ACCA P4 KAPLAN EXAM KIT - Advanced Financial Management, part - B - Answers

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  • 1. Advanced Financial Management KAPLAN EXAM KIT Part- B : Answers
  • 2. KAPLAN PUBLISHING 129 Section 3 ANSWERS TO PRACTICE QUESTIONS – SECTION A ROLE OF SENIOR FINANCIAL ADVISER IN THE MULTINATIONAL ORGANISATION 1 VADENER PLC (JUN 06 ADAPTED) Key answer tips Requirement (a) is a standard corporate appraisal. To achieve a good answer ensure that you discuss all ratios calculated and conclude by commenting on the firm’s resource allocation plans. Part (b) is easier if you think of issues as you approach part (a), rather than as a separate exercise. In part (c) the key issue is that translation losses are unrealised unless the division or asset concerned is sold. Part (d) covers the problem of using options for speculation rather than hedging. (a) Group performance may be analysed by using financial ratios, growth trends and comparative market data. Alternative definitions exist for some ratios, and other ratios are equally valid. Operating and profitability ratios: 20X3 20X4 20X5 Return on capital employed: EBIT Capital employed 410 1,486 = 27.6% 540 1,665 = 32.4% 560 1,876 = 29.9% Asset turnover: Sales Capital employed 1,120 1,486 = 0.81 1,410 1,665 = 0.85 1,490 1,876 = 0.79 Profit margin: EBIT Sales 410 1,210 = 33.9% 540 1,410 = 38.3% 560 1,490 = 37.6%
  • 3. PAPER P4 : ADVANCED FINANCIAL MANAGEMENT 130 KAPLAN PUBLISHING Liquidity ratios: Current ratio: Current assets Current liabilities 728 565 = 1.29 863 728 = 1.19 1,015 799 = 1.27 Acid test: Current assets – Inventory Current liabilities 388 565 = 0.69 453 728 = 0.62 525 799 = 0.66 Market ratios: Dividend yield: Dividend per share Market price 48.7 1,220 = 4.0% 56.7 1,417 = 4.0% 61.7 1,542 = 4.0% Earnings per share (pence): Earnings after tax Number of shares 259 300 = 86.3 339 300 = 113.0 346 300 = 115.3 PE ratio Market price Earnings per share 1,220 86.3 = 14.1 1,417 113 = 12.5 1,542 115.3 = 13.4 Gearing: Total borrowing Borrowing + Equity 535 1,621 = 33% 580 1,835 = 32% 671 2,077 = 32% It is difficult to reach conclusions about the performance of Vadener without more comparative data from similar companies. Return on capital at around 30% is dominated by the effect of high profit margins, but the split between divisions is not provided. Asset utilisation is well below 1, which implies relatively inefficient utilisation of assets. Vadener might investigate whether this could be improved. Liquidity has improved during the last year, and although below some commonly used benchmarks might be satisfactory for the sectors that Vadener is involved with. However, some aspects of working capital require attention. Stock levels have increased from 28% of revenue in 20X3 to 33% in 20X5, and the collection period for debtors has similarly increased from 114 days to 125 days. Creditors have also increased more than proportionately to revenue. Vadener should take action to improve the efficiency of its working capital management. In contrast operating costs have fallen over the three years from 66% to 62% of revenue, indicating greater efficiency. Gearing appears to be relatively low at around 32%, but comparative data is needed, and interest cover is high at more than eight times in 20X5. Investors do not appear to be entirely satisfied with group performance. The FT market index has increased by 34% between 20X3 and 20X5, whereas Vadener’s share price has only increased by 26%. With an equity beta of 1.1 Vadener’s share price would be expected to increase by more than the market index. Vadener’s PE ratios are also lower than those of similar companies, suggesting that investors do not value the company’s future prospects as highly as those of its competitors. The required return from Vadener’s shares may be estimated using the capital asset pricing model (CAPM). Required return = 5% + (12% – 5%) 1.1 = 12.7%
  • 4. ANSWERS TO PRACTICE QUESTIONS – SECTION A : SECTION 3 KAPLAN PUBLISHING 131 An approximation of the actual return from Vadener’s shares is the 12% average annual increase in share price plus 4% annual dividend yield, or 16%. The total return is higher than expected for the systematic risk. Given this, Vadener should investigate the reasons why its share price has performed relatively poorly. One possibility is the company’s dividend policy. Dividends have consistently been more than 50% of available after tax earnings, which might not be popular with investors. Divisional performance The information on the individual divisions is very sparse. All divisions are profitable, but the return from the pharmaceutical division is relatively low for its systematic risk. Using CAPM to approximate required returns: Required return Actual return Construction 5% + (12% – 5%) 0.75 = 10.25% 13% Leisure 5% + (12% – 5%) 1.1 = 12.7% 16% Pharmaceuticals 5% + (12% – 5%) 1.40 = 14.8%1 14% 1 It is assumed that the same market parameters are valid for the US based division. The construction and leisure divisions appear to have greater than expected returns (a positive alpha) and the pharmaceutical division slightly less than expected for the risk of the division. The pharmaceutical division has recently suffered a translation loss due to the weakness of the US dollar, and the potential economic exposure from changes in the value of the dollar should be investigated. From a financial perspective it would appear that the company should not devote equal resources to the divisions, and should focus its efforts on construction and leisure. However, the future prospects of the sectors are not known, nor the long term strategy of Vadener, which might be to expand international operations in the USA or elsewhere. The strategic use of resources should not be decided on the basis of the limited financial information that is available. (b) Other information that would be useful includes: (i) Cash flow forecasts for the group and the individual divisions. (ii) Full product and market information for each of the divisions. (iii) Details of recent investments in each of the divisions and the expected impact of such investment on future performance. (iv) Detailed historic performance data of the divisions over at least three years, and similar data for companies in the relevant sectors. (v) Competitors and potential growth rates in each of the sectors. (vi) The economic exposure of the US division (vii) The future strategic plans of Vadener. Are there any other proposed initiatives? (viii) How the company’s equal resource strategy will be viewed by investors. The company has performed worse than the market in recent years despite having a higher beta than the market.
  • 5. PAPER P4 : ADVANCED FINANCIAL MANAGEMENT 132 KAPLAN PUBLISHING (c) A translation loss of £10 million is not necessarily a problem for Vadener plc. Translation exposure, sometimes known as accounting exposure, often does not reflect any real cash flow changes. It is changes in cash flow that, in an efficient market, will impact on the share price and value of a company. For example, a translation loss might in part reflect a lower home currency value of an overseas factory, but the factory will still be the same and will still be producing goods. It is the impact on the home currency cash flows from the continuing operations of the factory that will affect share price. However, if the market is not efficient, investors might not understand that there are no real cash flow implications from the exposure, and might be worried about the effect of the translation loss on Vadener, and possibly sell their shares. If this is the case Vadener might consider internal hedges to reduce translation exposure. In most cases this would not be recommended, and companies must also be careful that hedges to manage translation exposure do not adversely affect the efficient operations of the business, or be contrary to hedges that are being undertaken to protect against other forms of currency exposure such as transaction exposure. (d) Income may be increased by writing (selling) options, as the writer of the option receives the option premium. However, unless the option is hedged, writing options exposes the writer to a theoretically unlimited loss. Uncovered writing of options is effectively speculating, involves very high risk, and is not normally recommended as a strategy to companies such as Vadener. ADVANCED INVESTMENT APPRAISAL 2 AVTO (DEC 03 ADAPTED) Key answer tips This question requires analysis of the viability of an overseas investment taking into account all relevant financial and non-financial effects, including possible blockage of remittances from the country.
  • 6. ANSWERS TO PRACTICE QUESTIONS – SECTION A : SECTION 3 KAPLAN PUBLISHING 133 (a) Financial appraisal (Appendix to the report) Projected cash flows: Terranian francs (million) Year 0 1 2 3 4 5 Sales (W2) 659 735 785 838 Labour (W3) 228 262 288 317 Local components (W4) 90 104 114 125 German components (W5) 41 47 52 57 Distribution (W6) 20 23 25 28 Fixed costs (W6) 50 58 63 70 ––––– ––––– ––––– ––––– Total costs (429) (494) (542) (597) ––––– ––––– ––––– ––––– Taxable cash flows 230 241 243 241 Tax on cash flows at 20% (46) (48) (49) (48) Tax saved from depreciation (W7) 29 22 16 12 Equipment (580) 150 Working capital (W8) (170) (34) (31) (23) (26) 284 ––––– ––––– ––––– ––––– ––––– ––––– Remittable to the UK (750) 179 184 187 329 284 ––––– ––––– ––––– ––––– ––––– ––––– Remittable to the UK (W9) (20.35) 4.13 3.80 3.62 5.96 4.82 Additional 10% UK tax on Terranian cash flow (W10) (0.20) (0.27) (0.31) (0.33) ––––– ––––– ––––– ––––– ––––– ––––– (20.35) 3.93 3.53 3.31 5.63 4.82 Discount factors at 15% (W11) 1.000 0.870 0.756 0.658 0.572 0.497 Present values (20.35) 3.42 2.67 2.18 3.22 2.40 Net present value = (£6.46 million) Workings: (W1) Exchange rates Exchange rates are assumed to change in line with changes in inflation rates, in accordance with the purchasing power parity theory. Year 0 1 2 3 4 5 Change factor × (1.20/1.02) × (1.15/1.03) × (1.10/1.03) × (1.10/1.03) × (1.10/1.03) T franc/£1 36.85 43.35 48.40 51.69 55.20 58.96 T franc/€1 23.32 27.44 30.63 32.71 34.94 (W2) Sales Year 1 2 3 4 Sales (units) 50,000 50,000 50,000 50,000 Sales price (€) €480 €480 €480 €480 Revenue (€m) 24.0 24.0 24.0 24.0 Exchange rate (W1) 27.44 30.63 32.71 34.94 Revenue (T francs m) 659 735 785 838
  • 7. PAPER P4 : ADVANCED FINANCIAL MANAGEMENT 134 KAPLAN PUBLISHING (W3) Labour Labour cost has been increased by a factor of 1.20 to reflect the use of 300 workers in order to gain use of the rent-free factory. The cost of 50 extra workers in Year 1 is (50/250) × (3,800 T francs × 50,000) = 38 million francs. The annual after-tax costing of renting the factory would be 75 million × (1 – 0.20) = 60 million francs. Avto would select the rent-free factory as the cost is lower. The cost of 300 workers in Year 1 is (in T francs millions): (3,800 × 50,000) + 38.0 = 228. This will rise due to inflation by 15% in Year 2, 10% in Year 3 and 10% in Year 4. (W4) Local components Cost in Year 1 = 50,000 units × 1,800 T francs = 90 million T francs. This will rise with inflation by 15% in Year 2, 10% in Year 3 and 10% in Year 4. (W5) German components Cost in Year 1 = 50,000 units × €30 = €1,500,000. This cost will rise with inflation by 3% each year from Year 2 onwards. Year 1 2 3 4 Cost (€000) 1,500 1,545 1,591 1,639 Exchange rate (W1) 27.44 30.63 32.71 34.94 Cost in T francs (m) 41 47 52 57 (W6) Distribution costs, fixed costs and feasibility study costs The sales and distribution costs in Year 1 will be 50,000 × 400 T francs = 20 million T francs. These costs will rise with inflation, by 15% in Year 2, 10% in Year 3 and 10% in Year 4. The fixed costs in Year 1 will be 50 million T francs. These costs will rise with inflation, by 15% in Year 2, 10% in Year 3 and 10% in Year 4. The cost of the feasibility study is irrelevant, because it is a sunk cost. (W7) Tax saved from depreciation In T francs millions Year 1 Year 2 Year 3 Year 4 Written down value at start of year 580 435 326 244 Tax-allowable depreciation (25%) 145 109 82 61 Tax saving (20%) 29 22 16 12 (W8) Working capital Working capital is assumed to increase each year in line with inflation in Terrania, and to be released at the end of Year 5. In TF millions Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Working capital requirement 170 204 235 258 284 0 Cash flow in year (170) (34) (31) (23) (26) 284
  • 8. ANSWERS TO PRACTICE QUESTIONS – SECTION A : SECTION 3 KAPLAN PUBLISHING 135 Tutorial note (on the working capital assumption) The solution here gives the examiner’s preferred approach to calculating the working capital cash flows. This assumes that working capital builds up into Year 4 and the investment in working capital is not recovered until Year 5. An alternative approach would be to assume that the working capital is recovered early in Year 5, i.e. at the end of Year 4 rather than at the end of Year 5. If you prefer this assumption, the cash flow in Year 4 would be +258 rather than –26, and there would be no cash flow at all in Year 5. This alternative solution would have been fully acceptable, but the calculations of the cash flows and project NPV, and the analysis, would then be different. (W9) Funds remittable to the UK Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 In TF millions (750) 179 184 187 329 284 Exchange rate (W1) 36.85 43.35 48.40 51.69 55.20 58.96 In £ millions (20.35) 4.13 3.80 3.62 5.96 4.82 (W10) Additional UK tax on Terranian cash flow Since a bilateral tax treaty exists between the UK and Terrania, and tax in Terrania is lower than tax in the UK by 10% (30% – 20%), an additional 10% taxation will be levied on Terranian cash flows in the UK. In T francs millions Year 1 Year 2 Year 3 Year 4 Taxable cash flows 230 241 243 241 Tax-allowable depreciation (25%) 145 109 82 61 ––– ––– ––– ––– Taxable in Terrania 85 132 161 180 ––– ––– ––– ––– Extra 10% tax 8.5 13.2 16.1 18.0 Exchange rate 43.35 48.40 51.69 55.20 Extra tax in £ millions £0.20m £0.27m £0.31m £0.33m (W11) Discount rate, Terranian investment Cost of capital = 4.5% + 1.5 (11.5 – 4.5)% = 15%. (W12) Discount rate, UK investment Cost of capital = 4.5% + 1.1 (11.5 – 4.5)% = 12.2%, say 12%. (W13) Net cost of closure in Year 0 £m Closure costs (35.0) Tax saving (30%) 10.5 Proceeds from asset disposals 20.0 ––– Net cash flow (4.5) –––
  • 9. PAPER P4 : ADVANCED FINANCIAL MANAGEMENT 136 KAPLAN PUBLISHING (W14) Net cost of downsizing in Year 0 £m Closure costs (20.0) Tax saving (30%) 6.0 Proceeds from asset disposals 10.0 ––– Net cash flow (4.0) ––– REPORT: Appraisal of the proposed investment in Terrania The investment will be evaluated using both financial and non-financial criteria, including the possible political risk involved with investing in Terrania. However, international direct investment is sometimes undertaken for strategic reasons, which, at least in the short term, might outweigh financial considerations. Analysis The expected NPV is: (£6.46) million (see Appendix). The expected investment in Terrania if viewed alone does not appear to be financially viable. However, the closure or downsizing of UK operations should also be considered. Closure would have a Year 0 net cost, after tax, of at least £4.5 million (see W13). The cost could be more if the full existing market in the EU cannot be supplied from Terrania, and closure might have other adverse effects on the local community that have not been quantified, and on the government in terms of extra support for redundant workers and their families. Downsizing would still have some of these effects, but would also offer the opportunity of selling to a larger market that could not otherwise have been supplied from Terrania alone. If the UK operation is downsized, the Year 0 net cost, after tax, of downsizing is £4 million (see W14). Expected annual net cash flows are (£4 million, less tax at 30%) £2.8 million at Year 0 values. Increasing these net cash flows by UK inflation, we can calculate a present value of the cash flows from downsizing, as follows: In £ millions Year 0 Year 1 Year 2 Year 3 Year 4 Cash flow (4.0) 2.86 2.94 3.03 3.12 Discount factor at 12% (W12) 1.000 0.893 0.797 0.712 0.636 Present value of cash flow (4.0) 2.55 2.34 2.16 1.98 Net present value = £5.03m The total present value of cash flows from downsizing is £5.03 million over the four- year period. Downsizing results in a much more favourable outcome than total closure. If a period of longer than four years were considered, the expected present value from downsizing would be even larger. Overall, the investment in Terrania plus downsizing does not appear to be financially viable, with an expected NPV of (£1.43) million (= £5.03m – £6.46m). However, one major problem with the cash flow estimates is the realisable value used for the Terranian assets in Year 4. If the Terranian investment is to continue beyond four years, which is implied in the information provided, then the present value of cash flows beyond four years should be considered, not the realisable value of assets. This present value is likely to be substantially higher. For example, even ignoring growth, the value of the operating cash flows (179 million Terranian francs in Year 4) for an
  • 10. ANSWERS TO PRACTICE QUESTIONS – SECTION A : SECTION 3 KAPLAN PUBLISHING 137 additional 10 years at a discount rate of 15% would be TF 898 million (179 million × 5.019). This is much more than the TF 150 million estimated realisable value of assets used above in the DCF analysis. Wider commercial considerations Aspects of the cash flows that would need to be investigated further before a decision was made include: (i) What rent would be payable for the factory after Year 4? (ii) How accurate are the forecasts of sales, costs, tax rates, etc? Sensitivity analysis or simulation analysis might be used to investigate the effect of changes in key cash flows. (iii) Will the investment lead to other opportunities (future options)? If so, an attempt should be made to value such options. (iv) The strategic importance of the investment to the company. (v) The political risk of Terrania. The fact that the country has had 12 changes of government in the last 10 years does not necessarily mean that there is substantial political risk. Countries such as Italy have also experienced frequent changes of government. However, the degree of international indebtedness and potential lack of support from the IMF could affect the future prospects of the country. It would be useful to know the ability of Terrania to service its debt, given the problems with the banana crop and competition from neighbouring countries. (vi) The existence of better opportunities elsewhere. For example, would it be possible to produce the DVD players in neighbouring countries where labour costs are even lower? Conclusion Any final decision regarding investment in Terrania must also take into account other non-financial factors such as the nature of the country’s legal system, bureaucracy, efficiency of internal processes, cultural and religious differences, and local business practices and ethics. (b) The impact of blocked remittances Avto should investigate how likely are further restrictions on remittances from Terrania. If remittance restrictions are introduced, Avto could partially mitigate their effects by investing in the Terranian money market, but the effect of the restrictions would still reduce the present value of expected cash flows by approximately £1.83 million (see below) unless increased direct investment in Terrania was planned. Remittance restrictions might be avoided by increasing transfer prices paid by the foreign subsidiary to the parent company, or by trying to move cash out of Terrania by means of other forms of payment such as royalties, payment for patents, or management fees. It is likely that the Terranian government would try to prevent many of thes
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