study question bank - Becker Professional Education

Transcription

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December 2014–June 2015 Edition
STUDY QUESTION BANK
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ACCA
Paper F9 | FINANCIAL MANAGEMENT
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ACCA
PAPER F9
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FINANCIAL MANAGEMENT
STUDY QUESTION BANK
For Examinations to June 2015
®
©2014 DeVry/Becker Educational Development Corp. All rights reserved.
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STUDY QUESTION BANK – FINANCIAL MANAGEMENT (F9)
CONTENTS
Question
Page
Answer
Marks
MULTIPLE CHOICE QUESTIONS
The Financial Management Function
The Financial Management Environment
Investment Decisions
Discounted Cash Flow Techniques
Relevant Cash Flows
Applications of DCF Techniques
Project Appraisal under Risk
Equity Finance
Debt Finance
Security Valuation and Cost of Capital
Weighted Average Cost of Capital and Gearing
Capital Asset Pricing Model
Working Capital Management
Inventory Management
Cash Management
Management of Accounts Receivable and Payable
Risk Management
Business Valuation and Ratio Analysis
1
1
2
3
5
8
9
10
11
12
14
17
19
20
21
22
24
25
1001
1001
1001
1002
1003
1005
1006
1007
1007
1008
1009
1010
1010
1011
1012
1012
1013
1014
10
10
12
20
20
10
10
10
10
20
16
12
14
10
10
12
12
20
28
1015
10
28
28
1016
1017
10
10
28
1018
12
29
30
31
31
31
1019
1022
1024
1024
1025
18
30
12
4
13
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1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
THE FINANCIAL MANAGEMENT FUNCTION
Private and public sector objectives
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1
THE FINANCIAL MANAGEMENT ENVIRONMENT
2
3
Capital market efficiency
Corporate governance
INVESTMENT DECISIONS
4
Elvira Co
DISCOUNTED CASH FLOW TECHNIQUES
5
6
7
8
9
Khan Co
Discounted cash flow
Gerrard
Despatch Co
Carter Co
RELEVANT CASH FLOWS FOR DISCOUNTED CASH FLOW TECHNIQUES
10
11
12
Blackwater Co (ACCA D97)
ARG Co (ACCA D04)
BFD Co (ACCA D05)
32
33
36
1026
1027
1030
20
31
45
(iii)
FINANCIAL MANAGEMENT (F9) – STUDY QUESTION BANK
Question
Name or subject
Page
Answer
Marks
APPLICATIONS OF DISCOUNTED CASH FLOW TECHNIQUES
13
14
15
16
17
Sticky Fingers Co
Taleb Co
Stan Beldark
Armstrong Co
Sassone Co (ACCA D04)
38
38
39
40
41
1034
1036
1037
1038
1040
13
10
10
20
38
43
1043
10
PROJECT APPRAISAL UNDER RISK
Sensitivity analysis
EQUITY FINANCE
19
20
Moorgate Co
Greiner Co
DEBT FINANCE
21
22
23
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18
Mr Fidelio
Equity and debt issues (ACCA D03)
Hendil Co (ACCA D06)
43
44
1044
1046
25
12
44
45
45
1048
1049
1051
10
16
50
47
48
1056
1058
15
20
49
50
1061
1064
20
15
51
52
53
1066
1068
1071
25
20
30
56
57
1073
1074
10
6
57
58
1075
1076
10
10
58
1077
20
SECURITY VALUATION AND THE COST OF CAPITAL
Cost of capital
Kelly Co
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24
25
WEIGHTED AVERAGE COST OF CAPITAL AND GEARING
26
27
Redskins Co
Berlan Co
CAPITAL ASSET PRICING MODEL
28
29
30
Crestlee Co (ACCA D92)
Wemere (ACCA J90)
Guidance manual
WORKING CAPITAL MANAGEMENT
31
32
Mugwump Co
Dire Co
INVENTORY MANAGEMENT
33
34
Wagtail Co
Tipex Co
CASH MANAGEMENT
35
(iv)
Mr Colorado
Question
Name or subject
Page
Answer
Marks
MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE
36
37
38
39
Worral Co
Moore Co
Frantic Co
Merton Co (ACCA J06)
59
61
61
63
1079
1081
1083
1088
20
12
50
50
66
66
67
68
69
1094
1095
1097
1098
1101
10
16
12
40
10
69
71
74
1102
1107
1109
30
25
12
76
76
76
76
77
77
1111
1112
1113
1114
1117
1118
10
10
10
10
10
10
78
1120
8
78
1120
10
78
79
79
79
80
1123
1124
1126
1128
1139
15
10
15
15
5
RISK MANAGEMENT
Fourx Co
Storace Co
Three small companies (ACCA J93)
Vertid (ACCA J95)
Omnitown Co (ACCA D91)
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40
41
42
43
44
BUSINESS VALUATION AND RATIO ANALYSIS
45
46
47
British Industrial Group
Twello Co
Salween
FURTHER PRACTICE QUESTIONS
THE FINANCIAL MANAGEMENT FUNCTION
Non-financial objectives (ACCA D01)
Stakeholders (ACCA D02)
Corporate governance (ACCA D02)
RZP Co (ACCA J05)
GGG Co (ACCA J09)
Management remuneration (ACCA J05)
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48
49
50
51
52
53
THE FINANCIAL MANAGEMENT ENVIRONMENT
54
Monopoly (ACCA D03)
INVESTMENT DECISIONS
55
ARR and Payback (ACCA J00)
DISCOUNTED CASH FLOW TECHNIQUES
56
57
58
59
60
Charm Co (ACCA J06)
Investment appraisal methods (ACCA J06)
Duo (ACCA D07)
SC Co (ACCA J08)
NPV and shareholder wealth (ACCA J08)
(v)
Question
Name or subject
Page
Answer
Marks
APPLICATIONS OF DISCOUNTED CASH FLOW TECHNIQUES
61
62
63
64
65
Bread Products
Leaminger Co (ACCA D02)
Capital rationing
AGD Co (ACCA D05)
Single and multi-period rationing (ACCA D06)
80
81
82
82
82
1130
1131
1133
1134
1136
10
15
10
15
10
82
83
1137
1137
5
15
84
85
86
87
88
88
89
1139
1141
1142
1144
1145
1146
1148
15
15
10
10
15
15
15
89
89
90
91
1149
1150
1152
1154
10
15
15
15
92
92
1155
1157
15
15
93
93
93
94
1158
1159
1160
1163
10
10
15
15
95
1164
15
96
96
96
1165
1166
1167
15
8
15
PROJECT APPRAISAL UNDER RISK
Risk and uncertainty (ACCA D04)
Umunat Co (ACCA D04)
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66
67
EQUITY FINANCE AND DEBT FINANCE
68
69
70
71
72
73
74
Arwin (ACCA J04)
Tirwen Co (ACCA D04)
Echo (ACCA D07)
Echo Echo (ACCA D07)
JJG Co (ACCA J09)
NG Co (ACCA D09)
Debt issue (ACCA D08)
COST OF CAPITAL AND GEARING
Dangers of high gearing (ACCA J04)
Oxfield Co
YGV Co (ACCA J10)
Close Co (ACCA D11)
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75
76
77
78
CAPITAL ASSET PRICING MODEL
79
80
Burse Co (ACCA J08)
Rupab Co (ACCA D08)
WORKING CAPITAL MANAGEMENT
81
82
83
84
Cash operating cycle (ACCA J04)
Level of current assets (ACCA J09)
Associated International Supplies
Anjo Co (ACCA D06)
INVENTORY MANAGEMENT
85
TNG Co (ACCA J05)
CASH MANAGEMENT
86
87
88
(vi)
Thorne Co (ACCA D05)
Optimal cash level (ACCA D06)
ZSE Co (ACCA J10)
Question
Name or subject
Page
Answer
Marks
MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE
89
90
91
Factoring and discounting (ACCA J09)
Overseas receivables (ACCA J09)
Gorla (ACCA D08)
97
97
97
1169
1170
1171
6
8
15
98
99
1172
1173
10
10
RISK MANAGEMENT
Interest rate management (ACCA J01)
Gitlor (ACCA D02)
BUSINESS VALUATION
Tundra (ACCA J03)
NGN (ACCA J09)
Phobis Co (ACCA D07)
THP Co (ACCA J08)
Dartig Co (ACCA D08)
99
99
100
100
101
1174
1174
1175
1176
1177
8
6
10
15
15
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94
95
96
97
98
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92
93
(vii)
STUDY MULTIPLE CHOICE QUESTION BANK – FINANCIAL MANAGEMENT (F9)
1
The Financial Management Function
1.1
Which of the following is NEVER consistent with the objective of maximising
shareholder wealth?
A
B
C
D
In which of the following principal/agent relationships is the principal named second?
A
B
C
D
1.3
Which of the following is a sign that a company is failing to maximise shareholder
wealth?
A
B
C
D
1.4
Shareholders and managers
Customers and the company
Shareholders and debt-holders
Employers and employees
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1.2
Following corporate social responsibility
Increasing sales levels
Satisficing
Paying dividends
Management has challenging performance bonuses
Investment decisions are evaluated on the basis of their net present value
The company has not diversified its operations
Financing of the company is via equity finance alone
Which of the following are not usually considered to be agency costs?
Costs associated with giving share options to managers
Costs of monitoring managers
Costs of obtaining a listing on the stock exchange
Costs of divergent behaviour by managers
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A
B
C
D
1.5
Which of the following is LEAST likely to solve the agency problem between
shareholders and managers?
A
B
C
D
Giving managers profit-related rewards
Using external auditors to gauge company performance
Writing restrictive covenants into bond contracts
Monitoring managers’ actions
2
The Financial Management Environment
2.1
Which of the following statements about interest rates is/are true?
(1)
In a period of high inflation, one would expect nominal interest rates to be higher
than in a period of low inflation.
(2)
Overdraft interest rates will normally increase in direct proportion to the balance
outstanding.
A
B
C
D
1 only
2 only
Both 1 and 2
Neither 1 nor 2
1
FINANCIAL MANAGEMENT (F9) – STUDY MULTIPLE CHOICE QUESTION BANK
Freely fluctuating exchange rates perform which of the following functions?
A
B
C
D
2.3
Which of the following investments is not acceptable as a way for companies to invest
short-term cash surpluses?
A
B
C
D
2.4
Bank deposit account
Ordinary shares
Certificates of deposit
Treasury bills
Supply side policy is designed for what purpose?
A
B
C
D
2.5
They tend to correct a lack of equilibrium between imports and exports
They make imports cheaper and exports more expensive
They impose constraints on the domestic economy
They eliminate the need for foreign currency hedging
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2.2
To raise the level of aggregate monetary demand in the economy
To manage the money supply in the economy
To improve the ability of the economy to produce goods and services
To reduce unemployment by limiting the supply of labour
Which ONE of the following government policies would NOT tend to raise national
income over time?
Increased expenditure on the economic infrastructure
Tax cuts to encourage higher demand from consumers
Policies to encourage the training of labour
Financial incentives to encourage personal saving
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A
B
C
D
3
Investment Decisions
3.1
Which investment appraisal method is generally considered the best model for longrange decision making?
A
B
C
D
3.2
Which of the following statements concerning the payback method is correct?
A
B
C
D
3.3
It does not consider the time value of money
It is the time required to recover the investment and earn a profit
It is a measure of how profitable one investment project is compared to another
It is reliable for project selection decisions
In considering the payback period for three projects, Fly Co gathered the following data about
cash flows:
Project A
Project B
Project C
2
Payback
Accounting rate of return
Internal rate of return
Net present value
Year 1
$
(10,000)
(25,000)
(10,000)
Year 2
$
3,000
15,000
5,000
Year 3
$
3,000
15,000
5,000
Year 4
$
3,000
(10,000)
Year 5
$
3,000
15,000
Which of the projects will achieve payback within three years?
A
B
C
D
Which of the following decision-making models equates the initial investment with the
present value of the future cash inflows?
A
B
C
D
3.5
Payback period
Profitability index
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3.4
Projects A, B, and C
Projects B and C only
Project B only
Projects A and C only
A company wants to know how many years it will take before the accumulated cash flows
from an investment equal the initial investment cost, without taking the time value of money
into account.
Which of the following methods should be used?
A
B
C
D
In making capital budgeting decisions, management may consider factors that are broader
than relevant costs alone.
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3.6
Payback period
Discounted payback period
Net present value
Which one of the following factors is LEAST likely to be considered a non-financial or
qualitative factor?
A
B
C
D
Increase in manufacturing flexibility
Improved corporate image
Reduced waste and product reworking
Reduction in new product development time
4
Discounted Cash Flow Techniques
4.1
Which of the following limitations is common to the calculations of payback period,
discounted payback, internal rate of return and net present value?
A
B
C
D
They do not consider the time value of money
They require multiple trial and error calculations
They require knowledge of a company’s cost of capital
They rely on the forecasting of future data
3
4.2
Salem Co is considering a project that produces annual net cash inflows of $420,000 for
Years 1 through 5 and a net cash inflow of $100,000 in Year 6. The project will require an
initial investment of $1,800,000. Salem’s cost of capital is 10%.
What is the net present value for this project to the nearest $100?
A
B
C
D
A company is considering purchasing a machine that costs $100,000 and has a $20,000 scrap
value. The machine will produce annual operating cash inflows of $25,000 each year and has
a six-year life. The company uses a discount rate of 10%.
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4.3
$83,000
($108,200)
($151,400)
($442,000)
What is the net present value of the machine?
A
B
C
D
4.4
($2,405)
$8,875
$20,155
$28,875
An investment in a new product will require an initial outlay of $20,000. The cash inflow
from the project will be $4,000 a year for the next six years.
Using an 8% discount rate what is the net present value of the investment?
($4,876)
($1,508)
($29)
$1,508
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A
B
C
D
4.5
Which of the following phrases defines the internal rate of return on a project?
A
B
C
D
4.6
If a project has a required rate of return of 6%, which of the following statements is
correct?
A
B
C
D
4.7
The NPV will be positive if the IRR is equal to 5%
The project will be rejected if the IRR is equal to 7%
The NPV will be negative if the IRR is greater than 6%
The project will be accepted if the IRR is greater than 6%
Which of the following statements is true if the net present value of a project is negative
$4,000 and the required rate of return is 5%?
A
B
C
D
4
The number of years it takes to recover the investment
The discount rate at which the net present value of the project equals zero
The discount rate at which the net present value of the project equals one
The weighted-average cost of capital used to finance the project
The project’s IRR is less than 5%
The required rate of return is lower than the IRR
The NPV assumes cash flows are reinvested at the IRR
The NPV would be positive if the IRR was equal to 5%
4.8
4.9
Which of the following items describes a weakness of the internal rate of return (IRR)
method?
A
IRR is can only be estimated using a financial calculator or spreadsheet
B
Cash flows from the investment are assumed to be reinvested at the IRR
C
The IRR calculation ignores the time value of money
D
The IRR calculation ignores project cash flows occurring after the initial investment
is recovered
A firm is contemplating investing $10,000 on 31 December 20X1 to earn a single sum of
$12,100 receivable on 1 January 20X4.
A
B
C
D
4.10
6.5%
7.0%
10.0%
10.5%
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What is the internal rate of return of this investment?
Consider the following graph.
NPV
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Project X
Project Y
0
15%
Discount rate
Which ONE of the following statements is true?
A
B
C
D
Project Y has a higher internal rate of return than project X
At discount rate of less than 15%, project Y is preferred to project X
Project X is preferred to project Y irrespective of discount rate
Project Y is preferred to project X irrespective of discount rate
5
Relevant Cash Flows
5.1
Gunning Industries is considering investment in a new machine which has a five year life.
The investment in the new machine would also require an immediate increase in working
capital of $35,000. Gunning is subject to a 40% corporate tax rate and has a 10% weighted
average cost of capital
What is the overall discounted cash flow effect on Gunning Industries’ working capital
investment over the life of the new machine?
A
B
C
D
($7,959)
($10,680)
($13,265)
($35,000)
5
5.2
Moore Co is considering the acquisition of a new machine costing $105,000. It is estimated
that the machine will have a 10-year life and scrap value of $5,000. Over its life the machine
is expected to produce 2,000 units each year with a sales price per unit of $500 and combined
material and labour costs of $450 per unit. Capital allowances are available on a straight-line
basis on cost over five years. Moore has a 40% tax rate and tax is paid in the year of returns.
What is the post-tax cash flow for the tenth year of the project?
A
B
C
D
Which one of the following will normally affect a project’s net present value?
A
B
C
D
5.4
Estimated scrap value of the asset
Net book value of the asset
Amount of annual depreciation on the asset
Amoun of head office costs recharged to the project
What is a capital allowance?
A
B
C
D
A government grant
A reduction in taxable proft
Depreciation expense
Impairment to an asset’s value
Carter Co paid $1,000,000 for land three years ago. Carter estimates that it could sell the land
today for $1,200,000. If the land is not sold, Carter plans to develop the land at an initial cost
of $1,500,000. Carter estimates the net operating cash inflow during the first year following
development would be $500,000.
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5.5
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5.3
$81,000
$68,400
$63,000
$60,000
What is Carter’s opportunity cost of the development?
A
B
C
D
5.6
$1,500,000
$1,200,000
$1,000,000
$500,000
A firm is considering investment in new labour-saving equipment costing $1 million. The
current wage rate is $5 per hour but the firm expects this to increase by 5% each year into the
foreseeable future. The equipment is expected to save 20,000 labour hours per year.
The company’s nominal (money) cost of capital is 15.5%.
What (to the nearest $000) is the present value of the savings over a ten year planning
period?
A
B
C
D
6
$385,000
$558,000
$615,000
$676,000
5.7
Oze Co uses the net present value approach in evaluating projects. Data for a particular
project are given below.
Cost of capital in real terms
General inflation rate
Annual cash inflow (CI) from the project
is expected to increase by
Annual cash outlay (CO) on the project
is expected to increase by
% per year
10
5
6
4
5.8
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Which one of the following sets of adjustments will lead to the correct NPV being
calculated?
A
CI and CO to be increased by 5% each year and discounted by 15% each year
B
CI to be increased by 6% each year, CO to be increased by 4% each year and both
discounted by 15% each year
C
CI to be increased by 6% each year, CO to be increased by 4% each year and both
discounted by 15.5% each year
D
CI and CO to be unadjusted and discounted by 10% each year
Paisley Co plans to purchase a machine costing $13,500. The machine will save labour costs
of $7,000 in the first year. Labour rates in the second year will increase by 10%. The general
rate of inflation is 8% and the company’s real cost of capital is estimated at 12%.
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The machine has a two year life with an estimated scrap value of $5,000.
What is the NPV (to the nearest $10) of the proposed investment?
A
B
C
D
5.9
Net present value as used in investment decision-making is based on which ONE of the
following?
A
B
C
D
5.10
$550
$770
$970
$1,150
Net income
Earnings before interest, taxes and depreciation
Earnings before interest and taxes
Cash flows
A firm expects to receive annual cash flows of $75,000 per year in current price terms for a
period of five years. The cash flows will inflate at 4% and the firm’s nominal cost of capital
is 10%.
What is the present value of the expected cash flows (to the nearest $1,000)?
A
B
C
D
$318,000
$375,000
$284,000
$296,000
7
6
Applications of DCF Techniques
6.1
The profitability index is a variation of which of the following capital budgeting models?
A
B
C
D
6.2
Return on investment
Net present value
Discounted payback
Progress Co has the following non-divisible projects available:
Project
PV Cash outflows
$
200,000
450,000
350,000
900,000
600,000
Profitability index
1.50
1.61
1.21
1.44
1.67
pl
e
1
2
3
4
5
PV Cash inflows
$
300,000
725,000
425,000
1,300,000
1,000,000
Assuming the company has $1,000,000 to invest in capital projects, which combination
of projects should Progress Co accept?
A
B
C
D
A company should accept all positive NPV projects when which of the following
conditions is true?
Sa
m
6.3
1 and 5 only
2 and 4 only
3 and 5 only
1, 2 and 3 only
A
B
C
D
6.4
The company has extremely limited resources for capital investment
The company has excess cash on its statement of financial position
The company has virtually unlimited resources for capital investment
The company currently has limited resources for capital investment but is planning
to issue new equity
A company will lease new machinery. The lease term is five years and lease payments of
$10,000 will be made annually in advance.
What is the present value of the lease payments using a discount rate of 10%?
A
B
C
D
6.5
8
$4,170
$6,209
$37,910
$41,700
Which one of the following is a possible formula for calculating the profitability index of
a project?
A
Subtract actual net income from the minimum required return in dollars
B
Divide the present value of the annual cash inflows by the original cash invested in
the project
C
Divide the initial investment for the project by the net annual cash inflow
D
Multiply net profit margin by asset turnover
7
Project Appraisal under Risk
7.1
Dough Co has decided to increase its daily muffin purchases by 100 boxes. A box of muffins
costs $2 and sells for $3 in normal shops. Any boxes not sold in normal shops are sold
through Dough’s economy shop for $1. Dough estimates the following probabilities to
selling additional boxes:
Normal
shop sales
60
100
Economy
shop sales
40
0
Probability
0.6
0.4
A
B
C
D
7.2
$28
$40
$52
$68
pl
e
What is the expected value of Dough’s decision to buy 100 additional boxes of muffins?
Blane Co purchases a new machine for $340,000. The machine is expected to increase annual
cash flows by $110,000 per year for the next four years. The appropriate discount rate is 4%.
Using the discounted payback period method, approximately how many years will it
take for Blane to recover its investment?
3.09 years
3.16 years
3.37 years
3.58 years
Sa
m
A
B
C
D
7.3
A supplier offered Wyatt Co $25,000 compensation for losses resulting from faulty raw
materials. Alternately, a lawyer offered to represent Wyatt in a lawsuit against the supplier
for a $12,000 minimum fee and 50% of any award over $35,000. Possible court awards with
their associated probabilities are:
Award
$75,000
$0
Probability
0.6
0.4
Compared to accepting the supplier’s offer, what is the expected value for Wyatt of
taking the matter to court?
A
B
C
D
7.4
$4,000 loss
$18,200 gain
$21,000 gain
$38,000 gain
Dallara runs an office sandwich delivery service. He orders sandwiches at the start of each
day for 45 cents each and takes them round to local offices where he sells them for 75 cents.
Any unsold sandwiches are thrown away. Possible levels of daily demand are as follows:
Demand
50
60
70
80
Probability
0.2
0.3
0.4
0.1
9
How many sandwiches should be ordered each day to maximise long-term profit?
A
B
C
D
7.5
50
60
64
70
The annual sales volume and the contribution per unit of a new product are uncertain.
Estimates for these two variables are as follows:
Probability
0.1
0.6
0.3
Contribution
Probability
$2.00
$1.50
0.5
0.5
pl
e
Sales volume
(units)
80,000
75,000
50,000
The sales volume and contribution per unit can be assumed to be independent.
If the annual fixed costs are $130,000, what is the probability that the company will
make a loss?
A
B
C
D
0.30
0.50
0.65
1.00
Equity Finance
8.1
A firm’s current share price is $4. The company then makes a 2 for 3 rights issue at an issue
price of $2.
Sa
m
8
What is the theoretical ex-rights price?
A
B
C
D
8.2
$2·50
$2·80
$3·00
$3·20
A company makes a rights issue and the following prices apply:
Current share price
Rights issue price
Theoretical ex-rights price
$10
$6
$9
What were the terms of the rights issue?
A
B
C
D
10
1 for 3
3 for 1
1 for 4
4 for 1
8.3
What effect would making a scrip issue of shares have?
A
B
C
D
8.4
Decreases the debt/equity ratio of the company
Decreases earnings per share
Increases individual shareholder wealth
Increases the market price of the share
Sutton Co has announced a 1 for 3 rights issue at $2 per share. The current share price is
$3.04.
A
B
C
D
8.5
$0.26
$0.35
$0.78
$1.04
pl
e
What is the theoretical value of one right per existing share?
A company, whose shares currently sell at $75 each, plans to make a rights issue of one share
at $60 for every four existing shares.
What is the theoretical ex-rights price of the shares after the issue?
A
B
C
D
$75.00
$72.00
$67.50
$63.00
Debt Finance
9.1
For what reason would a firm issue convertible debt?
Sa
m
9
A
B
C
D
9.2
It is cheaper to service than ordinary debt
Sales and earnings are expected to fall over the next few years
If conversion takes place, it will not change the firm’s financial gearing ratio
If conversion takes place, it will generate additional finance for the firm
A company is evaluating the advantages and disadvantages of short-term and long-term
financing options.
Which of the following two characteristics are usually true?
A
B
C
D
9.3
Short-term financing
Lower rollover risk
Higher rollover risk
Lower rollover risk
Higher rollover risk
Long-term financing
Lower cost
Higher cost
Higher cost
Lower cost
Which of the following best describes the term “coupon rate” as applied to bonds?
A
The annual interest paid on the face value of the bond
B
The annual interest divided by the current market price of the bond
C
The total return on a bond, taking into account capital repayment as well as interest
payments
D
The annual interest paid on the market price of the bond
11
9.5
Which one of the following best describes a participating preference share?
A
A preference share which has the right to be converted into ordinary shares at some
future date
B
A preference share which entitles to the holder to a guaranteed minimum dividend
with the possibility of an additional amount
C
A preference share which carries forward the right to dividends, if unpaid, from one
year to the next
D
A preference share which entitles the shareholder to a fixed rate of dividend
Which of the following are reasons why a company may prefer debt financing to equity
financing?
pl
e
9.4
(1)
(2)
(3)
(4)
Debt, unlike equity finance, will not need to be secured against assets
Debt can be raised for finite time periods
Debt finance can be raised more quickly than equity finance
Interest payments are tax-deductible
A
B
C
D
1, 2 and 3 only
2, 3 and 4 only
1, 3 and 4 only
1, 2 and 4 only
Security Valuation and Cost of Capital
10.1
Davis wants to buy shares of Epoch Co.
Sa
m
10
If Davis uses a zero growth model, a required rate of return of 20% and an annual
dividend of $10, what is Epoch’s share price?
A
B
C
D
10.2
If Brewer Co’s bonds have a yield to maturity (gross redemption yield) of 8%, why
would the company’s cost of debt be lower?
A
B
C
D
10.3
Market interest rates have increased
Additional debt can be issued more cheaply that the original debt
Interest is deductible for tax purposes
There is a mixture of old and new debt
Which capital structure theory suggests that the weighted average cost of capital
(WACC) will initially decrease, reach a minimum and then increase?
A
B
C
D
12
$2
$20
$50
$100
Pecking order theory
The traditional trade-off view
Modigliani and Miller without tax
Modigliani and Miller with tax
10.4
Which one of a firm’s sources of new capital usually has the lowest after-tax cost?
A
B
C
D
10.5
Retained earnings
Bonds
Preference shares
Ordinary shares
The capital structure of a firm includes bonds with a coupon rate of 12% and a yield to
maturity (gross redemption yield) of 14%. The corporate tax rate is 30%.
A
B
C
D
10.6
8.4%
9.8%
12.0%
14.0%
pl
e
What is the firm’s net cost of debt?
The shares of Fargo Co are selling for $85. The dividend after one year is expected to be
$4.25 and is expected to then grow at a rate of 7%. The corporate tax rate is 30%.
What is the firm’s cost of equity?
A
B
C
D
A firm distributes 80% of its earnings. The return on its projects is 15%. the firm’s market
capitalisation is $1.5 million and most recent net income is $125,000.
Sa
m
10.7
5.0%
8.4%
12.0%
12.35%
A
B
C
D
10.8
9.6%
9.9%
18.7%
19.5%
Quinton Co’s most recent income statement is as follows:
Profit before tax
Taxation
Net income
Dividends on ordinary shares
Retained profit
$000
500
(100)
–––––
400
(300)
–––––
100
–––––
Net assets in the statement of financial position were $4,500,000.
What is the annual dividend growth rate computed using Gordon’s growth
approximation?
A
B
C
D
3.70%
2.96%
2.78%
2.22%
13
10.9
A company has 15% coupon $100 nominal value bonds in issue. Investors currently require a
gross redemption yield (yield to maturity) of 12% on bonds of this class of risk.
If the corporation tax rate is 35% what is the cost of the bonds to the company?
A
B
C
D
10.10
7.80%
9.00%
9.75%
11.25%
The following data relate to an unquoted company:
$180,000
40%
15%
20%
pl
e
Dividend (just paid)
Payout ratio
Return on investments
Cost of equity
What is the theoretical market value of equity (to the nearest $000)?
A
B
C
D
$900,000
$1,363,000
$1,636,000
$1,784,000
11
Weighted Average Cost of Capital and Gearing
11.1
DQZ Telecom has the following combination of debt and equity finance:
Bonds with a market value of $15 million.
Ordinary shares with a market capitalisation of $35 million.
Sa
m


The expected return on the equity market is 11%. Treasury bills are currently yielding 5%.
The equity beta for DQZ is estimated to be 0.80 and its bonds have a yield to maturity of 7%.
The tax rate is 30%.
What is the weighted average cost of capital?
A
B
C
D
11.2
9.80%
9.17%
8.96%
8.33%
ABC Co had debt with a market value of $1 million and an after-tax cost of debt of 8%. ABC
also had equity with a market value of $2 million and a cost of equity of 9%.
What is ABC’s weighted-average cost of capital?
A
B
C
D
14
8.0%
8.5%
8.7%
9.0%
Which ONE of the following factors might cause a firm to increase the debt in its
financial structure?
A
B
C
D
11.4
11.5
An increase in the corporate tax rate
Increased economic uncertainty
An increase in the price/earnings ratio
A decrease in the interest cover ratio
What is the weighted average cost of capital?
A
The rate of return on assets that covers the costs associated with the funds employed
B
The minimum rate a firm must earn on high-risk projects
C
The cost of the firm’s equity capital at which the market value of the firm will
remain unchanged
D
The maximum rate of return on assets
pl
e
11.3
Youngsten Electric has the following capital structure:

8% $1 preference shares. There are 10 million preference shares in issue, each
trading at $1.30.

30 million ordinary shares with an equity beta of 1.45 and market price of $2.50 per
share.
The risk-free rate is 3%, the market risk premium is 5% and corporate tax rate 30%.
Sa
m
What is Youngsten’s weighted average cost of capital?
A
B
C
D
11.6
10.3%
9.6%
9.9%
6.2%
Bryan Co has 10 million ordinary shares in issue with a market price of 155 cents cum-div.
An annual dividend of 9 cents is just about to be paid. Annual dividends have been growing
at a steady rate of 6% each year. The company’s other major source of funds is a bank loan
of $7 million which has a pre-tax cost of 8%.
If Bryan Co pays corporation tax at a rate of 33%, what is its post-tax weighted average
cost of capital?
A
B
C
D
8.17%
8.50%
11.06%
10.21%
15
11.7
One of the following diagrams is consistent with the “traditional view” of capital structure,
where ke refers to the cost of equity and k refers to the weighted average cost of capital:
Diagram A
Diagram B
Cost
Cost
ke
ke
k
k
gearing
gearing
Diagram C
pl
e
Cost
Diagram D
ke
Cost
ke
k
k
gearing
gearing
Which diagram is correct?
Diagram A
Diagram B
Diagram C
Diagram D
Sa
m
A
B
C
D
16
11.8
One of the following diagrams is consistent with Modigliani and Miller’s model of capital
structure ignoring corporate tax, where ke refers to the cost of equity and k refers to the
weighted average cost of capital:
Diagram A
Diagram B
Cost
Cost
ke
ke
k
k
Debt value/
Equity value
pl
e
Debt value/
Equity value
Diagram C
Cost
Diagram D
ke
Cost
ke
k
k
Debt value/
Equity value
Debt value/
Equity value
Sa
m
Which diagram is correct?
A
B
C
D
Diagram A
Diagram B
Diagram C
Diagram D
12
Capital Asset Pricing Model
12.1
Which of the following statements about risk is/are true?
(1)
In order to reduce the risk of a portfolio, the returns on its securities must be
negatively correlated.
(2)
A risk-averse investor will always seek to minimise risk.
A
B
C
D
1 only
2 only
Both 1 and 2
Neither 1 nor 2
17
12.2
Capital investments require balancing risk and return. Managers have a responsibility to
ensure that the investments that they make increase shareholder value.
Managers have met that responsibility if the return on the capital investment meets
which ONE of the following conditions?
A
B
C
D
The equity market is expected to earn 12%. Treasury bills are currently yielding 5%. The
equity beta of DQZ Co is estimated to be 0.60 and the firm has a tax rate of 40%.
pl
e
12.3
It exceeds the rate of return associated with the firm’s beta factor
It is less than the rate of return associated with the firm’s beta factor
It is greater than the risk-free rate of return
It is less than the risk-free rate of return
What is DQZ’s cost of equity?
A
B
C
D
12.4
5.5%
9.2%
10.0%
12.2%
A firm has an equity beta of 1.25 and a debt beta of 0.20. The equity market premium is 8%
and the risk-free rate is 6%. The tax rate is 30%.
8.5%
11.2%
14%
16.0%
Sa
m
A
B
C
D
12.5
Assume that a firm’s equity beta is 0.90, the risk-free rate is 2.75% and the market return is
5.50%.
What is the cost of retained earnings using the capital asset pricing model?
A
B
C
D
12.6
What correlation between returns on shares held will best reduce risk?
A
B
C
D
18
5.25%
5.50%
7.70%
8.25%
Perfect positive correlation
No correlation
Perfect negative correlation
Weak correlation
13
Working Capital Management
13.1
Which of the following transactions would increase the current ratio and decrease net
profit?
A
B
C
D
Which of the following ratios would most likely be used by management to evaluate
short-term liquidity?
A
B
C
D
Which of the following items are included in the calculation of the cash conversion cycle
(working capital cycle)?
(1)
(2)
(3)
(4)
Inventory conversion period
Payables payment period
Receivables collection period
Settlement discount period
A
B
C
D
1, 2 and 3 only
2, 3 and 4 only
1, 3 and 4 only
1, 2 and 4 only
Sa
m
13.3
Return on total assets
Sales to cash
Accounts receivable turnover
Acid test (quick) ratio
pl
e
13.2
Tax due from the previous year is paid
A long-term bond is redeemed
A scrip dividend is paid
Land is sold for less than the net book value
13.4
The cash conversion cycle of an organisation would shorten under which of the
following combinations of changes?
A
B
C
D
13.5
Inventory
conversion period
Increase
Decrease
Increase
Decrease
Receivables
collection period
Increase
Decrease
Decrease
Decrease
Payables
payment period
Increase
Increase
Decrease
Decrease
Which ONE of the following situations will produce the most favourable operating
cycle?
A
B
C
D
Inventory
conversion period
Short
Long
Short
Long
Receivable
collection period
Short
Long
Short
Short
Payable
deferral period
Short
Short
Long
Long
19
13.6
What is the operating cycle of company Z given the following?
Inventory days
Days sales outstanding
Trade payables days
A
B
C
D
112 days
68 days
36 days
24 days
A company has a current ratio of 2. Due to having significant surplus cash balances, it has
decided to pay its trade payables after 30 days in future, rather than after 50 days as it has in
the past.
pl
e
13.7
30 days
38 days
44 days
What will be the effect of this change on the company’s current ratio and its cash
operating cycle?
A
B
C
D
Current ratio
Increase
Increase
Decrease
Decrease
Cash operating cycle
Increase
Decrease
Increase
Decrease
Inventory Management
14.1
Spotech Co’s budgeted sales and budgeted cost of sales for the coming year are $212,000,000
and $132,500,000 respectively. Short-term interest rates are expected to average 5%.
Sa
m
14
If Spotech could increase inventory turnover from its current 8 times per year to 10
times per year, its expected cost savings in the current year would be:
A
B
C
D
14.2
Which one of the following would tend to increase the amount of inventory that a
company holds?
A
B
C
D
14.3
$81,812
$165,625
$250,000
$331,250
Cost of holding inventory decreases
Variability of sales decreases
Cost of running out of inventory decreases
Lead time decreases
Stewart Co uses the Economic Order Quantity (EOQ) model for inventory management.
A decrease in which ONE of the following variables would increase the EOQ?
A
B
C
D
20
Cost per order
Level of buffer stock
Holding cost
Quantity demanded
14.4
An increase in which ONE of the following should cause management to reduce the
average inventory?
A
B
C
D
14.5
The cost of placing an order
The cost of holding inventory
The annual demand for the product
The lead time needed to acquire inventory
Lyle Co’s inventory reorder level is 500 units, the lead time is three weeks, and the sales
volume is estimated at 50 units per week.
A
B
C
D
150
350
500
650
pl
e
Lyle has established which of the following amounts as its safety stock?
15
Cash Management
15.1
Average daily cash outflows are $3 million for Evans Co. A new cash management system
can add two days to the cash payments schedule. Evans can earn 10% per annum on surplus
funds.
What is the maximum amount that Evans should be willing to pay each year for this
cash management system?
$3,000,000
$1,500,000
$600,000
$150,000
Sa
m
A
B
C
D
15.2
Each day a company sends cheques to suppliers totalling $10,000 and receives cheques from
customers totalling $10,000. It takes five days for the cheques sent to suppliers to be
deducted from the company’s account but only four days for the deposits to clear.
Based on this information what is the company’s bank balance?
A
B
C
D
15.3
$(10,000)
$0
$10,000
$25,000
The following items were extracted from a company’s budget for next month:
Purchases on credit
Expected decrease in inventory over the month
Expected increase in trade payables over the month
$
360,000
12,000
15,000
What is the budgeted payment to trade payables for the month?
A
B
C
D
$333,000
$345,000
$357,000
$375,000
21
15.4
A company commenced business on 1 April. Sales in April were $20,000, but this is
expected to increase at 2% a month. Credit sales amount to 60% of total sales.
The credit period allowed is one month. Bad debts are expected to be 3% of credit sales, but
other customers pay on time. Cash sales represent the other 40% of sales.
How much cash is expected to be received in May?
A
B
C
D
Which of the following would most likely be considered a disadvantage for a company to
maintain high levels of cash?
pl
e
15.5
$19,560
$19,640
$19,800
$20,160
A
Holding cash ensures liquidity
B
Occasionally, the company has an opportunity to buy inventory at a substantially
reduced price
C
Investor dissatisfaction with the firm’s asset allocation
D
The ability to cope with unexpected events
Management of Accounts Receivable and Payable
16.1
A factor has offering the following arrangement to Dino Co which has annual sales of
$1,500,000 and an average receivables period of one month:
Sa
m
16
The factor will advance 80% of the face value of receivables at a 10% annual interest rate and
charge a fee of 2% on turnover. Dino Co estimates that the firm would save $24,000 in
administration expenses over the year.
What is the annual net cost of factoring?
A
B
C
D
16.2
$12,000
$14,800
$16,000
$20,000
Jackson Distributors sells to retail stores on credit terms of 2% discount for settlement within
10 days or full payment within 30 days. Daily sales average 150 units at a price of $300 each.
Assuming that all sales are on credit and 60% of customers take the discount and pay on
day 10 while the rest of the customers pay on day 30, the amount of Jackson’s accounts
receivable is:
A
B
C
D
22
$990,000
$900,000
$810,000
$450,000
16.3
Foster Co is considering implementing a new cash collection system at a cost of $80,000 per
year. Annual sales are $90 million and the new system will reduce collection time by three
days.
If Foster can invest surplus funds at 8% per annum, what is the net gain/ (loss) from
implementing the new system? Assume a 360-day year.
A
B
C
D
The following information has been extracted from a company’s financial records:
Cash
Cash equivalents
Accounts receivable
Total current assets
Revenues
Expenses
Sa
m
Net income
pl
e
16.4
Net gain of $60,000 per year
Net loss of ($20,000) per year
Opening
balance
$
3,900
3,800
14,600
–––––––
22,300
–––––––
Closing
balance
$
3,000
4,400
12,900
–––––––
20,300
–––––––
103,200
20,430
–––––––
82,770
–––––––
What is the company’s receivable turnover ratio?
A
B
C
D
16.5
What does invoice discounting normally involve?
A
B
C
D
16.6
6.0
7.1
7.5
8.0
Offering a cash discount for early settlement of invoices
Selling all invoices to a finance house who takes over administration of the
receivables ledger
Receiving a cash advance from a finance house based on a percentage of face value
of selected invoices
Writing off an invoice, partly or in total, as a bad debt
When accounts receivable are sold to a debt factoring company, which of the following
is LEAST likely?
A
B
C
D
Cash will be received sooner than if receivables were not sold
The accounts receivable will be sold above their face value
The debt factoring company will make a profit on the service provided
Working capital will decrease
23
17
Risk Management
17.1
In relation to the term structure of interest rates what is an inversed yield curve?
A
B
C
D
17.2
Upward sloping
Downward sloping
U-shaped
Horizontal
Atlas Worldwide Industries conducts business in a number of different countries and is trying
to evaluate its economic exposure to long-term exchange rate trends.
17.3
pl
e
Which of the following statements is NOT correct?
A
Atlas will suffer an economic loss if it has net cash outflows in a foreign currency
and the foreign currency appreciates
B
Atlas will enjoy an economic gain if it has net cash outflows of a foreign currency
and the foreign currency depreciates
C
Atlas will suffer an economic loss if it has net cash inflows of a foreign currency
and the foreign currency appreciates
D
Atlas will suffer an economic loss if it has net cash inflows of a foreign currency
and the foreign currency depreciates
Universal Industries limits its operations to exports to foreign countries.
Sa
m
Which ONE of the following statements about Universal’s exposures to exchange rate
risk is correct?
17.4
A
Universal is subject to potential transaction, economic and translation exposures to
exchange rate risk
B
Universal is subject to potential transaction and economic exposures to exchange
rate risk
C
Universal is subject to economic and translation exposures to exchange rate risk
D
Universal is subject to transaction and translation exposures to exchange rate risk
What is the effect on a US-based company when a foreign competitor’s currency
becomes weaker compared to the US dollar?
A
B
C
D
24
The foreign company will have an advantage in the US market
The foreign company will be disadvantaged in the US market
The fluctuation has no effect on the US company’s sales or cost of goods sold
It is better for the US company when the value of the US dollar strengthens
17.5
Solway International is a US-based firm which is due to receive £10,000 in 60 days from a
UK customer. The current exchange rate is $1.30 per £1. Solway has purchased a put option
to sell £10,000 in 60 days for $1.25 per £1, and has paid a premium of $0.005 per £1.
If 60 days from now the spot exchange rate is $1.20, what will be the net benefit for
Solway International compared to not hedging?
A
B
C
D
Teseo Co, a UK-based firm, borrowed $120,000 in dollars and one year later repaid $132,000
in dollars. When the loan was taken the exchange rate was $1.50 per £1, and when the loan
was repaid the rate was $1.25 per £1.
pl
e
17.6
$0
$450
$500
$550
What was the effective annual cost of the loan in terms of the pounds sterling received
and paid by Teseo Co?
A
B
C
D
8.3% income
10.0% expense
24.2% expense
32.0% expense
Business Valuation and Ratio Analysis
18.1
Which of the following ratios would be used to evaluate a company’s profitability?
Sa
m
18
A
B
C
D
18.2
Current ratio
Inventory turnover ratio
Debt to total assets ratio
Gross margin ratio
Green Co, a financial investment-consulting firm, was engaged by Maple Co to provide
technical support for making investment decisions. Maple, a manufacturer of ceramic tiles,
was in the process of buying Bay Co, its main competitor.
Green’s financial analyst made an independent detailed analysis of Bay’s average
collection period to determine which of the following?
A
B
C
D
18.3
Financing
Return on equity
Liquidity
Operating profitability
Which ONE of the following statements about a company with high operating gearing is
true?
A
B
C
D
A change in sales will have a relatively small impact on profits
The company has a relatively high proportion of debt finance
The company will have higher risk and increased potential return
The company will have lower risk and decreased potential return
25
18.4
Coldwell is using the dividend valuation model with a constant growth rate to estimate the
value of an ordinary share.
Which of the following assumptions is Coldwell making?
A
B
C
D
What does a high price/earnings (P/E) ratio indicate to investors?
A
B
C
D
18.6
Which of the following describes the situation where investors overemphasise their
abilities to evaluate securities?
A
B
C
D
Excessive optimism
Overconfidence
Confirmation bias
Herd mentality
Harbor Co had sales of $1,500,000 an asset turnover ratio of 2 and a return on investment of
6%.
Sa
m
18.7
Earnings have growth potential
Earnings have peaked and will remain flat
Earnings have peaked and will likely fall
The company is undervalued
pl
e
18.5
The discount rate will grow at a constant rate
Dividends will grow at a rate higher than the cost of equity
The share price will grow at the same rate as the dividend
The share price will grow at the same amount as the dividend
What was Harbor’s total assets and operating profit?
A
B
C
D
18.8
Assets
$500,000
$750,000
$750,000
$3,000,000
Operating profit
$30,000
$45,000
$90,000
$90,000
A firm designs its cost structure to include a higher degree of operating fixed costs than
variable costs by electing to pay salaries instead of commissions.
The firm is magnifying the impact of each additional sales dollar using which concept?
A
B
C
D
18.9
26
Operating gearing
Fixed gearing
Financial gearing
Combined gearing
Which ONE of the following statements concerning operating gearing is true?
A
Above the breakeven point, a company with lower operating gearing will increase
profits with less additional sales than a company with higher operating gearing.
B
A company that riases debt to finance its operations is increasing its operating
gearing.
C
A company with high operating gearing is less profitable than another company
with the same amount of sales and lower operating gearing.
D
A company with relatively high fixed operating costs has high operating gearing.
18.10
Which ONE of the following would be implied by an increase in a company’s operating
gearing ratio?
The company has a greater proportion of costs that are variable
The company has profits which are more sensitive to changes in sales volume
The company is more profitable
The company is less risky
Sa
m
pl
e
A
B
C
D
27
Answer 1 PRIVATE AND PUBLIC SECTOR OBJECTIVES
(b)
Financial objectives
(i)
State owned enterprise
(1)
The overall objective is commonly to fulfil a social need.
(2)
Because of problems of measuring attainment of social needs the government
usually sets specific targets in accounting terms.
(3)
Examples include target returns on capital employed, requirement to be selffinancing, cash or budget limits.
(ii)
Private sector
(1)
The firm has more freedom to determine its own objectives.
(2)
A capital market quotation will mean that return to shareholders becomes an
important objective.
(3)
Traditionally financial management sees firms as attempting to maximise
shareholder wealth. Note that other objectives may exist, e.g. social responsibilities,
and the concept of satisficing various parties are important.
pl
e
(a)
Strategic and operational decisions
Sa
m
The major change in emphasis will be that decisions will now have to be made on a largely
commercial basis. Profit and share price considerations will become paramount. The
following are examples of where significant changes might occur:

Financing decisions. The firm will have to compete for a wide range of sources of
finance. Choices between various types of finance will now have to be made, e.g.
debt versus equity.

Dividend decision. The firm will now have to consider its policy on dividend
payments to shareholders.

Investment decision. Commercial rather than social considerations will become of
major importance. Diversifications into other products and markets will now be
possible. Expansion by merger and takeover can also be considered.

Threat of takeover. If the government completely relinquishes its ownership it is
possible that the firm could be subject to takeover bids.

Other areas. Pricing, marketing, staffing, etc. will now be largely free of
government constraints.
©2014 DeVry/Becker Educational Development Corp. All rights reserved. 1015
Answer 2 CAPITAL MARKET EFFICIENCY
The efficient market hypothesis is often considered in terms of three levels of market efficiency:
(1)
(2)
(3)
Weak-form efficiency;
Semi-strong form efficiency; and
Strong-form efficiency.
pl
e
The accuracy of the statement in the question depends in part upon which form of market efficiency is
being considered. The first sentence states that all shares prices are correct at all times. If “correct”
means that prices reflect true values (the true value being an equilibrium price which incorporates all
relevant information that exists at a particular point in time), then strong-form efficiency does suggest
that prices are always correct. Weak and semi-strong prices are not likely to be correct as they do not
fully consider all information (e.g. semi-strong efficiency does not include inside information). It might
be argued that even strong-form efficiency does not lead to correct prices at all times as, although an
efficient market will react quickly to new relevant information, the reaction is not instant and there will
be a short period of time when prices are not correct.
The second sentence in the statement suggests that prices move randomly when new information is
publicly announced. Share prices do not move randomly when new information is announced. Prices
may follow a random walk in that successive price changes are independent of each other. However,
prices will move to reflect accurately any new relevant information that is announced, moving up when
favourable information is announced, and down with unfavourable information. If strong-form
efficiency exists, prices might not move at all when new information is publicly announced, as the
market will already be aware of the information prior to public announcement and will have already
reacted to the information.
Sa
m
Information from published accounts is only one possible determinant of share price movement. Others
include the announcement of investment plans, dividend announcements, government changes in
monetary and fiscal policies, inflation levels, exchange rates, and many more.
Fundamental and technical analysts play an important role in producing market efficiency. An efficient
market requires competition among a large numb of analysts to achieve “correct” share prices, and the
information disseminated by analysts (through their companies) helps to fulfil one of the requirements
of market efficiency (i.e. that information is widely and cheaply available).
An efficient market implies that there is no way for investors or analysts to achieve consistently
superior rates of return. This does not say that analysts cannot accurately predict future share prices.
By pure chance some analysts will accurately predict share prices. However, the implication is that
analysts will not be able to do so consistently. The same argument may be used for corporate financial
managers. If, however, the market is only semi-strong efficient, then it is possible that financial
managers, having inside information, would be able to produce a superior estimate of the future share
price of their own companies and that, if analysts have access to inside information, they could earn
superior returns.
1016
Answer 3 CORPORATE GOVERNANCE
(a)
Factors influencing the development of corporate governance codes
There are a variety of factors that have led to the introduction of the various codes of
corporate governance. These include: a trend towards global investment; there have been a
number of well publicised financial collapses; there are concerns about the standards of
financial reporting; additionally there are concerns about potential insider dealing; concerns
about institutions being run in the interests of their directors and executives rather than their
shareholders and concerns about accountability to other stakeholders.
(b)
Impact of codes on corporate governance
pl
e
The Cadbury report introduced a variety of recommendations aimed at improvements in
corporate governance systems, such as at least three non-executive directors, importance that
the board of directors meet on a regular basis, it suggested a split in the roles of chairman and
chief executive. Additionally the annual report should include a statement about the
organisation’s ability to continue as a going concern and to report on the effectiveness of its
internal controls. In the Greenbury report the two main recommendations were on the need
for a remuneration committee responsible for setting remuneration for senior executives and
for reporting of the remuneration policy and directors’ remuneration.
Sa
m
The recommendations of the Hempel report included: identifying a senior non-executive
director; the establishment of a remuneration committee and at the AGM shareholders should
have the opportunity to vote separately on each issue rather than bundled proposals with
related papers being sent to shareholders 20 working days before the AGM. There were also
recommendations on Accountability and audit including stressing the importance of the audit
committee.
The Hempel committee also recommended a single combined set of
recommendations that became the Combined Code. The Combined Code amends and
combines recommendations from the Cadbury, Greenbury and Hempel committees and calls
for such things as the: division of board responsibilities; separation of role of chairman and
chief executive; one third of the board to be non-executive directors; the directors’ report in
the annual statement to include a statement about the organisation’s ability to continue as a
going concern and to report on the effectiveness of its internal controls; encourages dialogue
between the company’s board and its shareholders and that directors should maintain a sound
system of internal control and review the system of controls at least annually.
The Turnbull report: main elements of which concerned the need for a robust system of
internal control to safeguard the shareholders’ investment and the company’s assets and
management should review control systems at least annually. Also risk management is the
collective responsibility of the board of directors and the risks facing the business should be
regularly evaluated and managed. OECD principles in the areas of the rights of shareholders,
the equitable treatment of shareholders, the role of stakeholders, disclosure and transparency
and the responsibilities of the board.
Each of the above have contributed to increasing the awareness of the importance of corporate
governance systems and led to some improvements; however, some issues remain unresolved.
Answer 4 ELVIRA CO
(b)
A
$100,000/$40,000 = 2.5 years (or 3 years, if cash flows arise at year end)
B
After 4 years net position is $120,000-$40,000 = $80,000 negative.
Payback = 4 years + $80,000/$200,000 = 4.4 years
C
After one year cash $50,000 negative. Payback = 1 + $50,000/$80,000 = 1.6 years
A
Total profit = total inflow – total depreciation = 160 - (100-10) = 70
Average profit = 70/4 = 17.5
Average investment = (cost + residual value)/2 = (100+10)/2 = 55
ARR = 17.5/55 = 31.8%
B
40.0%
C
27.3%
Net present value at 15%
A
– $100,000 + ($40,000  2.855) + ($10,000  0.572)
= $19,920
B
– $120,000 + ($10,000  2.855) + ($212,000  0.497)
= $13,914
C
– $150,000 + ($100,000  0.870) + ($95,000  0.756)
= $8,820
Sa
m
(c)
Payback period
pl
e
(a)
(d)
NPV at 20%
A
– $100,000 + $40,000  2.589 + $10,000  0.482
=
B
– $120,000 + $10,000  2.589 + $212,000  0.402
= – $8,886
C
– $150,000 + $100,000  0.833 + $95,000  0.694
=
$8,380
– $770
IRR
A
15 
B
15 
C
15 
19,920
 (20 – 15) = 24%
19,920  8,380 
13,914
13,914  8,886
8,820
8,820  770 
 (20 – 15) = 18%
 (20 – 15) = 20%
Summary
Payback (years)
ARR (%)
NPV ($000)
IRR (%)
1018
A
3
32
20
24
B
5
40
14
18
C
2
27
9
20
Preferred
C
B
A
A
Answer 5 KHAN CO
(a)
NPV and IRR calculations
Promotion method
NPV
$
+ 3,100
+ 3,470
Alternative 1
Alternative 2
IRR
%
5 or 50
23
WORKINGS
Alternative 1
Net present value
Year 0
Year 1
Year 2
pl
e
(i)
Cash
flow
$000
(100.0)
255.0
(157.5)
Net present value
(ii)
20%
Present
discount
value
factor
$000
1.000 (100.00)
0.833
212.41
0.694 (109.31)
———
3.10
———
Sa
m
At 20% cost of capital the NPV is positive – suggesting the IRR is above 20%. Trial and
error shows that IRR = 50% (-100 + 255/1,5 – 157.5/1.52 = 0)
However this project does not have a conventional cash flow structure (i.e. there is a cash
outflow at the end of its life). In this situation the project may have two IRR’s. These can
be found by setting up and solving a quadratic equation.
Tutorial note: you would not be asked to solve a quadratic equation in the exam. The proof
below is provided for reference only
– 100 + 255 (1 + r)-1 – 157.5 (1 + r)-2 = 0
Multiply each side of the equation by – (1 + r)2
100 (1 + r)2 – 255 (1 + r) + 157.5 = 0
 b  (b 2  4ac)
Using the quadratic formula: x =
2a
(1 + r)
=
255  (255 2  (4  100  157.5)
So (1 + r) = + 1.05
or (1 + r) = + 1.50
2  100
=
255  45
200
r = 0.05 or 5%
r = 0.50 or 50%
Thus Alternative 1 has two internal rates of return: 5% and 50%.
Alternative 2
(i)
Net present value
Cash
flow
$000
(50)
0
42
42
Year 0
Year 1
Year 2
Year 3
20%
discount
factor
1.000
0.833
0.694
0.579
(ii)
pl
e
Net present value
Present
value
$000
(50.00)
0
29.15
24.32
———
3.47
———
The internal rate of return is estimated using linear interpolation.
Using a 20% discount rate (see above), the cash flow has an NPV of $3,470.
Using a 25% discount rate, the NPV of the cash flow is as follows:
Sa
m
Year 0
Year 1
Year 2
Year 3
Cash
flow
$000
(50)
0
42
42
25%
discount
factor
1.000
0.800
0.640
0.512
Net present value
Present
value
$000
(50.00)
0
26.88
21.50
———
(1.62)
———
Therefore, the IRR (the discount rate that reduces net present value to zero) lies
between 20% and 25%.
IRR ≈ 0. 20 
3,470
 (0.25 – 0.2) = 0.234
3,470  1,620 
The internal rate of return is approximately 23%.
(b)
Choice of project
The net present value calculations indicate that Alternative 2 is more favourable and should
be undertaken. It has the larger positive net present value and should therefore add the greater
extra amount to shareholders’ wealth; although it should be noted that there is relatively little
difference between the NPV of the two alternatives.
However, it would be unwise to make the final decision solely on the basis of these
calculations without investigating the risk attached to each alternative and the marketing and
manpower factors that may be involved. For example, the heavy advertising characteristic of
alternative 1 may have a beneficial impact on the company’s other products, or the
widespread use of agents with this alternative may benefit the promotion of other products
imported by Khan.
1020
In terms of the risk aspects, it may be judged that novelty products generally are high risk
short-lived undertakings and that alternative 1, which promotes the product for only a single
year, may be a less risky approach than alternative 2, which appears to extend the life by a
further one or two years.
In addition, there are many other considerations which may be relevant to the decision, such
as whether the promotion of this particular novelty product will adversely affect other
products sold by the company.
pl
e
The internal rates of return of the two alternatives have been ignored in formulating the
decision advice for two main reasons. The first is that alternative 1 has two internal rates of
return, one above, the other below, the required rate. This conflicting investment advice
clearly indicates that the use of internal rates of return is an unreliable tool.
The second reason for rejecting the IRR approach is that it assumes that the surplus cash
flows generated by a project can be reinvested into other projects which generate the same
IRR. This is unlikely to be true in practice.
(c)
Comments on Mr Court’s views
(i)
Payback method
The payback method of investment appraisal is relatively quick and simple to operate and
understand. It calculates how quickly a project’s outlay is recovered from its operating cash
flows. However setting a maximum acceptable payback period is subjective.
Sa
m
Payback can also be criticised for not taking into account the time value of money – although
discounted payback can be calculated. The major weakness of payback period is its failure to
consider cash flows that occur after payback is reached.
However, payback can act as a useful guide when liquidity is a problem for a company and
the speed of a project’s return is of prime importance.
(ii)
Investment appraisal and reported profits
Most investment opportunities undertaken by firms have returns whose generation covers a
relatively long time period (several years). It is one of the tasks of published accounts (and
particularly the income statement) to cut up this continuous stream of wealth generation into a
series of time periods (i.e. the accounting year).
It is certainly a powerful argument that, as well as undertaking NPV calculations,
management should also consider the implications for the published accounts of any
investment opportunity – especially if the projects are of a substantial size. For instance, if a
particular project had a healthy positive NPV but its acceptance would have an adverse effect
on the published financial accounts, although it would be unwise for the project to be rejected
on these grounds alone, management should make efforts to ensure that its investment plans
are fully communicated to and understood by the shareholders.
In this case the comment has been made earlier that, although Alternative 2 is the more
favoured on the basis of its net present value, there is really little difference between the
NPVs of the two alternatives. If the acceptance of Alternative 2 would have a substantial and
adverse effect on the company’s reported profits, this may well be a legitimate reason in these
circumstances to review the NPV decision.
Answer 6 DISCOUNTED CASH FLOW
(i)
Alternative machines
Year
8% Factor
0
1
2
3
4
5
6
7
1
0.926
0.857
0.794
0.735
0.681
0.630
0.583
Machine 1
$
(10,000)
1,000
1,600
2,500
2,500
2,500
1,500
2,500
PV
$
(10,000)
926
1,371
1,985
1,838
1,702
945
1,458
———
225
———
Machine 2
$
(9,000)
1,200
1,500
3,500
2,000
2,000
2,000
PV
$
(9,000)
1,111
1,286
2,779
1,470
1,362
1,260
pl
e
(a)
———
268
———
Since both projects have positive NPVs either machine is a good investment. However, the
NPV for machine 2 is slightly higher and this machine should therefore be preferred.
(ii)
Comment on results
Since the difference between the two figures is marginal it may be prudent to carry out a
“sensitivity analysis” on the result.
Sa
m
The cash flow figures are estimates for several years ahead. A small change in any of these
figures could affect the result to such an extent that machine 1 might be the better investment.
Changes could even lead to the projects having negative NPVs since the values are only small
positive figures. Investments with negative NPVs should be rejected.
(b)
Production decision
Time
Cash
$
1
2 – 29
(40,000)
2,000
7% factor
0.935
12.278 (W) – 0.935
Negative NPV
PV
$
(37,400)
22,686
———
(14,714)
———
Therefore, the firm should not produce the device.
WORKING
=
1022
1  (1  0.07) 29
= 12.278
0.07
(c)
Investment in crusher
Time
Cash
$
0
3–
(6,000)
1,200
12% factor
PV
$
1
1/0.12 – 1.690 = 6.643
(6,000)
7,972
———
1,972
———
Positive NPV
Therefore, the crusher should be purchased.
Time
Cash
$
3–
(d)
pl
e
Alternatively
Time
1,200 is the same as
1–
= $1,200 
Therefore, NPV of project
= – $6,000 + $7,972 = $1,972
=
1
1.12 2
Equal annual inflow
475
 100 =
 100 = 9.5%
Initial investment
5,000
Sa
m
IRR of perpetuity
1,200 
1
1

= $7,972
2
0.12
1.12
Therefore, PV of perpetuity
IRR
Cash
$
Since the internal rate of return is greater than the return which J can obtain elsewhere, he
would be advised to invest in the scheme.
(e)
(i)
IRR
Time
Cash flow
$
10% Factor
10% NPV
$
7% Factor
7% NPV
$
0
1
2&3
4 – 11
(10,000)
(10,000)
4,000
3,000
1
0.909
1.577
4.008 (W1)
(10,000)
(9,090)
6,308
12,024
———
(758)
———
1
0.935
1.689
4.875 (W2)
(10,000)
(9,350)
6,756
14,625
———
2,031
———
WORKINGS
(1)
(2)
@10% DF1–11 – DF1–3
= 6.495 – 2.487 = 4.008
@7%
= 7.499 – 2.624 = 4.875
 2,031 
IRR = 7% + 
  (10 – 7) % = 7% + 2.18% ~ 9%
 2,031  758 
Since the IRR of this project is less than the required rate of return, it should not be
undertaken. Therefore, the ball and crane should not be bought.
(ii)
Alternative methods
An alternative approach to this problem would be to discount the cash flows at 10%. Since
the project has a negative NPV at 10% (the desired rate of return), the project would not be
accepted.
Answer 7 GERRARD
NPV and IRR
Year end
Machinery
0
1
2
3
4
5
(50)
(25)
Year end
Receipts
+
+
30
30
30
30
30
(8)
(8)
(8)
(8)
(8)
+
+
+
+
Net
cash flow
$000
Discount
factors 12%
(58.0)
(3.5)
21.5
21.5
21.5
29.5
1.000
0.893
0.797
0.712
0.636
0.567
PV
(c)
Net
cash flow
$000
Salary
+
+
+
+
+
=
=
=
=
=
=
(0.5)
(0.5)
(0.5)
(0.5)
(0.5)
Discount
factors 14%
$000
(58.00)
(3.13)
17.14
15.31
13.67
16.73
–——
NPV = 1.72
–——
Sa
m
0
1
2
3
4
5
Paper
(58.0)
(3.5)
21.5
21.5
21.5
29.5
pl
e
(a) (b)
PV
$000
1.000
0.877
0.769
0.675
0.592
0.519
(58.00)
(3.07)
16.53
14.51
12.73
15.31
–——
NPV = (1.99)
–——
Comment on results
In view of the project’s positive NPV at 12%, expansion is (just) worthwhile.
The IRR of the project is approximately 13% (i.e. half way between 12 & 14%) or
IRR
= 12% +
172
.
(14 – 12) % = 12.9%
172
.  199
.
This gain indicates that the project is worthwhile.
Answer 8 DESPATCH CO
Time
Cash
$
0
1 – 10
10
(12,000)
2,000
500
14% factor
1
5.216
0.27
PV
$
(12,000)
10,432
135
———
(1,433)
———
As the NPV is negative at 14% the company should not undertake this project.
1024
Answer 9 CARTER CO
(a)
(i)
Net present value
Time
Cash flow
$
(32,000)
5,000
0
1 – 15
10% factor
Present value
$
(32,000)
38,030
———
6,030
———
1
7.606
Positive NPV
(ii)
pl
e
In view of the positive NPV the project should be undertaken.
The internal rate of return is calculated by finding a 15 year cumulative discount factor as
follows:
32,000
Investment
15 year factor @ IRR
=
=
= 6.4
Annual cash flow
5,000
Therefore,
IRR
= 13%
The project should be undertaken as the IRR exceeds the cost of borrowing (10%).
(b)
(i)
Book value of $2,000
Sa
m
This information does not affect the NPV as a book value is not a cash flow.
(ii)
Reduced project duration to ten years
Revised NPV calculation:
Time
0
1 – 10
Cash flow
$
Net investments
Net savings
(32,000)
5,000
10%
factor
Present
value
$
1
6.145
(32,000)
30,725
———
(1,275)
———
Negative NPV
The reduction in the project duration means that it is no longer worthwhile.
(iii)
Changes in allocation and apportionment
This information does not affect the NPV as allocation and apportionment are arbitrary. The
cash flows are unchanged.
(iv)
Revised scrap values
With the existing equipment having a scrap value of $2,000 in 15 years’ time, if the project is
undertaken this $2,000 in year 15 will be forgone. The NPV will therefore be reduced be
reduced by the present value of $2,000 discounted for 15 years.
NPV
= $6,030 – ($2,000  0.239) = $5,552
The project will still be accepted though the NPV is reduced.
Answer 10 BLACKWATER CO
(a)
Expected NPV
Expected value of fines
= (0.3 × 0.50) + (0.5 × 1.40) + (0.2 × 2.0)
= 0.15 + 0.70 + 0.40 = $1.25m
Tutorial note: there is no need to discount the fines as they were stated in the question in
present value terms.
To determine the overall NPV of the project, Blackwater must compare the present value of
the costs incurred to the expected value of the fines avoided.
3
4
(0.331)
0.104
0.141
0.062
(0.165)
0.797
(0.132)
(0.347)
0.109
0.105
0.047
(0.191)
0.712
(0.136)
(0.365)
0.115
0.316
0.035
(0.215)
0.636
(0.137)
pl
e
Year
2
Item ($m)
Outlay
EU grant
FSL’s fee
Increased operating costs
Tax saving at 33%
WDA
Tax saving at 33%
Net cash flows
Discount factor at 12%
PV
PV = ($1.307m)
0
(1.000)
1
0.250
(0.050)
(0.315)
0.250
(1.000)
1.000
(1.000)
0.188
0.083
(0.032)
0.893
(0.029)
5
0.120
0.104
0.224
0.567
0.127
Sa
m
Tutorial notes: as the equipment will be purchased on the last day of a financial year i.e. on
the date of a tax computation, the initial WDA can be claimed instantly. This WDA of
1m×25% = 0.25 is not a cash flow but will save cash tax of 0.25 × 33% = 0.083 one year
later.
WDA’s are then claimed on a reducing balance basis at the end of the first three years of
operating the equipment, At the end of the fourth year the brought forward tax written down
value of 1 - 0.25 – 0.188 – 0.141 – 0.105 = 0.316 is compared to the scrap value (zero) and
written off as a balancing allowance, saving tax of 0.316 × 33% = 0,104 one year later.
Overall NPV = ($1.307m) - $1.25m = ($0.057)
It appears that the project is not viable in financial terms.
(b)
Memorandum
Memo to:
Subject:
From:
Date:
Blackwater Co management.
Proposed Pollution Control Project.
Financial consultant.
Black Monday.
On purely non-financial criteria, it can be suggested that as a regular violator of the
environmental regulation, our company has a moral responsibility to install this equipment, so
long as it does not jeopardise the long-term survival of the company.
1026
But the figures appended suggest that the project is not wealth-creating for Blackwater’s
shareholders as the EV of the fines is less than the expected NPV of the project. However,
this conclusion relies on accepting the validity of the probability distribution, which is
debatable. Not only are the magnitudes of the fines merely estimates, but the probabilities
shown are subjective. Different decision-makers may well arrive at different assessments
which could lead to the opposite decision on financial criteria.
pl
e
More fundamentally, the use of the expected value principle is only reliable when the
probability distribution approximates to the normal. In this case, it is slightly skewed toward
the lower outcomes. But more significantly, if the distribution itself is examined more
closely, it appears to indicate that there is a 70% chance (0.5 + 0.2) of fines of at least $1 4m,
which exceeds the NPV of the costs of the pollution control project. In other words, there is a
70% chance that the project will be worthwhile. It therefore seems perverse to reject it on
these figures.
Moreover, given that Blackwater is a persistent offender, and that the green lobby is
becoming more influential, there must be a strong likelihood that the level of fines will
increase in the future, suggesting that the data given are under-estimates. Higher expected
fines would further enhance the appeal of the project.
It is also possible that the company may sell more output, perhaps at a higher price, if it is
perceived to be more environmentally friendly and if customers are swayed by this. This may
be less likely for industrial companies although it would create opportunities for self-publicity
on both sides. In addition, there may be more general image effects which may foster
enhanced self-esteem among the workforce, as well as increasing the acceptability of the
company in the local community.
Sa
m
It is even possible that the company’s share price may benefit from managers of “ethical”
investment funds deciding to include Blackwater in their portfolios.
Finally, this may be only a short-term solution. As the operating life of the equipment is only
four years, we will face a further investment decision after this period, although technological
and legal changes may well have altered the situation by then.
Answer 11 ARG CO
(a)
NPV calculation for Alpha and Beta
Year
Sales revenue
Material cost
Fixed costs
Advertising
Taxable profit
Taxation
WDA tax benefit
Fixed asset sale
WC recovery
Net cash flow
Discount factors
Present values
1
2
3
4
$
$
$
$
3,585,000
6,769,675
6,339,000
1,958,775
(1,395,000) (2,634,225) (2,466,750)
(761,925)
(1,000,000) (1,050,000) (1,102,500) (1,157,625)
(500,000)
(200,000)
(200,000)
–––––––––– –––––––––– –––––––––– ––––––––––
690,000
2,885,450
2,569,750
39,225
(172,500)
(721,362)
(642,438)
(9,806)
250,000
1,200,000
1,000,000
–––––––––– –––––––––– –––––––––– ––––––––––
767,500
2,164,088
1,927,312
2,229,419
0·885
0·783
0·693
0·613
–––––––––– –––––––––– –––––––––– ––––––––––
679,237
1,694,481
1,335,626
1,366,634
$
5,075,978
3,000,000
–––––––––––
Net present value
2,075,978
–––––––––––
The positive NPV indicates that the investment is financially acceptable.
Sum of present values
Initial investment
WORKINGS
Alpha sales revenue
1
31·00
60,000
1,860,000
2
31·93
110,000
3,512,300
3
32·89
100,000
3,289,000
4
33·88
30,000
1,016,400
Year
Selling price ($/unit)
Sales (units/year)
Sales revenue ($/year)
1
23·00
75,000
1,725,000
2
23·69
137,500
3,257,375
3
24·40
125,000
3,050,000
4
25·13
37,500
942,375
Year
1
3,585,000
2
6,769,675
3
6,339,000
4
1,958,775
Beta sales revenue
pl
e
Year
Sales (units/year)
Sa
m
Alpha direct material cost
Year
Material cost ($/unit)
Sales (units/year)
Material cost ($/year)
1
12·00
60,000
720,000
2
12·36
110,000
1,359,600
3
12·73
100,000
1,273,000
4
13·11
30,000
393,300
Year
Material cost ($/unit)
Sales (units/year)
1
9·00
75,000
675,000
2
9·27
137,500
1,274,625
3
9·55
125,000
1,193,750
4
9·83
37,500
368,625
Year
1
1,395,000
2
2,634,225
3
2,466,750
4
761,925
Beta direct material cost
(b)
Limitations in evaluation of proposed investment
The evaluation assumes that several key variables will remain constant, such as the discount
rate, inflation rates and the taxation rate. In practice this is unlikely. The taxation rate is a
matter of government policy and so may change due to political or economic necessity.
Specific inflation rates are difficult to predict for more than a short distance into the future
and in practice are found to be constantly changing. The range of inflation rates used in the
evaluation is questionable, since over time one would expect the rates to converge. Given the
uncertainty of future inflation rates, using a single average inflation rate might well be
preferable to using specific inflation rates.
1028
The discount rate is likely to change as the company’s capital structure changes. For
example, issuing debentures with an interest rate of 9% is likely to decrease the average cost
of capital.
Looking at the incremental fixed production costs, it seems odd that nominal fixed production
costs continue to increase even when sales are falling. It also seems odd that incremental
fixed production costs remain constant in real terms when production volumes are changing.
It is possible that some of these fixed production costs are stepped, in which case they should
decrease.
pl
e
The forecasts of sales volume seem to be too precise, predicting as they do the growth,
maturity and decline phases of the product life-cycle. In practice it is likely that
improvements or redesign could extend the life of the two products beyond five years. The
assumption of constant product mix seems unrealistic, as the products are substitutes and it is
possible that one will be relatively more successful. The sales price has been raised in line
with inflation, but a lower sales price could be used in the decline stage to encourage sales.
Net working capital is to remain constant in nominal terms. In practice, the level of working
capital will depend on the working capital policies of the company, the value of goods, the
credit offered to customers, the credit taken from suppliers and so on. It is unlikely that the
constant real value will be maintained.
The net present value is heavily dependent on the terminal value derived from the sale of
fixed assets after five years. It is unlikely that this value will be achieved in practice. It is
also possible that the machinery can be used to produce other products, rather than be used
solely to produce Alpha and Beta.
Proposal to finance investment with $3 million 9% convertible debenture issue
Sa
m
(c)
ARG currently has $50m of fixed assets and long-term debt of $10m. The issue of $3m of
9% debentures will increase fixed assets by $2m of buildings and machinery. There seems to
be ample security for the new issue.
Interest cover is currently 5·1 (4,560/900) which is less than the sector average, and this will
fall to 3·9 (4,560/(900 + 3m × 9%)) following the debenture issue. The new products will
increase profit by $440,000 ($690,000 – $250,000 of depreciation), increasing interest cover
to 4·3 (5,000/1,170). Although on the low side and less than the sector average, this
evaluation ignores any increase in profits from current activities. Interest cover may not be a
cause for concern.
Current gearing using debt/equity based on book values of 32% (10,000/30,900) will rise to
42% (13,000/30,900) after the debenture issue. Both values are less than the sector average
and ignore any increase in reserves due to next year’s profits. Financial risk appears to be at
an acceptable level and gearing does not appear to be a problem.
The debentures are convertible after eight years into 20 ordinary shares per $100 debenture.
The current share price is $4·00, giving a conversion value of $80. For conversion to be
likely, a minimum annual growth rate of only 2·83% is needed ((5·00/4·00)0·125 – 1). This
growth rate could well be exceeded, making conversion after eight years a likely prospect.
This analysis assumes that the floor value on the conversion date is the par value of $100: the
actual floor value could well be different in eight years’ time, depending on the prevailing
cost of debt.
Conversion of the debentures into ordinary shares will eliminate the need to redeem them, as
well as reducing the company’s gearing.
The current share price may be depressed by the on-going recovery from the loss-making
magazine publication venture. Annual share price growth may therefore be substantially in
excess of 2·83%, making the conversion terms too generous (assuming a floor value equal to
par value on the conversion date). On conversion, 600,000 new shares will be issued,
representing 23% (100 × 0·6m/2·6m) of share capital. The company must seek the views and
approval of existing shareholders regarding this potential dilution of ownership and control.
The maturity of the debentures (12 years) does not match the product life-cycle (four years).
This may be caution on the part of the company’s managers, but a shorter period could be
used.
Answer 12 BFD CO
(a)
pl
e
It has been proposed that $1 million of the debenture issue would be used to finance the
working capital needs of the project. Financing all working capital from a long-term source is
a very conservative approach to working capital financing. ARG could consider financing
fluctuating current assets from a short-term source such as an overdraft. By linking the
maturity of the finance to the maturity of the assets being financed, ARG would be applying
the matching principle.
Net present value evaluation of proposed investment
Sales revenue
Variable costs
2006/7
$000
2,160
1,020
––––––
1,140
450
––––––
690
173
––––––
517
0·797
––––––
412
––––––
Sa
m
Contribution
Fixed costs
2005/6
$000
1,800
850
––––––
950
450
––––––
500
125
––––––
375
0·893
––––––
335
––––––
Net cash flow
Taxation
After-tax cash flow
12% discount factors
Present values
Sum of present values
PV of tax benefits
PV of cash flows after Year 4 =
Less initial investment
Net present value
1030
2007/8
$000
2,340
1,105
––––––
1,235
450
––––––
785
196
––––––
589
0·712
––––––
419
––––––
2008/9
$000
2,520
1,190
––––––
1,330
450
––––––
880
220
––––––
660
0·636
––––––
419
––––––
$
1,585,000
423,750
3,498,000
–––––––––
5,506,750
3,200,000
–––––––––
2,306,750
–––––––––
WORKINGS
Sales volume (units)
Sales revenue ($)
Variable costs ($/unit)
Variable costs ($)
2005/6
100,000
18·00
1,800,000
8·50
850,000
2006/7
120,000
18·00
2,160,000
8·50
1,020,000
2007/8
130,000
18·00
2,340,000
8·50
1,105,000
2008/9
140,000
18·00
2,520,000
8·50
1,190,000
Fixed costs = 4·50 × 100,000 = $450,000 per year
pl
e
Annual writing down allowance = 3,000,000/10 = $300,000
Annual writing down allowance tax benefits = 25% × 300,000 = $75,000
Ten-year annuity factor at 12% = 5·650
Present value of writing down allowance tax benefits = 75,000 × 5·650 = $423,750
Year 4 value of year 5 after-tax cash flows in perpetuity = 660,000/0·12 = $5,500,000
Present value of these cash flows = 5,500,000 × 0·636 = $3,498,000
(b)
Acceptability of proposed investment
From a NPV perspective the proposed investment is acceptable, since NPV is large and
positive. However, a large part of the present value of benefits (63%) derives from the
assumption that cash flows will continue indefinitely after Year 4. This is very unlikely to
occur in practice and excluding these cash flows will result in a negative net present value of
approximately $1·2m. In fact the proposed investment will not show a positive NPV until
more than seven years have passed.
Sa
m
Before rejecting the proposal, steps should be taken to address some of the limitations of the
analysis performed.
Inflation
Forecasts of future inflation of sales prices and variable costs should be prepared, so that a
nominal NPV evaluation can be undertaken. This evaluation should employ a nominal aftertax cost of capital: it is not stated whether the 12% after-tax cost of capital is in nominal or
real terms. Sales price is assumed to be constant in real terms, but in practice substitute
products are likely to arise, leading to downward pressure on sales price and sales volumes.
Constant fixed costs
The assumption of constant fixed costs should be verified as being acceptable. Sales volumes
are forecast to increase by 40% and this increase may result in an increase in incremental
fixed costs.
Constant working capital
The assumption of constant working capital should be investigated. Net working capital is
likely to increase in line with sales and so additional investment in working capital may be
needed in future years. Inflation will increase required incremental working capital
investment.
Taxation and capital allowances
The assumptions made regarding taxation should be investigated. The tax rate has been
assumed to be constant, when there may be different rates of profit tax applied to companies
of different size. The method available for claiming capital allowances should be confirmed,
since it is usual to find a different method being applied to buildings compared to that applied
to machinery, whereas in this case they are the same.
Machine replacement
The purchase of replacement machinery has been ignored, which seems unreasonable. Future
reinvestment in new machinery will be needed and this will reduce the net present value of
the proposed investment.
Changes in technology
Technological change is also possible, bringing perhaps new manufacturing methods and
improved or substitute products, and these may affect the size of future cash flows.
Financing
(c)
pl
e
The method of financing the proposed investment should be considered. It may be that
leasing will be cheaper than borrowing to buy, increasing the net present value and making
the project more attractive. The amount of the investment is large compared to the current
long-term capital employed by BFD and the after-tax cost of capital is likely to change as a
result. A lower cost of capital would increase the NPV.
Offer for manufacturing rights for a 10-year period
Annual after-tax cash flow after Year 4 = $660,000
Present value of this cash flow over six years at 12% = 660,000 × 4·111 = $2,713,260
Present value of post-Year 4 cash flows = 2,713,260 × 0·636 = $1,725,633
Sa
m
Sum of present values over 4 years
PV of tax benefits
PV of cash flows from Year 5 to Year 10 =
Less initial investment
Net present value
1,585,000
423,750
1,725,633
–––––––––
3,734,383
3,200,000
–––––––––
534,383
–––––––––
This net present value is equivalent to an annual benefit of 534,383/ 5·650 = $94,581.
The after-tax value of the offer of $300,000 per year for 10 years = 300,000 × 0·75 = $225,000.
In the absence of other information, the offer should be accepted.
An alternative approach is to calculate the present value of the offer:
300,000 × 0·75 × 5·650 = $1,271,250
Since this is greater than the NPV of investing by $736,867 the offer should be accepted.
(d)
To:
The Board of BFD Co
From: Finance Director
Date:
Subject: Proposal to seek $3·2 million of Debt Finance
1.
1032
Introduction
This report considers whether seeking $3·2 million of debt finance is likely to be
successful in the light of our current financial position and recent financial
performance.
2.
Sector Data
I have obtained some benchmark data relating to companies active in our business
sector. The sector data applies to the current year and may not be applicable in
previous years.
3.
Analysis of Financial Data
Analysis of our financial statements gives the following results.
2002/3
31%
33%
19%
165
4·7
104
56
69
2·2
0·9
4%
2003/4
53%
63%
17%
17
6·2
130
91
95
1·4
0·7
33%
2004/5
12%
9
9·5
116
98
90
1·2
0·6
54%
Sector value
9%
15
pl
e
Turnover growth
Cost of sales growth
Net profit margin
Interest cover
Sales/net working capital
Inventory days
Receivables days
Payables days
Current ratio
Quick ratio
Gearing (debt/equity ratio)
85
75
70
2·1
0·8
40%
Tutorial note: gearing calculations are based on our average overdraft, as our company has
no long-term debt. This seems a reasonable approach to calculating gearing, since our
overdraft is a large and increasing one.
2002/3
3,000
50,000
400,000
Sa
m
WORKINGS
Annual interest at 6% ($)
Overdraft ($)
Trade payables ($)
4.
2003/4
34,000
567,000
733,000
2004/5
70,000
1,167,000
1,133,000
Comment on Financial Position and Performance
BFD has experienced rapid growth in turnover since its formation three years ago,
but it has been unable to maintain net profit margin, which has fallen from 19% in
2002 to 12% in 2004. On a positive note, our net profit margin is higher than the
sector average, but this may also indicate that a further decrease may arise.
Our growth in turnover has not been matched by growth in long-term finance.
Apart from the original equity investment made by the founder directors, growth in
long-term finance has been through retained earnings alone. Our company has
increasingly relied on short-term finance and over the three-year period the
overdraft has grown from $50,000 to $1,167,000. From a financial risk point of
view, gearing has increased from 4% to 54% and interest cover has declined from
165 times to nine times. Both ratios are currently worse than the comparable sector
average. The average period of time in which we settle with trade payables has
grown from 69 days to 90 days compared to a sector average of 70 days.
The average amount of credit extended by the sector is 75 days but our receivables’
ratio has grown from 56 days to 98 days. This has increased the amount of working
capital finance we need, as has the growth in inventory days from 104 days to 116
days compared to a sector average of 85 days. Funds which are tied up in inventory
and receivables decrease profitability.
There is further bad news in the area of working capital management since both our
current ratio and quick ratio are less than the current sector average, having declined
in each of the past two years.
Effect of Additional Debt Finance on Current Financial Position
Debt finance of $3·2m would increase gearing on a book value basis from 54% to
203% ((1,167 + 3,200)/2,150), which is five times the sector average. If the
overdraft is ignored in calculating gearing it would still be four times the sector
average at 148% (3,200/2,150). Assuming interest at a fixed rate of 8%, our interest
cover would fall from 9 times to 1·9 times (630/ (272 + 70)). This is a dangerously
low level of interest cover. We would need to assess whether we could offer
security for a loan of this size.
6.
Chances of Success in Application for Debt Finance
I must advise you that there are signs of overtrading in our recent financial
statements and our company is approaching its overdraft limit of $1·25 million. We
will need to obtain further long-term finance regardless of whether our application
for a $3·2 million bank loan is successful.
pl
e
5.
I note that no further equity investment is available from the current directors. It
may be in our best interests to address our overall long-term financing needs rather
than seeking finance only for the proposed investment in Product FT7 manufacture.
Our overall long-term financing need is greater than $3·2 million.
Sa
m
It is my opinion, based on our recent financial performance, our current financial
position, and the effect of such a large amount of debt on our capital structure, that
an application for a $3·2 million bank loan would not be successful and that
alternative sources of finance should be sought. I would be pleased to advise on
these if the board requested.
Answer 13 STICKY FINGERS CO
(a)
No rationing
Year
Time
Discount factor
Project A
Project B
Project C
Project D
Project E
Project A
Project B
Project C
Project D
Project E
1034
0
t0
1
$000
(1,500)
(2,000)
(1,750)
(2,500)
(1,600)
Present values
1
2
3
t1
t2
t3
0.870
0.756
0.658
4
t4
0.572
$000
(435)
(870)
435
609
(435)
$000
172
1,430
572
172
1,316
$000
907
1,890
832
680
151
$000
395
1,645
921
855
1,842
NPV
$000
(461)
2,095 Therefore, accept all projects with a
1,010 positive NPV - projects B, C and E
(184)
1,274
(b)
Single-period capital rationing
Project
NPV ($000)
Investment, t0 ($000)
A
(461)
1,500
NPV/$
Rank
–
–
Therefore, accept B and
C
1,010
1,750
$1.05
1st
$0.58
3rd
D
(184)
2,500
–
–
E
1,274
1,600
$0.80
2nd
E.
Single-period capital rationing – inflows and outflows, negative NPVs
Using benefit cost ratios
Project A
Project B
Project C
Project D
Project E
Notes
Benefit/cost
NPV per
$1 invested
$2,095/$1,000
$2.10
$184/$700
$1,274/$500
$0.26
$2.55
Ranking
*
2
*
**
1
Project A would never be accepted because it has a negative NPV and uses up
funds in the restricted year.
Sa
m
*
NPV
Rationed investment
pl
e
(c)
10
16
B
2,095
2,000
Project C would always be accepted since it has a positive NPV and releases
funds in the restricted year. A total of $700,000 is then available.
**
Project D has a negative NPV but releases funds at t1.
If project D is accepted, this makes an extra $700,000 available at t1. However, in doing
so a negative NPV (– $184,000) is incurred. Thus, it is necessary to examine whether the
extra positive NPV generated by the additional investment finance outweighs this cost.
(d)
(1)
Available capital = $200,000. Accept projects C, E and 20% B. Total NPV =
$2,703,000.
(2)
If D is accepted the available capital becomes $1,400,000 [$200,000 +
$500,000 (from project C) + $700,000 (from project D)]. Accept projects C, D,
E and 90% B. Total NPV = $3,985,500. This is the optimal solution.
Indivisible projects
Possible investment “portfolios” are B or C or E or (C and E)
The portfolio which has the highest NPV is C and E requiring an investment of $3.35
million and generating $2.3 million.
Answer 14 TALEB CO
Summary showing the optimal replacement policy for Taleb’s Dot machines
Annual equivalent net revenue
$000
8.0
11.1 *
9.8
10.3
Replacement cycle
1 year
2 years
3 years
4 years
* optimal policy
WORKINGS
pl
e
Replacement of the Dot machine every two years results in the greatest annual equivalent net
revenue for the company (i.e. $11,100) and therefore is the recommended replacement policy.
Annual production/sales (units)
Annual revenue ($0.12 per unit)
Less Annual variable costs ($0.04 per unit)
(i)
500,000
400,000
$
60,000
(20,000)
———
40,000
———
$
48,000
(16,000)
———
32,000
———
One year replacement
Year 1
$000
Sa
m
Machine outlay
Scrap value
Running costs
Contribution
Year 0
$000
(60)
——
(60)
——
Net cash flow
Net present values
40
(6)
40
——
74
——
= – 60 + (74  0.909) = 7.266
= 7.266 ÷ 0.909  $7,993
———
Two year replacement
Annual equivalent
(ii)
Machine outlay
Scrap value
Running costs
Contribution
Net cash flow

1036
Year 0
$000
(60.0)
———
(60.0)
———
Years 1
$000
Year 2
$000
(6.0)
40.0
———
34.0
———
25.0
(6.5)
40.0
———
58.5
———
Net present values
= – 60 + (34  0.909) + (58.5  0.826)
= 19.227
Annual equivalent


= 19.227 ÷ 1.736
 $11,075
———–
(iii)
Three year replacement
Year 0
$000
(60.0)
Machine outlay
Scrap value
Running costs
Contribution
———
(60.0)
———
Net cash flow
Year 1
$000
Year 2
$000
Year 3
$000
(6.0)
40.0
———
34.0
———
(6.5)
40.0
———
33.5
———
10.0
(7.5)
32.0
———
34.5
———
Net present values
= – 60 + (34  0.909) + (33.5  0.826) + (34.5  0.751) = 24.4865
Annual equivalent
= 24.4865 ÷ 2.487  
pl
e
(iv)
Four year replacement



Machine outlay
Scrap value
Running costs
Contribution


Year 0
$000
(60.0)
———
(60.0)
———
Net cash flow
Year 1
$000
Year 2
$000
Year 3
$000
Year 4
$000
(6.0)
40.0
———
34.0
———
(6.5)
40.0
———
33.5
———
(7.5)
32.0
———
24.5
———
0
(9.0)
32.0
———
23.0
———
= – 60 + (34  0.909) + (33.5  0.826) + (24.5  0.751) + (23  0.683)
Sa
m
Net present values
 $9,846
———
= 32.6855

Annual equivalent
= 32.6855 ÷ 3.170

 $10,311
———–

Answer 15 STAN BELDARK
(a)
Optimal replacement period
The effects of increasing running costs and decreasing resale value have to be weighed up
against capital cost. Road fund licence, etc. can be ignored, since Stan will always pay
$300 per year per car.
The following table is one of the quickest ways to reach an answer:
Life 1
Life 2
Life 3
Running
cost
$
3,000
3,500
4,300
PV Cum PV Resale PV of
of RC of RC
value
RV
$
$
$
$
2,727 2,727
3,500 3,182
2,891 5,618
2,100 1,735
3,229 8,847
900
676
NPV of Cum
car discount
$
factor
5,045 0.909
9,383 1.736
13,671 2.487
EAC
$
5,550
5,405
5,497
From the above table it can be seen that the optimal replacement period is every two years.
(b)
Discussion of investment appraisal and high inflation rates
The existence of high inflation creates problems in investment appraisal by contributing to the
uncertainty attached both to the cash flows and to the appropriate discount rate. It is unlikely
that in any investment appraisal each cash flow stream will be affected in the same way by
inflation. Higher rates of inflation will tend to be more volatile than lower rates, especially as
government action will be directed to reducing them.
pl
e
With different inflation rates applying to each item (e.g. materials and labour), the value of an
investment could be highly sensitive to changes in those rates. The extent to which the effect
of inflation can be passed on by raising selling prices must also become less certain as
government controls, competitors’ reactions and the elasticity of demand become more
important. The appraisal procedures must therefore focus more attention on predicting the
effect of inflation on each type of cash flow.
The existence of high rates of inflation will also affect the discount rate used. The
conventional treatment is to discount the anticipated money cash flows at a money discount
rate. This money rate would normally be the yield for shareholders and the required rate of
return for other suppliers of capital such as debenture holders. Such a required rate of return
will be a rate reflecting the time value of money to the provider of funds, plus an additional
return to compensate for the decrease in purchasing power caused by inflation.
Sa
m
Clearly, with higher anticipated inflation rates such a money rate will be higher than with
lower rates. However, the company must anticipate such a required rate of return when
evaluating capital projects. With high inflation rates this anticipation becomes more difficult,
as again the expectations of the shareholders as to the effect of inflation on them will become
more diverse. Moreover, with the increased probability of changes in inflation in the future
the required rate of return is unlikely to be constant over the life of the project. The company
will be faced with increasing uncertainty as to whether it is acting in the best interests of
shareholders by accepting/rejecting a particular project.
Answer 16 ARMSTRONG CO
(a)
Investment decision
t0
$
Contribution from
new product
Contribution forgone
from old product
Advertising
Tax at 35%
Land
New building
CAs (W1)
Discount factor
at 15%
Present value
$(150,000)
t1
$
t2
$
t3
$
t4
$
t5
$
30,000
50,000
60,000
122,500
122,500
(30,000) (22,500) (4,500) (1,500)
(14,200)
———– ——— ——— ——— ———
–
27,500 41,300 121,000
(9,625) (14,455)
(120,000)
(30,000)
420
420
420
420
———– ——— ——— ——— ———–
(150,000)
420 27,920 32,095 106,965
———– ——— ——— ——— ———–
1
0.870
0.756
0.658
0.572
365
21,108
21,119
61,184
t6
$
–
—–——
122,500
(42,350)
160,000
25,000
420
———–
265,570
———–
0.497
———
(42,875)
(350)
———
(43,225)
———
0.432
131,988 (18,673)
NPV = $67,091
–––––––
1038
This NPV does not include cash flows relating to the acquisition of the burnishing machine.
Of the two options for the acquisition, leasing has the lower present value of costs, at $61,981
(see part (b)). Since this is lower than the present value of the benefits from the project
($67,091 above), the project is worthwhile, and should be undertaken.
(b)
Financing options (burnishing machine)
(i)
Purchase
Present value
$
100,000
(25,996)
———–
74,004
———–
(ii)
Leasing
pl
e
Purchase price
Tax saved (W2)
Lease rentals $21,800  (1 + 3.170)
Tax relief $21,800  0.35  3.791
Present value
$
90,206
(28,925)
———
61,981
———
Sa
m
The above calculations demonstrate that, at a discount rate of 10%, leasing is the preferred
method of financing the machine. This does not mean, however, that the project is worth
undertaking. As shown in (a) above, the decision must be taken after comparison of the
present value of the cheaper option with the present value of the benefits to be obtained
from acquiring the machine and undertaking the project.
The calculations above have been made at a discount rate of 10%, the after-tax cost of
borrowing from the bank to finance the purchase. This rate is taken to be risk-free and is
the appropriate rate to use for risk-less flows such as those in the two financing options.
WORKINGS
Capital allowances
(1)
Building
Years 0 to 4
WDA 4%  $30,000
Tax saved 35%  $1,200
$
1,200
———
420
———
Timing t1 to t5
Year 5
Sale proceeds
Written down value $30,000 – 5  $1,200
Balancing charge
Tax effect at 35%
©2014 DeVry/Becker Educational Development Corp. All rights reserved. 25,000
(24,000)
———
1,000
———
350
———
1039
(2)
Burnishing plant
Tax
WDV
$
100,000
(25,000)
———
75,000
(18,750)
———
56,250
(14,062)
———
42,188
(10,547)
———
31,641
(7,911)
———
23,730
Cost (t0)
WDA (year 0)
WDA (year 2)
WDA (year 3)
WDA (year 4)
SV (year 5)
$
Time
Discount
factor
at 10%
PV
$
$
25,000
8,750
t1
0.909
7,954
18,750
6,563
t2
0.826
5,421
14,062
4,922
t3
0.751
3,696
10,547
3,691
t4
0.683
2,521
7,911
2,769
t5
0.621
1,720
23,730 23,730 8,305
——— ———– ———
100,000 35,000
———– ———
t6
0.564
4,684
———
25,996
———
pl
e
WDA (year 1)
CAs Tax saved
at 35%
–
———
Sa
m
Balancing allowance
(year 5)
Answer 17 SASSONE CO
(a)
Optimal replacement cycle
Machine One
Year
Initial Investment
Maintenance
0
$
(238,850)
1
$
2
$
3
$
(10,000) (13,000) (16,000)
1·000
0·901
0·812
0·731
––––––– –––––– –––––– ––––––
(238,850) (9,010) (10,556) (11,696)
––––––– –––––– –––––– ––––––
Present value of costs = $295,679
Annuity factor for five years at 11% = 3·696
Equivalent annual cost = 295,679/3·696 = $80,000 per year
4
$
5
$
(19,000)
0·659
––––––
(12,521)
––––––
(22,000)
0·593
––––––
(13,046)
––––––
Machine Two
Year
Initial Investment
Maintenance
1040
0
$
(215,000)
1
$
2
$
3
$
(10,000) (15,000) (20,000)
1·000
0·901
0·812
0·731
––––––– –––––– –––––– ––––––
(215,000) (9,010) (12,180) (14,620)
––––––– –––––– –––––– ––––––
4
$
(25,000)
0·659
––––––
(16,475)
––––––
pl
e
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