ACCA

Financial Management (FM)

Final Mock – December 2018

Marking scheme and suggested

solutions
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Section A
1 B The clientele theory does not assume that shareholders require a consistent dividend payment.
If dividends are fluctuating because investment is being prioritised over the payment of
dividends this can attract a type of shareholder (clientele) who prefers this policy.
Modigliani and Miller stated that shareholders are indifferent between capital gains and
dividends.
A cash dividend may involve debt being taken on to pay the dividend, however a scrip dividend
is a dividend paid in shares and so will not involve any new borrowing.
2 A Treasury bills are discount instruments.
3 A Keeping dividend cover above a certain level is a control to make sure that dividend payments
are not too high. EPS does not take account of risk, it is only a measure of profit.
Staff turnover is a numerical objective but it is not financial.
4 B Revenue per year = 450,000/5 = 90,000
Variable cost per year = 200,000/5 = 40,000
Contribution per year = 90,000 – 40,000 = 50,000
Present value of contribution = 50,000  3.605 = 180,250
Where 3.605 is the annuity factor over five years at 12%
Sensitivity to number of units sold = NPV of project/PV of contribution
= ($160,000/$180,250))  100%
= 88.77%
If you calculate 49% you have used the present value of sales revenue in the above
calculation. Remember that 'units sold' affects variable cost as well as revenue so contribution
should be used as the basis for this sensitivity calculation as shown above.
The other answers can be obtained by misreading the question and thinking that the numbers
given are in already in present value terms.
5 B Increasing credit limits to customers will lengthen the working capital cycle.
Inventory will fall if raw materials are ordered when they are needed, this will increase
inventory turnover (cost of sales/inventory) and this in turn will decrease the working capital
cycle.
The working capital cycle will also fall if more time is taken to pay creditors (because this
means that creditor days will increase).
6 D Total operating cash flow = 23,200 over five years
Total depreciation = 20,000 – 4,000 = 16,000
Total Profit = 23,200 – 16,000 = 7,200
Average annual profit = 7,200/five years = 1,440
Average investment = (20,000 + 4,000)/2 = 12,000
ARR = 1,440/12,000  100% = 12%
You may have calculated the answer as 38.7% if you have forgotten to deduct depreciation.
The other answers are possible if you have used the initial investment of 20,000 instead of the
average investment.

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7 A (4,000 – 400 – 170 – 300)/10,000 = 0.31
Earnings measure the maximum ordinary dividend that could be paid out of the current years'
profits. This is profits after interest, tax and preference dividend. If you chose 0.29 you have
incorrectly taken off the ordinary dividend.
8 D It depends on the current level of gearing. According to traditional theory, an increase in
financial gearing can either increase or decrease the WACC, depending on the level of existing
gearing.
9 C Share option schemes will reward managers if the share price is high, this may be the result of
changes in the economy as opposed to good performance. Also, share option schemes will not
reward managers if the share price is low, again this may be the result of changes in the
economy as opposed to poor performance.
10 A Using the dividend valuation model
D0 (1 g)
P0 
re  g

0.20(1  0.02)
P0 
0.08   0.02

= $1.96
11 D All of these are investing a third party's money so they are intermediaries.
12 B Statement 2 defines allocative efficiency.
13 C (4 + 1)  $2.80 = $14.00
4  $3 = $12.00
Offer price $2.00
Finance raised = $2.00  (10m/4) = $5,000,000
14 A $107  0.926 = $99.08
15 C Business angel financing is provided by wealthy individuals willing to risk their own personal
wealth in new business ventures.

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Section B
16 B Current average collections period = 30 + 15 = 45 days
Current accounts receivable = M$15m  45/360 = M$1,875,000
Average collection period under new policy = (40%  10 days) + (60%  60 days) = 40 days
New level of credit sales = M$15m  1.04 = M$15.6m
Accounts receivable after policy change = M$15.6m  40/360 = M$1,733,333
Decrease in financing cost = M$(1,875,000 – 1,733,333)  6% = M$8,500
A change of $8,384 is calculated if you use a 365 day year ie
Current accounts receivable = M$15m  45/365 = M$1,849,315
Accounts receivable after policy change = M$15.6m  40/365 = M$1,709,589
Decrease in financing cost = M$(1,849,315 – 1,709,589)  6% = M$8,384
17 A
M$
Costs
Incremental costs ($15.6m  0.0025) 39,000
Cost of discount (40%  $15.6m  2%) 124,800
Increase in costs 163,800

The incorrect answers are obtained either by forgetting that 0.25% = 0.0025 or by forgetting
that only 40% of customers are expected to take the discount.
18 B An exact calculation is not required, but is shown below. The size of the increase in
contribution outweighs all of the other effects.
M$
Costs
Increase in costs 163,800
Benefits
Decrease in financing costs 8,500
Contribution from increased sales ($15m  4%  65%) 390,000
398,500
Net benefit of policy change 234,700

The proposed policy will therefore increase the profitability of MJG Co.
19 C A letter of contract would mean that the contract was with the bank of the customer, and they
will be obliged to make a payment once delivery has taken place.
A non-recourse debt factor removes the risk of bad debts, but a with-recourse factor does not.
A bill of exchange is acknowledgement that money is owed, but it does not offer any guarantee
of payment.
A certificate of deposit does not relate to export trade.
20 D A favourable movement would be a fall in the value of the M$.
A contractionary fiscal policy may depress demand in country M and may make exporting
more attractive but has no direct impact on the exchange rate.
An increase in real interest rates (i.e. interest rates after adjusting for inflation) will raise
demand from overseas investors for the M$ and increase its price ie its exchange rate.

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 A tightening of health and safety legislation would have no impact on the exchange rates or on
exports.
An increase in the money supply could decrease the price of the M$ (an increase in the supply
of anything generally reduces its price).
21 C The forward rate offered to JKL will allow it to buy C$ at 1.2362 + 0.0028 = 1.2390
This rate is agreed today for exchange in three months, converting to 2,350,000/1.2390
= C$1,896,691
The other answers result from either using 1.2362 – 0.0028 = 1.2334, and/or multiplying by the
exchange rate to convert from euros to C$.
22 A JKL needs to borrow now in euros to match the euro receipts it will receive.
Interest rates are quoted annually, so the three month interest rate in Europe is 1.2%/4 = 0.3%
(ie 0.003 as a number) and the three month interest rate in Country C is 2.2%/4 = 0.55%
(ie 0.0055).
2,350,000
Amount to be borrowed = = €2,342,971
1  0.003

Current spot = 1.2358 + 0.0004 = 1.2362

2,342,971
Converting at spot rate = C$1,895,301
1.2362
Investment proceeds =1,895,301  (1 + 0.0055)
= C$1,905,725
23 B A futures contract can be closed out at any time up to its maturity date, whereas a forward is
valid for a specific date. It is therefore easier to cope with late payment if a futures contract is
used.
An increase in the value of the C$ would be bad news for an exporter, and anyway it is an
option not a future that can give the flexibility of using a favourable exchange rate.
Futures are more complex than forwards, and a standard contract size is a disadvantage
because it means that JKL could not get exactly the cover that it is looking for.
A contract to buy could potentially result in a better outcome than a forward, however JKL will
want a contract to sell euros so this is not a relevant point here.
24 C An exchange traded options contract can be closed out at any time up to its maturity date,
whereas a forward is valid for a specific date. It is therefore easier to cope with late payment if
an exchange-traded options contract is used.
An fall in the value of the C$ would be good news for JKL, and an option gives the flexibility of
using a favourable exchange rate. The type of option that would be used here is an option to
sell euros (a put option).
The problem with options is that they are expensive – but forwards normally have no up-front
costs.
25 A Importers find it cheaper to import if their own currency is strong.
26 B JEH is in the same business as Predator (it is a rival) but has higher gearing. So the P/E ratio
takes some account of business risk but not of financial risk.
The third statement would be correct if it referred to overvaluing JEH since an unlisted
company would not be worth as much as an equivalent listed company (especially if its
financial gearing was higher as is the case here).

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27 D Number of JEH shares = $15m/0.5 = 30m
Operating profits are before interest and tax
Interest = 0.09  50 = 4.5
So profits before tax = 38.25 – 4.5 = $33.75m
Tax is 20% so profits after tax = $33.75m – (0.2  33.75) = $27m
So EPS = $27m/30m = 0.9
So share price = P/E  eps = 7  0.9 = $6.3
Alternative (incorrect) answers:
Using 15 million shares (which ignores the nominal value of $0.50) gives an eps of 1.8 and a
share price of 7  1.8 = $12.6m
Ignoring interest gives post tax profits of $30.6 and an eps of $1.02 and a share price of
7  1.02 = $7.14
Ignoring interest and tax gives an eps of $1.275 and a share price of 7  1.275 = $8.93
28 C Dividend payout = 1 – 0.55 = 0.45 or 45%
Dividend per share of JEH = EPS  0.45 = 90c  45% = 40.5c
D0 (1 g)
P0 
Ke  g

0.405  (1  0.045)
Value of shares =
0.15  0.045

= $4.03
29 C The P/E ratio reflects the market's appraisal of the share's future growth prospects and risk. If
it is higher then either growth prospects are higher or risk is lower.
30 D Only Modigliani & Miller theory with tax always recommends the use of debt finance to fund
investments.

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Section C

31 NMG Co
Marking scheme
Marks
(a) Cost of equity calculation 2
Cost of debt calculation 3
Market value of equity 1
Market value of debt 1
WACC calculation 2
9
(b) Relationship between risk and return 3
Specific examples for this company 5 8
(c) How conventional finance providers make profit 1
This is forbidden under Sharia law 1
Risks & rewards should be shared between provider & client 1
3
20

Suggested solution
(a) Cost of equity
Using the CAPM: E(ri) = Rf + i (E(rm) – Rf)
E(ri) = 2% + 1.3(8% – 2%)
= 9.8%
Cost of debt (1) – bonds
After-tax interest payment = 100  7%  (1 – 30%) = $4.90
10% 5%
discount discount
Year Cash flow factors PV factors PV
$m $m $m
0 Market value (92.60) 1.000 (92.60) 1.000 (92.60)
1–7 Interest 4.90 4.868 23.85 5.786 28.35
7 Capital repayment 100.00 0.513 51.30 0.711 71.10
(17.45) 6.85
Calculate the cost of debt using an IRR calculation.

 NPVa 
IRR = a%    (b – a)%
 NPVa – NPVb 

6.85 (10%  5%)

= 5% +
6.85  17.45
= 6.4% The after tax cost of debt is therefore 6.4%

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 Number of shares issued by NMG Co
= $40m/0.5 = 80 million shares
Cost of debt (2) – bank loan
This costs 8% pre-tax
Value of equity
Ve = 0.5357  7  80 million
= $300m
Value of debt
Vd = 35 million  92.6/100
= $32.41 (bonds)
Vd = $17.59m (loan)
Ve + Vd = 300 + 32.41 + 17.59 = $350m

 Ve   Vd 
WACC =   ke +   kd (1 – t)
 Ve + Vd   Ve + Vd 

 300   32.41   17.59 

=   9.8 +   6.4 +   8 (1 – 0.3)
 350   350   350 
= 8.40% + 0.59% + 0.28% = 9.27%
(b) Risk and return
Investors will require a higher return to compensate for risk.
Ordinary shareholders will expect the highest return. Ordinary shares are the last to be paid in
the event of a company going into liquidation, and there is also no guarantee that dividends
will be paid.
The holders of debt often have security pledged for the loan and also are entitled to receive a
regular interest payment.
For this reason the cost of equity will be higher than the cost of debt.
This is confirmed by the data from part (a) where Ke is 9.8% which is higher than either type
of debt.
Another reason the cost of debt is lower is that debt attracts tax relief, here at a rate of 30%.
This will reduce the cost of debt by approximately 30% and this is another significant reason
why the cost of debt for NMG is lower than the cost of equity.
We can also see that the cost of debt is different for a bank loan and a bond.
Bonds will often be cheaper than bank loans because they are easier for the investor to sell on.
However here the cost of the bank loan is below the cost of the bond (5.6% compared to
6.4%).
This can be explained by two factors:
1 The longer time period until the bonds mature which exposes the bond holders to extra
risk.
2 The better quality of security on the bank loan which is secured by a fixed charge on
NMG's property.

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 (c) Conventional finance providers make a profit based upon the lower interest they pay on
customer deposits and the higher interest they charge on money loaned out to customers.
Making profits from lending alone and charging of interest is forbidden under Sharia's law.
Islamic finance transactions are based upon the concept of sharing risk and rewards between
the investor and user of the funds. Wealth should be generated via trade or investments. The
Islamic finance provider's profitability is therefore closely tied to that of the client.

32 Duo Co
Marking scheme
(a) Marks
Annual contribution 2
Fixed costs 1
Taxation 1
TAD tax benefits 3
Scrap value 1
Discount factors 1
Net present value 1
Comment 1
Maximum 10

(b)
Internal rate of return calculation 2
Comment 1
Maximum 3

(c) Risk and uncertainty 2–3

Discussion and sensitivity analysis 2–3
Discussion and probability analysis 2–3
Maximum 7
20

(a) Calculation of NPV

1 2 3 4 5
$'000 $'000 $'000 $'000 $'000
Contribution (W1) 440 550 660 660
Fixed costs (240) (260) (280) (300)
Net cash flow 200 290 380 360
Taxation (60) (87) (114) (108)
Tax saved from
tax-allowable
depreciation (W2) 60 45 34 92
Scrap value 30
After-tax cash flow 200 290 338 310 (16)
Discount factor @10% 0.909 0.826 0.751 0.683 0.621
Present values 182 240 254 212 (10)

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 $'000
PV of benefits 878
Investment 800
NPV 78

Workings
1
Year 1 2 3 4
Additional demand (kg) 400,000 500,000 600,000 700,000
Output of new machine 400,000 500,000 600,000 600,000
Contribution per kg (8 – 5 – 1.9) 1.10 1.10 1.10 1.10
Contribution per year 440,000 550,000 660,000 660,000
2 Tax allowable depreciation Tax benefits
Year $ Year $
1 800,000  0.25 = 200,000 2 200,000  0.3 = 60,000
2 200,000  0.75 = 150,000 3 150,000  0.3 = 45,000
3 150,000  0.75 = 112,500 4 112,500  0.3 = 33,750
462,500
Scrap value 30,000
492,500
4 By difference 307,500 5 307,500  0.3 = 92,250
800,000

The acceptability of the proposed purchase

The net present value is positive so the proposed purchase is financially acceptable.
(b) Internal rate of return
1 2 3 4 5
$'000 $'000 $'000 $'000 $'000
After-tax cash flow 200 338 310 (16)
290
Discount factor @15% 0.870 0.756 0.658 0.572 0.497
Present values 174 219 222 177 (8)

$
PV of benefits 784
Investment 800
NPV (16)

 NPVa  
IRR  a +    (b  a)  %
 
  NPVa  NPVb  
where a = 10%
b = 15%
NPVa = 78
NPVb = (16)

 78  
IRR  10     15  10
 78  16  
 10 + 4.15
 14.2%

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 The acceptability of the proposed purchase
The internal rate of return is approximately 14% which is greater than the 10% weighted
average cost of capital used for investment appraisal by Duo Co. This means that the project is
financially acceptable using the IRR criteria.
(c) Risk and uncertainty
Risk can be applied to a situation where there are several possible outcomes and, on the basis
of past relevant experience, probabilities can be assigned to the various outcomes that could
prevail. The risk of a project increases as the variability of returns increases.
Uncertainty can be applied to a situation where there are several possible outcomes but there
is little past relevant experience to enable the probability of the possible outcomes to be
predicted. Uncertainty increases as the project life increases.
Sensitivity analysis
The basic approach of sensitivity analysis is to calculate the project's net present value
(NPV) under alternative assumptions to determine how sensitive it is to changing conditions.
An indication is thus provided of those variables to which the NPV is most sensitive (critical
variables) and the extent to which those variables may change before the investment results
in a negative NPV.
Sensitivity analysis therefore provides an indication of why a project might fail. Management
should review critical variables to assess whether or not there is a strong possibility of events
occurring which will lead to a negative NPV. Management should also pay particular attention
to controlling those variables to which the NPV is particularly sensitive, once the decision has
been taken to accept the investment.
Weaknesses of sensitivity analysis
The method requires that changes in each key variable are isolated. However management is
more interested in the combination of the effects of changes in two or more key variables and
looking at factors in isolation is unrealistic since they are often interdependent.
Sensitivity analysis does not examine the probability that any particular variation in costs or
revenues might occur and critical factors may be those over which managers have no control.
Probability analysis
A probability distribution of 'expected cash flows' can often be estimated, recognising there
are several possible outcomes, not just one. An expected value of NPV can be calculated and
risk measured by calculating the worst possible outcome and its probability and/or the
probability that the project will fail to achieve a positive NPV.
Weaknesses of probability analysis
An investment may be one-off, and 'expected' NPV may never actually occur. Also, assigning
probabilities to events is highly subjective.

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