p4 mock

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ACCA P4 final mock june2014

ACCA P4 Advanced Financial Management

June2014

Final Mock Exam Question+Answer Paper

Q2-4: choose 2 out of 3

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Lesco Group Limited, April 2014

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or

transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or

otherwise, without the prior written permission of Lesco Group Limited.

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Q1

Tramont Co is a listed company based in the USA and manufactures electronic devices. One

of its devices, the X-IT, is produced exclusively for the American market. Tramont Co is

considering ceasing the production of the X-IT gradually over a period of four years because

it needs the manufacturing facilities used to make the X-IT for other products.

The government of Gamala, a country based in south-east Asia, is keen to develop its

manufacturing industry and has offered Tramont Co first rights to produce the X-IT in

Gamala and sell it to the USA market for a period of four years. At the end of the four-year

period, the full production rights will be sold to a government backed company for Gamalan

Rupiahs (GR) 450 million after tax (this amount is not subject to inflationary increases).

Tramont Co has to decide whether to continue production of the X-IT in the USA for the

next four years or to move the production to Gamala immediately.

Currently each X-IT unit sold makes a unit contribution of $20. This unit contribution is not

expected to be subject to any inflationary increase in the next four years. Next years production and sales estimated at 40,000 units will fall by 20% each year for the following

three years. It is anticipated that after four years the production of X-IT will stop. It is

expected that the financial impact of the gradual closure over the four years will be cost

neutral (the revenue from sale of assets will equal the closure costs). If production is

stopped immediately, the excess assets would be sold for $2.3 million and the costs of

closure, including redundancy costs of excess labour, would be $1.7 million.

The following information relates to the production of the X-IT moving to Gamala. The

Gamalan project will require an initial investment of GR 230 million, to pay for the cost of

land and buildings (GR 150 million) and machinery (GR 80 million). The cost of machinery is

tax allowable and will be depreciated on a straight line basis over the next four years, at the

end of which it will have a negligible value.

Tramont Co will also need GR 40 million for working capital immediately. It is expected that

the working capital requirement will increase in line with the annual inflation rate in Gamala.

When the project is sold, the working capital will not form part of the sale price and will be

released back to Tramont Co.

Production and sales of the device are expected to be 12,000 units in the first year, rising to

22,000 units, 47,000 units and 60,000 units in the next three years respectively.

The following revenues and costs apply to the first year of operation:

Each unit will be sold for $70; The variable cost per unit comprising of locally sourced materials and labour will be GR 1,350, and;

In addition to the variable cost above, each unit will require a component bought from Tramont Co for $7, on which Tramont Co makes $4 contribution per unit;

Total fixed costs for the first year will be GR 30 million.

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The costs are expected to increase by their countries respective rates of inflation, but the selling price will remain fixed at $70 per unit for the four-year period.

The annual corporation tax rate in Gamala is 20% and Tramont Co currently pays

corporation tax at a rate of 30% per year. Both countries corporation taxes are payable in the year that the tax liability arises. A bi-lateral tax treaty exists between the USA and

Gamala, which permits offset of overseas tax against any US tax liability on overseas

earnings.

The USA and Gamalan tax authorities allow losses to be carried forward and written off

against future profits for taxation purposes.

Tramont Co has decided to finance the project by borrowing the funds required in Gamala.

The commercial borrowing rate is 13% but the Gamalan government has offered Tramont

Co a 6% subsidised loan for the entire amount of the initial funds required. The Gamalan

government has agreed that it will not ask for the loan to be repaid as long as Tramont Co

fulfils its contract to undertake the project for the four years. Tramont Co can borrow dollar

funds at an interest rate of 5%.

Tramont Cos financing consists of 25 million shares currently trading at $2.40 each and $40 million 7% bonds trading at $1,428 per $1,000. Tramont Cos quoted beta is 1.17. The current risk free rate of return is estimated at 3% and the market risk premium is 6%. Due

to the nature of the project, it is estimated that the beta applicable to the project if it is all-

equity financed will be 0.4 more than the current all-equity financed beta of Tramont Co. If

the Gamalan project is undertaken, the cost of capital applicable to the cash flows in the

USA is expected to be 7%.

The spot exchange rate between the dollar and the Gamalan Rupiah is GR 55 per $1. The

annual inflation rates are currently 3% in the USA and 9% in Gamala. It can be assumed

that these inflation rates will not change for the foreseeable future. All net cash flows arising

from the project will be remitted back to Tramont Co at the end of each year.

There are two main political parties in Gamala: the Gamala Liberal (GL) Party and the

Gamala Republican (GR) Party.

Gamala is currently governed by the GL Party but general elections are due to be held soon.

If the GR Party wins the election, it promises to increase taxes of international companies

operating in Gamala and review any commercial benefits given to these businesses by the

previous government.

Required:

(a) Prepare a report for the Board of Directors (BoD) of Tramont Co that

(i) Evaluates whether or not Tramont Co should undertake the project to produce

the X-IT in Gamala and cease its production in the USA immediately. In the

evaluation, include all relevant calculations in the form of a financial assessment

and explain any assumptions made.

It is suggested that the financial assessment should be based on present value of

the operating cash flows from the Gamalan project, discounted by an appropriate

all-equity rate, and adjusted by the present value of all other relevant cash flows.

(27 marks)

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(ii) Discusses the potential change in government and other business factors that

Tramont Co should consider before making a final decision. (8 marks)

Professional marks for format, structure and presentation of the report for part (a)

(4 marks)

(b) Although not mandatory for external reporting purposes, one of the members

of the BoD suggested that adopting a triple bottom line approach when monitoring

the X-IT investment after its implementation, would provide a better

assessment of how successful it has been.

Discuss how adopting aspects of triple bottom line reporting may provide a better

assessment of the success of the X-IT. (6 marks)

(c) Another member of the BoD felt that, despite Tramont Co having a wide range

of shareholders holding welldiversified portfolios of investments, moving the

production of the X-IT to Gamala would result in further risk diversification

benefits.

Discuss whether moving the production of the X-IT to Gamala may result in

further risk diversification for the shareholders already holding well diversified

portfolios. (5 marks)

(50 marks)

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Q2

Alecto Co, a large listed company based in Europe, is expecting to borrow

22,000,000 in four months time on 1 May 2012 and today is 1 DEC2011. It

expects to make a full repayment of the borrowed amount nine months from now.

Currently there is some uncertainty in the markets, with higher than normal rates

of inflation, but an expectation that the inflation level may soon come down. This

has led some economists to predict a rise in interest rates and others suggesting an

unchanged outlook or maybe even a small fall in interest rates over the next six

months.

Although Alecto Co is of the opinion that interest rates could increase by 05% in

four months, it wishes to protect itself from interest rate fluctuations by using

derivatives. The company can borrow at LIBOR plus 80 basis points and LIBOR is

currently 33%. The company is considering using interest rate futures as possible

hedging choices.

The following information and quotes from an appropriate exchange are provided

on Euro futures and options. Margin requirements may be ignored.

Three month Euro futures, 1,000,000 contract, tick size 001% and tick value 25

March 9627

June 9616

September 9590

Required:

(a)Show the outcome of hedge by using interest rate futures. (15marks)

(b)Calculate the effective interest costs as a result of interest rate future

hedge.(2marks)

(c)Alecto Co is considering to selling the hotel properties, the board of directors is

considering a demerger of the hotel services and a separate property company which would

own the hotel properties. The property company would take over 70% of Alecto Co s long-

term debt and pay Alecto Co cash for the balance of the property value.

Required:

Explain what a demerger is, and the possible benefits and drawbacks of pursuing

the demerger option as opposed to selling the hotel properties. (8 marks)

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Q3

Doric Co has two manufacturing divisions: parts and fridges. Although the parts

division is profitable, the fridges division is not, and as a result its share price has

declined to $0.50 per share from a high of $2.83 per share around three years ago.

Assume it is now 1 January 2013 .

The board of directors are considering two proposals:

(i) To cease trading and close down the company entirely, or;

(ii) To close the fridges division and continue the parts division through a leveraged

management buyout.. The new company will continue with manufacturing parts

only, but will make an additional investment of $50 million in order to grow the

parts division after-tax cash flows by 3.5% in perpetuity. The proceeds from the

sale of the fridges division will be used to pay the outstanding liabilities. The

finance raised from the management buy-out will pay for any remaining

liabilities, the funds required for the additional investment, and to purchase the

current equity shares at a premium of 20%. The fridges division is twice the

size of the parts division in terms of its assets attributable to it.

Extracts from the most recent financial statements:

Financial Position as at 31 December 2012

$m

Non-Current Assets 110

Current Assets 220

Share capital ($0.40 per share par

value)

40

Reserves 10

Liabilities (Non-current and current) 280

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Income Statement for the year ended 31 December 2012

Sales revenue: Parts division

Fridges division

170

340

Costs prior to depreciation, interest payments and tax:

Parts division

Fridges division

(340)

(120)

Depreciation, tax and interest (34)

Loss (14)

If the entire companys assets are sold, the estimated realisable values of

assets are as follows:

$m

Non-current assets 100

Current assets 110

The following additional information has been provided

Redundancy and other costs will be approximately $54 million if the whole company

is closed, and pro rata for individual divisions that are closed. These costs have

priority for payment before any other liabilities in case of closure.

The taxation effects relating to this may be ignored.

Corporation tax on profits is 20% and it can be assumed that tax is payable in the

year incurred. Annual depreciation on non-current assets is 10% and this is the

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amount of investment needed to maintain the current level of activity. The new

companys cost of capital is expected to be 11%.

Required:

(a) Briefly discuss the possible benefits of Doric Cos parts division being

divested through a management buy-out.

(4 marks)

(b) Estimate the return the liability holders and the shareholders would

receive in the event that Doric Co is closed and all its assets sold.

(3 marks)

(c) Estimate the additional amount of finance needed and the value of the

new company, if only the assets of fridges division are sold and the parts

division is divested through a management buy-out. Briefly discuss

whether or not the management buy-out would be beneficial.

(10 marks)

(d) Doric Cos directors are of the opinion that they could receive a better

price if the fridges division is sold as a going concern instead of its assets

sold separately. They have been told that they need to consider two

aspects when

selling a company or part of a company:

(i) Seeking potential buyers and negotiating the sale price; and,

(ii) Due diligence.

Discuss the issues that should be taken into consideration with each

aspect.

(8 marks)

(25 marks)

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Q4

Hav Co is a publicly listed company involved in the production of highly technical and

sophisticated electronic components for complex machinery. It has a number of diverse and

popular products, an active research and development department, significant cash reserves

and a highly talented management who are very good in getting products to market quickly.

A new industry that Hav Co is looking to venture into is biotechnology, which has been

expanding rapidly and there are strong indications that this recent growth is set to continue.

However, Hav Co has limited experience in this industry. Therefore it believes that the best

and quickest way to expand would be through acquiring a company already operating in this

industry sector.

Strand Co is a private company operating in the biotechnology industry and is owned by a

consortium of business angels and company managers. The owner-managers are highly

skilled scientists who have developed a number of technically complex products, but have

found it difficult to commercialise them.

They have also been increasingly constrained by the lack of funds to develop their

innovative products further.

Discussions have taken place about the possibility of Strand Co being acquired by Hav Co.

Strand Cos managers have indicated that the consortium of owners is happy for the negotiations to proceed. If Strand Co is acquired, it is expected that its managers would

continue to run the Strand Co part of the larger combined company.

Strand Co is of the opinion that most of its value is in its intangible assets, comprising

intellectual capital. Therefore, the premium payable on acquisition should be based on the

present value to infinity of the after tax excess earnings the company has generated in the

past three years, over the average return on capital employed of the biotechnological

industry. However, Hav Co is of the opinion that the premium should be assessed on

synergy benefits created by the acquisition and the changes in value, due to the changes in

the price-to-earnings (PE) ratio before and after the acquisition.

Given below are extracts of financial information for Hav Co for 2013 and Strand Co for

2011, 2012 and 2013:

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The current average PE ratio of the biotechnology industry is 164 times and it has been

estimated that Strand Cos PE ratio is 10% higher than this. However, it is thought that the PE ratio of the combined company would fall to 145 times after the acquisition. The annual

after tax earnings will increase by $140 million due to synergy benefits resulting from

combining the two companies.

Both companies pay tax at 20% per annum and Strand Cos annual cost of capital is estimated at 7%. Hav Cos current share price is $924 per share. The biotechnology industrys pre-tax return on capital employed is currently estimated to be 20% per annum.

Hav Co has proposed to pay for the acquisition using one of the following three methods:

(i) A cash offer of $572 for each Strand Co share; or

(ii) A cash offer of $133 for each Strand Co share plus one Hav Co share for every two

Strand Co shares; or

(iii) A cash offer of $125 for each Strand Co share plus one $100 3% convertible bond for

every $5 nominal value of Strand Co shares. In six years, the bond can be converted into

12 Hav Co shares or redeemed at par.

Required:

(a) Distinguish between the different types of synergy and discuss possible

sources of synergy based on the above scenario. (9 marks)

(b) Based on the two different opinions expressed by Hav Co and Strand Co,

calculate the maximum acquisition premium payable in each case. (6 marks)

(c) Calculate the percentage premium per share that Strand Cos shareholders will receive under each acquisition payment method and justify, with explanations,

which payment method would be most acceptable to them. (10 marks)

(25 marks)

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ACCA P4 Advanced Financial Management

June2014

Final Mock Exam Answer Paper

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Lesco Group Limited, April 2014

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or

transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or

otherwise, without the prior written permission of Lesco Group Limited.

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Q1

Report

To:board of directors

From: financial analyst

Date:

Subject: project appraisal.

Introduction: This report addresses the above subjects in turn.

(i)

Evaluation: [all calculations are in the appendix]

We firstly calculate base case NPV for projects started in GAMALA and then

adjusted for any other financing effect and other relevant cash flows.

Based on the calculation in the appendix, the APV is $2.4m and this suggests that

company should move its production to GAMALA.

Assumptions:

We have used cost of capital to discount the subsidy instead of risk free rate but

risk free rate can be used as well.

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We borrow money for the full amount of $270 but in the real world this would be

based on the debt capacity rather than full amount.

The exchange rate is predicted using purchasing power parity and this may not be

accurate.

(ii)

Other factors:

There would be a government change soon and this would increase company taxes

and hence reduce companys profit.

Company should consider whether it has international trade experience as well, ie,

fit into GAMALAs culture?

Company should also consider other real options as well, eg, option to delay

projects given a large amount of opportunity costs incurred in year 1.

Company would need to consider whether or not the investment fits into the overall

companys strategy.

Co needs to consider the impact on its reputation due to possible redundancies.

Conclusion:

Following a detailed analysis by using NPV, APV, government changes and other

factors and it would be advisable to move company to GAMALA.

Appendix: (copy from tutor)

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(b)

Triple bottom line measures profit, planet and people.

Management should make sure that when making a decision that they have

considered all these three factors and produce a report as long as the benefit or it

exceeds the costs of it.

Eg, moving company to GAMALA then company can highlight its impact on planet

and people and this would make company become a good citizen and hence

improve its reputation as well.

Also, company can claim more potential government grant from being a good

citizen as well.

And hence this would further improve companys reputation and allow company to

make more profit.

And this in turn would create more jobs opportunities to the society as well.

(C)

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Shareholders would suffer systematic risk and this cannot be diversified away.

Eg, inflation; economic recession.

Shareholders would diversify unsystematic risk if they hold well diversified

portfolios.

Eg, companys specific risk.

In the Q, it is not clear whether diversification benefits will result in the investment

in Gamala because it depends on the size of the investment and the nature of the

business operations as well and also whether the investment is the diversification

away from the market as well.

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Q2 answer

(a)

Consider (borrow) (3.3%+0.5%)+(80/100 %) X22,000,000X5/12 (421,667)

Profit or loss from future market(W1) 12,950

Actual borrow 408,717

W1: Profit or loss from future market:

P/L per future contract(W2) X number of contracts(W3) XContract size = total P/L

Or

Ticks (P/L per future contract(W2)(already in %)/ (0.01%): 0.14 %/0.01% =14ticks )

X number of contracts(W3) :37

X tick value(25 given. Or 0.01%X 1,000,000X3/12)

= total P/L=14X37X25=12,950

W2: P/L per future contract (Table)

Now(DEC2011) Settlement(1may2012) P/L

Spot 96.7 (3.3%) 96.2 (3.3%+0.5%) 0.5

Future 96.16(sell June) 96.02(buy) 0.14

Basis 0.54 0.54X2(unexpired)/6(total)

1may-30june

DEC11-30june

96.16-96.02=0.14 or for interest rate future we can use a trick:

9616-9602=14ticks(when calculate ticks)

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W3: number of contracts

No of contracts= Amount X duration

Contract Size 3

=22,000,000 X 5(begin in 4months and pay back in 9 months: so duration=5months)

1,000,000 3

=36.6=37contracts

(b) Effective(net) cost= effective rate x amount X 5/12

So effective rate=effective cost/amount /5 X12

=408,717/22,000,000/5 X12=4.46%

(c)

Definition:

De-merger means to split one company into two parts.

Each company then would remain independent.

Benefits:

By separating companies into hotel and property then it would make the individual

value of each company more apparent.

Separate management teams would focus on individual company and to create

more value to each company.

This would not lower down the value of company comparing to selling lots of

properties to the outside.

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Drawbacks:

The process would be expensive to the company and hence decrease market value

of company.

The new property company would need to raise the extra finance to pay the cash

for the remaining property values

Coeden Co may not have the expertise among its existing management team to

manage a property company.

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Q3

(a) Benefits:

This would have fewer costs compared to other ways to dispose because for example, company doesnt need to incur advertising expense relating to management buy-outs.

Its quick by raising money from management buy-outs.

There would be less resistance from the managers and employees making the process smoother.

The offer price would be more given management has knowledge in this field and they are able to make it successful.

(b)

If total assets are sole then we should use net realizable value for the assets to

reflect the salable assets value.

Noncurrent assets 100

+ Current assets 110

Total assets 210

- Redundancy & other costs (54)

Net proceeds 156

Liabilities(SOFP) 280

The debt holders would get 156/280= $0.56 per $1 liability (owing to them).

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And because there would be no residual value after using the net proceeds to pay

off the liabilities and hence there would be nothing to pay back to shareholders any

more.

(C)

Sell off the PARTS Division to existing management:

Funds needed:

Debt {total liability-2/3xnet proceeds of 156(b)=(280-104)}

176

Equity (OSC+reserves:40+10)X(1+20%) 60

Others New investment

50

Funds required: $286m

New value of company= CF in perpetuity (W1)

Cost of capital growth rate

=33.4X(1+3.5%)

11%-3.5%

=$461m

W1: CF in perpetuity:

Sales 170

-Costs (120)

-

depreciation[(100X1/3)+50]X10%=

(8.3)

PBT 41.7

-tax (41.7X20%) (8.3)

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PAT(assume CF) 33.4

Decision:

Because the total value of new company is $461m which is 1.6times greater than funds required for MBO so it would be beneficial to proceed with the MBO.

But the estimation of value of new company may be wrong and subject to future changes and hence it would be more appropriate to use other methods to value

the company like using free cash flow method as well.

(d)

Seeking buyers

The potential buyers may be sought through a long process from market or agent.

To seek who is going to buy should be careful because some of them would be competitors and company may subject to hostile bid and hence making the overall price of the company being forced to drag down.

Negotiate the price

The negotiation of the price would be a long process as well with the buyer.

Buyer would use lots of techniques estimating the value of the company and this would be based on the due diligence result below.

Due diligence

This would mean the buyer would assess the financial information and non-financial information of the target company.

Doric should present the most up to date account to the buyer as well as all

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legal documents relating to the assets being transferred as well to the potential buyer.

Doric would need to assess how the buyer would finance the acquisition and time it takes as well to complete the sale.

Also Doric should have a legal team to assess any contractual issues as well.

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Q4 answer

(a)

The reason why business combined together is because they want to have

synergies, ie, 1+1>2.

There are three types of synergies:

Revenue synergy

Cost synergy

Financial synergy

Revenue synergy:

This means after combination, business can further increase their sales revenue.

In the scenario:

1. Hav Co can use its funds to help advertise Strand Co products and hence get

more sales revenue.

2. Hav and Strand co can share the active research and development department to

create profitable products.

3. Some of the Strand products would need components in Hav Co and hence cross

selling chances would arise and hence increase sales revenue.

Cost synergy:

This means after combination, business can further save their costs.

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In the scenario:

1. The combined entity would have more power as a buyer and hence this would

decrease the price paid to suppliers.

2. Functions within company can be combined like accounting department and

company would benefit from economic of scale and hence reduce its costs.

Financing synergy:

This means after combination, business can further use up the funds and increase

debt borrowing.

In the scenario:

Hav Co surplus funds can be used to develop Strand Co products.

Finance would be cheaper given the equity issued by company.

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(b)

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(c) Comment:

The cash and bond offer gives the highest return of 31.3%.

The convertible bond would be converted into equity in 6 years in 12 shares, ie,

including current share price, it would be 12sharesX$9.24/share-$110 which is

better than redeem $100 as cash.

The cash and share for share offer would allow shareholders to become the owner

of Hav company and they would have an option to sell their shares immediately and

if this is the case then it would cause the share price to decrease and hence the

overall return would be lower.

For cash consideration only, its the quickest way to get cash although the return is

lowest.

For Strand Co shareholders and managers who would like to continue to work in

Hav co and they may choose the cash+bond offer.

But for some of them who may prefer cash offer and this would depend on different

attitude of risks and other factors.

p4 mock

Documents

years production

production of x

production rights

closure costs

costs of closure

machinery gr

government of gamala

unit contribution