Financial Management Exam

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Financial Management
Thursday 9 June 2011

Time allowed
Reading and planning:
Writing:

15 minutes
3 hours

ALL FOUR questions are compulsory and MUST be attempted.
Formulae Sheet, Present Value and Annuity Tables are on
pages 7, 8 and 9.
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor.
This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level – Skills Module

ALL FOUR questions are compulsory and MUST be attempted
1

BRT Co has developed a new confectionery line that can be sold for $5·00 per box and that is expected to have continuing popularity for many years. The Finance Director has proposed that investment in the new product should be evaluated over a four-year time-horizon, even though sales would continue after the fourth year, on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both in current price terms) will depend on sales volume, as follows. Sales volume (boxes)

Variable cost ($ per box)
Total fixed costs ($)

less than 1 million
2·80
1 million

1–1·9 million
3·00
1·8 million

2–2·9 million
3·00
2·8 million

3–3·9 million
3·05
3·8 million

Forecast sales volumes are as follows.
Year
Demand (boxes)

1
0·7 million

2
1·6 million

3
2·1 million

4
3·0 million

The production equipment for the new confectionery line would cost $2 million and an additional initial investment of $750,000 would be needed for working capital. Capital allowances (tax-allowable depreciation) on a 25% reducing balance basis could be claimed on the cost of equipment. Profit tax of 30% per year will be payable one year in arrears. A balancing allowance would be claimed in the fourth year of operation. The average general level of inflation is expected to be 3% per year and selling price, variable costs, fixed costs and working capital would all experience inflation of this level. BRT Co uses a nominal after-tax cost of capital of 12% to appraise new investment projects.

Required:
(a) Assuming that production only lasts for four years, calculate the net present value of investing in the new product using a nominal terms approach and advise on its financial acceptability (work to the nearest $1,000).

(13 marks)
(b) Comment briefly on the proposal to use a four-year time horizon, and calculate and discuss a value that could be placed on after-tax cash flows arising after the fourth year of operation, using a perpetuity approach. Assume, for this part of the question only, that before-tax cash flows and profit tax are constant from year five onwards, and that capital allowances and working capital can be ignored. (5 marks)

(c) Discuss THREE ways of incorporating risk into the investment appraisal process.

(7 marks)
(25 marks)

2

2

The finance director of AQR Co has heard that the market value of the company will increase if the weighted average cost of capital of the company is decreased. The company, which is listed on a stock exchange, has 100 million shares in issue and the current ex div ordinary share price is $2·50 per share. AQR Co also has in issue bonds with a book value of $60 million and their current ex interest market price is $104 per $100 bond. The current after-tax cost of debt of AQR Co is 7% and the tax rate is 30%.

The recent dividends per share of the company are as follows. Year
Dividend per share (cents)

2006
19·38

2007
20·20

2008
20·41

2009
21·02

2010
21·80

The finance director proposes to decrease the weighted average cost of capital of AQR Co, and hence increase its market value, by issuing $40 million of bonds at their par value of $100 per bond. These bonds would pay annual interest of...
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