ACCA P4 Advanced Financial Management - 2010 - Study text

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Practice questions

40 Imperfect hedge and basis 465

41 Currency hedge 466

42 Hedging with STIRs 466

43 More hedging with STIRs 467

44 FRAs and futures 468

Options and hedging with options

45 Traded equity options 469

46 Currency options 469

47 Interest rate hedge 470

Option pricing and delta hedging

48 Black-Scholes 470

49 Put-call parity 471

50 Delta hedge 471

51 Bonus scheme 471

52 Delta neutral 472

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1 Corporate social responsibility

(a) What are the main issues that might be covered by a company’s policy on

corporate social responsibility?

(b) What types of company are most likely to face CSR risks?

2 Corporate governance

(a) What is the main purpose of statutory or voluntary codes of corporate

governance?

(b) What are the main problems or issues that a code of corporate governance

might be expected to cover?

3 Dividends and retentions

The directors of an all-equity company are considering the company’s policy on

dividends and retentions. The cost of capital is 9% and the company is able to invest

in new capital projects that will earn this return. The company’s shares are quoted

and traded on a major stock market.

In the year just ended, the earnings per share were $2.00 per share. The company

pays a dividend annually, and is about to pay a dividend for the year just ended on

the basis of its selected dividend and retentions policy.

Required

Suggest what the company’s share price might be if the directors select a policy of

paying annual dividends that are equal to:

(a) 25% of earnings

(b) 50% of earnings

4 Financial plan

The board of directors of NNW have asked for a four-year financial plan to be

prepared for Year 5 to Year 8. They have approved the following assumptions for

the plan:

(1) Sales growth will be at the rate of 6% each year into the foreseeable future.

(2) Cash operating costs will be 70% of sales.

(3) Investment in new plant and equipment is expected to grow in line with the

growth in sales, and the net book value of plant and equipment will grow at

the same rate.

(4) Tax-allowable depreciation will grow in line with the growth in sales.

(5) Inventory, receivables, cash and trade payables will also increase at the same

rate as the growth in sales.

Practice questions

(6) There will be no change in long-term borrowing. Interest on the bank

overdraft will be payable at 7%. The interest charge for bank overdraft in the

income statement each year should be calculated on the opening bank

overdraft at the beginning of the year.

(7) Tax on company profits will be 30%.

(8) The company policy is to pay dividends as a constant percentage amount of

earnings. This policy will not change.

(9) The cost of equity capital has been estimated as 12%.

The income statement of NNW for the year to 31st December Year 4 is as follows:

$ million

Sales 1,800

Cash operating costs (1,260)

EBITDA 540

Tax allowable depreciation (160)

Earnings before interest 380

Interest (78)

Profit before tax 302

Tax at 30% (91)

Profit after tax 211

Dividends (135)

Retained profit 76

The balance sheet of NNW as at the end of Year 4 is as follows:

$ m $ m

Plant and equipment 2,020

Current assets

Inventory 520

Receivables 640

Cash 30

1,190

Total assets 3,210

Share capital (shares of $0.05 each) 450

Reserves 1,200

1,650

Long term loan at 8% 800

Trade payables 450

Bank overdraft 310

3,210

Required

(a) Prepare a financial plan for Years 5 to 8, showing the profit after tax,

dividends, retained profits for each year and a summary balance sheet as at

the end of each year.

(b) Calculate the expected free cash flow in each year of the financial plan.

Paper P4: Advanced Financial Management

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(d) Use the dividend growth model to estimate a market value per share as at the

end of Year 8 (the end of the financial planning period). State any assumptions

that you make in your estimate.

5 DCF exercises

(a) Calculate the NPV of an investment with the following estimated cash flows,

assuming a cost of capital of 8%:

Years Annual cash flow

0 (3,000,000)

–

4 500,000

–

8 400,000

–

10 300,000

11 onwards in perpetuity (per year)

100,000

(b) The cash flows for an investment project have been estimated at current

prices, as follows:

Year Equipment Revenue Running costs

$ $ $

0 (900,000)

800,000

(400,000)

800,000

(400,000)

600,000

(350,000)

4 200,000

400,000

(300,000)

It is expected that the cash flows will differ because of inflation. The annual

rates of inflation are expected to be:

 Equipment value: 4% per year

 Revenue: 3% per year

 Running costs: 5% per year.

The cost of capital is 12%

Required

(i) Calculate the NPV of the project ignoring inflation.

(ii) Calculate the NPV of the project allowing for inflation.

6 DCF and tax

A company is considering whether or not to invest in a four-year investment

project. The project will require the purchase of equipment costing $800,000. This

will have an estimated residual value of $200,000 at the end of Year 4. The

equipment will be depreciated by the straight-line method.

The profits before interest and tax from the project are expected to be $250,000 each

year. Tax is payable at 30% one year in arrears.

Practice questions

The equipment will qualify for capital allowances (tax depreciation allowances) of

25% each year, using the reducing balance method. The first claim for an allowance

would be made against Year 0 profits.

The after-tax cost of capital is 15%.

Required

Calculate the NPV of the project.

7 Free cash flow

A company expects to make profits before interest and tax next year of $3 million.

Other budgeted information is as follows:

Interest charges 400,000

Taxation 600,000

Dividend payments 1,200,000

Depreciation charges 550,000

Increase in working capital 150,000

Capital expenditure:

Asset replacement expenditure 1,000,000

Discretionary expenditure 700,000

Required

Calculated the expected amount of free cash flow next year.

8 Two-asset portfolio

An investor is planning to invest in two securities, Security X and Security Y. The

expected return from each security will depend on the state of the economy, as

follows:

State of the

economy

Probability

Return from

Security X

Return from

Security Y

% %

Strong 0.25 15

Fair 0.60 10

Wea

0.15 2

(6)

Required

(a) Calculate the mean and standard deviation of the expected return from Security

(b) Calculate the mean and standard deviation of the expected return from

Security Y.

formula for a covariance is:

Cov

x,y

rx− x

()

y − y

()

Paper P4: Advanced Financial Management

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(d) Calculate the correlation coefficient for returns from Security X and Security Y,

for a portfolio consisting of 50% of the funds invested in Security X and 50% of

the funds invested in Security Y. The formula for correlation coefficient is:

x,y

= Cov

x,y

x σ

where:

σ = the standard deviation of returns from Security X

σ = the standard deviation of returns from Security Y

Comment on the correlation coefficient.

(e) Calculate expected return, the variance and standard deviation of a portfolio

consisting of 50% of the funds invested in Security X and 50% of the funds

invested in Security Y. The formula for correlation coefficient is:

(Variance X)

+ (1 – a)

(Variance Y)

+ 2a(1 – a) Cov

x,y

where:

a = the proportion of the portfolio invested in Security X

(1 – a) = the proportion of the portfolio invested in Security Y

Variance X = the variance of the returns from Security X

Variance Y = the variance of the returns from Security Y

(f) Calculate expected return, the variance and standard deviation of a portfolio

consisting of 80% of the funds invested in Security X and 20% of the funds

invested in Security Y.

9 Risk and return

A divisional manager’s attitude to investing in new projects is affected by his

attitude to risk. He is prepared to invest in a project that is more risky, provided that

it offers a higher expected return.

He is currently considering four mutually exclusive projects, for which the

estimated returns and risk are as follows:

Project Estimated project NPV Risk (σ)

Project 1 80% chance of + $4 million, 20% chance of + $2 million 0.80

Project 2 70% chance of + $5 million, 30% chance of + $1.5 million

1.60

Project 3 60% chance of + $6 million, 40% chance of + $1 million

Not yet calculated

Project 4 50% chance of + $8 million, 50% chance of

–

$1 million

Not yet calculated

Required

(a) Calculate the risk with Project 3 and Project 4.

(b) Suggest which of the four projects the divisional manager will select.

10 Coefficient of variation

A multinational company is planning to invest in two developing countries, and it

will invest equal amounts of capital in each country. It is looking at returns and risk

in each of three possible countries that might be selected for investment.

Practice questions

The company is particularly concerned about the political risk in each country, and

the threat of political risk to its expected returns. A firm of management consultants

has produced the following statistical estimates of expected returns ad political risk

in each of the countries.

Country

Expected investment

return (%)

Political

risk (%)

Country A 16 25

Country B 22

Country C 30

The expected return from investing in any of the three countries is independent of

the returns that would be obtained from the other countries.

Required

(a) Calculate the risk, return and coefficient of variation of the following three

investment portfolios:

(i) 50% in Country A, 50% in Country B

(ii) 50% in Country A, 50% in Country C

(iii) 50% in Country B, 50% in Country C

(b) Comment on the results.

11 Capital market line

The risk-free rate of return is 3%. The return on the market portfolio is 9%.

Suggest how an investor should create a portfolio to provide a return of 7% with

minimum risk.

12 Obtaining a beta factor

A beta factor will be estimated for Security Y from the following data.

Month

Returns from the

market portfolio

Returns from

Security Y

% %

1 + 2

+ 3

–

4 + 3

+ 5

EV of monthly return + 0.5

+ 1.0

Required

(a) Use this data to calculate:

(i) the standard deviation of the monthly return from the market portfolio

and

(ii) the standard deviation of the monthly return from Security Y.

Paper P4: Advanced Financial Management

(b) Calculate the correlation coefficient for the market returns and the returns

from Security Y. This is calculated as:

m,y

= Cov

m,y

x σ

where:

σ = the standard deviation of returns from the market portfolio

= the standard deviation of returns from Security Y

The formula for the covariance is:

Cov

x,y

x − x

()

y − y

()

(c)

Use this data to calculate the beta factor for Security Y. You can use either of

the following formulas.

β=

Cov

m,y

Var

Alternatively

β=

m,y

x σ

13 WACC

A company has just paid an annual dividend of $0.18. Investors expect the annual

dividend to grow by 3% each year in perpetuity, The current share price is $1.55 and

the total market value of the company’s shares is $1,200,000.

The company has debt capital on which the yield is 7.8% before tax. The rate of tax

is 30%. The total value of the company’s debt is $350,000.

Calculate the weighted average cost of capital. Use the dividend growth model to

estimate the cost of equity.

14 Optimal WACC

A company has estimated that its cost of debt capital varies according to the level of

gearing, as follows:

Gearing Cost of debt

20 5.0

30 5.4

40 5.8

50 6.5

60 7.2

Gearing is measured as the market value of the company’s debt as a proportion of

the total market value of its equity plus debt.

The rate of tax is 30%. The ungeared equity beta factor for the company is 0.90.

The risk-free rate of return is 4% and the return on the market portfolio is 9%

Practice questions

Required

Identify the optimal gearing level and WACC.

15 Change in gearing

A company is all-equity financed, with 60 million shares. The current market value

of the shares is $5 each. The company currently makes an annual profit before

interest and tax of $40 million. There are no expectations of growth in annual

profits.

The company is considering whether to raise $100 million in debt. The pre-tax

interest rate would be 8% and the tax rate is 25%. The debt capital would be used to

repurchase and cancel some equity shares.

Required

Use appropriate Modigliani-Miller formulas to estimate the effect the issue of debt

and repurchase of shares would have on the weighted average cost of capital

(WACC).

16 Geared beta

A company has $1,500,000 in equity capital and $500,000 in debt capital (at market

values). The beta value of the equity is 1.126 and the beta of the debt capital is 0.

The risk-free cost of capital is 5% and the market portfolio return is 11%. The tax

rate is 30%.

Required

(a) Calculate the current weighted average cost of capital (WACC).

(b)

Calculate what the WACC would be if the company consisted of 60% equity

and 40% debt.

17 APV method

A company in the engineering industry is considering making an investment in a

telecommunications project. The investment will cost $2,000,000, and will be

financed by a new issue of $1,000,000 in equity and a new issue of $1,000,000 debt

capital.

The company’s current gearing level is 30% debt and 70% equity.

The telecommunications industry has an average industry equity beta of 1.30625.

The average gearing ratio in the industry is 20% debt and 80% equity.

The rate of taxation is 25%.

The risk-free rate of return is 4% and the average market return is 9%. The

company’s debt is risk-free.

Paper P4: Advanced Financial Management

The cash flows from the project before taxation are expected to be:

Year Cash flow

1 100,000

2 140,000

3 120,000

Tax is payable one year in arrears.

You should ignore tax depreciation (capital allowances) on the initial investment.

The costs of raising the equity capital will be 4% of the amount raised. The costs of

raising the debt capital will be 3% of the amount raised. The debt will be in the form

of a three-year loan, and the principal will be repaid in full at the end of Year 3.

Required

Calculate:

(a) the NPV of the project, using the Modigliani and Miller formulas to derive a

cost of capital for the project

(b) calculate the adjusted present value (APV) of the project.

18 Adjusted Present Value

Harvey is an aluminium engineering company. It now wishes to diversify its

operations into the plastics business. The proposed investment project will require

the purchase of a machine costing $450,000. This will produce cash flows of $220,000

for each of the three years of its life, and it will have no residual value at the end of

that time.

It is proposed to finance the purchase of the machine with a mixture of debt and

equity capital. 40% of the cost will be financed by a three-year loan that will be

repaid in three equal instalments. The remaining 60% of the cost will be financed by

a placing of new equity.

Issue costs, which are tax-allowable, will be 5% for the equity and 2% for the debt,

measured as a percentage of the net finance raised.

The plastics industry has an average equity beta of 1.356 and an average debt:

equity ratio of 1:5, at market values. Harvey’s current equity beta is 1.8 and 20% of

its capital (at market value) consists of long-term debt which is regarded as risk-free.

The risk-free rate is 10% per annum and the expected return on an average market

portfolio is 15%. Corporation tax is at 35%, payable one year in arrears. The machine

will attract a 70% capital allowance in the first year, and the balance will be

allowable against tax over the next three years, at an equal amount in each year.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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