Paper F9 - June 2015

OpenTuitions
suggested answers
Please note:

They are only suggested answers - the official ACCA answers will not
be published until closer to the results day. These answers are not
guaranteed to be 100% correct (although I certainly guarantee that they
would score very high marks :-) )
Answers to the written parts of the questions are not intended to be full
answers but an indication of the sort of points that could be mentioned
I have set out my calculations the way I find the easiest, however if you
set them out in a different way then that is no problem (provided,
obviously, that they are clear for the marker to follow) - marks are for
each part of the workings rather than for the final answer.

Apologies if I have made any errors (especially typing mistakes) - do let

me know in the Ask the Tutor Forum if I have :-)

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ACCA F9
June 2015 Answers Section A
1!

2!

3!

4!

5!

6!

7!

8!

9!

10!

11!

12!

13!

14!

15!

16!

17!

18!

19!

20!

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Section B
Question 1
(a)

Using the forward market, the receipt in 6 months time will be fixed at:
750,000 / 2.412 = $310,945

Using a money market hedge:

- Borrow for 6 months at 4% (6/12 x 8%)
750,000 / 1.04 =

721,154

- Convert at spot
721,154 / 2.349 =

$307,005

- Deposit for 6 months at 1% (6/12 x 2%)

307,005 x 1.01 =

$310,075

Therefore the receipt in 6 months time is fixed at $310,075

The forward market is recommended because it gives a larger receipt (subject to

bank charges, which have been ignored).

(b)

A forward rate agreement (FRA) is the fixing of an interest rate for a loan of a fixed amount,
for a fixed term, starting on a fixed future date.
When the loan starts, the company will pay whatever interest rate is being quoted on that
date, but they will then settle with the provider of the FRA such that the resultant net
interest is fixed at the agreed rate.
A company can use FRAs as a way of protecting themselves against changes in the
interest rates both between now and the date on which the loan starts, and during the
period of the loan.
Note that the question asked for both an explanation of FRAs, and for a discussion of how
an FRA could be used.

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Section B
Question 2

(a)

Current dividend = 41.4% x $13.84M = $5.72976M

Current retention rate = 100 - 41.4 = 58.6%
Therefore estimate of future growth = Re x b = 12.5% x 58.6% = 7.325%
Using the dividend valuation formula,
Market value = (5.72976M x 1.07325) / (0.125 - 0.07325) = $118,830,240

Note:

(i)
(ii)

(b)

It would be OK to calculate the market value per share, and then

multiply by the number of shares
Although the future expected growth rate is what is needed for the
dividend valuation model, I would expect that the examiner will give
full marks if the past growth rate had been used instead.

Current earnings = $13.84M

Therefore equity market value = $13.84M / 8.2% = $168,780,488

(c)

Theoretically, the market value is be the present value of future expected dividends
discounted at the shareholders required rate of return, and this is what the dividend growth
model is calculating.
However, the problem is knowing what growth rate shareholders are expecting, and the
assumption that they are expecting it to be a constant growth rate.
The earnings yield method (similar to the PE ratio method) is more practical in that the
information is readily available.
However it does assume that similar listed companies are similar in all respects - in
particular with regard to their future growth potential.

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Section B
Question 3
(a)

Depending on what material you studied from, there are two alternative approaches - both
of which give the same net benefit and are therefore both acceptable
This question was almost identical to one that the same examiner set many years ago
(which is why it appears in the Revision/Exam Kits :-) )

Approach 1:
Benefits per year of using the factor:

Saved administration costs

50,000

Saved bad debts

(70% x 1% x $26.75M)

187,250

Saved interest:
Current receivables
4,458,000
New receivables (W1) 520,139
Saving:

5% x 3,937,861 =

Total benefits:

196,893

434,143 per year

Costs per year of using the factor:

Annual fee
(0.75% x $26.75M)

200,625

Factors interest charge

(7% x 80% x $26.75M x 35/360)

145,639

W1

Total costs:

346,264 per year

Net benefit:

$87,879 per year

80% of receivables will be received immediately from the factor.

The remaining 20% will take 35 days. So average overall collection period
is 20% x 35 days = 7 days. 7/360 x $26.75M = $520,139

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Approach 2:
Benefits per year of using the factor:

Saved administration costs

50,000

Saved bad debts

(70% x 1% x $26.75M)

187,250

Saved interest:
Current receivables
New receivables
(35/360 x $26.75M)
Saving:

4,458,000
2,600,694

5% x 1,857,306 =

Total benefits:

92,865

$330,115 per year

Costs per year of using the factor:

Annual fee
(0.75% x $26.75M)

200,625

Factors additional interest charge

(2% x 80% x $26.75M x 35/360)

41,611

Total costs:

242,236 per year

Net benefit:

$87,879 per year

Whichever approach you used , since there is a net benefit the company should employ
the factor.

(b)

Points that could be mentioned include:

- checking with credit agencies
- asking for references from other suppliers used by the customers
- asking for references from their bank
- examination of their financial statements

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Section B
Question 4

(a)

The current wealth of the shareholders = 20M shares x $3.50 = $70M

The current PE ratio = total market value / total earnings = 70M / 8.4M = 8.3333

The loan notes will be repaid at a cost of $104 x 1.05 = $109.20 per $100 nominal
Therefore nominal value of loan notes repaid = $11.2M x 100/109.20 = $10.25641M
So interest saved (after tax relief) = 8% x $10.25641M x 70% = $574,359 per year
Therefore new total earnings will be 8,400,000 + 574,358 = $8,974,358 per year
Given that the PE ratio is to remain as before at 8.3333,
the new total market value will equal:
8.3333 x $8,974,358 = $74,786,018

Therefore the wealth of the shareholders will increase by:

74,786,018 - 70,000,000 = $4,786,018

(b)

Modigliani and Miller proved that in the absence of tax then there is no optimal capital
structure and that the cost of capital and total market value of a business is independent of
the level of gearing.
They further proved that when there is corporation tax (as in the case of Grenarp) that a
company should be as highly geared as possible. Although more gearing makes things
more risky for the shareholders, this is more than compensated for by the tax relief on the
interest payable.
As a result, with higher gearing, the cost of capital will be reduced and the total market
value increased.
Although Modigliani and Miller made various assumptions that may not hold perfectly true
in real life, it is therefore extremely unlikely that by making a rights issue and repaying the
loan notes (and therefore reducing their gearing) that Grenarp would achieve its optimal
capital structure. It is more likely to be the reverse!

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Section B
Question 5

(a)

There are several ways of dealing with the uncertainty regarding the future economic
states. The solution can be calculated using the expected selling price per unit (as in the
answer below). Alternatively, the NPV can be calculated three times - using each selling
price - and then an expected NPV calculated. Or, alternatively, the present value of the
revenue can be calculated three times - using each selling price - then an expected present
value of the revenue could be combined with the present value of the other flows.
All three approaches would result in the same final expected NPV (and would deserve full
marks), but the approach below is by far the quickest!
Appreciate that whatever approach is taken, the question specifically required the expected
NPV.
The question asked for the expected NPV only. If you did three separate NPVs then fine provided you then wrote down the expected NPV. However there was no requirement to do
all of that which would obviously have taken a lot more time.

Workings:
Expected selling price (at current prices) = (35% x $25) + (50% x $30) + (15% x $35)
= $29 per unit

Nominal revenue cash flows each year:

Year 1:
Year 2:
Year 3:
Year 4:

150,000 units x $29 x 1.04

250,000 units x $29 x (1.04)2
400,000 units x $29 x (1.04)3
300,000 units x $29 x (1.04)4

=
=
=
=

$4,524,000
$7,841,600
$13,048,422
$10,177,769

Capital allowances:
First 3 years: $5M / 4 = $1,250,000 per year
Fourth year:
Tax written down value = 5,000,000 - (3 x 1,250,000) = 1,250,000
Therefore balancing allowance = 1,250,000 - 500,000 = 750,000

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All figures in $000s

4,524

7,842

13,048

10,178

(2,385)

(4,200)

(7,080)

(5,730)

Overheads

(440)

(484)

(532)

(586)

Net operating flow

1,699

3,158

5,436

3,862

Tax on operating flow at 30%

(510)

(947)

(1,631)

(1,159)

Revenue
Variable cost

Initial cost

(5,000)

Scrap value

500

Tax saving on capital allowances

Net cash flow
d.f. at 11%
Present values

375

375

375

225

(5,000)

1,564

2,586

4,180

3,428

0.901

0.812

0.731

0.659

(5,000)

1,409

2,100

3,056

2,259

Expected Net Present Value: $3,824,000

The expected net present value is positive and therefore the project is financially
acceptable.
However, this is subject, as always, to the accuracy of the cash flow estimates (especially
the inflation rates), and in particular to the fact that the future economic state will result in
one of three selling prices (and therefore one of three revenue streams and one of three net
present values - the expected revenues will not actually occur). This means that the actual
NPV will not equal the expected NPV as calculated and may be higher (if the economic
state is strong or medium) or may be lower (if the economic state is weak).

Note that the tax could have been dealt with in an alternative way - subtracting the capital
allowances from the operating flow, then calculating the tax on the net figure, and then adding back
the capital allowances (as a non-cash flow). The final net cash flows would be exactly the same,
and this would be perfectly acceptable.

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(b)

Sensitivity analysis measures the %age change in individual estimates (e.g. the estimate of
the overheads, the estimate of the cost of capital) that can be afforded before the NPV
became negative and therefore the project becomes unacceptable.
It is useful in that it can help identify those estimates that are more critical and to which
therefore more attention needs to be paid.
However, there are two main limitations. One is that it can only examine one factor at a
time, whereas several factors may be inter-related. For example, the inflation applied to the
selling prices - if changed - may impact upon the sales volume.
A much bigger problem in relation to this project is that the revenue and hence the NPV
depends on the future economic state and will not be equal to the expected NPV. This
means that the actual NPV may be higher or lower than the expected NPV. In addition it is
unlikely that there will be only three possibilities - it is more likely to be a range of
possibilities - and even if there were, there is the question as to how reliable are the
probabilities of the different states
A better approach to dealing with the risk would be a simulation approach - calculating the
NPV for each of the whole range of possible outcomes, and then basing the decision on the
likelihood of the eventual NPV being positive.

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