Fundamentals Level –Skills Module, Paper F9Financial Management1( - PDF document

Fundamentals Level –Skills Module, Paper F9Financial Management1(a)After-tax cost of borrowing = 8·6 x (1 – 0·3) = 6% per yearEvaluation of leasingYearCash flowAmount ($)6% Discount factorsPresent value ($)0–3Lease rentals(380,000)1·000 + 2·673 = 3·673(1,395,740)2–5Tax savings114,0004·212 – 0·943 = 3·269372,666Present value of cost of leasing = $1,023,074Evaluation of borrowing to buyLicenceTaxNet cash6% discountPresentYearCapitalfeebenefitsflowfactorsvalue$$$$$ 0(1,000,000)(1,000,000)1·000(1,000,000)1(104,000)(104,000)0·943(98,072)2(108,160)106,200(1,960)0·890(1,744)3(112,486)88,698(23,788)0·840(19,982)4100,000(116,986)75,93458,9480·79246,6875131,659131,6590·74798,349Present value of cost of borrowing to buy = $974,762WorkingsYearCapital allowanceTax benefitstax benefitsTotal$$$$21,000,000 x 0·25 = 250,00075,00031,200106,2003750,000 x 0·25 = 187,50056,25032,44888,6984562,500 x 0·25 =140,62542,18833,74675,9345421,875 – 100,000 = 321,87596,56335,096131,659ASOP Co should buy the new technology, since the present cost of borrowing to buy is lower than the present cost of leasing.Year12345Cost savings365,400479,250637,450564,000Tax liabilities(109,620)(143,775)(191,235)(169,200)–––––––––––––––––––––––––––––––––––––––––––Net cash flow365,400369,630493,675372,765(169,200)Discount at 11%0·9010·8120·7310·6590·593–––––––––––––––––––––––––––––––––––––––––––Present values329,225300,140360,876245,652(100,336)–––––––––––––––––––––––––––––––––––––––––––Present value of benefits1,135,557Present cost of financing(974,762)Net present value160,795The investment in new technology is acceptable on financial grounds, as it has a positive net present value of $160,795.WorkingsYear1234Operating cost saving ($/unit)6·096·396·717·05Production (units/year)60,00075,00095,00080,000––––––––––––––––––––––––––––––––Operating cost savings ($/year)365,400479,250637,450564,000Tax liabilities at 30% ($/year)109,620143,775191,235169,200(Examiner’s note: Including the financing cash flows in the NPV evaluation and discounting them by the WACC of 11% isalso acceptable) 11 working capital financing policy, which uses short-term funds to finance fluctuating current assets and a proportion ofpermanent current assets as well. Between these two extremes lies the moderate (or matching) policy, which uses long-termfunds to finance long-term assets (non-current assets and permanent current assets) and short-term funds to finance short-term assets (fluctuating current assets).The current statement of financial position shows that APX Co uses trade payables and an overdraft as sources of short-termfinance. In terms of the balance between short- and long-term finance, 89% of current assets (100 x 4·1/4·6) are financedfrom short-term sources and only 11% are financed from long-term sources. Since a high proportion of current assets arepermanent in nature, this appears to be a very aggressive working capital financing policy which carries significant risk. If toverdraft were called in, for example, APX Co might have to turn to more expensive short-term financing.The forecast statement of financial position shows a lower reliance on short-term finance, since 79% of current assets (100x 5·36/6·75) are financed from short-term sources and 21% are financed from long-term sources. This decreased relianceAPX Co has little scope for taking on more long-term debt. An increase in equity funding to decrease reliance on short-termfinance could be considered.Working capital management Financial analysis shows deterioration in key working capital ratios. The inventory turnover period is expected to increase fro81 days to 110 days, the trade receivables period is expected to increase from 50 days to 65 days and the trade payablesperiod is expected to increase from 64 days to 75 days. It is also a cause for concern here that the values of these workingcapital ratios for the next year are forecast, i.e. APX Co appears to be anticipating a worsening in its working capital position.The current and forecast values could be compared to average or sector values in order to confirm whether this is in fact theexpected to increase in the next year, the current ratio from 1·12 times to 1·26 times and the quick ratio from 0·54 times to0·58 times. Again, comparison with sector average values for these ratios would be useful in making an assessment of theworking capital management of APX Co. The balance between trade payables and overdraft finance is approximately the samein both years (trade payables are 46% of current liabilities in the current statement of financial position and 47% of currentliabilities in the forecast statement of financial position), although reliance on short-term finance is expected to fall slighthe next year.The deteriorating working capital position may be linked to an expected deterioration in the overall financial performance ofAPX Co. For example, the forecast gross profit margin (30%) and net profit margin (20%) are both less than the current valuesof these ratios (32% and 23% respectively), and despite the increase in turnover, return on capital employed (ROCE) isexpected to fall from 16·35% to 14·83%.Extracts from current income statement:Turnover16·00Cost of sales10·88Gross profit5·12Other expenses1·44Net profit3·68CurrentForecastGross profit margin (100 x 5·12/16·00)32%Net profit margin (100 x 3·68/16·00)23%ROCE(100 x 3·68/22·5)16·35%(100 x 3·469/23·39)14·83%Inventory period (365 x 2·4/10·88)81 daysReceivables period (365 x 2·2/16·00)50 daysPayables period (365 x 1·9/10·88)64 daysCurrent ratio(4·6/4·1)1·12 times(6·75/5·36)1·26 timesQuick ratio(2·2/4·1)0·54 times(3·09/5·36)0·58 times 16 Fundamentals Level –Skills Module, Paper F9Financial ManagementDecember 2009 Marking SchemeMarksMarks1(a)Present value of lease rentals2Present value of lease rental tax benefits1Present value of cost of leasing1Investment and scrap values1Capital allowance tax benefits2Licence fee tax benefits1Present value of cost of borrowing to buy1Appropriate decision on leasing versus buying1Inflated cost savings2Tax liabilitiesPresent values of net cash flows1Net present value1Advice on acceptability of investment1Definition of equivalent cost or benefit1Relevant discussion1Appropriate illustration1Capital rationing1–2Divisible projects and profitability index2–3Indivisible projects and combinations1–2Maximum52(a)Calculation of cost of debt of Bond A3Term structure of interest rates1–2Liquidity preference theory1–2Expectations theory1–2Market segmentation theory1–2Other relevant discussion1–2Maximum6Cost of equityDividend growth rate1Share price using dividend growth model2Capital gearingWeighted average cost of capital2Dividend irrelevance3–4Dividend relevance3–4Maximum7 17 MarksMarks3(a)Amount of equity finance to be raised in dollars1Rights issue price1Theoretical ex rights price2Current EPSIncrease in PBIT from investment1Interest on bond issue1Revised dollar profit after tax2Revised EPSRevised share price using PER method1Comment on effect on shareholder wealth1–3Maximum9Transaction risk1–2Translation risk1–2Link to question1–2Maximum4Euro accountForward market hedge1Illustration of forward market hedge1–2Money-market hedge1Illustration of money-market hedge1–2Other hedging strategies, including derivatives1–2Maximum84(a)Relevant discussion on financial intermediaries4Profit before taxRetained profitInventoryTrade receivables1Trade payablesReservesOverdraftLayout and format1Maximum9Working capital financing policies2–3Financial analysis1–2Working capital financing policy of company2–3Maximum6Discussion of working capital management3–4Financial analysis2–4Maximum6 18