F9_2015_Jun_A
Fundamentals Level – Skills Module, Paper F9
Financial Management June 2015 Answers Section A
1A
2D
3D
Mean growth in earnings per share = 100 x [(35·7/30·0)1/3– 1] = 5·97% or 6%
4A
5D
6B
7A
8C
9D
10B
Market value = (6 x 5·971) + (105 x 0·582) = 35·83 + 61·11 = $96·94
11C
12D
13C
Year CF15%PV20%PV)
($m)DF($m)DF($m)
0(6·5)1·000(6·500)1·000(6·500)
12·40·8702·0880·8331·999
23·10·7562·3440·6942·151
32·10·6581·3820·5791·216
41·80·5721·0300·4820·868
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0·344(0·266)
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IRR = 15 + [(5 x 0·344)/(0·344 + 0·266)] = 15 + 2·82 = 17·8%
14A
15C
Optimum cash conversion = (2 x 400 x 150,000/(0·05 –0·01))0·5= $54,772
16A
17C
T welve-month forward rate = 1·415 x (1·02/1·018) = €1·418 per $1
18B
19D
Cost of equity = 4 + (1·2 x 5) = 4 + 6 = 10%
WACC = (10 x 0·7) + (6 x 0·3) = 7 + 1·8 = 8·8%
20A
Net asset value (NAV) = 140m – 15m – 20m = $105m
Number of ordinary shares = 25m/0·5 = 50m shares
NAV per share = 105m/50m = $2·10 per share
Section B
1(a)Forward market hedge:
The dollar value of a forward market hedge in six months’ time can be calculated:
Future value = 750,000/2·412 = $310,945
Money market hedge:
Rose Co is expecting a euro receipt in six months’ time and it can hedge this receipt in the money markets by borrowing euros to create a euro liability. These euros can be converted into dollars at spot and then placed on deposit for six months.
Euro borrowing rate for 6 months = 8·0/2 = 4%
Dollar deposit rate for 6 months = 2·0/2 = 1%
Euros to be borrowed now = 750,000/1·04 = €721,154
Dollar value of these euros at spot = 721,154/2·349 = $307,005
Future value of dollar deposit = 307,005 x 1·01 = $310,075
The forward market hedge would be better by 310,945 –310,075 = $870 and would therefore be preferred on financial grounds by Rose Co.
(b) A forward rate agreement (FRA) can fix the borrowing rate on a sum of money for an agreed period starting on an agreed
future date.
A company can use an FRA to manage interest rate risk because the FRA fixes the future borrowing rate for an agreed period,
and hence fixes the company’s future borrowing cost.
If the future interest rate paid by the company turns out to be higher than the borrowing rate in the FRA, the bank will compensate the company with the difference between the two rates applied to the agreed sum for the agreed period. If the future interest rate paid by the company turns out to be less than the borrowing rate in the FRA, the opposite occurs and the company compensates the bank. The net effect is that the company is locked into the borrowing rate specified in the FRA.
Because the company is locked into the FRA borrowing rate, the FRA does not allow the company to benefit from favourable interest rate movements.
The bank which is a party to the FRA does not need to be the same bank which offers the funds to be borrowed.
2(a)As the payout ratio has increased from 40·0% in the year to March 2014 to 41·4% in the year to March 2015, the total dividend has increased from $5,280,000 (13,200,000 x 0·4) for the year to March 2014 to $5,729,760 (13,840,000 x 0·414) for the year to March 2015. This represents dividend growth of 8·52% (5,729,760/5,280,000).
Provided the future dividend growth rate is expected to be similar to the historic dividend growth rate, the calculated dividend growth rate of 8·52% can be used in the dividend growth model.
The equity market value using the dividend growth model is therefore:
(5,729,760 x 1·0852)/(0·125 – 0·0852) = $156,229,537 or $156·2 million.
Examiner’s Note:
Full credit could be obtained by calculating the equity market value from a share price calculated using the dividend growth model, although calculating a share price was not necessary.
Number of shares = 8,000,000/0·5 = 16,000,000 shares
Earnings per share = 100 x 13,840,000/16,000,000 = 86·5 cents per share
Dividend per share = 86·5 x 0·414 = 35·8 cents per share
Share price = (35·8 x 1·0852)/(0·125 – 0·0852) = 976 cents or $9·76 per share
Equity market value = 9·76 x 16,000,000 = $156·2 million
(b)Equity market value using the earnings yield approach:
Earnings/earnings yield = 13,840,000/0·082 = $168,780,488 or $168·8 million
(c)Cash-flow valuation models tend to be preferred to profit-based valuation models and so the dividend growth model (DGM)
could be preferred to the earnings yield method (EYM), as the DGM uses cash, while the EYM uses profit.
The DGM has used information specific to Chad Co, whereas the earnings yield method has used an average earnings yield relating to companies which are similar to Chad Co. The DGM valuation is therefore likely to be more relevant to Chad Co than the EYM valuation, as Chad Co is likely to be different from the average company in its business area.
The two valuation methods relate to different valuation purposes in an acquisition context. The dividend growth model values
a minority shareholding in a target company, while the earnings yield valuation gives a value from the perspective of the
acquirer, provided the earnings yield used is appropriate.
Both the DGM and the EYM assume that relevant valuation variables, such as the dividend growth rate, the cost of equity and the earnings yield, will remain constant in the future in perpetuity. This is very unlikely to be true and reduces the usefulness of the two valuation methods.
3(a)The factor’s offer will be financially acceptable to Widnor Co if it results in a net benefit rather than a net cost.
$
Current trade receivables4,458,000
Revised trade receivables = 26,750,000 x 35/360 =2,600,694
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Reduction in trade receivables1,857,306
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$$
Reduction in financing cost = 1,857,306 x 0·05 =92,865
Saving in bad debts = 26,750,000 x 0·01 x 0·7 =187,250
Reduction in administration costs50,000
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Benefits330,115
Increase in financing cost = 2,600,694 x 0·8 x (0·07 – 0·05) =41,611
Factor’s annual fee = 26,750,000 x 0·0075 =200,625
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Costs(242,236)
––––––––Net benefit87,879
––––––––The factor’s offer is financially acceptable to Widnor Co as it results, on current figures, in a net benefit of $87,879 per year.
(b)The creditworthiness of potential customers can be assessed from a range of different sources of information. References are
useful in this respect, and potential customers should supply a bank reference and a trade or other reference when seeking credit on purchases. Another source of information is the credit rating of the potential customer, which can be checked by a credit rating agency or credit reference agency. For larger potential customers, a file can be opened where additional information can be located, evaluated and stored, such as the annual report and accounts of the potential customer, press releases and so on.
4(a)Rights issue price = 3·50 x 0·8 = $2·80 per share
Grenarp Co currently has 20 million shares in issue ($10m/0·5)
The number of new shares issued = 20m/5 = 4 million shares
Cash raised by the rights issue before issue costs = 4m x 2·80 = $11,200,000
Net cash raised by the rights issue after issue costs = 11,200,000 – 280,000 = $10,920,000
Revised number of shares = 20m + 4m = 24 million shares
Market value of Grenarp Co before the rights issue = 20,000,000 x 3·50 = $70,000,000
Market value of Grenarp Co after the rights issue = 70,000,000 + 10,920,000 = $80,920,000
Theoretical ex rights price per share = 80,920,000/24,000,000 = $3·37 per share
(Alternatively, issue costs are $0·07 per share (280,000/4m) and this is a 1 for 5 rights issue, so the theoretical ex rights price = (5 x 3·50 + (2·80 – 0·07))/6 = 20·23/6 = $3·37 per share)
Redemption price of loan notes = 104 x 1·05 = $109·20 per loan note
Nominal value of loan notes redeemed = 10,920,000/(109·20/100) = $10,000,000
Before-tax interest saving = 10,000,000 x 0·08 = $800,000 per year
After-tax interest saving = 800,000 x (1 – 0·3) = $560,000 per year
Earnings after redeeming loan notes = 8,400,000 + 560,000 = $8,960,000 per year
Revised earnings per share = 100 x (8,960,000/24,000,000) = $0·373 per share
Price/earnings ratio of Grenarp Co before the rights issue = 3·50/0·42 = 8·33 times
This price/earnings ratio is not expected to be affected by the redemption of loan notes
Share price of Grenarp Co after redeeming loan notes = 8·33 x 0·373 = $3·11 per share
The wealth of shareholders of Grenarp Co has decreased as they have experienced a capital loss of $0·26 per share ($3·37 –$3·11) compared to the theoretical ex rights price per share.
(b)The capital structure is considered to be optimal when the weighted average cost of capital (WACC) is at a minimum and the
market value of a company is at a maximum. The goal of maximising shareholder wealth might be achieved if the capital structure is optimal.
The question of whether Grenarp Co might achieve its optimal capital structure following the rights issue can be discussed from a theoretical perspective by looking at the traditional view of capital structure, the views of Miller and Modigliani on capital structure, and other views such as the market imperfections approach. It is assumed that a company pays out all of its earnings as dividends, and that these earnings and the business risk of the company are constant. It is further assumed that companies can change their capital structure by replacing equity with debt, and vice versa, so that the amount of finance invested remains constant, irrespective of capital structure. The term ‘gearing up’ therefore refers to replacing equity with debt in the context of theoretical discussions of capital structure.
Traditional view
The traditional view of capital structure, which ignores taxation, held that an optimal capital structure did exist. It reached this conclusion by assuming that shareholders of a company financed entirely by equity would not be very concerned about the company gearing up to a small extent. As expensive equity was replaced by cheaper debt, therefore, the WACC would initially decrease. As the company continued to gear up, shareholders would demand an increasing return as financial risk continued to increase, and the WACC would reach a minimum and start to increase. At higher levels of gearing still, the cost of debt would start to increase, for example, because of bankruptcy risk, further increasing the WACC.
Views of Miller and Modigliani
Miller and Modigliani assumed a perfect capital market, where bankruptcy risk does not exist and the cost of debt is constant.
In a perfect capital market, there is a linear relationship between the cost of equity and financial risk, as measured by gearing.
Ignoring taxation, the increase in the cost of equity as gearing increases exactly offsets the decrease in the WACC caused by the replacement of expensive equity by cheaper debt, so that the WACC is constant. The value of a company is therefore not affected by its capital structure.
When Miller and Modigliani included the effect of corporate taxation, so that the after-tax cost of debt was used instead of the before-tax cost of debt, the decrease in the WACC caused by the replacement of expensive equity by cheaper debt was greater than the increase in the cost of equity, so that the WACC decreased as a company geared up. The implication in terms of optimal capital structure was that a company should gear up as much as possible in order to decrease its WACC as much as it could.
Market imperfections view
When other market imperfections are considered in addition to the existence of corporate taxation, the view of Miller and Modigliani that a company should gear up as much as possible is no longer true. These other market imperfections relate to high levels of gearing, bankruptcy risk and the costs of financial distress, and they cause the cost of debt and the cost of equity to increase, so that the WACC increases at high levels of gearing.
Grenarp Co
The question of whether Grenarp Co might achieve its optimal capital structure following the rights issue can also be discussed from a practical perspective, by considering if increasing the gearing of the company would decrease its WACC.
This would happen if the marginal cost of capital of the company were less than its WACC. Unfortunately, there is no information provided on the marginal cost of capital of Grenarp Co, although its gearing is not high. Before the rights issue, the debt/equity ratio of Grenarp Co was 35% on a book value basis and 45% on a market value basis, while after the redemption of loan notes the debt/equity ratio would fall to 21% on a book value basis and 28% on a market value basis.
5(a)Calculation of expected net present value
Year1234
$000$000$000$000
Revenue4,5247,84313,04810,179
Variable cost(2,385)(4,200)(7,080)(5,730)
––––––––––––––––––––––––––
Contribution2,1393,6435,9684,449
Overhead(440)(484)(532)(586)
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Cash flow before tax1,6993,1595,4363,863
T ax(510)(948)(1,631)(1,159)
Depreciation benefits338338338338
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Cash flow after tax1,5272,5494,1433,042
Scrap value500
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Project cash flow1,5272,5494,1433,542
Discount at 11%0·9010·8120·7310·659
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Present values1,3762,0703,0292,334
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$000
PV of future cash flows8,809
Initial investment(5,000)
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Expected net present value (ENPV)3,809
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The investment project has a positive ENPV of $3,809,000. This is a mean or average NPV which will result from the project being repeated many times. However, as the project is not being repeated, the NPVs associated with each future economic state must be calculated as it is one of these NPVs which is expected to occur. The decision by management on the financial acceptability of the project will be based on these NPVs and the risk associated with each one.
Workings
Mean or average selling price = (25 x 0·35) + (30 x 0·5) + (35 x 0·15) = $29 per unit
Year1234
Inflated selling price ($ per unit)30·1631·3732·6233·93
Sales volume (units/year)150,000250,000400,000300,000
Sales revenue ($000/year)4,5247,84313,04810,179
Year1234
Inflated overhead ($000/year)440484532586
T otal tax-allowable depreciation = 5,000,000 – 500,000 = $4,500,000
Annual tax-allowable depreciation = 4,500,000/4 = $1,125,000 per year
Annual cash flow from tax-allowable depreciation = 1,125,000 x 0·3 = $337,500 per year
(b)Sensitivity analysis assesses the extent to which the net present value (NPV) of an investment project responds to changes
in project variables. T wo methods are commonly used: one method determines the percentage change in a project variable which results in a negative NPV, while the other method determines the percentage change in NPV which results from a fixed percentage change (for example, 5%) in each project variable in turn. Whichever method is used, the key or critical project variables are identified as those to which the NPV is most sensitive, for example, those where the smallest percentage change results in a negative NPV. Sensitivity analysis is therefore concerned with calculating relative changes in project variables.
When discussing risk in the context of investment appraisal, it is important to note that, unlike uncertainty, risk can be quantified and measured. The probabilities of the occurrence of particular future outcomes can be assessed, for example, and used to evaluate the volatility of future cash flows, for example, by calculating their standard deviation. The probabilities of the future economic states in the assessment of the investment project of Hraxin Co are an example of probability analysis and these probabilities can lead to an assessment of project risk.
Sensitivity analysis is usually studied in investment appraisal in relation to understanding how risk can be incorporated in the investment appraisal process. While sensitivity analysis can indicate the critical variables of an investment project, however, sensitivity analysis does not give any indication of the probability of a change in any critical variable. Selling price may be a critical variable, for example, but sensitivity analysis is not able to say whether a change in selling price is likely to occur. In the appraisal of the investment project of Hraxin Co, the probabilities of different selling prices arising with related economic states have come from probability analysis, not from sensitivity analysis.
Sensitivity analysis will not therefore directly assist Hraxin Co in assessing the risk of the investment project. However, it does provide useful information which helps management to gain a deeper understanding of the investment project and which focuses management attention on aspects of the investment project where problems may arise.
Fundamentals Level –Skills Module, Paper F9
Financial Management June 2015 Marking Scheme
Marks Marks
Section A
1–20T wo marks per question40
Section B
1(a)Dollar value of forward market hedge1
Euro borrowing rate1
Dollar deposit rate1
Dollar value of money market hedge1
Decision as to best hedge1
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5
(b)Explanation of forward rate agreement1
Relevant discussion4
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5
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10
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2(a)Dividend growth rate1
Equity market value using dividend growth model2
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3
(b)Equity market value using earnings yield method2
(c)Cash-based and profit-based valuation methods1–2
Information used by valuation methods1–2
Other relevant discussion1–2
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Maximum5
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10
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3(a)Reduction in trade receivables1
Reduction in financing cost1
Reduction in administration costs1
Saving in bad debts1
Increase in financing cost1
Factor’s annual fee1
Advice on acceptance of factor’s offer1
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7
(b)Bank and other references1
Credit rating1
Other relevant discussion1
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3
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10
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Marks Marks 4(a)Rights issue price0·5 New shares issued0·5
Net cash raised by rights issue0·5
Theoretical ex rights price per share1
Buy-back price of loan notes0·5
Nominal value of loan notes redeemed1
Before-tax interest saving0·5
After-tax interest saving0·5
Revised earnings0·5
Revised earnings per share0·5
Revised share price using price/earnings ratio method1
Comment on effect of redemption on shareholders’ wealth1
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8
(b)T raditional view of capital structure1–3
Miller and Modigliani views of capital structure1–3
Other relevant discussion1–3
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Maximum7
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15
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5(a)Mean selling price per unit0·5 Inflated selling price per unit1
Inflated revenue1
Inflated overhead1
T ax liabilities1
Timing of tax liabilities1
T ax-allowable depreciation benefits1
Scrap value0·5
Present values of future cash flows1
Comment on financial acceptability1
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9
(b)Explanation of sensitivity analysis1–3
Explanation of risk in investment appraisal1–2
Discussion of sensitivity analysis and risk1–3
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Maximum6
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15
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