F9 MOCKS 09 2

Final Assessment

KAPLAN PUBLISHING Page 1 of 10

ACCA FINAL ASSESSMENT

Financial Management

JUNE 2009

QUESTION PAPER

Do not open this paper until instructed by the supervisor

Time allowed Reading and planning 15 minutes; Writing 3 hours All FOUR questions are compulsory and MUST be attempted Mathematical Tables and Formulae are on pages 3, 4 and 5

Kaplan Publishing/Kaplan Financial

ACCA F9 Financial Management

© Kaplan Financial Limited, 2008

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

Page 2 of 10 KAPLAN PUBLISHING

Final Assessment

MATHEMATICAL TABLES AND FORMULAE

TABLES

Present value table

Present value of 1 i.e. (1 + r)-n where r = discount rate n = number of periods until payment Periods Discount rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% _______________________________________________________________________________________

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15 _______________________________________________________________________________________ 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% _______________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15



Annuity table

Present value of an annuity of 1 i.e. r

r) + (1 - 1 -n

where r = discount rate n = number of periods Periods Discount rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% _______________________________________________________________________________________

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10 11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11 12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12 13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13 14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14 15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15 _______________________________________________________________________________________ 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% _______________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15


Final Assessment

FORMULAE

Economic order quantity = H

o

CD2C

Miller-Orr Model

Return point = Lower limit + (31

× spread)

Spread =

31

rate Interest

flows cash of Variance× cost nTransactio×43

3

The Capital Asset Pricing Model

E(r)j = Rf + βj (E(rm) – Rf)

The asset beta formula βa = ))T-1(V+V(

V

de

e βe + ))T-1(V+V()T-1(V

de

d βd

The Growth Model

P0 = g)-(r

g)Do(1

e

+

Gordon’s growth approximation

g = bre

The weighted average cost of capital

WACC = V+V

V

de

e ke + V+V

V

de

d kd(1-T)

The Fisher Formula

(1 + i) = (1 + r) (1 + h)

Purchasing power parity and interest rate parity

S1 = S0 × )h(1)h(1

b

c

++

Fo = So × )i(1)i(1

b

c

++



All FOUR questions are compulsory and MUST be attempted

QUESTION 1

(a) The Treasurer of Russell Co is contemplating a change in financial policy. At present, Russell's balance sheet shows that non-current assets are of equal magnitude to the amount of long-term debt and equity financing. It is proposed to take advantage of a recent fall in interest rates by replacing the long-term debt capital with an overdraft. In addition, the Treasurer wants to speed up receivables collection by offering early payment discounts to customers and to slow down the rate of payment to suppliers.

Required:

As his assistant, you are required to write a brief memorandum to other board members explaining the rationales of the old and new policies and pinpointing the factors to be considered in making such a switch of policy. (5 marks)

(b) The Treasurer is also reviewing her cash management procedures. She plans to introduce the use of cash management models and has asked you to investigate their applicability to the company. The following information is available:

• The company has agreed with its bank that it will maintain a minimum daily cash balance of $15,000. Severe financial penalties will apply if this balance is not maintained.

• A forecast of daily cash movements for the next twelve months shows a standard deviation of daily cash flows of $3,000.

• The daily interest rate is at present 0.0236% and this is not expected to change in the foreseeable future.

• The transaction cost for each sale or purchase is $25.

Required:

As her assistant advise the Treasurer on:

(i) The advantages and disadvantages of cash management models over more

traditional methods of cash forecasting. (4 marks) (ii) Explain the Miller Orr model for cash management and contrast it with the

Baumol model. (5 marks) (iii) Using the information given above, calculate the spread, upper limit and

return point applicable to Russell Co. (6 marks)

(c) Explain the advantages and disadvantages to a company of paying suppliers by using an electronic funds transfer system instead of cheques by post (5 marks)

(Total: 25 marks)


Final Assessment

QUESTION 2

The following is an extract from the balance sheet of Leisure International Co at 30 June 20X7:

$000

Ordinary shares of 50c each 5,200 Reserves 4,850 9% preference shares of $1 each 4,500 14% irredeemable debentures 5,000 ______ Total long-term funds 19,550 ______

The ordinary shares are quoted at 80c ex-div. Assume that the market estimate of the next ordinary dividend is 4c, growing thereafter at 12% per annum indefinitely. The preference shares, which are irredeemable, are quoted at 72c and the debentures are quoted at par. Corporation tax is 35%.

Required:

(a) Use the relevant data above to estimate the company's weighted average cost of capital (WACC), i.e. the return required by the providers of the three types of capital, using the respective market values as weighting factors. (10 marks)

(b) Explain how the capital asset pricing model would be used as an alternative method of estimating the cost of equity, indicating what information would be required and how it would be obtained. (7 marks)

(c) Assume that the debentures have recently been issued specifically to fund the company's expansion programme under which a number of projects are being considered. It has been suggested at a project appraisal meeting that, because these projects are to be financed by the debentures, the cut-off rate for project acceptance should be the after-tax interest rate on the debentures rather than the WACC.

Comment on this suggestion. (8 marks)

(Total: 25 marks)



QUESTION 3

Borrows plc is a UK based company and has decided to embark upon a new investment strategy. Traditionally a mining company operating coal, silver, gold and other mines throughout the world, it has now decided to use its expertise to move into international oil exploration with a view to setting up joint ventures to exploit any oilfields it discovers. The company feels that it requires another £200 million finance to support new operations for the next eight years, and it has identified three possible sources:

(1) An issue of ordinary shares. The company proposes to make a rights issue at a 10% discount to the current market price.

(2) An issue of a ten-year 7% $300 million Eurodollar bond (secured).

(3) A sale of 8% convertible unsecured loan stock of £100 each. Each of these can be converted by holders at any time into 40 ordinary shares. Any outstanding stocks will be redeemed at par in five years’ time.

The balance sheet for Borrows at 31 March 20X7 is as follows: £m £m Non-current assets 1,400 Current assets 600 Less: Current liabilities* ( 200)___

Net current assets 400 _____ 1,800 Less: Non-current liabilities: 10% debentures (300)_____

Net assets 1,500 _____ Capital and reserves Issued ordinary shares (50p par) 500 Reserves 1,000 _____ 1,500 _____

*Current liabilities include £80 million overdraft.

The current market price per share is 210p, and price per debenture £90 per cent.

The current exchange rate of £1=$1.50 is expected to be maintained in the medium term.

The income statement (year-end 31 March 20X7) for the company is: £m Operating profit* 208 − Interest 40 ___ Earnings before tax 168 − Tax (30%) 50 ___ Earnings attributable to ordinary shareholders 118 ___

*Operating profit is expected to increase to £250m per annum after expansion into oil exploration.


Final Assessment

Required:

(a) Explain why a rights issue generally results in a fall in the market price of shares. Calculate the theoretical ex-rights price of the share if the issue is undertaken. Under what circumstances would you expect the share price to actually go to this price? Ignore issue costs in this question. (7 marks)

(b) Discuss the financial implications of all three options by calculating the following accounting ratios:

(i) gearing (book value of debt/book value of equity)

(ii) earnings per share

(iii) interest cover. (18 marks)

(Total: 25 marks)

QUESTION 4

(a) The current managing director John Grant formed Grant and Co 12 years ago. He is now thinking about retirement and would like to release part of his investment in the company. Some of the other board members are also reaching retirement age and they would like to convert at least part of their shareholdings into cash. The company also needs to raise approximately $1 million to finance a major new investment opportunity, which the board believes could contribute further to the long-term success of the company. The board is now considering floatation on the Alternative Investment Market (AIM) as a way of achieving the twin objectives of raising additional finance and releasing part of the board’s equity investment. The intention is that the directors will sell 25% of their existing shareholding and issue new shares to raise the $1 million of new finance required. The plans are still very much at a preliminary stage.

The following summarised financial data applies to Grant and Co:

20X7 20X8 $000 $000

Profit after tax 427 538 Non-current assets: Land and buildings 850 850 Plant and equipment (net) 1,450 _____ 1,350 _____ 2,300 2,200 Current assets: Inventory 1,025 1,400 Total net assets 2,325 2,575 Ordinary shares (25 cents) 750 750



Additional information

(i) Profit before tax is expected to grow at approximately 10% per year. Dividend growth is expected to be in line with this growth in earnings.

(ii) The existing directors, who own 95% of the shares, declared dividends of $288,000 in the latest financial year.

(iii)

(iii) The average price earnings ratio of AIM listed companies in the same industry as Grant is 8.33, and average earnings per share is 20 cents.

(iv) The value of freehold land and buildings (never revalued) has fallen by 25% since purchased due to a recession.

(v) Grant’s cost of equity is estimated to be 18%.

(vi) The replacement cost of plant and equipment is $1,500,000 but its current realisable value is $1,125,000.

(vii) $180,000 of inventory is obsolete and could only be sold for $10,000 as scrap.

Required:

Estimate the value of a share in Grant and Co using:

(i) the dividend valuation model

(ii) a suitable PE ratio

(iii) an asset based value.

Comment on the reliability of your estimates. (14 marks)

(b) Required:

Explain briefly the potential strategies a company could adopt when it is faced with foreign exchange risk. Distinguish between those strategies which offer protection against the risk and those which do not. For those strategies offering protection distinguish between those that will enable the company to benefit from favourable exchange rate movements and those that will not. (11 marks)

(Total: 25 marks)


Final Assessment

ACCA

Paper F9

Financial Management June 2009

Final Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the final assessment questions and submitted them for marking.



© Kaplan Financial Limited, 2008

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.


Final Assessment


ANSWER 1

(a) Memo to: Russell Co Main Board

From: Assistant Treasurer

Subject: Alternative Financial Strategies

The present policy is termed a 'matching' financial policy. This attempts to match the maturity of financial liabilities to the lifetime of the assets acquired with this finance. It involves financing long-term assets with long-term finance such as equity or loan stock and financing short-term assets with short-term finance such as trade credit or bank overdrafts. This avoids the potential wastefulness of over-capitalisation whereby short-term assets are purchased with long-term finance, i.e. the company having to service finance not continuously invested in income-earning assets. It also avoids the dangers of under-capitalisation which entails exposure to finance being withdrawn when the company is not easily able to liquidate its assets. In practice, some short-term assets may be regarded as permanent and it may be thought sensible to finance these by long-term finance and the fluctuating remainder by short-term finance.

The proposed policy is an 'aggressive policy' which involves far heavier reliance on short-term finance, thus attempting to minimise long-term financing costs. This requires very careful manipulation of the relationship between payables and receivables (maximising trade payables and minimising receivables), and highly efficient inventory control and cash management. While it may offer financial savings, it exposes the company to the risk of illiquidity and hence possible failure to meet financial obligations. In addition, it involves greater exposure to interest rate risk. The company should be mindful of the inverse relationship between interest rate changes and the value of its assets and liabilities.

Before embarking on such an aggressive policy, the board should consider the following factors:

• How good are we at forecasting cash inflows and outflows? How volatile is our net cash flow? Is there any seasonal pattern evident?

• How efficiently do we manage our cash balances? Do we ever have excessive cash holdings which can be reduced by careful and active management?

• Do we have suitable information systems to provide early warnings of illiquidity?

• Do we have any holdings of marketable securities that can be realised if we run into unexpected liquidity problems?

• How liquid are our non-current assets? Can any of these be converted into cash without unduly disrupting productive operations?

• Do we have any unused long- or short-term credit lines? These may have to be utilised if we meet liquidity problems.

• How will the stock market perceive our switch towards a more aggressive and less liquid financial policy?

(b) (i) Cash management models’ great advantages are that they make management aware of the many variables that affect cash management and the difficult trade off that must be made between liquidity and profitability when deciding how much cash to hold and in which type of deposit or


security. The main disadvantages of such models is that they ignore the fact that cash flows are to some extent controllable e.g. managers can delay some payments and may be able to encourage receipts.

In practice any experienced cash manager, using a detailed cash budget, should be able to perform better than any cash management model and allow the company to operate using a lower cash balance. The main use of these simple cash management models is to allow us to measure the performance of the cash manager by comparing the results obtained by a 'hands on' expert with those of a simple 'hands off' control model.

(ii) Miller and Orr devised a cash management model that assumes that daily cash flows are random and hence unpredictable. This would result in a pattern of cash flow as shown in the following diagram.

Cash balance

Upper limit

Return point

Lower limit

Time

The treasurer sets upper and lower limits and either transfers cash into the account when the lower limit is reached or transfers cash out by buying marketable securities when the upper limit is reached. The return point determines the amount of cash introduced or withdrawn.

Two questions must be answered:

• How do we decide where to set the limits? This is determined by the variability of daily cash flows, transactions costs and market interest rates. Where variability is great, transactions costs are high and market interest rates are low, the limits will be set far apart. The Miller-Orr formula for setting the limits is:

Range between upper and lower limits =

3 3

1

rate Interestflow cash in Variancecost nTransactio

43

⎭⎬⎫

⎩⎨⎧ ×

×


Final Assessment


• Why isn't the return point midway between the two? The Miller-Orr equation for the return point is:

Return point = Lower limit + (Range/3)

By setting the return point below the mid-point between the upper and lower limits the average cash balance on which interest is charged is reduced.

The Baumol and Miller-Orr models are really two extremes. The Baumol model assumes that cash flows are constant whereas the Miller-Orr model assumes they are random and hence completely unpredictable.

(iii) The lower limit should be set at the minimum daily cash balance of $15,000.

The spread can be calculated as:

The upper limit = $15,000 + $26,827 = $41,827

The return point = $15,000 + = $23,942

(c) The advantages of using electronic funds transfer system are:

• Less clerical time and thus cost are involved than in the writing out, signing and posting of a cheque. Also, no postage costs are incurred.

• Electronic transfer reduces the amount of paper work and the likelihood of errors occurring, such as a cheque being made out with words and figures differing or being sent to an incorrect address.

• It is likely to be preferred by a supplier, who may reward their customers who pay by electronic means with longer credit periods, or special offers or other preferential treatment.

The only disadvantage of electronic funds transfer to the payer is that funds leave their account at the time of payment. If a cheque is made out it takes time in the post and in the clearing system before it is debited to the payers account. Thus interest is forgone by the payer on a credit balance (or more interest is paid if an overdraft is maintained)


MARKING GUIDE

Marks

(a) Rationales – 1 each 2 Factors – 1 each 3 __

5 (b) (i) 1 mark per relevant point 4 (ii) Explanation of Miller Orr (1 mark per relevant point) 4 Contrast with Baumol 1 (iii) Lower limit 1 Spread 3 Upper limit 1 Return point 1 __

15 (c) 1 mark per explained advantage or disadvantage 5 __ Total 25 __

ANSWER 2

(a) Cost of equity Ke = e

o

Pgg)(1d ++

= 804 + 12% = 17%

Cost of preference shares = 9/72 = 12.5%

Cost of debentures = 0.65 × 14% = 9.1%

The market values of these sources of funding are as follows:

$m Equity (10.4m × $0.80) 8.32 Preference shares (4.5m × $0.72) 3.24 Debentures 5.00 _____ Total 16.56 _____

Therefore the company's weighted average cost of capital is:

13.73%9.1%16.56

512.5%16.563.2417%

16.568.32

=⎟⎠⎞

⎜⎝⎛ ×+⎟

⎠⎞

⎜⎝⎛ ×+⎟

⎠⎞

⎜⎝⎛ ×


Final Assessment


(b) CAPM would estimate the cost of equity using the equation:

)R - )(E(r R )E(r fmfi iβ+=

Rf is the risk free rate of return. This could be estimated as the current return offered by irredeemable gilts. This can be looked up in the financial pages of any quality newspaper.

β is the volatility of the company's share price relative to the market. This can either be calculated from recent periods' data or can be read off from pre-calculated figures published by professional organisations. Either method has problems. In calculating β oneself, the value of β will be different depending on the number of recent periods used in the analysis. If pre-calculated figures are used, one is forced to accept the organisation's choice of period; for example the London Business School calculates β on the basis of monthly returns for the past five years and updates its figures quarterly.

Rm is the return currently available from the equity market. Indices are published such as the FT-Actuaries All Share Index to replicate this return over recent periods of time. Again the choice of period will affect the observed return.

(c) There is no absolute right or wrong answer to the question of whether it is possible to link one source of finance to one segment of a company's activities. Some commentators dismiss the idea immediately, claiming that the company is one entity in law which happens to be financed by a variety of sources of funds. The sources of funds define the sharing out of profits between the shareholders, but their effect is all to support the activities of the business. They argue that it is the projected cash flows that should be looked at from any new investment idea, and that these cash flows should be discounted at the opportunity cost of new capital.

Other commentators disagree, arguing that a particularly large project can certainly be identified with a source of funding raised specifically for the project, and that it is artificial to ignore the relationship between the two.

It is probably possible to accept both arguments – that small projects are financed by the general pool of funds available to a company, on which the company pays the weighted average cost of capital; but with large projects it is possible to link the project with a particular source of finance with its own specific cost.


MARKING GUIDE

Marks

(a) Cost and MV of equity 3 Cost and MV of prefs 2 Cost and MV of debt 2 WACC 3 __

10 (b) Brief explanation 1 Rf, Rm, Beta & how each is obtained 6 __

7 (c) Max 3 marks per explained point 8 __ Total 25 __

ANSWER 3

(a) Rights issues tend to reduce the market price of shares because they are sold at a discount to the market price. This is a necessary (but not a sufficient) requirement of a successful rights issue (potential investors still need to be convinced that taking up the rights represents a good investment on their part).

The theoretical ex-rights price is:

New finance required £200m

Issue price (210p less 10%) 189p

Number of new shares (i.e. £200m/£1.89) 105.82m

Existing number of shares 1,000.00m

New number of shares 1,105.82m

Existing market value (1,000m × £2.10) £2,100m

Value of new issue £200m

New market value £2,300m

New share price (£2,300/1,105.82) £2.08

The actual market price will be greater than the theoretical ex-rights price if the new money is invested in positive NPV projects, i.e. the money will earn a greater return than the required return for that investment. Thus the market price of the share will only equal the theoretical ex-rights price if the new money earns just the required return for the investment (i.e. the NPV of the investment is zero).

However, very often any positive NPV expected for a project will already be reflected in the existing market price of the share.


Final Assessment


(b) Gearing

Ignoring the overdraft, the gearing ratios will be:

Current Equity finance Debt finance (both types)

Debt 300 300 500 Equity 1,500 1,700 1,500 Gearing 20% 17.6% 33.3%

Alternatively, since it is substantial, you may include the overdraft as follows:

Current Equity finance Debt finance (both types)

Debt 380 380 580 Equity 1,500 1,700 1,500 Gearing 25.3% 22.4% 38.7%

Gearing is currently 20% (or 25.3%). This is relatively low, reflecting the risky nature of current operations.

With a new share issue, gearing will fall to 17.6% (or 22.4%) whereas, with more debt, it will rise to 33.3% (38.7%). Although debt financing is more risky, the gearing is still relatively low.

EPS

EPS is currently 118/1,000 = 11.8p

The projected income statement is (£m)

Ordinary Eurodollar CULS

Operating profit 250 250 250 Interest 40 _______ 54* _______ 56 _______ Profit before tax 210 196 194 Tax 63 _______ 59 _______ 58 _______ Profit after tax 147 137 136 Number of shares 1,106 _______ 1,000 _______ 1,000 _______ EPS 13.3p _______ 13.7p _______ 13.6p_______

*The existing £40 + ($300m × 7% ÷ 1.50) = £54m


The higher EPS if the company expands using debt may compensate for the higher financial risk borne by the ordinary shareholders. If the Eurodollar bond is used the company will also be exposed to additional foreign exchange risk.

Interest cover – currently 5.2, i.e. 208/40, and changes to:

Ordinary Eurodollar CULS

6.2 4.6 4.5

All look relatively comfortable – reducing the risk regarding financing.

MARKING GUIDE

Marks

(a) Why share price falls 1 TERP calculation 4 When TERP will occur 2 __

7 (b) 4 marks per set of ratios 12 2 marks for discussion on each set of ratios 6 __

18 __ Total 25 __

ANSWER 4

(a) (i) The value of a share may be estimated using the dividend valuation model (DVM). This states:

P0 = D0(1 + g)/(re – g). Using the information in the question:

D0 = $288,000

'g' is anticipated to be 10%.

re = 18%

This gives a total value of 288,000(1 + 0.10)/(0.18 – 0.10) = 3,960,000.

This results in an estimated share price of 3,960/3,000 = $1.32.

A number of factors need to be considered before relying too heavily on this estimate.

(1) The model assumes constant growth in perpetuity which is always unlikely.


Final Assessment


(2) The estimate of dividend growth has been based on forecast earnings growth. Dividends may not grow at the same rate as earnings.

(3) The use of the dividend model is always unreliable for small owner managed companies. In such companies dividends paid often have more to do with the financial circumstances of the directors rather than the commercial position of the company.

(ii) An alternative valuation may be found by multiplying EPS by a suitable PE ratio. The latest EPS for Grant & Co is 538/3000 = 17.9 cents. The average PE ratio is 8 .33. This is a PER for quoted companies and Grant & Co is unquoted which usually means that a lower PER is appropriate. The conventional wisdom is that the PER ratio for an unquoted company should be approximately 60 – 70% of that for a similar quoted company. A PER ratio of approximately 5 may be appropriate for valuing an Grant & Co share which means a value of 17.9 × 5 = 90 cents.

The weakness of this valuation is that the adjustment to the PER is entirely arbitrary. We have no way of knowing how Grant & Co compares with average companies in the industry in terms of risk, earnings and dividend growth.

(iii) The final valuation is based on the assets of the business. Since Grant & Co is to continue in business after floatation, the replacement cost of the assets which is usually considered to be the best asset based valuation for valuing the business as a going concern will be used.

$000

Net assets from the balance sheet 2,575 Revaluation of land and buildings: 0.25 × 850 = (213) Revaluation of plant and equipment: 1,500 − 1,350 = 150 Revaluation of stock: 180 − 10 = (170)

_____ Replacement cost of assets 2,342 Number of shares 3,000

_____ Asset based value per share 78 cents

The obvious limitation of this valuation is that it takes no account of the 'goodwill' of the business. As a going concern companies are almost always worth more than the value of their net tangible assets.

(b) Strategies which offer no protection include:

(i) Doing nothing – this is reasonable as long as the risk is not material to the company.

(ii) Leading & lagging – this is where a company attempts to benefit from expected exchange rate movements by the timing of its receipts and payments. In effect this is low level speculation. If exchange rates move differently to what was expected losses will be made.


Strategies which offer protection include:

(i) Dealing in own currency – this passes all risk to the other party and is often hard to do in reality.

(ii) Netting/matching – matching foreign currency assets and liabilities can be netted off. Risk only remains on items which cannot be netted off in this way.

(iii) Forward contract – this is an agreement with a bank to buy or sell a certain amount of foreign currency at a certain future date and at a certain rate.

(iv) Money market hedge – this is where a company creates a foreign currency asset or liability by investing or borrowing in the foreign currency in order to match an existing liability or asset in that currency. In this way the risk is extinguished.

(v) Futures – this is where currency futures are bought or sold such that any loss that arises due to foreign exchange rate movements on the actual transaction is matched by a compensating gain on the futures transaction.

(vi) Options – this is where the company has the right but not the obligation to buy or sell a certain amount of foreign currency at a certain future date and at a certain rate.

Of the above strategies only options have the flexibility to allow the company to benefit if there are favourable exchange rate movements. Obtaining this flexibility is costly as a premium is payable by the company in order to obtain an option.

MARKING GUIDE

Marks

(a) Max 3 per value calculation Max 3 for comments on each valuation Max 14 (b) Brief explanation of strategies offering no protection 3 Brief explanation of strategies offering protection 6 Identification of the strategy offering flexibility 2 __

11 __ Total 25 __


F9 MOCKS 09 2

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