = (60,000/1,805) = 33 Order Cost (33 x 95) = 3,135 [ HC ] Holding Cost Average Stock (Order Size / 2) = 903 Stock Holding Cost (903 x 3.50) = 3,160 [ TC ] Total Stock Cost pa (minimum) = 6,295



Solution 2 contd., (c) Should the company extend its credit period to 60 days ? (5 marks) * Tutor’s note: Your chosen LAYOUT should clearly identify the RELEVANT INCREMENTAL CASH FLOWS BEFORE …….Change in Credit Policy Existing Policy Credit Terms offered to Customers 30 days Actual Credit Taken in days 45 days Average Debtor Balance in B/S pa - 40 million x 45 ÷ 365 $4,931,507 Cost of Financing $4,931,507 on average per annum @ 16% $789,041 Total Cost of Existing Policy pa $789,041 *Tutors Note: Assuming the16% Return on Investments is the appropriate cost of capital in this instance- for example, equivalent perhaps to the Bank Overdraft Rate AFTER …….Change in Credit Policy New Policy Average Debtor Balance in B/S pa - $40 million x 1.19 x 60 / 365 $7,824,657 Cost of Financing $7,824,657 @ 16% $1,251,945 Cost of additional internal credit control procedures $190,000 Total Cost of New Policy pa $1,441,945 Incremental Cash Flows (Costs and Savings under New Policy) Increase in credit control system costs (1,441,945 – 789,041) $652,904 Increase in Contribution earned (40 million x .19 x .10) $760,000 Net Change (BENEFIT) in Cash Flows under New Policy $107,096 DECISION ACCEPT NEW POLICY



Solution 3 Foreign Exchange & Interest Rate Risk Management


Chapter 21 Forecasting Foreign Currency Exchange Rates Chapter 22 Foreign Exchange Risk Management

Chapter 23 Interest Rate Risk Management Solution 3 (a) Write a report to the Group Treasury Manager advising, with explanations, what

options are available to the UK company wishing to reduce it’s FX Risk (In your answer consider the relevance of some or all of the INTERNAL and/or EXTERNAL hedging techniques available in this instance) (7 marks) Report To: From Date Subject Options available for reducing Transactions Risk Exposure Generally, FX risk is categorized as follows: Types of Foreign Exchange Risk Transactions Risk / Exposure Translation Exposure It is these 3 you need to Economic Exposure be most clear on for F9 Contingent Exposure Political Risk Exposure UK company is facing risk from Transactions Exposure and is advised to take cover accordingly. This particular type of forex risk may be explained as follows: Definition arises when you have short-term assets or liabilities denominated in a foreign currency (ie.Debtors and/or Creditors). Therefore, it arises from Importing / Exporting …on credit in the foreign currency! Protection? You protect against TRANSACTION RISK by adopting a hedged position – ie. entering into a counter-balancing contract (asset or liability) to off-set the risk/exposure.



* Tutor’s note: In your Exam answer………consider the relevance of some or all of the INTERNAL and/or EXTERNAL hedging techniques as follows: Depending on the type and size of company involved, together with the nature of the exposure, there are a number of hedging techniques available as follows: Internal Hedging Devices Foreign Exchange Risk Management within a Group =>’s

• Invoice in home currency • Foreign Currency Overdraft – saves on transaction costs • Leading & Lagging – refers to “speeds of settlement” - lead and lag inter-

company payments • Netting - Bi-lateral netting (2 parties independently)

- Multi-lateral netting ! arranged through Central Treasury ! Base currency established ! Positions netted

You net inter-company debts (Multi-Lateral Netting / Bi-Lateral Netting) or net- off individual $ receipts against individual $ payments, so that you are only at risk on the Net Amounts. • Matching - match Income & Expenses / Receipts & Payments / Assets &

Liabilities in the same Currency (Natural v Parallel Matching).

* Tutor’s note: For example, say company has income each year in a foreign currency ($’s), then it makes sure it creates an expense / liability in the same currency (say, buys goods from America or borrows money in $’s rather than the home currency and so has an interest expense / liability in $’s) - so as it’s income goes up and down so also does its expense go up and down in tandem with the same movement in the $ exchange rate…. and in this way the exposure is off-set or reduced. Netting and Matching are terms that are frequently used inter-changeably, although there are distinctions – strictly speaking netting is a term applied within a group context whereas matching can be applied both intra-group and third- party balancing.

! Adjust contract prices to forward rate. External Hedging Devices

• Forward Contracts – over the counter and normally 1,3,6,12 month contracts Normally, 2 Types (1) Fixed Forward Contract (F/R, F/D, F/A) and (2) “Forward Option Date Contract” (F/R, F/A, Option on the Dates).



The key features of Forward Contracts are: - Fixed Forward Contract (Fixed Rate / Fixed Date / Fixed Amount). - OTC deal … over the counter with a bank - Tailor made … any amount, any currency, any date - Binding obligation - Forward "Option Date Contract" - (sell @ 2 days notice @ fixed rate between any 2 dates).

• Money Market Hedge - short term foreign currency Loans and/or Deposits

- Applies the “Matching Principle” to Hedge Forex Risk – Match asset with liability and vice versa. * Tutor’s note: Whether the exposure arises on foreign currency Debtors or Creditors, the key features of a Money Market Hedge and the mechanics involved are listed below under Part b.

• Foreign Currency Futures … are a traded derivative Tutor’s note: Whether the exposure arises on foreign currency Debtors or Creditors, the key features of a Futures Market Hedge are listed below in Part c. • Foreign Currency Options - OTC or Traded (on a Futures Exchange).

Currency Option Contracts “The Right … but not the Obligation” Tutor’s note: remember that what is important here for the F9 Exam is to be able to describe and outline the key features of the two main types of Currency Option Contracts … i.e. OTC and Traded contracts. What follows is a brief tutorial on options which I trust will enhance your understanding and preparation for the exam. Currency Option Contracts are particularly useful for contingent situations as discussed below (ie when faced with a Contingent Exposure – the exposure is not certain). There is UNCERTAINTY as to whether the foreign exchange transaction will materialize or not. As an example, just consider Bidding / Tendering for an overseas contract. Or, imagine having to publish Price Lists in a foreign currency. You can hedge (take cover!) in a situation like this using a “Currency Option Contract”. You only use an option to stop you from making an exchange loss – the Currency Option “fixes” your maximum currency loss => the PREMIUM or COST of the option.. If you are going to make an exchange gain you ABANDON the option ! Options allow companies to benefit from favorable movements in the exchange rate – ie. profit from an Appreciating (strengthening) or Depreciating (weakening) currency. !Definition: An option gives you the right but not the obligation to buy/sell the foreign currency at a given price.



Fx Risk when Bidding for an Overseas Contract:

January March June December Invited to bid for a

US Contract Bids must be

submitted The contract is

awarded Payment is made

As soon as you put in the bid you are exposed to uncertainty about how much

sterling you will receive in December.

How do you hedge this contingent exposure to f/x risk? Tutor’s note: You can’t use the normal hedging techniques because the exposure is not certain i.e. it’s contingent (on winning the contract). Answer: We can hedge through using a “Currency Option Contract” Currency Option Contracts: 2 Types of contract:

• Over the Counter Option - OTC. • Traded Currency Option ~ is a standardized deal

What do we mean by OTC?

• A tailored made deal – “negotiated options” – any amount, any date, any agreed price

• Over the counter from the bank. eg. Nat West , Barclays, etc. • 2 types of OTC option contracts.

- Call option. (Buy) - Put option. (Sell) Call option: An option to buy a specific amount of currency at a specific rate (strike price or exercise price) of exchange on a specific future date (expiry date). The specific rate of exchange is known as the exercise or strike price of the option. The specific future date is known as the expiry date. Put option: Is an offer to sell a specific amount of currency, at a specific rate of exchange on a specific future date. Option Premium: The cost of buying the Call or the Put option .... the Initial (upfront) Fee # Expensive … represents the most the BUYER of the option can lose.

• Foreign Currency Swaps

* Tutor’s note: There is an excellent description, with an example, of the key features of Currency Swaps contained in Chapter 22 of the OpenTuition.com Course Notes. However, a brief summary of the key features of currency swaps is as follows:



Definition of Currency Swaps: - are contracts to exchange cash flows, relating to Debt obligations, in one currency for that of another – Principal and Interest payments. - Unlike an Interest Rate Swap, there is an exchange of Principal (either Notional or - Physical) at the beginning and end of the contract. - Useful for medium to long-term hedging Procedure - Exchange of Principal at spot, either notional or physical, in order to provide the basis for computing interest. - Exchange of Interest streams thereby avoiding forex risk on respective interest payments. - Re-exchange of Principal on terms agreed at the outset. * Tutor’s note on Transaction Exposure: Finally, a further option when considering what action to take so as to hedge against transaction exposure is to “Do Nothing” - not to adopt a hedged position … but this policy may conflict with “Good Corporate Governance” and the perceived Role of the Corporate Treasurer vis his duty to protect the interests of various stakeholders of the company. Solution 3 contd., (b) Calculate the outcome if using a Forward Market hedging technique (3 marks) Establish Net FX Exposure: Typically, this can be achieved on a multi-lateral basis between subsidiaries. Receives $1m Pays $0.6m Net exposure $0.4m Forward Market Hedge Fixed Forward Contract (Fixed Rate / Fixed Date / Fixed Amount). Sell $0.4m 3 months fwd @ 1.8270 ! 0.4 m / 1.8270 = £218,938 (receivable in 3 months)



Solution 3 contd., (c) Calculate the outcome if using a Money Market hedging technique (5 marks) Money Market Hedge * Tutor’s note: Applies the “Matching Principle” to hedge Forex Risk – Match asset with liability and vice versa. An exporter (=>’s Debtor) who invoices in a foreign currency can:

! Borrow “x” in the foreign currency now…. ( Borrow ”x” in $’s now ) ! Convert now the foreign currency borrowed into the domestic currency at the spot

rate …. ( Convert to £’s now ) ! Repay the foreign loan and interest out of the foreign proceeds received from the

Debtor ! Add the Deposit Interest earned in £’s

* Tutor’s note: An importer (=>’s Creditor) who has to make a foreign currency payment in the future can:

! Borrow “x” in £’s now ! Convert to $’s now ( Buy the foreign currency now ) ! Put it on Deposit in the foreign currency ($’s) ! The interest and principal deposited should be enough to repay the amount due in

the foreign currency In both cases you will have to work backwards to figure out the amount to lend/borrow. We have a $0.4m asset that matures in 3 months time ! we need to create a liability of $0.4m that will also mature in 3 months time ! the steps to follow are as follows: Borrow $X from the bank …. for 3 months. - $ loan rate p.a. = 14% - Borrow $X from bank for 3 months @ 14/4 = 3.5% so that: - $X (1 + 0.035) = $400,000 - $X = 400,000/1.035 = $386,473 Meanwhile, sell @ spot and buy £. - $386,473/1.8020 = £214,469 (received now) * Tutor’s note: Question - which is the better hedge (Forward Market or Money Market ) ? NOW 3 MTS. TIME Fwd market hedge £218,938 Money market hedge £214,469



Answer - Notice that the 2 results are not strictly comparable. ! We need to consider the time value of money - i.e. whether to compound forward or discount back to now (to). The convention is to compound forward using the appropriate deposit interest rate given in the question ( = 10% ). - 10% / 4 = 2.5% qtr. - £214,469 x 1.025% = £219,831 …. receivable in 3 months time Conclusion: The Money Market hedge (£219,831) is better than the Forward Market Hedge (£218,938) in this instance….from a strictly financial point of view. But, transaction cost differentials between the two mechanisms have been ignored. In Practice, there is not much difference between the two BECAUSE the forex markets are efficient … the interest rate differential is reflected in the forward rate. Solution 3 contd., (d) Outline the key distinguishing characteristics of a Futures Market Contract and a Forward Market Contract. (5 marks) Forward Market Hedge –v- Futures Contract Forward Market Hedge The key features are:

! Fixed Forward Contract (Fixed Rate / Fixed Date / Fixed Amount). ! OTC deal … over the counter with a bank ! Tailor made … any amount, any currency, any date ! Binding obligation ! Forward "Option Date Contract" - (sell @ 2 days notice @ fixed rate between any

2 dates). Futures Market Hedge * Tutor’s note: a Futures Market is an exchange market for the trading (purchase or sale) of a standard quantity of “underlying” item such as a currency, a commodity, or shares) for settlement at a future date, at an agreed price. ! How to Hedge in the case of foreign currency ? You are “fixing” the exchange rate in advance by entering into a “counter-balancing” arrangement to the underlying transactions exposure (ie. an opposite asset or liability). The key features are:



! Exchange traded “Instrument” # LIFFE or CME (Chicago Mercantile Exchange, which has a London office

! Binding Obligations ! Fixed Contract Size # Standardised Deal # Cheaper transaction costs The futures have to be bought in standard amounts (standard amount of currency). ! Contract Price # all currency futures are denominated in US Dlrs ! Limited range of currencies available # only the major currencies are available for futures trading – about 10 / 12 in all as there is little demand for other currencies

# $/£ => Sterling Contract £62,500 # $/SFR => Swiss Franc SFR125,000 # $/" => Euro contract "125,000 # $/* => Yen contract *12,500,000

! Time Periods # only 4 time periods forward available (Settlement Dates / Expiry Dates / Delivery Dates / Maturity Dates)… and it is on these dates that all futures trading on a particular contract stops - and all accounts must be settled. These are the 3rd Wednesday in March, June, September & December.

* Tutor’s note: But remember, the “Futures Exchange” prices and trades these futures on a daily basis which is what makes these derivatives useful as hedging techniques (or as instruments for speculation!). ! Whole Contracts # can only deal in whole number of contracts. ! Basis Risk # The Futures Contract Price and the Spot exchange price may not

move by exactly the same amount by the time the Contract is “closed-out” => leads to basis risk

! Margin 2 types # Initial Margin (when contract is taken out) # Daily Variation Margin (as the Contract fluctuates)

! Tick Size # the smallest measured movement in the Contract Price. For currency futures this is the movement in the fourth decimal place.

* Tutor’s note: Market Traders compute gains or losses on their futures positions by reference to the number of ticks by which a contract price has moved. For example, the standard size of a 3 month ! futures contract is !125,000. Tick Size? => The minimum price movement (i.e. .0001 ) x by 125,000 = $12.50 ! “Ticks” are just another name for “Basis Points”. ! A perfect Hedge? # “whole contracts” => that there are often “un-hedged” or

unmatched amounts (or amounts that need to be hedged separately). ! Technically complex # Difficult to understand !may only suit larger

companies with specialist Corporate Treasurers employed. Also, the Contract Size only suits larger companies.

* Tutor’s note: Back to Example … Are we buying or selling contracts? Look at cash markets " we will be receiving $400,000 in 3 months time ! we will be selling dollars and buying sterling in 3 months time. Therefore, hedge now by buying the



sterling now …BUY sterling futures now " counter balancing liability to be settled later when we “close-out” the deal. * Tutor’s note: Futures Market Hedge – A NUMERIC question will NOT be asked in the F9 Exam. BUT a theory question as just described above is very possible! Solution 3 contd., (e) Corporate Treasury has a number of rolling loan facilities in place with a variety of banks. A requirement has now (July) arisen whereby Treasury will need to drawdown $5 million in 3 months time. Consequently, Treasury have negotiated with one of their banks an FRA 3 – 6 on $5 million at 5.75 – 5.50. Required: Calculate the result of the FRA & the effective loan rate if the 3 month FRA benchmark rate has moved to (i) 5.25 % & (ii) 8.50 %. Describe alternative Internal & External interest rate hedging techniques available. (5 marks) Calculate the result of the FRA @ 5.75% At 5.25% the actual interest rate on the underlying loan has fallen below the FRA. UK Co will therefore pay the bank: $ FRA payment $5 million x (5.75% - 5.25%) x 1/4 6,250 Payment on underlying loan 5.25% x $5 million x # 65,625 Net payment on loan 71,875 Effective interest rate on loan 5.75% At 8.50% the actual interest rate on the underlying loan has risen above the FRA. Bank will therefore pay the company: $ FRA payment $5 million x (8.50% - 5.75%) x 1/4 (34,375) Payment on underlying loan 8.50% x $5 million x # 106,250 Net payment on loan 71,875 Effective interest rate on loan 5.75%

Describe alternative Internal & External interest rate hedging techniques available * Tutor’s note on: Interest Rate Risk Management Interest Rates Definition … are effectively the “prices” governing Lending and Borrowing.



Interest Rate Risk Definition – The risk of incurring losses due to adverse movements in interest rates. – The risk that Borrowing Costs may rise or Deposit Income fall … as a result of adverse movements in interest rates. Implications of Interest Rate Changes Changes in Interest Rates can affect: o The sensitivity / volatility of profit and cash flows. o Operating Cash Flows & Profits (EAT / EPS / MPS) o Cost of Capital ( Ke, KDAT, WACC ) … the Discount Factor (df) used for Investment

Appraisal decision making Interest Rate Hedging Techniques ? Internal Methods o Matching … assets and liabilities with a common interest rate are matched (=> used

by Banks) o Smoothing …. is where a company maintains a balance of between its Fixed and

Floating rate borrowing. External Methods o FRA o IRF o IRG (OPTIONS) - Cap - Collar - Floor o IRS (SWAP) * Tutor’s note on: see Chapter 23 of the OpenTuition.com Lecture Notes for a list of the key features of each of these hedging techniques.



Solution 4 Capital Budgeting & Investment Appraisal

Before attempting this question you are advised to have carefully revised the following chapters in the OpenTuition.com Course Notes

Chapter 2 The Financial Management Environment Chapter 7 Investment Appraisal - methods Chapter 8 Relevant Cash Flows for DCF

Solution 4 (a) Calculate the payback & discounted payback periods for each project (6 marks) Payback A: 3 + 350 – 319 => 3 + 31 => 3.29 years ** 107 107 B: 3 years C: 2 years *** Workings – Understanding Payback Tutor’s note: The following headings & layout provide a useful basis for understanding the payback model and for learning a STRUCTURED approach to its calculation. Of course in the exam, you need to carefully watch your time and so short cuts (like above) are necessary too. Project A: Initial Investment ($ 000’s) 350 Periodic Cumulative Net Cash Flows ($) NCF’s NCF’s Year 1 95 95 2 115 210 3 109 319 Project pays for itself 4 107 426 between years 3 & 4 - 5 143 569 as above, it is 31/107 6 160 729 x by the full year 4 c/f 7 175 904 => 3.29 years ** 904 Discounted Payback Tutor’s note: To calculate the discounted payback period for each project you will first of all need to derive the Present Values of the periodic Net Cash Flows outlined above.



These Present Value calculations normally form part of a standard NPV calculation and so will usually appear as a separate line item within your normal NPV “Table of Relevant Cash Flows” If you have read the requirements of question 1carefully in full before commencing your answers you will have noticedwhile doing your overall ANSWER PLAN that NPV calculations are an implicit, yet essential, requirement of your answer to Part(C)…… so why not leave enough space on your answer sheet here and skip over the calculations of discounted P/B until you have first of all derived the Present Values of the Net Cash Flows for each project under Part (C). Then come back here to complete your answer to Part (a). Here now are the discounted payback calculations assuming you followed this approach: Discounted Payback A: 5 + 350 – 329.89 => 5 + 20.11 => 5.38 years *** 52.80 52.80 B: 4 + 350 – 345.60 => 4 + 4.40 => 4.07 years 66.00 66.00 C: 2 + 350 – 268.80 => 2 + 81.20 => 2.57 years 141.65 141.65 *** Workings – Understanding Discounted Payback Tutor’s note: As with the normal payback calculation outlined above, the following headings & layout provide a useful basis for understanding the discounted payback model and for learning a structured approach to its calculation. Project A: Initial Investment ($ 000’s) 350 Periodic Cumulative Present Values ($) PV’s PV’s Year 1 78.85 78.85 2 79.35 158.20 3 63.13 221.33 Project pays for itself 4 51.36 272.69 between years 5 & 6 5 57.20 329.89 - it is 20.11 / 52.80 6 52.80 382.69 x by full year 6 dcf 7 49.00 431.69 => 5.38 years *** 431.69



Solution 4 contd., (b) Calculate the accounting rate of return (ARR) for each project (4 marks) Tutor’s note: Firstly, in the exam, you should define ARR. Normally, you have 2 choices as follows: Definition: Average Annual Profit or Average Annual Profit Average Investment *** Initial Investment *** Average Investment = Initial Investment + Residual Value 2 Tutor’s note: Read the question carefully, but ordinarily it doesn’t matter which one you use so long as you are consistent in your comparisons between firms in the same industry, overtime or between budget and actual, etc., Having said that, you will have noticed from the F9 past papers that your examiner has favored the “average investment” method. Initial Average Project A: (904 – 350) / 7 = 79.14 = 23% 79.14 = 45% 350 – 0 350 175 Project B: (770 – 350) / 5 = 84.0 = 24% 84.0 = 48% 350 – 0 350 175 Project C: (630 – 350) / 4 = 70.0 = 20% 79.14 = 40% 350 – 0 350 175 *** Workings – Understanding ARR Tutor’s note: The following headings & layout provide a useful basis for understanding the ARR model and for learning a structured 2- step approach to its calculation. Again in the exam you need to carefully watch your time and so short cuts (like above) are necessary too. Project A: Step1 Average Annual Profit Total Net Cash Flows 904 Less: Depreciation 350 (Cost 350 minus zero ScrapValue) Equals Total Profit 554 ÷ No. of Years 7 Equals Average Profit pa 79.14



Step 2 Average Investment Initial Investment 350 Plus: Residual Value 0 Total Investment 350 Average Investment ÷ 2 175 ARR = 79.14/175 x 100 = 45% Solution 4 contd., (c) Prepare a report for the chairman with supporting calculations indicating which project should be preferred by the ordinary shareholders of OTP Plc. (10 marks) Tutor’s note: As in every exam question, there will be sections/parts which not only test your knowledge of a particular syllabus area but also IMPORTANTLY your ability to PLAN YOUR ANSWER in a way that logically provides a MARKING SCHEME back to the MARKER. Producing an ANSWER PLAN in this way is a hugely important element of EXAM TECHNIQUE and if you practice the following approach, not only in F9 but also your other ACCA subjects as well, you could see your success in the ACCA exams improve significantly! In a nutshell, this is applied “MARK - TIME – AWARENESS”. So your ANSWER PLAN will need you to quickly think about a suitable approach or answer STRUCTURE…using appropriate HEADINGS and then suitable POINTS within each heading. In this way you have developed a successful MARKING SCHEME to progress your answer to the question. PRACTICE, practice and then practice this approach using the past ACCA exam questions and it will become more automatic for you after awhile! So, my suggested approach to this question is as follows (bearing in mind that there is no universally correct answer): N.B> I am giving you an idea about how to structure an Answer Plan here … so relax, you would not be expected to do all of the following within the exam time constraints to earn the 10 marks available! Approach to developing an ANSWER PLAN: Imagined Marking Scheme (1) Correct NPV calculations – A, B, C 3 marks (2) Tabulate results of the various appraisal techniques in the question so far – ARR, IRR, P/B, Discounted P/B 1 mark (3) Report Format 2 marks (4) Favor Project with highest NPV! 1 mark (5) Define and Explain NPV 2 marks (6) Advantages of NPV 1 mark (7) Disadvantages of ARR, P/B, IRR, etc., 3 marks (8) etc., etc., etc., (9) Conclusion 2 marks Potential (you need 10 marks) Circa 15 marks



Workings…..(Appendix 1 to Chairman’s Report) (1) NPV Calculations – Projects A, B C: Project A: Table of Cashflows to t1 t2 t3 t4 t5 t6 t7 NCF -350 95 115 109 107 143 160 175 Df@20% 1.0 .83 .69 .58 .48 .40 .33 .28 PV -350 78.85 79.35 63.13 51.36 57.2 52.8 49.0 NPV 81.69 Project B: Table of Cashflows to t1 t2 t3 t4 t5 t6 t7 NCF -350 35 105 210 255 165 - - Df@20% 1.0 .83 .69 .58 .48 .40 .33 .28 PV -350 29.05 72.45 121.7 122.4 66.0 - - NPV 61.60 Project C: Table of Cashflows to t1 t2 t3 t4 t5 t6 t7 NCF -350 195 155 245 35 - - - Df@20% 1.0 .83 .69 .57 .48 .40 .33 .28 PV -350 161.85 106.95 141.65 16.8 - - - NPV 77.25 (2) Tabulation of Results – Projects A, B C: - DCF Techniques - - Non-DCF Methods - NPV IRR Discounted ARR Payback Payback Project A: 1 2 3 2 3 Project B: 3 3 2 1 2 Project C: 2 1 1 3 1 Tutor’s note: As expected, each DCF and Non-DCF method produces a different result (recommendation). After all this is hardly surprising, as each model is based on different assumptions and so will naturally produce different outcomes. So how do you deal with this apparent CONFLICT ? Your answer will ALWAYS favor NPV … therefore your recommendation to the Chairman will be Project A! This is a crucially important underlying assumption of the entire F9 syllabus – we assume throughout the syllabus that our KEY primary corporate objective is the



MAXIMIZATION of SHAREHOLDER WEALTH. It is important to understand that this is a THEORETICAL objective and essentially a FINANCIAL objective and so the model or the theory explicitly ignores all NON-FINANCIAL FACTORS or what we often call QUALITATIVE FACTORS. So in a nutshell, there is no need for confusion as your answer will always be based on the assumed objective of financial management … which is assumed to be the “maximization of shareholder wealth”. In the exam therefore you can gain easy marks by always qualifying your answer and outlining the point that your recommendation to the chairman ignores all relevant non-financial or qualitative factors! This then brings us logically to point (5) in our Answer Plan. (5) Define NPV DEFINITION (i) In theory, NPV represents the immediate increase in wealth as a result of acceptance of a project (ii) NPV also represents the amount over and above the cost of the project that you could borrow and know that the net cash inflows from the project will be sufficient to repay the whole loan Tutor’s note: Via this definition you are providing the Chairman with the theoretical basis underlying your recommendation and ultimate choice of Project A (6) Advantages of NPV Tutor’s note: By outlining some of the key advantages of NPV you are providing further support to your choice of project A (your recommendation to the Chairman). In addition to NPV’s link with the assumed theoretical objective of Financial Management - the Maximization of Shareholder wealth – NPV also: - considers the time value of money - is an absolute measure of return. - is based on cash flows not profits. - considers the whole life the project. Tutor’s note: You would of course explain to the Chairman the significance of each of the above advantages (7) Disadvantages of ARR, P/B, IRR, etc., Tutor’s note: By outlining some of the key dis-advantages of IRR, ARR and Payback you are providing yet further support to NPV and your choice of project A (your recommendation to the Chairman).



DEFINITION of IRR IRR is that Rate of Discount or Cost of Capital at which the NPV is Zero – which implies the investment must be earning exactly that % return. (IRR is the highest Rate of Interest at which you can borrow money and know that the cash flows from the project will repay the whole loan) DISADVANTAGES of IRR (i) IRR can not cope with Different Sized Projects - project A cost (1k) / NPV +1k / IRR 20% - project B cost (10k) / NPV +12k / IRR 19%. Common sense suggests you would prefer B to A but A has the higher Internal Rate of Return! Therefore, IRR can not cope with different sized projects. (ii) Interpolation only provides an estimate. (iii) Fairly complicated to calculate - even though spreadsheets have in-built programs. (iv) Multiple Yield Problem (v) Non-conventional cash flows may give rise to multiple IRRs. That is, it is possible to find individual projects with more than one IRR (vi) Re-investment Assumption - The “NPV Rule” assumes that the Cost of Capital is the “Opportunity Cost of Capital”…which is a sensible re-investment assumption. The “IRR Rule” assumes re-investment of individual cash flows can take place at the IRR rate….not a sensible re-investment assumption. DEFINITION of ARR Measures the impact of an investment on short-run reported accounting profits…. (not a Cash Flow Model) DISADVANTAGES of ARR (i) ARR ignores the time value of money. (ii) Based upon (subjective) accounting profit - Profit is an ambiguous concept and is unlikely to provide a suitable basis for Decision Making (examples; Accounting Policies, Depreciation, Stocks, Overhead Absorption Rates, Notional Management Charges, Transfer Pricing, etc., ) (ii) It is not an absolute measure of return. DEFINITION of PAYBACK Payback represents the number of years it takes to recover the cost of the project from the cash flows it generates (a cash flow model – Costs v Benefits = Cash Surplus or Deficit)



DISADVANTAGES of PAYBACK (i) Ignores the time value of money (ii) Ignores cash flows after the payback (iii) There is no measure of return. (iv) Can lead to Sub-optimal Decision Making - Payback can make sense and be logical when funds are constrained. But when funds are NOT constrained it can lead to sub-optimal decisions being taken through too much focus on the short term and not the long-term profitability of the company. (9) Conclusion Advise proceeding with Project A on the basis of NPV but with RESERVATIONS – for example, NPV ignores the impact of decisions on short-run reported profits. Tutor’s note: To explain, according to NPV, all anybody is interested in is a forecast of expected future cash flows. But in practice this ignores the impact of decisions on Short-Run reported profits and in practice SR profits are of immense interest to Management, Shareholders and the Stock Market alike………which is one reason why ARR has such value). There are however difficulties with NPV. For example, (i) NPV is not easily explained to managers. (ii) Relatively complex. (iii) Requires that the rate of interest (or cost of capital) is known….. and we know that it is virtually impossible to accurately determine the cost of capital for a company, let alone use it to discount future (uncertain) cash flows in an economy comprising massive uncertainty & changing interest rates every other month – look at the last 3 months alone for example! (iv) Ignores many non-financial (qualitative) considerations. Finally, in practice most companies will probably be pursuing a multitude of objectives…. and indeed this point alone is the source of much conflict among participating groups and stakeholders. But in the absence of any additional information to the contrary Project A is to be recommended because as outlined above the project with the highest NPV enjoys strong theoretical support.



Solution 4 contd., (d) Discuss Michael’s view about stock market efficiency that is implicit in his

interest in the short-term accounting profits and the market price per share of the company. (5 marks)

Developing an ANSWER PLAN: Imagined Marking Scheme (1) Define Stock Market Efficiency 1 mark (2) Levels of Efficiency 3 marks (3) Conclusion 2 marks Definition of the EMH Market efficiency refers to the SPEED & ACCURACY with which all relevant INFORMATION is REFLECTED in the SHARE PRICE as it becomes AVAILABLE. Levels of Efficiency (i) Weak Form EMH (ii) Semi-Strong Form EMH (ii) Strong Form EMH (i) Weak Form EMH Weak Form Efficiency implies that share prices fully reflect all the information that is available from an historical analysis of the past movements in share prices. The process of ‘Chartism’ or ‘Technical Analysis’ is very popular among some professional investors (called chartists) and involves charting the past movements of a share and trying to extrapolate potential future movements from this chart. However, the general consensus is that you cannot predict future share price movements from a study of past movements. Thus share prices in effect are said to follow a random walk. That is, that the market is what is termed ‘Weak-Form Efficient’ (ii) Semi-Strong Form EMH Semi-strong efficiency proponents believe that all publicly available information is completely, rapidly and unbiasedly reflected in share prices. Thus, there is nothing to be gained in terms of discovering under-priced shares from an analysis of publicly available data such as accounting reports, industry reports etc. Since past price data is publicly available information, the market must be weak form efficient in order to be efficient in the semi-strong form. The activity of using publicly available information to find under-priced shares is termed Fundamental Analysis or Security Analysis. Practicing Fundamental



analysts generally believe that the market is not fully efficient in the semi-strong sense. (iii) Strong Form EMH Strong-form efficiency refers to all available information - both PUBLIC and PRIVATE. If the market is efficient in the strong sense, all information, public or private is reflected in share prices and you could not make a profit from even privately held information. To be efficient in the strong form, the market would also have to be efficient in the Weak and Semi-Strong forms. It would be virtually impossible for the market to be completely strong form efficient otherwise share dealers would have to react to information which they were unaware of. Conclusion There are many possible reasons why Michael wishes to see the accounting profits and the share price trading as high as possible in his third and final year with the company. His remuneration may be tied to relative share price performance through a share option scheme or a share bonus scheme. His future employment prospects may depend very much on these factors also. Whatever the precise nature of his motivations Michael’s strategy is based on the belief that the market is Semi-Strong Efficient and that it is NOT Strong Efficient. Michael believes that under the semi-strong form the market will quickly and accurately digest the publication of any increase in accounting profits or EPS and that this information will in turn lead to a rapid increase in the prevailing market price per share. Michael believes that the stock market doesn’t have access to all information even in a Semi-Strongly Efficient market and so it will read a lot into things like: - Increases in Accounting Profits - Increases/decreases in EPS or Dividends - Rights Issues, and so on… He may believe that the market is not completely efficient to see though any Window dressing of the accounts that might be undertaken.

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