Financial management paper f9 revision question bankF9FM RQB qs d08

REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
Question 1 COMPANY OBJECTIVES
Justify and criticise the usual assumption made in financial management literature that the
objective of a company is to maximise the wealth of the shareholders. (Do not consider how this
wealth is to be measured).
Outline other goals that companies claim to follow, and explain why these might be adopted in
preference to the maximisation of shareholder wealth.
(20 marks)
Question 2 NON-FINANCIAL OBJECTIVES
What non-financial objectives might organisations have? In your answer, identify any
stakeholder group that may have a non-financial interest.
(12 marks)
Question 3 STAKEHOLDERS
Private sector companies have multiple stakeholders who are likely to have divergent interests.
Required:
(a)

Identify five stakeholder groups and briefly discuss their financial and other objectives.
(12 marks)

(b)

Examine the extent to which good corporate governance procedures can help manage
the problems arising from the divergent interests of multiple stakeholder groups in
private sector companies in the UK.
(13 marks)
(25 marks)

Question 4 NOT-FOR-PROFIT
Discuss the nature of the financial objectives that may be set in a not-for-profit organisation such
as a charity or a hospital.

(8 marks)
Question 5 TAGNA
Tagna is a medium-sized company that manufactures luxury goods for several well-known chain stores.
In real terms, the company has experienced only a small growth in turnover in recent years, but it has
managed to maintain a constant, if low, level of reported profits by careful control of costs. It has paid a
constant nominal (money terms) dividend for several years and its managing director has publicly
stated that the primary objective of the company is to increase the wealth of shareholders. Tagna is
financed as follows:
Overdraft
10 year fixed interest bank loan
Share capital and reserves

$m
1·0
2·0
4·5
–––
7·5
–––

1


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Tagna has the agreement of its existing shareholders to make a new issue of shares on the stock market
but has been informed by its bank that current circumstances are unsuitable. The bank has stated that if
new shares were to be issued now they would be significantly under-priced by the stock market,
causing Tagna to issue many more shares than necessary in order to raise the amount of finance it
requires. The bank recommends that the company waits for at least six months before issuing new
shares, by which time it expects the stock market to have become strong-form efficient.

The financial press has reported that it expects the Central Bank to make a substantial increase in
interest rate in the near future in response to rapidly increasing consumer demand and a sharp rise in
inflation. The financial press has also reported that the rapid increase in consumer demand has been
associated with an increase in consumer credit to record levels.
Required:
(a)

Discuss the meaning and significance of the different forms of market efficiency (weak,
semi-strong and strong) and comment on the recommendation of the bank that Tagna
waits for six months before issuing new shares on the stock market.
(9 marks)

(b)

On the assumption that the Central Bank makes a substantial interest rate increase,
discuss the possible consequences for Tagna in the following areas:
(i)
(ii)
(iii)

(c)

sales;
operating costs; and,
earnings (profit after tax).

(10 marks)

Explain and compare the public sector objective of “value for money” and the private
sector objective of “maximisation of shareholder wealth”.

(6 marks)
(25 marks)

Question 6 MONOPOLY
An important element in the economic and financial management environment of companies is the
regulation of markets to discourage monopoly.
Required:
Outline the economic problems caused by monopoly and explain the role of government in
maintaining competition between companies.
(9 marks)
Question 7 EFFICIENT MARKET HYPOTHESIS
Explain the meaning of the term “Efficient Market Hypothesis” and discuss the implications for a
company if the stock market on which it is listed has been found to be semi-strong form efficient.
(9 marks)

2


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
Question 8 BURLEY PLC
(a)

Burley plc, a manufacturer of building products, mainly supplies the wholesale trade. It has
recently suffered falling demand due to economic recession, and thus has spare capacity. It
now perceives an opportunity to produce designer ceramic tiles for the home improvement
market. It has already paid $0.5m for development expenditure, market research and a
feasibility study.
The analysis reveals scope for selling 150,000 boxes per annum over a five-year period at an
initial price of $20 per box. Estimated operating costs, largely based on experience, are as
follows:

Cost per box of tiles ($) (at today’s prices):
Material cost
Direct labour
Variable overhead
Fixed overhead (allocated)
Distribution, etc.

8.00
2.00
1.50
1.50
2.00

Production can take place in existing facilities although initial re-design and set-up costs
would be $2m after allowing for all relevant tax reliefs. Returns from the project would be
taxed at 33%.
Burley’s shareholders require a nominal return of 14% per annum, which includes allowance
for generally-expected inflation of 5.5% per annum. It can be assumed that all operating cash
flows will inflate at 5.5%.
Required:
Assess the financial desirability of this venture, finding both the Net Present Value and
the Internal Rate of Return (to the nearest 1%) offered by the project.
Note: Assume no tax delay.

(7 marks)

(b)

Briefly explain the purpose of sensitivity analysis in relation to project appraisal,
indicating the drawbacks with this procedure.

(6 marks)

(c)

Determine the values of
(i)
(ii)

price
volume

at which the project’s NPV becomes zero.
Discuss your results, suggesting appropriate management action.

(7 marks)
(20 marks)

3


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Question 9 DEIGHTON PLC
You are the chief accountant of Deighton plc, which manufactures a wide range of building and
plumbing fittings. It has recently taken over a smaller unquoted competitor, Linton Ltd. Deighton is
currently checking through various documents at Linton’s head office, including a number of
investment appraisals. One of these, a recently rejected application involving an outlay on equipment of
$900,000, is reproduced below. It was rejected because it failed to offer Linton’s target return on
investment of 25% (average profit to-initial investment outlay). Closer inspection reveals several errors
in the appraisal.
Evaluation of profitability of proposed project NT17

(all values in nominal terms)
Item ($000)
Sales
Materials
Direct labour
Overheads
Interest
Depreciation
Profit pre-tax
Tax at 33%
Post-tax profit
Outlay
Inventory
Equipment
Market research

0

1
1,400
(400)
(400)
(100)
(120)
(225)
155
(51)
104

2

1,600
(450)
(450)
(100)
(120)
(225)
255
(84)
171

3
1,800
(500)
(500)
(100)
(120)
(225)
355
(117)
238

4
1,000
(250)
(250)
(100)
(120)
(225)
55
(18)

37

(100)
(900)
(200)
_____
(1,200)
_____

Rate of return =

Average profit
138
= 11.5%
=
1,200
Investment

You discover the following further details:
(1)

Linton’s policy was to finance both working capital and fixed investment by a bank overdraft.
A 12% interest rate applied at the time of the evaluation.

(2)

A 25% writing down allowance (WDA) on a reducing balance basis is offered for new
investment. Linton’s profits are sufficient to utilise fully this allowance throughout the
project.

(3)

Corporate tax is paid a year in arrears.

(4)

Of the overhead charge, about half reflects absorption of existing overhead costs.

(5)

The market research was actually undertaken to investigate two proposals, the other project
also having been rejected. The total bill for all this research has already been paid.

(6)

Deighton itself requires a nominal return on new projects of 20% after taxes, is currently
ungeared and has no plans to use any debt finance in the future.

4


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
Required:
Write a report to the finance director in which you:
(a)

Identify the mistakes made in Linton’s evaluation.

(b)

Restate the investment appraisal in terms of the post-tax net present value to Deighton,
recommending whether the project should be undertaken or not.
(10 marks)

(10 marks)

(20 marks)
Question 10 BLACKWATER PLC

Blackwater plc, a manufacturer of speciality chemicals, has been reported to the anti-pollution
authorities on several occasions in recent years, and fined substantial amounts for making excessive
toxic discharges into local rivers. Both the environmental lobby and Blackwater’s shareholders demand
that it clean up its operations.
It is estimated that the total fines it may incur over the next four years can be summarised by the
following probability distribution (all figures are expressed in present values):
Level of fine
$0.5m
$1.4m
$2.0m

Probability
0.3
0.5
0.2

Filta & Strayne Ltd (FSL), a firm of environmental consultants; has advised that new equipment costing
$1m can be installed to virtually eliminate illegal discharges. Unlike fines, expenditure on pollution
control equipment is tax-allowable via a 25% writing-down allowance (reducing balance). The rate of
corporate tax is 33%, paid with a one-year delay. The equipment will have no resale value after its
expected four-year working life, but can be in full working order immediately prior to Blackwater’s

next financial year.
A European Union Common Pollution Policy grant of 25% of gross expenditure is available, but with
payment delayed by a year. Immediately on receipt of the grant from the EU, Blackwater will pay 20%
of the grant to FSL as commission. These transactions have no tax implications for Blackwater.
A disadvantage of the new equipment is that it will raise production costs by $30 per tonne over its
operating life. Current production is 10,000 tonnes per annum, but expected to grow by 5% per annum
compound. It can be assumed that other production costs and product price are constant over the next
four years. No change in working capital is envisaged.
Blackwater applies a discount rate of 12% after all taxes to investment projects of this nature. All cash
inflows and outflows occur at year ends.
Required:
(a)

Calculate the expected net present value of the investment assuming a four-year
operating period. Briefly comment on your results.
(12 marks)

(b)

Write a memorandum to Blackwater’s management as to the desirability of the project,
taking into account both financial and non-financial criteria.
(8 marks)
(20 marks)

5


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Question 11 ARR AND PAYBACK
(a)

Explain and illustrate (using simple numerical examples) the Accounting Rate of Return
and Payback approaches to investment appraisal, paying particular attention to the
limitations of each approach.
(6 marks)

(b)

(i)

Explain the differences between NPV and IRR as methods of Discounted Cash
Flow analysis.
(6 marks)

(ii)

A company with a cost of capital of 14% is trying to determine the optimal
replacement cycle for the laptop computers used by its sales team. The following
information is relevant to the decision:
The cost of each laptop is $2,400. Maintenance costs are payable at the end of each
full year of ownership, but not in the year of replacement e.g. if the laptop is owned
for two years, then the maintenance cost is payable at the end of year 1.
Interval between
Replacement (years)
1
2
3

Trade-in Value ($)

Maintenance cost ($)

1200
800
300

Zero
75 (payable at end of Year 1)
150 (payable at end of Year 2)

Required:
Ignoring taxation, calculate the equivalent annual cost of the three different
replacement cycles, and recommend which should be adopted. What other factors
should the company take into account when determining the optimal cycle?
(8 marks)
(20 marks)
Question 12 LEAMINGER PLC

Leaminger plc has decided it must replace its major turbine machine on 31 December 2002. The
machine is essential to the operations of the company. The company is, however, considering whether
to purchase the machine outright or to use lease financing.
Purchasing the machine outright

The machine is expected to cost $360,000 if it is purchased outright, payable on 31 December 2002.
After four years the company expects new technology to make the machine redundant and it will be
sold on 31 December 2006 generating proceeds of $20,000. Capital allowances for tax purposes are
available on the cost of the machine at the rate of 25% per annum reducing balance. A full year’s
allowance is given in the year of acquisition but no writing down allowance is available in the year of
disposal. The difference between the proceeds and the tax written down value in the year of disposal is
allowable or chargeable for tax as appropriate.

Leasing

The company has approached its bank with a view to arranging a lease to finance the machine
acquisition. The bank has offered two options with respect to leasing which are as follows:

Contract length (years)
Annual rental
First rent payable

6

Finance
Lease
4
$135,000
31 December 2003

Operating
Lease
1
$140,000
31 December 2002


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
General

For both the purchasing and the finance lease option, maintenance costs of $15,000 per year are payable
at the end of each year. All lease rentals (for both finance and operating options) can be assumed to be
allowable for tax purposes in full in the year of payment. Assume that tax is payable one year after the

end of the accounting year in which the transaction occurs. For the operating lease only, contracts are
renewable annually at the discretion of either party. Leaminger plc has adequate taxable profits to
relieve all its costs. The rate of corporation tax can be assumed to be 30%. The company’s accounting
year-end is 31 December. The company’s annual after tax cost of capital is 10%.
Required:
(a)

Calculate the net present value at 31 December 2002, using the after tax cost of capital,
for
(i)

purchasing the machine outright;

(ii)

using the finance lease to acquire the machine; and

(iii)

using the operating lease to acquire the machine.

Recommend the optimal method.
(b)

(12 marks)

Assume now that the company is facing capital rationing up until 30 December 2003 when it
expects to make a share issue. During this time the most marginal investment project, which
is perfectly divisible, requires an outlay of $500,000 and would generate a net present value
of $100,000. Investment in the turbine would reduce funds available for this project.

Investments cannot be delayed.
Calculate the revised net present values of the three options for the turbine given capital
rationing. Advise whether your recommendation in (a) would change.
(5 marks)

(c)

As their business advisor, prepare a report for the directors of Leaminger plc that
assesses the issues that need to be considered in acquiring the turbine with respect to
capital rationing.
(8 marks)
(25 marks)

Question 13 BASRIL PLC

Basril plc is reviewing investment proposals that have been submitted by divisional managers. The
investment funds of the company are limited to $800,000 in the current year. Details of three possible
investments, none of which can be delayed, are given below.
Project 1

An investment of $300,000 in work station assessments. Each assessment would be on an individual
employee basis and would lead to savings in labour costs from increased efficiency and from reduced
absenteeism due to work-related illness. Savings in labour costs from these assessments in money terms
are expected to be as follows:
Year
Cash flows ($000)

1
85

2
90

3
95

4
100

5
95

Project 2

An investment of $450,000 in individual workstations for staff that is expected to reduce administration
costs by $140,800 per annum in money terms for the next five years.
7


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Project 3

An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per annum are
expected in current price terms and these are expected to increase by 3·6% per annum due to inflation
during the five-year life of the machines.
Basril plc has a money cost of capital of 12% and taxation should be ignored.
Required:
(a)

Determine the best way for Basril plc to invest the available funds and calculate the

resultant NPV:
(i)

on the assumption that each of the three projects is divisible;

(ii)

on the assumption that none of the projects are divisible.

(10 marks)

(b)

Explain how the NPV investment appraisal method is applied in situations where capital
is rationed.
(3 marks)

(c)

Discuss the reasons why capital rationing may arise.

(d)

Discuss the meaning of the term “relevant cash flows” in the context of investment
appraisal, giving examples to illustrate your discussion.
(5 marks)

(7 marks)

(25 marks)

Question 14 LKL PLC

LKL plc is a manufacturer of sports equipment and is proposing to start project VZ, a new product line.
This project would be for the four years from the start of year 19X1 to the end of 19X4. There would be
no production of the new product after 19X4.
You have recently joined the company’s accounting and finance team and have been provided with the
following information relating to the project:
Capital expenditure

A feasibility study costing $45,000 was completed and paid for last year. This study recommended that
the company buy new plant and machinery costing $1,640,000 to be paid for at the start of the project.
The machinery and plant would be depreciated at 20% of cost per annum and sold during year 19X5 for
$242,000 receivable at the end of 19X5. As a result of the proposed project it was also recommended
that an old machine be sold for cash at the start of the project for its book value of $16,000. This
machine had been scheduled to be sold for cash at the end of 19X2 for its book value of $12,000.

8


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)

Other data relating to the new product line:
19X1
$000
1,000
84

Sales
Receivables (at the year end)
Lost contribution

on existing products
30
Purchases
400
Payables (at the year end)
80
Payments to sub-contractors,
60
including prepayments of
5
Net tax payable
associated with this project
96
Fixed overheads and advertising:
With new line
1,330
Without new line
1,200

19X2
$000
1,300
115

19X3
$000
1,500
140

19X4

$000
1,800
160

40
500
100
90
10

40
580
110
80
8

36
620
120
80
8

142

174

275

1,100
1,000

990
900

900
800

Notes

−
−
−
−
−

The year-end receivables and payables are received and paid in the following year.
The net tax payable has taken into account the effect of any capital allowances. There is a one
year time-lag in the payment of tax.
The company’s cost of capital is a constant 10% per annum.
It can be assumed that operating cash flows occur at the year end.
Apart from the data and information supplied there are no other financial implications after
19X4.

Labour costs

From the start of the project, three employees currently working in another department and earning
$12,000 each would be transferred to work on the new product line, and an employee currently earning
$20,000 would be promoted to work on the new line at a salary of $30,000 per annum. The effect of the
transfer of employees from the other department to the project is included in the lost contribution
figures given above.

As a direct result of introducing the new product line, four employees in another department currently
earning $10,000 each would have to be made redundant at the end of 19X1 and paid redundancy pay of
$I5,500 each at the end of 19X2.
Agreement had been reached with the trade unions for wages and salaries to be increased by 5% each
year from the start of 19X2.
Material costs

Material XNT which is already in inventory, and for which the company has no other use, cost the
company $6,400 last year, and can be used in the manufacture of the new product. If it is not used the
company would have to dispose of it at a cost to the company of $2,000 in 19X1.
Material XPZ is also in inventory and will be used on the new line. It cost the company $11,500 some
years ago. The company has no other use for it, but could sell it on the open market for $3,000 in 19X1.

9


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Required:
(a)

Prepare and present a cash flow budget for project VZ, for the period 19X1 to 19X5 and
calculate the net present value of the project.
(14 marks)

(b)

Write a short report for the board of directors which:

(c)

(i)

explains why certain figures which were provided in (a) were excluded from
your cash flow budget, and

(ii)

advises them on whether or not the project should be undertaken, and lists
other factors which would also need to be considered.
(7 marks)

LKL needs to raise $5 million to finance project VZ, and other new projects. The proposed
investment of the $5 million is expected to yield pre-tax profits of $2 million per annum.
Earnings on existing investments are expected to remain at their current level. From the data
supplied below:
Statement of Financial Position (extract from last year):
Authorised share capital Ordinary shares of 50c each

$000
20,000
_____

Issued ordinary share capital, Shares of 50c each
Reserves
10% Debentures (19X4)
Bank Overdraft (secured)

2,500
4,000
2,000

2,000
_____
10,500
_____

Other information:
Turnover
Net profit after interest and tax
Interest paid
Dividends paid and proposed

$000
55,000
3,000
200
800

The 50c ordinary shares are currently quoted at $2.25 per share: The company’s tax rate is
33%. The average gearing percentage for the industry in which the company operates is 35%
(computed as debt as a percentage of debt plus equity, based on book values, and excluding
bank overdrafts).
(i)

Calculate and comment briefly on the company’s current capital gearing.

Discuss briefly the effect on gearing and EPS at the end of the first full year following the
new investment if the $5 million new finance is raised in each of the following ways;
(ii)

By issuing ordinary shares at $2 each.

(iii)

By issuing 5% convertible loan stock, convertible in 19X4. The conversion
ratio is 40 shares per $ 100 of loan stock.

(iv)

By issuing 7.5% undated debentures.

(You should ignore issue costs in your answers to parts (ii) – (iv))

(14 marks)
(35 marks)

10


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
Question 15 SPRINGBANK PLC

Springbank plc is a medium-sized manufacturing company that plans to increase capacity by
purchasing new machinery at an initial cost of $3m. The following are the most recent financial
statements of the company:
Income Statements for years ending 31 December
2002
$000
5,000
3,100
––––––

1,900
400
––––––
1,500
400
––––––
1,100
330
––––––
770
390
––––––
380
––––––

Sales
Cost of Sales
Gross Profit
Administration and Distribution Expenses
Profit before Interest and Tax
Interest
Profit before Tax
Tax
Profit after Tax
Dividends
Retained Earnings

2001
$000
5,000

3,000
––––––
2,000
250
––––––
1,750
380
––––––
1,370
400
––––––
970
390
––––––
580
––––––

Statements of Financial Position as at 31 December

Fixed Assets
Current Assets
Inventory
Receivables
Cash
Current Liabilities

10% Debentures 2007

Capital and Reserves

$000
1,170
850
130
––––––
2,150
1,150
––––––

2002

$000
6,500

1,000
––––––
7,500
3,500
––––––
4,000
––––––
4,000
––––––

$000
1,000
900
100
––––––
2,000

1,280
––––––

2001

$000
6,400

720
––––––
7,120
3,500
––––––
3,620
––––––
3,620
––––––

11


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK

The investment is expected to increase annual sales by 5,500 units. Investment in replacement
machinery would be needed after five years. Financial data on the additional units to be sold is as
follows:
$
500
200

Selling price per unit
Production costs per unit

Variable administration and distribution expenses are expected to increase by $220,000 per year as a
result of the increase in capacity. In addition to the initial investment in new machinery, $400,000
would need to be invested in working capital. The full amount of the initial investment in new
machinery of $3 million will give rise to capital allowances on a 25% per year reducing balance basis.
The scrap value of the machinery after five years is expected to be negligible. Tax liabilities are paid in
the year in which they arise and Springbank plc pays tax at 30% of annual profits.
The Finance Director of Springbank plc has proposed that the $3·4 million investment should be
financed by an issue of debentures at a fixed rate of 8% per year.
Springbank plc uses an after tax discount rate of 12% to evaluate investment proposals. In preparing its
financial statements, Springbank plc uses straight-line depreciation over the expected life of fixed
assets.
Average data for the business sector in which Springbank operates is as follows:
Gearing (book value of debt/book value of equity)
Interest Cover
Current Ratio
Inventory Days
Return before Interest and Tax/Capital Employed

100%
4 times
2:1
90 days
25%

Required:
(a)

Calculate the net present value of the proposed investment in increased capacity of
Springbank plc, clearly stating any assumptions that you make in your calculations.
(11 marks)

(b)

Calculate the increase in sales (in units) that would produce a zero net present value for
the proposed investment.
(4 marks)

(c)

(i)

Calculate the effect on the gearing and interest cover of Springbank plc of
financing the proposed investment with an issue of debentures and compare
your results with the sector averages.
(6 marks)

(ii)

Analyse and comment on the recent financial performance of the company.
(13 marks)

(iii)

On the basis of your previous calculations and analysis, comment on the
acceptability of the proposed investment and discuss whether the proposed
method of financing can be recommended.
(10 marks)

(d)

Briefly discuss the possible advantages to Springbank plc of using an issue of ordinary
shares to finance the investment.
(6 marks)
(50 marks)

12


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
Question 16 NESPA PLC

Nespa is a profitable medium-sized toy manufacturer that has been listed on a stock exchange for three
years. Although the company has an overdraft, it has no long-term debt and its current interest cover is
high compared to similar companies. Its return on capital employed, however, is close to the average
for its business sector. One of its machines is leased under an operating lease, but the company has no
other leasing or hire purchase commitments. The company owns two factories and the land on which
they are built, as well as a small fleet of delivery vehicles. The company does not own any retail outlets
through which to distribute its manufactured output.
Nespa is considering an investment in a new machine, with a maximum output of 200,000 units per
annum, in order to manufacture a new toy. Market research undertaken for the company indicated a link
between selling price and demand, and the research agency involved has suggested two sales strategies
that could be implemented, as follows:
Strategy 1
Selling price (in current price terms)
$8·00 per unit
Sales volume in first year
100,000 units

Annual increase in sales volume after first year
5%

Strategy 2
$7·00 per unit
110,000 units
15%

The services of the market research agency have cost $75,000 and this amount has yet to be paid.
Nespa expects economies of scale to reduce the variable cost per unit as the level of production
increases. When 100,000 units are produced in a year, the variable cost per unit is expected to be $3·00
(in current price terms). For each additional 10,000 units produced in excess of 100,000 units, a
reduction in average variable cost per unit of $0·05 is expected to occur. The average variable cost per
unit when production is between 110,000 units and 119,999 units, for example, is expected to be $2·95
(in current price terms); and the average variable cost per unit when production is between 120,000
units and 129,999 units is expected to be $2·90 (in current price terms), and so on.
The new machine would cost $1,500,000 and would not be expected to have any resale value at the end
of its life. Capital allowances would be available on the investment on a 25% reducing balance basis.
Although the machine may have a longer useful economic life, Nespa uses a five-year planning period
for all investment projects. The company pays tax at an annual rate of 30% and settles tax liabilities in
the year in which they arise.
Operation of the new machine will cause fixed costs to increase by $110,000 (in current price terms).
Inflation is expected to increase these costs by 4% per year. Annual inflation on the selling price and
unit variable costs is expected to be 3% per year. For profit reporting purposes Nespa depreciates
machinery on a straight-line basis over its planning period.
Nespa applies three investment appraisal methods to new projects because it believes that a single
investment appraisal method is unable to capture the true value of a proposed investment. The methods
it uses are net present value, internal rate of return and return on capital employed (accounting rate of
return). The company believes that net present value measures the potential increase in company value
of an investment project: that a high internal rate of return offers a margin of safety for risky projects;

and that a project’s before-tax return on capital employed should be greater than the company’s beforetax return on capital employed, which is 20%. Nespa does not use any explicit method of assessing
project risk and has an average cost of capital of 10% in money (nominal) terms.
The company has not yet decided on a method of financing the purchase of the new machine, although
the finance director believes that a new issue of equity finance is appropriate given the amount of
finance required.

13


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Required:
(a)

Determine the sales strategy which maximizes the present value of total contribution.
Ignore taxation in this part of the question.
(9 marks)

(b)

Evaluate the investment in the new machine using internal rate of return.

(c)

Evaluate the investment in the new machine using return on capital employed
(accounting rate of return) based on the average investment.
(5 marks)

(d)

Critically discuss the relative advantages and disadvantages of internal rate of return

and return on capital employed (accounting rate of return), and comment on Nespa’s
views on investment appraisal methods.
(8 marks)

(e)

Discuss TWO methods that could be used to assess the risk or level of uncertainty
associated with an investment project.
(8 marks)

(f)

Discuss the factors that Nespa should consider when selecting an appropriate source of
finance for the new machine.
(8 marks)

(12 marks)

(50 marks)
Question 17 BREAD PRODUCTS LTD

Bread Products Ltd is considering the replacement policy for its industrial size ovens which are used as
part of a production line that bakes bread. Given its heavy usage each oven has to be replaced
frequently. The choice is between replacing every two years or every three years. Only one type of oven
is used, each of which costs $24,500. Maintenance costs and resale values are as follows:
Year

1
2
3

Maintenance
per annum
$
500
800
1,500

Resale value

$
15,600
11,200

Original cost, maintenance costs and resale values are expressed in current prices. That is, for example,
maintenance for a two year old oven would cost $800 for maintenance undertaken now. It is expected
that maintenance costs will increase at 10% per annum and oven replacement cost and resale values at
5% per annum. The money discount rate is 15%.
Required:
(a)

Calculate the preferred replacement policy for the ovens in a choice between a two year
or three year replacement cycle.
(12 marks)

(b)

Identify the limitations of Net Present Value techniques when applied generally to
investment appraisal.
(13 marks)

(25 marks)

14


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
Question 18 SASSONE PLC

Sassone plc is a medium-sized profitable company that manufactures engineering products. Its stated
objectives are to maximise shareholder wealth and to maintain an ethical approach to the production
and distribution of engineering products. It has in issue two million ordinary shares, held as follows:
Pension funds
Insurance companies
Investment trusts
Unit trusts
Directors of Sassone
Other shareholders

Number of shares
550,000
250,000
200,000
100,000
350,000
550,000
––––––––––
2,000,000
––––––––––

The Managing Director of Sassone plc is considering two items that have been placed on the agenda of

the next Board Meeting:
(1)

Complaint by institutional investors

A number of institutional investors complained at the recent Annual General Meeting of the
company that expenditure on environmentally-friendly and socially responsible projects was
at too high a level, resulting in a less than acceptable increase in annual dividend payments.
They had warned that they would vote against the re-appointment of directors if matters had
not improved by the next Annual General Meeting.
(2)

Proposal to increase manufacturing capacity

The directors of Sassone plc need to increase capacity in order to meet expected demand for a
new product, Product G, which is to be used in the manufacture of new-generation personal
computers. Product G cannot be manufactured on existing machines. The directors have
identified two machines which can manufacture Product G, each with a capacity of 60,000
units per year, as follows:
Machine One

This machine will cost $238,850 and last for five years, at the end of which time it will have
zero scrap value. Maintenance costs will be $10,000 in the first year of operation, increasing
by $3,000 per year for each year of operation.
Machine Two

This machine will cost $215,000 and last for four years, at the end of which time it will have
zero scrap value. Maintenance costs will be $10,000 in the first year of operation, increasing
by $5,000 per year for each year of operation.
Sassone plc expects demand for Product G to be 30,000 units per year in the first year, and to

increase by a further 10,000 units per year in each subsequent year. Selling price is expected
to be $10·00 per unit and the marginal cost of production is expected to be $7·80 per unit.
Incremental fixed production overheads of $10,000 per year will be incurred. Selling price
and costs are all in current price terms.

15


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK

Annual inflation rates are expected to be as follows:
Selling price of Product G:
Marginal cost of production:
Maintenance costs:
Fixed production overheads:

4% per year
4% per year
5% per year
6% per year

Other information

Sassone plc has a real cost of capital of 8% and uses a nominal (money) cost of capital of 11% in
investment appraisal. The company pays tax one year in arrears at an annual rate of 30% and can claim
capital allowances on a 25% reducing balance basis, with a balancing allowance at the end of the life of
the machines. The company depreciates fixed assets on a straight-line basis over the life of the asset and
has a target before-tax return on capital employed (accounting rate of return) of 25%.
Required:
(a)

Using equivalent annual cost and considering machine purchase prices and maintenance
costs only, determine which machine should be purchased by Sassone. Ignore inflation
and taxation in this part of the question only.
(6 marks)

(b)

Calculate the net present value of the incremental cash flows arising from purchasing
Machine Two and advise on its acquisition.
(18 marks)

(c)

Calculate the before-tax return on capital employed (accounting rate of return) of the
incremental cash flows arising from purchasing Machine Two based on the average
investment and comment on your findings.
(4 marks)

(d)

Discuss the conflict that may arise between corporate objectives, using the information
provided on Sassone plc to illustrate your answer.
(10 marks)
(38 marks)

Question 19 UMUNAT PLC

Umunat plc is considering investing $50,000 in a new machine with an expected life of five years. The
machine will have no scrap value at the end of five years. It is expected that 20,000 units will be sold

each year at a selling price of $3·00 per unit. Variable production costs are expected to be $1·65 per
unit, while incremental fixed costs, mainly the wages of a maintenance engineer, are expected to be
$10,000 per year. Umunat plc uses a discount rate of 12% for investment appraisal purposes and
expects investment projects to recover their initial investment within two years.
Required:
(a)

Explain why risk and uncertainty should be considered in the investment appraisal
process.
(5 marks)

(b)

Calculate and comment on the payback period of the project.

(c)

Evaluate the sensitivity of the project’s net present value to a change in the following
project variables:
(i)
(ii)
(iii)

(4 marks)

sales volume;
sales price;
variable cost;

and discuss the use of sensitivity analysis as a way of evaluating project risk. (10 marks)

16


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
(d)

Upon further investigation it is found that there is a significant chance that the expected sales
volume of 20,000 units per year will not be achieved. The sales manager of Umunat plc
suggests that sales volumes could depend on expected economic states that could be assigned
the following probabilities:
Economic state
Probability
Annual sales volume (units)

Poor
0·3
17,500

Normal
0·6
20,000

Good
0·1
22,500

Calculate and comment on the expected net present value of the project.

(6 marks)
(25 marks)

Question 20 ARG CO

ARG Co is a leisure company that is recovering from a loss-making venture into magazine publication
three years ago. Recent financial statements of the company are as follows.
Income Statement for year ending 30 June 2005

Turnover
Cost of sales
Gross profit
Administration costs
Profit before interest and tax
Interest
Profit before tax
Taxation
Profit after taxation
Dividends
Retained profit

$000
140,400
112,840
––––––––
27,560
23,000
––––––––
4,560
900
––––––––
3,660

1,098
––––––––
2,562
400
––––––––
2,162
––––––––

17


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Statement of Financial Position as at 30 June 2005

$000

Fixed assets
Current assets
Inventory
Receivables
Cash

2,400
20,000
1,500
–––––––
23,900
33,000
–––––––

Current liabilities

9% Debentures 2014

Financed by:
Ordinary shares, $1 par value
Reserves
Retained earnings

$000
50,000

(9,100)
–––––––
40,900
10,000
–––––––
30,900
–––––––
2,000
27,000
1,900
–––––––
30,900
–––––––

The company plans to launch two new products, Alpha and Beta, at the start of July 2005, which it
believes will each have a life-cycle of four years. Alpha is the deluxe version of Beta. The sales mix is
assumed to be constant. Expected sales volumes for the two products are as follows.
Year

Alpha
Beta

1
60,000
75,000

2
110,000
137,500

3
100,000
125,000

4
30,000
37,500

The standard selling price and standard costs for each product in the first year will be as follows.
Product

Direct material costs
Incremental fixed production costs
Total absorption cost
Standard mark-up
Selling price

Alpha
$/unit

12·00
8·64
––––––
20·64
10·36
––––––
31·00
––––––

Beta
$/unit
9·00
6·42
––––––
15·42
7·58
––––––
23·00
––––––

ARG traditionally operates a cost-plus approach to product pricing.
Incremental fixed production costs are expected to be $1 million in the first year of operation and are
apportioned on the basis of sales value. Advertising costs will be $500,000 in the first year of operation
and then $200,000 per year for the following two years. There are no incremental non-production fixed
costs other than advertising costs.

18


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)

In order to produce the two products, investment of $1 million in premises, $1 million in machinery and
$1 million in working capital will be needed, payable at the start of July 2005. The investment will be
financed by the issue of $3 million of 9% debentures, each $100 debenture being convertible into 20
ordinary shares of ARG Co after 8 years or redeemable at par after 12 years.
Selling price per unit, direct material cost per unit and incremental fixed production costs are expected
to increase after the first year of operation due to inflation:
Selling price inflation
Direct material cost inflation
Fixed production cost inflation

3·0% per year
3·0% per year
5·0% per year

These inflation rates are applied to the standard selling price and standard cost data provided above.
Working capital will be recovered at the end of the fourth year of operation, at which time production
will cease and ARG Co expects to be able to recover $1·2 million from the sale of premises and
machinery. All staff involved in the production and sale of Alpha and Beta will be redeployed
elsewhere in the company.
ARG Co pays tax in the year in which the taxable profit occurs at an annual rate of 25%. Investment in
machinery attracts a first-year capital allowance of 100%. ARG Co has sufficient profits to take the full
benefit of this allowance in the first year. For the purpose of reporting accounting profit, ARG Co
depreciates machinery on a straight line basis over four years. ARG Co uses an after-tax discount rate
of 13% for investment appraisal.
Other information

Assume that it is now 30 June 2005
The ordinary share price of ARG Co is currently $4·00
Average interest cover for ARG Co’s sector is 7

Average gearing for ARG Co’s sector is 45% (long-term debt/equity using book values)
Required:
(a)

Calculate the net present value of the proposed investment in products Alpha and Beta.
(17 marks)

(b)

Identify and discuss any likely limitations in the evaluation of the proposed investment
in Alpha and Beta.
(6 marks)

(c)

Evaluate and discuss the proposal to finance the investment with a $3 million 9%
convertible debenture issue.
(8 marks)
(31 marks)

19


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Question 21 BFD CO

BFD Co is a private company formed three years ago by four brothers who, as directors, retain sole
ownership of its ordinary share capital. One quarter of the initial share capital was provided by each
brother. The company has returned a profit in each year of operation as shown by the following
financial statements.

Income Statements for years ending 30 November
2005
$000
5,200
4,570
––––––
630
70
––––––
560
140
––––––
420
20
––––––
400
––––––

Turnover
Cost of sales
Profit before interest and tax
Interest
Profit before tax
Tax
Profit after tax
Dividends
Retained profit

2004
$000

3,400
2,806
––––––
594
34
––––––
560
140
––––––
420
20
––––––
400
––––––

2003
$000
2,600
2,104
––––––
496
3
––––––
493
123
––––––
370
20
––––––
350

––––––

Statements of Financial Position as at 30 November

Fixed assets
Current assets
Inventory
Receivables
Current liabilities
Net current assets

Ordinary shares ($1 par)
Reserves

2005
$000 $000
1,600

1,450
1,400
––––––
2,850
2,300
––––––

550
––––––
2,150
––––––
1,000

1,150
––––––
2,150
––––––

2004
$000 $000
1,200

1,000
850
––––––
1,850
1,300
––––––

550
––––––
1,750
––––––
1,000
750
––––––
1,750
––––––

2003
$000 $000
800

600
400
––––––
1,000
450
––––––

550
––––––
1,350
––––––
1,000
350
––––––
1,350
––––––

BFD Co has an overdraft limit of $1·25 million and pays interest on its overdraft at a rate of 6% per
year. Current liabilities consist of trade payables and overdraft finance in each of the three years.
The directors are delighted with the rapid growth of BFD Co and are considering further expansion
through buying new premises and machinery to manufacture Product FT7. This new product has only
just been developed and patented by BFD Co. Test marketing has indicated considerable demand for
the product, as shown by the following research data.
20


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
Year of operation
Accounting year
Sales volume (units)

1
2005/6
100,000

2
2006/7
120,000

3
2007/8
130,000

4
2008/9
140,000

Sales after 2008/9 (the fourth year of operation) are expected to continue at the 2008/9 level in
perpetuity.
Initial investment of $3,000,000 would be required in new premises and machinery, as well as an
additional $200,000 of working capital. The directors have no further financial resources to offer and
are considering approaching their bank for a loan to meet their investment needs. Selling price and cost
data for Product FT7, based on an annual budgeted volume of 100,000 units, are as follows.
$ per unit
18·00
7·00
1·50
4·50

Selling price

Direct material
Direct labour
Fixed production overhead

The fixed production overhead is incurred exclusively in the production of Product FT7 and excludes
depreciation. Selling price and unit variable cost data for Product FT7 are expected to remain constant.
BFD Co expects to be able to claim writing down allowances on the initial investment of $3,000,000 on
a straight-line basis over 10 years. The company pays tax on profit at an annual rate of 25% in the year
in which the liability arises and has an after-tax cost of capital of 12%.
Average data for companies similar to BFD Co

Net profit margin:
Interest cover:
Inventory days:
Receivables days:

9%
15 times
85 days
75 days

Payables days:
Current ratio:
Quick ratio:
Debt/equity ratio:

70 days
2·1 times
0·8 times
40% (using book values)

Required:
(a)

Calculate the net present value of the proposed investment in Product FT7. Assume that
it is now 1 December 2005.
(16 marks)

(b)

Comment on the acceptability of the proposed investment in Product FT7 and discuss
what additional information might improve the decision-making process.
(7 marks)

(c)

BFD Co has received an offer from a rival company of $300,000 per year for 10 years for the
manufacturing rights for Product FT7. If BFD Co accepts this offer, it would not be able to
manufacture Product FT7 for the duration of the agreement.
Required:
Determine whether BFD Co should accept the offer for the manufacturing rights to
Product FT7. In this part of the question only, ignore cash flows occurring after the tenyear period of the offer. Assume that it is 1 December 2005.
(6 marks)

(d)

As the newly-appointed finance director of BFD Co, write a report to the board which
discusses whether the company is likely to be successful if it approaches its bank for a
loan. Your discussion should include an analysis of the current financial position and
recent financial performance of the company.

(16 marks)
(45 marks)
21


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK
Question 22 AGD CO

AGD Co is a profitable company which is considering the purchase of a machine costing $320,000. If
purchased, AGD Co would incur annual maintenance costs of $25,000. The machine would be used for
three years and at the end of this period would be sold for $50,000. Alternatively, the machine could be
obtained under an operating lease for an annual lease rental of $120,000 per year, payable in advance.
AGD Co can claim capital allowances on a 25% reducing balance basis. The company pays tax on
profits at an annual rate of 30% and all tax liabilities are paid one year in arrears. AGD Co has an
accounting year that ends on 31 December. If the machine is purchased, payment will be made in
January of the first year of operation. If leased, annual lease rentals will be paid in January of each year
of operation.
Required:
(a)

Using an after-tax borrowing rate of 7%, evaluate whether AGD Co should purchase or
lease the new machine.
(12 marks)

(b)

Explain and discuss the key differences between an operating lease and a finance lease.
(8 marks)

(c)

The after-tax borrowing rate of 7% was used in the evaluation because a bank had offered to
lend AGD Co $320,000 for a period of five years at a before-tax rate of 10% per year with
interest payable every six months.
Required:
(i)

Calculate the annual percentage rate (APR) implied by the bank’s offer to lend
at 10% per year with interest payable every six months.
(2 marks)

(ii)

Calculate the amount to be repaid at the end of each six-month period if the
offered loan is to be repaid in equal instalments.
(3 marks)
(25 marks)

Question 23 CHARM PLC

Charm plc, a software company, has developed a new game, “Fingo”, which it plans to launch in the
near future. Sales of the new game are expected to be very strong, following a favourable review by a
popular PC magazine. Charm plc has been informed that the review will give the game a “Best Buy”
recommendation. Sales volumes, production volumes and selling prices for “Fingo” over its four-year
life are expected to be as follows.
Year
Sales and production (units)
Selling price

1

150,000
$25

2
70,000
$24

3
60,000
$23

Financial information on “Fingo” for the first year of production is as follows:
Direct material cost
Other variable production cost
Fixed costs

22

$5·40 per game
$6·00 per game
$4·00 per game

4
60,000
$22


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)

Advertising costs to stimulate demand are expected to be $650,000 in the first year of production and

$100,000 in the second year of production. No advertising costs are expected in the third and fourth
years of production. Fixed costs represent incremental cash fixed production overheads. “Fingo” will be
produced on a new production machine costing $800,000. Although this production machine is
expected to have a useful life of up to ten years, government legislation allows Charm plc to claim the
capital cost of the machine against the manufacture of a single product. Capital allowances will
therefore be claimed on a straight-line basis over four years.
Charm plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which
they arise. Charm plc uses an after-tax discount rate of 10% when appraising new capital investments.
Ignore inflation.
Required:
(a)

Calculate the net present value of the proposed investment and comment on your
findings.
(11 marks)

(b)

Calculate the internal rate of return of the proposed investment and comment on your
findings.
(5 marks)

(c)

Discuss the reasons why the net present value investment appraisal method is preferred
to other investment appraisal methods such as payback, return on capital employed and
internal rate of return.
(9 marks)
(25 marks)

Question 24 JERONIMO PLC

Jeronimo plc currently has 5 million ordinary shares in issue, which have a market value of $1·60 each.
The company wishes to raise finance for a major investment project by means of a rights issue, and is
proposing to issue shares on the basis of 1 for 5 at a price of $1·30 each.
James Brown currently owns 10,000 shares in Jeronimo plc and is seeking advice on whether or not to
take up the proposed rights.
Required:
(a)

Explain the difference between a rights issue and a scrip issue. Your answer should
include comment on the reasons why companies make such issues and the effect of the
issues on private investors.
(6 marks)

(b)

Calculate:
(i)
(ii)

the theoretical value of James Brown’s shareholding if he takes up his rights;
and
the theoretical value of James Brown’s rights if he chooses to sell them.
(4 marks)

23


FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK

(c)

Using only the information given below, and applying the dividend growth model
formula, calculate the required return on equity for an investor in Jeronimo plc.

Jeronimo plc:
Current (1999) share price: $1·60
Number of shares in issue: 5 million
Current earnings: $1·5 million
Dividend Paid (cents per share):
1995: 8
1996: 9
1997: 11
1998: 11
1999: 12
(d)

(4 marks)

If the stock market is believed to operate with a strong level of efficiency, what effect
might this have on the behaviour of the finance directors of publicly quoted companies?
(6 marks)
(20 marks)

Question 25 PLY, AXIS & SPIN
Food Retailers: Ordinary Shares, Key Stock Market Statistics,
Company

Ply
Axis

Spin

Current
63
291
187

Share price (cents)
52 week high 52 week low
112
54
317
187
201
151

Dividend Yield (%) P/E Ratio
1·8
14·2
2·1
13·0
2·3
21·1

Required:
(a)

Illustrating your answer by use of data in the table above, define and explain the term
P/E ratio, and comment on the way it may be used by an investor to appraise a possible
share purchase.

(6 marks)

(b)

Using data in the above table, calculate the dividend cover for Spin and Axis, and
explain the meaning and significance of the measure from the point of view of equity
investors.
(8 marks)

(c)

Under what circumstances might a company be tempted to pay dividends which are in
excess of earnings, and what are the dangers associated with such an approach?
You should ignore tax in answering this question.

(6 marks)
(20 marks)

24


REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)
Question 26 SME FINANCE
Explain why very Small to Medium-size Enterprises (SMEs) might face problems in obtaining
appropriate sources of finance. In your answer pay particular attention to problems and issues
associated with:
(i)

uncertainty concerning the business;

(ii)

assets available to offer as collateral or security; and

(iii)

potential sources of finance for very new SMEs excluding sources from capital markets.
(12 marks)

Question 27 TECHFOOLS.COM

Techfools.com has just issued convertible debentures with an 8% per annum coupon to the value of
$5m. The nominal value of the debentures is $100 and the issue price was $105. The conversion details
are that 45 shares will be issued for every $100 convertible debentures held with a date for conversion
in five years exactly. Redemption, should the debenture not be converted, will also take place in exactly
five years. Debentures will be redeemed at $110 per $100 nominal convertibles held. It is widely
expected that the share price of the company will be $4 in five years’ time.
Assume an investor required return of 15%.
Ignore taxation in your answer.
Required:
(a)

Briefly explain why convertibles might be an attractive source of finance for companies.
(4 marks)

(b)

(i)

Estimate the current market value of the debentures, assuming conversion

takes place, using net present value methods and assess if it is likely that
conversion will take place.
(5 marks)

(ii)

Identify and briefly comment on a single major reservation you have with your
evaluation in part b(i).
(2 marks)

(c)

Explain why an issuing company seeks to maximise its conversion premium and why
companies can issue convertibles with a high conversion premium.
(4 marks)

(d)

Explain what is meant by the concept of intermediation (the role of a banking sector)
and how such a process benefits both investors and companies.
(10 marks)
(25 marks)

25