ACCA-Advanced Financial Management (AFM)-September Mock-As PDF

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ACCA Advanced Financial Management (AFM) Final Mock – September 2018

Guidance, Marking scheme and Suggested solutions

Guidance on improving your exam performance To help improve your performance you should focus on these key areas.

Strategy Make sure your answers are as focused and specific to the organisation in each scenario as possible. Show clear workings for your calculations briefly explain why are performing them where appropriate. Write full sentences in your explanations and, most importantly, explain their relevance to the scenario.

Time management Don’t rush in to the question without carefully reading the scenario and the requirements; allocate about 20% of your time to planning to make sure that your answer is relevant. Don’t hurry into the calculations.

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1 Valtick Marking scheme Marks (a)

Advantages of joint ventures (0.5 marks per point, to a maximum of 1 mark, if not related to the scenario; for any relevant point up to 1 mark per point)

4

Disadvantages of joint ventures (0.5 marks per point, to a maximum of 1 mark, if not related to the scenario; for any relevant point up to 1 mark per point)

4 Max 7

(b)(i) Expected exchange rates Peso cash flows Sales Costs Tax allowable depreciation Marantintan taxation Cash flows – Valtick UK cash flows Exports foregone Aid Patent's opportunity cost Additional UK taxation Correct discount rate NPV and conclusion

3

(b)(ii) Assumptions – up to 2 marks per assumption discussed Up to 2 marks per issue/risk discussed

6 8

3 2 2 2 1 2 1 2 3 1 1 Max 23

Max 14 (b)(iii) Reasoned recommendation linking to earlier points in the report

Max 3

Presentation marks (report format/structure/appendices/style)

Max 4 50

Note. Throughout the calculations, rounding differences do not matter. Top tips. Part a is not an excuse to make general points about internal expansion, your points need to be specific to the scenario, and to the concerns raised about risk. In part (b)(i), the main calculation, like most on foreign investments, is very long. You are very unlikely to get the NPV completely correct, either here or in the real exam. You should concentrate on a logical approach, and a neat layout with headings for workings. These should be given in an appendix, which under exam conditions you may write before the main report. Don't rush the easier calculations. The Marantintan cash flows, the exports foregone, the exchange rate forecasts, the aid and opportunity costs offer marks which you should have time to obtain. The tax calculations are the icing on the cake, so don't worry too much if you didn't get this but got most of the rest of the figures correct. In part (b)(ii), make sure that you address both parts of the question.

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Suggested solution (a)

Aims of establishing international operations Valtick Co is aiming to establish international operations in order to prolong the lifecycle of its electronic devices. The aims of establishing foreign operations include development of new markets, reducing risk by international diversification, creation of economies of scale, profiting from the comparative advantage of different countries (here the reduction in costs), and circumventing trade barriers. Advantages of joint venture A joint venture with a local partner is one way of achieving these aims, with the following specific advantages: (i) Costs and risks are shared by more than one party. This will be important for Valtick because its cash reserves are low and it is loss making, so it will be difficult for Valtick to establish overseas manufacturing facilities without a joint venture partner. (ii)

A good local partner will have specific knowledge of the environment, including culture, market analysis, competition, distribution methods, availability of skills, preferred methods of doing business and associated constraints. Each party to the joint venture can use their specific expertise and experience. A local partner should have expertise in the parts of the operation to which they will contribute.

(iii)

A joint venture can make it easier to enter international markets either because of the availability of government incentives (more likely as profits are being shared with a local partner) or because some governments insist that foreign direct investment is conducted by way of joint venture with a local firm.

Disadvantages of joint venture

(b)

(i)

Divergence of objectives may mean that the joint venture is more difficult to manage than an direct overseas investment would be. There may be differing views between the partners on ethical employment practices, or quality management.

(ii)

If the joint venture is not succeeding it may be difficult for Valtick to implement what it believes to be the required changes. As such, it would be much lower risk to license out the use of the patent to a South American company.

(iii)

There is the risk of technology transfer to the local partner, enabling them to set up independently. Patent agreements may not be enforceable locally. Here there is the risk that after four years the local partner will be able to enter Valtick Co’s current markets in Europe.

(iv)

There is the risk that the commitments of the partner are not fulfilled, in this case especially the risk of non-payment at the end of the four year agreement.

(v)

Governments pursuing a policy of nationalisation may seize the assets of foreign companies, this may be reduced if a joint venture is in place than if the investment is 100% owned by a foreign company but other forms of international expansion such as licensing do not face this risk.

To: Board of Directors of Valtick From: Accountant Date: XX/XX/XXXX Report on the proposed joint venture Introduction The purpose of this report is to which evaluate whether or not Valtick plc should participate in the joint venture in Marantinta. This report will discuss the financial acceptability of the joint venture, and other factors that are considered to be relevant to the decision. Approach used Assuming that its share of profits is remitted to UK annually, the method used will be to convert Valtick's share of the foreign cash flows to sterling and to discount these cash flows using a suitable cost of capital. The detailed calculations are shown in the appendix to this report.

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(i)

Financial analysis From the estimates made (see appendix), the net present value is approximately £69,000 negative, indicating that the investment is not worthwhile because it does not give the required 18% return. However, there may be scope to increase Valtick's share of the cash flows from 50%, which might make the project viable.

(ii)

Other factors affecting the decision Assumptions made in producing the financial projections It is assumed that all the estimates such as sales revenue, costs, royalties, initial investment costs, working capital, and costs of capital and inflation figures are accurate. There is considerable uncertainty surrounding the accuracy of these and a small change in them could change the forecasts of the project quite considerably. A number of projections using sensitivity and scenario analysis may aid in the decision-making process. It is assumed that future exchange rates will reflect the differential in inflation rates between the respective countries. However, it is unlikely that the exchange rates will move fully in line with the inflation rate differentials. The basis for using a cost of capital of 18% is not clear and an explanation is not provided about whether or not this is an accurate or reasonable figure. The underpinning basis for how this has been determined may need further investigation. It is notable that, as shown below, the project still gives a negative NPV at our normal cost of capital of 14%. Time Cash flows £'000s DF 14% PV NPV

0 (517) 1.000 (517) (12)

1 25 0.877 22

2 76 0.769 58

3 91 0.675 62

4 624 0.592 369

5 (11) 0.519 (6)

Other risks and issues Investing in Marantinta may result in significant political risks. Valtick Co needs to assess how likely it is that the Government may change during the time it is operating in Yilandwe and the impact of the change. Valtick Co will need to assess the likelihood of changes in tax rates, laws and regulations, and to consider strategies to mitigate such eventualities. The financial projections are prepared on the basis that positive cash flows from the joint venture can be remitted back to the UK. Valtick Co needs to establish that this is indeed the case and that it is likely to continue in the future. Valtick Co needs to be careful about its ethical stance and its values, and the impact on its reputation of its joint venture operations in Marantinta. Valtick Co should assess and value alternative real options which it may have. For example, the option to sell to the joint venture partner is a put option and will have some value. Valuation of this option is not possible given the information provided but further investigation could be undertaken to provide a valuation of this put option. Valtick could also consider whether entry into Marantinta may provide Valtick Co with other business opportunities. Besides South and North America, the joint venture may be able to supply other markets such as Asia or Europe. If so, the effect on the Welsh facility would need to be evaluated. The discount rate has been increased arbitrarily by 4% to allow for the risk of operating in Marantinta. This may not be appropriate to Valtick's shareholders who are concerned with the project's impact on systematic (market) risk. The investment might actually lower systematic risk if the investors are not already exposed to the Marantintan economy, and other risk aspects (eg political, cultural, foreign exchange risk) are to a large extent unsystematic or reduceable by hedging.

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(iii)

Recommendation The result from the financial projections is that the project should be not accepted because it results in a negative net present value. It is recommended that the financial projections should be considered in conjunction with the assumptions, the issues and risks, and the implications of these, before a final decision is made. There is considerable scope for further investigation and analysis. It is recommended that sensitivity and scenario analysis be undertaken to take into consideration continuing the project beyond four years and so on. The value of any alternative real options should also be considered and incorporated into the decision. Consideration must also be given to the issues, risks and factors beyond financial considerations, such as the impact on the ethical stance of the company and the impact on its image. Given the negative project NPV and the heavy reliance of the project on the ability of the joint venture partner to buy our share of the venture in four years' time for 30 million pesos, this report recommends that the joint venture does not proceed on the terms that have been suggested. Instead it is recommended that the opportunity to sell the patent to another South American company is pursued.

Appendix Cash flows in m pesos Peso sales (W2) Dollar sales (W1 and W3) Direct costs (W4) Fixed costs Net operating cash flows 20% tax (W5) Valtick's share Investment/terminal value Valtick cash flows Exchange rate (W1) Sterling cash flows (£'000s) Extra tax in UK (W6) Technical assistance Technical aid (inflate from time 0) Lost exports (inflate from time 0) Patent income lost Tax saved (on UK costs) Total UK £'000s DF 18% PV £'000s NPV £'000s

0

(13.50) (13.50) 32.78 (412)

1 19.20 6.28 (10.00) (4.00) 11.48

2 25.34 7.18 (12.96) (4.80) 14.76

3 32.06 7.86 (16.12) (5.52) 18.28

11.48 5.74

14.76 7.38

18.28 9.14

5.74 38.19 150

7.38 44.49 166

9.14 49.67 184 (10)

4 40.56 8.61 (20.07) (6.35) 22.75 (1.91) 20.84 10.42 30.00 40.42 55.46 729 (18)

5

(52) (33) (40)

(56) (35) (40) 38 91 0.609 55

(58) (36) (40) 39 624 0.516 322

40 (11) 0.437 (5)

3 49.67 26.21

4 55.46 28.71

5 61.92 31.44

(4.05) (4.05) (2.03) (2.03) 61.92 (33)

(105)

(517) 1.000 (517) (69)

25 0.847 21

(54) (34) (40) 38 76 0.718 55

0 32.78 18.32

1 38.19 20.94

2 44.49 23.93

Workings 1

Forecast exchange rates Peso/£ Peso/$

Using inflation to forecast exchange rates eg year 4 Peso/£ = 32.78  (1.2/1.03)  (1.2/1.03)  (1.15/1.03)  (1.15/1.03) = 55.46. Note. Ignore small rounding differences.

6

2

Peso sales m pesos Unit price Units sold Total m pesos

3

Dollar sales m pesos 10,000 units at $30 ($'000s) Total m pesos

0

1 2 3 480 576 662.4 40,000 44,000 48,400 19.20 25.34 32.06 300 6.28

300 7.18

300 7.86

4 761.8 53,240 40.56

5

300 8.61

(Eg year 1 = $300m  20.94 from working 1 = 6.28m peso) 4

Total sales (US + Marantinta) Direct costs/unit Total m pesos

5

Tax payments in Marantinta Time Net operating cash flows Tax allowances PBT Marantinta tax

50,000 200 10.00

0

54,000 240 12.96

58,400 276 16.12

63,240 317.4 20.07

1 11.48 (20.00)

2 14.76 (10.00)

3 18.28 (5.00)

4 22.75 (2.50)

(8.52)

4.76 1.70

13.28 (0.95)

20.25 (2.66)

5

(4.05)

Tax credits will not be given so tax cash flows in years 1 and 2 are rolled into year 3. Tax allowances are calculated on the total investment made by the joint venture of 45 million peso, 5 million of this is working capital, so the investment in fixed assets is 40 million. Actual payments 0.00 0.00 (1.91) (4.05) Or (alternative method) Net operating cash flows 11.48 14.76 18.28 22.75 Tax paid (2.30) (2.95) (3.66) (4.55) Tax allowances 20.00 10.00 5.00 2.50 Tax saved 4.00 2.00 1.00 0.50 Tax paid (actual payments net of savings) 6

0.00

0.00

(1.91)

(4.05)

Extra tax to pay in the UK Time 0 1 PBT in peso (m) 0.00 (Year 3 is the total of year 1–3 PBT) Valtick 50% share Extra 10% tax Exchange rate £'000s Time when tax is paid Note. Credit will be given for any reasonable approach.

7

2 0.00

3 9.52

4 20.25

4.76 (0.48) 49.67

10.13 (1.01) 55.46

(10) Time 4

(18) Time 5

2 Macawber Marking scheme Note to students. The solution to part (a) shows both the monetary and percentage approaches to interest rate options hedging, both of which are equally correct. You would only be expected to use one of these approaches in the exam. Marks (a) Advantages and disadvantages: one mark per valid point up to a maximum of (max 3 marks per type of hedge) 8 Style and presentation 1 Forward contract 2 Futures contract 4 Options contract (full marks for using any 1 option price) 4 Max 17 (b) Total payment with swap 2 Total payment without swap 2 Illustration of gain 1 Illustration of swap that is beneficial to both companies 3 Max 8 25

Suggested solution Top tips. Hedging is a key part of the syllabus so this type of question should not be a surprise. It might be a good idea to deal with advantages and disadvantages of each type of hedge as you are dealing with the relevant calculations, thus keeping all the information on each method together. This makes it easier for you when tackling the question, and the marker. Easy marks. Advantages and disadvantages of each type of hedge can be lifted quite easily from the BPP Study Text. (a)

REPORT To: From: Date: Subject:

Finance Director Financial Accountant 9 January 20X3 Hedging methods

Current position If we are still able to borrow at the current rate in three months' time, the interest charge will be: $20m  6.9%  6/12 = $690,000 If however interest rates increase by 0.5%, the interest charge will be: $20m  7.4%  6/12 = $740,000 The hedging methods we can use are as follows. Forward rate agreement A forward rate agreement effectively fixes the rate of interest for borrowing at a certain time in the future. If the actual interest rate is above the rate agreed, the ban will pay the company the difference. If the actual rate is lower than the rate agreed, the company pays the bank the difference. Advantages of forward rate agreements (i)

A forward rate agreement fixes the sum that Macawber has to pay, and eliminates the possibility of large losses if interest rate increases are greater than are currently expected.

8

(ii)

The forward rate should be an unbiased predictor of the future exchange rate, based on the information.

(iii)

Macawber should have no difficulty obtaining a forward rate agreement, since the size of the loan and the time period are both of appropriate magnitude for such an agreement.

(iv)

Forward rate agreements have no margin requirements.

Disadvantages of forward rate agreements (i)

The spot rate may not move in the direction or to the extent predicted by the forward rate agreement, and Macawber will be unable to take advantage of favourable spot rate movements.

(ii)

There may be problems renewing the agreement if it turns out that Macawber needs the finance for much longer than anticipated.

Using a forward rate agreement Use a 3–9 agreement with a rate of 6.38% If the LIBOR rate increases to 6.50%, and the borrowing rate therefore rises to 7.40%, the cost is: $ 740,000 (12,000) 728,000

Payment on loan as above (0.074  $20m  6/12) Less receipt from FRA (6.50 – 6.38)%  $20m  6/12 Futures

Interest rate futures are similar to FRAs, except that the terms, amounts and periods are standardised. Advantages of futures (i)

The futures price is likely to vary with changes in interest rates, and this acts as a hedge against adverse interest rate movements.

(ii)

Transaction costs should be lower than for the other hedging methods.

(iii)

The exact date of the interest receipt or payment does not have to be known, as the contract can be closed out on the date that the payment is made.

Disadvantages of futures (i)

Contracts cannot be tailored to Macawber's exact requirements.

(ii)

Hedge inefficiencies arise because Macawber has to deal in a whole number of contracts and by basis risk.

(iii)

Futures are only available on certain financial instruments.

(iv)

Macawber will be required to deposit a margin (cash or securities).

Using futures Set up (i)

What contract: three month contract

(ii)

What type: sell March contracts (as the funding will be needed in March)

(iii)

How many contracts

(iv)

Tick size = $12.50

Exposure Contract size



Loan period Length of contract

9

=

20, 000, 000 500, 000



6 3

= 80 contracts

Closing price and basis Current basis ...