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General Comments n]6xrsE
Congratulations to candidates who passed Paper F9 in December2010!Successful candidates demonstrated their wide understanding of the F9syllabus,since the examination paper covered many aspects of the syllabus.As inprevious examination diets,some very high marks were awarded.I hope thatunsuccessful candidates have learned from their experience and will besuccessful at their next attempt. z#8GF^U:T
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Specific Comments < ;SQ1^N
Question One |Tf}8e
Most candidates gained good marks in parts (a) and (c),while part (b)was rarely answered well. dB^J }_wp
Part (a) asked candidates to calculate the net present value (NPV) ofProject A,allowing for inflation and taxation. .e"De- u
Most candidates inflatedcorrectly selling price,selling cost and variable cost in order to find thebefore-tax cash flows over the four-year appraisal period required by thedirectors of the company.Some candidates did not defer tax liability by oneyear,although the question required this.Some candidates calculated correctlythe tax benefit arising from capital allowances (tax-allowable depreciation),butdid not provide a balancing allowance in the final year,as the directorsrequired.The directors also required that scrap value be excluded from theevaluation. \,ir]e,1
The treatment of working capital was a problem for somecandidates.Three elements of working capital can be relevant in investmentappraisal,namely initial investment,incremental investment and recovery at theend of the investment project.The first two elements were needed here,withincremental investment arising from general inflation.Working capital recoverywas excluded by the directors’ views on investment appraisal.Even though workingcapital investment was specified in the question as an initial investment,somecandidates inflated the initial investment and placed it at the end of yearone. g
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The inflated after-tax cash flows were nominal (money-terms) cashflows and the question provided a nominal weighted average after-tax cost ofcapital.This was the discount rate needed for Project A,although some candidatescalculated another incorrect discount rate by either inflating or deflating thediscount rate provided. (s,Nq ~O
The calculated NPV of Project A was negative and so the investmentproject was not financially acceptable. DIkD6n?V
In part (b),candidates were asked tocritically discuss the directors’ views on investment appraisal.These views wererequirements to use either payback period or return on capital employed(ROCE),to evaluate over a four-year planning period,to ignore any scrap value orworking capital recovery,and to claim a balancing allowance at the end of thefour-year evaluation period. :*)~nPVV
Although part (b) asked for a critical discussion,a significantnumber of candidates calculated and commented on the payback period and the ROCEof Project A.This was not what the question asked for and gained no credit.Manycandidates limited their discussion to payback and ROCE,and therefore lost marksbecause they did not discuss the four-year planning period,ignoring any scrapvalue or working capital recovery,and claiming a balancing allowance at the endof four years. 6
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The directors’ views were not consistent with a theoretically soundevaluation of Project A using relevant cash flows,A critical discussion shouldhave focused on this. ^['% wA%
Part (c) required candidates to calculate a project-specific cost ofequity for Project B,which was a diversification into a new business area,and toexplain the stages of their calculation. o T5?*3f
Answers that calculated a project-specific weighted average cost ofcapital (WACC) in addition to a project-specific cost of equity did not gain anyadditional credit,since this was not required.In fact,the WACC could not becalculated,since the question did not include a cost ofdebt. CNM/}|N^Si
Better answers ungeared the equity beta of the proxy company to givean asset beta,regeared the asset beta to give a project-specific equity beta,andthen used this equity beta and the capital asset pricing model (CAPM) tocalculate a project-specific cost of equity,explaining the stages of thecalculation in terms of systematic risk,business risk and financialrisk. }\ OLBg/
Question Two ` i,ZwnLh{
Many students gained good marks on parts (b) and (c) of thisquestion,while not doing very well on part (a). Cdot l$'
In part (a) of this question,candidates were provided with financialinformation for a company and asked to evaluate suitable methods for it to raise$200 million,using both analysis and critical discussion.Many answers struggledto gain good marks for reasons such as poor understanding of sources offinance,a lack of analysis or errors in analysis,misunderstanding of thefinancial position and performance of the company,and a shortage ofdiscussion. f|w+} z
The question said that the current assets of the company did notinclude any cash,but many answers suggested that $121 million of the $200million needed could be provided from $121 million of retained earnings in thebalance sheet.As the company had no cash,this was of course not possible andshows a misunderstanding of the nature of retainedearnings. n|yl 3v
Some answers suggested asking the bank to increase the $160 millionoverdraft to $360 million in order to provide the finance for the $200 millionacquisition.Since the acquisition was a long-term investment,short-term financecould not be used under the matching principle.Suggestions of using leasefinance were also not appropriate,although discussion of the sale and leasebackof the company’s non-current assets was relevant.Some answers discussed businessangels,government grants and venture capital,but these sources of finance arenot relevant to a $200 million acquisition. EYcvD^!1g
Analysis of the financial information given in the question wasneeded to support any critical discussion of ways of raising the $200 millionrequired.Some answers gave no analysis or very little analysis and so were quitegeneral in nature,outlining for example the differences between equity financeand debt finance.Errors in ratio calculations were common,highlighting the needfor candidates to understand accounting ratio definitions.Four years ofprofitability information was provided,allowing trends and growth rates to becalculated,although some answers considered only information from the first yearand the last year.The information,when analysed,gave a very gloomy picture andindicated that the company would have difficulty raising the cash itneeded,whether from debt finance or equity finance.Taking on more debt wouldcause gearing,interest cover and financial risk to rise to dangerouslevels,while existing and potential shareholders would not look favourably on acompany that had not paid dividends for four years,especially one whose growthin profitability was on a downward trend. \aU^c24>
Part (b) asked candidates to briefly explain the factors thatinfluence the interest rate charged on a new issue of bonds,i.e.traded debt.Goodanswers discussed such factors as the period to redemption,the risk of theissuing company,the general level of interest rates in the economy,expectationsof future inflation,redemption value and so on,and easily gained fullmarks.Poorer answers did not show understanding of the relationship for a bondbetween market value,interest rate,period to redemption,redemption value andcost of debt. J<>z}L{
Part (c) asked candidates to identify and describe the three forms ofefficiency that can be found in a capital market and many answers correctlyidentified and described weak form efficiency,semi-strong form efficiency andstrong form efficiency.Some answers incorrectly stated that capital marketefficiency was about the information available in the market,when in factcapital market efficiency is concerned with pricing efficiency,i.e.the nature ofthe information reflected in the market prices of traded securities,somethingwhich is investigated by carrying out empirical tests.From this point of view,itis theoretically possible for a capital market to be simultaneously weakform,semi-strong form and strong form efficient. Bl3G_Ep
Question Three Lk4&&5q
Many candidates gained full marks in answering part (a),picked upreasonable marks on parts (b) and (d),but in many cases gave poor answers topart (c). 8Rc4+g
Part (a) required candidates to calculate the cost of a currentinventory ordering policy,and the change in inventory management costs when theeconomic ordering quantity (EOQ) model was used to find the optimum ordersize. 3@XCP- `
A number of answers failed to gain full marks because they did notcalculate the change in inventory management costs,even after correctlycalculating these costs under the current ordering policy and after applying theEOQ model. Gx y>aS3
Poorer answers showed a lack of understanding of the relationshipbetween ordering costs and holding costs,and an inability to calculate thesecosts. Rr |VGtg
In part (b),candidates were required to describe briefly the benefitsof a just-in-time (JIT) procurement policy.No credit was given for discussingthe disadvantages of such a policy,as these were not required.Many answers gavea short list of benefits,rather a description of the benefits,and so were notable to gain full marks. ipw _AC ~
Part (c) asked candidates to calculate and comment on whether aproposed change in receivables management (offering an early settlementdiscount) was acceptable,and to calculate the maximum discount that could beoffered. F, %qG,
Some candidates gained full marks for calculating correctly thereduction in financing cost,the cost of the discount and the net benefit ofoffering the discount.The reduction in financing cost and the cost of thediscount were both based on credit sales for the year of $87.6million. f?2Y np=@
Poorer answers based their calculations on current trade receivablesof $18 million,even though the question stated that the early settlementdiscount would be offered to 25% of credit customers.Comparing current tradereceivables and current credit sales showed that current receivables paid onaverage after 75 days,a credit period that would be reduced to 60 days throughimproved operational procedures.Some candidates assumed incorrectly that thecurrent trade receivables period was 60 days and made incorrect calculations asa result. WFjNS'WI_
The maximum discount that could be offered would be equal to thebenefit gained from the discount,i.e.the saving in administration and operatingcosts added to the reduction in financing cost. vObP(@0AM
Feedback from markers indicated that some answers to this part ofquestion 3 were disorganised,with unlabelled calculations and a lack ofexplanation.It is important to help the marking process by labellingcalculations,explaining workings and using correct notation,e.g.‘$ peryear’,'$m’,'days’ and so on. n<"?+bz"<
Part (d) required candidates to discuss the factors that should beconsidered in formulating working capital policy on the management of tradereceivables. `0= 0IPVd
Poorer answers offered a list of actions that could be met in tradereceivables management,such as “send out letters to trade receivables”,"callcustomers on the telephone”,"produce an aged receivables analysisregularly”. hG2btmBht
Working capital policy on trade receivables management shouldconsider what period of credit to offer,how to determine the amount of creditoffered,when creditworthiness needs to be assessed and to what extent,and soon,and it is often informed by the trade receivables management policies ofcompetitors.The policy should provide the framework within which the actionsreferred to above would be undertaken. NA]7qb%%<
Question Four *<Fz1~%*
Many candidates did well in parts (a)(i),(b) and (c),while doingpoorly in part (a)(ii) and struggling to remain focused on the question asked inpart (d). {{tH$j? Q
In part (a) candidates were required to calculate the equity valueof a company using the dividend growth model (DGM) and then the net assetvalue. \G#Qe*"'K
Many candidates calculated correctly the share price of the companyusing the DGM,although some candidates failed to multiply this share price bythe number of shares to give the equity value of the company.Poorer answersre-arranged the DGM in order to calculate a cost of equity using the currentshare price,but this was unnecessary,as the cost of equity was given in thequestion. 9c=Y+=<
The net asset value calculated by many candidates showed that theywere uncertain as to the meaning of ‘net asset value’.Some candidates gave a netasset value of $94 million,a figure which fails to treat preference sharecapital as prior charge capital and hence include it with long-termliabilities. fP&F$"o8
Part (b) asked candidates to calculate the after-tax cost of debt ofa company.Many candidates gained full marks by calculating the after-taxinterest payment,using two discount rates to calculate two net present valuesfor investing in the bond,and using linear interpolation to calculate theafter-tax cost of debt.Answers that did not gain full marks contained errorssuch as using the wrong tax rate (it was 25%),addition or multiplicationerrors,using the before-tax interest payment,or putting incorrect values tovariables in the linear interpolation calculation. &:S_ewJK7
Some answers calculated the cost of capital of preference shares inaddition to calculating the after-tax cost of debt,and then attempted to averagethe two costs of capital.While preference shares are classed as prior chargecapital,they pay a dividend,not interest,and preference shares are notdebt. T9*\I TA
In part (c),candidates were required to calculate the weightedaverage cost of capital (WACC) of a company.Candidates therefore needed tocalculate the market values of ordinary shares,preference shares and bonds,andthe preference share cost of capital,having already calculated the after-taxcost of debt and being given the cost of equity by thequestion. q 4xB`G
The most common reason for not gaining full marks was calculatingincorrectly the cost of capital of the preference shares.This can be found bydividing the preference dividend by the market price of the preference share,butmany candidates used the dividend rate of the preference shares (8% per year) asthe dividend,instead of calculating the preference dividend from the nominalvalue (par value),i.e.8% of 50 cents giving a dividend of 4 cents pershare. {5
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Other reasons for losing marks included aggregating the market valuesof ordinary shares and preference shares,before applying the cost of equity toboth:omitting the preference share capital from the WACC calculation;multiplyingthe after-tax cost of debt by (1–t) (one minus the tax rate);and calculating anew cost of equity,even though the cost of equity was given in thequestion. \-#~)LB
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Part (d) asked for a discussion of the factors to be considered informulating the dividend policy of a stock exchange listed company.Therequirement was worded carefully to encourage candidates to consider thedividend policy of a company faced by the demanding business environment of thereal world.Little credit was therefore given to discussions of the dividendirrelevance theory of Miler and Modigliani,which is based on the assumption of aperfect capital market,since capital markets in the real world are no more thansemi-strong form efficient. 0u'4kF!P!
While a discussion of dividend relevance theory compared to dividendirrelevance theory was not asked for,some credit was given to answers thatdiscussed dividend relevance theory where points were made that had real worldrelevance.These points included the signalling effect of dividends,shareholderpreference for certain dividends rather uncertain capital gains,and theimportance of the clientele effect in imperfect capitalmarkets. 9bMM-~
Better answers focused on some of the factors covered in thesuggested answer,including the need to consider liquidity,the importance ofrelating dividend decisions to investment and financing decisions,and the needto consider financial risk.
