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ACCA F9 Workbook

Lecture 1 Financial Strategy

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ACCA F9 Financial Management Full Course Workbook Questions! www.mapitaccountancy.com

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Shareholder Wealth - Illustration 1

Year Share Price Dividend Paid

2007 3.30 40c

2008 3.56 42c

2009 3.47 44c

2010 3.75 46c

2011 3.99 48c

There are 2 million shares in issue.! ! ! ! ! ! ! ! ! ! ! ! Calculate the increase in shareholder wealth for each year:II. Per shareIII. As a percentageIV. For the business as a whole




EPS - Illustration 2

2010$‘000

2011$‘000

PBIT 2000 2100

Interest 200 300

Tax 300 400

Profit After Tax 1500 1400

Preference Dividend 300 400

Dividend 800 900

Retained Earnings 400 100

Share Capital (50c) 5000 5000

Reserves 3000 3100

Share Price $2.50 $2.80

Calculate the EPS for 2010 and 2011.




Test Your Knowledge

If you can’t answer all of the questions below without looking at the answer then you need to do some more work on this area!

Multiple Choice Questions

1. The 3 main areas of the business that Finance Managers plan are:

A. Investments, Financing & Profitability.B. Dividend Policy, Financing & Investments.C. Return on Capital, Investments, Profitability.D. Earnings per share, Profitability, Maximising shareholder wealth.

2. Examples of 3 external stakeholders are:

A. Shareholders, Customers & Managers.B. Banks, Customers & Employees.C. Suppliers, Government & Customers.D. Unions, Suppliers & Investors.

3. The Agency Relationship exists between:

A. Shareholders and Managers.B. Auditors and Managers.C. Shareholders and Stakeholders.D. Stakeholders and Managers.

4. The Agency problem exists because...

A. Managers may be interested in maximising their own earnings.B. Shareholders have to rely on management to safeguard the assets of the business.C. Managers may be interested in short term gains over long term stability.D. All of the above.




5. In order to maximise the wealth of shareholders, Finance Managers need to increase shareholder wealth. Shareholder wealth increases are made up of:

A. Profit for the year + Dividends Paid.B. Earnings per share + Dividends Per Share.C. Share Price + Dividends Paid.D. Share Price movement + Dividends Paid.

6. ABC Co. Paid out a dividend of 35c last year and 42c this year per share. Their share price has increased from $4.33 to $5.24 in that time. What is the percentage shareholder return in the current year.

A. 20.00%B. 21.10%C. 30.72%D. 24.39%

7. The following information relates to ABC Co.

Year Share Price Dividend Paid

1 $4.50 82c

2 $4.71 84c

3 $3.85 86c

Which of the following statements is correct?

A. Between Year 1 and Year 2 shareholder wealth decreased.B. Between Year 2 and Year 3 shareholder wealth decreased.C. There was no increase in shareholder wealth between Year 2 and Year 3.D. None of the above.

8. In order for dividends to be paid a company must have made profits in the current year.

Is this statement TRUE or FALSE?

Answer FALSE




9. Miller and Modigliani stated in their theory that dividends were ..........................

10. If a company does not pay dividends then the result will be

A. More tax will be paid.B. Less profit will be made.C. More cash is available for investments.D. More debt will be required.

11. The ‘signaling effect’ refers to

A. A signal sent by managers to the auditors to inform them of the dividend.B. A signal sent by Auditors to inform shareholders of the dividend.C. The signal sent to the market by a company announcing their dividend for the year.D. A warning announcement that a firm will make less profit than expected.

12. The ‘Bird in the hand’ argument refers to the fact that

A. Investors prefer a dividend now rather than later as there is a risk that the company could not pay a dividend at all.

B. Managers prefer not to pay a dividend as they can re-invest the cash saved into new investments.

C. The government want the company to pay their tax on time.D. The company has an ethical policy to look after any injured birds they might find.




13. Which of the following best explains the ‘Clientele Effect’?

A. The clients of the company want as cheap prices as possible.B. The company should choose a dividend policy and stick to it to attract investors who

want that type of policy.C. The company should have a vote every year to ask investors what their dividend policy

should be for the year.D. The company should not pay a dividend.

14. A company can reward investors through script dividends without paying out any cash.

Is the above statement TRUE or FALSE

15. A ‘script dividend’ is where a company:

A. Pays no dividend at all.B. Pays a dividend every other year.C. Pays a larger than average dividend.D. Pays a dividend in shares rather than cash.

16. A ‘share buy back scheme’ refers to a situation where a company buys back it’s own shares from shareholders and then cancels those shares.

Is the above statement TRUE or FALSE?

17. A company may decide on a ‘Share-buy-back Scheme’ because

A. It doesn’t have enough cash to pay a dividend.B. It has large cash reserves and wants to reward shareholders.C. The government tells it that it has too many shares.D. It wants to receive cash to pay off some of it’s debt.




18. A company may decide not to pay a dividend for which of the following reasons

A. It has retained losses rather than profits.B. It has several new investments it would like to make.C. It has low cash reserves.D. All of the above.

19. Investors would like to see a company pay a steadily rising dividend growing at a rate in excess of inflation.

Is the above statement TRUE or FALSE?

20. Which of the following is an assumption of Miller and Modigliani’s dividend irrelevancy theory?

A. A company pays a steadily rising dividend that grows every year.B. Dividends and capital gains are taxed at the same rate.C. Investors are irrational.D. All share dealing transactions incur heavy costs.




Short Form Questions

1. What are the 3 things that financial managers need to plan?

2. What is Corporate Strategy?

3. Describe the Agency Problem.

4. What are the 3 main financial objectives of the financial manager?

5. How do you calculate the increase in shareholder wealth?

6. How do you calculate EPS?

7. Outline 2 potential dividend payment strategies.

8. Why did Miller & Modigliani say that dividends were irrelevant?

9. Outline the Clientele Effect.

10. What is a script dividend?

If you’ve successfully answered all of the above questions then you’re ready to do the exam questions below:

December 2010 Q4 Part (d)June 2010 Q4 Part (c)

Now do it!

!




Lecture 2 Performance Measurement







Performance Analysis Illustration

X1 X2 X3

Non Current Assets 500 700 1000

Current Assets 150 200 300

650 900 1300

Ordinary Shares ($1) 300 300 300

Reserves 100 280 430

Loan Notes 150 200 300

Payables 100 120 270

650 900 1300

Revenue 3000 3500 4200

COS 2000 2400 3200

Gross Profit 1000 1100 1000

Admin Costs 300 350 400

Distribution Costs 200 250 300

PBIT 500 500 300

Interest 100 150 220

Tax 120 90 50

Profit After Tax 280 260 30

Dividends 100 110 30

Retained Earnings 180 150 0

Share Price $3.30 $4.00 $2.20




Using the information on the previous page calculate and comment on the following Ratios:

I. Return on Capital EmployedII. Return on EquityIII. Gross MarginIV. Net MarginV. Operating MarginVI. Revenue GrowthVII. GearingVIII. Interest CoverIX. Dividend CoverX. Dividend YieldXI. P/E Ratio




Test Your Knowledge

If you can’t answer all of the questions below without looking at the answer then you need to do some more work on this area!

1. In the ROCE calculation what are the 3 ways of calculating Capital Employed?

2. What is the top line of the ROE calculation?

3. Why do we use PAT - Pref DIvs in the ROE calculation?

4. What should we compare the ratios we calculate with?

5. What does gearing tell us?

6. How do you calculate interest cover?

7. How do you calculate EPS?

8. What does the P/E Ratio tell us?

9. How do you calculate dividend cover?

10. What does dividend yield tell us?

If you’ve successfully answered all of the above questions then you’re ready to do the exam question below:

June 2009 Q4 (a)

Now do it!




Lecture 3 Finance Sources







Rights Issue - Illustration 1

XYZ Ltd. intends to raise capital via a rights issue.

The current share price is $8.

They are offering a 1 for 4 issue at a price of $6.

Calculate the Theoretical Ex-rights Price.

Rights Issue - Illustration 2

ABC Ltd. has decided to raise capital via a rights issue.

The share price is currently $5.50 and ABC intends to raise $5m.

There are currently 6.25m shares in issue and ABC is offering a 1 for 5 rights issue.

Calculate the Theoretical Ex-Rights Price.




Test Your Knowledge

If you can’t answer all of the questions below without looking at the answer then you need to do some more work on this area!Multiple Choice Questions

1. Which of the following is NOT something a company will consider when choosing a source of finance?

A. The cost of the finance to the firm.B. The number of employees in the firm.C. Any security that will need to be used.D. Current and future gearing levels.

2. What is NOT a function of the stock market?

A. To enable companies to raise capital.B. To enable individuals to sell shares in a company.C. To facilitate transactions between buyers and sellers.D. To increase the cost of equity of listed companies.

3. Which of the following are advantages to a company of being listed on the stock exchange?

1. It will lead to a better perception of the firm by potential investors.2. It will be more difficult for the firm to raise capital.3. Listing may well lower the cost of equity of the firm as investors will see it as a safer

investment and thus accept a lower return.4. The company may be required to disclose more information about it’s operations.

A. 1 and 2B. 2 and 3C. 2 and 4D. 1 and 3




4. Which of the following are disadvantages to a company of being listed on the stock exchange?

1. It is expensive to become listed.2. There are ongoing costs of listing compliance.3. Control by the current owners will be increased.4. Listing may well lower the cost of equity of the firm as investors will see it as a safer

investment and thus accept a lower return.


5. A company has 10m shares in issue at a share price of $7 and undertakes a rights issue of 1 for 5 to raise $12m. What is the Theoretical ex-rights price?

A. $6.17B. $6.83C. $6.00D. $6.44

6. Which of the following best describes an IPO?

A. All of the new Shares being issued to one large institutional investor. B. An offering of new shares to all investors in the market to enable them to purchase

them if they wish.C. Offering shares to current shareholders in the same proportion as they currently own

them.D. An issue to current shareholders of shares instead of dividends.




7. Which of the following are disadvantages of an IPO?

i) It can be very expensive.ii) It may need to be underwritten to ensure the shares are taken up.iii)The company will need to to deal with one large institutional investor only.iv)The share price achieved for the issue may not be as high as expected.

A. i) iii) and iv) onlyB. i) ii) and iv) onlyC. All of the aboveD. i) ii) and iii) only

8. Which of the following best describes a placing as a means of issuing shares?

A. All of the new Shares being issued to one large institutional investor. B. An offering of new shares to all investors in the market to enable them to purchase

them if they wish.C. Offering shares to current shareholders in the same proportion as they currently own

them.D. An issue to current shareholders of shares instead of dividends.

9. Who demands covenants to be placed on debt?

A. ShareholdersB. BanksC. The marketD. The government

10. Which of the following is NOT a function of the treasury department in a company?

A. To set and achieve the financial objectives of the firm.B. To manage the liquidity of the firm.C. To prepare the financial statements of the firm.D. To manage any currency risk that the firm may be exposed to.





1. What 5 things will a company consider when choosing a source of finance?

2. What is the primary function of the stock market?

3. What are the advantages to the company of being listed?

4. Are there any disadvantages of being listed?

5. A company has 10m shares in issue at a share price of $7 and undertakes a rights issue of 1 for 5 to raise $12m. What is the Theoretical ex-rights price?

6. What is an IPO?

7. What are the disadvantages of an IPO?

8. What is a placing?

9. Who demands covenants to be placed on debt?

10. What is the function of the treasury department in a company?


June 2009 Q4 (b) & (c)

Now do it!




Lecture 4 Economic

Environment







Test Your Knowledge


1. Which of the following is not a target of government economic policy?

A. Full employment.B. Price stability.C. High, stable growth.D. Low consumer prices.

2. Which of the following are examples of cost-push inflation.

1. Wage increases.2. Rising cost of commodities.3. Sales tax decreases.4. High demand in the economy


3. Fiscal policy can be described as tax revenues raised by the government and spent on services and subsidies for the public.

Is this statement

A. TRUEB. FALSE




4. An increase in interest rates is likely to lead to which of the following:

1. Higher cost of borrowing for companies.2. More consumer demand in the economy.3. More sales for many companies.4. Less consumer demand in the economy


5. Which of the following might cause policy makers to decide to decrease interest rates?

1. Excessive consumer demand in the economy.2. Reduced consumer demand in the economy.3. Concerns that growth in the economy may be low.4. Expectations that the economy will grow strongly.


6. Money markets could be best described as:

A. A market for newly printed notes and coins.B. A market for the trade of foreign currency.C. A market for the trade of commodities such as oil and wheat.D. A market to enable banks to borrow and lend to each other.




7. How can financial intermediaries help to make the market more efficient?

A. By buying commodities from sellers and trading them on the commodities exchange.B. By providing insurance on transactions for buyers and sellers.C. By providing finance to enable transactions to take place.D. By selling foreign currency on the currencies exchange.


1. What are the 4 targets of economic policy?

2. Name 2 examples of cost-push inflation.

3. What is fiscal policy?

4. How is an increase in interest rates likely to effect the economy?

5. When might policy makers decide to decrease interest rates?

6. What are the money markets?

7. How can financial intermediaries help to make the market more efficient?

8. Name 5 types of securities?


Now do it!




Lecture 5 Working Capital







Working Capital Illustration

Balance Sheet

$‘000

ASSETS

Non Current Assets 1000

Inventory 300

Receivables 200

Cash 300

1800

LIABILITIES

Ordinary Shares 800

Reserves 200

Long term Liabilities 700

Payables 100

Overdraft -

1800

Income Statement

$‘000

Revenue 1000

COS 800

Gross Profit 200

Other Costs 100

Net Profit 100

Other Information:

All sales are made on credit.

Required:

Calculate the Cash Operating Cycle for Inter Ltd.




Working Capital Illustration Part II

Show the journal entries and calculate the Revised Balance sheet if the operating cycle changes to:

Item Days

Inventory Period 200

Collection Period 100

Less:

Payables Period 30

270

Working Capital Illustration Part III

Show the journal entries and calculate the Revised Balance sheet if the operating cycle changes to:

Item Days

Inventory Period 90

Collection Period 30

Less:

Payables Period 60

60




Test Your Knowledge


1. Which of the following are components of working capital within the financial statements:

1. Non Current Assets.2. Inventory.3. Payables.4. Intangible Assets.


2. Which of the following are indicators of overtrading.

i) Reliance on long term finance.ii) Offering lax credit terms.iii) Build up of inventory.iv) Rapidly decreasing sales.v) Deteriorating Current ratio.

A. i) iii) and iv) onlyB. ii) iii) and v) onlyC. All of the aboveD. i) ii) and iii) only




3. The following information has been calculated for A Co:

Trade receivables collection period 52 daysRaw material inventory turnover period 42 daysWork in progress inventory turnover period 30 daysTrade payables payment period 66 daysFinished goods inventory turnover period 45 days

What is the length of the working capital cycle?

A 103 days B 131 days C 235 days D 31 days

4. If inventory days go up from 100 to 150 the company will need to invest more cash in the business.

Is this statement:

A. TRUEB. FALSE

5. Which of the following statements concerning working capital management are correct?

1 The twin objectives of working capital management are profitability and liquidity 2 A conservative approach to working capital investment will increase profitability 3 Working capital management is a key factor in a company’s long-term success

A 1 and 2 only B 1 and 3 only C 2 and 3 only D 1, 2 and 3





1 The twin objectives of working capital management are profitability and liquidity 2 A aggressive approach to working capital investment will increase profitability 3 Working capital management is not a key factor in a company’s long-term success



1 The twin objectives of working capital management are profitability and liquidity 2 A moderate approach to working capital investment will increase profitability 3 An aggressive approach to working capital investment uses more long term finance than short term.



1 A conservative approach to working capital investment employs uses long term finance to finance some fluctuating current assets.2 An aggressive approach to working capital investment will increase profitability 3 Working capital management has no effect on profitability of the company.






1. What are the components of working capital?

2. State 6 indicators of overtrading.

3. What is the Quick Ratio and what does it tell us?

4. How do we calculate the cash operating cycle?

5. If my inventory days go up from 100 to 150 will I need to invest more or less cash in the business?

6. What are permanent current assets?

7. What are fluctuating current assets?

8. What is the matching principle?

9. What are the advantages of an aggressive working capital financing policy?

10. What are the advantages of a conservative working capital financing policy?


June 2009 Q3 (a) & (b)

Now do it!




Lecture 6 Managing

Receivables







Receivables - Illustration 1

Credit sales: 1200

3 month credit terms

Overdraft rate = 10%

New Policy

2% discount if paid in less than 10 days

2 month terms for everyone else.

20% will take the discount

Receivables - Illustration 2

Receivables are currently $4,600,000. Sales are $37,400,000

A factor has offered to take over the administration of trade receivables on a non-recourse basis for an annual fee of 3% of credit sales. The factor will maintain a trade receivables collection period of 30 days and Gorwa Co will save $100,000 per year in administration costs and $350,000 per year in bad debts. A condition of the factoring agreement is that the factor would advance 80% of the face value of receivables at an annual interest rate of 7%. The current overdraft rate is 5%




Test Your Knowledge


1. How can a company assess the credit worthiness of their customers?

1. Get trade references from other suppliers or from banks.2. Use a credit rating agency. 3. Offer initial high levels of credit.4. Ask for a written promise to pay.


2. Which of the following are benefits of a company offering a discount to customers for early payment of invoices?

1. Better liquidity for the firm.2. Less interest as less or no overdraft will be required.3. Risk of more bad debt as customers take longer to pay.4. Loss of customers who don’t take advantage of the discount.





3. The management of XYZ Co has annual credit sales of $20 million and accounts receivable of $4 million. Working capital is financed by an overdraft at 12% interest per year. Assume 365 days in a year.

What is the annual finance cost saving if the management reduces the collection period to 60 days?

A $85,479 B $394,521 C $78,904 D $68,384

4. Which of the following are disadvantages of debt factoring for a company?

1. It can be expensive.2. It creates a bad impression with customers because the debt is collected by the factor.3. It can increase the liquidity of the company.4. It can lose the goodwill of customers.


5. Which of the following statements relate to invoice discounting through a factor?

1. The company retains the risk of bad debt.2. The factor collects the debt.3. The factor advances a percentage of the invoice value to the company.4. Invoice discounting can be used by any company.






1. How can a company assess the credit worthiness of their customers?

2. Outline 3 ways of maintaining good credit control.

3. What are the benefits of offering a discount to customers?

4. How do you decide whether to offer a discount or not?

5. What is debt factoring?

6. What are the disadvantages of factoring for a company?

7. What is invoice discounting?

8. How can a company seek to ensure that foreign receivables are collected?


Now do it!




Lecture 7 Inventory

Management







EOQ - Illustration 1

Demand of 1200 units per month.

Cost of making an order of $12.

Cost of one unit $10.

Holding cost per year of 10% of the purchase price of the goods.

Calculate the EOQ & check that it is correct.

Buffer Stock - Illustration 2

Company orders when the level of stock reaches 50,000

It takes 4 weeks to receive new stock from the time of ordering.

The company uses 7,500 units on average per week.

Calculate the buffer stock.




EOQ With Buffer Stock - Illustration 3

Dec 07 Exam Question

The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet production requirements during the next year is 625,000 units. The cost of placing and processing an order is €250, while the cost of holding a unit in stores is €0·50 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant throughout the year.

Calculate EOQ with buffer stock

EOQ with discounts - Illustration 4

Demand is 1000 units per month.

Purchase cost per unit £11.

Order cost £30

Holding cost 10% p.a. of stock value.

Required

Calculate the minimum total cost with a discount of 1% given on orders of 1500 and over




Test Your Knowledge


1. Which of the following types of cost we are seeking to minimise by using the Economic Order Quantity?

A. Holding costs and inventory movement costsB. Ordering costs and holding costsC. Ordering costs and insurance costsD. Holding costs and security costs

2. If a company uses the Economic Order Quantity as the level at which to order, how will they calculate total ordering costs for the year?

A. Cost per order x (Annual Demand / EOQ)B. Annual Demand x (Cost per order /EOQ)C. (EOQ / Cost per order) x Holding costsD. Annual demand x EOQ

3. ABC Co. sells widgets and expects annual demand of 3.4m units. The cost of making an order is $49.71 and the cost of holding one unit for one year is $0.50.

What is the total ordering costs per year:

A. $5,687.34B. $6,413.81C. $6,500.54D. $6,430.32




3. ABC Co. sells widgets and expects annual demand of 1.2m units. The cost of making an order is $25.21 and the cost of holding one unit for one year is $0.50.

What is the total holding costs per year:

A. $2,850B. $3,750C. $2,450D. $2,750

4. Layla Co. sells 200m wigs in a year with each order taking 15 days to be delivered once made. They make an order every time their stock levels reach 10m wigs.

What is the buffer stock level for Layla Co.

A. 1,780,822B. 6,666,666C. 9,333,333D. 2,345,632

5. Which of the following are drawbacks of a company using the Economic Order Quantity method of stock management?

1. Assumes constant ordering costs.2. Assumes constant demand.3. Assumes known annual demand.4. Assumes no buffer stock or lead time.

A 1, 2 and 4 only B 1 and 3 only C All of the aboveD 1, 2 and 3




6. Stavros Co’s current inventory policy is to order 60,000 units when the inventory level falls to 55,000 units. Forecast demand to meet production requirements during the next year is 800,000 units. The cost of placing and processing an order is $90, while the cost of holding a unit in stores is $1 per unit per year. Both costs are expected to be constant during the next year. Orders are received three weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant throughout the year.

What is the total cost of ordering at the EOQ level?

A. $12,000B. $6,000C. $7,000D. $19,000


1. What are the two types of cost we are seeking to minimise?

2. How do we calculate total ordering costs for the year?

3. How do we calculate total holding costs for the year?

4. How do we calculate the buffer stock?

5. What are the problems with the EOQ method?

6. What are the steps in calculating the total costs when there is a buffer stock?

8. Why might we not use the EOQ when there are bulk discounts available?


June 2009 Q3 (d)December 2010 Q3 (a)

Now do it!




Lecture 8 Cash Management







Baumol Cash Model - Illustration 1

A business expects to move 500,000 from it’s interest bearing account into cash over the course of one year.

The interest rate is 7% and the cost of making a transfer is $250.

How much should the business transfer into cash each time it makes a transfer?


Using the information in illustration 1 calculate the total cost to the business each year of their cash management policy.


Subsonic Speaker Systems (SSS) has annual transactions of $9 million.

The fixed cost of converting securities into cash is $264.50 per conversion.

The annual opportunity cost of funds is 9%.

What is the optimal deposit size?




Miller-Orr Model - Illustration 4

If a company must maintain a minimum cash balance of £8,000, and the variance of its daily cash flows is £4m (ie std deviation £2,000). The cost of buying/ selling securities is £50 & the daily interest rate is 0.025 %.

Calculate the spread, the upper limit & the return point




Test Your Knowledge


1. Which of the following are the reasons for a company to hold cash?

1. Speculation2. Persuasion3. Transaction4. Reaction


2. Revaile Co. has annual transactions of $30 million. The fixed cost of converting securities into cash is $500 per conversion. The annual opportunity cost of funds is 6%. What is the optimal deposit size?

A. $21,213B. $42,426C. $707,107D. $42.43

3. Which of the following are problems with the Baumol Model?

1. Assumes constant cash disbursements2. Assumes that there are no cash receipts, just movements3. Assumes a risk free interest rate4. Assumes no safety buffer for cash





4. If a company must maintain a minimum cash balance of £20,000, and the variance of its daily cash flows is £6.25m (ie std deviation £2,500). The cost of buying/ selling securities is £80 & the daily interest rate is 0.035 %.

What is the upper-limit using the Miller-Orr model of cash management?


1. What are the three reasons to hold cash?

2. What does the Baumol Model tell us?

3. Why is there a cost of holding cash?

4. How do we calculate the total trading costs in the year?

5. How do we calculate the total holding costs in the year?

6. What are the problems with the Baumol Model?

7. Why does the Miller-Orr model tell us to buy securities with extra cash?

8. How do we calculate the variance of cash flows?

9. If the interest rate is 8% what figure should be included in the Miller-Orr model for i?

10. How do we calculate the upper limit?


Pilot Paper Q3 (You now know enough to do this all)

Now do it!




Lecture 9 Investment Appraisal I







ARR - Illustration 1

ABC Ltd are considering expanding their internet cafe business by buying a business which will cost $275,000 to buy and a further $175,000 to refurbish.

They expect the following cash to come in:

Year Net Cash Profits (£)

1 45,000

2 75,000

3 80,000

4 50,000

5 50,000

6 60,000

The equipment will be depreciated to a zero resale value over the same period and, after the sixth year, they can sell the business for $200,000

Calculate the ARR or ROCE of this investment




Relevant Cash Flow Criteria - Illustration 2

A business is considering investing in a new project. They have already spent $20,000 on a feasibility study which suggests that the project will be profitable.

The headquarters of the company has spare floor space which will be allocated to the project with $7,000 of the current monthly rent allocated to the project.

New equipment costing $2.5m will have to be bought and will be depreciated on a straight line basis over 10 years.

A manager who earns $30,000 per year and currently runs a similar project will also manage the new project taking up 25% of his time.

State whether each of the following items are relevant cash flows and explain your answer.

I. The cost of the feasibility study.

II. The rent charged to the project.

III. The new equipment.

IV. The depreciation on the new equipment.

V. The Managers salary.




Payback Period - Illustration 3

Initial Investment of $5.8m.

Annual Cash Flows of $400,000.

Calculate the Payback Period.

Payback Period - Illustration 4

Initial Investment of $6.2m.

Cash Flows of:

Year 1: ! $1,200,000

Year 2:! $2,200,000

Year 3:! $2,500,000

Year 4:! $1,700,000

Calculate the Payback Period.




Discounted Cash-flows - Illustration 5

An investor wants a real return of 10%. Inflation is 5%

What is the MONEY/NOMINAL rate required?


A company undertakes a project with the following cash-flows:

Year Cash-Flows

1 5,000

2 7,000

3 8,000

4 10,000

5 11,000

6 9,000

The company has a cost of capital of 10%.

Calculate the present value of the cash flows for each of the six years and in total.





A company undertakes a project with the following cash-flows:

Year Cash-Flows

1 5,000

2 5,000

3 5,000

4 5,000

5 5,000

6 5,000

The company has a cost of capital of 10%.

Calculate the present value of the total cash flows for the six years


A company expects to receive $100,000 per year forever.

Their cost of capital is 10%.

Calculate the present value of the perpetuity.




Test Your Knowledge


1. JoJo Ltd are considering investing in a new project which will cost an initial $375,000 and they expect the following cash to come in:

Year Net Cash Profits (£) 1 25,000 2 55,000 3 70,000 4 80,000 5 40,000 6 30,000

The investment will be depreciated to a scrap value of $175,000 over the period of the project.

What is the Accounting Rate of Return (Return on Capital Employed) of the project?

A. 6%B. 3%C. 18%D. 12%

2. Which of the following are weaknesses of the Accounting Rate of Return (Return on Capital Employed)?

1. The calculation uses accounting profit rather than cash.2. It disregards the timing of the inflows.3. It does not consider the whole life of the project.4. No discount rate is used to allow for inflation and risk.

A 1, 2 and 4 B 1 and 3 only C 2 and 3 only D 1, 2 and 3




3. Aldios Co. intends to make an investment of $4.5m in a project lasting 5 years. The project cashflows are forecast to be as follows:

Year Net Cash Profits (£) 1 250,000 2 550,000 3 2,700,000 4 2,800,000 5 400,000

The investment will be depreciated to a scrap value of $1.5m over the period of the project.

What is the Payback period of the investment?

A. 3 Years 4 monthsB. 2 Years 6 monthsC. 4 Years 2 monthsD. 2 Years 4 months

4. Jpeg Co. uses a real discount rate of 8%. They are carrying out an investment appraisal using an inflation rate of 5%.

What discount rate should be used to discount the cash flows for the project:

A. 8%B. 5%C. 13%D. 11%





1. What are the 6 steps in investment appraisal?

2. Why carry out a post-completion audit?

3. What is the calculation for the ARR or ROCE?

4. How do you calculate the average investment?

5. What are the weaknesses of the ARR?

6. What are the 3 relevant criteria for cash-flows in investment appraisal?

7. What are the advantages of using the payback period method?

8. Why do we need to discount cash-flows?

9. If the real discount rate is 7% and inflation is running at 3% what is the nominal/money discount rate?

10. If I am going to receive $8,000 per year for 6 years and my cost of capital (discount rate) is 8% what is the present value of the total of these cash-flows?


June 2009 Q2 (a)

Now do it!




Lecture 10 Investment Appraisal II







WDA - Illustration 1

A business buys a piece of equipment for $100.

Capital allowances are available at 25% reducing balance.

The tax rate is 30%

After the 4 year project the equipment can be sold for $25.

Working Capital - Illustration 2

A business requires the following working capital investment into a four year project:

Initial Investment:! ! 30,000

Year 1!! ! ! 35,000

Year 2!! ! ! 45,000

Year 3!! ! ! 32,000

Show the working capital line in the NPV calculation.




NPV - Illustration 3

A business is evaluating a project for which the following information is relevant:

I. Sales will be $100,000 in the first year and are expected to increase by 5% per year.

II. Costs will be $50,000 and are expected to increase by 7% per year.

III. Capital investment will be $200,000 and attracts tax allowable depreciation of the full value of the investment over the 5 year length of the project.

IV. The tax rate is 30% and tax is payable in the following year.

V. Working Capital invested will be 20% of projected sales for the following year.

VI. General inflation is expected to be 3% over the course of the project and the business uses a real discount rate of 9%.

Calculate the NPV for the project.




Test Your Knowledge


1. Asfor Co. plans to undertake a project with an initial investment of $5m. The inflation adjusted cash flows expected from the project are as follows:

Year $

1 $1.2m

2 $1.8m

3 $2.1m

4 $2.2m

5 $2.5m

Asfor Co. uses a real discount rate of 6% and general inflation is expected to be 5% per year for the duration of the project.

What is the NPV of the project ignoring tax:

A. $8,178B. $8,108C. $2,010D. $7,010




2. Asfor Co. plans to undertake a project with an initial investment of $16m. The cash flows (profit) before inflation expected from the project are as follows:

Year $

1 $4.2m

2 $4.9m

3 $5.5m

4 $5.8m

5 $6.1m

Asfor Co. uses a real discount rate of 10% and general inflation is expected to be 3% per year for the duration of the project.

The tax rate on profits is 30% payable the following year.

What is the NPV of the project:

A. $417B. $2,048C. -$298D. $2,233




3. Asfor Co. plans to undertake a project with an initial investment of $16m and a scrap value of $3m at the end of the project. The cash flows after inflation expected from the project are as follows:

Year $

1 $4.2m

2 $4.9m

3 $5.5m

4 $5.8m

5 $6.1m

Asfor Co. uses a nominal discount rate of 10%. Inflation is expected to be 3% per year.

The tax rate on profits is 30% payable the following year. Tax allowable depreciation is available at 25% reducing balance.


A. $1,477B. $6,945C. $17,477D. $3,340




4. Asfor Co. plans to undertake a project with an initial investment of $10m. The cash flows (profit) after inflation expected from the project are as follows:

Year $

1 $4.2m

2 $4.9m

3 $5.5m

4 $5.8m

5 $6.1m

Asfor Co. uses a nominal discount rate of 10%.

The working capital requirement will initially be $1m rising by 5% each year before being returned at the end of the project.



A. $4,605B. $9.566C. $4,097D. $4,293

Answer D




5. Asfor Co. plans to undertake a project with an initial investment of $6m and scrap value of $1m. The sales price per unit in real terms is $30 with cost per unit of $15.

Year Units

1 200,000

2 300,000

3 350,000

4 400,000

5 320,000


The sales are expected to be subject to inflation of 5% with the costs subject to inflation of 3%.



A. $11,079B. $5,912C. $4,097D. $8,111




6. Asfor Co. plans to undertake a project with an initial investment of $600,000 and scrap value of $100,000. The sales and costs in real terms are forecast to be

Year Sales$

Costs$

1 200,000 100,000

2 300,000 125,000

3 350,000 155,000

4 400,000 160,000

5 320,000 145,000


The sales are expected to be subject to inflation of 5% with the costs subject to inflation of 3%.


What is the NPV of the project to the nearest ‘000?

A. -$33,000B. -$2,000C. $72,000D. $107,000





1. What are we comparing in NPV analysis?

2. Why do we need a period 0?

3. Why do we assume that cash-flows occur at the end of each period?

4. If I have profits in period 2 of $4,000 and a tax rate of 30% how much tax will I pay and when?

5. If I receive 25% capital allowances and have a tax rate of 20% what will my tax saving be in each year over a 5 year project if the capital investment is $7,500 with a residual value of $1,500?

6. What makes up working capital?

7. How do we account for working capital in NPV analysis?

8. If my cash flows in my NPV analysis are inflated should I use the real or the nominal discount rate?


June 2010 Q3 (a) & (b)

Now do it!




Lecture 11 Investment

Appraisal III







IRR - Illustration 1

ABC has evaluated a project and come to the following conclusions.

At a discount rate of 10% the NPV will be $100,000

At a discount rate of 15% the NPV will be -$75,000

What is the IRR?




Test Your Knowledge


1. Which of the following best describes the result of calculating the Internal Rate of Return of a prospective project?

A. The forecast return on the project as a percentage of the capital invested.B. The amount of time expected to be taken for the capital invested in the project to be

returned.C. The amount of shareholder wealth expected to be created by the project.D. The discount rate at which the NPV of the project is expected to be zero.

2. If a project has cash inflows of $5,000 per year for 5 years and had an initial investment of $17,000 what is the IRR?

A. 14.5%B. 11.5%C. 10.0%D. 15.0%


A. 11.05%B. 10.07%C. 12.07%D. 9.23%




4. Which of the following are advantages of using the Internal Rate of Return (IRR) as an investment appraisal technique?

1. IRR gives an answer in the form of an understandable percentage.2. IRR uses accounting profit to assess the project.3. IRR covers the payback period of the project.4. IRR focuses on the maximisation of shareholder wealth.

A 1 and 2 only B 1 and 3 only C 2 and 3 only D 1 and 4 only

5. Which of the following are disadvantages of using the Internal Rate of Return (IRR) as an investment appraisal technique?

1. It gives an absolute figure rather than a percentage as the result.2. All of the figures are based on forecasts.3. It is possible to get multiple IRRs depending on the timing of the cashflows.4. IRR assumes that all returns are re-invested in the project which is not necessarily the

case.

A 1, 2 and 4 B 2, 3 and 4 C 2 and 3 only D 1 and 3 only





1. What are we trying to find with the Internal Rate of Return?

2. What is the formula for the IRR?


4. What are the advantages of the IRR?

5. What are the disadvantages of the IRR?


June 2009 Q2 (b) & (c)December 2010 Q1 (a) & (b)December 2007 Q2 (a) & (b)Pilot Paper Q4

Now do it!




Lecture 12 Further Appraisal







Expected Values - Illustration 1

A business is considering 2 different projects. The likely profit made from each project is outlined below:

Project AProject A Project BProject B

Projected Profit Percentage Likely-hood


$10,000 10% $10,000 15%

$15,000 30% $15,000 25%

$20,000 40% $20,000 30%

$23,000 20% $23,000 30%

Calculate the expected value for each of the projects.

Sensitivity Margin - Illustration 2

A business is considering a project which will cost them an initial 20,000

The sales expected for the 2 year duration are 20,000pa.

The variable costs are 2,000pa

Cost of capital 10%

Calculate the sensitivity margin of:

I. The initial investment.

II. The variable costs of the projects.

III. The sales of the project.




Lease V Buy - Illustration 3

Machine cost $10,000

The Machine has a useful economic life of 5 years with no scrap value

Capital allowances available at 25% reducing balance

Finance choices

1) 5 year loan 14.28% pre tax cost

2) 5 year Finance Lease @ $2,200 pa in advance

If the machine is purchased then maintenance costs of $100 per year will be incurred.

The tax rate is 30%.

The leasing company will maintain the machine if it is leased.

Should the company lease or buy the machine.




Equivalent Annual Cost - Illustration 4

Machine Cost 30,000

Running costs

Year 1 10,000

Year 2 11,500

Residual Value (if sold after..)

Year 1 19,000

Year 2 16,000

Cost of capital = 10%

Is it better to replace the machine every year or to replace it every 2 years?




Test Your Knowledge


1. A business is considering 2 different projects. The likely profit made from each project is outlined below:

Project 1Project 1 Project 2Project 2



$12,000 10% $12,000 15%

$16,000 30% $16,000 25%

$25,000 40% $25,000 30%

$30,000 20% $30,000 30%

Project 3Project 3 Project 4Project 4



$12,000 12% $12,000 18%

$16,000 35% $16,000 30%

$25,000 44% $25,000 30%

$30,000 9% $30,000 22%

Which of the projects should be chosen on the basis of the Expected Values?

A Project 1B Project 2C Project 3D Project 4




2. A company is considering investing in a project with an expected life of four years. The project has a positive net present value of $280,000 when cash flows are discounted at 12% per annum. The project’s estimated cash flows include net cash inflows of $320,000 for each of the four years. No tax is payable on projects of this type.

What is the sensitivity margin of the cash inflows of the project?

A 87.5%

B 21.9%

C 3.5%

D 28.8%

3. A five year investment project has a positive net present value of $320,000 when discounted at the cost of capital of 10% per annum. The project includes annual net cash inflows of $100,000 which occur at the end of each of the five years.

What is the sensitivity margin of the cash inflows of the project?

A 31.25%

B 118.5%

C 84.4%

D 18.5%

4. Davos Co. intends to lease a machine on a 5 year operating lease for a payment of $3,500 payable in advance. The tax rate is 30%. The pre-tax cost of borrowing is 15.71%.

What is the present value cost to the business of leasing the machine?

A. $9,440B. $10,480C. $10,864D. $10,974




5. Davos Co. intends to buy a machine a payment of $2m. Tax allowable depreciation is allowable over 5 years at 25% reducing balance. The tax rate is 30%. The pre-tax cost of borrowing is 17.14%. Maintenance costs of $65,000 are payable each year.

What is the present value cost to the business of buying the machine?

A. -$1,786B. -$1,615C. -$1,849D. -$2,172

6. Kevlar Co. has a piece of machinery which cost $40,000 and is trying to decide how often to replace it based on the Equivalent Annual Cost (EAQ). The following information relates to the machine.

Machine Cost 40,000

Running costs

$12,000 per year

Residual Value (if sold after..)

Year 1 19,000

Year 2 16,000

Year 3!! 14,000

Year 4!! 14,000

Cost of capital = 12%

When is best to replace the machine based on the EAQ?

A. At the end of year 1B. At the end of year 2C. At the end of year 3D. At the end of year 4





1. What is the difference between risk and uncertainty?

2. How can we deal with each of risk and uncertainty in investment appraisal?

3. What is an operating lease?

4. Why might a company want to lease an item rather than buy it?

5. What are the relevant costs of buying the item?

6. What are the relevant costs of leasing the item?

7. If I have a pre-tax borrowing rate of 13% and the tax rate is 25% what is the post-tax borrowing rate?

8. What does the equivalent annual cost method tell us?

9. What is the equation for the EAC?

10. I have an item of plant costing $30,000 new and $5,000 to maintain each year. The residual value after 3 years is $7,000 and after 4 years is $5,000. If I have a cost of capital of 10% after how long should I replace the asset?


December 2009 Q1 (a) & (b)December 2007 Q2 (c)

Now do it!




Lecture 13 Further Appraisal II







Profitability Index - Illustration 1

A business has identified the following projects. They have $200,000 to invest and the projects are divisible.

Project Investment NPV

A 90,000 15,000

B 110,000 25,000

C 50,000 10,000

D 75,000 22,000

E 70,000 -8,000

Which projects should the business undertake?

Investment Choices - Illustration 2

A business has identified the following projects. They have $200,000 to invest and the projects are non-divisible.


A 90,000 15,000

B 110,000 25,000

C 50,000 10,000

D 75,000 22,000

Which projects should the business undertake?




Equivalent Annual Annuity - Illustration 3

! ! ! ! NPV Duration

Project 1 300 5 yrs

Project 2 200 3 yrs

Project 3 350 6 yrs

Calculate the EEA of each project given a cost of capital of 10%




Test Your Knowledge


1. An investment project requires an initial investment of $500,000 and has a residual value of $130,000 at the end of five years. The net present value of the project is $140,500 after discounting at the company’s cost of capital of 12% per annum.

The profitability index of the project is:

A 0.38 B 0.54 C 0.28 D 0.26




2. A company has a maximum of $80 million available for investment and seven independent projects in which it could invest as follows:


A 10 4.20

B 40 6.10

C 20 8.50

D 40 13.70

E 50 3.80

F 20 4.90

G 20 4.33

None of the projects can be carried out more than once. Each project is divisible therefore investment in part of a project can be undertaken.

What is the maximum NPV that could be achieved from investing the $80m using the Profitability Index?

A. $28.85B. $31.3mC. $45.53mD. $26.4m

3. Which of the following best describes ‘hard’ capital rationing?

A. A limited amount of capital is available to the company due to external factors such as banks unwillingness to lend.

B. A limited amount of capital is available to the company due to internal factors such as management unwillingness to take more risk.

C. Extra capital is available to the company due to external factors such as banks who are keen to lend.

D. Extra capital is available to the company due to internal factors such as excess cash from operations.




4. Which of the following best describes ‘soft’ capital rationing?

A. A limited amount of capital is available to the company due to external factors such as banks unwillingness to lend.

B. A limited amount of capital is available to the company due to internal factors such as management unwillingness to take more risk.

C. Extra capital is available to the company due to external factors such as banks who are keen to lend.

D. Extra capital is available to the company due to internal factors such as excess cash from operations.


1. What is the difference between divisible and non-divisible projects?

2. If the projects are divisible,which method should be used to decide which projects to undertake?

3. How do we calculate the Profitability Index?

4. If projects are non divisible how do we make a decision?

5. What is the equivalent annual benefit?

6. What is capital rationing?

7. What is hard capital rationing?

8. What is soft capital rationing?


December 2009 Q1 (c) & (d)

Now do it!




Lecture 14 Business Valuations







Net Assets Valuation Method Illustration 1

Non Current Assets 550,000

Current Assets 170,000

Current Liabilities -80,000

Share Capital 300,000

Reserves 200,000

10% Loan Notes 150,000

The Market Value of property in the Non Current Assets is $50,000 more than the book value.The Market Value of property in the Non Current Assets is $50,000 more than the book value.

The Loan Notes are redeemable at a 5% premium.The Loan Notes are redeemable at a 5% premium.

What is the value of a 70% holding using the net assets valuation basis?

DVM - Illustration 2

ABC pays a constant dividend of 45c. It has 3m ordinary shares.

The shareholders require a return of 15%.

What is the Value of the business?




DVM - Illustration 3

A business has Share Capital made up of 50c shares of $3 millionDividend per share (just paid) 30cDividend paid four years ago 22cRequired Return = 12%

Calculate the Value of the business using the dividend valuation method.

P/E Ratio Method - Illustration 4

X1 X2 X3

$‘000 $‘000 $‘000

Revenue 3000 3500 4200

COS 2000 2400 3200




PBIT 500 500 300


Tax 120 90 50




Industry P/E Average 13 12 14

Calculate the Value of the Company for each of the 3 years using the P/E Ratio method.




P/E Ratio Method - Illustration 5

X1 X2 X3

$‘000 $‘000 $‘000

Revenue 3200 3800 4800

COS 2000 2400 3200




PBIT 700 800 900


Tax 120 90 50




Industry P/E Average 17 15 18

Number of Shares 3m 3m 3m

Calculate the Earnings Per Share for each of the 3 years

Calculate the Value of the Company for each of the 3 years using the EPS you calculate.




Earnings Yield - Illustration 6

X1 X2 X3

$‘000 $‘000 $‘000

Revenue 3100 3700 4600

COS 2000 2400 3200




PBIT 600 700 700


Tax 120 90 50




Earnings Yield 0.15 0.18 0.17

Number of Shares 4m 4m 4m

Calculate the Earnings Per Share for each of the 3 years and the share price using the earnings yield.




Present Value of Future Cash Flows - Illustration 7

ABC Company earned $100,000 in cash inflows this year.

They expect this to increase in each of the next 5 years by 5% and after that to increase by 2% forever.

The company uses a cost of capital of 10%.

Calculate the value of the company using the present value of future cash flows method.




Test Your Knowledge


1.

Non Current Assets 700,000

Current Assets 250,000

Current Liabilities -100,000

Share Capital 500,000

Reserves 300,000

10% Loan Notes 200,000

The Market Value of property in the Non Current Assets is $100,000 more than the book value.The Market Value of property in the Non Current Assets is $100,000 more than the book value.

The Loan Notes are redeemable at a 10% premium.The Loan Notes are redeemable at a 10% premium.

What is the value of a 80% holding using the net assets valuation basis?

A. $730,000B. $664,000C. $584,000D. $444,000




2. ABC Co. has Share Capital made up of 50c shares of $5 million. They have just paid a dividend per share of 50c and paid a dividend per share four years ago of 35c.The cost of capital is 14%.

Calculate the Value of the business using the dividend valuation method.

A. $343.6mB. $389.3mC. $109.3mD. $54.65m

3. SKV Co has paid the following dividends per share in recent years:

Year 2013 2012 2011 2010

Dividends 36.0 33.8 32.8 31.1

The dividend for 2013 has just been paid and SKV Co has a cost of equity of 12%.

Using the geometric average historical dividend growth rate and the dividend growth model, what is the market price of SKV Co shares to the nearest cent on an ex dividend basis?

A $4·67 B $5·14 C $5·40 D $6·97




4. The following information relates to Stovie Co.

$‘000

Revenue 3000

COS 2000

Gross Profit 1000

Op. Costs 500

Net Profit 500

Number of Shares 1m

Share Price $5

Industry P/E Average 15

What is the the Value of the Company Using the P/E ratio calculation?

A. $5m B. $7.5mC. $8mD. $5.5m

5. Archie Company expects to earn $100,000 in cash inflows this year.

They expect this to increase in each of the following 4 years by 8% and after that to increase by 4% forever.


Calculate the value of the company to the nearest $‘000 using the present value of future cash flows method.

A. $1,902,000B. $2,795,000C. $1,340,000D. $3,675,000




6. Archie Company expects to earn $500,000 in cash inflows this year.

They expect this to increase in each of the following 4 years by 7% and after that to increase by 3% forever.


Calculate the value of the company to the nearest $‘000 using the present value of future cash flows method.

A. $7,569,000B. $9,638,000C. $8,137,000D. $11,790,000





1. When is it appropriate to use the Net Assets Valuation method?

2. What are the downsides of using the Net Assets Valuation method?

3. A company pays a constant dividend of 50c and has a cost of capital of 13%. Calculate the share price using DVM.

4. A company pays a dividend of 50c and paid a dividend of 40c 4 years ago. The company has a cost of capital of 13%. Calculate the share price using DVM.

5. What are the downsides of using DVM?

6. Why do we use a proxy P/E Ratio when valuing a business with this method?

7. When and how can we adjust the P/E Ratio used?

8. The industry average P/E ratio for the fashion industry is 13. We are valuing an unlisted fashion business who have an EPS of 22c and 12m shares in issue. What is the value of the firm?

9. What are the downsides of using the P/E ratio method?

10. A business is expected to earn $250,000 this year that is expected to grow at 4% forever. What is the value of the business using the present value of future cash flows if their cost of capital is 14%?


December 2007 Q1 (a)June 2008 Q2 (a) & (b)December 2008 Q1

Now do it!




Lecture 15 WACC I







Cost of Equity using DVM - Illustration 1

ABC Company has just paid a dividend of 35c.

The current share price is $3.25.

Calculate the Cost of Equity (Ke) using DVM.

Cost of Equity using DVM - Illustration 2

ABC Company has just paid a dividend of 35c.

The dividend paid has grown by 4% per year for the past 5 years.


Calculate the Cost of Equity (Ke) using DVM.




Cost of Equity using CAPM - Illustration 3

Company A has a Beta of 1.2.

Government bonds are currently trading at 4%.

The average return than investors in the market can expect is 15%.

Calculate the Cost of Equity using CAPM.

Cost of Equity using CAPM - Illustration 4


Company B has a Beta of 1.


The average return than investors in the market can expect is 12%.

Calculate the Cost of Equity using CAPM for each company.




Cost of Equity using CAPM Illustration 5


Company B has a Beta of 1.2.


The average market risk premium is 6%.

Calculate the Cost of Equity using CAPM for each company.




Test Your Knowledge


1. Entrie Company has just paid a dividend of 75c. The dividend paid has grown by 3% per year for the past 4 years. The current share price is $6.54

What is the cost of equity using the dividend growth model?

A. 12%B. 15%C. 7%D. 11%

2. Company Alpha has a Beta of 1.1.Government bonds are currently trading at 4%. The average market risk premium is 7%.

What is the cost of equity using the capital assets pricing model?

A. 12.2%B. 11.7%C. 7.3%D. 11.4%

3. Which of the following statements about ‘systematic risk’ are correct when referring to the capital assets pricing model?

A. Systematic risk affects the overall market, not just a particular stock or industry. B. Systematic risk is company or industry specific risk.C. Systematic risk is risk that can be diversified away by investors.D. Systematic risk is determined by the gearing of the company.




4. Which of the following statements about ‘unsystematic risk’ are correct when referring to the capital assets pricing model?

A. Systematic risk affects the overall market, not just a particular stock or industry. B. Systematic risk is company or industry specific risk.C. Systematic risk is risk that can be diversified away by investors.D. Systematic risk is determined by the gearing of the company.

5. Which of the following are assumptions made by the capital asset pricing model (CAPM) are correct?

1. It assumes that investors can borrow at the risk free rate.2. It assumes a capital market with high transaction costs.3. It assumes that all investors are diversified.4. It assumes that the risk free rate is 5%


6. Which of the following are downsides of the capital assets pricing model (CAPM) are correct?

1. The Beta used is calculated using historic data.2. The dividend growth is based on historic data.3. The assumptions it makes are not necessarily reflected in reality.4. The share price fluctuates on a daily basis.






1. What is the weighted average cost of capital?

2. Set out the creditors hierarchy.

3. Why is debt cheaper to service than equity (2 reasons!)?

4. If a company has a dividend of 40c and a share price of $3.45 what is the cost of equity?

5. If the dividend in question 4 is growing at a rate of 5% what is the cost of equity?

6. What are the two types of risk mentioned in the CAPM lecture?

7. Why can we ignore unsystematic risk?

8. What type of risk is CAPM a measure of?

9. What does Beta tell us?

10. What are the assumptions of CAPM?

11. A company has a Beta of 1.3. The market risk premium is 6% and government bonds are trading at 4%. Calculate the cost of equity using CAPM.

12. Is a company with a Beta of 1.2 a more risky or less risky investment than a company with a Beta of 1.6?

13. How is Beta calculated?

14. What are the downsides of CAPM?

If you’ve successfully answered all of the above questions then you’re ready to do the exam questions below:You’re not Ready Yet - Do the next lecture!

Now do it!




Lecture 16 WACC II







Irredeemable Debt - Illustration 1

A company has issued 10% irredeemable debt.

The market value of the debt is $90.

The tax rate is 30%

Calculate the cost of debt (Kd).

Redeemable Debt - Illustration 2

A Company has issued debt which is redeemable in 5 years time.

Interest is payable at 8%.

The current market value of the debt is $102.

Ignore taxation.

Calculate the Cost of Debt (Kd).




Redeemable Debt - Illustration 3

A Company has issued debt which is redeemable in 5 years time.



Tax is payable at 30%.


Convertible Debt - Illustration 4

A Company has issued debt which is convertible in 5 years time.



On conversion, investors will have a choice of either:

I. Cash at a 15% premium; or

II. 18 shares per loan note.

The current share price is $6 and it is expected to grow in value by 4% per year.

Tax is payable at 30%.





Preference Shares - Illustration 5

A company has issued 8% preference shares with a nominal value of $1.

The market value of the shares is 80c.


Calculate the cost of the preference shares (Kd).

Bank Debt - Illustration 6

A company has a bank loan of $2m at an interest rate of 10%.


Calculate the cost of debt (Kd).




WACC - Illustration 7

Company A is funded as follows:

Item Capital Structure Cost

Equity 85% 15%

Debt 15% 7%

Calculate the Weighted Average Cost of Capital.






Balance Sheet Extract

Ordinary Shares (50c) 3000

Loan Notes 2000

Bank Loan 1000

The cost to the company of each of the above items has been calculated as:

Ordinary Shares 13%

Loan Notes 8%

Bank Loan 5%

The Loan notes are currently trading at $94.

The current share price is $1.50









12% Loan Notes 1500

8% Preference Shares ($1) 500

Bank Loan 750

Details on these are as follows.

The company has an equity beta of 1.2. Government bonds are currently trading at 6% and the average market risk premium is 7%.

The Loan notes are currently trading at $106 and are redeemable at par in 5 years time.

The preference shares are trading at 92c.

The bank loan has an interest rate of 10%.







Test Your Knowledge


1. Avecas Co. has irredeemable debt in issue that interest at a rate of 12%. The market value of the debt is $84 and the tax rate is 30%.

What is the cost of debt?

A. 14%B. 12%C. 10%D. 11%

2. A company has 10% irredeemable debt in issue at a market value of $97. If the tax rate is 30% what is the cost of the debt?

A. 7.2%B. 9.7%C. 6.5%D. 8.2%

3. A Company has issued debt which is redeemable in 5 years time. Interest is payable at 12%. The current market value of the debt is $102. Tax is payable at 30%.

What is the cost of debt (kd) using linear extrapolation and discount rates of 5% and 15% in the calculation?

A. 12.00%B. 8.47%C. 9.00%D. 7.24%




4. A company has 5 year 8% redeemable debt in issue at a market value of $103. The tax rate is 25%.

What is the cost of debt (kd) using linear extrapolation and discount rates of 5% and 15% in the calculation?

A. 6.26%B. 5.95%C. 7.19%D. 5.4%

5. Jeeves Company has issued debt which is convertible in 5 years time. Interest is payable at 12% and the current market value of the debt is $108.

On conversion, investors will have a choice of either:

Cash at a 10% premium; or

14 shares per loan note.

The current share price is $7 and it is expected to grow in value by 3.5% per year.

Which of the following statements is correct?

A. Based on the information available, investors would be better off choosing to take the cash option by $6.39.

B. Based on the information available, investors would be better off choosing to take the conversion option by $6.39.

C. Based on the information available, investors would be indifferent between the cash and conversion option.

D. Based on the information available, investors would be better of choosing to take the cash option by $8.94.

6. A company has 8% preference share in issue at a current value of 94c. The tax rate is 30%. What is the cost of the preference shares?

A. 8.5%B. 6.0%C. 8.0%D. 5.6%




7. A company has a bank loan of $7m at a rate of 6%. The tax rate is 35%. What is the cost of the bank debt?

A. 6.0%B. 2.1%C. 3.9%D. 4.2%

8. Company A is funded as follows:



Loan Notes 1000

Bank Loan 500

The cost to the company of each of the above items has been calculated as:

Ordinary Shares 17%

Loan Notes 7%

Bank Loan 6%

The Loan notes are currently trading at $98.

The current share price is $3.50

What is the Weighted Average Cost of Capital?

A. 11.56%B. 16.19%C. 13.34%D. 17.24%





1. What is the nominal value of issued debt?

2. What is convertible debt convertible into?

3. What is the calculation for irredeemable debt?

4. A company has 10% irredeemable debt in issue at a market value of $97. If the tax rate is 30% what is the cost of the debt?

5. A company has 5 year 8% redeemable debt in issue at a market value of $103. The tax rate is 25%. What is the cost of the debt?

6. A company has 10% convertible debt in issue at a market value of $111 that is redeemable in 5 years at either cash or 5 shares per nominal. The current share price is $18 and is expected to grow at 2%. The tax rate is 30%. What is the cost of debt?

7. A company has 8% preference share in issue at a current value of 94c. What is the cost of the preference shares.

8. A company has a bank loan of $7m at a rate of 6%. The tax rate is 35%. What is the cost of the bank debt?

9. The company has each of the types of debt in questions 4 to 6 on their balance sheet at a book value of $10m for each of them except for the bank debt which is on the balance sheet at $7m. If the company has a market value of $110m with a cost of equity of 14% then what is the company’s weighted average cost of capital?

10. What if the company has each of the types of debt in questions 4 to 6 on their balance sheet at a book value of $8m for each of them except for the bank debt which is on the balance sheet at $7m. If the company has a market value of $99m with a cost of equity of 12% then what is the company’s weighted average cost of capital?

If you’ve successfully answered all of the above questions then you’re ready to do the exam questions below:December 2008 Q3 (a)June 2010 Q2June 2008 Q1

Now do it!




Lecture 17 Capital Structure







Capital Structure - Illustration 1

A company has total capital of $1,000 with debt making up $300 and equity making up $700 of the total. The company’s cost of debt is 5% and cost of equity is 14%.

I. Calculate the company’s current WACC.II. Calculate the WACC if the company substitutes $200 of equity for $200 of debt

causing their cost of equity to rise to 16%.III. Calculate the WACC if the company substitutes $300 of equity for $300 of debt

causing their cost of equity to rise to 25%.




Test Your Knowledge


1. Which of the following statements concerning capital structure theory is correct?

A. In the traditional view, there is a linear relationship between the cost of equity and financial risk

B. Modigliani and Miller said that, in the absence of tax, the cost of equity would remain constant

C. Pecking order theory indicates that preference shares are preferred to convertible debt as a source of finance

D. Business risk is assumed to be constant

2. Which of the following statements concerning capital structure theory is correct?

A. The traditional view of capital structure suggests that the company can minimise their weighted average cost of capital

B. Modigliani and Miller said that, incorporating tax, the weighted average cost of capital would remain constant

C. Pecking order theory indicates that preference shares are preferred to convertible debt as a source of finance

D. Modigliani and Miller said that, incorporating tax, as gearing levels increase so the value of the company will decrease

3. Which of the following are assumptions that Modigliani and Miller made in their ‘no tax’ model?

1. No risk of bankruptcy no matter how much debt the company has.2. High transaction charges.3. The company is able to borrow at the risk free rate.4. The company has no debt in it’s capital structure.





4. What does the M&M model with tax suggest a company should do with their capital structure?

A. As there is greater financial risk at high levels of gearing the company should have as little debt as possible.

B. As the transaction costs will be high the company should retain their current capital structure for as long as possible.

C. As taking on more debt reduces the weighted average cost of capital the company should increase their gearing levels.

D. The company should find the optimum capital structure at which it can minimise its weighted average cost of capital.


1. What is capital structure?

2. What does the traditional view suggest you can do with the WACC?

3. Why would you want to do this?

4. What other assumptions did M & M make?

5. What does the M&M model with tax suggest we should do with our capital structure?


Pilot Paper Q1 (b)June 2009 Q1 (c)

Now do it!




Lecture 18 Financing & Investment







Project Specific Discount Rate - Illustration 1

Company A intends to undertake a project in an unrelated industry.

The following details are relevant:

Item Company A Proxy Company

Equity Beta (βe) 1.2 1.4

Value of Equity 1000 800

Value of Debt 400 500

The risk free rate is 4%.

The average return on the market is 12%.

Calculate a project specific discount rate.

Ignore Tax




Project Specific Discount Rate - Illustration 2

Company A intends to undertake a project in an unrelated industry.

The following details are relevant:

Item Company A Proxy Company

Equity Beta (βe) 1.1 1.3

Value of Equity 1200 900

Value of Debt 500 450

The risk free rate is 4%.

The average return on the market is 12%.


Calculate a project specific discount rate.

Ignore Tax




Test Your Knowledge


1. Company Alpha is financed with $1,000 of equity and $400 of debt and intends to undertake a project in an unrelated industry. They have identified Horizon Co. as a company in the new industry with $700 of equity and $300 of debt. Alpha Co. has a Beta of 1.3 whereas Horizon Co. has a Beta of 1.2. The risk free rate is 4% and the average return on the market is 12%. The tax rate is 30%.

Which of the following would be the project specific discount rate for Alpha Co. when entering the new industry?

A. 12.34%B. 10.25%C. 11.12%D. 13.42%

2. Company Alpha is financed with 60% equity and 40% debt and intends to undertake a project in an unrelated industry. They have identified Horizon Co. as a company in the new industry with 75% equity and 25% debt. Alpha Co. has a Beta of 1.1 whereas Horizon Co. has a Beta of 1.4. The risk free rate is 6% and the average return on the market is 14%. The tax rate is 30%.


A. 19.38%B. 18.00%C. 17.20%D. 16.32%




3. Company Alpha is financed with debt/equity of 1/4 and intends to undertake a project in an unrelated industry. They have identified Horizon Co. as a company in the new industry with debt/equity 1/3. Alpha Co. has a Beta of 1.05 whereas Horizon Co. has a Beta of 1.24. The risk free rate is 6% and the average return on the market is 14%. The tax rate is 30%.


A. 16.23%B. 15.49%C. 17.26%D. 18.28%


1. What are the two types of risk included in a company’s equity Beta?

2. When do we use the WACC as a discount rate?

3. What is capital structure?

4. What are the steps to calculate a project specific discount rate?

5. Our business has a Beta of 1.2, debt with a market value of 100 and equity with a market value of 400. If the proxy has a Beta of 1.4, debt with a market value of 100 and equity with a market value of 200 calculate a project specific discount rate. The risk free rate is 4% and the average market risk premium is 7%. Ignore tax.

6. What are the 3 types of market efficiency?

7. Describe weak form market efficiency.


December 2008 Q3 (c)June 2010 Q3 (c) (iii)December 2010 Q1 (c)

Now do it!




Lecture 19 More Debt







December 07 Exam Question (6 marks)

Phobis Co has in issue 9% bonds which are redeemable at their par value of $100 in five years’ time.

Alternatively, each bond may be converted on that date into 20 ordinary shares of the company. The current ordinary share price of Phobis Co is $4·45 and this is expected to grow at a rate of 6·5% per year for the foreseeable future. Phobis Co has a cost of debt of 7% per year.

Required: Calculate the following current values for each $100 convertible bond: (i) market value; (ii) floor value; (iii) conversion premium.




Test Your Knowledge


1. Luke Co has 8% convertible loan notes in issue which are redeemable in five years’ time at their nominal value of $100 per loan note. Alternatively, each loan note could be converted after five years into 70 equity shares with a nominal value of $1 each.

The equity shares of Luke Co are currently trading at $1·25 per share and this share price is expected to grow by 4% per year. The before-tax cost of debt of Luke Co is 10% and the after-tax cost of debt of Luke Co is 7%.

What is the current market value of each loan note to the nearest dollar?

A. $92 B. $96 C. $104 D. $109

2. A bond has a coupon rate of 8.5% per annum. The next interest payment will be made in one year’s time. The bond will repay the par value of $100 when it matures in seven years’ time. The before-tax cost of debt is 7% and the after-tax cost of debt is 5%.

What is the the expected current market price of the bond to the nearest dollar?

A. $98 B. $93 C. $108 D. $106




3. A bond has a coupon rate of 6% per annum and will repay its face value of $100 on its maturity in four years’ time. The yield to maturity on similar bonds is 4% per annum. The annual interest has just been paid for the current year.


A. $96 B. $92 C. $110 D. $107

4. Angus Co has 8% convertible loan notes in issue which are redeemable in five years’ time at their nominal value of $100 per loan note. Alternatively, each loan note could be converted after five years into 35 equity shares with a nominal value of $1 each. The tax rate is 30%

The equity shares of Angus Co are currently trading at $2·25 per share and this share price is expected to grow by 6% per year. The before-tax cost of debt of Luke Co is 10% and the after-tax cost of debt of Luke Co is 7%.

What is the current market value of each loan note to the nearest dollar?

A. $87 B. $96 C. $98 D. $108

5. A $100 bond has a coupon rate of 8% per annum and is due to mature in four years time. The next interest payment is due in one year’s time. Similar bonds have a yield to maturity of 10%.


A. $96 B. $94 C. $110 D. $100





1. How is the market value of convertible debt calculated?

2. What will the capital repaid figure in the IRR calculation be the higher of?

3. What is the floor value of convertible debt?

4. How is the floor value calculated?

5. What is the conversion premium?


Now do it!




Lecture 20 Currency Risk I







Buy or Sell Currency - Illustration 1

You have an invoice to pay to a US business of $1250 and you are a UK business.

The rate offered by the bank is $:£ 1.2500 - 1.3500

How many £ will it take to pay the $125?

Buy or Sell Currency - Illustration 2

You have issued an invoice to a US customer of $2000 and you are a UK business.

The rate offered by the bank is $:£ 1.4500 - 1.5500

How many £ will you receive for the $2000?




Purchasing Power Parity Theory - Illustration 3

The current exchange rate is 2$ per £.

Inflation in the US is 6%.

Inflation in the UK is 8%.

What will the FX rate be in 1 years time?

Interest Rate Parity Theory - Illustration 4

The current exchange rate is 2$ per £.

The interest rate in the US is 3%.

The interest rate in the UK is 2%.

What will the FX rate be in 1 years time?

Forward Rate - Illustration 5

ABC Company has entered into a contract whereby they will receive $500,000 from a US customer in 3 months.

ABC is a UK company.

A 3 month forward rate is available at $:£ 1.6000 +/- 0.0500.

Calculate the amount of £ ABC would receive under the forward contract.




Money Market Hedge - Illustration 6

A UK business needs to pay $350,000 to a US supplier in 3 months time.

Exchange rate now: $:£ 1.6500 - 1.7000

Deposit rates UK 4% annual US 6% annual

Borrowing rates UK 5% annual US 6.5% annual

How much £ will the transaction cost using a money market hedge?

Money Market Hedge Illustration 7

A UK business will receive $350,000 from a US supplier in 3 months time.

Exchange rate now: $:£ 1.6500 - 1.7000

Deposit rates UK 4% annual US 6% annual

Borrowing rates UK 5% annual US 6.5% annual

How much £ will the business receive using a money market hedge?




Test Your Knowledge


1. The home currency of ACB Co is the dollar ($) and it trades with a company in a foreign country whose home currency is the Dinar. The following information is available:

Home Country Foreign Country

Spot Rate 20.00 Dinar per $

Interest Rate 3% per year 7% per year

Inflation Rate 2% per year 5% per year

What is the six-month forward exchange rate?

A 20·39 Dinar per $ B 20·30 Dinar per $ C 20·59 Dinar per $ D 20·78 Dinar per $

2. What is the impact of a fall in a country’s exchange rate?

1 Exports will be given a stimulus 2 The rate of domestic inflation will rise

A 1 only B 2 only C Both1 and 2 D Neither 1 nor 2




3. The date is 31 January 2014 and Avecas Co. has entered into a contract whereby they will receive $300,000 from a US customer on 01 April 2014. Avecas Co. is a UK company.

The following forward rates are available:

2 Month Rate $:£ 1.6000 +/- 0.0500.3 Month Rate $:£ 1.5000 +/- 0.0500.6 Month Rate $:£ 1.4000 +/- 0.0500.

What amount in £ will Avecas Co. receive under the appropriate forward contract to the nearest £.?

A. £181,818B. £193,548C. £206,897D. £495,000

4. Hilasys Co. is a UK business that needs to pay $250,000 to a US supplier in 3 months time. The spot rate now is: $:£ 1.6500 - 1.7000. Deposit rates in the UK are 5% annual and in the US are 7% annual. Borrowing rates in the UK are 3% annual and in the US are 4.5% annual.

What will the transaction cost Hilasys Co. to the nearest £ using a money market hedge?

A. £181,818B. £245,700C. £148,909D. £150,026

5. Varys Co is a UK business that will receive $500,000 from a US supplier in 3 months time. The spot rate now is: $:£ 1.6500 - 1.7000. Deposit rates in the UK are 5% annual and in the US are 6.5% annual. Borrowing rates in the UK are 3% annual and in the US are 4% annual

How much to the nearest £ will the Varys receive using a money market hedge?

A. £256,732B. £294,846C. £291,206D. £495,050





1. $/£ 1.35 - 1.45 which currency is the counter currency?

2. UK company receiving $500. Spot rate is $/£ 1.35 - 1.45. How many £ will the company receive?

3. UK inflation is 5%, US inflation is 2%. The spot rate is $/£ 1.35. What will the FX rate be in one year’s time?

4. What are the internal methods of hedging currency risk?

5. What are the disadvantages of a forward contract?

6. How many £ will a company receive if they take a forward contract at a rate of $/£ 1.55 +/- 0.05 for an amount of $400,000?

7. How does a money market hedge eliminate the foreign currency risk?

8. A UK company is going to pay $400,000 to a US supplier in 3 months time. The UK deposit rate is 4.5% and the borrowing rate is 5.5%. The US deposit rate is 5.5% and the borrowing rate is 6.5%. Calculate the cost of the payment if the company uses a money market hedge?


Pilot Paper Q2 (All except part (a))December 2008 Q4 (a), (b) & (c)

Now do it!




Lecture 21 Currency Risk II







Test Your Knowledge


1. ‘There is a risk that the value of our foreign currency-denominated assets and liabilities will change when we prepare our accounts.’

To which risk does the above statement refer? A Translation risk B Economic risk C Transaction risk D Interest rate risk

2. Which of the following are advantages of a using a futures contract to hedge foreign exchange risk?

1. High transaction costs.2. It can be traded and thus closed out at any time.3. It is an effective hedge.4. The company can take advantage of “upside risk”.


3. Which of the following are disadvantages of a using a futures contract to hedge foreign exchange risk?

1. They can be arranged for standard contract sizes only2. They are available for a a wide range of currencies3. There is no upside risk if the currency movement is in your favour4. There is a large premium to pay on the contract.





4. Which of the following are advantages of a using an option on a currency to hedge foreign exchange risk?

1. High transaction costs.2. It can be traded and thus closed out at any time.3. It is an effective hedge.4. The company can take advantage of “upside risk”.


5. Which of the following are disadvantages of a using an option on a currency to hedge foreign exchange risk?

1. They can be arranged for standard contract sizes only2. They are available for a a wide range of currencies3. There is no upside risk if the currency movement is in your favour4. There is a large premium to pay on the contract.






1. What are the 3 types of FX risk?

2. Explain each of the 3.

3. What is a futures contract?

4. What are the advantages of a future?

5. What are the disadvantages of a future?

6. How do you undertake a future contract?

7. What is an option?

8. What is the main advantage of an option?

9. Are there any downsides to an option?

10.What type of risk will an option hedge?


Pilot Paper Q2 (a)December 2008 Q4 (d)

Now do it!




Lecture 22 Interest Rate Risk







Test Your Knowledge


1. In relation to hedging interest rate risk, which of the following statements is correct?

A. The flexible nature of interest rate futures means that they can always be matched with a specific interest rate exposure

B. Interest rate options carry an obligation to the holder to complete the contract at maturity

C. Forward rate agreements are the interest rate equivalent of forward exchange contracts D. Matching is where a balance is maintained between fixed rate and floating rate debt

2. Which of the following are disadvantages of using an interest rate swap to hedge interest rate risk?

1. There is a risk that one of the parties fails to pay their side of the swap.2. It is a reversible agreement.3. The decision to move into the swap may be the wrong decision as interest rates may

change unexpectedly.4. The transactions costs can be very high.


3. Which of the following statements are correct in reference to using an ‘over the counter’ interest rate option to manage interest rate risk?

A. It constitutes an contract with a bank to secure a specific interest rate no matter what happens.

B. It is an agreement with a bank that ensures that the company can take advantage of low rates, but secure against high rates.

C. It is an exchange traded contract that can be closed out at any time.D. It enables the company to swap from a fixed interest rate to a floating rate or vice-versa.




4. In relation to hedging interest rate risk, which of the following statements is correct?

A. The flexible nature of interest rate futures means that they can always be matched with a specific interest rate exposure

B. Interest rate options carry an obligation to the holder to complete the contract at maturity

C. Forward rate agreements are the interest rate equivalent of money market hedging of foreign exchange risk

D. Smoothing is where a balance is maintained between fixed rate and floating rate debt

5. Which of the following statements about the yield curve is correct?

1. In normal circumstances the curve is upward sloping.2. Liquidity preference theory explains the yield curve on the basis that investors generally

prefer cash.3. Expectations theory explains the yield curve as the market generally expects interest

rates to be lower in the future.4. The yield curve can be used to predict interest rates.

A 1, 2 and 3 only B 1 and 3 only C 2 and 3 only D 1, 2 and 4 only





1. What internal methods may a firm use to manage interest rate risk?

2. What is an FRA?

3. Why might a firm use an interest rate option to manage interest rate risk?

4. What is an Interest Rate Swap?

5. What are the disadvantages of an interest rate swap?

6. What does a Yield Curve plot?

7. In what way does a Yield Curve slope?

8. What are the three ways in which theorists have sought to explain the slope of the yield curve?


Now do it!




Lecture 23 Islamic Finance







Test Your Knowledge

If you can’t answer all of the questions below without looking at the answer then you need to do some more work on this area!Multiple Choice

1. In relation to Islamic Finance, which of the following statements is correct?

A. It is possible under certain circumstances to charge interest on an Islamic Finance product.

B. There is a lot of use of partnerships and joint ventures under Islamic Finance.C. It is not possible for a financial product to be compatible with Sharia law.D. Islamic Finance is only available to those of the muslim faith.


1. What is the main principle behind islamic finance?

2. What should money only be generated by?

3. What are the Islamic terms for ‘forbidden’ and ‘permitted’?

4. How will a mortgage work under islamic financial principles?

5. What is the islamic term for a bank loan?

6. How will lease finance (ijara) work under islamic finance?

7. What must debt finance relate to under islamic finance principles?

8. What is the islamic finance term for a joint venture?


Now do it!




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