2013 Paper F9 QandA Sample

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Practice Questions and Answers Paper F9: Financial Management

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ACCA Paper F9: FINANCIAL MANAGEMENTDiagnostic Tests - Questions and Answers

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+Add Vance Study Material

Data MapCopyright Statement Environmental Notice Contents For the ladies only Electronic links Icons within this E-book Test your knowledge now!

Syllabus Study guideThe structure of the syllabus A. Financial management functionIntellectual levels B. Financial management environmentLearning hours C. Working capital managementGuide to exam structure D. Investment appraisalGuide to examination assessment E. Business finance

Aim F. Cost of capitalMain capabilities G. Business valuationsRelational diagram of main capabilities H. Risk managementRational Detailed syllabus

Approach to examining the syl lab us

ToolsPV table

Annuity table Formulae sheet Symbols and notations

Diagnost ic Test Topics1. Financial management function 2. Financial analysis 3. Financial management environment 4. Working capital Management 5. Cash management 6. Capital investment appraisal 7. Nature and role of financial markets and instit utions 8. Business finance 9. Cost of capital 10. Business and asset valuation

11. Risk management

Past Exam Questio ns and Answers

Addit ional study textIslamic finance

ACCA Paper F9Financial Management (FM)

Practice Questions & Answers

Only Topic 5 is activated for this free sample


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Contents

Tutorial Syllabus classificationScreen

Questions Answers

Tutorial 1 Financial management function 24 27

Tutorial 2 Financial analysis 31 39

Tutorial 3 Financial management environment 53 57

Tutorial 4 Working capital Management 68 79

Tutorial 5 Cash management 97 106

Tutorial 6 Capital investment appraisal 120 132

Tutorial 7 Nature and ro le of financial markets andinstitutions 159 164

Tutorial 8 Business finance 177 195

Tutorial 9 Cost of capital 231 239

Tutor ial 10 Business and asset valuation 254 261

Tutor ial 11 Risk management 272 290

Text Islamic finance 329

Past Exam Questions and Answers 354

Tony Surridge +Add Vance Study Materials ACCA F9 Diagnostic Tests – Practice Questions and Answers

Trust in Allah, but tie your camel first.

Arabic proverb




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ACCA Paper F9

Financial Management

Diagnostic Test:Cash management

Questions




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Question 1 What are the FOUR main responsibilities of the finance manager?

(4 marks )

Question 2 Strategic financial management in a company is concerned withTHREE key decisions. What are they? (3 marks )

Question 3 List FIVE responsibilities of a 'Cash manager' working in a largecompany. ( 5 marks)

Question 4 Write a formula which describes liquidity ? (1 mark)

Question 5 List FOUR categories of revenue expenses . (4 marks )

Question 6 List the FOUR main business motives for holding cash. (4 marks )

Question 7 One model used for forecasting cash is the 'Receipts and Payments Forecast'. List the SIX stagesinvolved in this model. (6 marks )

Question 8

Give THREE possible reasons for surplus cash. (3 marks )

Question 9 When the cash forecast shows surplus funds, plans are needed for putting them to use. List EIGHTfactors to be considered before investing these funds. (8 marks )

Question 10 Different investments bring different yields. ListTHREE main factors that influence the level ofyield. (3 marks)

Question 11 List FIVE short-term investments that a companymight make with temporary cash surpluses. (5 marks)

Question 12 In addition to deciding how much cash to hold in total and where spare cash should be invested, acompany must decide upon the proportion held as liquid cash. List FOUR factors which influence thisdecision. (4 marks )

Question 13 One model for determining the optimal cash balance is the 'economic quantity' model ('Baumol'model). State the equation which makes up this model. (2 marks)

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Brush up your knowledge by

working through smallquestions. Large questionsare made up of small parts

Question 14XYZ Company has a high investment of some $12m in short-term securities, which currently earn anaverage return of 5.4% per annum, or 0.45 percent for a one-month period ( i). The company's finance

director estimates a cash need of $2,000,000 ( P ) over a one-

month period where the cash is expected to be dispersed at aconstant rate. The transaction fee ( T) each time money iswithdrawn from the short-term securities is $200.

Calculate, by using the Baumol model:

(a) the optimal transaction size (withdrawal lot size) ( Q);(2 marks)

(b) the average cash balance; and (1 mark)

(c) the number of transactions which the company shouldmake during the month. (1 mark)

Question 15D Company expects to have a steady demand for cash for the next year amounting to $800,000. Thetransaction cost associated with selling marketable securities or borrowing each time the firm needs toreplenish its cash balances is $100. The company's opportunity interest rate is 8 percent per year.

Required:

(i) Calculate D Company's optimum transaction size (in $s). (2 marks)

(ii) Calculate the approximate number of transactions made each year, and their total cost.(1 mark)

(iii) Suppose the company's opportunity interest rate increases from 8 percent to 10 percent. Calculatethe revised optimum transaction size, and the total cost of transactions over the next year.

(2 marks)

(iv) Now suppose transaction costs increase from $100 to $150 but the interest rate remains 8 percent.Calculate the revised optimum transaction size, and the total cost of transactions over the year.

(2 marks)

The following formula should be used:

)securities marketableonforegonereturnof (ratecashholdingof costyopportunit i borrowingorsecurities selling of action per trans costsfixed T

period specified over the ctionsfor transa needed cashnewnetof amounttotal P accountcashsfirm' thetotransfertofundsof amountoptimal Q :

iT xP x2

====

=

Where

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Question 16

The last 50 day period had been analysed to determine the cash balance positions for XYZ Company.The analysis showed the following pattern of cash balances (to the nearest $2,000):

Days $5 12,000

10 14,00020 18,000

8 22,0007 24,000

50

You are required to calculate:

(a) the probability distribution for the cash position over the 50-day period; (2 marks )

(b) the 'expected' (arithmetic mean) cash balance for any day; (2 marks )

(c) the daily variance of cash flows. (2 marks )

(d) the standard deviation of cash per day. (1 mark)

For parts (c) and (d) you are to use the following formula:

Calculations are to be to the nearest $1.

Question 17Describe how the Miller-Orr model attempts to provide an approach to cash management

(2 marks )

Question 18The Miller-Orr model is based on a 'return point'. State the formula by which the return point iscalculated. (1 mark)

Question 19State the formula for the 'spread' of daily cash (used in the Miller-Orr model). (2 marks )

FOR YOUR INTEREST ONLY: NOT EXAMINABLE. This question will help you understand the dailyvariance that is used in the Miller-Orr model.

( )

balancecashdailymeancarithmetri x

balancecashactual x balancecashactualtheof y probabilit p

rootsquare

balancecashdailytheof deviationstandard :Where

2x -x p

=

==

==

Σ=σ

σ

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Question 20 Using the logic of Miller-Orr state the formula for the ‘upper limit’ of daily cash. (1 mark)

Question 21

Data is provided for XYZ Company which use the Miller-Orr cash model for treasury purposes.- The company's policy is to operate with a minimum cash balance of $8,000.- The fixed transaction cost for buying and selling securities is $12.- The opportunity interest rate on short-term securities is 0.028 per cent per day.- The company’s daily cash variance is $14,393,600, equivalent to a standard deviation of $3,794.

You are required to calculate:

(a) the company's upper limit of daily cash balance; (3 marks )(b) the cash 'return point‘; (1 mark)

which can then be used as a decision rule by the company's treasury management.

Question 22 Briefly describe the steps necessary to use the Miller-Orr model. (3 marks )

Question 23 A company’s cash forecast shows a serious cash deficit, even though the company has a good profitforecast. List FIVE ways that plans may be implemented to improve the future cash flow.

(5 marks )

Question 24 Antro Company is thinking of purchasing new plant and machinery. With this new plant andmachinery, the company expects sales to increase from $16,000,000 to $20,000,000.

Management know that the company's assets, debtors and accrued expenses vary directly with sales. Thecompany's after-tax profit margin on sales is 8 percent, and management plans to pay 40 percent of its after-tax earnings in dividends. The company's current statement of financial position is given below.

Statement of Financial Position$'000

Current assets 6,000Non-current assets 24,000Total assets 30,000

Accounts payable 8,000 Accrued expenses 2,000Long-term debt 6,000Ordinary share capital 4,000Retained earnings 10,000Total liabilities and net worth 30,000

You are required to prepare an estimated statement of financial position for the year after acquiring thenew plant and machinery and to determine the additional funds needed by the company by the end of thatyear.

(4 marks )

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Question 25The following sales budget is given for Saspong Company for the second quarter of 2013.

Apri l May Ju ne Total Sales budget $90,000 $100,000 $120,000 $310,000

Credit sales are collected as follows: 70 percent in month of sale, 20 percent in month following sale, 8percent in second month following sale, and 2 percent bad debts. The accounts receivable balance at thebeginning of the second quarter is $36,000, of which $7,200 represents uncollected February sales, and$28,800 represents uncollected March sales.

You are required to :

(a) calculate the total sales for February and March 2013. ( 3 marks)

(b) calculate the budgeted cash receipts from sales for April, May and June 2013. Without prejudice toyour answer at (a), assume February sales equal $80,000 and March sales equal $100,000.

(4 marks )

Question 26

The treasurer of Ernhar Company plans for the company to have a cash balance of $182,000 on1st June. Sales during June are estimated at $1,800,000. May sales amounted to $1,200,000 and Aprilsales amounted to $1,000,000. Cash payments for June have been budgeted at $1,160,000. Cashcollections have been estimated as follows: 60 percent of the sales for the month to be collected during themonth, 30 percent of the sales for the preceding month to be collected during the month, and 8 percent ofthe sales for the second preceding month to be collected during the month.

The treasurer plans to accelerate collections by allowing a 2 percent discount for prompt payment. Withthe discount policy, she expects to collect 70 percent of the current sales and will permit the discountreduction on these collections. Sales of the preceding month will be collected to the extent of 15 percentwith no discount allowed, and 10 percent of the sales of the second month will be collected with no discountallowed. This pattern of collection can be expected in subsequent months. During the transitional monthof June, collections may run somewhat higher. However, the treasurer prefers to estimate collections onthe basis of the new patterns so that estimates will be somewhat conservative.

You are required to :

(a) estimate cash collections (receipts) for June and the cash balance at 30 th June under the present policy;(3 marks )(b) estimate cash collections for June and the cash balance at 30 th June according to the new policy

allowing discounts; and (3 marks )

(c) Advise the company whether the discount policy is economically worthwhile. (1 mark)

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Question 27

Elizabeth Stores wants to estimate cash payments (disbursements) for cash budgeting purposes for the first3 months of 2013 from the data given below.

(i) Cost of merchandise sold, estimated

2012: December $450,0002013: January $500,000

February $560,000March $420,000

The cost of merchandise is to be paid for as follows: 35 percent in the month of sale and 65 percent inthe following month.

(ii) Wages for each month are estimated as follows:

2012: December $46,0002013: January $52,000

February $62,000March $50,000

All wages are paid as incurred.

(iii) Other expenses are to be paid every other month at the amount of $640 per month. The first paymentis to be made in February.

(iv) Six months' rent and insurance amounting to a total of $19,400 is to be paid in January.

(v) Corporation tax of $25,000 is to be paid in March.

(vi) Depreciation on equipment has been estimated at $15,000 for the year.

(vii) New equipment costing $100,000 is to be acquired in February, with a down payment of $8,000required at the date of purchase. The balance is to be paid in April using a 6%, 2-year loannegotiated with the bank. Repayment is by monthly payments of capital plus interest.

(viii) Other operating expenses have been estimated at $4,500 per month, which are to be paid each

month.

You are required to prepare a cash payments budget for each of the first 3 months of 2013. (7 marks)

Question 28Companies experience cash flow problems (deficit cash) for various reasons. List FIVE reasons.

(5 marks )

Question 29Define the term 'float' (as it relates to cash management practice). (1 mark)

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Question 30 Describe THREE reasons why there may be a lengthy float. (3 marks )

Question 31Describe SIX ways the float could be reduced. (6 marks )

- END -

End of the Diagnostic Testbased on ‘Cash management’

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ACCA Paper F9

Financial Management

Diagnostic Test:Cash management

Answer Guides




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Answer to Quest ion 1 The work of financial management includes the following.

1. The maintenance and production of statutory accounts.2. The provision of management accounting and management accounting information services.

3. Treasury management and strategic financial decisions.4. Internal audit (probably reporting to the 'Audit Committee')

Answer to Quest ion 2 1. How funds should be invested.2. How to obtain such funds.

3. Dividend policy.

Answer to Quest ion 31. Cash budgeting; daily, weekly, monthly, quarterly, annually and possibly longer term.2. Cashier's duties of making transactions payments to suppliers and paying wages, etc.3. Banking receipts.4. The management of short-term marketable securities (e.g. investing short-term surplus funds).5. Advising senior management of forecast cash deficit balances and advising on ways to deal

with this problem.

Answer to Quest ion 4

Liquidity = Cash + Current account + Sight deposits + Short-term securities(cheque account)

Answer to Quest ion 5 1. Material inputs2. Labour wages3. Direct expenses4. Overhead expenses

Bouncing cheque!

Click and bounceback to the question

screen

When the going gets tough, the tough get going.Kennedy family motto

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Answer to Quest ion 61. Transactions motive.2. Finance motive - repay loans, finance acquisition of assets.3. Precautionary motive - a cushion to meet unplanned spending.4. Speculation motive - to take advantage of short-term investment opportunities.

Answ er to Quest ion 71. Decide the budget period.2. Forecast sales for the budget period (usually month by month).3. Estimate ALL cash receipts (time lag to convert receivables to cash, and other cash receipts).4. Estimate ALL cash payments (supplies of raw materials, and other purchases and payments).5. Compute net cash flow per period within the budget period (often monthly).6. Develop a cash summary.

Answer to Quest ion 8 1. Over funding.2. A reduction in operating assets (the sale of assets).3. A surplus of retained earnings over the increase in net assets employed.

Answer to Quest ion 9Factors to consider are:1. the amount of funds available;2. the period for which funds are available;3. alternative yields that can be obtained;4. expectation of future interest rates;5. risk that unexpected liquidity will be required;6. tax considerations (different investment have different tax implications);7. risk and return from the investment; and8. does the company have outstanding borrowings that could be repaid early

(from the cash available).

Answer to Quest ion 10 1. Risk.2. Term.3. Marketability (or realisability)Note:The lower the risk, the lower the yield (and vice versa).The longer the term, the higher the yield (and vice versa).Investments which cannot be realised (sold) quickly offer higher yields than those which can.

Answer to Quest ion 111. Reduce its bank overdraft.2. Invest in deposit account(s) (retail bank or investment [merchant] bank).3. Invest in term deposit(s), probably linked to 'Certificate of Deposit'.4. Buy government or local authority loans/securities, such as Treasury bills (TBs).5. Invest in other money-market instruments, such as Certificates of deposit (CDs).

Every path has its puddle.

English proverb

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Answer to Quest ion 12 Four factors which influence the decision are:

1. the rate of interest earned from short-term investments (a higher rate will mean a greater cost ofkeeping money in a current account);

2. the cost of transferring money between the short-term investments and the current account (a highercost will mean that more money should be kept in the current account so that less frequent transfersare required);

3. the uncertainty of cash requirement (if there is a great volatility in daily cash flows then more moneywill be needed in the current account);

4. the consequence of running out of liquid resources (if these are serious then more liquidcash should be held).



(a) Optimum transaction size

(b) Averag e cash balance $421,637/2 = $210,819

(c) Number of transactions $2,000,000/$421,637 = 5

)securities marketableonforegonereturnof (ratecashholding of costyopportunit i

borrowingorsecurities selling of action per trans costs fixed T period specified over the ctionsfor transa needed cashnewnetof amounttotal P

accountcashsfirm' thetotransfertofunds of amountoptimal Q :i

T xP x2

====

=

Where

Q

$421,637

0.0045 0.45/100 0.0045

$200 x$2,000,000 x2 * *

=

===Q

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Answer to Quest ion 15 The following formula should be used:

(i) D Company's opt imal transaction size

(ii) Number of transactions made each year

No of T = P/Q = $800,000/44,722 = approx. 18 transactionsTotal transaction cost = 18 x $100 = $1,800

(iii) Revised optimal cash balance: interest rate at 10%

(iv) Revised optimal cash balance: transaction cost at $150

)securities marketableonforegonereturnof (ratecashholdingof costyopportunit i borrowingorsecurities selling of action per trans costsfixed T

period specified over the ctionsfor transa needed cashnewnetof amounttotal P accountcashsfirm' thetotransfertofundsof amountoptimal Q : i

T xP x2

====

=

Where

Q

$44,722 0.08

$100 x$800,000 x2

=

=Q

$2,000

$100 x$40,000

$800,000 :onstransactiof Cost

$40,000 0.1

$100 x$800,000 x2

=

=

=Q

$2,191

$150 x$54,773

$800,000 :onstransactiof Cost

$54,773 0.08

$150 x$800,000 x2

=

=

=Q

To a certain extent, a little blindness is necessary when you undertake a risk.

Bill GatesMicrosoft founder

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(a) The probability distribution is as follows:$ p

12,000 0.10 * (i.e. 5/50)14,000 0.20 (i.e. 10/50)18,000 0.40 (i.e. 20/50)22,000 0.16 (i.e. 8/50)24,000 0.14 (i.e. 7/50)

1.00

Workings for (b), (c) and (d):

- 12,000 0.10 1,200 (6,080) 36,966,400 3,696,640

14,000 0.20 2,800 (4,080) 16,646,400 3,329,28018,000 0.40 7,200 ( 80) 6,400 2,56022,000 0.16 3,520 3,920 15,366,400 2,458,62424,000 0.14 3,360 5,920 35,046,400 4,906,496

1.00 18,080 Daily variance = 14,393,600

(b) The 'expected' cash balance for any day is $18,080.

(c) The daily variance of cash flows is $14,393,600.

(d) The standard deviation of cash per day is:

Note: The standard deviation ( σ ) is not required in the Miller-Orr model, but it is worth remembering that thevariance is σ 2 (i.e. in this case $3,794 2 = $14,393,600) if the examiner gets you to calculate it this way.

= x

( ) ( ) ( ) 22 x x p x x x x xp p x −−−

$3,794say8,$3,793.889 0$14,393,60 Variance ===σ

If you need helpunderstanding what a

variance is then click here.

Slow and steady wins the race.

Aesop, c. 620 – 560 B.C.The Hare and the Tortoise

HELP

* 5/50 = 0.1

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The Miller-Orr model is a stochastic model for cash management where uncertainty exists for cashpayments and receipts. In other words there is irregularity of cash payments. The Miller-Orr model placesan upper and lower limit for cash balances. When the upper limit is reached a transfer of cash to marketable securities or other suitable investments is made. When the lower limit is reached a transferfrom securities to cash occurs. In both cases the investment/withdrawal will bring the cash balance to a'return point'. A transaction will not occur as long as the cash balance falls between the upper and lowerlimits.


Return point = Minimum limit + ⅓Spread

(Stated in the ‘Formulae Sheet’ which is issued in the exam.)


Note: For ease of using your calculator treat ⅓ as 0.3333…(recurring).(This formula is stated in the ‘Formula Sheet’ which is issued in the exam.

Answer to Quest ion 20 Upper limit = Minimum limit + Spread


(a)

Hence:Upper limit = $8,000 + $23,203

= $31,203

(b) Return point = $8,000 + 1/3($23,203)= $15,734

=

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interestdailyflowscashof iancedaily var cost xntransactio

x0.753 Spread

$23,203

0.00028 0.028/100 * 0.00028

0$14,393,60 x$12 x0.753

interestdailyflowscashof iancedaily var cost xntransactio

x0.753 Spread

31

*

31

=

=

=

=

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The steps involves in using the Miller-Orr model are as follows.

1. The minimum level of cash is set, as a policy. This may be zero, or it may be set at some safetymargin above zero.

2. The variance of cash flows is estimated. This can be calculated by using sample observations for anumber of days past.

3. Estimate/determine both the opportunity interest rate and the fixed transaction cost for each sale orpurchase of securities.

4. Compute the 'spread' between the upper and minimum levels and use it to calculate the 'return point'and the upper level.

5. Implement the limits strategy. When the upper limit is reached invest enough funds in short-termsecurities to bring the cash level to the 'return point'. When the minimum level is reached drawsufficient funds from short-term securities to bring the cash balance to the 'return point'.


1. Delay selected payments.2. Reduce or cancel selected discretionary purchase payments.3. Fund forecast capital purchases from other sources, such as leases where applicable.4. Liquidate short-term marketable securities or other short-term assets.5. Reduce working capital investment (shorten the working capital cycle).


An tro Company

Estimated Financial Position (at end of first year)

Present level % of sales Projected level(based on sales of $20m)

$m $mNon-current assets 24 150.0 30.0Current assets: 6 37.5 7.5Current liabilities:

accounts payable (8) 50.0 (10.0)accrued expenses (2) 12.5 ( 2.5)

Net assets employed 20 25.0

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Answer to Quest ion 24 (continued)

An tro CompanyEstimated Financial Position (at end of first year) continued

Present level % of sales Projected level(based on sales of $20m)

$m $mCapital represented by:Long term debt 6 n.a. 6.0Ordinary share capital:

issued capital 4 n.a. 4.0retained earnings 10 n.a. 10.96 (note 1)

Total funds provided 20 20.96 Additional funds required 4.04Total funds required 25.00

Note 1Retained earnings

$mProfit for the period ($20m x 0.08) 1.60 Less dividends, this period ($1.6m x 0.4) 0.64To retained earnings 0.96

Add brought forward retained earnings 10.00Retained earnings balance 10.96

CONCLUSION: The additional funds required are $4,040,000.

Answer to Quest ion 25(a)

(b) Cash collection s Apri l May June

$ $ $February ($80,000 x 0.08) 6,400March ($100,000 x 0.2) 20,000

($100,000 x 0.08) 8,000 April ($90,000 x 0.7) 63,000

($90,000 x 0.2) 18,000($90,000 x 0.08) 7,200

May ($100,000 x 0.7) 70,000($100,000 x 0.2) 20,000June ($120,000 x 0.7) 84,000

89,400 96,000 111,200

00096 ,$ 30%$28,800

salesMarch

$28,800 sales)(of 30% 70%) - (100%salesMarchApril March

$72,000 10%

$7,200 salesFebruary

$7,200 sales) (of 10% 20%) - 70% - (100% salesFebruaryAprilMarchFebruary

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Answer to Quest ion 26(a) and (b) (a) (b)

Cash collection Cash collection under the present policy under the discount policy

$ $Opening balance at 1 st June 182,000 182,000Collections:

from June sales 1,080,000 ($1,800,000 x 0.6) 1,234,800 (note 1)from May sales 360,000 ($1,200,000 x 0.3) 180,000 ($1,200,000 x 0.15)from April sales 80,000 ($1,000,000 x 0.08) 100,000 ($1,000,000 x 0.10)

Total cash available 1,702,000 1,696,800 Less cash payments 1,160,000 1,160,000Balance at 30 th June 542,000 536,800

Note 1$1,800,000 x 0.7 x 0.98 = $1,234,800

(c) No, the policy is not economically worthwhile, since, under the discount policy, the 30th June cashbalance will be smaller. It seems that the discount will not increase the level of sales and willcause an increase in bad debts from 2% to 5%.


Elizabeth Sto resCash Payments Budget for 3 mont hs January - March 2013

January February March Total

$'000 $'000 $'000 $'000Payments for variable materials:35% current month 175.0 196.00 147.0 518.0065% preceding month 292.5 325.00 364.0 981.50

Total payments for variable materials 467.5 521.00 511.0 1,499.50Wages 52.0 62.00 50.0 164.00Other expenses 0.64 0.64Rent and insurance 19.4 19.40Corporation tax 25.0 25.00Equipment, down payment 8.00 8.00Other operating expenses 4.5 4.50 4.5 13.50Total payments 543.4 596.14 590.5 1,730.04

Notes: 1. Depreciation does not affect cash flow.2. The bank loan is not taken out until April 2013.

If you need help followingthe payment pattern forvariable materials then

click here.HELP

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Answer to Quest ion 28Companies experience cash flow problems for the following reasons.

1. The company is continually trading at a loss .2. Because the company is growing and needs to increase its working capital and acquire more fixed

assets.3. When a business has seasonal or cyclical sales, and for example needs to build inventory for a periodbefore a sales period.

4. In a period of inflation the company will need ever-increasing amounts of cash to replace used-up andworn-out assets.

5. When the company needs to spend money on one-off items of expenditure, such as the redemption ofa loan.

Answer to Quest ion 29Float describes the amount of money tied up (usually in the form of cheques) between the time whena payment is initiated (for example when a receivable posts a cheque) and the time when the funds become

available for use in the recipient's bank account. It includes the amount of transactions (cheques, etc.) intransit between banks and not yet credited.

Answer to Quest ion 30Reasons why there may be a lengthy float include:

1. The time taken by a bank to clear a cheque (clearance delay).2. Transmission delay (such as the period of time the money is held in the postal system, which is

longer for overseas post.)3. Delay in the recipient banking the payments received (lodgement delay).

Answer to Quest ion 31There are several measures that could be taken to reduce the float.

1. The recipient could ensure that the lodgement delay is kept to a minimum. (For example bypresenting cheques to the bank on day of receipt.)

2. For regular payment, standing orders or direct debits might be used.

3. In certain circumstances bank cards or credit cards may be used to receive payments.

4. BACS (Bankers' Automated Clearing Services Company) is a banking service which provides for

the computerised transfer of funds between banks (e.g. the payer's bank and the recipient's bank).The payer (customer) is required to supply a disk to BACS, which contains details of payments, andpayment will then be made in two days.

5. CHAPS (Clearing House Automated Payments Syst em) is a computerised service for banks to makesame-day clearances between each other. Each member bank of CHAPS can allow its corporatecustomers to make immediate transfer of funds through CHAPS. However, there is a largeminimum size of payment using CHAPS.

6. The recipient might, in some cases, arrange to collect cheques from the payer's premises.This is only practicable if the payer is local.

- END -

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Score sheet:Diagnostic Test: Cash management

Questionnumber Marksavailable Score

1 4

2 3

3 5

4 1

5 4

6 4

7 6

8 3

9 8

10 3

11 5

12 4

13 2

14 4

15 7

16 7

17 2

18 1

19 2

20 1

Total score c/fwd

Questionnumber Marksavailable Score

Total score b/fwd

21 4

22 3

23 5

24 4

25 7

26 7

27 7

28 5

29 1

30 3

31 6

Total

score128

Percentage (%)

91 – 128 marks 65 – 90marks 0 – 64 marks




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Measure of dispersion: VARIANCE

The extent of dispersion of a given value is reflected in the extent of its deviation from the average (mean)value of all the items. Take the following two examples:

Example 1 Example 2Value Deviation Deviation 2 Value Deviation Deviation 2

from average from average4 - 1 1 11 +6 366 +1 1 3 - 2 45 0 0 1 - 4 16

15 2/2 = 1 15 56/2 = 28Variance = 1 Variance = 28

The average is 5 (15/3) The average is also 5 (15/3)

The averages are the same but the dispersions are different. By virtue of the definition of the mean the sum ofthe deviations will be zero (e.g. in Example 1, - 1 + +1), but if we square the deviations (as shown in the thirdcolumn of each example), because all the squared items will be positive, the sum will be non-zero. If this sumis divided by one less than the number of items, i.e. 2 in both examples (the reason for this is not discussedhere) a representative measure of dispersion is obtained. This is known as the variance and its square root isknown as the standard deviation. Although not strictly the full picture, it does give us as idea of what avariance is. The calculations are slightly different when probabilities are involved, as in the case of XYZCompany. It is worth remembering that variances can have very high values.

Return

If two line on a graph cross, it must be important.

Ernest F.CookeUniversity of Baltimore

Remark to a student, February 1985




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Payments for variable materials.

Let’s produce a matrix to see the pattern of payments:

Month that variable material(merchandise) is used Cost of materials Month of payment

January February March$’000 $’000 $’000 $’000

December 450 (x 0.65) 292.5January 500 (x 0.35) 175.0 (x 0.65) 325February 560 (x 0.35) 196 (x 0.65) 364March 420 (x 0.35) 147

467.5 521 511 Return

How often have I said to you that when you have eliminated theimpossible, whatever remains, however improbable, must be the truth.

Sherlock Holmes Arthur Conan Doyle, 1859 - 1930




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Past ExamQuestions and Answers

ACCA Paper F9

Performance ManagementScroll through the screens




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Contents: Exam-status Questions – 1 of 5Pages

Question Answer

Droxfol Co : Pilot PaperCalculation of current weighted cost of capital, interest coverage ratio,financial gearing, earnings per share.

360 361

Nedwen Co: Pilot PaperDiscussion of different foreign exchange exposures, use of the purchasingpower parity method of forecasting exchange rates, calculations using theforward market and also a money-market hedge and discussion of hedgingmethods.

366 367

Ulnad Co: Pilot PaperEvaluation of proposed early settlement discount, the use of the Miller-Orrcash model, key areas of accounts receivable management and workingcapital funding policy.

371 372

Trecor Co : Pilot PaperCalculation of net present value (NPV) and accounting rate of return (ARR).Discussion of strengths and weaknesses of internal rate of return (IRR)

377 378

Phobis Co: December 2007Calculation of (a) value of a company using P/E ratio and dividend growthmodels and (b) two values of a convertible bond. Difference between weak,semi-strong and strong forms of stock market efficiency.

380 381

Duo Co: December 2007Calculation of (a) NPV with a need to also calculate WACC, and (b) IRR.Discussion - difference between risk and uncertainty and the use of (a)sensitivity analysis and probability analysis.

387 388

Echo Co: December 2007 Analysis and discussion re three proposals concerning (a) increasing dividend,(b) a bond issue and (c) a rights issue. Discussion - attractions of operatingleasing as a source of finance.

393 395

PKA Co: December 2007Discussion – objectives of working capital management. Calculation of the

cost of the current ordering policy and saving that could be made by using theEOQ model. Evaluation of a money market hedge, a forward market hedgeand a lead payment.

402 403

Burse Co: June 2008Calculation of market value WACC and statement of assumptions. Discussionof circumstances under which the WACC can be used. Comparison betweenthe dividend growth model and the asset pricing model.

407 408

THP Co: June 2008Calculation of value using the dividend growth model. Calculations re a rightsissue. Calculation of value using the P/E ratio method. Implications of theabove results in a semi-efficient capital market. Choice of equity or debtfinance.

412 413




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Question Answer

FLG Co: June 2008

Discussion re (a) level of current assets and (b) factoring and invoicediscounting. Calculation – size of overdraft, net working capital and the cost offinancing the current assets. Calculation – (a) the total cost of inventory whenusing the EOQ and (b) whether to accept a bulk purchase discount.

418 419

SC Co: June 2008Calculation of (a) NPV (with inflation) and (b) IRR. Discussion on (a) results ofabove and (b) evaluation of the use of NPV.

423 424

Dartig Co: December 2008Calculation of (a) theoretical ex rights price and (b) share price using the P/Eratio method. Discussion on the use of a rights issue and calculation of ashare price using the dividend growth model. Explanation of the nature of theagency problem and the use of share option schemes.

430 431

Gorwa Co: December 2008Discussion/calculation of the effects of an increase in interest rates. Analysisof whether the company is overtrading. Evaluation of a proposal to factortrade receivables.

436 438

Rupab Co: December 2008Calculation of (a) the WACC and (b) NPV (with inflation). Explanation of howthe CAPM can be used to calculate a project-specific discount rate and

discussion of the limitations of the CAPM.

443 444

Boluje Co: December 2008Reasons why a company may issue debt finance. Calculation of the totalmarket value of foreign bonds (valued in an overseas currency). Explanationand illustration of a market hedge and comparison of a money market hedgeand a forward market hedge. Description of other hedging techniquesincluding derivatives.

448 449

KFP Co: June 2009Calculation of (a) WACC, (b) total value of a target company using (i) the P/Eratio model, and (ii) the dividend growth model. Discussion of the relationshipbetween capital structure and the WACC, and its implications for KFP.

454 455

PV Co: June 2009Identification of key stages in the capital investment decision-making process.Calculation of NPV, IRR, ARR and discounted payback period. Discussion onwhether the investment proposal is financially acceptable.

458 459

HGR Co: June 2009Discussion re the working capital financing strategy. Calculation/comments ofthe bank balance in two situations. Discussion on how risks arising fromgranting credit to foreign customers can be managed and reduced.

464 465

JJG Co: June 2009Evaluation of finance performance (using ratio analysis). Calculation/comments concerning a rights issue. Discussion on the relative merits of (i) arights issue, (ii) a placing and (iii) an issue of bonds.

471 472




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Question Answer

ASOP Co: December 2009

Calculation/discussion re lease or buy decision. Calculation of NPV (includinginflation). Discussion/illustration of the use of equivalent annual cost/benefit.Discussion on how an optimal investment schedule can be formulated whencapital is rationed and projects are (i) divisible and (ii) non-divisible.

476 477

DD Co: December 2009Calculation of cost of debt. Discussion on costs of debt. Calculation (i) cost ofequity (using the CAPM), (ii) share price (using the dividend growth model),(iii) capital gearing and (iv) market WACC. Discussion on whether a changein dividend policy will affect share price.

481 482

NG Co: December 2009Calculation of theoretical ex right price. Evaluation of the effect of an overseasinvestment on (i) earnings per share, and (ii) the wealth of the shareholders.Explanation of the difference between transaction risk and translation risk.Identification/calculation that illustrates two hedging methods.

490 491

APX Co: December 2009Discussion on the role of financial intermediaries. Preparation of financialstatements: (i) an income statement, and (ii) a statement of financial position.

Analysis/discussion of (i) the working capital financing policy and (ii) forecastfinancial performance in terms of working capital management.

495 497

ZSE Co: June 2010Calculation/discussion of (i) expected values, (ii) the probability of a negativecash balance and (iii) the probability of exceeding the overdraft limit.Discussion of (i) factors to be considered in formulating a trade receivablemanagement policy and (ii) whether profitability or liquidity is the primaryobjective of working capital management.

501 502

YGV Co: June 2010Calculation of (i) after-tax cost of debt, (ii) the effect of a bond issue on theWACC and (iii) the effect of using the bond issue on (1) the interest coverageratio and (2) gearing. Evaluation of the proposal to use the bond issue withdiscussion of alternative sources of finance.

506 508

OKM Co: June 2010Identification of any errors in a prepared investment appraisal and thepreparation of a revised NPV. Discussion of problems faced whenundertaking investment appraisal and how these problems are overcome inthree situations.

513 515

QSX Co: June 2010Calculation of dividend yield, capital gain and total shareholder return withrespect to the CAPM and the other financial information provided. Calculation/commentary on the share price using the dividend growth model in

circumstances (i) based on the historical information, and (ii) if the proposedchange in dividend policy is implemented. Discussion on the relationshipbetween investment decisions, dividend decisions and financing decisions.

525 526




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Question Answer

CJ Co: December 2010Calculation/discussion of NPV (with inflation). Critical discussion re directors’

view (as stated). Calculation of a project-specific cost of equity andexplanation of the calculation.

530 531

Nugfer Co: December 2010Evaluation of suitable financing methods (using stated figures) supporting theevaluation with analysis/critical discussion. Explanation of factors that willinfluence the rate of interest charged on a new issue of bonds. Identificationof three forms of efficiency found in a capital market.

536 538

WQZ Co: December 2010Calculation of the cost of the current ordering policy and the change in thecosts of inventory that will arise if the economic order quantity is used.Description of benefits of JIT procurement. Calculation on (i) whetherproposed changes in receivables management will be acceptable and (ii)acceptance of an early settlement discount.

542 543

NN Co: December 2010Calculation of equity value using (i) the dividend growth model and (ii) netasset value. Calculation of (i) the after-tax cost of debt and (ii) the WACC.Discussion of the factors to be considered in formulating the dividend policy.

547 549

BRT Co: June 2011Calculation of NPV (with inflation). Calculation of an after-tax cash flow value,using a perpetuity approach. Discussion of three ways of incorporating riskinto the investment appraisal process.

552 553

AQR: June 2011Calculation/discussion of WACC (i) before the new issue of bonds, and (ii)after the new issue of bonds. Identification/discussion of factors that influencethe market value of traded bonds. Discussion of the view that issuing tradedbonds will decrease the WACC and thereby increase corporate value.

558 559

YNM Co: June 2011 Analysis/discussion of financial performance. Discussion of sources of financein terms of (i) equity finance and (ii) sale and leaseback. Explanation of the

nature of a scrip (share) dividend and discussion of its advantages anddisadvantages.

564 566

ZPS Co: June 2011Explanation of relationships between (i) exchange rates and interest rates,and (ii) exchange rates and inflation rates. Calculation/discussion of (i) aforward market hedge and (ii) a money market hedge. Discussion of factorsthat influence the formulation of working capital policy. Calculation of whetherthe company will benefit financially by accepting the offer of (i) the earlysettlement discount and (ii) the bulk purchase discount.

572 573

Warden Co: December 2011Calculation of (i) NPV and (ii) IRR. Explanation of ‘sensitivity analysis’ in thecontext of investment appraisal. Calculation of the sensitivity of theinvestment. Discussion on the nature and causes of the problem of capitalrationing and how this problem can be overcome.

582 583




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Question Answer

Bold Co : December 2011Explanation/discussion of (i) ‘cash operating cycle, (ii) relationship between

the cash operating cycle and the level of investment in working capital.Calculation of the cash operating cycle. Calculation of the value of a factor’soffer (i) on a with-recourse basis and (ii) on a non-recourse basis.Commentary on the financial acceptability of the factor’s offer and possiblebenefits of the company factoring its trade receivables.

591 593

Close Co: December 2011Calculation of corporate value using (i) net asset value method, (ii) dividendgrowth model and (iii) earnings yield method. Discussion on the weaknessesof the dividend growth model as a way of valuing a company. Calculation ofthe WACC. Discussion of circumstances under which the WACC can be usedas a discount rate in investment appraisal.

596 598

Bar Co: December 2011Calculation of theoretical ex rights price per share following a rights issue.Calculation/discussion on the policy of buying back bonds. Calculation/discussion of the effect of the company using the cash raised by the rightsissue to buy back bonds on the financial risk as measured by (i) its interestcoverage ratio and (ii) its book value to equity value. Comparison of thefinancial objectives of a stock exchange listed company and the financialobjectives of a not-for-profit organisation.

603 604

Ridag Co: June 2012Calculation/commentary of NPV. Calculation/discussion of equivalent annualcosts. Critical discussion of the use of sensitivity analysis and probabilityanalysis as ways of including risk in the investment appraisal process.

609 610

Wobnig Co: June 2012Evaluation on whether the company is overtrading. Critical discussion on thesimilarities and differences between working capital in two areas: (i) workingcapital investment and (ii) working capital financing. Calculation of the Miller-Orr upper limit and return point and explanation of how these would be used tomanage the cash balances,

615 617

Zigto Co: June 2012Discussion on the reasons why small and medium-sized entities mightexperience less conflict between the objectives of shareholders and directorsthan large listed companies. Discussion of the factors that the companyshould consider when choosing a source of debt finance and the factors thatmay be considered by providers of finance. Explanation of the nature of amudaraba contract. Calculation whether a forward exchange contract or amoney market hedge would be financially preferred. Calculation of the one-year (future) spot rate predicted by purchasing power parity theory and anexplanation of the relationship between the expected spot rate and the currentforward exchange rate.

621 622

Corhig Co: June 2012Estimation/discussion of value using the P/E ratio method. Calculation of thecurrent cost and, using this value, the value of the company using the dividendvaluation model. Calculation of the current WACC and the WACC followingthe new debt issue and commentary on the difference between the two values.Discussion re (i) business risk, (ii) financial risk and (iii) systematic risk.

626 627




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Droxfol Co is a listed company that plans to spend $10m on expanding its existing business. It hasbeen suggested that the money could be raised by issuing 9% loan notes redeemable in ten years’time. Current financial information on Droxfol Co is as follows.

Income statement information for the last year

$000Profit before interest and tax 7,000Interest (500)Profit before tax 6,500Tax (1,950)Profit for the period 4,550

Balance sheet for the last year $000 $000Non-current assets 20,000

Current assets 20,000Total assets 40,000

Equity and liabilitiesOrdinary shares, par value $1 5,000Retained earnings 22,500Total equity 27,50010% loan notes 5,0009% preference shares, par value $1 2,500Total non-current liabilities 7,500Current liabilities 5,000Total equity and liabilities 40,000

The current ex div ordinary share price is $4.50 per share. An ordinary dividend of 35 cents per sharehas just been paid and dividends are expected to increase by 4% per year for the foreseeable future.The current ex div preference share price is 76.2 cents. The loan notes are secured on the existingnon-current assets of Droxfol Co and are redeemable at par in eight years’ time. They have a currentex interest market price of $105 per $100 loan note. Droxfol Co pays tax on profits at an annual rate of30%.

The expansion of business is expected to increase profit before interest and tax by 12% in the firstyear. Droxfol Co has no overdraft.

Averag e sec to r rat io s:

Financial gearing: 45% (prior charge capital divided by equity capital on a book value basis)Interest coverage ratio: 12 times

Required:(a) Calculate the current weighted average cost of capital of Droxfol Co. (9 marks )

(b) Discuss whether financial management theory suggests that Droxfol Co can reduce its weightedaverage costof capital to a minimum level. (8 marks )

(c) Evaluate and comment on the effects, after one year, of the loan note issue and the expansionof business on the following ratios:

(i) interest coverage ratio;

(ii) financial gearing;

(iii) earnings per share.

Assume that the dividend growth rate of 4% is unchanged. (8 marks )(25 marks)

Droxfol Co: Question A Calculation of current weighted cost of capital, interest coverage ratio, financial gearing,

earnings per share.

A

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(a) Calculation of weighted average cost of capital (WACC)

Market values

Step 1: r equity Step 2: r preference

Use of dividend growth model

Step 3: debt

Trial and error approach1st trial 2 nd trial

Year Cash flow $ 10% DF PV ($) 5% DF PV ($)0 market value (105) 1.000 (105.00) 1.000 (105.00)

1–8 interest (10 x 0.7) 7 5.335 37.34 6.463 45.248 redemption 100 0.467 46.70 0.677 67.70

(20.96) 7.94

Thus:

Step 4: Market values and WACC

Market value of equity = 5m x 4.50 = $22.5 millionMarket value of preference shares = 2.5m x .0762 = $1.905 millionMarket value of 10% loan notes = 5m x (105/ 100) = $5.25 millionTotal market value = 22.5m + 1.905m + 5.25m = $29.655 million

WACC =

[(12.08% x 22.5) + (11.81% x 1.905) + (6.37% x 5.25)]/ 29.655 = 11.05%

(b) Droxfol Co has long-term finance provided by ordinary shares, preference shares and loannotes. The rate of return required by each source of finance depends on its risk from an investorpoint of view, with equity (ordinary shares) being seen as the most risky and debt (in this caseloan notes) seen as the least risky. Ignoring taxation, the weighted average cost of capital(WACC) would therefore be expected to decrease as equity is replaced by debt, since debt ischeaper than equity, i.e. the cost of debt is less than the cost of equity.

Droxfol Co: Answer A Calculation of current weighted cost of capital, interest coverage ratio, financial gearing,

earnings per share.

( )

12.08%

0.04 450

1.04 x35

g P

g 1D r

0

0e

=

+=

++=

11.81%

76.29

P

d r

r

d P

0

p p

p

p0

=

=

=

=

( )

6.37%

5 - 10 x7.94 20.96

7.94 5% r %d

=

++=

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However, financial risk increases as equity is replaced by debt and so the cost of equity willincrease as a company gears up, offsetting the effect of cheaper debt. At low and moderatelevels of gearing, the before-tax cost of debt will be constant, but it will increase at high levels ofgearing due to the possibility of bankruptcy. At high levels of gearing, the cost of equity willincrease to reflect bankruptcy risk in addition to financial risk.

In the traditional view of capital structure, ordinary shareholders are relatively indifferent to theaddition of small amounts of debt in terms of increasing financial risk and so the WACC falls asa company gears up. As gearing up continues, the cost of equity increases to include a financialrisk premium and the WACC reaches a minimum value. Beyond this minimum point, the WACCincreases due to the effect of increasing financial risk on the cost of equity and, at higher levelsof gearing, due to the effect of increasing bankruptcy risk on both the cost of equity and the costof debt. On this traditional view, therefore, Droxfol Co can gear up using debt and reduce itsWACC to a minimum, at which point its market value (the present value of future corporate cashflows) will be maximised. (For a diagram showing the traditional view click two screens on.)

In contrast to the traditional view, continuing to ignore taxation but assuming a perfect capital

market, Miller and Modigliani demonstrated that the WACC remained constant as a companygeared up, with the increase in the cost of equity due to financial risk exactly balancing thedecrease in the WACC caused by the lower before-tax cost of debt. Since in a prefect capitalmarket the possibility of bankruptcy risk does not arise, the WACC is constant at all gearinglevels and the market value of the company is also constant. Miller and Modigliani showed,therefore, that the market value of a company depends on its business risk alone, and not on itsfinancial risk. On this view, therefore, Droxfol Co cannot reduce its WACC to a minimum. (For adiagram showing the M&M view click three screens on.)

When corporate tax was admitted into the analysis of Miller and Modigliani, a different pictureemerged. The interest payments on debt reduced tax liability, which meant that the WACC fell

as gearing increased, due to the tax shield given to profits. On this view, Droxfol Co couldreduce its WACC to a minimum by taking on as much debt as possible.

However, a perfect capital market is not available in the real world and at high levels of gearingthe tax shield offered by interest payments is more than offset by the effects of bankruptcy riskand other costs associated with the need to service large amounts of debt. Droxfol Co shouldtherefore be able to reduce its WACC by gearing up, although it may be difficult to determinewhether it has reached a capital structure giving a minimum WACC.

(c) (i) Interest coverage ratioCurrent interest coverage ratio = 7,000/ 500 = 14 timesIncreased profit before interest and tax = 7,000 x 1.12 = $7.84mIncreased interest payment = (10m x 0.09) + 0.5m = $1.4mInterest coverage ratio after one year = 7.84/ 1.4 = 5.6 timesThe current interest coverage of Droxfol Co is higher than the sector average and can beregarded as quiet safe. Following the new loan note issue, however, interest coverage isless than half of the sector average, perhaps indicating that Droxfol Co may not find iteasy to meet its interest payments.

Aide-mémoire:

What is a perfect market?

Any market in which assets are priced with total efficiency. In a perfect capital market,there are no possibilities for arbitrage. (Arbitrage is the simultaneous buying and sellingof a security at two different prices in two different markets, resulting in profits withoutrisk.)

End of Aide-mémoire


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(ii) Financial gearingThis ratio is defined here as prior charge capital/equity share capital on a book valuebasis

Current financial gearing = 100 x (5,000 + 2,500)/ (5,000 + 22,500) = 27%Ordinary dividend after one year = 0.35 x 5m x 1.04 = $1.82 millionTotal preference dividend = 2,500 x 0.09 = $225,000

Income statement after one year$000 $000

Profit before interest and tax 7,840Interest (1,400)Profit before tax 6,440Income tax expense (1,932)Profit for the period 4,508Preference dividends 225Ordinary dividends 1,820

(2,045)Retained earnings 2,463

Financial gearing after one year = 100 x (15,000 + 2,500)/ (5,000 + 22,500 + 2,463)= 58%

The current financial gearing of Droxfol Co is 40% ((45-27)/45) less (in relative terms)than the sector average and after the new loan note issue it is 29% ((58-45)/45) more (inrelative terms). This level of financial gearing may be a cause of concern for investors andthe stock market. Continued annual growth of 12%, however, will reduce financial gearingover time.

(iii) Earnings per shareCurrent earnings per share = (4,550 - 225)/5,000 = 86.5 centsEarnings per share after one year = (4,508 - 225)/5,000 = 85.7 cents

Earnings per share is seen as a key accounting ratio by investors and the stock market,and the decrease will not be welcomed. However, the decrease is quiet small and futuregrowth in earnings should quickly eliminate it.

The analysis indicates that an issue of new debt has a negative effect on the company’sfinancial position, at least initially. There are further difficulties in considering a new issueof debt. The existing non-current assets are security for the existing 10% loan notes andmay not available for securing new debt, which would then need to be secured on anynew noncurrent assets purchased. These are likely to be lower in value than the new debt

and so there may be insufficient security for a new loan note issue. Redemption orrefinancing would also pose a problem, with Droxfol Co needing to redeem or refinance$10 million of debt after both eight years and ten years. Ten years may therefore be tooshort a maturity for the new debt issue.

An equity issue should be considered and compared to an issue of debt. This could be inthe form of a rights issue or an issue to new equity investors.


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C o s

t o

f c a p

i t a

l

Ke

WACC

Kd

m0

Level of gearing

Figure 14.3: Traditional model of capital structure

The shape of the graph can be explained as follows:

1. Starting from a zero gearing level (left side of the ‘x’ axis’), as debt is progressivelyintroduced into the capital structure (and the gearing increases), the cost of debt, k d,at first remains unchanged.

2. Initially, borrowing additional debt on a low geared basis will not be regarded byshareholders as an additional risk and they will not expect an increased return, k e.

3. Because the return expected by debt providers is less than that expected byshareholders, the effect on the WACC is that it falls initially as new debt isintroduced. This reflects the benefit of taking on lower cost debt.

4. The cost of equity, k e, can be seen to increase as the level of financial gearingincreases. This is because, in the traditionalists’ view, as the level of gearingincreases, the level of financial risk to which the shareholders are exposed alsoincreases. Consequently they will expect higher returns.

5. Beyond a certain point the cost of debt also begins to rise. This is because theproviders of debt now also perceive a greater financial risk and therefore expect ahigher return.

6. The effect on the WACC is that it falls initially until it’s curve eventually reaches aminimum point, ‘m’ in the graph, and then begins to increase when the cost of equityand the cost of debt begin to rise.

7. The graph, and its logic, would suggest that there is a optimum capital structure.

Note: remember that the expected return expected by an investor, r, also represents thefirm’s cost of capital, k.

Traditional model of capital structure


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Risk-free debt Risky debt

C o s

t o

f c a p

i t a

l

Ke

WACC

Kd

0

Levelof gearing

The shape of the graph can be explained as follows:

1. Starting from a zero gearing level (left side of the ‘x’ axis’), as debt is progressivelyintroduced into the capital structure (and the gearing increases), the cost of debt, k d, atfirst remains unchanged.

2. The cost of equity, k e, can be seen to increase as new debt is introduced and the level offinancial gearing increases. This is because according to the M&M view, as the level ofgearing increases, the level of financial risk to which the shareholders are exposed alsoincreases. Consequently they will expect higher returns.

3. Because the return expected by debt providers is less than that expected by shareholders, butat the same time the expected return of shareholders rises, the effect on the WACC is that itremains constant.

4. Beyond a certain point the cost of debt also begins to rise. This is because the providers of

debt now also perceive a greater financial risk and therefore expect a higher return. Howeverbecause the risk associated with the firm’s asset’s is increasingly being transferred from theshareholders to the debt providers, the rise in the expected returns of the equity holdersbecomes progressively less.

6. The effect on the WACC is that it remains constant.

7. The graph, and its logic, would suggest that there is not an a optimum capital structure.

Note : remember that the expected return expected by an investor, r, also represents the firm’scost of capital, k.

M&M’s Proposition 11

x

M&M’s Proposition II


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Practice Questions and Answers Paper F9: Financial ManagementMAIN PAGE CONTENTS FORMULAE PRESENT VALUE ANNUITY

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2013 Paper F9 QandA Sample