ACCA
Financial
Management(FM)
串讲课
答案解析
ACCA- Financia Management (FM)-Revision
Answer
CONTENT
PART A ........................................................................................................................................................... 2
Section A ...................................................................................................................................................................................... 2
PART B ........................................................................................................................................................... 2
Section A ...................................................................................................................................................................................... 2
PART C ........................................................................................................................................................... 2
Section A ...................................................................................................................................................................................... 2
Section C ...................................................................................................................................................................................... 2
1. ZXC Co (2015 Sep/Dec） ......................................................................................................................................... 2
2. ZPS Co (June 2011)..................................................................................................................................................... 3
3. Dusty Co (Sep/Dec 2019) ......................................................................................................................................... 4
4. Oscar Co (Sep/Dec 2018) ......................................................................................................................................... 6
5. Gorwa Co (Dec 2008)................................................................................................................................................. 8
6. Pangli Co (Mar/Jun 2017) ......................................................................................................................................... 9
PART D .......................................................................................................................................................... 11
Section A .................................................................................................................................................................................... 11
Section B .................................................................................................................................................................................... 11
Section C .................................................................................................................................................................................... 11
2. Pelta Co (Sep/Dec 2017)......................................................................................................................................... 13
3. Degnis Co (2016 Mar/June sample).................................................................................................................... 14
4. Melanie Co (Sep/Dec 2018) ................................................................................................................................... 15
5. OAP Co (June 2014) ................................................................................................................................................. 17
6. SC Co (Jun 2008) ....................................................................................................................................................... 19
7. Dink Co (Sep/Dec 2019) ......................................................................................................................................... 21
PART E .......................................................................................................................................................... 23
Section A .................................................................................................................................................................................... 23
Section B .................................................................................................................................................................................... 23
Section A .................................................................................................................................................................................... 23
Section B .................................................................................................................................................................................... 23
Section C .................................................................................................................................................................................... 24
1. Corfe Co (Mar/Jun 2019) ........................................................................................................................................ 24
2. Card Co (Dec 2013) .................................................................................................................................................. 25
3. Nugfer Co (Dec 2010).............................................................................................................................................. 26
4. KQK Co (Sep/Dec 2015) .......................................................................................................................................... 28
PART F........................................................................................................................................................... 30
Section A .................................................................................................................................................................................... 30
Section B .................................................................................................................................................................................... 30
PART G .......................................................................................................................................................... 30
Section A .................................................................................................................................................................................... 30
Section B .................................................................................................................................................................................... 30
1
ACCA- Financia Management (FM)-Revision
Answer
PART A
Section A
1.D
2.A
3.C
4.D
5.A
6.A
3.C
4.B
5. 3.80
3.D
4.B
5.C
7.C
8.A&B
PART B
Section A
1.D
2.A
PART C
Section A
1.A
2.B
6.A
7. 10.8
8. 30200
Section C
1. ZXC Co (2015 Sep/Dec）
(a)
Current credit sales =$30mx 0.8 = $24m; Credit sales after introducing discount=$24m x 1.2=$28.8m
Increase in income by introducing discount = $24,m x 0.2 = $4.8m
Increase in net profit (profit before interest and tax) = $4.8m x 0.1 = $0.48m
Current level of bad debts = $24m x 0.005 = $120k /year
Revised level of bad debts = $28.8mx 0.00375 = $108k /year; This would be a benefit of $120k– $108k= $12k/year
$’000
Trade receivables taking discount = $28,800,000 x 0.75 x 30/360 =
1,800
Trade receivables not taking discount = $28,800,000 x 0.25 x 51/360 =
1,020
Revised level of trade receivables
2,820
Current trade receivables = $24,000,000 x 51/360 =
3,400
Reduction in trade receivables
580
Benefits
Reduction in financing costs = 580,000 x 0.04 =
Increase in net profit =
Reduction in bad debts =
$
23,200
480,000
12,000
$
515,200
Costs
Increase in administration costs
Cost of discount = $28,800,000 x 0.005 x 0.75 =
Net benefit of proposed early settlement discount =
2
35,000
108,000
143,000
372,200
ACCA- Financia Management (FM)-Revision
Answer
(b)
A company could reduce the risk associated with foreign accounts receivable, such as export credit risk, by
reducing the level of investment in them, for example, by using bills of exchange.
If payment by the foreign customer is linked to bills of exchange, these can either be discounted or negotiated by a
company with its bank. Discounting means that the trade bills (term bills) are sold to the bank at a discount to their
face value. The company gets cash when the bills are discounted, thereby decreasing the outstanding level of trade
receivables. Negotiation means that the bank makes an advance of cash to the company, with the debt being settled
when the bills of exchange (sight bills) are paid.
Advances against collection means that the bank handling the collection of payment on behalf of the selling
company could be prepared to make a cash advance of up to 90% of the face value of the payment instrument, for
example, bills of exchange. Again, this would reduce the level of investment in foreign accounts receivable.
The risk of non-payment by foreign accounts receivable can be reduced by raising an international letter of credit
(documentary credit) linked to the contract for the sale of goods. This could be confirmed (guaranteed) by a bank
in the foreign customer’s country.
The exporting company could also arrange for export credit insurance (export credit cover) against the risk of nonpayment, which could occur for reasons outside the control of the foreign customer.
The risk of foreign accounts receivable becoming bad debts can be reduced by performing the same
creditworthiness assessment processes on foreign credit customers as those used with domestic credit customers,
such as seeking credit references and bank references.
Examiner’s note: Only TWO methods were required to be discussed.
2. ZPS Co (June 2011)
(i)
Working capital policies can cover the level of investment in current assets, the way in which current assets are
financed, and the procedures to follow in managing elements of working capital such as inventory, trade receivables,
cash and trade payables. The twin objectives of working capital management are liquidity and profitability, and
working capital policies support the achievement of these objectives. There are several factors that influence the
formulation of working capital policies, as follows.
Nature of the business
The nature of the business influences the formulation of working capital policy because it influences the size of the
elements of working capital. A manufacturing company, for example, may have high levels of inventory and trade
receivables, a service company may have low levels of inventory and high levels of trade receivables, and a
supermarket chain may have high levels of inventory and low levels of trade receivables.
The operating cycle
The length of the operating cycle, together with the desired level of investment in current assets, will determine the
amount of working capital finance needed. Working capital policies will therefore be formulated so as to optimise
as much as possible the length of the operating cycle and its components, which are the inventory conversion period,
the receivables conversion period and payables deferral period.
Terms of trade
Since a company must compete with other companies to be successful, a key factor in the formulation of working
capital policy will be the terms of trade offered by competitors. The terms of trade must be comparable with those
of competitorsand the level of receivables will be determined by the credit period offered and the average credit
period taken by customers.
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ACCA- Financia Management (FM)-Revision
Answer
Risk appetite of company
A risk-averse company will tend to operate with higher levels of inventory and receivables than a company
which is more risk-seeking. Similarly, a risk-averse company will seek to use long-term finance for permanent
current assets and some of its fluctuating current assets (conservative policy), while a more risk-seeking
company will seek to use short-term finance for fluctuating current assets as well as for a portion of the
permanent current assets of the company (an aggressive policy).
(ii) Early settlement discount
Annual cost of components = 120,000 x 7.50 = $900,000 /year
Value of discount offered = 900,000 x 0.005 = $4,500; current payables = 900,000 x 90/365 = $221,918
Revised payables = 900,000 x 30/365 = $73,973; reduction in payables = 221,918 – 73,973 = $147,945
Annual cost of borrowing = 4.5% /year; increase in financing cost by taking discount = 147,945 x 0.045 = $6,657
Since the increase in financing cost is $2,157 greater than the discount offered, ZPS Co will not benefit financially by
taking the early settlement discount.
Bulk purchase discount
Current number of orders = 120,000/10,000 = 12 orders; current ordering cost = 12 x 200 = $2,400 /year
Current holding cost = (10,000/2) x 1 = $5,000 /year; annual cost of components = $900,000 /year
Total cost = 900,000 + 2,400 + 5,000 = $907,400 /year
With bulk purchase discount
Number of orders = 120,000/30,000 = 4 orders /year; ordering cost = 4 x 200 = $800 /year
Holding cost= (30,000/2) x 2.2 = $33,000/year; annual cost of components =120,000 x 7.50 x 0.964 = $867,600/year
Total = 867,600 + 800 + 33,000 = $901,400 /year; Net saving = 907,400 – 901,400 = $6,000
It is financially beneficial. So ZPS Co should take the bulk discount offered by the supplier.
3. Dusty Co (Sep/Dec 2019)
(a)
(i) Annual holding and ordering costs of the current inventory management system
Each current order is 1,500,000/12 = 125,000 units per order; Average inventory = 125,000/2 = 62,500 units
Current holding cost = 62,500 x 0.21 = $13,125 /year; Current ordering cost = 12 x 252 = $3,024 /year
Current total inventory management cost = $13,125 + $3,024 = $16,149 /year
(ii)
Financial effect of adopting EOQ model
EOQ = (2 x 252 x 1,500,000/0.21)0.5 = 60,000 units/order
Number of orders = 1,500,000/60,000 = 25 orders/year
Average inventory = 60,000/2 = 30,000 units; Holding cost = 30,000 x 0.21 = $6,300/year
Ordering cost = 25 x 252 = $6,300 /year
EOQ total inventory management cost = $6,300 + $6,300 = $12,600/year
Reduction in total inventory management cost = $16,149 – $12,600 = $3,549 /year
Reduction in average inventory = (62,500 – 30,000) x 14 = $455,000
The overdraft will decrease by the same amount.
Finance cost saving = 455,000 x 0.03 = $13,650 /year; Overall saving = $3,549 + $13,650 = $17,199
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ACCA- Financia Management (FM)-Revision
Answer
(iii)
Financial effect of accepting the bulk order discount
Number of orders = 1,500,000/250,000 = 6 orders /year
Average inventory = 250,000/2 = 125,000 units;
Holding cost = 125,000 x 0.21 = $26,250 /year
Ordering cost = 6 x 252 = $1,512 /year
Total inventory management cost = $26,250 + $1,512 = $27,762/year
Increase in total inventory management cost = $27,762 – $16,149 = $11,613/year
Increase in value of average inventory = (125,000 x 13.93) – (62,500 x 14) = $866,250
The overdraft will increase by the same amount.
Finance cost increase = 866,250 x 0.03 = $25,988 /year
Bulk order discount = 1,500,000 x 14 x 0.005 = $105,000 /year
Overall saving = $105,000 – $11,613 – $25,988 = $67,399
(iv)
The bulk order discount saves $67,399 compared to the current position, while the EOQ approach saves $17,199.
The bulk order discount is recommended as it leads to the greater cost saving.
Tutorial note: It would also have been acceptable to revise the holding costs in (ii) and (iii) to reflect the finance cost
of holding inventory (e.g. $0.63 in (ii)) and this approach could be awarded full credit if correct.
(b)
Key factors in determining working capital funding strategies
Permanent and fluctuating current assets
One key factor when discussing working capital funding strategies is to distinguish between permanent and
fluctuating current assets. Permanent current assets represent the core level of current assets needed to support
normal levels of business activity, for example, the level of trade receivables associated with the normal level of
credit sales and existing terms of trade. Business activity will be subject to unexpected variations, however, such as
some customers being late in settling their accounts, leading to unexpected variations in current assets. These can
be termed fluctuating current assets.
Relative cost and risk of short-term and long-term finance
A second key factor is the relative cost of short-term and long-term finance. The normal yield curve suggests that
long-term debt finance is more expensive than short-term debt finance, for example, because of investor liquidity
preference or default risk. Provided the terms of loan agreements are adhered to and interest is paid when due,
however, long-term debt finance is a secure form of finance and hence low risk.
While short-term debt finance is lower cost than long-term debt finance, it is higher risk. For example, an overdraft
is technically repayable on demand, while a short-term loan is subject to the risk that it may be renewed on less
favourable terms than those currently enjoyed.
Matching principle
A third key factor is the matching principle, which states that the maturity of assets should be reflected in the
maturity of the finance used to support them. Short-term finance should be used for fluctuating current assets,
while long-term finance should be used for permanent current assets and non-current assets.
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ACCA- Financia Management (FM)-Revision
Answer
Relative costs and benefits of different funding policies
A matching funding policy would use long-term finance for permanent current assets and non-current assets, and
short-term finance for fluctuating current assets. A conservative funding policy would use long-term finance for
permanent current assets, non-current assets and some of the fluctuating current assets, with short-term finance
being used for the remaining fluctuating current assets. An aggressive funding policy would use long-term finance
for the non-current assets and part of the permanent current assets, and short-term finance for fluctuating current
assets and the balance of the permanent current assets.
A conservative funding policy, using relatively more long-term finance, would be lower in risk but lower in
profitability. An aggressive funding policy, using relatively more short-term finance, would be higher in risk but
higher in profitability. A matching funding policy would balance risk and profitability, avoiding the extremes of a
conservative or an aggressive funding policy.
Other key factors
Other key factors in working capital funding strategies include managerial attitudes to risk, previous funding
decisions and organisation size. Managerial attitudes to risk can lead to a company preferring one working capital
funding policy over another, for example, a risk-averse managerial team might prefer a conservative working capital
funding policy. Previous funding decisions dictate the current short-term/long-term financing mix of a company.
Organisational size can be an important factor in relation to, for example, access to different forms of finance in
support of a favoured working capital funding policy.
4. Oscar Co (Sep/Dec 2018)
(a)
Option 1
Current trade receivables
Revised trade receivables
Reduction in receivables
$
5,370,000
2,301,370
3,068,630
Reduction in financing cost
Reduction in admin costs
Benefits
Factor’s fee
Net benefit
$
214,804
30,000
$
244,804
(140,000)
104,804
Option 2
Reduction in financing cost
Reduction in admin costs
Bad debts saved
Benefits
Increase in finance cost
Factor’s fee
Costs
Net benefit
$
214,804
30,000
560,000
$
804,804
36,822
420,000
(456,822)
347,982
Both options are financially acceptable to Oscar Co, with Option 2 offering the greatest benefit and therefore it
should be accepted.
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ACCA- Financia Management (FM)-Revision
Answer
(b)
Oscar Co may benefit from the services offered by the factoring company for several different reasons, as follows:
Economies of specialisation
Factors specialise in trade receivables management and therefore can offer ‘economies of specialisation’. They are
experts at getting customers to pay promptly and may be able to achieve payment periods and bad debt levels
which clients could not achieve themselves. The factor may be able to persuade the large multinational companies
which Oscar Co supplies to pay on time.
Scale economies
In addition, because of the scale of their operations, factors are often able to do this more cheaply than clients such
as Oscar Co could do on their own. Factor fees, even after allowing for the factor’s profit margin, can be less than
the clients’ own receivables administration cost.
Free up management time
Factoring can free up management time and allow them to focus on more important tasks. This could be a major
benefit for Oscar Co, where directors are currently spending a large amount of time attempting to persuade
customers to pay on time.
Bad debts insurance
The insurance against bad debts shields clients from non-payment by customers; although this comes at a cost, it
can be particularly attractive to small companies who may not be able to stand the financial shock of a large bad
debt. This could well be the case for Oscar Co. As a small company which supplies much larger car manufacturing
companies, it is particularly exposed to default by customers. On the other hand, it could be argued that large
multinational companies are financially secure and default is unlikely, rendering bad debt insurance unnecessary.
Accelerate cash inflow
Factor finance can be useful to companies who have exhausted other sources of finance. This could be useful to
Oscar Co if it cannot negotiate an increase in its overdraft limit.
Finance through growth
Although factor finance is generally more expensive than a bank overdraft, the funding level is linked to the
company’s volume of sales. This can help to finance expansion and protects the company against overtrading. In a
rapid growth company such as Oscar Co, this could be a major advantage of factor finance.
(c)
A company’s working capital investment is equal to the sum of its inventories and its accounts receivable, less
its accounts payable. The following factors will determine the level of a company’s investment in working capital:
The nature of the industry and the length of the working capital cycle
Some businesses have long production processes which inevitably lead to long working capital cycles and large
investments in working capital. Housebuilding, for example, requires the building company to acquire land, gain
government permission to build, build houses and when complete, sell them to customers. This process can often
take more than a year and require large investment in work-in-progress and therefore in working capital.
Other industries, such as supermarkets, buy goods on long credit terms, have rapid inventory turnover and sell to
customers for cash. They often receive payment from customers before they need to pay suppliers and therefore
have little (or negative) investment in working capital.
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ACCA- Financia Management (FM)-Revision
Answer
Working capital investment policy
Some companies take a conservative approach to working capital investment, offering long periods of credit to
customers (to promote sales), carrying high levels of inventory (to protect against stock-outs), and paying suppliers
promptly (to maintain good relationships). This approach offers many benefits, but it necessitates a large
investment in working capital.
Others take a more aggressive approach offering minimal credit, carrying low levels of inventory and delaying
payments to suppliers. This will result in a low level of working capital investment.
Efficiency of management and terms of trade
If management of the components of working capital is neglected, then investment in working capital can increase.
For example, a failure to apply credit control procedures such as warning letters or stop lists can result in high levels
of accounts receivable. Failure to control inventory by using the EOQ model, or JIT inventory management principles,
can lead to high level of inventory.
5. Gorwa Co (Dec 2008)
Financial analysis:
Inventory days
Receivables days
Payables days
Current ratio
Quick ratio
Sales/net working capital
(365 x 2,400)/23,781
(365 x 4,600)/34,408
(365 x 2,200)/26,720
(365 x 4,600)/37,400
(365 x 2,000)/23,781
(365 x 4,750)/34,408
4,600/3,600
9,200/7,975
2,200/3,600
4,600/7,975
26,720/1,000
37,400/1,225
2007
2006
49 days
37 days
45 days
30 days
51 days
31 days
1.15 times
1.3 times
0.58 times
0.61 times
30.5 times
26.7 times
Turnover increase
37,400/26,720
40%
Non-current assets increase
13,632/12,750
7%
Inventory increase
4,600/2,400
92%
Receivables increase
4,600/2,200
109%
Payables increase
4,750/2,000
138%
Overdraft increase
3,225/1,600
102%
Discussion
Overtrading arises when a company has too small a capital base to support its level of business activity. Difficulties
with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they fall
due. Overtrading is often associated with rapid increase in turnover, inventory, receivables, payables and shortterm loan. And furthermore, investment in working capital has not matched the increase in sales. Sales revenue of
Gorwa Co has increased by 40% in 2007. And sales/working capital ratio has increased from 26.7 times to 30.5 times.
It indicates that working capital has not matched the increase in sales.
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ACCA- Financia Management (FM)-Revision
Answer
Inventory days have increased from 37 days to 49 days, while inventory has increased by 92%. It is possible that
inventory has been stockpiled in anticipation of a further increase in turnover, leading to an increase in operating
costs.
Receivables have increased by 109%. The increase in turnover may have been fuelled in part by a relaxation of
credit terms.
The overdraft of Gorwa Co has more than doubled in size to $3.225 million, while trade payables have increased by
137%. There is evidence here of an increased reliance on short-term finance sources.
Overtrading can also be indicated by decreases in the current ratio and the quick ratio. The current ratio of Gorwa
Co has fallen from 1.3 times to 1.15 times, while its quick ratio has fallen from 0.61 times to 0.58 times.
Conclusion
There are clear indications that Gorwa Co is experiencing the kinds of symptoms usually associated with overtrading.
A more complete and meaningful analysis could be undertaken if appropriate benchmarks were available.
6. Pangli Co (Mar/Jun 2017)
(a) (i)
The cash operating cycle can be calculated by adding inventory days and receivables days, and subtracting payables
days.
Cost of sales = 3,500,000 x (1 – 0.4) = $2,100,000; Inventory days = 360 x 455,000/2,100,000 = 78 days
Trade receivables days = 360 x 408,350/3,500,000 = 42 days
Trade payables days = 360 x 186,700/2,100,000 = 32 days; Cash operating cycle of Pangli Co = 78+42-32 = 88 days
(ii)
Inventory at end of January 20X7 = 455,000 + 52,250 = $507,250
At the start of January 20X7, 100% of December 20X6 receivables will be outstanding ($300,000), together with 40%
of November 20X6 receivables ($108,350 = 40% x 270,875), a total of $408,350 as given.
$
Trade receivables at start of January 20X7
408,350
Outstanding November 20X6 receivables paid
(108,350)
December 20X6 receivables, 60% paid
(180,000)
January 20X7 credit sales
350,000
Trade receivables at end of January 20X7
470,000
$
Trade payables at start of January 20X7
186,700
Payment of 70% of trade payables
(130,690)
January 20X7 credit purchases
250,000
Trade payables at end of January 20X7
306,010
$
Overdraft at start of January 20X7
240,250
Cash received from customers
(288,350)
Cash paid to suppliers
130,690
Interest payment
70,000
Operating cash outflows
146,500
Overdraft expected at end of January 20X7
299,090
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ACCA- Financia Management (FM)-Revision
Answer
(iii)
Current assets at start of January 20X7 = 455,000 + 408,350 = $863,350
Current liabilities at start of January 20X7 = 186,700 + 240,250 = $426,950
Current ratio at start of January 20X7 = 863,350/426,950 = 2·03 times
Current assets at end of January 20X7 = 507,250 + 470,000 = $977,250
Current liabilities at end of January 20X7 = 306,010 + 299,090 = $605,100
Current ratio at end of January 20X7 = 977,250/605,100 = 1.62 times
(b)
Pangli Co could use the following techniques in managing trade receivables: assessing creditworthiness; managing
accounts receivable; collecting amounts owing; offering early settlement discounts; using factoring and invoice
discounting; and managing foreign accounts receivable.
Assessing creditworthiness
Pangli Co can seek to reduce its exposure to the risks of bad debt and late payment by assessing the creditworthiness
of new customers. In order to do this, the company needs to review information from a range of sources. These
sources include trade references, bank references, credit reference agencies and published accounts. To help it to
review this information, Pangli Co might develop its own credit scoring process. After assessing the creditworthiness
of new customers, Pangli Co can decide on how much credit to offer and on what terms.
Managing accounts receivable
Pangli Co needs to make sure that its credit customers abide by the terms of trade agreed when credit was granted
following credit assessment. The company wants its customers to settle their outstanding accounts on time and also
to keep to their agreed credit limits. Key information here will be the number of overdue accounts and the degree
of lateness of amounts outstanding. An aged receivables analysis can provide this information.
Pangli Co also needs to make sure that its credit customers are aware of the outstanding invoices on their accounts.
The company will therefore remind them when payment is due and regularly send out statements of account.
Collecting amounts owing
Ideally, credit customers will pay on time and there will be no need to chase late payers. There are many ways to
make payment in the modern business world and Pangli Co must make sure that its credit customers are able to
pay quickly and easily. If an account becomes overdue, Pangli Co must make sure it is followed up quickly. Credit
control staff must assess whether payment is likely to be forthcoming and if not, a clear policy must be in place on
further steps to take. These further steps might include legal action and using the services of a debt collection
agency.
Offering early settlement discounts
Pangli Co can encourage its credit customers to settle outstanding amounts by offering an early settlement discount.
This will offer a reduction in the outstanding amount (the discount) in exchange for settlement before the due date.
For example, if the credit customer agreed to pay in full after 40 days, an early settlement discount might offer a
2% discount for settling after 25 days. Pangli Co must weigh the benefit of offering such an early settlement discount
against the benefit expected to arise from its use by credit customers. One possible benefit might be a reduction in
the amount of interest the company pays on its overdraft. Another possible benefit might be matching or bettering
the terms of trade of a competitor.
Using factoring and invoice discounting
Pangli Co might use a factor to help manage its accounts receivable, either on a recourse or non-recourse basis. The
factor could offer assistance in credit assessment, managing accounts receivable and collecting amounts owing. For
a fee, the factor could advance a percentage of the face value of outstanding invoices. The service offered by the
factor would be tailored to the needs of the company.
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ACCA- Financia Management (FM)-Revision
Answer
Invoice discounting is a service whereby a third party, usually a factor, pays a percentage of the face value of a
collection of high value invoices. When the invoices are settled, the outstanding balance is paid to the company,
less the invoice discounter’s fee.
Managing foreign accounts receivable
Foreign accounts receivable can engender increased risk of non-payment by customers and can increase the value
of outstanding receivables due to the longer time over which foreign accounts receivable are outstanding. Pangli
Co could reduce the risk of non-payment by assessing creditworthiness, employing an export factor, taking out
export credit insurance, using documentary credits and entering into countertrade agreements. The company could
reduce the amount of investment in foreign accounts receivable through using techniques such as advances against
collections and negotiating or discounting bills of exchange
Examiner’s note: Only five techniques were required to be discussed.
PART D
Section A
1. C
2. D
3. C
4. B
5. C
4. B
5. C
Section B
Ridag Co (2016.Specimen)
1. A
2. A
3. D
Section C
1. OKM Co (June 2010)
(a)
Errors in the original investment appraisal:
Inflation was incorrectly applied to selling prices and variable costs in calculating contribution, since only one year’s
inflation was allowed for in each year of operation.
The fixed costs were correctly infl ated, but included $200,000 per year before infl ation that was not a relevant
cost. Only relevant costs should be included in investment appraisal.
Straight-line accounting depreciation had been used in the calculation, but this depreciation method is not
acceptable to the tax authorities. The approved method using 25% reducing balance capital allowances should be
used.
Interest payments have been included in the investment appraisal, but these are allowed for by the discount rate
used in calculating the net present value.
The interest rate on the debt fi nance has been used as the discount rate, when the nominal weighted average cost
of capital should have been used to discount the calculated nominal after-tax cash flows.
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ACCA- Financia Management (FM)-Revision
Answer
(b)
Nominal weighted average cost of capital = 1.07 x 1.047 = 1.12, i.e. 12% /year
NPV calculation
Year
0
$
1
$
1,330
(318)
2
$
2,264
(337)
3
$
3,010
(357)
4
$
1,600
(379)
Taxable cash flow
Taxation
CA benefits
1,012
1,927
(304)
150
2,653
(578)
112
1,221
(796)
84
(366)
178
After-tax cash flow
Initial cost
Scrap value
1,012
1,773
2,187
509
(188)
(2,000)
Free cash flow
Discount rate 12%
(2,000)
1
1,012
0.893
1,773
0.797
2,187
0.712
759
0.635
(188)
0.567
Present value
(2,000)
904
1,413
1,557
482
(107)
Contribution
Fixed costs
5
$
250
NPV=2,249
The net present value is positive and so the investment is financially acceptable.
Workings:
Annual contribution
Year
1
2
3
4
$
$
$
$
Selling volume
250,000
400,000
500,000
250,000
Selling price ($/units)
12.60
13.23
13.89
14.59
Variable cost ($/units)
7.28
7.57
7.87
8.19
Contribution ($/units)
5.32
5.66
6.02
6.40
1,330,000
2,264,000
3,010,000
1,600,000
Contribution
Capital allowance (CA) tax benefits
Year
Capital allowance
1
500,000
2
375,000
3
281,250
4
593,750
Scrap value
250,000
2,000,000
12
Tax benifit
150,000
112,500
84,375
178,125
ACCA- Financia Management (FM)-Revision
Answer
2. Pelta Co (Sep/Dec 2017)
Year
1
2
3
4
5
$'000
$'000
$'000
$'000
$'000
Sales income
16,224
20,248
24,196
27,655
Variable costs
(5,356)
(6,752)
(8,313)
(9,694)
Contribution
10,868
13,495
15,883
17,962
(700)
(735)
(779)
(841)
10,168
12,760
15,104
17,121
Corporation tax
(3,050)
(3,828)
(4,531)
(5,136)
TAD tax benefits
1,875
1,406
1,055
2,789
11,585
12,682
13,644
(2,347)
Fixed costs
Cash flow before tax
After-tax cash flow
10,168
Terminal value
1,250
Project cash flow
10,168
11,585
12,682
14,894
(2,347)
Discount at 12%
0.893
0.797
0.712
0.636
0.567
Present values
9,080
9,233
9,030
9,473
(1,331)
PV of future cash flows ($000)
35,485
Initial investment ($000)
(25,000)
NPV
10,485
Workings
Year
Sales volume (units/year)
Selling price ($/unit)
Inflated by 4% per year
Income ($'000/year)
1
520,000
30.00
31.20
16,224
2
624,000
30.00
32.45
20,248
3
717,000
30.00
33.75
24,196
4
788,000
30.00
35.10
27,655
Sales volume (units/year)
Variable costs ($/unit)
Inflated by 3% per year
Variable costs ($'000/year)
520,000
10.00
10.30
5,356
624,000
10.20
10.82
6,752
717,000
10.61
11.59
8,313
788,000
10.93
12.30
9,694
Fixed costs ($'000 per year)
700
735
779
841
6,250
1,875
4,688
1,406
3,516
1,055
9,297
2,789
3
$'000
9,030
2,343
4
$'000
9,473
11,815
TAD ($'000 per year)
TAD benefits ($'000/year)
(ii)
Year
Present values
Cumulative net present value
Discounted payback (years)
1
2
$'000
$'000
9,080
9,233
(15,920)
6,687
2.7*(2+(6,687/9,030))
5
$'000
(1,331)
10,485
13
ACCA- Financia Management (FM)-Revision
Answer
(b)
The investment project is financially acceptable under the NPV decision rule because it has a substantial positive
NPV.The discounted payback period of 2.7 years is greater than the maximum target discounted payback period of
two years and so from this perspective the investment project is not financially acceptable.
The correct advice is given by the NPV method, however, and so the investment project is financially acceptable.
(c)
The views of the directors on investment appraisal can be discussed from several perspectives.
Evaluation period
Sales are expected to continue beyond year 4 and so the view of the directors that all investment projects must be
evaluated over four years of operations does not seem sensible. The investment appraisal would be more accurate
if the cash flows from further years of operation were considered.
Assumed terminal value
The view of the directors that a terminal value of 5% of the initial investment should be assumed has no factual or
analytical basis to it. Terminal values for individual projects could be higher or lower than 5% of the initial
investment and in fact may have no relationship to the initial investment at all. A more accurate approach would
be to calculate a year 4 terminal value based on the expected value of future sales.
Discounted payback method
The directors need to explain their view that an investment project’s discounted payback must be no greater than
two years.Perhaps they think that an earlier payback will indicate an investment project with a lower level of risk.
Although the discounted payback method does overcome the failure of simple payback to take account of the time
value of money, it still fails to consider cash flows outside the payback period. Theoretically, Pelta Co should rely
on the NPV investment appraisal method.
3. Degnis Co (2016 Mar/June sample)
(a)
Calculation of NPV over four years
Year
Sales income
Conversion cost
Contribution
Fixed costs
Before-tax cash flow
Tax liability at 28%
Tax allowable depreciation benefits
After-tax cash flow
Discount at 11%
Present values
NPV
1
$'000
12,525
(7,913)
4,612
(4,000)
612
(171)
112
553
0.901
498
( 139 )
2
$'000
15,030
(9,495)
5,535
(5,000)
535
(150)
112
497
0.812
404
3
$'000
22,545
(14,243)
8,302
(5,500)
2,802
(785)
112
2,129
0.731
1,556
4
$'000
22,545
(14,243)
8,302
(5,500)
2,802
(785)
112
2,129
0.659
1,403
Workings:
Average selling price = (30,000 x 0.20) + (42,000 x 0.45) + (72,000 x 0.35) = $50,100 per unit
Average conversion cost = (23,000 x 0.20) + (29,000 x 0.45) + (40,000 x 0.35) = $31,650 per unit
14
ACCA- Financia Management (FM)-Revision
Year
Sales volum
Average
selling price
sales income
Answer
1
2
3
4
250
300
450
450
50,100
50,100
50,100
50,100
12,525
15,030
22,545
22,545
Year
1
2
3
4
250
300
450
450
31,650
31,650
31,650
31,650
7,913
9,495
14,243
14,243
Sales volum
Average
conversion cost
Conversion cost
Contribution may be calculated directly, with small rounding differences.
Average contribution = 50,100 – 31,650 = $18,450 per unit.
Year
1
2
3
4
Sales volume
250
300
450
450
Average contribution 18,450
18,450
18,450
18,450
Contribution
4,613
5,535
8,303
8,303
Tax allowable depreciation=4m/10=$0.4m/year; Benefit of tax allowable depreciation=0.4m x 0.28 = $0.112k /year
(b)
Ignoring tax allowable depreciation, after-tax cash flow from year 5 onwards=2,802,000-785,000=$2,017,000/year
Present value of this cash flow in perpetuity = (2,017,000/0.11)*0.659=$12,083,664. There would be a further six
years of tax benefits from tax allowable depreciation.
The present value of these cash flows would be 112,000 x 4.231* 0.659=$312,282. Increase in NPV of production
and sales continuing beyond the first four years=12,083,664+312,282 = $12,395,946 or approximately $12.4 million.
If only the first four years of operation are considered, the NPV of the planned investment is negative and so it
would not be financially acceptable. If production and sales beyond the first four years are considered, the NPV is
strongly positive and so the planned investment is financially acceptable.
In fact, the NPV of the planned investment becomes positive if only one further year of operation is considered:
NPV = (2,129,000 x 0.593) – 139,000 = 1,262,497 – 139,000 = $1,123,497
4. Melanie Co (Sep/Dec 2018)
(a) (i)
Year
Lease
Payment
PV factor at 8%
PV
PV cost
0
$
(55,000)
1.000
(55,000)
(153,065)
1
$
(55,000)
0.926
(50,930)
2
$
(55,000)
0.857
(47,135)
3
$
Borrow & buy
Initial cost
(160,000)
Residual value
40,000
Maintenance
(8,000)
(8,000)
(8,000)
Total
(160,000)
(8,000)
(8,000)
32,000
PV factor @8%
1.000
0.926
0.857
0.794
PV
(160,000)
(7,408)
(6,856)
25,408
PV cost
(148,856)
As borrow and buy offers the cheapest present value cost the machine should be financed by borrowing.
15
ACCA- Financia Management (FM)-Revision
Answer
(ii)
3-year replacement cycle
Year
0
1
2
3
4
Lease
$
$
$
$
$
Initial cost
(160,000)
Residual value
40,000
Maintenance
(8,000)
(8,000)
(8,000)
Total
(160,000)
(8,000)
(8,000)
32,000
PV factor @10%
1.000
0.909
0.826
0.751
PV
(160,000)
(7,272)
(6,608)
24,032
PV cost
(149,848)
EAC 3-year cycle = PV cost/Annuity factor 3 years at 10%; EAC=-$149,848/2.487=-60,253
4-year replacement cycle
Year
0
1
2
3
4
Lease
$
$
$
$
$
Initial cost
(160,000)
Residual value
11,000
Maintenance
(12,000)
(12,000)
(12,000)
(12,000)
Total
(160,000)
(12,000)
(12,000)
(12,000)
(1,000)
PV factor @10%
1.000
0.909
0.826
0.751
0.683
PV
(160,000)
(10,908)
(9,912)
(9,012)
(683)
PV cost
(190,515)
EAC 4-year cycle = PV cost/Annuity factor 4 years at 10%; EAC = -$190,515/3.170=-60,099
Recommendation
The machine should be replaced every four years as the equivalent annual cost is lower.
(b)
In most simple accept or reject decisions, IRR and NPV will select the same project. However, NPV has certain
advantages over IRR as an investment appraisal technique.
NPV and shareholder wealth: The NPV of a proposed project, if calculated at an appropriate cost of capital, is equal
to the increase in shareholder wealth which the project offers. In this way NPV is directly linked to the assumed
financial objective of the company, the maximisation of shareholder wealth. IRR calculates the rate of return on
projects, and although this can show the attractiveness of the project to shareholders, it does not measure the
absolute increase in wealth which the project offers.
Absolute measure: NPV looks at absolute increases in wealth and thus can be used to compare projects of different
sizes. IRR looks at relative rates of return and in doing so ignores the relative size of the compared investment
projects.
Non-conventional cash flows: In situations involving multiple reversals in project cash flows, it is possible that the
IRR method may produce multiple IRRs (that is, there can be more than one interest rate which would produce an
NPV of zero). If decision-makers are aware of the existence of multiple IRRs, it is still possible for them to make the
correct decision using IRR, but if unaware they could make the wrong decision.
16
ACCA- Financia Management (FM)-Revision
Answer
Mutually-exclusive projects: In situations of mutually-exclusive projects, it is possible that the IRR method will
(incorrectly) rank projects in a different order to the NPV method. This is due to the inbuilt reinvestment assumption
of the IRR method. The IRR method assumes that any net cash inflows generated during the life of the project will
be reinvested at the project’s IRR. NPV on the other hand assumes a reinvestment rate equal to the cost of capital.
Generally NPV’s assumed reinvestment rate is more realistic and hence it ranks projects correctly.
Changes in cost of capital: NPV can be used in situations where the cost of capital changes from year to year.
Although IRR can be calculated in these circumstances, it can be difficult to make accept or reject decisions as it is
difficult to know which cost of capital to compare it with.
Note: Only four reasons were required to be discussed.
5. OAP Co (June 2014)
(a)
Year
1
$'000
5,670
(3,307)
2,363
(776)
1,587
2
$'000
6,808
(4,090)
2,718
(803)
1,915
(444)
350
1,821
3
$'000
5,788
(3,514)
2,274
(832)
1,442
(536)
263
1,169
4
$'000
6,928
(4,040)
2,888
(861)
2,027
(404)
197
1,820
400
2,220
0.613
1,361
5
$'000
Sales income
Variable costs
Contribution
Fixed costs
Cash flow before tax
Tax at 28%
(567)
Dep tax benefits
479
After-tax cash flow
1,587
(88)
Scrap value
Net Cash flow
1,587
1,821
1,169
(88)
Discount at 13%
0.885
0.783
0.693
0.543
Present values
1,405
1,426
810
(48)
Net present value = -46
Although the NPV of the project is negative and so financially it is not acceptable, the Board of OAP Co have decided
that it must be undertaken as it strategically important.
Workings
Year
1
2
3
4
450
475
500
570
472.50
523.69
578.81
692.84
Sales volume
12,000
13,000
10,000
10,000
Sales income
5,670
6,808
5,788
6,928
Selling price
Inflated selling
price
Year
1
2
3
4
260
280
295
320
275.60
314.61
351.35
403.99
Sales volume
12,000
13,000
10,000
10,000
Variable cost
3,307
4,090
3,514
4,040
Variable cost
Inflated
variable cost
Year
Tax allowable depreciation
Tax benefit
1
5,000,000 x 0.25 = $1,250,000
1,250,000 x 0.28 = $350,000
2
3,750,000 x 0.25 = $937,500
937,500 x 0.28 = $262,500
3
2,812,500 x 0.25 = $703,125
703,125 x 0.28 = $196,875
4
1,709,375*
1,709,375 x 0.28 = $478,625
*5000,000 – 1,250,000 – 937,500 – 703,125 – 400,000
17
ACCA- Financia Management (FM)-Revision
Answer
Alternative calculation of cash flow after tax
1
2
3
4
5
$'000
$'000
$'000
$'000
$'000
Year
1,587
1,915
1,442
2,027
(1,250)
(937.5)
(703)
(1,709)
337
978
739
318
(94)
(274)
(207)
Cash flow before tax
Tax allowable depreciation
Taxable profit
Tax at 28%
Tax allowable depreciation
1,250
937.5
703
1,709
Cash flow after tax
1,587
1,821
1,168
1,820
(89)
(89)
(b)
Calculation of maximum NPV
Project
A
B
C
D
E
Investment ($000)
2,500
2,200
2,600
1,900
5,000
NPV ($000)
1,000
1,550
1,350
1,500
nil
PV of future CF
3,500
3,750
3,950
3,400
5,000
Profitability index
1.400
1.705
1.519
1.789
1.000
Project E has been ranked first as it must be undertaken. Project B cannot be undertaken if Project D is undertaken,
as the two projects are mutually exclusive.
Calculation of maximum NPV
Investment
NPV
Project E
5,000
nil
Project D
1,900
1,500
Project C
2,600
1,350
Project A
500
200
10,000
3,050
As Project A is divisible and only $500,000 (20%) of its $2,500,000 initial cost is available after cumulative investment
in Projects E, D and C, the NPV from the project is $200,000 (20% of $1,000,000)
18
ACCA- Financia Management (FM)-Revision
Answer
6. SC Co (Jun 2008)
(a)
Calculation of net present value
Year
0
$
Sales revenue
Variable costs
Contribution
Capital allowance
Taxable profit
Taxation
After -tax profit
Capital allowance
After-tax cash flow
Initial investment
(1,000,000)
Working capital
(50,960)
Net cash flows
(1,050,960)
Discount at 12%
1.000
Present values
(1,050,960)
NPV=$91,154
1
$
728,000
(441,000)
287,000
(250,000)
37,000
(11,100)
25,900
250,000
275,900
2
$
1,146,390
(701,190)
445,200
(250,000)
195,200
(58,560)
136,640
250,000
386,640
3
$
1,687,500
(1,041,750)
645,750
(250,000)
395,750
(118,725)
277,025
250,000
527,025
4
$
842,400
(524,880)
317,520
(250,000)
67,250
(20,255)
47,264
250,000
297,264
29,287
246,613
0.893
220,225
(37,878)
348,762
0.797
277,963
59,157
586,182
0.712
417,362
58,968
356,232
0.636
226.564
Workings
Sales revenue
Year
Selling price ($/unit)
Sales volum (units)
Sales revenue ($)
1
20.80
35,000
728,000
2
21.63
53,000
1,146,390
3
22.50
75,000
1,687,500
4
23.40
36,000
842,400
Variable costs
Year
Variable cost ($/unit)
Sales volum (units)
Variable costs ($)
1
12.60
35,000
441,000
2
13.23
53,000
701,190
3
13.89
75,000
1,041,750
4
14.58
36,000
524,880
Total investment in working capital
Year 0 investment = 728,000 x 0·07 = $50,960
Year 1 investment = 1,146,390 x 0·07 = $80,247
Year 2 investment = 1,687,500 x 0·07 = $118,125
Year 3 investment = 842,400 x 0·07 = $58,968
Incremental investment in working capital
Year 0 investment = 728,000 x 0·07 = $50,960
Year 1 investment = 80,247 – 50,960 = $29,287
Year 2 investment = 118,125 – 80,247 = $37,878
Year 3 recovery = 58,968 – 118,125 = $59,157
Year 4 recovery = $58,968
19
ACCA- Financia Management (FM)-Revision
Answer
(b)
Calculation of internal rate of return
Year
Net cash flows
Discount at 20%
Present values
0
1
2
3
4
$
$
$
$
$
(1,050,960)
264,613
348,762
586,182
356,232
1.000
0.833
0.694
0.579
0.482
(1,050,960)
205,429
242,041
339,99
171,704
NPV at 20% = ($92,387)
NPV at 12% = $91,154
IRR = 12 + [(20 – 12) x 91,154/(91,154 + 92,387)] = 12 + 4 = 16%
(c)
Acceptability of the proposed investment in Product P
The NPV is positive and so the proposed investment can be recommended on financial grounds.
The IRR is greater than the discount rate used by SC Co for investment appraisal purposes and so the proposed
investment is financially acceptable. The cash flows of the proposed investment are conventional and so there is
only one internal rate of return. Furthermore, only one proposed investment is being considered and so there is no
conflict between the advice offered by the IRR and NPV investment appraisal methods.
Limitations of the investment evaluations
Both the NPV and IRR evaluations are heavily dependent on the production and sales volumes that have been
forecast and so SC Co should investigate the key assumptions underlying these forecast volumes. It is difficult to
forecast the length and features of a product’s life cycle so there is likely to be a degree of uncertainty associated
with the forecast sales volumes. Scenario analysis may be of assistance here in providing information on other
possible outcomes to the proposed investment.
The inflation rates for selling price per unit and variable cost per unit have been assumed to be constant in future
periods. In reality, interaction between a range of economic and other forces influencing selling price per unit and
variable cost per unit will lead to unanticipated changes in both of these project variables. The assumption of
constant inflation rates limits the accuracy of the investment evaluations and could be an important consideration
if the investment were only marginally acceptable.
Since no increase in fixed costs is expected because SC Co has spare capacity in both space and labour terms, fixed
costs are not relevant to the evaluation and have been omitted. No information has been offered on whether the
spare capacity exists in future periods as well as in the current period. Since production of Product P is expected to
more than double over three years, future capacity needs should be assessed before a decision is made to proceed,
in order to determine whether any future incremental fixed costs may arise.
(d)
The primary financial management objective of private sector companies is often stated to be the maximisation of
the wealth of its shareholders. While other corporate objectives are also important, for example due to the
existence of other corporate stakeholders than shareholders, financial management theory emphasises the
importance of the objective of shareholder wealth maximisation.
20
ACCA- Financia Management (FM)-Revision
Answer
Shareholder wealth increases through receiving dividends and through share prices increasing over time. Changes
in share prices can therefore be used to assess whether a financial management decision is of benefit to
shareholders. In fact, the objective of maximising the wealth of shareholders is usually substituted by the objective
of maximising the share price of a company.
The net present value (NPV) investment appraisal method advises that an investment should be accepted if it has
a positive NPV. If a company accepts an investment with a positive NPV, the market value of the company,
theoretically at least, increases by the amount of the NPV. A company with a market value of $10 million investing
in a project with an NPV of $1 million will have a market value of $11 million once the investment is made.
Shareholder wealth is therefore increased if positive NPV projects are accepted and, again theoretically,
shareholder wealth will be maximised if a company invests in all projects with a positive NPV. This is sometimes
referred to as the optimum investment schedule for a company.
The NPV investment appraisal method also contributes towards the objective of maximising the wealth of
shareholders by using the cost of capital of a company as a discount rate when calculating the present values of
future cash flows. A positive NPV represents an investment return that is greater than that required by a company’s
providers of finance, offering the possibility of increased dividends being paid to shareholders from future cash
flows.
7. Dink Co (Sep/Dec 2019)
(a)
(i) After-tax cost of borrowing = 8·6 x (1 – 0·3) = 8·6 x 0·7 = 6%
Calculating PV of cost of borrowing to buy:
Year
0
1
2
$
$
$
Purchase
(750,000)
Residual value
(23,000)
(23,000)
Service costs
56,250
TAD benefit
6,900
Service cost tax benifit
(750,000)
(23,000)
40,150
Net cash flow
0.747
0.943
0.890
Discount at 6%
(750,000)
(21,689)
(35,734)
3
$
(23,000)
42,188
6,900
26,088
0.840
(21,914)
4
$
(23,000)
31,641
6,900
65,541
0.792
(51,908)
5
$
79,922
6,900
86,822
0.747
(64,856)
PV of cost of borrowing to buy is $597,277.
Using the spreadsheet NPV function and spreadsheet-calculated discount factors, PV of cost of borrowing to buy is
$597,268.
Working: TAD benefit
Year
Purchase
TAD
30% TAD benifit
0
$
750,000
1
$
187,500
2
$
140,625
56,250
3
$
105,469
42,188
4
$
266,406*
31,641
5
$
79,922
*750,000 – 187,500 – 140,625 – 105,469 – 50,000 = $266,406
21
ACCA- Financia Management (FM)-Revision
Answer
(ii) Calculating PV of cost of leasing:
Year
Lease rental
Tax benefit
Net cash flow
Discount at 6%
0
$
(200,000)
(200,000)
1.000
(200,000)
1
$
(200,000)
(200,000)
0.943
(180,600)
2
$
(200,000)
60,000
(140,000)
0.890
(124,600)
3
$
(200,000)
60,000
(140,000)
0.840
(117,600)
4
$
5
$
60,000
60,000
0.792
47,520
60,000
60,000
0.747
44,820
PV of cost of leasing is $538,460.
Using the spreadsheet NPV function and spreadsheet-calculated discount factors, PV of cost of leasing is
$538,464.
(iii) Financial benefit of leasing = $597,277 – $538,460 = $58,817
Using the spreadsheet NPV function and spreadsheet-calculated discount factors, financial benefit of leasing
= $597,268 – $538,464 = $58,804. Leasing the new machine is recommended as the option which is more
attractive in financial terms to Dink Co.
(b)
(i) Reasons why investment capital may be rationed
Theoretically, the objective of maximising shareholder wealth can be achieved in a perfect capital market by
investing in all projects with a positive NPV. In practice, companies experience capital rationing and are limited
in the amount of investment finance available, so shareholder wealth is not maximised.
Hard capital rationing is due to external factors, while soft capital rationing is due to internal factors or
management decisions.
General reasons for hard capital rationing affect many companies, for example, the availability of new finance
may be limited because share prices are depressed on the stock market or because of government-imposed
restrictions on bank lending.
If a company only requires a small amount of finance, issue costs may be so high that using external sources
of finance is not practical.
Reasons for hard capital rationing may be company-specific, for example, a company may not be able to
raise new debt finance if banks or investors see the company as being too risky to lend to. The company may
have high gearing or low interest cover, or a poor track record, or if recently incorporated, no track record at
all. Companies in the service sector may not be able to offer assets as security for new loans.
Reasons for soft capital rationing include managerial aversion to issuing new equity, for example, a company
may want to avoid potential dilution of its EPS or avoid the possibility of becoming a takeover target.
Managers might alternatively be averse to issuing new debt and taking on a commitment to increased fixed
interest payments, for example, if the economic outlook for its markets is poor.
Soft capital rationing might also arise because managers wish to finance new investment from retained
earnings, for example, as part of a policy of controlled organisational growth, rather than a sudden increase
in size which might result from undertaking all investments with a positive net present value.
One reason for soft capital rationing may be that managers want investment projects to compete for funds,
in the belief that this will result in the acceptance of stronger, more robust investment projects.
22
ACCA- Financia Management (FM)-Revision
Answer
(ii) Ways in which Dink Co’s external capital rationing might be overcome
Dink Co is a small company and the hard capital rationing it is experiencing is a common problem for SMEs,
referred to as the funding gap. A first step towards overcoming its capital rationing could be for Dink Co to
obtain information about available sources of finance, since SMEs may lack understanding in this area.
One way of overcoming the company’s capital rationing might be business angel financing. This informal
source of finance is from wealthy individuals or groups of investors who invest directly in the company and
who are prepared to take higher risks in the hope of higher returns. Information requirements for this form
of finance may be less demanding than those associated with more common sources of finance.
Dink Co could consider crowdfunding, whereby many investors provide finance for a business venture, for
example, via an internet-based platform, although this form of finance is usually associated with
entrepreneurial ventures.
Dink Co might be entitled to grant aid from a government, national or regional source which could be linked
to a specific business area or to economic regeneration in a specified geographical area.
On a more general basis, Dink Co could consider a joint venture as a way of decreasing the need for additional
finance, depending on the nature of its business and its business plans, and whether the directors of Dink Co
are prepared to sacrifice some control to the joint venture partner.
Rather than conventional sources of finance, Dink Co could evaluate whether Islamic finance, for example, an
ijara contract, might be available, again depending on the nature of its business and its business plans.
PART E
Section A
1. D
2. B
3. B
4. A
5. D
3. B
4. C
5. B
3. A
4. 13.4%
6. D
7. B
8. 8.8%
9. True/True/True
Section B
Par Co (2016.Specimen)
1. D
2. C
Section A
1. D
2. C
5. D
6. D
7. 13.4%
Section B
Tulip Co (Mar/Jun 2019)
1. B
2. D
3. A
4. C
5. B
23
ACCA- Financia Management (FM)-Revision
Answer
Section C
1. Corfe Co (Mar/Jun 2019)
(a)
ke = 3.5% + (1.25 x 6.8%) = 12.00%
kpref = (0.06 x 0.75)/0.64 = 7.03%
Loan notes
After tax interest payment:
Nominal value of loan notes
Market value of loan notes
Time to redemption
Redemption premium
Year
0
1-5
5
MV
Interest
Redeem
8% x (1-0.2) = 6.4%
100·00
103·50
5 years
10%
$
(103.50)
6.40
110.00
5% DF
1.000
4.329
0.784
PV($)
(103.50)
27.71
76.24
10.45
10%DF
1.000
3.791
0.621
PV($)
(103.50)
24.26
68.31
(10.93)
IRR = 5 + ((10 – 5) x (10.45/(10.45 + 10.93))) = 7.44%
This figure can also be used for the cost of debt of the bank loan.
Market values and WACC calculation
Equity shares
Preference shares
Loan notes
Bank loan
BV($m)
15
6
8
5
Norminal
1.00
0.75
100.00
MV
6.10
0.64
103.50
MV($m)
91.50
5.12
8.28
5.00
109.90
Cost(%)
12.00
7.03
7.44
7.44
MV x Cost(%)
1098.00
35.99
61.60
37.20
1232.79
WACC = 11.22%
(b)
Director A
Director A is incorrect in saying that $29m of cash reserves are available. Reserves are $29m, but this figure
represents backing for all Corfe Co’s assets and not just cash.
Corfe Co has $4m of cash. Some of this could be used for investment, although the company will need a minimum
balance of cash to maintain liquidity for its day-to-day operations.
Corfe Co’s current ratio is (20/7) = 2.86. This may be a high figure (depending on the industry Corfe Co is in), so
Corfe Co may have scope to generate some extra cash by reducing working capital. Inventory levels could be
reduced by just-in-time policies, trade receivables reduced by tighter credit control and payments delayed to
suppliers. All of these have possible drawbacks.
24
ACCA- Financia Management (FM)-Revision
Answer
Just-in-time policies may result in running out of inventory, and tighter policies for trade receivables and payables
may worsen relations with customers and suppliers. Again also, Corfe Co would have to maintain minimum levels
of each element of working capital, so it seems unlikely that it could raise the maximum $25m solely by doing
what Director A suggests.
Director B
Selling the headquarters would raise most of the sum required for investment, assuming that Director B’s
assessment of sales price is accurate. However, Corfe Co would lose the benefit of the value of the site increasing
in future, which may happen if the headquarters is in a prime location in the capital city.
Being able to sell the headquarters would be subject to the agreement of lenders if the property had been used as
security for a loan. Even if it has not been used as security, the sale could reduce the borrowing capacity of the
company by reducing the availability of assets to offer as security.
An ongoing commitment to property management costs of an owned site would be replaced by a commitment to
pay rent, which might also include some responsibility for property costs for the locations rented. It is possible
that good deals for renting are available outside the capital city. However, in the longer term, the rent may
become more expensive if there are frequent rent reviews.
There may also be visible and invisible costs attached to moving and splitting up the functions. There will be oneoff costs of moving and disruption to work around the time of the move. Staff replacement costs may increase if
staff are moved to a location which is not convenient for them and then leave. Senior managers may find it more
difficult to manage functions which are in different locations rather than the same place. There may be a loss of
synergies through staff in different functions not being able to communicate easily face-to-face any more.
Director C
The dividend just paid of $13.5m seems a large amount compared with total reserves. If a similar level of funds is
available for distribution over the next two years, not paying a dividend would fund the forecast expenditure.
However, shareholders may well expect a consistent or steadily growing dividend. A cut in dividend may represent
a significant loss of income for them. If this is so, shareholders may be unhappy about seeing dividends cut or not
paid, particularly if they have doubts about the directors’ future investment plans. They may see this as a signal
that the company has poor prospects, particularly if they are unsure about why the directors are not seeking finance
from external sources.
The directors’ dividend policy may also be questioned if the dividend just paid was a one-off, high payment. Such a
payment is normally made if a company has surplus cash and does not have plans to use it. However, the directors
are planning investments, and shareholders may wonder why a high dividend was paid when the directors need
money for investments.
2. Card Co (Dec 2013)
(a) Cost of equity of Card Co using DGM
The average dividend growth rate in recent years is 4%:
(62.0/55.1)0.333 – 1 = 1.040 – 1 = 0.04 or 4% /year
Using the dividend growth model:
Ke = 0.04 + [(62 x 1.04)/716] = 0.04 + 0.09 = 0.13 or 13%
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ACCA- Financia Management (FM)-Revision
Answer
(b)
Cost of debt of Card Co
The annual after-tax interest payment is 8.5 x (1 – 0.3) = $5.95 per bond
Using linear interpolation:
Year
$
0
Market price
1-5
Interest
5
Redemption
5% DF
PV($)
6%DF
PV($)
1.000 (103.42)
1.000
(103.42)
5.95
4.329
25.76
4.212
25.06
100.00
0.784
78.40
0.747
74.70
(103.42)
0.74
(3.66)
After-tax cost of debt = 5 + [((6 – 5) x 0.74)/(0.74 + 3.66)] = 5 + 0.17 = 5.17%
Market values
Equity: 8m x 7.16 =
Bonds: 5m x 103.42/100 =
Total value of Card Co
$’000
57,280
5,171
62,451
WACC of Card Co = [(12 x 57,280) + (5.17 x 5,171)]/62,451 = 11.4%
(c)
Project-specific cost of equity
First, the proxy company equity beta must be ungeared:
Asset beta = (1.038 x 0.75)/(0.75 + (0.25 x 0.7)) = 0.842
The asset beta must then be regeared to reflect the financial risk of Card Co:
Equity beta = 0.842 x (57,280 + (5,171 x 0.7))/57,280 = 0.895
Project-specific cost of equity = 4 + (0.895 x 5) = 8.5%
3. Nugfer Co (Dec 2010)
Nugfer Co is looking to raise $200m in cash in order to acquire a competitor. Any recommendation as to the source
of finance to be used by the company must take account of the recent financial performance of the company, its
current financial position and its expected financial performance in the future, presumably after the acquisition has
occurred.
Recent financial performance
The recent financial performance of Nugfer Co will be taken into account by potential providers of finance because
it will help them to form an opinion as to the quality of the management running the company and the financial
problems the company may be facing. Analysis of the recent performance of Nugfer Co gives the following
information:
Year
Operating profit
Net profit margin
Interest coverage ratio
Revenue growth
Operating profit growth
Finance charges growth
Profit after tax growth
26
2007
$41.7m
34%
7 times
2008
$43.3m
34%
7 times
3.8%
3.8%
3.3%
4.0%
2009
$50.1m
32%
4 times
23.0%
15.7%
101.6%
1.2%
2010
$56.7m
30%
3 times
20.9%
13.2%
50.4%
0.8%
ACCA- Financia Management (FM)-Revision
Answer
Geometric average growth in turnover = (189.3/122.6)0.33 – 1 = 15.6%
Geometric average operating profit growth = (56.7/41.7)0.33 – 1 = 10.8%
One positive feature indicated by this analysis is the growth in revenue, which grew by 23% in 2009 and by 21% in
2010. Slightly less positive is the growth in operating profit, which was 16% in 2009 and 13% in 2010. Both years
were significantly better in revenue growth and operating profit growth than 2008. One query here is why growth
in operating profit is so much lower than growth in revenue. Better control of operating and other costs might
improve operating profit substantially and decrease the financial risk of Nugfer Co.
The growing financial risk of the company is a clear cause for concern. The interest coverage ratio has declined each
year in the period under review and has reached a dangerous level in 2010. The increase in operating profit each
year has clearly been less than the increase in finance charges, which have tripled over the period under review.
The reason for the large increase in debt is not known, but the high level of financial risk must be considered in
selecting an appropriate source of finance to provide the $200m in cash that is needed.
Current financial position
The current financial position of Nugfer Co will be considered by potential providers of finance in their assessment
of the financial risk of the company. Analysis of the current financial position of Nugfer Co shows the following:
Debt/equity ratio = long-term debt/total equity = 100 x (100/221) = 45%
Debt equity/ratio including short-term borrowings = 100 x ((100 + 160)/221) = 118%
The debt/equity ratio based on long-term debt is not particularly high. However, the interest coverage ratio
indicated a high level of financial risk and it is clear from the financial position statement that the short-term
borrowings of $160m are greater than the long-term borrowings of $100m. In fact, short-term borrowings account
for 62% of the debt burden of Nugfer Co. If we include the short-term borrowings, the debt/equity ratio increases
to 118%, which is certainly high enough to be a cause for concern. The short-term borrowings are also at a higher
interest rate (8%) than the long-term borrowings (6%) and as a result, interest on short-term borrowings account
for 68% of the finance charges in the income statement.
It should also be noted that the long-term borrowings are bonds that are repayable in 2012. Nugfer Co needs
therefore to plan for the redemption and refinancing of $100m of debt in two years’ time, a factor that cannot be
ignored when selecting a suitable source of finance to provide the $200m of cash needed.
Recommendation of suitable financing method
There are strong indications that it would be unwise for Nugfer Co to raise the $200m of cash required by means
of debt finance, for example the low interest coverage ratio and the high level of gearing.
If no further debt is raised, the interest coverage ratio would improve after the acquisition due to the increased
level of operating profit, i.e. (56.7m + 28m)/18.8 = 4.5 times. Assuming that $200m of 8% debt is raised, the interest
coverage ratio would fall to ((84.7/(18.8 + 16)) = 2.4 times and the debt/equity ratio would increase to 100 x (260
+ 200)/221 = 208%.
If convertible debt were used, the increase in gearing and the decrease in interest coverage would continue only
until conversion occurred, assuming that the company’s share price increased sufficiently for conversion to be
attractive to bondholders. Once conversion occurred, the debt capacity of the company would increase due both
to the liquidation of the convertible debt and to the issuing of new ordinary shares to bond holders. In the period
until conversion, however, the financial risk of the company as measured by gearing and interest coverage would
remain at a very high level.
27
ACCA- Financia Management (FM)-Revision
Answer
If Nugfer Co were able to use equity finance, the interest coverage ratio would increase to 4.5 times and the
debt/equity ratio would fall to 100 x (260/(221 + 200)) = 62%. Although the debt/equity ratio is still on the high side,
this would fall if some of the short-term borrowings were able to be paid off, although the recent financial
performance of Nugfer Co indicates that this may not be easy to do. The problem of redeeming the current longterm bonds in two years also remains to be solved.
However, since the company has not paid any dividend for at least four years, it is unlikely that current shareholders
would be receptive to a rights issue, unless they were persuaded that dividends would be forthcoming in the near
future. Acquisition of the competitor may be the only way of generating the cash flows needed to support dividend
payments.
A similar negative view could be taken by new shareholders if Nugfer Co were to seek to raise equity finance via a
placing or a public issue.
Sale and leaseback of non-current assets could be considered, although the nature and quality of the non-current
assets is not known. The financial position statement indicates that Nugfer Co has $300m of non-current assets,
$100m of long-term borrowings and $160m of short-term borrowings. Since its borrowings are likely to be secured
on some of the existing non-current assets, there appears to be limited scope for sale and leaseback.
Venture capital could also be considered, but it is unlikely that such finance would be available for an acquisition
and no business case has been provided for the proposed acquisition.
While combinations of finance could also be proposed, the overall impression is that Nugfer Co is in poor financial
health and, despite its best efforts, it may not be able to raise the $200m in cash that it needs to acquire its
competitor.
4. KQK Co (Sep/Dec 2015)
The financial statement information of KQK Co can be projected forwards by one year.
Income
Cost of sales and other expenses
Profit before interest and tax
Finance charges (interest)
Profit before tax
Taxation
Profit after tax
Current position
$m
140.0
112.0
28.0
2.8
25.2
7.6
17.6
$m
Equity finance
Ordinary shares
Reserve
Non-current liabilities
Current liabilities
Total equity and liabilities
28
25.0
118.5
$m
143.5
36.0
38.3
217.8
Projected position
$m
147.0
115.4
31.6
4.4
27.2
8.2
19.0
$m
25.0
129.9
$m
154.9
56.0
39.5
250.4
ACCA- Financia Management (FM)-Revision
Answer
The changes in key financial ratios can be compared with the average values of other companies similar to KQK Co.
Current
Forecast
Average
Debt/equity ratio
25.1%
36.2%
30.0%
Interest cover
10 times
7.2 times
10 times
Operational gearing
2.6 times
2.4 times
2 times
Return on equity
12.3%
12.3%
15%
Dividend per share
$0.28
$0.30
Return on capital employed
15.6%
15.0%
Impact on financial position and financial risk.
The business expansion would lead to a slight fall in operational gearing, from 2.6 times to 2.4 times, indicating a
slight fall in business risk. This would occur because the fixed costs would be unchanged, even though income has
increased by 5%. Irrespective of the method of finance, the business expansion would therefore exert downward
pressure on the total risk of KQK Co.
As might be expected, financing the business expansion through an issue of loan notes would increase gearing as
measured by the debt/equity ratio, from 25.1% at the start of the year to 36.2% at the end of the year, indicating
an increase in the financial risk of KQK Co. From being currently below the average gearing level of similar companies,
KQK Co would have a gearing higher than the average debt/equity ratio. The increase in financial risk is confirmed
by looking at interest cover, which would fall from 10 times to 7.2 times, below the 10 times average interest cover
of similar companies.
Impact on shareholder wealth
The return on equity is lower than that of similar companies and the expansion of business, financed by the loan
note issue, would leave it unchanged at 12.3%. Return on capital employed, the primary accounting ratio, would fall
slightly from 15.6% to 15%. Shareholder wealth would be positively influenced, however, by the 7.1% increase in
dividend per share from $0.28 per share to $0.30 per share. The overall impact on shareholder wealth of the debtfinanced business expansion will depend largely on how the share price reacts to the increase in financial risk.
Workings
Forecast income = 140.0m x 1.05 = $147.0 million
Current variable costs = 112.0m x 0.6 = $67.2 million
Current fixed costs = 112.0m x 0.4 = $44.8 million
Forecast variable costs = 67.2 x 1.05 = $70.56 million
Forecast cost of sales and other expenses = 44.8m + 70.56m = $115.4 million
Increase in finance charges = 20m x 0.08 = $1.6 million
Forecast finance charges = 2.8m + 1.6m = $4.4 million
Forecast reserves = 118.5m + (19.0m x 0.6) = $129.9 million
Forecast current liabilities = 38.3m x 1.03 = $39.5 million
Current operational gearing = (140m – 67.2m)/28m = 2.6 times
Forecast operational gearing = (147m – 70.56m)/31.6m = 2.4 times
29
ACCA- Financia Management (FM)-Revision
Answer
PART F
Section A
1. C
2. B
3. A
4. C
5. B
6. A&C
Section B
Bluebell Co (Mar/Jun 2019)
1.C
2.C
3. A
4. C
5. B
PART G
Section A
1. C
2. A
3. C
4. A
5.
A
8. D
9. A
10. C
11. B
12. 73500
Section B
ZPS Co (2016.Specimen)
1. A
30
2. B
3. C
4. C
5. A
6. B
13. C&F
7. B