Episode # 4: Bus Financ Dcis Vs Adv Financial Mgmt

Episode # 4: Bus Financ Dcis Vs Adv Financial Mgmt - Printable Version

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Episode # 4: Bus Financ Dcis Vs Adv Financial Mgmt - Muhammad Amir - 04-20-2008

Episode # 4 CA Module âFâ F-19 âBusiness Finance Decisionsâ Vs ACCA âProfessional Levelâ P-4 âAdvanced Financial Managementâ.

Look at these papers in the perspectives of paper pattern, assessment criteria and marking scheme.

I am comparing winter (December) 2006 paper of âBusiness Finance Decisionsâ with December 2007 paper of âAdvanced Financial Managementâ.

At the end of the topic I will post the differences between paper pattern, assessment criteria and marking schemes of both bodies.

So lets start with CA Module âEâ âBusiness Finance Decisionsâ paper.

Q.1 Following data has been extracted from the published financial statements of
Progressive Limited.

Required

Prepare a brief note containing the following

(a) Computation of 'Free cash flows' of the company along with other inflows. (07)

(b) Brief comments on application of the funds generated from the free cash flows
and other inflows. (07)

(c) Review of retention policy from the shareholders' perspective, for each year
separately. (09)

Q.2 Management of Accurate Limited is interested in evaluating the expected effect of a
recently announced tax rate reduction by the government on its share price and the cost
of capital. The announced tax cut has reduced the tax from 35% to 30%.

The companyâs shares are currently trading at Rs 32 per share ex-dividend, and
debentures at Rs 125 per debenture.
Prior to tax change, the value of companyâs equity beta was 1.2. The market return is
13% p.a. The tax cut is expected to increase the net present value of companyâs
operating cash flows by Rs 150 million.

Required
(a) Estimate the companyâs current cost of capital ACCA F9 Level Question (05)

(b) Using Modigliani & Millerâs theory of capital structure, estimate the following
after the change in tax rate

(i) the expected share price (04)

(ii) the companyâs expected cost of capital (07)
 M&M Theory, And Traditional View and Pecking Order Theory they are ACCA F-9 Level subjects
(c) Explain why a 5% fall in tax rate could not materially affect companyâs cost of
capital? 4 marks for this question are very strange it is certain that if the company has no debt or very few level of debt then it will have no savings of tax as Interest on Debt is Tax allowable expanse and Traditional View says that the additional use of Debt will lower the WACC until the optimum capital Structure is reached but M&M say that the Optimum Capital Structure is 99.9% debt (04)

Q.3 You are the management accountant of a company that is in the process of evaluating a
new investment opportunity. Traditionally, the company has been using the Net
Present Value method for such evaluation, using its cost of capital of 10% as the
discount rate.
You have recently studied the concept of Residual Income and are keen to apply the
methodology at this new project. Following is the data you have collected about this
project

(i) Sales in the first operating years are expected to be Rs 1 million. The sale in
nominal terms is expected to increase by 20% p.a. that includes price increase
of 2% per annum.

(ii) Raw material cost in first year of the operation is expected to be 30% of sales
revenue. The raw material price is subject to an annual increase of 5%.

(iii) The production will require specialized labour. In first operating year, labour
cost is estimated to be 25% of sales revenue. An annual increment rate of 10%
has been agreed with the labour union.

(iv) All other production costs (predominantly fixed) will be Rs 100,000 in todayâs
terms. Any increase in price of such expenses is expected to be matched with
efficiency.

(v) Project life is spanned over five operating years.

(vi) Funding requirement will be Rs 1 million upfront to start the project. The
funding source is not expected to alter the companyâs required rate of return.
The company plans to redeem the combined equity raised for this specific project
along with the cost thereon in five equal installments

Required
Using annuity depreciation as appropriate, compute the residual income expected from
the project, in respect of each of the five years. (09)

Q.4 Fresh Limited is a manufacturer of four products A, B, C and D. While planning for
the coming year, the management is concerned about declining trend in the sales of A
and expected increase of variable cost of B. However, they are confident about the
continuity of the sale of B, C and D.

Required
The management has made the budget with reasonable care. Given the circumstances
the real challenge for the management would be to at least maintain the last yearâs
profitability. Determine which of the following variable is most sensitive when viewed
in relation to the objective of maintaining the level of profitability.
- Volume of product A
- Price of product A
- Variable cost of product B. (14)

Q.5 A company is analysing its short term investment strategy so as to select the
appropriate risk level in relation to investments for the coming year. Return for the
coming year is a function of the level of risk taken by the company in investment
strategy and the performance of market in the year ahead.
For decision making purposes, the level of risk that can be taken has been classified in
discrete categories representing High, Medium or Low level of risk. Similarly the
market performance has also been divided into similar performance achievements i.e.
High, Medium and Low levels of performance.
A schedule has been prepared showing the expected absolute returns in each of the
possible scenarios as follows

Required
(a) Advise the company as to what level of risk it should be willing to take for its
investments in the coming year without hiring the services of analyst, to
maximize expected value? (08)

(b) Assuming that the information generated by the analyst will be perfect, what is
the maximum amount that the company may pay for such services? (04)

Q.6 Prudent Limited imports two major chemicals from USA, which are sold to a limited
number of buyers. Company negotiates the price of the product with the buyers at the
start of every half year.
Historically, US $ is getting stronger against Pak Re. that exposes the company to
exchange rate risk. For many years the company has been hedging all of its forex
transactions by way of forward booking.
You have recently joined the company as finance director and have been assigned to
prepare financial plan for the coming half year starting from January 01, 2007. While
reviewing forex hedging policy, you noticed that other avenues like futures and options
have never been evaluated by the management.
Following information is available with you
- Company plans its imports on half yearly basis.
- The buyers have indicated their requirements at 6,000 kgs. for the coming year.
- The chemical is currently available at US $ 106/kg.
- Supply to buyers is almost evenly divided into months.
- Economic Order Quantity for the chemical is 500kgs.
- Import bills are paid one month after the date of order.
- Rates of interest on Rupee account and on US $ account are 10% and 5% per
annum respectively.

Required
(a) Suggest your preferred hedging choice with justification. (04)

(b) To evaluate your suggestion given in (a) above, the board has requested you to
prepare a comparison of hedging effect in money term through forward, options
and futures assuming that following spot rates will be quoted in the market.
January 01, 07 60.10/$ - 60.50/$
January 31, 07 60.50/$ - 60.75/$
February 28, 07 60.05/$ - 60.20/$
March 31, 07 60.75/$ - 60.90/$(18)

Money Market Hedging, Forward Rate Hedging, Lead and Lag payments are F-9 level topics

(THE END)

So, you have seen this paper and its marking scheme now lets see the criteria of ACCA âProfessional Levelâ P-4 âAdvanced Financial Managementâ paper.

- Muhammad Amir - 04-20-2008

Again it is almost impossible for me to post full paper of ACCA P4 Advanced Financial Management, I am only posting Question Requirements because every scenario is having 2 to 3 pages plus lots of tabular information that canât be posted in forum because of incapability of this forum.

Section A â BOTH questions are compulsory and MUST be attempted
1 You are the chief financial officer of International Enterprises, a multinational company with interests in Europe and the Far East. You are concerned about certain aspects of the companyâs financial management. The company has enjoyed a high rate of growth over the last three years as a result of a single productâs development. This product has had a big impact in the fast moving mobile communications industry. However, the company does not have any new
products in development and is relying on expanding its market share and developing upgraded versions of the current product.

As part of your preparation for the board meeting to discuss the 2007 draft accounts, you have prepared a projected income statement and balance sheet for the year ending 31 December 2008. These projections are based upon a number of agreed assumptions taken from the companyâs strategic plan. As part of the agenda, the board will also consider its dividend target for the forthcoming year.

International Enterprises The projected figures assume

(i) $10 million of the existing loans will be repaid during the year.

(ii) Capital investment in plant and equipment of $80 million will be undertaken.

The company is quoted on an international stock exchange and its beta value (based upon three years of monthly return data) is 1Â·40. The current risk free rate is 3% and the equity risk premium is 5%. The current share price is $16Â·20 and the sector price/earnings ratio is 24. The companyâs cost of debt capital remains at its current rate of 5%. You may assume that the current cost of equity capital remains unchanged over the term of the projection.

Required
(a) Prepare a cash flow forecast for the year ended 31 December 2008.
Note the format does not need to comply with accounting standards. (6 marks)

(b) Estimate the companyâs maximum dividend capacity after the target level of capital reinvestment is undertaken and making any working capital adjustments you deem necessary. (6 marks)

(c) Draft a brief report for senior management reviewing the potential performance of the business in the year ended 31 December 2008 if the expectations contained within the strategic plan are fulfilled. You should use the Economic Value Added (EVAâ¢) and any other performance measures you think appropriate.

Note requirement (c) includes 2 professional marks. (18 marks)

(30 marks)

2 Burcolene is a large European-based petrochemical manufacturer, with a wide range of basic bulk chemicals in its product range and with strong markets in Europe and the Pacific region. In recent years, margins have fallen as a result of competition from China and, more importantly, Eastern European countries that have favourable access to the Russian petrochemical industry. However, the company has managed to sustain a 5% growth rate in earnings through aggressive management of its cost base, the management of its risk and careful attention to its value base.

As part of its strategic development, Burcolene is considering a leveraged (debt-financed) acquisition of PetroFrancais, a large petrochemical business that has engaged in a number of high quality alliances with oil drilling and extraction companies in the newly opened Russian Arctic fields. However, the growth of the company has not been particularly strong in recent years, although Burcolene believes that an expected long term growth of 4% per annum is realistic under its current management.

Preliminary discussions with its banks have led Burcolene to the conclusion that an acquisition of 100% of the equity of PetroFrancais, financed via a bond issue, would not have a significant impact upon the companyâs existing credit rating. The key issues, according to the companyâs advisors, are the terms of the deal and the likely effect of the acquisition on the companyâs value and its financial leverage.

Both companies are quoted on an international stock exchange and below are relevant data relating to each company

Financial data as at 30 November 2007

The global equity risk premium is 4Â·0% and the most appropriate risk free rate derived from the returns on government stock is 3Â·0%.

Burcolene has a share option scheme as part of its executive remuneration package. In accordance with the accounting standards, the company has expensed its share options at fair value. The share options held by the employees of Burcolene were granted on 1 January 2004. The vesting date is 30 November 2009 and the exercise date is 30 November 2010. Currently, the company has a 5% attrition rate as members leave the company and, of those remaining at the vesting date, 20% are expected not to have achieved the standard of performance required.
Your estimate is that the options have a time value of $7Â·31.

PetroFrancais operates a defined benefits pension scheme which, at its current actuarial valuation, shows a deficit of $430 million.

You have been appointed to advise the senior management team of Burcolene on the validity of the free cash flow to equity model as a basis for valuing both firms and on the financial implications of this acquisition for Burcolene.

Following your initial discussions with management, you decide that the following points are relevant

1. The free cash flow to all classes of capital invested can be reliably approximated as net operating profit after tax (NOPAT) less net reinvestment.

2. Given the rumours in the market concerning a potential acquisition, the existing market valuations may not fully reflect each companyâs value.

3. The acquisition would be financed by a new debt issue by Burcolene.

Required

(a) Estimate the weighted average cost of capital and the current entity value for each business, taking into account the impact of the share option scheme and the pension fund deficit on the value of each company. (16 marks)

(b) Write a briefing paper for management, advising them on

(i) The validity of the free cash flow model, given the growth rate assumptions made by management for both firms;

(ii) The most appropriate method of deriving a bid price; and

(iii) The implications of an acquisition such as this for Burcoleneâs gearing and cost of capital.

Note requirement (b) includes 2 professional marks. (14 marks)

(30 marks)

Section B â TWO questions ONLY to be attempted
3 Digunder, a property development company, has gained planning permission for the development of a housing complex at Newtown which will be developed over a three year period. The resulting property sales less building costs have an expected net present value of $4 million at a cost of capital of 10% per annum. Digunder has an option to acquire the land in Newtown, at an agreed price of $24 million, which must be exercised within the next two years.

Immediate building of the housing complex would be risky as the project has a volatility attaching to its net present value of 25%. One source of risk is the potential for development of Newtown as a regional commercial centre for the large number of professional firms leaving the capital, Bigcity, because of high rents and local business taxes. Within the next two years, an announcement by the government will be made about the development of transport links into Newtown from outlying districts including the area where Digunder hold the land option concerned. The risk free rate of interest is 5% per annum.

Required
(a) Estimate the value of the option to delay the start of the project for two years using the Black and Scholes option pricing model and comment upon your findings. Assume that the government will make its announcement about the potential transport link at the end of the two-year period. (12 marks)

(b) On the basis of your valuation of the option to delay, estimate the overall value of the project, giving a concise rationale for the valuation method you have used. (4 marks)

(c) Describe the limitations of the valuation method you used in (a) above and describe how you would value the option if the government were to make the announcement at ANY time over the next two years. (4 marks)

(20 marks)

4 The chairman of your company has become concerned about the accumulation of cash in hand and in the deposit accounts shown in the companyâs balance sheet. The company is in the manufacturing sector, supplying aerospace components to the civil aviation markets in the UK and Europe. For the last 20 years the company has grown predominantly by acquisition and has not invested significantly in research and development on its own account. The acquisitions have given the company the technology that it has required and have all tended to be small, relative to
the companyâs total market capitalisation. The company has a healthy current asset ratio of 1Â·3, although its working capital cycle has an average of 24 unfunded days. The company has not systematically embraced new manufacturing technologies nor has it sought to reduce costs as a way of rebuilding profitability. Managerial and structural problems within divisions have led to a number of substantial projects overrunning and losses being incurred as a result. It has also proven difficult to ensure the accountability of managers promoting projects â many of which have not subsequently earned the cash flows originally promised. At the corporate level, much of the companyâs accounting is on a contracts basis and over the years it has tended to be cautious in its revenue recognition practices. This has meant that earnings growth has lagged behind cash flow.

Over the last 12 months the company has come under strong competitive pressure on the dominant defence side of its business which, coupled with the slow-down in spending in this area across the major western economies, has slowed the rate of growth of its earnings. The companyâs gearing ratio is very low at 12% of total market capitalization and borrowing has invariably been obtained in the European fixed interest market and used to support capital
investment in its European production facility. In the current year, investment plans are at the lowest they have been in real terms since the company was founded in the 1930s.
In discussion, the chairman comments upon the poor nature of the companyâs buildings and its poor levels of pay which could, in his view, be improved to reflect standards across the industry. Directorsâ pay, he reminds you, is some 15% below industry benchmarks and there is very little equity participation by the board of directors. He also points out that the companyâs environmental performance has not been good. Last year the company was fined for an untreated discharge into a local river. There are, he says, many useful things the company could do with the money
to help improve the long-term health of the business. However, he does admit some pessimism that business opportunities will ever again be the same as in previous years and he would like a free and frank discussion at the next board meeting about the options for the company. The company has a very open culture where ideas are encouraged and freely debated.

The chairman asks if you, as the newly appointed chief financial officer, would lead the discussion at the next board.

Required
(a) In preparation for a board paper entitled âAgenda for Changeâ, write brief notes which
identify the strategic financial issues the company faces and the alternatives it might pursue. (10 marks)

(b) Identify and discuss any ethical issues you believe are in the above case and how the various alternatives you have identified in (a) may lead to their resolution. (10 marks)
(20 marks)

5 Your company, which is in the airline business, is considering raising new capital of $400 million in the bond market for the acquisition of new aircraft. The debt would have a term to maturity of four years. The market capitalisation of the companyâs equity is $1Â·2 billion and it has a 25% market gearing ratio (market value of debt to total market value of the company). This new issue would be ranked for payment, in the event of default, equally with the companyâs other long-term debt and the latest credit risk assessment places the company at AA. Interest would be paid to holders annually. The companyâs current debt carries an average coupon of 4% and has three years to maturity. The companyâs effective rate of tax is 30%.

The current yield curve suggests that, at three years, government treasuries yield 3Â·5% and at four years they yield 5Â·1%. The current credit risk spread is estimated to be 50 basis points at AA. If the issue proceeds, the companyâs investment bankers suggest that a 90 basis point spread will need to be offered to guarantee take up by its institutional clients.

Required

(a) Advise on the coupon rate that should be applied to the new debt issue to ensure that it is fully subscribed. (4 marks)

(b) Estimate the current and revised market valuation of the companyâs debt and the increase in the companyâs effective cost of debt capital. (8 marks)

(c) Discuss the relative advantages and disadvantages of this mode of capital financing in the context of the companyâs financial objectives. (8 marks)

(20 marks)

- Muhammad Amir - 04-20-2008

Paper P4 is again much more than BFD(Although we can compare BFD's Curriculum and paper pattern in comparison to ACCA's F9),

ACCA F9(Fundmental Level) course include, Capital Budgeting(Capital Investment Appraisal), Working Capital Management, Business Valuation, Capital Asset Pricing Model(CAPM), Cost Of Capital(Including WACC, M&M Theory and so on), Capiatal Structure, Econimic Environment, Risk Management(Both Currency Rate Risk And Interest Rate Risk Hedging including, GAP Analysis of Fixed Rate Interest With Floating Rate Interest, Interest Rate Parity Theory, Purchasing Power Parity Theory, Options, SWAPS, Forwards, Futures, Money Market Hedging Technique, and many more)!!!!!!!