revision question bank - Becker Professional Education

Transcription

PL
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June 2015 Edition
REVISION QUESTION BANK
ACCA
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Paper F9 | FINANCIAL MANAGEMENT
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ACCA
PAPER F9
SA
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FINANCIAL MANAGEMENT
REVISION QUESTION BANK
For Examinations to June 2015
®
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REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
CONTENTS
Question
Page
Answer
Marks
1001
1001
1002
1003
1004
1005
1007
1008
1010
1010
1011
1012
1012
1013
1014
22
20
12
20
10
12
34
22
16
18
14
12
14
30
30
Date worked
MULTIPLE CHOICE QUESTIONS (Section A Questions)
1
3
4
6
8
10
12
15
17
19
21
22
23
25
28
E
The Financial Management Function
The Financial Management Environment
Investment Decisions
Discounted Cash Flow Techniques
Applications of Discounted Cash Flow Techniques
Project Appraisal under Risk
Equity Finance and Debt Finance
Cost of Capital
Capital Asset Pricing Model
Working Capital Management
Inventory Management
Cash Management
Management of Accounts Receivable and Payable
Risk Management
Business Valuation and Ratio Analysis
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1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Section B of the Examination will not include questions with less than 10 marks. Those included
below provide additional question practice on topics that could be examined within longer questions.
THE FINANCIAL MANAGEMENT FUNCTION
Company objectives
The financial management function
Financial management decisions (ACCA J10)
Value for money (ACCA J03)
Non-For-Profit (ACCA D11)
QSX Co (ACCA J10)
Agency problem (ACCA D08)
Listed company objectives (ACCA J13)
Goal congruence (ACCA D13)
SA
M
1
2
3
4
5
6
7
8
9
32
32
32
32
32
32
33
33
33
1016
1018
1018
1019
1019
1020
1022
1022
1023
10
10
10
6
10
10
10
6
6
33
34
34
1024
1024
1025
6
10
5
34
35
1025
1026
10
10
35
36
36
37
38
39
1027
1030
1031
1034
1036
1038
15
10
15
15
15
15
THE FINANCIAL MANAGEMENT ENVIRONMENT
10
11
12
Money markets
Tagna (ACCA J03)
Financial intermediaries (ACCA D09)
INVESTMENT DECISIONS
13
14
Payback and ROCE (ACCA D04)
Directors’ views (ACCA D10)
DISCOUNTED CASH FLOW TECHNIQUES
15
16
17
18
19
20
OKM Co (ACCA J10)
Limitations of NPV
Ridag Co (ACCA J12)
BQK Co (ACCA D12)
HDW (ACCA J13)
Darn Co (ACCA D13)
(iii)
FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Question
Page
Answer
Marks
1040
1042
1044
1045
1047
1048
15
15
15
15
10
15
Date worked
APPLICATIONS OF DISCOUNTED CASH FLOW TECHNIQUES
21
22
23
24
25
26
Replacement cycles (ACCA J10)
Basril Co (ACCA D03)
Cavic Co (ACCA D06)
ASOP Co (ACCA D09)
Equivalent annual benefit (ACCA D09)
Spot Co (ACCA D13)
39
40
41
41
42
42
27
28
29
E
PROJECT APPRAISAL UNDER RISK
Risk and uncertainty (ACCA D07)
Warden Co (ACCA D11)
Incorporating risk (ACCA J12)
42
43
43
30
31
32
33
34
35
36
37
38
10
15
10
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EQUITY FINANCE AND DEBT FINANCE
1049
1049
1051
Islamic finance
Short-term finance
SME finance (ACCA D01)
Nugfer Co (ACCA D10)
Bar Co (ACCA D11)
Dividend policy (ACCA D10)
Zigto Co (ACCA J12)
Bonds, placing and venture capital (ACCA J13)
Riba (ACCA D13)
43
43
44
44
45
46
46
46
47
1052
1054
1055
1056
1059
1060
1061
1063
1064
10
10
10
15
15
10
15
10
10
47
48
48
49
49
1065
1067
1068
1069
1071
15
10
15
15
10
Project-specific discount rate (ACCA D08)
50
CJ Co (ACCA D10)
50
Business, financial and systematic risk (ACCA J12) 51
CAPM and risk (ACCA J13)
51
Card Co (ACCA D13)
51
1071
1072
1074
1075
1075
10
15
10
10
15
1077
1079
1080
1082
1083
1085
15
10
15
10
15
10
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COST OF CAPITAL AND GEARING
39
40
41
42
43
KFP Co (ACCA J09)
DD Co (ACCA D09)
BKB Co (ACCA D12)
AMH Co (ACCA J13)
Capital structure and company value (ACCA D13)
CAPITAL ASSET PRICING MODEL
44
45
46
47
48
WORKING CAPITAL MANAGEMENT
49
50
51
52
53
54
(iv)
Blin (ACCA J04)
Bold Co (ACCA D11)
AXP Co (ACCA D09)
Working capital policy (ACCA J12)
TGA Co (ACCA J13)
Objectives, role and policy (ACCA D13)
52
52
53
54
54
55
Question
Page
Answer
Marks
55
56
56
1086
1088
1088
15
15
10
57
57
58
59
1089
1090
1093
1095
10
15
15
10
59
60
61
62
62
1096
1098
1099
1100
1102
15
15
15
10
15
63
64
65
65
66
66
67
1103
1104
1105
1106
1107
1108
1109
10
10
10
10
10
10
10
67
68
68
69
69
70
71
72
73
1110
1111
1111
1113
1113
1114
1115
1117
1118
10
10
10
6
10
15
15
10
15
74
80
80
81
82
83
1120
1121
1122
1123
1124
1126
40
10
10
10
15
15
Date worked
INVENTORY MANAGEMENT
55
56
57
EOQ and JIT
FLG Co (ACCA J08)
Product KN5 (ACCA D10)
CASH MANAGEMENT
Baumol model (ACCA D05)
HRG Co (ACCA J09)
Wobnig (ACCA J12)
Cash and receivables management (ACCA D12)
E
58
59
60
61
MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE
PKA (ACCA D07)
WQZ Co (ACCA D10)
Bolder Co (ACCA D11)
KXP (ACCA D12)
Plot Co (ACCA D13)
RISK MANAGEMENT
GN Co (ACCA D09)
Gorwa Co (ACCA D08)
Boluje Co (ACCA D08)
Zigzag (ACCA J12)
Interest rate risk (ACCA D12)
BNB Co (ACCA D12)
Types of currency risk (ACCA J13)
SA
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67
68
69
70
71
72
73
PL
62
63
64
65
66
BUSINESS VALUATION
74
75
76
77
78
79
80
81
82
NSX (ACCA J10)
XB Co
Closer (ACCA D11)
Phobia Co (ACCA D07)
Efficient Markets Hypothesis (ACCA D07)
NN Co (ACCA D10)
Corhig Co (ACCA J12)
WWW Co (ACCA D12)
GXG Co (ACCA J13)
ACCA SPECIMEN EXAMINATION PAPER
1
2
3
4
5
MCQ
Cat Co
GWW Co
ZPS Co
PV Co
DD Co
(v)
Formula Sheet
Economic order quantity
=
2Co D
Ch
Miller – Orr Model
Return point = Lower limit + (1/3 × spread)
1
E
3
3
 4  transaction cost  variance of cash flows 
Spread = 3 

interest rate




PL
The Capital Asset Pricing Model
E(ri) = Rf + βi(E(rm)–Rf)
The asset beta formula


V
V 1  T 


d
e
βa = 
βe  + 
βd 


V


V
V
1
T




d
 e Vd 1  T  
 e

The Growth Model
D O 1  g 
re  g 
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PO =
Gordon’s growth approximation
g = bre
The weighted average cost of capital
 Vd 
 Ve 
WACC = 
 K d 1  T 
 Ke + 
 Ve  Vd 
 Ve  Vd 
The Fisher formula
(1 + i) = (1 + r) (1 + h)
Purchasing power parity and interest rate parity
S1 = S0 ×
(vi)
1  h c 
1  h b 
F0 = S0 ×
1  i c 
1  i b 
Present Value Table
Present value of 1 i.e. (1 + r)–n
where
r = discount rate
n = number of periods until payment
Discount rate (r)
Periods
(n)
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
0.935
0.873
0.816
0.763
0.713
0.926
0.857
0.794
0.735
0.681
0.917
0.842
0.772
0.708
0.650
0.909
0.826
0.751
0.683
0.621
1
2
3
4
5
0.666
0.623
0.582
0.544
0.508
0.630
0.583
0.540
0.500
0.463
0.596
0.547
0.502
0.460
0.422
0.564
0.513
0.467
0.424
0.386
6
7
8
9
10
11
12
13
14
15
0.990
0.980
0.971
0.961
0.951
0.980
0.961
0.942
0.924
0.906
0.971
0.943
0.915
0.888
0.863
0.962
0.925
0.889
0.855
0.822
0.952
0.907
0.864
0.823
0.784
0.943
0.890
0.840
0.792
0.747
6
7
8
9
10
0.942
0.933
0.923
0.914
0.905
0.888
0.871
0.853
0.837
0.820
0.837
0.813
0.789
0.766
0.744
0.790
0.760
0.731
0.703
0.676
0.746
0.711
0.677
0.645
0.614
0.705
0.665
0.627
0.592
0.558
11
12
13
14
15
0.896
0.887
0.879
0.870
0.861
0.804
0.788
0.773
0.758
0.743
0.722
0.701
0.681
0.661
0.642
0.650
0.625
0.601
0.577
0.555
0.585
0.557
0.530
0.505
0.481
0.527
0.497
0.469
0.442
0.417
0.475
0.444
0.415
0.388
0.362
0.429
0.397
0.368
0.340
0.315
0.388
0.356
0.326
0.299
0.275
0.350
0.319
0.290
0.263
0.239
(n)
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
2
3
4
5
0.901
0.812
0.731
0.659
0.593
0.893
0.797
0.712
0.636
0.567
0.885
0.783
0.693
0.613
0.543
0.877
0.769
0.675
0.592
0.519
0.870
0.756
0.658
0.572
0.497
0.862
0.743
0.641
0.552
0.476
0.855
0.731
0.624
0.534
0.456
0.847
0.718
0.609
0.516
0.437
0.840
0.706
0.593
0.499
0.419
0.833
0.694
0.579
0.482
0.402
1
2
3
4
5
6
7
8
9
10
0.535
0.482
0.434
0.391
0.352
0.507
0.452
0.404
0.361
0.322
0.480
0.425
0.376
0.333
0.295
0.456
0.400
0.351
0.308
0.270
0.432
0.376
0.327
0.284
0.247
0.410
0.354
0.305
0.263
0.227
0.390
0.333
0.285
0.243
0.208
0.370
0.314
0.266
0.225
0.191
0.352
0.296
0.249
0.209
0.176
0.335
0.279
0.233
0.194
0.162
6
7
8
9
10
11
12
13
14
15
0.317
0.286
0.258
0.232
0.209
0.287
0.257
0.229
0.205
0.183
0.261
0.231
0.204
0.181
0.160
0.237
0.208
0.182
0.160
0.140
0.215
0.187
0.163
0.141
0.123
0.195
0.168
0.145
0.125
0.108
0.178
0.152
0.130
0.111
0.095
0.162
0.137
0.116
0.099
0.084
0.148
0.124
0.104
0.088
0.074
0.135
0.112
0.093
0.078
0.065
11
12
13
14
15
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1
2
3
4
5
(vii)
Annuity Table
Present value of an annuity of 1 i.e.
where
1  (1  r )  n
r
r = discount rate
n = number of periods
Discount rate (r)
2%
3%
4%
5%
6%
0.962
1.886
2.775
3.630
4.452
0.952
1.859
2.723
3.546
4.329
0.943
1.833
2.673
3.465
4.212
7%
8%
9%
10%
0.935
1.808
2.624
3.387
4.100
0.926
1.783
2.577
3.312
3.993
0.917
1.759
2.531
3.240
3.890
0.909
1.736
2.487
3.170
3.791
E
Periods
(n)
1%
0.990
1.970
2.941
3.902
4.853
0.980
1.942
2.884
3.808
4.713
0.971
1.913
2.829
3.717
4.580
6
7
8
9
10
5.795
6.728
7.652
8.566
9.471
5.601
6.472
7.325
8.162
8.983
5.417
6.230
7.020
7.786
8.530
5.242
6.002
6.733
7.435
8.111
5.076
5.786
6.463
7.108
7.722
4.917
5.582
6.210
6.802
7.360
4.767
5.389
5.971
6.515
7.024
4.623
5.206
5.747
6.247
6.710
4.486
5.033
5.535
5.995
6.418
4.355
4.868
5.335
5.759
6.145
6
7
8
9
10
11
12
13
14
15
10.37
11.26
12.13
13.00
13.87
9.787
10.58
11.35
12.11
12.85
9.253
9.954
10.63
11.30
11.94
8.760
9.385
9.986
10.56
11.12
8.306
8.863
9.394
9.899
10.38
7.887
8.384
8.853
9.295
9.712
7.499
7.943
8.358
8.745
9.108
7.139
7.536
7.904
8.244
8.559
6.805
7.161
7.487
7.786
8.061
6.495
6.814
7.103
7.367
7.606
11
12
13
14
15
(n)
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
2
3
4
5
0.901
1.713
2.444
3.102
3.696
0.893
1.690
2.402
3.037
3.605
0.885
1.668
2.361
2.974
3.517
0.877
1.647
2.322
2.914
3.433
0.870
1.626
2.283
2.855
3.352
0.862
1.605
2.246
2.798
3.274
0.855
1.585
2.210
2.743
3.199
0.847
1.566
2.174
2.690
3.127
0.840
1.547
2.140
2.639
3.058
0.833
1.528
2.106
2.589
2.991
1
2
3
4
5
6
7
8
9
10
4.231
4.712
5.146
5.537
5.889
4.111
4.564
4.968
5.328
5.650
3.998
4.423
4.799
5.132
5.426
3.889
4.288
4.639
4.946
5.216
3.784
4.160
4.487
4.772
5.019
3.685
4.039
4.344
4.607
4.833
3.589
3.922
4.207
4.451
4.659
3.498
3.812
4.078
4.303
4.494
3.410
3.706
3.954
4.163
4.339
3.326
3.605
3.837
4.031
4.192
6
7
8
9
10
11
12
13
14
15
6.207
6.492
6.750
6.982
7.191
5.938
6.194
6.424
6.628
6.811
5.687
5.918
6.122
6.302
6.462
5.453
5.660
5.842
6.002
6.142
5.234
5.421
5.583
5.724
5.847
5.029
5.197
5.342
5.468
5.575
4.836
4.988
5.118
5.229
5.324
4.656
4.793
4.910
5.008
5.092
4.586
4.611
4.715
4.802
4.876
4.327
4.439
4.533
4.611
4.675
11
12
13
14
15
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2
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4
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(viii)
1
2
3
4
5
REVISION MULTIPLE CHOICE QUESTION BANK – FINANCIAL MANAGEMENT (F9)
MULTIPLE CHOICE QUESTIONS
1
The Financial Management Function
1.1
Which of the following is one of the 3Es “value for money” concept?
A
B
C
D
A
B
C
D
1.3
Which of the following statements is correct?
A
B
C
D
1.4
Profit maximisation
Market share growth
Minimising the firm’s cost of capital
Maximising earnings per share
E
Which of the following is most consistent with maximising shareholder wealth?
PL
1.2
Earnings
Equity
Evaluation
Effectiveness
Profit maximisation results in shareholder wealth maximisation
Divorce of ownership and control can lead to agency costs
Maximising earnings per share results in shareholder wealth maximisation
Increasing market share will lead to increased shareholder wealth
Which of the following is the best indicator of shareholder wealth?
Profit before interest and tax
Sales revenues
Market price of the share
Price/earnings ratio
SA
M
A
B
C
D
1.5
Which of the following is not a consequence or symptom of the agency problem?
A
B
C
D
1.6
Managers diverting funds into their own pet projects
Managers selecting quick payback projects
Managers engaging in empire building
Managers increasing the firm’s level of financial gearing
Hathaway Co has just paid a dividend of 21 cents per share and its share price is $3·50 per
share. One year ago its share price was $3·60 per share.
Working to one decimal place, what is the total shareholder return over the period?
A
B
C
D
1.7
8·9%
8·6%
3·1%
0·9%
Which of the following actions is MOST likely to increase shareholder wealth?
A
B
C
D
The average cost of capital is increased by a recent financing decision
The firm’s cash operating cycle becomes longer
The board of directors decides to invest in a project with a quick payback period
The annual report declares full compliance with the corporate governance code
1
FINANCIAL MANAGEMENT (F9) – REVISION MULTIPLE CHOICE QUESTION BANK
1.9
Which of the following statements concerning not-for-profit organisations is correct?
A
Not-for-profit organisations often have multiple stakeholders with conflicting
objectives
B
The provision of value for money embodies economy, equality and effectiveness
C
Not-for-profit organisations usually have one dominant stakeholder
D
The key objective of not-for-profit organisations is to make profits
The following are extracts from the statement of profit or loss of IQ Co:
Sales income
Cost of sales
Profit before tax
Tax
Profit after tax
PL
Profit before interest and tax
Interest
$000
60,000
50,000
––––––
10,000
4,000
––––––
6,000
4,500
––––––
1,500
––––––
E
1.8
80% of the cost of sales is variable costs.
What is the operational gearing of IQ Co?
2·0 times
2·5 times
0·5 times
3·0 times
SA
M
A
B
C
D
1.10
1.11
Which of the following statements concerning financial management are correct?
(1)
(2)
(3)
It is concerned with investment decisions, financing decisions and dividend decisions
It may use information from management accounting
It must hedge all of the firm’s currency risks
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Which ONE of the following statements concerning a company with low operating
gearing is true?
A
B
C
D
A change in sales will have a relatively small impact on profits
The company has a relatively low proportion of debt finance
The company will have higher risk and increased potential return
The company will have low interest cover
(22 marks)
2
2
The Financial Management Environment
2.1
Which of the following is least likely to act as a financial intermediary?
A
B
C
D
Which of the following lists of securities is ranked in order of increasing risk to the
investor?
2.3
Which of the following best describes commercial paper?
A
B
C
D
2.4
Ordinary share; Unsecured loan; Preference share
Unsecured loan; Preference share; Ordinary share
Preference share; Unsecured loan; Ordinary share
Ordinary share; Preference share; Unsecured loan
E
A
B
C
D
PL
2.2
Insurance company
Pension fund
Credit rating agency
Islamic bank
Secured long-term loan notes issued by companies
Secured short-term loan notes issued by companies
Unsecured long-term loan notes issued by companies
Unsecured short-term loan notes issued by companies
Which of the following would be LEAST likely to be a function of a treasury
department?
Managing relationships with banks
Liquidity management including investment of surplus funds
Currency management
Investment appraisal
SA
M
A
B
C
D
2.5
Which of the following is likely to have the LOWEST expected rate of return?
A
B
C
D
2.6
Unsecured bank loan
Preference shares
Secured bonds
Ordinary shares
Which of the following statements are features of money market instruments?
(1)
(2)
(3)
Interest-bearing instruments usually trade at less than face value
The yield on commercial paper is usually higher than that on treasury bills
Negotiable instruments can be sold before their maturity date
A
B
C
D
2 only
1 and 3 only
2 and 3 only
1, 2 and 3
3
2.7
Governments have a number of economic targets as part of their fiscal policy.
Which of the following targets relate predominantly to fiscal policy?
A
B
C
D
1 only
1 and 3
2 and 4 only
2, 3 and 4
Freely fluctuating exchange rates perform which of the following functions?
A
B
C
D
2.9
They tend to correct a trade surplus or deficit
They make imports cheaper and exports more expensive
They eliminate the opportunity for currency speculation
They eliminate business’ exposure to currency risk
Supply side economic policy is designed for what purpose?
A
B
C
D
To raise the level of demand in the economy
To increase the provision of state services
To improve the ability of the economy to produce goods and services
To reduce interest rates by increasing the money supply
Which ONE of the following government policies would NOT tend to raise national
income over time?
SA
M
2.10
E
Increasing tax revenue
Controlling the growth in the size of the money supply
Reducing public expenditure
Keeping interest rates low
PL
2.8
(1)
(2)
(3)
(4)
A
B
C
D
Increased expenditure on infrastructure
Tax cuts to encourage higher spending by consumers
Supply side policies to increase labour flexibility
Incentives to encourage personal saving
(20 marks)
3
Investment Decisions
3.1
Harvey Co is evaluating a capital investment proposal with the following information:
Initial cost
Life
Annual operating cash inflow
Scrap value
$500,000
10 years
$200,000
$100,000
The investment will be depreciated using the straight-line method.
What is the payback period for this investment?
A
B
C
D
4
3.25 years
2.67 years
2.5 years
2 years
3.2
A project requires an initial outlay of $1,000. The forecast cash inflows are:
Year 1
Year 2
Year 3
Year 4
$200
$200
$400
$400
What is the investment’s payback period?
3.4
Which of the following statements about investment decision making methods is true?
A
The discounted payback method takes into account cash flows for all periods
B
The payback method ignores all cash flows after the end of the payback period
C
The net present value rule is to accept investment opportunities when their rates of
return exceed the company’s weighted avergae cost of capital
D
The internal rate of return rule is to accept the investment if the weighted average
cost of capital is greater than the internal rate of return
PL
3.3
4.0 years
3.5 years
3.4 years
3.0 years
E
A
B
C
D
Which of the following statements is correct regarding investment decision making?
Opportunity costs are not relevant
The accounting rate of return considers the time value of money
A strength of the payback method is that it is based on profitability
Capital budgeting is based on predictions of an uncertain future
SA
M
A
B
C
D
3.5
A company with an 8% cost of capital purchases a machine for $43,000. The forecast
operating cash flows generated by the machine are as follows:
Year 1
Year 2
Year 3
Year 4
$10,000
$15,000
$20,000
$27,000
What is the discounted payback period in years?
A
B
C
D
3.6
3.10
3.25
2.90
3.14
Kuchman Kookies will invest $100,000 in new equipment. The firm’s discount rate is 8%
and the operating cash flows from the investment are expected to be as follows:
Year 1
Year 2
Year 3
Year 4
Year 5
$35,000
$38,000
$25,000
$20,000
$10,000
5
What is the investment’s payback period in years?
A
B
C
D
2.3
3.1
4.0
4.7
(12 marks)
Discounted Cash Flow Techniques
4.1
Gunning Industries is considering investment in a new machine. The following information is
provided:
E
4
The new machine will cost $190,000 and has a five year life with zero scrap value.

The investment in the new machine will also require an increase in working capital
of $35,000.

Tax-allowable depreciation is available on a straight-line basis.

Gunning is subject to a 40% tax rate and has a 10% cost of capital.
PL

What is the present value of the tax saving on the first year’s tax-allowable
depreciation?
$13,817
$15,200
$16,762
$20,725
SA
M
A
B
C
D
4.2
Wendy’s Sandwich Shop acquires an asset for $100,000 that has no residual value and a 10year life. Wendy’s tax rate is 40%. Tax-allowable depreciation is available on a straight-line
basis.
What is Wendy’s annual tax saving from the asset?
A
B
C
D
4.3
Which of the following events would decrease the internal rate of return of a potential
investment?
A
B
C
D
4.4
Decreased tax-allowable depreciation available on the investment
Decreased working capital requirements
Decreased cost of capital
Using reducing balance, instead of straight-line depreciation
Which of the following changes would result in the highest present value for a series of
cash flows?
A
B
C
D
6
$10,000
$6,000
$4,000
$2,000
A $100 decrease in taxes each year for four years
A $100 decrease in the cash outflow each year for three years
A $100 increase in disposal value at the end of four years
A $100 increase in cash inflow each year for three years
4.5
Which of the following is an advantage of the net present value method?
A
B
C
D
4.6
It is measured in time, not dollars
It uses accrual basis, not cash basis accounting for a project
It uses the accounting rate of return
It accounts for compounding of returns
ABC Co plans to buy a new machine. The cost of the machine is $100,000 and it has a fiveyear life with no disposal value. The machine will be depreciated on a straight line basis
which matches the policy for tax-allowable depreciation. The machine will increase annual
operating cash flows by $50,000. ABC’s profit tax rate is 35%.
4.7
$19,500
$30,000
$32,500
$39,500
PL
A
B
C
D
E
What is the annual after-tax cash flow generated by the machine?
A company has identified two mutually-exclusive projects which have an equivalent effect on
the risk profile of the company:
Project I
Project II
Discounted payback period
2.8 years
3.2 years
Net present value
$17,200
$15,700
Internal rate of return
18%
22%
Accounting rate of return
19%
21%
The company’s cost of capital is 15%.
SA
M
Assuming that the directors wish to maximise shareholder wealth and no shortage of
capital is expected, which project should the company choose?
A
B
C
D
4.8
Project I because it has the shorter payback period
Project I because it has the higher net present value
Project II because it has the higher internal rate of return
Project II because it has the higher accounting rate of return
A project has an initial cash outflow followed by several years of cash inflows.
What would be the effects on the internal rate of return (IRR) of the project and its
discounted payback period (DPP) of a decrease in the company’s cost of capital?
A
B
C
D
IRR
Decrease
Decrease
No change
No change
DPP
Decrease
Increase
Decrease
Increase
7
4.9
A company has a “money” cost of capital of 21% per year. The general inflation rate is 9%
per year.
What is the “real” cost of capital?
A
B
C
D
4.10
9%
11%
12%
21%
The following data is relevant to the evaluation of a particular project:
10% per year
5% per year
E
Cost of capital in real terms
General inflation rate
Specific inflation rate of the project’s annual cash inflow 6% per year
Specific inflation rate of the project’s annual cash outflow 4% per year
A
B
C
D
PL
Which of the following sets of adjustments will lead to the correct calculation of net
present value?
Cash inflow
5% annual increase
6% annual increase
6% annual increase
Unadjusted
Cash outflow
5% annual increase
4% annual increase
4% annual increase
Unadjusted
Discount rate
15.5%
15.0%
15.5%
10.0%
(20 marks)
Applications of Discounted Cash Flow Techniques
SA
M
5
5.1
Which of the following is a limitation of the profitability index?
A
B
C
D
5.2
It uses accounting profits rather than cash flows
It ignores the time value of money
It is inconsistent with the goal of shareholder wealth maximisation
It cannot deal with multi-period capital rationing
ABC Co is trying to decide between keeping an existing machine and replacing it with a new
machine. The old machine was purchased just two years ago for $50,000 and had an expected
life of 10 years. It now costs $1,000 a month for maintenance and repairs due to a mechanical
problem. A new machine is being considered to replace it at a cost of $60,000. The new
machine is more efficient and it will only cost $200 a month for maintenance and repairs.
The new machine has an expected life of 10 years.
In deciding to replace the old machine, which of the following factors should ABC not
consider?
A
B
C
D
8
Any estimated scrap value on the old machine
The original cost of the old machine
The estimated useful life of the new machine
The lower maintenance cost on the new machine
5.3
A company is considering whether to buy or lease two assets:
Asset 1 has a 10-year economic life with a zero residual value. It can be purchased for
$80,000 payable immediately. Alternatively, it can be leased with 10 lease rentals of $12,000
per year payable annually in advance.
Asset 2 has a five-year economic life. It can be purchased for $81,000 payable immediately
and will have a residual value of $40,000 after five years. Alternatively, it can be leased with
five lease rentals of $14,000 per year payable annually in arrears.
How should the company finance each asset?
5.4
Asset 1
Lease
Lease
Buy
Buy
Asset 2
Lease
Buy
Lease
Buy
PL
A
B
C
D
E
The appropriate discount rate is 10% per year.
The cost of purchasing a machine is $100,000 payable immediately. Its disposal value is
expected to be $10,000 in five years’ time.
The same asset can be leased for a period of five years with rentals of $25,000 payable
annually in advance.
SA
M
What is the net present value (to the nearest $10) to the lessor if it purchases the
machine then leases it to the user on the above terms if it applies an annual discount rate
of 10%?
A
B
C
D
5.5
$990 positive
$10,460 positive
$1,960 negative
$11,440 negative
A machine costing $150,000 has a useful life of eight years, after which time its estimated
resale value will be $25,000. Annual running costs will be $5,000 for the first three years of
use and then $8,000 for each of the next five years. All running costs are payable on the last
day of the year to which they relate.
Using a discount rate of 20%, what is the equivalent annual cost of the machine (to the
nearest $100)?
A
B
C
D
$46,600
$43,900
$43,300
$21,100
(10 marks)
9
Project Appraisal under Risk
6.1
During a typical year, Deet Co experiences the following power cuts:
Number of power cuts
per month
0
1
2
3
Number of
months
3
2
4
3
–––
12
–––
E
6
Each power cut results in additional costs of $400. For $500 per month, Deet can lease a
generator to provide electricity during power cuts.
A
B
C
D
6.2
PL
If Deet leases the generator what is the estimated annual savings/ (additional cost)?
($3,600)
($1,200)
$1,600
$1,900
Excalibur Co has developed a model to predict sales levels for its beachwear based on longrange weather forecasts. The probability of various temperatures and related sales units are as
follows:
SA
M
Unit sales
10,000
30,000
50,000
40,000
25,000
Temperature Probability
below 20°
5%
20-24
25%
24-28
50%
28-32
15%
over 32
5%
What sales volume, in units, would Excalibur Co anticipate using the expected value
approach?
A
B
C
D
6.3
31,000
40,250
50,000
155,000
A shopkeeper has determined the following probability distribution of weekly demand for one
of his most popular products.
Demand
300
400
500
600
700
Probability
0.2
0.3
0.3
0.1
0.1
The shopkeeper must order each week’s sales in advance and any items left in inventory at the
end of the week are scrapped. The items cost the shopkeeper $2.50 and he sells them for $3
each.
10
What is the optimal quantity to be ordered each week?
A
B
C
D
A company has constructed a model for predicting profits. Net profit or loss depends on two
variables: gross profit and overheads. The following are independent probability
distributions of the two variables.
Gross profit
$
12,000
6,000
4,000
3,000
Probability
0.1
0.4
0.4
0.1
Overheads
$
6,000
4,000
3,000
2,000
Probability
E
6.4
300
400
450
500
0.3
0.3
0.3
0.1
A
B
C
D
Adrian is contemplating purchasing for $60,000 a machine which he will use to produce
10,000 disks per year for five years. These disks will be sold for $9 each and unit variable
costs are expected to be $5. Incremental fixed costs will be $14,000 per year for production
costs and $5,000 per year for selling and administration costs. Adrian has a discount rate of
10% per year.
SA
M
6.5
0.27
0.55
0.73
0.82
PL
What is the probability that the company will make a positive net profit?
By how many units must the estimate of production and sales volume fall for the project
to be regarded as not worthwhile?
A
B
C
D
6.6
575
1,293
1,623
2,463
The following financial information relates to an investment project:
Present value of sales revenue
Present value of variable costs
Present value of contribution
Present value of fixed costs
Present value of operating income
Initial investment
$000
50,025
25,475
––––––
24,550
18,250
––––––
6,300
5,000
11
What is the sensitivity of the net present value of the investment project to a change in
fixed costs?
A
B
C
D
7·1%
5·3%
5·1%
2·6%
(12 marks)
Equity Finance and Debt Finance
7.1
What is a major advantage of issuing long-term debt?
A
B
C
D
When issuing new bonds what would be the primary reason for a debt covenant limiting
the firm’s future level of debt?
A
B
C
D
To cause the firm’s share price to rise
To lower the company’s credit rating
To reduce issue costs
To reduce the coupon rate
Bander Co is determining how to finance some long-term projects. Bander has decided that it
prefers the flexibility of no fixed servicing cost, no fixed maturity date and an increase in the
credit rating of the company.
SA
M
7.3
Increased financial flexibility
The reduction in profit before tax
Decreased financial risk
The reduction of shareholders’ control over the company
PL
7.2
E
7
Which of the following would best meet Bander’s financing requirements?
A
B
C
D
7.4
7.5
Which of the following statements is/are correct regarding corporate debt and equity
securities?
(1)
(2)
Both debt and equity holders have an ownership interest in the company.
Both debt and equity securities have an obligation to pay income.
A
B
C
D
1 only
2 only
Both 1 and 2
Neither 1 nor 2
Which of the following types of bonds is most likely to maintain a constant market
value?
A
B
C
D
12
Irredeemable bonds
Ordinary shares
Long-term bank loans
Preference shares
Zero-coupon
Floating-rate
Irredeemable
Convertible
7.6
A company currently has 1,000 ordinary shares in issue and no debt. It has the choice of
raising an additional $100,000 by issuing 9% long-term debt, or issuing 500 ordinary shares.
The company has a 40% tax rate.
What level of earnings before interest and taxes (EBIT) would result in the same
earnings per share (EPS) for the two financing options?
A
B
C
D
A company currently has 10 million $1 shares in issue with a market value of $3 per share.
The company wishes to raise new funds using a 1 for 4 rights issue. The resulting theoretical
ex-rights price per share has been calculated as $2·80.
How much new finance was raised?
7.8
$2,500,000
$4,000,000
$5,000,000
$7,000,000
PL
A
B
C
D
E
7.7
$27,000
$21,000
$18,000
$10,800
Which of the following may be regarded as an advantage to existing shareholders of
listing the firm on a major stock market?
Reduced disclosure requirements
Larger dividends can be paid
Shares become more marketable
Reduced risk of takeover
SA
M
A
B
C
D
7.9
Which of the following defines dividend cover?
A
B
C
D
7.10
Dividend per share divided by earnings per share.
Earnings per share divided by dividend per share.
Share price divided by dividend per share.
Retained profit per share divided by dividend per share
The Stock Exchange may provide a quotation for a company’s existing shares without that
company making any new shares available to the market.
What is this method of obtaining a quotation called?
A
B
C
D
An offer for sale
An introduction
A placing
A scrip issue
13
7.13
(1)
(2)
(3)
The use of debt
The financing of immoral activities
The use of derivatives
A
B
C
D
2 only
1 and 3
1, 2 and 3
2 and 3
Which of the following statements concerning a rights issue are correct?
(1)
(2)
(3)
(4)
The new shares are normally issued at a discount to the existing price
There will be no change in shareholder wealth
The main purpose of a rights issue is to raise finance
The new shareas must be issued to the existing shareholders
A
B
C
D
1, 2 and 3 only
2, 3 and 4 only
1, 3 and 4 only
1, 2 and 4 only
Which of the following statements concerning a bonus (scrip) issue is correct?
A
B
C
D
The new shares are issued at par value
Earnings per share would be expected to rise
The main purpose of a bonus issue is to raise finance
The bonus shares do not carry voting rights
Which of the following is the correct definition of a warrant?
SA
M
7.14
E
7.12
Which of the following is prohibited under Islamic financing principles?
PL
7.11
A
B
C
D
7.15
Which of the following is an example of supply chain finance?
A
B
C
D
7.16
Finance raised to invest in supply chain infrastructure
Taking loans from suppliers
Selling a sales invoice to a customer’s bank for immedidate payment
Issuing shares to a supplier
Which of the following is NOT true of peer-to-peer (P2P) lending?
A
B
C
D
14
Security or collateral provided for debt
Shares issued in lieu of a cash dividend
Restritive covenants written into debt contracts
Share options attached to a debt issue
It can also be referred to as “debt-based crowdfunding”
It involves individuals lending money to other individuals or to small businesses
It requires a financial institution to act as an intermediary
It is an example of “microfinance”
7.17
Which of the following statements concerning crowdfunding is correct?
A
B
C
D
It involves either issuing shares or loans to large group of investors
It is only available to unlisted companies
“Reward-based” crowdfunding does not raise any cash for the business
It is particularly appropriate for early stage “seed” finance
(34 marks)
Cost of Capital
8.1
Which of the following usually determines the optimal capital structure for an
organisation?
8.2
Which of the following rates is most commonly compared to a project’s internal rate of
return to evaluate whether to make an investment?
A
B
C
D
8.3
Maximum degree of financial gearing
Maximum degree of operating gearing
Lowest weighted average cost of capital
Capital structure used by competitors
PL
A
B
C
D
E
8
Risk-free rate
Accounting Rate of Return
Weighted average cost of capital
Cost of equity
A company with a tax rate of 30% has the following capital structure:
Instrument
Bonds
Ordinary shares
Preference shares
Pre-tax cost of capital
6%
12%
8%
SA
M
Weight
40%
50%
10%
What is the company’s weighted average cost of capital?
A
B
C
D
8.4
9.2%
7.7%
8.2%
8.5%
A company has in issue 9% $20 nominal value preference shares. Their current market price
is $40 and the company’s tax rate is 30%.
What is the company’s cost of preference shares?
A
B
C
D
4.5%
3.15%
9.0%
6.3%
15
8.6
Which three elements are needed to estimate the cost of equity using the dividend
growth model?
A
Current dividends per share, expected growth rate in earnings per share and current
market price per share
B
Current earnings per share, expected growth rate in dividends per share and current
C
Current earnings per share, expected growth rate in earnings per share and current
book value per share
D
Current dividends per share, expected growth rate in dividends per share and current
A firm has a share price of $30, a forecast dividend per share after one year of $3 and
thereafter an expected growth rate of 10%.
A
B
C
D
21.1%
12.2%
11.0%
20.0%
PL
What is the firm’s cost of equity?
8.7
E
8.5
A firm has a bank loan with a 10% interest rate. The firm also has in issue 8% preference
shares trading at par and has estimated that its cost of ordinary shares is 18%. The firm has a
30% tax rate.
SA
M
What is the weighted average cost of capital if the firm uses a capital structure
comprising 50% debt and an even split between preference and ordinary shares?
A
B
C
D
8.8
11.50%
10.00%
9.40%
8.05%
A firm’s weighted average cost of capital is minimised when its debt to equity ratio is 4:1.
Which of the following statements is most accurate?
A
B
C
D
16
The value of the firm is maximised when it uses more equity than debt
A higher ratio than 4:1 means debt holders will require a lower return
A higher ratio than 4:1 means equity holders will require a higher return
The value of the firm will be maximised if it is 75% debt financed
8.9
Recent statistics relating to the ordinary shares of Calc Co, a quoted company, are as follows:
Dividend (just paid)
Average annual growth rate of dividends
Dividend cover
5 cents
10%
2.4
8
A
B
C
D
8.10
13.8%
15.2%
15.7%
23.8%
A firm has achieved an average growth in dividends over the last five years of 10.5% per
year. It is now widely believed that the long-run average annual dividend growth rate will be
9.16% per year. The firm’s current dividend yield is 4.8%.
A
B
C
D
13.96%
14.40%
15.30%
15.80%
PL
What is the firm’s cost of equity?
Which of the following statements concerning capital structure theory is correct?
A
In the traditional view, there is a linear relationship between the cost of equity and
financial risk
B
Modigliani and Miller said that, in the absence of tax, the cost of equity would
remain constant
C
Pecking order theory does not suggest an optimal debt to equity ratio
D
Modigliani and Miller said that, in the presence of tax, the weighted average cost of
capital would remain constant
SA
M
8.11
E
What is Calc Co’s cost of equity?
(22 marks)
9
Capital Asset Pricing Model
9.1
Colt Co has an equity beta factor of 1.15 and an asset beta factor of 0.85. The risk-free rate of
return is 8.5% and the market return is estimated at 12.4%. The corporate tax rate is 25%.
What is Colt’s cost of equity geared?
A
B
C
D
11.82%
12.99%
9.74%
14.26%
17
9.2
The risk-free rate of return is 3% and the market premium is 6.5%. A firm’s equity beta is
1.15 and asset beta 0.85.
What will the firm’s cost of equity be if it redeems all outstanding debt?
A
B
C
D
A firm’s equity beta is 1.10 and its asset beta is 0.85. The market premium is 4.50% and the
risk-free rate 3%
E
9.3
7.0%
10.5%
8.5%
6.0%
A
B
C
D
9.4
What type of risk cannot be eliminated through diversification?
A
B
C
D
Business risk
Unsystematic risk
Financial risk
Systematic risk
The risk-free rate of return is 6% and the required return on a security with a beta factor of 1·2
is 15·6%.
SA
M
9.5
7.95%
4.65%
6.83%
4.28%
PL
What is the firm’s cost of equity geared?
What is the required annual rate of return on the market portfolio?
A
B
C
D
9.6
11·52%
13·00%
14·00%
17·52%
The beta of company X’s shares is 1·6, the risk free rate is 5% and the required return on
company X’s shares is 16·2%. Company Y is quoted in the same stock market, but its shares
have a beta of 1·4.
What is the required rate of return on company Y’s shares?
A
B
C
D
9.7
Which of the following measures business risk?
A
B
C
D
18
12·0%
13·0%
13·2%
14·8%
Equity beta
Debt beta
Volatility of net income
Asset beta
9.8
Which of the following are assumptions of the capital asset pricing model?
(1)
(2)
(3)
Linear relationship between risk and required return
Constant dividend growth rate
Perfect capital markets
A
B
C
D
2 only
1 and 3
1, 2 and 3
2 and 3
(16 marks)
Working Capital Management
10.1
Which of the following would increase the net working capital of a firm?
10.2
Cash collection of accounts receivable
Refinancing of accounts payable with a two-year bank loan
Payment to suppliers
Payment of a dividend
PL
A
B
C
D
E
10
During the year, Mason Co’s current assets increased by $120,000 and current liabilities
decreased by $50,000.
What was the effect on net working capital?
Increased by $70,000
Decreased by $170,000
Increased by $170,000
Decreased by $70,000
SA
M
A
B
C
D
10.3
Which of the following indicates that a company is becoming more conservative in its
working capital funding policy?
A
B
C
D
10.4
Which of the following may indicate overtrading?
A
B
C
D
10.5
Increase in the ratio of current liabilities to non-current liabilities
Decrease in the operating cycle
Decrease in the current ratio
Increase in the ratio of long-term finance to current liabilities
Significant new issues of long-term finance
Rising profits but falling margins
Rising receivables turnover
Falling revenues
Which working capital financing policy exposes the firm to the greatest risk of being
unable to meet its obligations as they fall due?
A
B
C
D
Financing fluctuating current assets with long-term debt
Financing permanent current assets with long-term debt
Financing permanent current assets with short-term debt
Financing fluctuating current assets with short-term debt
19
10.6
A company has a current ratio of 2·3 and a quick ratio of 0·8. It increases its overdraft in
order to buy more inventory as a cash purchase.
What will happen to the company’s ratios as a result of this transaction?
A
B
C
D
Increased short-term borrowing
Increased cash balances
Increased revenue
Reduced working capital
E
Which of the following is LEAST likely to characterise overtrading?
A
B
C
D
10.8
Quick ratio
Increase
Decrease
Increase
Decrease
PL
10.7
Current ratio
Increase
Increase
Decrease
Decrease
The following information has been calculated for AAA Co:
Trade receivables collection period
Raw material holding period
Length of the production cycle
Credit taken from suppliers
Finished goods holding period
25 days
24 days
30 days
56 days
34 days
What is the length of the working capital cycle?
3 days
27 days
57 days
169 days
SA
M
A
B
C
D
10.9
20
Which of the following statements concerning working capital management are correct?
(1)
(2)
(3)
The twin objectives of working capital management are profitability and liquidity
An aggressive approach to working capital financing can increase profitability
Poor working capital management is a signal of overtrading
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
(18 marks)
Inventory Management
11.1
Which of the following would affect the optimal level of inventory?
Holding cost per unit of inventory
Current level of inventory
Cost of placing an order for inventory
Demand
A
B
C
D
1, 2 and 3 only
2, 3 and 4 only
1, 3 and 4 only
1, 2 and 4 only
In inventory management, which of the following will tend to increase the level of safety
stock?
A
B
C
D
11.3
Holding cost increases
Cost of running out of inventory decreases
Variability of lead-time increases
Reliability of demand forecasting increases
PL
11.2
(1)
(2)
(3)
(4)
Which of the following assumptions is associated with the economic order quantity
model?
The holding cost per unit will vary with quantity ordered
The cost of placing an order will vary with quantity ordered
Holding costs depend on the average level of inventory
The purchase cost per unit will vary based on quantity discounts
SA
M
A
B
C
D
11.4
E
11
To measure inventory management performance, a company monitors its inventory turnover
ratio. Selected data from the company’s accounting records show the following:
Annual sales
Gross profit
Current year
2,525,000
40%
Prior year
2,125,000
35%
Opening finished goods inventory for the current year was 15% of the prior year’s annual
sales volume at cost and closing finished goods inventory was 22% of the current-year’s
annual sales volume at cost.
What was the company’s inventory turnover for the current year?
A
B
C
D
11.5
4.55 times
5.61 times
6.51 times
6.81 times
Which of the following statements about the economic order quantity (EOQ) and the reorder level (ROL) are true?
A
B
C
D
The EQO determines the ROL
The ROL determines the EOQ
Both are influnced by demand
Both are influnced by lead time
21
Which of the following is LEAST relevant to the economic order quantity model for
inventory?
A
B
C
D
Which of the following is/are usually seen as benefits of the just-in-time approach to
inventory management?
(1)
(2)
(3)
Reduced risk of stock outs
Reduced holding holds
Reduced dependence on suppliers
A
B
C
D
2 only
1 and 3 only
2 and 3 only
1, 2 and 3
E
11.7
Safety stock
Annual demand
Holding costs
Order costs
PL
11.6
(14 marks)
12
Cash Management
12.1
The CFO of Lang Co wants to earn a higher return on the company’s cash holdings.
Which of the following comparable maturity investments will earn Lang the highest
expected return?
Certficates of deposit
Treasury bills
Commercial paper
Bank deposits
SA
M
A
B
C
D
12.2
Which of the following securities has the least amount of default risk?
A
B
C
D
12.3
Which of the following best describes the risk associated with the ability to sell a shortterm investment quickly without significant impact on the price?
A
B
C
D
22
Corporate bonds
Treasury bills
Commercial paper
Bills of exchange
Interest rate risk
Purchasing power risk
Financial risk
Liquidity risk
(1)
The greater the variability in cash flows, the greater is the spread between the upper
and lower cash balance limits.
(2)
When short-term investments are liquidated the firm’s cash balance should return to
the lower limit.
A
B
C
D
1 only
2 only
Both 1 and 2
Neither 1 nor 2
E
12.5
Which of the following statements about the Miller-Orr cash management model is/are
true?
A company uses the Baumol cash management model. Cash disbursements are constant at
$20,000 each month. Short-term investments yield 5% a year, while cash held in the
company’s bank account earns zero interest. Switching costs (that is, for each purchase or
sale of short-term investments) are $30 for each transaction.
PL
12.4
What is the optimal amount (to the nearest $100) to be transferred in each transaction?
A
B
C
D
12.6
$500
$1,700
$4,900
$17,000
Which is the following is an assumption of the Baumol model but not of the Miller-Orr
model?
Constant usage of cash
Holding cash incurrs an opportunity cost
Fixed commission for switching between cash and cash equivalents
Variability of cash flows
SA
M
A
B
C
D
(12 marks)
13
Management of Accounts Receivable and Payable
13.1
A supplier offers a 3% discount for payment within 10 days or full payment within 45 days.
Assuming a 360-day year what is the annualised cost of not taking the discount?
A
B
C
D
13.2
37.11%
36.00%
24.74%
31.81%
A company has daily sales of $150,000. A debt factor has guaranteed to reduce the
company’s receivables collection time by four days for a monthly fee of $2,500. Cash
surpluses can be invested in money market deposits yielding 4% per annum.
What is the additional annual income/(loss) from using the cash management service?
A
B
C
D
$6,000
$(6,000)
$12,000
$(12,000)
23
13.3
Amicable Wireless Co offers customers credit terms of 2% discount for payment within 10
days or full payment within 25 days. 60% of Amicable’s customers take the 2% discount and
pay on day 10. The remainder of Amicable’s customers pay on day 30.
What is Amicable’s receivables days?
A
B
C
D
The CFO of a company is concerned about the company’s accounts receivable turnover ratio.
The company currently offers customers terms of 3% discount for settlement within 10 days
or full payment within 30 days.
E
13.4
16
12
18
20
Which of the following strategies would most likely improve the company’s accounts
receivable turnover ratio?
13.5
Using invoice discouting
Changing customer terms to a 1% discount for settelement within 10 days
Entering into a factoring agreement with a finance company
Changing customer terms to a 3% discount for settlment within 20 days
PL
A
B
C
D
Scrimpy Co buys materials from Frugal Enterprises. Frugal offers discount terms of 2%
discount for payment within 10 days or full payment within 30 days.
SA
M
Assuming a 360-day year, what is the annual percentage cost associated with Scrimpy’s
failure to take advantage of the discount offered by Frugal?
A
B
C
D
13.6
Which of the following statements about debt factoring and invoice discounting is
correct?
A
B
C
D
13.7
2.0%
33.3%
36.0%
36.7%
Factoring is with recourse whereas discounting is without recourse
Invoice discounting is usually performed on the entire receivables ledger
Both are relatively cheap sources of finance
Only factoring involves outsourcing the administration of the receivables ledger.
The management of XYZ Co has annual credit sales of $20 million and accounts receivable
of $4 million. Working capital is financed by an overdraft at 12% interest per year. Assume
365 days in a year.
What is the annual finance cost saving if the management reduces the collection period
by 60 days?
A
B
C
D
$85,479
$394,521
$78,904
$68,384
(14 marks)
24
14
Risk Management
14.1
Hedgehog International is a UK-based firm which must pay $500,000 to its foreign supplier
in 90 days. The current spot rate is $1.60 per £1. Hedgehog purchases an option to buy the
dollar in 90 days at $1.64 per £1, paying a premium of $0.07 per $1. The spot rate after 90
days is $1.58 per £1.
What will Hedgehog do on the payables’ settlement date?
Hedgehog International is a UK-based firm which will receive $500,000 to its overseas
customer in 90 days. The current spot rate is $1.60 per £1. Hedgehog purchases an option to
sell the dollar in 90 days at $1.61 per £1, paying a premium of $0.03 per $1. The spot rate
after 90 days is $1.58 per £1.
PL
14.2
Hedgehog will exercise the option
Hedgehog will not exercise the option
Hedgehog will be indifferent as to whether it exercises the option or not
Hedgehog will allow the option to lapse
E
A
B
C
D
What will Hedgehog do after 90 days?
A
B
C
D
14.3
Hedgehog will exercise its option
Hedgehog will lapse the option
Hedgehog will be indifferent as to whether it exercises the option or not
Hedgehog will receive a refund of the premium
A US importer expects to pay a European supplier €500,000 in three months.
SA
M
Which of the following hedges could be appropriate for the US importer?
A
B
C
D
14.4
Buying call options on the euro
Buying put options on the euro
Selling put options on the euro
Selling call options on the euro
Platinum Co is US-based and has a receivable due in 30 days for 30,000 euros. The treasurer
is concerned that the value of the euro relative to the dollar will drop before the payment is
received.
What should Platinum do to reduce this risk?
A
B
C
D
Deposit 30,000 euros today
Enter into an interest rate swap contract for 30 days
Enter into a forward contract to sell 30,000 euros in 30 days
Platinum cannot effectively reduce this risk
25
14.6
In evaluating the impact of relative inflation rates on the demand for a foreign currency,
which of the following is true?
A
Inflation is irrelevant to currency demand.
B
As inflation associated with a foreign economy increases in relation to a domestic
economy, demand for the foreign currency falls.
C
As inflation associated with a foreign economy increases in relation to a domestic
economy, demand for the foreign currency increases.
D
As inflation associated with a foreign economy decreases in relation to a domestic
economy, demand for the foreign currency falls.
E
14.5
A company has several long-term floating rate bonds outstanding and is considering hedging
interest rate risk.
Which of the following derivative instruments is recommended for this purpose?
Which of the following statements about the term structure of interest rates is/are true?
(1)
An “inverted” yield curve is where long-term interest rates are higher than shortterm interest rates.
(2)
A rising yield curve is caused when investors prefer to buy for long-dated bonds
A
B
C
D
1 only
2 only
Both 1 and 2
Neither 1 nor 2
SA
M
14.7
Money market hedge
Forward currency contract
Fixed rate bank loans
Interest rate swap
PL
A
B
C
D
14.8
26
In relation to hedging currency risk, which of the following statements is correct?
A
The flexible nature of currency futures means that they can always be matched with
a specific currency exposure
B
Currency options carry an obligation to the holder to exercise the option at maturity
C
Forward contracts require the payment of a premium
D
A money market hedge should give approximately the same result as a forward
contract
14.9
The home currency of GB Co is sterling (£) and it trades with a company in a foreign country
whose home currency is the rupee. The following information is available:
Home country
80·00 rupees per £
2% per year
1% per year
Spot rate
Interest rate
Inflation rate
Foreign country
9% per year
5% per year
A
B
C
D
14.11
What is the impact of an appreciation in the value of a country’s currency?
(1)
(2)
Exports will be given a stimulus
The rate of domestic inflation will rise
A
B
C
D
1 only
2 only
Both 1 and 2
Neither 1 nor 2
PL
14.10
E
What is the two-year forward exchange rate?
“There is a risk that the value of our export earnings will fall over the next few years due to an
appreciating domestic currency.”
To which risk does the above statement refer?
Translation risk
Economic risk
Transaction risk
Financial risk
SA
M
A
B
C
D
14.12
In relation to the term structure of interest rates what is a “normal” yield curve?
A
B
C
D
14.13
Upward sloping
Downward sloping
U-shaped
Horizontal
Burger Queen Co conducts business in a number of different countries and is trying to
evaluate its economic exposure to long-term exchange rate trends.
Which of the following statements is correct?
A
Burger Queen will suffer an economic loss if it has to make payments in a foreign
currency and its domestic currency appreciates
B
Burger Queen will enjoy an economic gain if it has to make payments in a foreign
currency and the foreign currency appreciates
C
Burger Queen will suffer an economic loss if it has net receipts of a foreign
currency and its domestic currency depreciates
D
Burger Queen will suffer an economic loss if it has net receipts of a foreign
currency and the foreign currency depreciates
27
14.14
Universal Exports Co limits its operations to exporting overseas.
Which ONE of the following statements concerning Universal’s exposures to exchange
rate risk is correct?
B
Universal is subject to transaction and economic exposure
C
Universal is only subject to transaction exposure
D
Universal is not subject to exchange rate risk as currency fluctuations would balance
out over time
E
Universal is subject to transaction, economic and translation exposure
What is the effect on a UK-based company when a foreign competitor’s currency
becomes weaker compared to sterling?
A
B
C
D
The foreign company will have an advantage in the UK market
The foreign company will be disadvantaged in the UK market
No effect
It is advantageous for the UK company when sterling strengthens
PL
14.15
A
(30 marks)
15
Business Valuation and Ratio Analysis
15.1
Assuming an increase in price levels over time, which of the following asset valuations
will produce the highest return on assets?
Net book value
Gross book value
Replacement cost
Depreciated replacement cost
SA
M
A
B
C
D
15.2
Kent Co had sales growth of 10% over the past year. EBIT grew by 15% and earnings
per share (EPS) grew by 25% over the same period.
Which of the following statements regarding Kent Co’s gearing is correct?
A
B
C
D
15.3
Total gearing is equal to 0.9
Total gearing is equal to 2.1
Financial gearing is equal to 0.6
Operating gearing is equal to 1.5
Jack Co owns a $1,000 face value bond purchased at par with an annual coupon of 5%.
What would happen to the market value of the bond if market interest rates later
decreased to 4% and why?
A
B
C
D
28
Increase because the bond pays a higher coupon than the current market rate
Stay the same since the bond pays a fixed coupon
Stay the same since the firm’s credit rating has not changed
Decrease since market interest rates have declined
15.4
Fernwell wants to buy shares of Gurst Co in two years. Fernwell uses the dividend valuation
model with an assumed dividend growth rate of 5%.
If Fernwell’s discount rate is 10% and Gurst’s current year dividend is $20, what is the
approximate price Fernwell will pay?
A
B
C
D
Harken Co’s price earnings ratio is 10, its earnings in the current year is $5 per share but the
earnings forecast for the next year is $8 per share.
A
B
C
D
15.6
Whichof the following is a basic premise of behavioural corporate finance?
A
B
C
D
Cost behaviour determines valuation
Behavioural characteristics of financial managers can distort judgment
Corporate behaviour will impact financial decisions
Corporate finance is inherently quantitative and objective
A financial manager believes that his actions will cause earnings to increase and the firm’s
share price to rise in direct proportion to earnings.
SA
M
15.7
$0.50
$0.80
$50
$80
PL
What is the current share price of Harken Co?
E
15.5
$400
$420
$441
$463
What does the manager’s behaviour illustrate?
A
B
C
D
15.8
Overconfidence
Excessive optimism
Illusion of control
Confirmation bias
A loan note has a fixed annual coupon of 7% and it will be repaid at its face value of $100 in
one year’s time. Similar loan notes have a gross redemption yield (i.e. yield to maturity) of
8%.
What is the current market value of the loan note?
A
B
C
D
$99·07
$100·00
$100·93
$106·07
29
15.10
Which of the following statements about the efficient market hypothesis is/are true?
(1)
In a strongly efficient market, the price/earnings ratios of all companies would be
the same.
(2)
In a semi-strong efficient market, the share price for a particular company should
not change when its financial statements are made public.
A
B
C
D
1 only
2 only
Both 1 and 2
Neither 1 nor 2
E
15.9
A firm maintains a 30% pay-out ratio. Future projects are expected to generate an annual
post-tax return on investment of 15% and a pre-tax return of 20%.
A
B
C
D
15.11
4·5%
6·0%
10·5%
14·0%
PL
What is the firm’s expected annual rate of growth?
Warren analyses publically available information about firms and uses this to try and predict
their share price movements.
To what extent does Warren believe capital markets to be efficient?
Not efficient at all
Weak form efficient
Semi-strong form efficient
Strong form efficient
SA
M
A
B
C
D
15.12
Korma Co has paid the following dividends per share in recent years:
Year
Dividend (cents per share)
2014
35·0
2013
33·8
2012
32·8
2011
31·1
The dividend for 2014 has just been paid and Korma Co has a cost of equity of 12%.
What is the market price of Korma Co shares to the nearest cent?
A
B
C
D
30
$4·01
$4·66
$4·07
$4·55
15.13
Donald Co has 8% convertible loan notes in issue which are redeemable in five years’ time at
their nominal value of $100 per loan note. Alternatively, each loan note could be converted
after five years into 60 equity shares with a nominal value of $1 each.
The equity shares of Donald Co are currently trading at $1·25 per share and this share price is
expected to grow by 4% per year. The yield to maturity (gross redemption yield) of the loan
notes is 10%
What is the current market value of each loan note to the nearest dollar?
15.14
$91
$92
$100
$103
E
A
B
C
D
Stern Bear is using the dividend valuation model with a constant growth rate to estimate the
value of an ordinary share.
A
B
C
D
15.15
PL
Which of the following assumptions is Stern Bear making?
The cost of equity will grow at a constant rate
Earnings will grow at a constant rate
The share price will grow at the same rate as the dividend
The share price will grow at the same amount as the dividend
What does a low price/earnings (P/E) ratio indicate to investors?
Earnings have limited growth potential
Earnings are expected to rise quickly
There are prolems with the company’s management
The company is overvalued
SA
M
A
B
C
D
(30 marks)
31
Question 1 COMPANY OBJECTIVES
Justify and criticise the usual assumption made in financial management literature that the
objective of a company is to maximise the wealth of the shareholders. (Do not consider how this
wealth is to be measured).
Outline other goals that companies claim to follow, and explain why these might be adopted in
preference to the maximisation of shareholder wealth.
(10 marks)
Question 2 THE FINANCIAL MANAGEMENT FUNCTION
Discuss the main decisions within the scope of financial management.
(5 marks)
(b)
Explain how management accounting information may assist the financial manager.
(5 marks)
E
(a)
PL
(10 marks)
Question 3 FINANCIAL MANAGEMENT DECISIONS
Discuss the relationship between investment decisions, dividend decisions and financing decisions
in the context of financial management, illustrating your discussion with examples where
appropriate.
(10 marks)
Question 4 VALUE FOR MONEY
SA
M
Explain and compare the public sector objective of “value for money” and the private sector
objective of “maximisation of shareholder wealth”.
(6 marks)
Question 5 NON-FOR-PROFIT
Compare and contrast the financial objectives of a stock exchange listed company and the
financial objectives of a not-for-profit organisation such as a large charity.
(10 marks)
Question 6 QSX CO
A shareholder of QSX Co is concerned about the recent performance of the company and has collected
the following financial information.
Year to 31 May
Revenue
Earnings per share
Dividend per share
Closing ex-dividend share price
Return on equity predicted by CAPM
2015
$6·8m
58·9c
40·0c
$6·48
8%
2014
$6·8m
64·2c
38·5c
$8·35
12%
2013
$6·6m
61·7c
37·0c
$7·40
The current cost of equity of QSX Co is 10% per year.
Assume that dividends are paid at the end of each year.
32
Required:
Calculate the dividend yield, capital gain and total shareholder return for 2014 and 2015, and
briefly discuss your findings with respect to:
(i)
(ii)
the returns predicted by the capital asset pricing model (CAPM);
the other financial information provided.
(10 marks)
Question 7 AGENCY PROBLEM
PL
Required:
E
At a recent board meeting of Dartig Co, a non-executive director suggested that the company’s
remuneration committee should consider scrapping the company’s current share option scheme, since
executive directors could be rewarded by the scheme even when they did not perform well. A second
non-executive director disagreed, saying the problem was that even when directors acted in ways which
decreased the agency problem, they might not be rewarded by the share option scheme if the stock
market were in decline.
Explain the nature of the agency problem and discuss the use of share option schemes and
performance-related pay as methods of reducing the agency problem in a stock-market listed
company such as Dartig Co.
(10 marks)
Question 8 LISTED COMPANY OBJECTIVES
SA
M
Identify TWO financial objectives of a listed company and discuss how each of these financial
objectives may be supported by investment in new projects.
(6 marks)
Question 9 GOAL CONGRUENCE
Explain ways in which the directors of a listed company can be encouraged to achieve the
objective of maximisation of shareholder wealth.
(6 marks)
Question 10 MONEY MARKETS
Explain the role of the money markets and give four examples of money market instruments.
(6 marks)
33
Question 11 TAGNA
Tagna is a medium-sized company that manufactures luxury goods for several well-known chain stores.
In real terms, the company has experienced only a small growth in revenue in recent years, but it has
managed to maintain a constant, if low, level of reported profits by careful control of costs. It has paid
a constant nominal (money terms) dividend for several years and its managing director has publicly
stated that the primary objective of the company is to increase the wealth of shareholders. Tagna is
financed as follows:
$m
1·0
2·0
4·5
–––
7·5
–––
E
Overdraft
10 year fixed interest bank loan
Share capital and reserves
Required:
PL
The financial press has reported that it expects the Central Bank to make a substantial increase in
interest rate in the near future in response to rapidly increasing consumer demand and a sharp rise in
inflation. The financial press has also reported that the rapid increase in consumer demand has been
associated with an increase in consumer credit to record levels.
On the assumption that the Central Bank makes a substantial interest rate increase, discuss the
possible consequences for Tagna in the following areas:
sales;
operating costs; and
earnings (profit after tax).
SA
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(i)
(ii)
(iii)
(10 marks)
Question 12 FINANCIAL INTERMEDIARIES
Discuss the role of financial intermediaries in providing short-term finance for use by business
organisations.
(5 marks)
Question 13 PAYBACK AND ROCE
Backpay Co is considering investing $50,000 in a new machine. The machine will have scrap value of
$10,000 at the end its five year life. It is expected that 20,000 units will be sold each year at a selling
price of $3·00 per unit. Variable production costs are expected to be $1·65 per unit, while incremental
fixed costs, mainly the wages of a maintenance engineer, are expected to be $10,000 per year. The
directors expect investment projects to recover their initial investment within two years and achieve a
return on capital employed (accounting rate of return) of 25% based on average investment.
Required:
(a)
Calculate and comment on the project’s payback period.
(5 marks)
(b)
Calculate and comment on the project’s return on capital employed based on average
investment.
(5 marks)
(10 marks)
34
Question 14 DIRECTORS’ VIEWS
The directors of a company require that all investment projects should be evaluated using either
payback period or return on capital employed (accounting rate of return). The target payback period of
the company is two years and the target return on capital employed is 20%, which is the firm’s current
return on capital employed. A project is accepted if it satisfies either of these investment criteria.
In addition the directors also require all investment projects to be evaluated using net present value
calculated over a four-year planning period, ignoring inflation, any scrap value or working capital
recovery, with a balancing allowance being claimed at the end of the fourth year of operation.
E
Required:
Critically discuss the directors’ views on investment appraisal.
(10 marks)
Question 15 OKM CO
PL
The following draft appraisal of a proposed investment project has been prepared for the finance
director of OKM Co by a trainee accountant. The project is consistent with the current business
operations of OKM Co.
2
400,000
3
500,000
4
250,000
$000
Contribution
1,330
Fixed costs
(530)
Depreciation
(438)
Interest payments (200)
––––––
Taxable profit
162
Taxation
––––––
Profit after tax
162
Scrap value
––––––
After-tax cash flows 162
Discount at 10% 0·909
––––––
Present values
147
––––––
$000
2,128
(562)
(438)
(200)
––––––
928
(49)
––––––
879
$000
2,660
(596)
(437)
(200)
––––––
1,427
(278)
––––––
1,149
––––––
879
0·826
––––––
726
––––––
––––––
1,149
0·751
––––––
863
––––––
$000
1,330
(631)
(437)
(200)
––––––
62
(428)
––––––
(366)
250
––––––
(116)
0·683
––––––
(79)
––––––
SA
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Year
1
Annual sales (units) 250,000
5
$000
(19)
––––––
(19)
(19)
0·621
––––––
(12)
––––––
Net present value = 1,645,000 – 2,000,000 = ($355,000) so reject the project.
The following information was included with the draft investment appraisal:
1.
The initial investment is $2 million, payable at the start of the first year
2.
Selling price: $12/unit (current price terms), selling price inflation is 5% per year
3.
Variable cost: $7/unit (current price terms), variable cost inflation is 4% per year
4.
Fixed overhead costs: $500,000/year (current price terms), fixed cost inflation is 6% per year
35
$200,000/year of the fixed costs are development costs that have already been incurred and
are being recovered by an annual charge to the project
6.
Investment financing is by a $2 million loan at a fixed interest rate of 10% per year
7.
OKM Co can claim 25% tax-allowable depreciation on a reducing balance basis on this
investment and pays taxation one year in arrears at a rate of 30% per year
8.
The scrap value of machinery at the end of the four-year project is $250,000
9.
The real weighted average cost of capital of OKM Co is 7% per year
10.
The general rate of inflation is expected to be 4·7% per year
E
5.
Required:
Identify and comment on any errors in the investment appraisal prepared by the trainee
accountant.
(5 marks)
(b)
Prepare a revised calculation of the net present value of the proposed investment project
and comment on the project’s acceptability.
(10 marks)
PL
(a)
(15 marks)
Question 16 LIMITATIONS OF NPV
Identify the limitations of Net Present Value techniques when applied generally to investment
appraisal.
(10 marks)
SA
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Question 17 RIDAG CO
Ridag Co is evaluating two investment projects, as follows.
Project 1
This is an investment in new machinery to produce a recently-developed product. The cost of the
machinery, which is payable immediately, is $1·5 million, and the scrap value of the machinery at the
end of four years is expected to be $100,000. Tax-allowable depreciation can be claimed on this
investment on a 25% reducing balance basis. Information on future returns from the investment has
been forecast to be as follows:
Year
Sales volume (units/year)
Selling price ($/unit)
Variable cost ($/unit)
Fixed costs ($/year)
1
50,000
25·00
10·00
105,000
2
95,000
24·00
11·00
115,000
3
140,000
23·00
12·00
125,000
4
75,000
23·00
12·50
125,000
This information must be adjusted to allow for selling price inflation of 4% per year and variable cost
inflation of 2·5% per year. Fixed costs, which are wholly attributable to the project, have already been
adjusted for inflation. Ridag Co pays profit tax of 30% per year one year in arrears.
36
Project 2
Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has
an initial cost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an
initial cost of $225,000 and will have a scrap value of $50,000 after three years. Annual maintenance
costs of the two machines are as follows:
Year
Machine 1 ($/year)
Machine 2 ($/year)
1
25,000
15,000
2
29,000
20,000
3
32,000
25,000
4
35,000
E
Where relevant, all information relating to Project 2 has already been adjusted to include expected
future inflation. Taxation and tax-allowable depreciation must be ignored in relation to Machine 1 and
Machine 2.
Other information
Required:
PL
Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax
weighted average cost of capital of 7%.
(a)
Calculate the net present value of Project 1 and comment on whether this project is
financially acceptable to Ridag Co.
(10 marks)
(b)
Calculate the equivalent annual costs of Machine 1 and Machine 2, and discuss which
machine should be purchased.
(5 marks)
SA
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(15 marks)
Question 18 BQK CO
BQK Co, a house-building company, plans to build 100 houses on a development site over the next four
years. The purchase cost of the development site is $4,000,000, payable at the start of the first year of
construction. Two types of house will be built, with annual sales of each house expected to be as
follows:
Year
Number of small houses sold:
Number of large houses sold:
1
15
7
2
20
8
3
15
15
4
5
15
Houses are built in the year of sale. Financial information relating to each type of house is as follows:
Selling price:
Variable cost of construction:
Small house
$200,000
$100,000
Large house
$350,000
$200,000
Selling prices and variable cost of construction are in current price terms, before allowing for selling
price inflation of 3% per year and variable cost of construction inflation of 4·5% per year.
Fixed infrastructure costs of $1,500,000 per year in current price terms would be incurred. These
would not relate to any specific house, but would be for the provision of new roads, gardens, drainage
and utilities. Infrastructure cost inflation is expected to be 2% per year.
37
BQK Co pays profit tax one year in arrears at an annual rate of 30%. The company can claim taxallowable depreciation on the purchase cost of the development site on a straight-line basis over the
four years of construction.
BQK Co has a real after-tax cost of capital of 9% per year and a nominal after-tax cost of capital of
12% per year.
New investments are required by the company to have a before-tax return on capital employed
(accounting rate of return) on an average investment basis of 20% per year.
Required:
Calculate the net present value of the proposed investment and comment on its financial
acceptability. Work to the nearest $1,000.
(11 marks)
(b)
Calculate the before-tax return on capital employed (accounting rate of return) of the
proposed investment on an average investment basis and discuss briefly its financial
acceptability.
(4 marks)
PL
E
(a)
(15 marks)
Question 19 HDW CO
HDW Co is a listed company which plans to meet increased demand for its products by buying new
machinery costing $5 million. The machinery would last for four years, at the end of which it would be
replaced. The scrap value of the machinery is expected to be 5% of the initial cost. Tax-allowable
depreciation would be available on the cost of the machinery on a 25% reducing balance basis, with a
balancing allowance or charge claimed in the final year of operation.
SA
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This investment will increase production capacity by 9,000 units per year and all of these units are
expected to be sold as they are produced. Relevant financial information in current price terms is as
follows:
Selling price
Variable cost
Incremental fixed costs
$650 per unit
$250 per unit
$250,000 per year
Forecast inflation
4·0% per year
5·5% per year
5·0% per year
In addition to the initial cost of the new machinery, initial investment in working capital of $500,000
will be required. Investment in working capital will be subject to the general rate of inflation, which is
expected to be 4·7% per year.
HDW Co pays tax on profits at the rate of 20% per year, one year in arrears. The company has a
nominal (money terms) after-tax cost of capital of 12% per year.
Required:
(a)
Calculate the net present value of the planned purchase of the new machinery using a
nominal (money terms) approach and comment on its financial acceptability. (11 marks)
(b)
Discuss the difference between a nominal (money terms) approach and a real terms
approach to calculating net present value.
(4 marks)
(15 marks)
38
Question 20 DARN CO
Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future cash flows
of an investment project with an expected life of four years, as follows:
Year
Sales revenue ($000)
Costs ($000)
1
1,250
500
2
2,570
1,000
3
6,890
2,500
4
4,530
1,750
E
These forecast cash flows are before taking account of general inflation of 4·7% per year. The capital
cost of the investment project, payable at the start of the first year, will be $2,000,000. The investment
project will have zero scrap value at the end of the fourth year. The level of working capital investment
at the start of each year is expected to be 10% of the sales revenue in that year.
Required:
PL
Tax-allowable depreciation would be available on the capital cost of the investment project on a 25%
reducing balance basis. Darn Co pays tax on profits at an annual rate of 30% per year, with tax being
paid one year in arrears. Darn Co has a nominal (money terms) after-tax cost of capital of 12% per
year.
(a)
Calculate the net present value of the investment project in nominal terms and comment
on its financial acceptability.
(10 marks)
(b)
Calculate the net present value of the investment project in real terms and comment on
its financial acceptability.
(5 marks)
(15 marks)
SA
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Question 21 REPLACEMENT CYCLES
(a)
(b)
Discuss the problems faced when undertaking investment appraisal in the following
areas and comment on how these problems can be overcome:
(i)
assets with replacement cycles of different lengths;
(ii)
an investment project has several internal rates of return;
(iii)
the business risk of an investment project is significantly different from the
business risk of current operations.
(8 marks)
A company with a cost of capital of 14% is trying to determine the optimal replacement cycle
for the notebook computers used by its sales team. The following information is relevant to
the decision:
The cost of each notebook is $2,400. Maintenance costs are payable at the end of each full
year of ownership, but not in the year of replacement (e.g. if the notebook is owned for three
years, then the maintenance cost is payable at the end of year 1 and at the end of year 2).
Interval between
Replacement (years)
1
2
3
Trade-in Value ($)
Maintenance cost ($)
1200
800
300
Zero
75 (payable at end of Year 1)
150 (payable at end of Year 2)
39
Answer 1 COMPANY OBJECTIVES
Financial management is concerned with making decisions about the provision and use of a firm’s
finances. A rational approach to decision-making requires a clear idea of the objectives of the decision
maker or, more importantly, the objectives of those on behalf of whom the decisions are being made.
E
There is little agreement in the literature as to what objectives of firms are or even what they ought to
be. However, most financial management textbooks make the assumption that the objective of a
limited company is to maximise the wealth of its shareholders. This assumption is normally justified in
terms of classical economic theory. In a market economy firms that achieve the highest returns for their
investors will be the firms that are providing customers with what they require. In turn these
companies, because they provide high returns to investors, will also find it easiest to raise new finance.
Hence the so called “invisible hand” theory will ensure optimal resource allocation and this should
automatically maximise the overall economic welfare of the nation.
PL
This argument can be criticised on several grounds. Firstly it ignores market imperfections. For
example it might not be in the public interest to allow monopolies to maximise profits. Secondly it
ignores social needs like health, police, defence etc.
From a more practical point of view directors have a legal duty to run the company on behalf of their
shareholders. This however begs the question as to what do shareholders actually require from firms.
Another justification from the individual firm’s point of view is to argue that it is in competition with
other firms for further capital and it therefore needs to provide returns at least as good as the
competition. If it does not it will lose the support of existing shareholders and will find it difficult to
raise funds in the future, as well as being vulnerable to potential take-over bids.
SA
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Against the traditional and “legal” view that the firm is run in order to maximise the wealth of ordinary
shareholders, there is an alternative view that the firm is a coalition of different groups: equity
shareholders, preference shareholders and lenders, employees, customers and suppliers. Each of these
groups must be paid a minimum “return” to encourage them to participate in the firm. Any excess
wealth created by the firm should be and is the subject of bargaining between these groups.
At first sight this seems an easy way out of the “objectives” problem. The directors of a company could
say “Let’s just make the profits first, then we’ll argue about who gets them at a later stage”. In other
words, maximising profits leads to the largest pool of benefits to be distributed among the participants
in the bargaining process. However, it does imply that all such participants must value profits in the
same way and that they are all willing to take the same risks.
In fact the real risk position and the attitude to risk of ordinary shareholders, loan payables and
employees are likely to be very different. For instance, a shareholder who has a diversified portfolio is
likely not to be as worried by the bankruptcy of one of his companies as will an employee of that
company, or a supplier whose main customer is that company. The problem of risk is one major reason
why there cannot be a single simple objective which is common to all companies.
Separate from the problem of which goal a company ought to pursue are the questions of which goals
companies claim to pursue and which goals they actually pursue.
Many objectives are quoted by large companies and sometimes are included in their annual accounts.
1016
Examples are:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
to produce an adequate return for shareholders;
to grow and survive autonomously;
to improve productivity;
to give the highest quality service to customers;
to maintain a contented workforce;
to be technical leaders in their field;
to be market leaders;
to acknowledge their social responsibilities.
Pure profitability goals (e.g. adequate return for shareholders).
“Surrogate” goals of profitability (e.g. improving productivity, happy workforce).
Constraints on profitability (e.g. acknowledging social responsibilities, no pollution, etc.).
“Dysfunctional” goals.
PL
(a)
(b)
(c)
(d)
E
Some of these stated objectives are probably a form of public relations exercise. At any rate, it is
possible to classify most of them into four categories which are related to profitability:
The last category are goals which should not be followed because they do not create benefit in the long
run. Examples here include the pursuit of market leadership at any cost, even profitability. This may
arise because management assumes that high sales equal high profits which is not necessarily so.
In practice the goals which a company actually pursues are affected to a large extent by the
management. As a last resort, the directors may always be removed by the shareholders or the
shareholders could vote for a take-over bid, but in large companies individual shareholders lack voting
power and information. These companies can, therefore, be dominated by the management.
SA
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There are two levels of argument here. Firstly, if the management do attempt to maximise profits, then
they are in a much more powerful position to decide how the profits are “carved up” than are the
shareholders.
Secondly, the management may actually be seeking “prestige” goals rather than profit maximisation:
Such goals might include growth for its own sake, including empire building or maximising revenue for
its own sake, or becoming leaders in the technical field for no reason other than general prestige. Such
goals are usually dysfunctional.
The dominance of management depends on individual shareholders having no real voting power, and in
this respect institutions have usually preferred to sell their shares rather than interfere with the
management of companies. There is some evidence, however, that they are now taking a more active
role in major company decisions.
From all that has been said above, it appears that each company should have its own unique decision
model. For example, it is possible to construct models where the objective is to maximise profit subject
to first fulfilling the target levels of other goals. However, it is not possible to develop the general
theory of financial management very far without making an initial simplifying assumption about
objectives. The objective of maximising the wealth of equity shareholders seems the least
objectionable.
1017
Answer 2 THE FINANCIAL MANAGEMENT FUNCTION
(b)
Decisions that are within the scope of financial management include:
How should the business be financed? The main choices here are internal finance
(reinvestment of surplus cash from operations) or external finance (issuing equity or
debt).

On which proposed investments should the funds be spent? This requires evaluation
of potential projects to establish which would have the greatest impact on
shareholder wealth.

How much dividend should be paid to the shareholders? The dividend decision is
closely linked to financing and investing decisions as a rise in dividend reduces the
amount of internal finance available for reinvestment.

How much working capital should the organisation have and how should it be
financed? In this context working capital refers to net operating current assets (i.e.
inventory plus receivables less payables).

Should risk be managed and, if so, how? Key risks may include foreign exchange
risk (e.g. the risk that an appreciating home currency damages the value of export
earnings) and interest rate risk (e.g. the risk that interest rates will rise and increase
the firm’s cost of debt finance).
E

PL
(a)
How management accounting information can assist the financial manager
The budgeting process may identify potential cash deficits/surpluses which the
financial manager must plan to finance/invest. Advance warning is particularly
important in the case of potential deficits, giving the financial manager time to
arrange bridging loans, for example.
SA
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

Analysis of costs into fixed and variable elements may assist financial management
decisions. Some costs may be semi-variable in nature and splitting them into fixed
and variable elements (e.g. using linear regression) will be critical for decision such
as business expansion,

Variance analysis may help to control the costs of new projects. At the planning
stage the project committee should set budgets for both capital expenditure and
project operating costs and the management accountant should check for overspends
during the implementation stage.
Answer 3 FINANCIAL MANAGEMENT DECISIONS
Investment decisions, dividend decisions and financing decisions have often been called the decision
triangle of financial management. The study of financial management is often divided up in accordance
with these three decision areas. However, they are not independent decisions, but closely connected.
For example, a decision to increase dividends might lead to a reduction in retained earnings and hence a
greater need for external finance in order to meet the requirements of proposed capital investment
projects. Similarly, a decision to increase capital investment spending will increase the need for
financing, which could be met in part by reducing dividends.
1018
The question of the relationship between the three decision areas was investigated by Miller and
Modigliani. They showed that, if a perfect capital market was assumed, the market value of a company
and its weighted average cost of capital (WACC) were independent of its capital structure. The market
value therefore depended on the business risk of the company and not on its financial risk. The
investment decision, which determined the operating income of a company, was therefore shown to be
important in determining its market value, while the financing decision, given their assumptions, was
shown to be not relevant in this context. In practice, it is recognised that capital structure can affect
WACC and hence the market value of the company.
PL
E
Miller and Modigliani also investigated the relationship between dividend policy and the share price of
a company (i.e. the market value of a company). They showed that, if a perfect capital market was
assumed, the share price of a company did not depend on its dividend policy (i.e. the dividend decision
was irrelevant to value of the share). The market value of the company and therefore the wealth of
shareholders were shown to be maximised when the company implemented its optimum investment
policy, which was to invest in all projects with a positive NPV. The investment decision was therefore
shown to be theoretically important with respect to the market value of the company, while the dividend
decision was not relevant.
In practice, capital markets are not perfect and a number of other factors become important in
discussing the relationship between the three decision areas. Pecking order theory, for example,
suggests that managers do not in practice make financing decisions with the objective of obtaining an
optimal capital structure, but on the basis of the convenience and relative cost of different sources of
finance. Retained earnings are the preferred source of finance from this perspective, with a resulting
pressure for annual dividends to be lower rather than higher.
Answer 4 VALUE FOR MONEY
SA
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The objectives of public sector organisations are often difficult to define. Even though the cost of
resources used can be measured, the benefits gained from the consumption of those resources can be
difficult, if not impossible, to quantify. Because of this difficulty, public sector organisations often
have financial targets imposed on them, such as a target rate of return on capital employed.
Furthermore, they will tend to focus on maximising the return on resources consumed by producing the
best possible combination of services for the lowest possible cost. This is the meaning of “value for
money”, often referred to as the pursuit of economy, efficiency and effectiveness.
Economy refers to seeking the lowest level of input costs for a given level of output. Efficiency refers
to seeking the highest level of output for a given level of input resources. Effectiveness refers to the
extent to which output produced meets the specified objectives (e.g. in terms of provision of a required
range of services).
In contrast, private sector organisations have to compete for funds in the capital markets and must offer
an adequate return to investors. The objective of maximisation of shareholder wealth equates to the
view that the primary financial objective of companies is to reward their owners. If this objective is not
followed, the directors may be replaced or a company may find it difficult to obtain funds in the market,
since investors will prefer companies that increase their wealth. However, shareholder wealth cannot
be maximised if companies do not seek both economy and efficiency in their business operations.
Answer 5 NON-FOR-PROFIT
A key financial objective for a stock exchange listed company is to maximise the wealth of
shareholders. This objective is usually replaced by the objective of maximising the company’s share
price, since maximising the market value of the company represents the maximum capital gain over a
given period. The need for dividends can be met by recognising that share prices can be seen as the
sum of the present values of future dividends.
1019
Maximising the company’s share price is the same as maximising the equity market value of the
company, since equity market value (market capitalisation) is equal to number of issued shares
multiplied by share price. Maximising equity market value can be achieved by maximising net
corporate cash income and the expected growth in that income, while minimising the corporate cost of
capital. Listed companies therefore have maximising net cash income as a key financial objective.
Not-for-profit (NFP) organisations seek to provide services to the public and this requires cash income.
Maximising net cash income is therefore a key financial objective for NFP organisations as well as
listed companies. A large charity seeks to raise as much funds as possible in order to achieve its
charitable objectives, which are non-financial in nature.
E
Both listed companies and NFP organisations need to control the use of cash within a given financial
period, and both types of organisations therefore use budgets. Another key financial objective for both
organisations is therefore to keep spending within budget.
PL
The objective of value for money (VFM) is often identified in connection with NFP organisations. This
objective refers to a focus on economy, efficiency and effectiveness. These three terms can be linked to
input (economy refers to securing resources as economically as possible), process (resources need to be
employed efficiently within the organisation) and output (the effective use of resources in achieving the
organisation’s objectives).
Described in these terms, it is clear that a listed company also seeks to achieve value for money in its
business operations. There is a difference in emphasis, however, which merits careful consideration. A
listed company has a profit motive, and so VFM for a listed company can be related to performance
measures linked to output (e.g. maximising the equity market value of the company). An NFP
organisation has service-related outputs that are difficult to measure in quantitative terms and so it
focuses on performance measures linked to input (e.g. minimising the input cost for a given level of
output).
SA
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Both listed companies and NFP organisations can use a variety of accounting ratios in the context of
financial objectives. For example, both types of organisation may use a target return on capital
employed, or a target level of income per employee, or a target current ratio.
Comparing and contrasting the financial objectives of a stock exchange listed company and a not-forprofit organisation, therefore, shows that while significant differences can be found, there is a
considerable amount of common ground in terms of financial objectives.
Answer 6 QSX CO
Dividend yield is calculated as the dividend divided by the share price at the start of the year.
2014: Dividend yield = 100 × 38·5/740 = 5·2%
2015: Dividend yield = 100 × 40·0/835 = 4·8%
The capital gain is the difference between the opening and closing share prices, and may be expressed
as a monetary amount or as a percentage of the opening share price.
2014: Capital gain = 835 – 740 = 95c or 12·8% (100 × 95/740)
2015: Capital gain = 648 – 835 = (187c) or (22·4%) (100 × –187/835)
The total shareholder return is the sum of the percentage capital gain and the dividend yield, or the sum
of the dividend paid and the monetary capital gain, expressed as a percentage of the opening share
price.
2014: Total shareholder return = 100 × (95 + 38·5)/740 = 18·0% (5·2% + 12·8%)
2015: Total shareholder return = 100 × (–187 + 40)/835 = –17·6% (4·8% – 22·4%)
1020
(i)
The return on equity predicted by the CAPM
The actual return for a shareholder of QSX Co, calculated as total shareholder return, is very
different from the return on equity predicted by the CAPM. In 2014 the company provided a
better return than predicted and in 2015 the company gave a negative return while the CAPM
predicted a positive return.
Year
Total shareholder return
Return on equity predicted by CAPM
2014
(17·6%)
8%
2014
18·0%
12%
(ii)
Other comments
PL
E
Because the risk-free rate of return is positive and the equity risk premium is either zero or
positive, and because negative equity betas are very rare, the return on equity predicted by the
CAPM is invariably positive. This reflects the reality that shareholders will always want a
return to compensate for taking on risk. In practice, companies sometimes give negative
returns, as is the case here. The return in 2014 was greater than the cost of equity, but the
figure of 10% quoted here is the current cost of equity; the cost of equity may have been
different in 2014.
QSX Co had revenue growth of 3% in 2014, but did not generate any growth in revenue in
2015. Earnings per share grew by 4·1% in 2014, but fell by 8·3% in 2015. Dividends per
share also grew by 4·1% in 2014, but unlike earnings per share, dividend per share growth
was maintained in 2015. It is common for dividends to be maintained when a company
suffers a setback, often in an attempt to give reassurance to shareholders.
SA
M
There are other negative signs apart from stagnant revenue and falling earnings per share.
The shareholder will be concerned about experiencing a capital loss in 2015. He will also be
concerned that the decline in the price/earnings ratio in 2015 might be a sign that the market
is losing confidence in the future of QSX Co. If the shareholder was aware of the proposal by
the finance director to suspend dividends, he would be even more concerned. It might be
argued that, in a semi-strong form-efficient market, the information would remain private. If
QSX Co desires to conserve cash because the company is experiencing liquidity problems,
however, these problems are likely to become public knowledge fairly quickly, for example
through the investigations of capital market analysts.
Tutorial note: It would be useful to benchmark the firm’s performance to its peers and to
compare its shareholders’ returns to those on the relevant stock market index.
WORKINGS
Year
Closing share price
Earnings per share
Year
Earnings per share
Dividend per share
Dividend cover
Earnings per share growth
Dividend per share growth
Revenue growth
2015
$6·48
58·9c
11 times
2014
$8·35
64·2c
13 times
2015
58·9c
40·0c
1·5 times
(8·3%)
3·9%
nil
2014
64·2c
38·5c
1·7 times
4·1%
4·1%
3%
2013
61·7c
2013
61·7c
37·0c
1·7 times
1021
Answer 7 AGENCY PROBLEM
Tutorial note: The agency problem refers to the fact that, in practice, actual total shareholder returns
(TSR) are usually below the theoretically possible TSR. The resulting loss in shareholder wealth is
known as “agency costs” and is caused by sub-optimal performance by management and the costs
incurred in controlling the management.
The primary financial management objective of a company is usually taken to be the maximisation of
shareholder wealth. In practice, the managers of a company acting as agents for the principals (the
shareholders) may act in ways which do not lead to shareholder wealth maximisation. The failure of
managers to maximise shareholder wealth is referred to as the agency problem.
E
Shareholder wealth increases through payment of dividends and through appreciation of share prices.
Since share prices reflect the value placed by buyers on the right to receive future dividends, analysis of
changes in shareholder wealth focuses on changes in share prices. The objective of maximising share
prices is commonly used as a substitute objective for that of maximising shareholder wealth.
PL
The agency problem arises because the objectives of managers differ from those of shareholders:
because there is a divorce or separation of ownership from control in modern companies; and because
there is an asymmetry of information between shareholders and managers which prevents shareholders
being aware of most managerial decisions.
SA
M
One way to encourage managers to act in ways that increase shareholder wealth is to offer them share
options. These are rights to buy shares on a future date at a price which is fixed when the share options
are issued. Share options will encourage managers to make decisions that are likely to lead to share
price increases (such as investing in projects with positive net present values), since this will increase
the rewards they receive from share options. The higher the share price in the market when the share
options are exercised, the greater will be the capital gain that could be made by managers owning the
options.
Share options therefore go some way towards reducing the differences between the objectives of
shareholders and managers. However, it is possible that managers may be rewarded for poor
performance if share prices in general are increasing. It is also possible that managers may not be
rewarded for good performance if share prices in general are falling. It is difficult to decide on a share
option exercise price and a share option exercise date that will encourage managers to focus on
increasing shareholder wealth while still remaining challenging, rather than being easily achievable.
Due to the potential problems with share option schemes it may be advisable to consider performancerelated pay as an alternative method of managing the agency problem. Performance-related pay is a
financial reward system for managers where some, or all, of their compensation is related to how their
performance is assessed relative to stated criteria. The criteria may include profitability targets and
whilst profit maximisation is not necessarily consistent with shareholder wealth maximisation at least
management should feel a direct link between their performance and profits, whereas the firm’s share
price may be influenced more by overall stock market conditions.
Answer 8 LISTED COMPANY OBJECTIVES
A listed company is likely to have a range of financial objectives. Maximisation of shareholder wealth
is often suggested to be the primary financial objective, and this can be substituted by the objective of
maximising the company’s share price. Other financial objectives could relate to earnings per share
(for example, a target EPS value for a given period), operating profit (for example, a target level of
profit before tax or PBIT), revenue (for example, a desired increase in revenue or sales) and so on.
These examples of financial objectives can all be quantified, so that progress towards meeting them can
be measured over time.
1022
New investments should lead to increased revenue and operating profit (profit before interest and tax),
so financial objectives relating to these accounting figures will be supported.
Whether a financial objective relating to increasing earnings per share (EPS) will be supported will
depend on how the investment is financed. For example, raising equity finance by issuing new shares
will dilute (decrease) EPS, while raising debt finance will increase interest payments, which will also
dilute EPS.
Answer 9 GOAL CONGRUENCE
E
An investment with a positive net present value (NPV) should increase the market value of the
company by the amount of the NPV. This increases the wealth of shareholders irrespective of how the
investment is financed, since financing costs were accounted for by the discount rate (whether nominal
or real). The investment would therefore support the objective of shareholder wealth maximisation.
The company directors can be encouraged to achieve the objective of maximising shareholder wealth
through managerial reward schemes and through regulatory requirements.
PL
Managerial reward schemes
As agents of the company’s shareholders, directors may not always act in ways which increase the
wealth of shareholders, a phenomenon called the agency problem. They can be encouraged to increase
or maximise shareholder wealth by managerial reward schemes such as performance-related pay and
share option schemes. Through these methods, the goals of shareholders and directors may increase in
congruence.
SA
M
Performance-related pay links part of the remuneration of directors to some aspect of corporate
performance, such as levels of profit or earnings per share. One problem here is that it is difficult to
choose an aspect of corporate performance which is not influenced by the actions of the directors,
leading to the possibility of managers influencing corporate affairs for their own benefit rather than the
benefit of shareholders, for example, focusing on short-term performance while neglecting the longer
term.
Share option schemes bring the goals of shareholders and directors closer together to the extent that
directors become shareholders themselves. Share options allow directors to purchase shares at a
specified price on a specified future date, encouraging them to make decisions which exert an upward
pressure on share prices. Unfortunately, a general increase in share prices can lead to directors being
rewarded for poor performance, while a general decrease in share prices can lead to managers not being
rewarded for good performance. However, share option schemes can lead to a culture of performance
improvement and so can bring continuing benefit to stakeholders.
Regulatory requirements
Regulatory requirements can be imposed through corporate governance codes of best practice and stock
market listing regulations. Corporate governance codes of best practice, such as the UK Corporate
Governance Code, seek to reduce corporate risk and increase corporate accountability. Responsibility
is placed on directors to identify, assess and manage risk within an organisation. An independent
perspective is brought to directors’ decisions by appointing non-executive directors to create a balanced
board of directors, and by appointing non-executive directors to remuneration committees and audit
committees.
Stock exchange listing regulations can place obligations on directors to manage companies in ways
which support the achievement of objectives such as the maximisation of shareholder wealth. For
example, listing regulations may require companies to publish regular financial reports, to provide
detailed information on directorial rewards and to publish detailed reports on corporate governance and
corporate social responsibility.
1023
Answer 10 MONEY MARKETS
The principal roles of the money markets are to:




transfer money from parties with surplus funds to parties with a deficit;
allow governments and businesses to raise short-term funds;
help governments to implement monetary policy;
determine short-term interest rates.
Common money market instruments include:
Certificate of Deposit (CD) – a savings certificate issued by a commercial bank entitling the
holder to receive interest. A CD bears a maturity date, a specified fixed interest rate and can
be issued in any denomination. CDs are generally issued for terms from one month to five
years. The holder can either keep the CD until its maturity date or resell it on the secondary
market.

Bills of exchange – a short-term financial instrument consisting of a written order addressed
by the seller of goods to the buyer requiring the latter to pay a certain sum of money on
demand or at a future time. Bills of exchange are often used in international transactions, and
the holder of such a bill may convert it immediately into cash by selling it to a bank at a
discount.

Repurchase agreements – short-term loans-normally for less than two weeks and frequently
for one day-arranged by selling securities to an investor with an agreement to repurchase them
at a fixed price on a fixed date.

Commercial paper – unsecured but high quality corporate debt with a fixed maturity of one to
270 days; usually sold at a discount to face value and carrying a zero coupon interest rate.
SA
M
PL
E


Municipal notes – short-term notes issued by municipalities in anticipation of tax receipts or
other revenues.

Treasury bills – short-term debt obligations of a national government that are issued to mature
in three to twelve months. Usually issued at a discount to face value and carry zero coupon.
Tutorial note: Only four examples were required
Answer 11 TAGNA
Consequence of a substantial interest rate increase
(i)
Sales
As a manufacturer and supplier of luxury goods, it is likely that Tagna will experience a sharp
decrease in sales as a result of the increase in interest rates. One reason for this is that sales of
luxury goods will be more sensitive to changes in disposable income than sales of basic
necessities, and disposable income is likely to fall as a result of the interest rate increase.
Another reason is the likely effect of the interest rate increase on consumer demand. If the
increase in demand has been supported, even in part, by the increase in consumer credit, the
substantial interest rate increase will have a negative effect on demand as the cost of
consumer credit increases. It is also likely that many chain store customers will buy Tagna’s
goods by using credit.
1024
(ii)
Operating costs
(iii)
E
Tagna may experience an increase in operating costs as a result of the substantial interest rate
increase, although this is likely to be a smaller effect and one that occurs more slowly than a
decrease in sales. As the higher cost of borrowing moves through the various supply chains
in the economy, producer prices may increase and material and other input costs for Tagna
may rise by more than the current rate of inflation. Labour costs may also increase sharply if
the recent sharp rise in inflation leads to high inflationary expectations being built into wage
demands. Acting against this will be the deflationary effect on consumer demand of the
interest rate increase. If the Central Bank has made an accurate assessment of the economic
situation when determining the interest rate increase, both the growth in consumer demand
and the rate of inflation may fall to more acceptable levels, leading to a lower increase in
operating costs.
Earnings
PL
The earnings (profit after tax) of Tagna are likely to fall as a result of the interest rate
increase. In addition to the decrease in sales and the possible increase in operating costs
discussed above, Tagna will experience an increase in interest costs arising from its overdraft.
The combination of these effects is likely to result in a sharp fall in earnings. The level of
reported profits has been low in recent years and so Tagna may be faced with insufficient
profits to maintain its dividend, or even a reported loss.
Answer 12 FINANCIAL INTERMEDIARIES
SA
M
The role of financial intermediaries in providing short-term finance for use by business organisations is
to provide a link between investors who have surplus cash and borrowers who have financing needs.
The amounts of cash provided by individual investors may be small, whereas borrowers need large
amounts of cash: one of the functions of financial intermediaries is therefore to aggregate invested
funds in order to meet the needs of borrowers. In so doing, they provide a convenient and readily
accessible route for business organisations to obtain necessary funds.
Small investors are likely to be averse to losing any capital value, so financial intermediaries will
assume the risk of loss on short-term funds borrowed by business organisations, either individually or
by pooling risks between financial intermediaries. This aspect of the role of financial intermediaries is
referred to as risk transformation. Financial intermediaries also offer maturity transformation, in that
investors can deposit funds for a long period of time while borrowers may require funds on a short-term
basis only, and vice versa. In this way the needs of both borrowers and lenders can be satisfied.
Answer 13 PAYBACK AND ROCE
(a)
Payback
Contribution per unit = 3·00 – 1·65 = $1·35 per unit
Total annual contribution = 20,000 × 1·35 = $27,000 per year
Annual cash flow after fixed costs = 27,000 – 10,000 = $17,000 per year
Payback period = 50,000/17,000 = 2·9 years
(assuming that cash flows occur evenly throughout the year)
The payback period calculated is greater than the maximum payback period used by Umunat
of two years and on this basis should be rejected. Use of payback period as an investment
appraisal method cannot be recommended, however, because payback period does not
consider all the cash flows arising from an investment project, as it ignores cash flows outside
of the payback period. Furthermore, payback period ignores the time value of money.
1025
The fact that the payback period is 2·9 years should not therefore be a reason for rejecting the project.
The project should be assessed using the net present value method as this would indicate the potential
dollar increase (or fall) in shareholder wealth due to the project.
(b)
ROCE
Annual cash flow after fixed costs = $17,000 (from above)
Annual depreciation = (50,000 – 10,000)/5 = $8,000
Annual operating profit = 17,000 - 8,000 = $9,000
Average investment = (50,000 + 10,000)/2 = $30,000
ROCE = 9,000/30,000 = 30%
PL
E
Although the project’s ROCE of 30% exceeds the directors’ target of 25% it does not
guarantee that the project would increase the wealth of shareholders. Although ROCE does
consider the whole life of the project it ignores the time value of money. Furthermore the
directors’ target return of 25% may be connected more with personal objectives (such as
receiving a bonus) then with the required return of shareholders. The final decision as to
whether to accept the project should be based upon a net present value appraisal.
Answer 14 DIRECTORS’ VIEWS
Evaluation using either payback or return on capital employed
SA
M
Both payback period and return on capital employed (ROCE) are inferior to discounted cash flow
(DCF) methods such as net present value (NPV) and internal rate of return (IRR). Payback ignores the
time value of money and cash flows outside of the payback period. ROCE uses profit instead of cash
flow. Both payback and ROCE have difficulty in justifying the target value used to determine
acceptability. Why, for example, use a maximum payback period of two years? DCF methods use the
weighted average cost of capital of an investing company as the basis of evaluation, or a projectspecific cost of capital, and both can be justified on academic grounds.
The company should also clarify why either method can be used, since they assess different aspects of
an investment project.
Regarding the directors’ policies on net present value (NPV) calculations the following comments can
be made:
Evaluation over a four-year planning period
Using a planning period or a specified investment appraisal time horizon is a way of reducing the
uncertainty associated with investment appraisal, since this increases with project life. However, it is
important to determine the expected life of an investment project if at all possible, since evaluation over
the whole life of a project may help a company avoid sub-optimal investment decisions.
Inflation is ignored
If selling prices and costs have different inflation rates then the only way to accurately calculate NPV is
to forecast each cash flow in nominal terms (incorporating the specific inflation rate affecting that cash
flow) and discount the total nominal cash flow at the firm’s nominal cost of capital (incorporating the
general inflation rate in the economy).
The only situation where ignoring inflation will lead to the correct NPV figure is when revenues and
costs all increase at the general inflation rate - in which case uninflated cash flows can be discounted at
the firm’s real cost of capital.
1026
Scrap value is ignored
Scrap value, salvage value or terminal value must be included in the evaluation of a project since it is a
cash inflow. Ignoring scrap value will reduce the NPV and may lead to rejection of an otherwise
acceptable investment project.
Working capital recovery is ignored
If an investment project ends, then working capital can be recovered and it must be included in the
evaluation of an investment project, since it is a cash inflow.
E
A balancing allowance is claimed at the end of the fourth year of operation
Answer 15 OKM CO
(a)
PL
Introducing a balancing allowance which can only be claimed when allowed by the taxation authorities
will distort the taxation aspects of the investment appraisal. If it is anticipated that a project will
continue beyond the fourth year, including a balancing allowance in the evaluation will overstate cash
inflows and hence the NPV, potentially leading to incorrect investment decisions being made.
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 inflated, but included $200,000 per year of sunk costs which
are not relevant for decision making.
Depreciation is not a cash cost and therefore not relevant.
SA
M
Straight-line accounting depreciation had been used in the tax calculation, but this
depreciation method is not acceptable to the tax authorities. The approved method using 25%
reducing balance tax-allowable depreciation should be used.
Interest payments have been shown as a project cash flow whereas finance costs are already
implied by the discounting process.
The interest rate on the debt finance has been used as the discount rate whereas surplus cash
from the project will accrue to the firm’s shareholders. The discount rate should therefore
reflect both the cost of debt and the cost of equity (i.e. weighted average cost of capital).
1027
(b)
Revised NPV
Tutorial note: As the cash flows will be forecast in nominal terms the WACC also needs to be
restated as nominal. Rather than simply adding the general inflation rate to the real WACC
the Fisher formula should be used.
Nominal weighted average cost of capital = (1·07 × 1·047) - 1 = 0·12 (i.e. 12% per year).
NPV calculation
Contribution
Fixed costs
After-tax cash flow
Scrap value
After-tax cash flows
Discount at 12%
Present values
2
$000
2,264
(337)
––––––
1,927
(304)
3
$000
3,010
(357)
––––––
2,653
(578)
4
$000
1,600
(379)
––––––
1,221
(796)
––––––
1,012
150
––––––
1,773
112
––––––
2,187
––––––
1,012
0·893
––––––
904
––––––
––––––
1,773
0·797
––––––
1,413
––––––
––––––
2,187
0·712
––––––
1,557
––––––
84
––––––
509
250
––––––
759
0·635
––––––
482
––––––
5
$000
(366)
178
––––––
(188)
PL
Taxable cash flow
Taxation
Allowable depreciation
tax benefits
1
$000
1,330
(318)
––––––
1,012
E
Year
$000
4,249
2,000
––––––
2,249
––––––
SA
M
Present value of future cash flows
Initial investment
––––––
(188)
0·567
––––––
(107)
––––––
Net present value
The net present value is positive and so the investment is financially acceptable.
1028
Alternative NPV calculation using taxable profit calculation
Contribution
Fixed costs
Taxable cash flow
Tax-allowable depreciation
Taxable profit
Taxation
Profit after tax
After-tax cash flows
Discount at 12%
Present values
––––––
512
500
––––––
1,012
2
$000
2,264
(337)
––––––
1,927
(375)
––––––
1,552
(154)
––––––
1,398
375
––––––
1,773
3
$000
3,010
(357)
––––––
2,653
(281)
––––––
2,372
(466)
––––––
1,906
281
––––––
2,187
––––––
1,012
0·893
––––––
904
––––––
––––––
1,773
0·797
––––––
1,413
––––––
––––––
2,187
0·712
––––––
1,557
––––––
Present value of future cash flows
Initial investment
5
$000
(188)
––––––
(188)
––––––
(188)
––––––
(188)
0·567
––––––
(107)
––––––
$000
4,249
2,000
––––––
2,249
––––––
SA
M
Net present value
4
$000
1,600
(379)
––––––
1,221
(594)
––––––
627
(712)
––––––
(85)
594
––––––
509
250
––––––
759
0·635
––––––
482
––––––
PL
After-tax cash flow
Scrap value
1
$000
1,330
(318)
––––––
1,012
(500)
––––––
512
E
Year
WORKINGS
Annual contribution
Year
Contribution ($/unit)
Contribution ($/year)
1
2
3
4
250,000
400,000
500,000
250,000
12·60
13·23
13·89
14·59
7·28
7·57
7·87
8·19
––––––––– ––––––––– ––––––––– –––––––––
5·32
5·66
6·02
6·40
––––––––– ––––––––– ––––––––– –––––––––
1,330,000 2,264,000 3,010,000 1,600,000
Tax-allowable depreciation tax benefits
1029
Tutorial note: Assuming that the capital expenditure is made at the start of the first year the
initial tax-allowable depreciation will be claimed at the end of year 1 and the related tax
saving received at the end of year 2.
1
2
3
4
Tax depreciation
$
500,000
375,000
281,250
Balancing allowance 593,750
Scrap value
250,000
–––––––––
2,000,000
–––––––––
Answer 16 LIMITATIONS OF NPV
Tax benefit
$
150,000
112,500
84,375
178,125
E
Year
Difficulties with NPV
PL
NPV is a commonly used technique in investment appraisal but is subject to a number of restrictive
assumptions and limitations which call into question its general relevance. Nonetheless, if the
assumptions and limitations are understood then its application is less likely to be undertaken in error.
NPV assumes that firms pursue an objective of maximising the wealth of their shareholders.
This is questionable given the wider range of stakeholders who might have conflicting
interests to those of the shareholders.

NPV is largely redundant if organisations are not wealth maximising. For example, public
sector organisations may wish to invest in capital assets but will use non-profit objectives as
part of their assessment.
SA
M


Estimating the correct discount rate to use. This is particularly so when questions arise as to
the incorporation of risk premiums in the discount rate since an evaluation of the risk of the
business, or of the project in particular, will have to be made and which may be difficult to
discern. Alternative approaches to risk analysis, such as sensitivity and decision trees are
subject to fairly severe limitations.

NPV assumes that cash surpluses can be reinvested at the discount rate. This is subject to
other projects being available which produce at least a zero NPV at the chosen discount rate.

NPV can most easily cope with cash flows arising at period ends and is not a technique that is
used easily when complicated, mid-period cash flows are present.

NPV is not universally employed, especially in a small business environment. The available
evidence suggests that businesses assess projects in a variety of ways (payback, IRR,
accounting rate of return). The fact that such methods are used calls into question the
practical benefits of NPV and therefore hints at certain practical limitations.

If reported profits are important to businesses then it is possible that there may be a conflict
between undertaking a positive NPV project and potentially adverse consequences on
reported profits. This will particularly be the case for projects with long horizons, large initial
investment and very delayed cash inflows. In such circumstances, businesses may prefer to
use accounting measures of investment appraisal.
1030
Managerial incentive schemes may not be consistent with NPV, particularly when long time
horizons are involved. Thus managers may be rewarded on the basis of accounting profits in
the short term and may be encouraged to act in accordance with these objectives and thus
ignore positive NPV projects.

NPV treats all time periods equally with the exception of discounting far cash flows more
than near cash flows. In other words, NPV only accounts for the time value of money. To
many businesses, distant horizons are less important than near horizons, if only because that
is the environment in which they work. For example, in the long term, nearly all aspects of
the business may change and hence a too-narrow focus on discounting means that NPV is of
limited value and more so the further the time horizon considered.

NPV does not take account of non-financial information which may even be relevant to
shareholders who want their wealth maximised. For example, issues of strategic benefit may
arise against which it is difficult to immediately quantify the benefits but for which there are
immediate costs. NPV would treat such a situation as an additional cost since it could not
incorporate the indiscernible benefit.
(a)
PL
Answer 17 RIDAG CO
E

Calculation of net present value (NPV)
As nominal after-tax cash flows are to be discounted, the nominal after-tax weighted average
cost of capital of 7% must be used.
Year
2
$000
2,466
(1,098)
––––––
1,368
(115)
––––––
1,253
(205)
113
––––––
1,161
3
$000
3,622
(1,809)
––––––
1,813
(125)
––––––
1,688
(376)
84
––––––
1,396
––––––
1,161
0·873
––––––
1,014
––––––
––––––
1,396
0·816
––––––
1,139
––––––
SA
M
Sales revenue
Variable costs
1
$000
1,300
(513)
––––––
787
(105)
––––––
682
Contribution
Fixed costs
Taxable cash flow
Tax liabilities
––––––
After-tax cash flow
682
Scrap value
––––––
Net cash flow
682
Discount at 7%
0·935
––––––
Present values
638
––––––
Present value of cash inflows
Cost of machine
NPV
4
$000
2,018
(1,035)
––––––
983
(125)
––––––
858
(506)
63
––––––
415
100
––––––
515
0·763
––––––
393
––––––
5
$000
(257)
160
––––––
(97)
––––––
(97)
0·713
––––––
(69)
––––––
$000
3,115
(1,500)
––––––
1,615
––––––
1031
Project 1 has a positive NPV of $1,615,000 and so it is financially acceptable to Ridag Co.
However, the discount rate used here is the current weighted average after-tax cost of capital.
As this is a recently-developed product, it may be appropriate to use a project-specific
discount rate that reflects the risk of the new product launch.
WORKINGS
Sales revenue
E
Year
1
2
3
4
25·00
24·00
23·00
23·00
Inflated selling price ($/unit)
26·00
25·96
25·87
26·91
50,000
95,000
140,000
75,000
Sales revenue ($/year)
1,300,000 2,466,200 3,621,800 2,018,250
Variable cost
PL
Year
1
2
3
4
10·00
11·00
12·00
12·50
Inflated variable cost ($/unit)
10·25
11·56
12·92
13·80
50,000
95,000
140,000
75,000
Variable costs ($/year)
512,500 1,098,200 1,808,800 1,035,000
Allowable depreciation
1,500,000 × 0·25 = $375,000
1,125,000 × 0·25 = $281,250
843,750 × 0·25 = $210,938
$532,812* 5
Tax benefit
Year benefit received
375,000 × 0·3 = $112,500
2
281,250 × 0·3 = $84,375
3
210,938 × 0·3 = $63,281
4
32,812 × 0·3 = $159,844
5
SA
M
Year
1
2
3
4
*843,750 – 210,938 – 100,000 = $532,812
Alternative calculation of net cash flow
Year
Taxable cash flow
Taxable profit
Taxation
After-tax profit
Add back allowances
After-tax cash flow
Scrap value
Net cash flow
Discount at 7%
Present values
1
$000
682
(375)
––––––
307
––––––
307
375
––––––
682
2
$000
1,253
(281)
––––––
972
(92)
––––––
880
281
––––––
1,161
3
$000
1,688
(211)
––––––
1,477
(292)
––––––
1,185
211
––––––
1,396
––––––
682
0·935
––––––
638
––––––
––––––
1,161
0·873
––––––
1,014
––––––
––––––
1,396
0·816
––––––
1,139
––––––
4
$000
858
(533)
––––––
325
(443)
––––––
(118)
533
––––––
415
100
––––––
515
0·763
––––––
393
––––––
5
$000
––––––
(98)
––––––
(98)
––––––
(98)
––––––
(98)
0·713
––––––
(70)
––––––
There are slight differences due to rounding.
1032
(b)
Calculation of equivalent annual cost for machine 1
Since taxation and tax-allowable depreciation are to be ignored, and where relevant all
information relating to project 2 has already been adjusted to include future inflation, the
correct discount rate to use here is the nominal before-tax weighted average cost of capital of
12%.
Year
Maintenance costs ($)
Investment and scrap ($)
0
1
(25,000)
2
(29,000)
3
(32,000)
PL
E
(200,000)
–––––––– –––––––– –––––––– ––––––––
Net cash flow ($)
(200,000) (25,000) (29,000) (32,000)
Discount at 12%
1·000
0·893
0·797
0·712
–––––––– –––––––– –––––––– ––––––––
Present values
(200,000) (22,325) (23,113) (22,784)
–––––––– –––––––– –––––––– ––––––––
Present value of cash flows
$274,582
Cumulative present value factor
3·037
Equivalent annual cost = 274,582/3·037 = $90,412
4
(35,000)
25,000
––––––––
(10,000)
0·636
––––––––
(6,360)
––––––––
Calculation of equivalent annual cost for machine 2
Year
Maintenance costs ($)
Investment and scrap ($)
0
1
(15,000)
2
(20,000)
SA
M
(225,000)
–––––––– –––––––– ––––––––
Net cash flow ($)
(225,000) (15,000) (20,000)
Discount at 12%
1·000
0·893
0·797
–––––––– –––––––– ––––––––
Present values
(225,000) (13,395) (15,940)
–––––––– –––––––– ––––––––
Present value of cash flows
$236,535
Cumulative present value factor
2·402
Equivalent annual cost = 236,535/2·402 = $98,474
3
(25,000)
50,000
––––––––
25,000
0·712
––––––––
17,800
––––––––
The machine with the lowest equivalent annual cost should be purchased and calculation
shows this to be Machine 1. If the present value of future cash flows had been considered
alone, Machine 2 (cost of $236,535) would have been preferred to Machine 1 (cost of
$274,582). However, the lives of the two machines are different and the equivalent annual
cost method allows this to be taken into consideration.
1033
Answer 18 BQK CO
NPV calculation
Year
1
$000
5,614
(3,031)
––––––
2,583
(1,530)
––––––
1,053
Sales revenue
Variable costs
Contribution
Fixed costs
3
$000
9,015
(5,135)
––––––
3,880
(1,592)
––––––
2,288
(517)
300
––––––
2,071
0·712
––––––
1,475
––––––
4
$000
7,034
(4,174)
––––––
2,860
(1,624)
––––––
1,236
(686)
300
––––––
850
0·636
––––––
541
––––––
5
$000
(371)
300
––––––
(71)
0·567
––––––
(40)
––––––
PL
Before-tax cash flow
Tax liability
––––––
After-tax cash flow
1,053
Discount at 12%
0·893
––––––
Present values
940
––––––
2
$000
7,214
(3,931)
––––––
3,283
(1,561)
––––––
1,722
(316)
300
––––––
1,706
0·797
––––––
1,360
––––––
E
(a)
$000
4,276
(4,000)
––––––
276
––––––
Comment: Since the proposed investment has a positive net present value of $276,000, it is
financially acceptable.
SA
M
PV of future cash flows
Initial investment
WORKINGS
Sales revenue
Year
Sales of small houses (houses/year)
Sales of large houses (houses/year)
Small house selling price ($000/house)
Large house selling price ($000/house)
Sales revenue (small houses) ($000/year)
Sales revenue (large houses) ($000/year)
Total sales revenue ($/year)
Inflated sales revenue ($/year)
1034
1
15
7
200
350
3,000
2,450
––––––
5,450
––––––
5,614
2
20
8
200
350
4,000
2,800
––––––
6,800
––––––
7,214
3
15
15
200
350
3,000
5,250
––––––
8,250
––––––
9,015
4
5
15
200
350
1,000
5,250
––––––
6,250
––––––
7,034
Variable costs of construction
Total variable cost ($/year)
Inflated total variable cost ($/year)
1
15
7
100
200
1,500
1,400
––––––
2,900
––––––
3,031
2
20
8
100
200
2,000
1,600
––––––
3,600
––––––
3,931
3
15
15
100
200
1,500
3,000
––––––
4,500
––––––
5,135
4
5
15
100
200
500
3,000
––––––
3,500
––––––
4,174
1
1,500
1,530
2
1,500
1,561
3
1,500
1,592
4
1,500
1,624
2
$000
1,722
(1,000)
––––––
722
(16)
––––––
706
1,000
––––––
1,706
0·797
––––––
1,360
––––––
3
$000
2,288
(1,000)
––––––
1,288
(217)
––––––
1,071
1,000
––––––
2,071
0·712
––––––
1,475
––––––
4
$000
1,236
(1,000)
––––––
236
(386)
––––––
(150)
1,000
––––––
850
0·636
––––––
541
––––––
5
$000
E
Year
Sales of small houses (houses/year)
Sales of large houses (houses/year)
Small house variable cost ($000/house)
Large house variable cost ($000/house)
Variable cost (small houses) ($000/year)
Variable cost (large houses) ($000/year)
Fixed infrastructure costs
PL
Year
Fixed costs ($000/year)
Inflated fixed costs ($000/year)
Alternative NPV calculation
Year
Before-tax cash flow
––––––
53
1,000
––––––
1,053
0·893
––––––
940
––––––
$000
4,276
(4,000)
––––––
276
––––––
SA
M
Taxable profit
Taxation
1
$000
1,053
(1,000)
––––––
53
Profit after tax
Add back allowances
After-tax cash flow
Discount at 12%
Present values
Initial investment
(b)
(71)
––––––
(71)
(71)
0·567
––––––
(40)
––––––
Calculation of return on capital employed (ROCE)
Total before-tax cash flow
Total depreciation
Total accounting profit
$6,299,000
$4,000,000
–––––––––
$2,299,000
Average annual profit ($000/year) = 2,299,000/4 = $574,750
Average investment ($000) = 4,000,000/2 = $2,000,000
ROCE (ARR) = 100 × 574,750/2,000,000 = 28·7%
1035
Discussion
The ROCE is greater than the 20% target ROCE of the investing company and so the
proposed investment is financially acceptable. However, the investment decision should be
made on the basis of information provided by a discounted cash flow (DCF) method, such as
net present value or internal rate of return.
Answer 19 HDW CO
Net present value of investment in new machinery
Year
Sales income
Variable cost
Cash flow
Taxation
tax benefits
After-tax cash flow
Working capital
Scrap value
3
$000
6,580
(2,642)
––––––
3,938
(289)
––––––
3,649
(709)
4
$000
6,844
(2,787)
––––––
4,057
(304)
––––––
3,753
(730)
––––––
3,447
(24)
250
––––––
3,108
(25)
188
––––––
3,128
(26)
––––––
3,423
0·893
––––––
3,057
––––––
––––––
3,083
0·797
––––––
2,457
––––––
––––––
3,102
0·712
––––––
2,209
––––––
141
––––––
3,164
(27)
250
––––––
3,387
0·636
––––––
2,154
––––––
SA
M
Net cash flow
Discount at 12%
2
$000
6,327
(2,504)
––––––
3,823
(276)
––––––
3,547
(689)
5
$000
PL
Contribution
Fixed costs
1
$000
6,084
(2,374)
––––––
3,710
(263)
––––––
3,447
E
(a)
Present values
Initial investment
Working capital
NPV
(751)
372
––––––
(379)
––––––
(379)
0·567
––––––
(215)
––––––
$000
9,662
(5,000)
(500)
––––––
4,162
––––––
As the net present value of $4·161 million is positive, the expansion can be recommended as
financially acceptable.
WORKINGS
1036
Year
Sales (units/year)
Sales income ($000)
1
676·00
9,000
6,084
2
703·04
9,000
6,327
3
731·16
9,000
6,580
4
760·41
9,000
6,844
Year
Sales (units/year)
Variable cost ($000)
1
263·75
9,000
2,374
2
278·26
9,000
2,504
3
293·56
9,000
2,642
4
309·71
9,000
2,787
Year
Tax benefit
Year
Working capital
Incremental
1
$000
1,250·0
250
2
$000
937·5
188
3
$000
703·1
141
4
$000
1,859·4
372
1
$000
523·50
24
2
$000
548·11
25
3
$000
573·87
26
4
$000
600·84
27
Alternative NPV calculation where tax-allowable depreciation is subtracted and added back
Taxable profit
Taxation
After-tax profit
After-tax cash flow
Working capital
Scrap value
3
$000
3,649
(703)
––––––
2,946
(522)
––––––
2,424
703
––––––
3,127
(26)
––––––
3,423
0·893
––––––
3,057
––––––
––––––
3,083
0·797
––––––
2,457
––––––
––––––
3,101
0·712
––––––
2,208
––––––
SA
M
Net cash flow
Discount at 12%
––––––
2,197
1,250
––––––
3,447
(24)
2
$000
3,547
(938)
––––––
2,609
(439)
––––––
2,170
938
––––––
3,108
(25)
4
$000
3,753
(1,859)
––––––
1,894
(589)
––––––
1,305
1,859
––––––
3,164
(27)
250
––––––
3,387
0·636
––––––
2,154
––––––
5
$000
(379)
––––––
(379)
PL
Cash flow
1
$000
3,447
(1,250)
––––––
2,197
E
Year
Present values
––––––
(379)
––––––
(379)
0·567
––––––
(215)
––––––
NPV = 9,661 – 5,000 – 500 = $4·161 million
Tutorial note: The model answer ignores the recovery of working capital at the end of the
four year evaluation period on the justification that the machinery will be replaced and hence
the investment in working capital would continue. However, there is a strong argument that
the recovery of working capital should be shown, in which case there would be a cash inflow
at the end of the fourth year of 575 (500 + 25 +26 + 26).
(b)
Nominal v real approach
A nominal (money terms) approach to investment appraisal discounts nominal cash flows
with a nominal cost of capital. Nominal cash flows are found by inflating forecast values
from current price estimates, for example, using specific inflation. Applying specific inflation
means that different project cash flows are inflated by different inflation rates in order to
generate nominal project cash flows.
A real terms approach to investment appraisal discounts real cash flows with a real cost of
capital. Real cash flows are found by deflating nominal cash flows by the general rate of
inflation. The real cost of capital is found by deflating the nominal cost of capital by the
general rate of inflation, using the Fisher equation:
(1 + real discount rate) × (1 + inflation rate) = (1 + nominal discount rate)
1037
The net present value for an investment project does not depend on whether a nominal terms
approach or a real terms approach is adopted, since nominal cash flows and the nominal
discount rate are both discounted by the general rate of inflation to give real cash flows and
the real discount rate, respectively. Both approaches give the same net present value.
Tutorial note for illustrative purposes:
The real after-tax cost of capital of HDW Co can be found as follows:
1·12/1·047 = 1·07 (i.e. the real after-tax cost of capital is 7%).
Nominal NCF
Real NCF
Discount at 7%
Present values
1
$000
3,423
3,269
0·935
––––––
3,057
––––––
2
$000
3,083
2,812
0·873
––––––
2,455
––––––
3
$000
3,102
2,703
0·816
––––––
2,206
––––––
4
$000
3,387
2,819
0·763
––––––
2,151
––––––
5
$000
(379)
(301)
0·713
––––––
(215)
––––––
PL
Year
E
The following illustration deflates nominal net cash flows (NCF) by the general rate of
inflation (4·7%) to give real NCF, which are then discounted by the real cost of capital (7%).
Allowing for rounding, the illustration shows that the present values of the real cash flows are
the same as the present values of the nominal cash flows, and that the real terms approach
NPV of $4·154 million is the same as the nominal terms approach NPV of $4·161 million.
The two approaches produce identical NPVs and offer the same investment advice.
SA
M
Answer 20 DARN CO
(a)
NPV using nominal method
Calculating the net present value of the investment project using a nominal terms approach
requires the discounting of nominal (money terms) cash flows using a nominal discount rate,
which is given as 12%.
Year
Sales revenue
Costs
Net revenue
Tax payable
tax benefits
After-tax cash flow
Working capital
Project cash flow
Discount at 12%
Present values
1038
1
2
3
4
5
$000
$000
$000
$000
$000
1,308·75 2,817·26 7,907·87 5,443·58
(523·50) (1,096·21) (2,869·33) (2,102·93)
––––––––– ––––––––– ––––––––– –––––––––
785·25 1,721·05 5,038·54 3,340·65
(235·58) (516·32) (1,511·56) (1,002·20)
150·00
112·50
84·38
253·13
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
785·25 1,635·47 4,634·72 1,913·47
(749·07)
(150·86) (509·06)
246·43
544·36
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
634·39 1,126·41 4,881·15 2,457·83
(749·07)
0·893
0·797
0·712
0·636
0·567
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
566·51
897·75 3,475·38 1,563·18
(424·72)
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
$000
6,078·10
(2,000·00)
(130·88)
–––––––––
NPV
3,947·22
–––––––––
The net present value is $3,947,220 and so the investment project is financially acceptable.
Initial investment
Working capital
WORKINGS
Year
Costs ($000)
Inflated costs ($000)
3
6,890
7,907·87
4
4,530
5,443·58
1
500
523·50
2
1,000
1,096·21
3
2,500
2,869·33
4
1,750
2,102·93
1
1,308·75
130·88
(130·88)
Year
Tax-allowable depreciation ($000)
Tax benefit ($000)
(b)
2
2,570
2,817·26
2
3
4
2,817·26 7,907·87 5,443·58
281·73
790·79
544·36
(150·86) (509·06)
246·43
PL
Year
Inflated sales revenue ($000)
Working capital ($000)
Incremental ($000)
1
1,250
1,308·75
E
Year
Inflated sales revenue ($000)
1
500·00
150·00
2
375·00
112·50
3
281·25
84·38
4
843·75
253·13
NPV using real method
SA
M
Calculating the net present value of the investment project using a real terms approach
requires discounting real terms cash flows with a real discount rate.
Real terms cash flows are found by deflating nominal cash flows by the general rate of
inflation. Since only the general rate of inflation is available, the real terms operating cash
flows are those given in the question.
The nominal discount rate is 12% and the general rate of inflation is 4·7%. The real discount
rate is therefore 7% (1·12/1·047).
Year
Sales revenue
Costs
Net revenue
Tax payable
tax benefits
After-tax cash flow
Working capital
Project cash flow
Discount at 7%
Present values
1
2
3
4
$000
$000
$000
$000
1,250
2,570
6,890
4,530
(500)
(1,000)
(2,500)
(1,750)
––––––––– ––––––––– ––––––––– –––––––––
750·00 1,570·00 4,390·00 2,780·00
(225·00) (471·00) (1,317·00)
5
$000
(834·00)
150·00
112·50
84·38
253·13
––––––––– ––––––––– ––––––––– –––––––––
750·00 1,495·00 4,031·50 1,547·38
(580·87)
(132·00) (432·00)
236·00
453·00
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
618·00 1,063·00 4,267·5
2,000·38
(580·87)
0·935
0·873
0·816
0·763
0·713
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
577·83
928·00 3,482·28 1,526·29
(414·16)
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
1039
Initial investment
Working capital
NPV
$000
6,100·24
(2,000·00)
(125·00)
–––––––––
3,975·24
–––––––––
WORKING
1
1,250
125
(125)
2
2,570
257
(132)
3
6,890
689
(432)
4
4,530
453
236
PL
Year
Working capital ($000)
Incremental ($000)
E
The net present value is $3,975,240 and so the investment project is financially acceptable.
The difference between the nominal terms NPV ($3,947,220) and the real terms NPV is due
primarily to two factors. First, the tax benefits from tax-allowable depreciation are not
affected by inflation and so will have different present values due to the change in discount
rate. Second, the working capital cash flows are timed differently to the sales income on
which they depend, and so their inflation effects are timed differently to the related inflation
effects in the discount rate.
Examiner’s note: An alternative approach is to deflate the nominal project cash flows from
part (a) by 4.7% per year to give real terms project cash flows, before discounting by the real
discount rate of 7%.
Year
SA
M
Project cash flow
Deflate at 4.7%
Discount at 7%
1
2
3
4
5
$000
$000
$000
$000
$000
634.39 1,126.41 4,881.15 2,457.83
(749.07)
605.91 1,027.55 4,252.87 2,045.34
(595.37)
0.935
0.873
0.816
0.763
0.713
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
566.53
897.05 3,470.34 1,560.59
(424.50)
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
Present values
Initial investment
Working capital
NPV
$000
6,070.01
(2,000.00)
(130.88)
–––––––––
3,939.13
–––––––––
Answer 21 REPLACEMENT CYCLES
(a)
Problems in investment appraisal
(i)
Asset replacement decisions
The problem here is that the net present value investment appraisal method may offer
incorrect advice about when an asset should be replaced. The lowest present value of costs
may not indicate the optimum replacement period.
1040
SA
M
PL
E
1128
E
PL
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M
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E
This ACCA Revision Question Bank has been reviewed
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Past examination questions, updated where relevant
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Model answers and suggested solutions
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SA
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