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For Examinations to June 2017

STUDY QUESTION BANK

ACCA

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Paper P4 | ADVANCED FINANCIAL MANAGEMENT

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ACCA

PAPER P4

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ADVANCED FINANCIAL MANAGEMENT

STUDY QUESTION BANK

For Examinations to June 2017

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4) CONTENTS Question Name

Page

Tables and formulae

Answer

Marks

Date worked

(v)

ROLE OF FINANCIAL STRATEGY 1 2

Agency relationships Ethics (ACCA D03)

1 1

1001 1002

10 15

3 4 5

Cost of capital Gaddes (ACCA J03) Stock market efficiency

1 2 3

6 7 8

Redskins Berlan Kulpar (ACCA D00)

PORTFOLIO THEORY AND CAPM Maltec (ACCA J01) Wemere Crestlee (ACCA D92) Hotalot (ACCA J89)

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9 10 11 12

1003 1005 1007

15 15 10

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WEIGHTED AVERAGE COST OF CAPITAL AND GEARING

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SECURITY VALUATION AND THE COST OF CAPITAL

3 4 5

1008 1010 1013

15 20 25

6 6 8 9

1015 1016 1018 1021

5 25 25 25

10 11

1023 1025

25 40

14 15

1030 1032

15 25

16 19

1036 1041

40 25

20 21 23 25

1043 1046 1049 1053

25 25 40 25

BASIC INVESTMENT APPRAISAL 13 14

Amble Progrow (ACCA D95)

ADVANCED INVESTMENT APPRAISAL 15 16

Tampem (ACCA D06) Project review (ACCA J09)

BUSINESS VALUATION 17 18

Daron (ACCA D96) Mercury training (ACCA J08)

MERGERS AND ACQUISITIONS 19 20 21 22

Bigun Demast (ACCA J94) Laceto (ACCA J01) Miniprice & Savealot (ACCA PP)

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(iii)

ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK Question Name

Page

Answer

Marks

Date worked

CORPORATE RECONSTRUCTION AND RE-ORGANISATION 23 24 25

Dricom (ACCA D97) Aster (ACCA J97) MBO

27 29 30

1056 1061 1063

25 25 10

31 31 33

1065 1066 1069

15 25 15

26 27 28

Equity and debt issues IXT New debt issue (ACCA D07)

DIVIDEND POLICY Pavlon TYR (ACCA D02)

OPTIONS 31 32

Uniglow (ACCA J02) Bioplasm (ACCA D03)

34 35

1071 1073

15 15

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29 30

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EQUITY ISSUES AND DEBT ISSUES

35 36

1075 1076

15 15

37 39 40 40

1078 1082 1085 1086

40 15 10 15

41 42 43 44

1087 1089 1093 1096

25 25 25 15

44 44 45

1098 1099 1100

15 15 10

45 46 48 48

1101 1103 1107 1108

15 40 15 15

49 51 53 55

1111 1113 1115 1117

25 25 12 40

FOREIGN EXCHANGE RISK MANAGEMENT Forun (ACCA J94) Storace Participating option (ACCA D00) MJY (ACCA D05)

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33 34 35 36

INTEREST RATE RISK MANAGEMENT 37 38 39 40

Omnitown Manling Murwald (ACCA D94) Turkey

THE ECONOMIC ENVIRONMENT FOR MULTINATIONALS 41 42 43

Global debt (ACCA J04) Beela Electronics (ACCA D01) IMF (ACCA PP)

INTERNATIONAL OPERATIONS 44 45 46 47

Polycalc Avto (ACCA D03) Servealot (ACCA J06) Kandover (ACCA D06)

FINANCIAL STATEMENT ANALYSIS 48 49 50 51

(iv)

Noifa Leisure Twello Sparks Wurrall (ACCA J04)

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4) Question 1 AGENCY RELATIONSHIPS Explain the term “agency relationships” and discuss the conflicts that might exist in the relationship between: (a) (b)

shareholders and managers; shareholders and creditors.

Explain the steps that might be taken to overcome these conflicts. (10 marks)

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Question 2 ETHICS

Question 3 COST OF CAPITAL (a)

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Discuss, and provide examples of, the types of non-financial, ethical and environmental issues that might influence the objectives of companies. Consider the impact of these non-financial, ethical and environmental issues on the achievement of primary financial objectives such as the maximisation of shareholder wealth. (15 marks)

Calculate the current pre-tax cost of the following debts: (i) (ii) (iii) (iv)

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(v)

A 10% coupon irredeemable loan note issued at nominal value. A 10% irredeemable loan note trading at $85 per $100 nominal value. A 10% redeemable loan note trading at $74 with three years to redemption at nominal value of $100. A 10% redeemable loan note trading at nominal value, with three years to redemption at nominal value. A 5% irredeemable $1 preference share trading at $0.65. (4 marks)

(b)

Calculate the current post-tax cost of the debts in (a) above, assuming a corporate tax rate of 35% (3 marks)

(c)

Given the following data about share prices, compute the cost of equity in each case:

(i)

Market price per share $1.50 ex-dividend. Dividend just paid $0.75, which is expected to remain constant.

(ii)

Market price per share $1.65 cum-dividend. Dividend about to be paid $0.15, which is expected to remain constant.

(iii)

Market price per share $1.20 ex-dividend. Dividend just paid $0.24, with expected annual growth rate of 5%.

(iv)

Market capitalisation of equity $10 million. Dividend just paid $1.5 million, which is expected to remain constant. (4 marks)

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1

ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK Calculate the market price per share and total market value of the following companies: (i)

W Co has 50,000 $1 ordinary shares in issue, current dividend per share $0.10 expected to remain constant; cost of equity 10%.

(ii)

X Co has 1,000 $1 ordinary shares in issue, total dividend $500, no growth expected; cost of equity 15%.

(iii)

Y Co has 1 million ordinary shares, the dividend just paid was $0.10 per share and it is expected to grow at 5% per year; cost of equity 15%.

(iv)

Z Co has 10,000 shares in issue, dividends for the next five years are expected to be constant at $0.10 per share and then grow at 5% per year to perpetuity; cost of equity 15%. (4 marks)

E

(d)

(15 marks)

Question 4 GADDES

Briefly discuss possible reasons for an upward sloping yield curve.

(4 marks)

(b)

The financial manager of Gaddes Co’s pension fund is reviewing strategy regarding the fund. Over 60% of the fund is invested in fixed rate long-term loan notes. Interest rates are expected to be quite volatile for the next few years. It is currently June 20X3.

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(a)

Among the pension fund’s current investments are two AAA rated loan notes: (1) (2)

Zero coupon June 20Y8 12% Gilt June 20Y8 (interest is payable semi-annually)

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The current annual redemption yield (yield to maturity) on both loan notes is 6%. The semiannual yield may be assumed to be 3%. Both loan notes have a nominal value and redemption value of $100.

Required: (i)

Estimate the market price of each of the loan notes if interest rates (yields): (a) (b)

increase by 1%; decrease by 1%.

The changes in interest rates may be assumed to be parallel shifts in the yield curve (yield changes by an equal amount at all points of the yield curve). (6 marks)

(ii)

Comment on and briefly explain the size of the expected price movements from the current prices and how such changes in interest rates might affect the strategy of the financial manager with respect to investing in the two loan notes. (3 marks)

(iii)

Comment on how the loan note investment strategy of the financial manager may be affected if the yield curve was expected to steepen (the gap between short- and long-term interest rates to widen) and interest rates are expected to rise. (2 marks) (15 marks)

2

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4) Question 5 STOCK MARKET EFFICIENCY The following statement contains several errors with reference to the three levels of market efficiency: “According to the efficient market hypothesis all share prices are correct at all times. This is achieved by prices moving randomly when new information is publicly announced. New information from published financial statements is the only determinant of the random movements in share price.

Required: Explain the errors in the above statement.

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“Fundamental and technical analysis of the stock market serves no function in making the market efficient and cannot predict future share prices. Corporate financial managers are also unable to predict future share prices.”

Question 6 REDSKINS

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(10 marks)

Redskins Co is a parent company owning shares in various subsidiary companies. Its directors are currently considering several projects to increase the range of the business activities undertaken by Redskins and its subsidiaries. The directors would like to use discounted cash flow techniques in their evaluation of these projects but as yet no weighted average cost of capital has been calculated.

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Redskins has an authorised share capital of 10 million $0.25 ordinary shares, of which 8 million have been issued. The current ex-div market price per ordinary share is $1.10. A dividend of $0.10 per share has been paid recently. The company’s project analyst has calculated that 18% is the most appropriate cost of equity capital. Extracts from the latest statement of financial position for both the group and the parent company are given below: Redskins Group Redskins $000 $000 Issued share capital 2,000 2,000 Share premium 1,960 1,960 Reserves 3,745 708 _____ _____ Shareholders’ funds

Non-controlling interest

7,705 _____ Redskins Group 895 _____

4,668 _____ Redskins – _____

3% irredeemable loan notes 9% loan notes 6% Loan notes Bank loans

1,400 1,500 2,000 1,540 _____

– 1,500 2,000 600 _____

Non-current liabilities

6,440 _____

4,100 _____

All debt interest is payable annually and all the current year’s payments will be made shortly. The cum-interest market prices for $100 nominal value debt are $31.60 and $103.26 for the 3% irredeemable and 9% loan notes respectively. Both the 9% loan notes and the 6% loan notes are redeemable at nominal value in 10 years’ time. The 6% loan note is not traded on the open market but the analyst estimates that its actual pre-tax cost is 10% per year. The bank loans bear interest at 2% above base rate (which is currently 11%) and are repayable in six years. The effective corporation tax rate of Redskins is 30%.

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3

STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4) Answer 1 AGENCY RELATIONSHIPS Agency relationships exist when one or more persons, the principal(s), hire another person, the agent, to perform some task on his (or their) behalf. The principal will delegate some decision-making authority to the agent. The problems of agency relationships occur when there is a conflict of interest between the principal(s) and the agent. (a)

Shareholders and managers



Managers might not work industriously to maximise shareholder wealth if they feel that they will not fairly share in the benefits of their labours.



There might be little incentive for managers to undertake significant creative activities, including looking for profitable new ventures or developing new technology.



Managers might award themselves high salaries or “perks”.



Managers might take a more short-term view of the firm’s performance than the shareholders would wish.

Shareholders and creditors

Creditors (including the lenders of loan finance) provide funds for a company on the basis of the company’s assets, gearing levels and cash flow (both present and anticipated). If the managers take on more risky projects than expected by the creditors, the burden of the extra risk will fall largely upon the creditors. Conversely, if the risky investments were successful, the benefits would accrue to the shareholders.

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

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(b)

E

As the manager’s share of total equity decreases (the divorce of ownership and control) the cost to him of decisions that are not optimal for other shareholders also decreases. Examples of possible conflict include the following:



If gearing is increased, the providers of “old debt” will face a greater risk of the company getting into financial distress or going into liquidation.

To try to ensure that managers act in the best interests of shareholders, the shareholders incur agency costs. Such costs include: (1) (2)

cost of monitoring management actions (e.g. management audit); cost of structuring corporate organisations to minimise undesirable management actions.

If the remuneration of management is partially a function of the success of the firm, then conflict of interest should be reduced. This might involve share option schemes, performance shares (e.g. based on earnings per share) and profit based salaries or bonuses. The threat of firing (including the board being “deposed” by discontented shareholders) is suggested to be an incentive for efficient management, as is the possibility of job loss if a company’s share price through management action is low and a takeover occurs.

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1001

ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK It has been suggested that the nature of the managerial labour market negates much of the agency problem. A manager’s wealth is made up of present wealth plus the present value of future income. The better the manager’s performance, the higher the company’s share price, and the greater the salary, both now and in the future, the manager can obtain. The manager’s desire for wealth maximisation will tend to cause him to act in the shareholders’ interests.

E

The main way in which creditors might protect themselves against conflicts of interest with shareholders is to insist on restrictive covenants being incorporated into loan agreements. Such covenants might restrict the level of additional debt finance that might be raised, or prevent management (here acting on the shareholders’ behalf) from disposing of major tangible assets without the agreement of the providers of debt, or restrict the level of dividends that can be paid. Additionally, if creditors perceive that they are being unfairly treated, they can either refuse to provide further credit, or only agree to provide future credit at higher than normal rates, both of which are likely to have adverse effects on shareholder wealth, and are deterrents to managers acting unfairly against the creditors’ interests. Answer 2 ETHICS

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Non-financial issues, ethical and environmental issues in many cases overlap, and have become of increasing significance to the achievement of primary financial objectives such as the maximisation of shareholder wealth. Most companies have a series of secondary objectives that encompass many of these issues. Traditional non-financial issues affecting companies include: 

Measures that increase the welfare of employees such as the provision of housing, good and safe working conditions, social and recreational facilities.

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These might also relate to managers and encompass generous perquisites. 

Welfare of the local community and society as a whole. This has become of increasing significance, with companies accepting that they have some responsibility beyond their normal stakeholders in that their actions may impact on the environment and the quality of life of third parties.



Provision of, or fulfilment of, a service. Many organisations, both in the public sector and private sector provide a service, for example to remote communities, which would not be provided on purely economic grounds.



Growth of an organisation, which might bring more power, prestige, and a larger market share, but might adversely affect shareholder wealth.



Quality. Many engineering companies have been accused of focusing upon quality rather than cost effective solutions.



Survival. Although to some extent linked to financial objectives, managers might place corporate survival (and hence retaining their jobs) ahead of wealth maximisation. An obvious effect might be to avoid undertaking risky investments.

Ethical issues of companies have been brought increasingly into focus by the actions of Enron and others. There is a trade-off between applying a high standard of ethics and increasing cash flow or maximisation of shareholder wealth. A company might face ethical dilemmas with respect to the amount and accuracy of information it provides to its stakeholders. An ethical issue attracting much attention is the possible payment of excessive remuneration to senior directors, including very large bonuses and “golden parachutes”.

1002

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4) Should bribes be paid to facilitate the company’s long-term aims? Are wages being paid in some countries below subsistence levels? Should they be? Are working conditions of an acceptable standard? Do the company’s activities involve experiments on animals, genetic modifications, etc? Should the company deal with or operate in countries that have a poor record of human rights? What is the impact of the company’s actions on pollution or other aspects of the local environment?

E

Environmental issues might have very direct effects on companies. If natural resources become depleted the company may not be able to sustain its activities, weather and climatic factors can influence the achievement of corporate objectives through their impact on crops, the availability of water etc. Extreme environmental disasters such as typhoons, floods, earthquakes, and volcanic eruptions will also impact on companies’ cash flow, as will obvious environmental considerations such as the location of mountains, deserts, or communications facilities. Should companies develop new technologies that will improve the environment, such as cleaner petrol or alternative fuels? Such developments might not be the cheapest alternative.

PL

Environmental legislation is a major influence in many countries. This includes limitations on where operations may be located and in what form, and regulations regarding waste products, noise and physical pollutants.

All of these issues have received considerable publicity and attention in recent years. Environmental pressure groups are prominent in many countries; companies are now producing social and environmental accounting reports, and/or corporate social responsibility reports. Companies increasingly have multiple objectives that address some or all of these three issues. In the short term non-financial, ethical and environmental issues might result in a reduction in shareholder wealth; in the longer term it is argued that only companies that address these issues will succeed. Answer 3 COST OF CAPITAL Cost of debt (pre-tax)

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(a)

(i)

Annual interest payment $10 = = 10% Issue proceeds (or market price) $100

(ii)

$10  11.76% $85

(iii)

The method is to find the IRR of the following cash flows:

t0 $(74)

t1 $10

t2 $10

t3 $110

By trial and error, NPV of the four cash flows at: 25% 20%

NPV NPV

Therefore: kd

= – $74 + 1.440 × $10 + 0.512 × $110 = – $3.28 = – $74 + 1.528 × $10 + 0.579 × $110 = $4.97 = 20% +

4.97 × (25% – 20%) = 23% 4.97  3.28

(iv)

As redeemable at current market price, then

(v)

Irredeemable,

$10 = 10% $100

$0.05  7.7% $0.65

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1003

ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK (b)

Cost of debt (post-tax)

(i)

10% (1 – 0.35)

(ii)

11.76% (1 – 0.35) = 7.64%

(iii)

The method is to find the IRR of the following cash flows: t0 $(74)

= 6.5%

t1 $6.5

t2 $6.5

t3 $106.5

15%

NPV

= – $74 + 1.626 × $6.5 + 0.658 × $106.5 =

20%

NPV

= – $74 + 1.528 × $6.5 + 0.579 × $106.5 = – $2.405 = 15% +

6.646 × (20% – 15%) = 19% 6.646  2.405

(iv)

10% × (1 – 0.35)

(v)

7.7% (no corporation tax relief on preference share dividend).

Cost of equity

= 6.5%

(i)

ke

=

0.075 × 100 1.50

(ii)

ke

=

0.15 × 100 1.65  0.15

(iii)

ke

=

0.24  (1  0.05) × 100 + 5 1.20

(iv)

ke

=

1 .5 × 100 10

= 5%

SA M (d)

= 10%

= 26%

= 15%

Dividend valuation model

(i)

No growth, hence P0 =

(ii)

D $0.10  50,000 = $50,000 = 0.1 ke

P0

=

$50,000 50,000

= $1.00

No growth, hence P0

=

$500 0.15

= $3,333

Per share

=

$3,333 1,000

= $3.33

Per share

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$6.646

PL

Therefore: kd

(c)

E

By trial and error:

P0

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Constant growth

P0

Per share (iv)

P0

=

D 0 (1  g) (ke  g)

=

$0.10  1m  (1.05) (0.15  0.05)

= $1.05 = PV of future dividends = $0.10 × 10,000 × 3.352 +

$0.10  10,000  (1.05) × 0.497 (0.15  0.05)

= $8,570 Per share ≈ $0.86

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Answer 4 GADDES Possible reasons for upward sloping yield curve 

Future expectations. If future short-term interest rates are expected to increase then the yield curve will be upward sloping.



Liquidity preference. It is argued that investors seek extra return for giving up a degree of liquidity with longer-term investments. Other things being equal, the longer the maturity of the investment, the higher the required return, leading to an upward sloping yield curve.



Preferred habitat/market segmentation. Different investors are more active in different segments of the yield curve. For example banks would tend to focus on the short-term end of the curve, whilst pension funds are likely to be more concerned with medium and long term segments. An upward sloping curve could in part be the result of a fall in demand in the longer term segment of the yield curve leading to lower loan note prices and higher yields.

SA M

(a)

(b)(i)

= $1.05m

E

(iii)

Market price

Current market prices

$100 = $41·73 (1·06)15

(1)

Zero coupon

(2)

12% gilt with a semi-annual coupon PV of an annuity for 30 periods at 3% is

PV of interest payments

1 PV of redemption using (1  0·03)30

1 - (1·03)-30 = 19·6004 0·03 $6 × 19·6004 = $100 × 0·4120 =

$ 117·60 41·20 ——— 158·80 ———

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1005

ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK (a)

If interest rates increase by 1%

(1)

Zero coupon

(2)

12% gilt

$100 = $36·25, a decrease of $5·48 or 13·1% (1·07)15

PV of an annuity for 30 periods at 3·5% is

PV of redemption using

$6 × 18·3920 = 1 (1  0·035)30

$ 110·35

E

PV of interest payments

1 - (1·035)-30 = 18·3920 0·035

$100 × 0·3563 =

35·63

——— 145·98 ———

PL

This is a decrease of $12·82 or 8·1%. (b)

If interest rates decrease by 1%

(1)

Zero coupon

(2)

12% gilt with a semi-annual coupon:

$100 = $48·10, an increase of $6·37 or 15·3% (1·05)15

SA M

PV of an annuity for 30 periods at 2·5% is

PV of interest payments PV of redemption using

1 - (1·025)-30 = 20·9303 0·025 $6 × 20·9303 =

1 (1  0·025)30

$100 × 0·4767 =

$ 125·58 47·67

——— 173·25 ———

This is an increase of $14·45 or 9·1%.

(ii)

Expected price movements

The price/yield relation is not linear; it has a convex shape. There is a bigger absolute movement in loan note prices when interest rates fall than when they rise. The percentage movement is also higher for low coupon loan notes than high coupon loan notes. Other things being equal, a financial manager would prefer to hold high coupon loan notes if interest rates are expected to increase and low or zero coupon loan notes when interest rates are expected to decrease. (iii)

Loan note investment strategy

If interest rates are expected to rise, and the gap between yields on short and long dated loan notes to widen, the financial manager would not want to hold longer dated loan notes as these would suffer a larger fall in price than short dated loan notes. Short dated loan notes, probably with high coupons, would be preferred.

1006

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4) Answer 5 STOCK MARKET EFFICIENCY

The efficient market hypothesis is often considered in terms of three levels of market efficiency: (1) (2) (3)

Weak form efficiency; Semi-strong form efficiency; Strong form efficiency.

E

The accuracy of the statement in the question depends in part upon which form of market efficiency is being considered. The first sentence states that all share prices are correct at all times. If “correct” means that prices reflect true values (the true value being an equilibrium price which incorporates all relevant information that exists at a particular point in time), then strong form efficiency does suggest that prices are always correct. Weak and semi-strong prices are not likely to be correct as they do not fully consider all information (e.g. semi-strong efficiency does not include inside information). It might be argued that even strong form efficiency does not lead to correct prices at all times as, although an efficient market will react quickly to new relevant information, the reaction is not instant and there will be a short period of time when prices are not correct.

PL

The second sentence in the statement suggests that prices move randomly when new information is publicly announced. Share prices do not move randomly when new information is announced. Prices may follow a random walk in that successive price changes are independent of each other. However, prices will move to reflect accurately any new relevant information that is announced, moving up when favourable information is announced, and down with unfavourable information. If strong form efficiency exists, prices might not move at all when new information is publicly announced, as the market will already be aware of the information prior to public announcement and will have already reacted to the information.

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Information from published accounts is only one possible determinant of share price movement. Other include the announcement of investment plans, dividend announcements, government changes in monetary and fiscal policies, inflation levels, exchange rates and many more.

Fundamental and technical analysts play an important role in producing market efficiency. An efficient market requires competition among a large number of analysts to achieve “correct” share prices, and the information disseminated by analysts (through their companies) helps to fulfil one of the requirements of market efficiency (i.e. that information is widely and cheaply available). An efficient market implies that there is no way for investors or analysts to achieve consistently superior rates of return. This does not say that analysts cannot accurately predict future share prices. By pure chance some analysts will accurately predict share prices. However, the implication is that analysts will not be able to do so consistently. The same argument may be used for corporate financial managers. If, however, the market is only semi-strong efficient, then it is possible that financial managers, having inside information, would be able to produce a superior estimate of the future share price of their own companies and that if analysts have access to inside information they could earn superior returns.

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This ACCA Study Question Bank has been reviewed by ACCA's examining team and includes: Question practice for every topic

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Model answers and suggested solutions

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Tutorial notes

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