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Financial Management Question Bank 2019 PDF
Financial Management Question Bank 2019 PDF
FINANCIAL
MANAGEMENT
Question Bank
www.icaew.com
Financial Management
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-50972-137-5
Previous ISBN: 978-1-78363-875-8
First edition 2007
Twelfth edition 2018
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system or transmitted in any form or by any means,
graphic, electronic or mechanical including photocopying, recording,
scanning or otherwise, without the prior written permission of the
publisher.
© ICAEW 2018
Risk management
34 Fratton plc (June 2011) 9, 10 30 45 50 220
35 Sunwin plc (December 2012) 9 26 39 51 222
36 Padd Shoes Ltd (March 2014) 9, 10 30 45 52 225
37 Stelvio Ltd (June 2014) 9, 10 30 45 53 227
38 JEK Computing Ltd (September 2014) 10 30 45 54 230
39 Lambourn plc (Sample paper) 9, 10 30 45 55 232
40 American Adventures Ltd
(December 2013) 9, 10 30 45 57 235
41 Hammond Beamish Software Ltd
(September 2010) 9, 10 30 45 58 238
42 Bridge Engineering plc (December
2015) 9 30 45 59 240
Syllabus Study
learning Manual
Topic area outcome(s) Question number(s) chapter(s)
2 Profitis plc
Profitis plc has a continuing need for a machine. At the level of intensity of use by the company,
after four years from new the machine is not capable of efficient working. It has been the
company's practice to replace it every four years. The production manager has pointed out that
in the fourth year the machine needs additional maintenance to keep it working at normal
efficiency. The question has therefore arisen as to whether to replace it after three years instead
of the usual four years.
3 Horton plc
3.1 The objective of the directors of Horton plc (Horton) is the maximisation of shareholder
wealth. The directors are currently considering Horton's capital investment strategy for
20Y0. Five potential investment projects have been identified, each one having an
expected life of four years. However, at this stage the directors are uncertain of the precise
financial situation the company will be in on 31 December 20X9 when it will actually make
its chosen investments. The company accountant has already undertaken net present value
calculations for each of the five potential investment projects as follows:
Initial Investment (31.12.X9) Net Present Value (31.12.X9)
£ £
Project 1 (2,400,000) 2,676,600
Project 2 (2,250,000) (461,700)
Project 3 (3,000,000) 4,111,500
Project 4 (2,630,000) 2,016,250
Project 5 (3,750,000) (45,250)
Whilst these net present value calculations include the impact of corporation tax, which the
company pays at 17%, they do not include the effect of capital allowances. Project 3 is the
only project that will attract capital allowances and these allowances will apply just to the
initial £3 million investment. The allowances will be at a rate of 18% per annum on a
5 ProBuild plc
ProBuild plc (ProBuild) runs a network of builders' merchants in northern England. The company
has a small subsidiary, Cabin Ltd (Cabin) that hires out various types of portable cabin used on
building sites. In recent years, Cabin's performance (relative to that of ProBuild's core business)
has been disappointing and the directors of ProBuild have decided that they should focus
resources on their core operations and dispose of Cabin.
Having advertised the business for sale, ProBuild has now been approached by the directors of
Brixham plc (Brixham) with an offer to buy Cabin on 31 December 20X3. Brixham has agreed, in
principle, to pay ProBuild the net present value (as at 31 December 20X3) of the projected
incremental net cash flows of Cabin over the four-year period to 31 December 20X7.
You have been asked by Brixham's directors to calculate an appropriate purchase price using
the following information which has been provided by ProBuild and verified by independent
accountants:
(1) All cash flows can be assumed to occur at the end of the relevant year unless otherwise
stated.
(2) Inflation is expected to average 2% pa for all costs and revenues.
(3) The real discount rates applicable to the appraisal of this investment are:
20X4: 5%
20X5: 6%
20X6: 7%
20X7: 7%
(4) During the past five years, Cabin's annual revenue (at 31 December 20X3 prices) has been
extremely volatile, having peaked at £2 million in one year, whilst falling to a low of
£1.2 million in another year.
(5) During the past five years, Cabin's variable costs have been similarly volatile, being as low
as 25% of annual revenue in one year, whilst having been as high as 30% of annual revenue
in another year. There has been no direct correlation between annual revenue and variable
costs during the past five years.
(6) It has been estimated that under Brixham's ownership, annual fixed costs will be
£0.6 million (at 31 December 20X3 prices), including a share of Brixham's existing head
office costs equal to £0.25 million.
To: A Newman
From: Diana Marshall
As you are aware, our chief accountant, John Smith, left Frome Lee earlier this week following a
disagreement over company policy.
As a result we desperately need financial advice from you. We are considering the purchase of
capital equipment for the manufacture of a new radio, The Pink 'Un. Our marketing team feels
that we would have a competitive advantage with this new radio for three years. Mr Smith had
prepared some estimated figures which we were going to consider at our next meeting on
Monday and he left some of them behind. You will find my summary of them (with some of my
notes) in the Appendix below. We would want to purchase the equipment at the end of our
financial year on 30 September, commence production very soon after and sell the equipment
at the end of September 20Y1.
Demand in each subsequent year of the project's life would remain at the first year's expected
level.
Financial information about the new machinery and NBL 1114 is shown here in Table 2:
Table 2
NBL 1114's period of competitive advantage (1 April 20X1 to 31 March 20X4) 3 years
Maximum annual output of new machinery (units of NBL 1114) 12,800
Cost of new machinery (payable on 31 March 20X1) £480,000
Scrap value of new machinery (at end of three year period, ie, 31 March 20X4) £nil
NBL 1114's contribution per unit (based on a selling price per unit of £65) £33
Additional annual fixed costs incurred (including annual depreciation charge of
£160,000) £300,000
Extra working capital required at 31 March 20X1 (recoverable in full on 31 March
20X4) £50,000
Working capital
The working capital requirement for each year must be in place at the start of the relevant year.
8 Newmarket plc
Newmarket plc (Newmarket), a listed company, has recently developed a new lawnmower, the
NL500. Development of the NL500 was supported by market research which was undertaken by
an external agency who agreed that their £10,000 fee would only be payable if the NL500 was
actually launched, with payment due at the end of the NL500's first year on the market.
Newmarket's directors estimate that the market life of the NL500 will be five years but they
would be willing to launch the NL500 only if they were satisfied that the required investment
would generate a net present value of at least £300,000, using a discount factor of 10% pa.
Production and sale of the NL500 would commence on 1 July 20X3 and would require
investment by Newmarket in new production equipment costing £750,000, payable on 30 June
20X3. On 30 June 20X8 it is expected that this equipment could be sold back to the original
vendor for £50,000. Newmarket depreciates plant and equipment in equal annual instalments
over its useful life.
The company's directors would like to assume that the corporation tax rate will be 17% for the
foreseeable future, and it can be assumed that tax payments would occur at the end of the
accounting year to which they relate. The directors are also assuming that the new production
facilities would attract capital allowances of 18% pa on a reducing balance basis commencing in
the year of purchase and continuing throughout the company's ownership of the equipment. A
balancing charge or allowance would arise on disposal of the equipment on 30 June 20X8. It
can be assumed that sufficient profits would be available for Newmarket to claim all such tax
allowances in the year they arise.
10 Wicklow plc
Wicklow plc (Wicklow) is a manufacturer of prestige cast iron cookers, having a long-standing
reputation for selling distinctive high price, high quality cookers to an increasingly global
market. In the face of growing competition from firms offering slightly more modern style
cookers at much lower prices, Wicklow's recent strategy has been to introduce a 'Heritage'
version of some of its major product lines. The aim has been to emphasise the original design
features of the brand and to differentiate itself further from its competitors.
Wicklow is currently considering the introduction of a 'Heritage' version of its existing 'Duo'
product, a standard two-oven cooker. Wicklow has recently spent £375,000 developing the new
version of the product, to be known as the Duo Heritage (DH).
Production of the DH would require Wicklow to invest £2 million in new machinery and
equipment on 31 December 20X8. Based on past experience, the directors are assuming that
this machinery and equipment will have a disposal value on 31 December 20Y2 of £200,000.
Sales of the DH would be expected to commence during the year ending 31 December 20X9.
Based on a unit selling price of £7,000, Wicklow's marketing director has estimated that unit
sales in 20X9 will be either 1,500 (0.65 probability) or 2,000 (0.35 probability). In view of the
12 Daniels Ltd
Daniels Ltd (Daniels) is a large civil engineering company and it has a financial year end of
31 May. Much of Daniels' work involves long-term contracts for the railway industry. You work for
Daniels and have been asked for advice by the board on the following problems:
Problem 1
Daniels is considering a major investment involving five possible projects in the West of England
and South Wales which have been put out to tender. Daniels' board of directors has prepared
the following estimated cash flows (and resultant net present values at 31 May 20X7) for the five
projects:
Investment Year to Year to Year to
Project Location on 31/5/X7 31/5/X8 31/5/X9 31/5/Y0 NPV
£'000 £'000 £'000 £'000 £'000
B Bristol (4,150) (1,290) 530 7,270 577
C Cardiff (3,870) (1,310) 3,130 1,550 (1,309)
G Gloucester (6,400) 1,770 2,160 3,160 (632)
S Swansea (5,000) (2,610) 6,450 6,520 2,856
T Tiverton (4,600) 1,290 2,870 3,620 1,664
You can assume that the net present values shown in the table above are accurate.
Due to financial constraints, the company, if successful with its tenders, would be unable to take
on all five projects. The board is prepared to release £8 million for initial investment (on 31 May
20X7) into one or more of the projects, but might increase this figure to £9 million if there are
grounds for doing so. An alternative scenario which has been considered would be to make
available sufficient funds to start all five projects in May 20X7, but this would limit the capital
available in the year to 31 May 20X8 to a maximum of only £500,000.
Problem 2
Daniels runs a fleet of vans to support its operations. Currently it replaces those vans every three
years, but the board is not sure whether this is in the company's best interests. Vans cost, on
average, £12,400 each. Daniels' transport manager has prepared the following schedule of
costs and resale values for the vans:
Maintenance and
running costs Resale value
£ £
In first year of van's life 4,300 After one year 9,800
In second year of van's life 4,800 After two years 7,000
In third year of van's life 5,100 After three years 5,000
Problem 3
About a year ago (March 20X6) Daniels completed construction of a factory for Kithill Ltd (Kithill).
This cost Daniels £720,000 to construct and Kithill is paying £190,000 a year for eight years.
Daniels will, therefore, ultimately make a profit of £800,000, which gives a return on the
investment of over 100%. When Kithill sent its first annual instalment last week, it indicated that
rather than make annual payments it would prefer to settle the outstanding balance by making a
one-off payment of £925,000 in a year's time (March 20X8). One of Daniels' directors is keen on
13 Adventurous plc
Adventurous plc (Adventurous) is a UK listed company that manufactures and sells global
positioning system (GPS) devices worldwide. Following favourable market research that cost
£20,000, Adventurous has developed a new GPS-based bicycle computer (BC). It intends to set
up a manufacturing facility in the UK, although the board of Adventurous had contemplated
setting up in an overseas country. The BC project will have a life of four years.
The selling price of the BC will be £295 per unit and sales in the first year to 31 December 20X4
are expected to be 10,000 units per month, increasing by 5% pa thereafter. Relevant direct
labour and materials costs are expected to be £170 per unit and incremental fixed production
costs are expected to be £3 million pa. The selling price and costs are stated in
31 December 20X3 prices and are expected to increase at the rate of 3% pa. Research and
development costs to 31 December 20X3 amounted to £1 million.
Investment in working capital will be £1.5 million on 31 December 20X3 and this will increase in
line with sales volumes and inflation. Working capital will be fully recoverable on
31 December 20X7.
Adventurous will need to rent a factory for the life of the project. Annual rent of £1 million will be
payable in advance on 31 December each year and will not increase over the life of the project.
15 Alliance plc
You should assume that the current date is 31 December 20X5.
Alliance plc (Alliance) is a manufacturer of electronic devices. At a recent board meeting two
agenda items were discussed as follows:
(1) The possible development of an automatic watering system (Autowater) for indoor potted
plants in private houses and business premises. The sales director commented that there
are similar more expensive products on the market and it is likely that competitors will
develop their technology and bring down their prices in future. Therefore, it would be
prudent to assume a life cycle of four years for the Autowater.
(2) For other projects that have already been appraised using NPV analysis, the 20X6 capital
expenditure budget (excluding Autowater) should not exceed £350 million. The
£350 million will be allocated to projects, excluding Autowater, on the basis of maximising
shareholder wealth.
The chairman of Alliance closed the meeting with the following statement:
"We will continue to see excellent opportunities to invest in profitable projects across
our business and we have no difficulty in raising finance. However we will be
disciplined in our approach to committing to capital expenditure. I would now like the
finance director to evaluate the Autowater project and to determine in which other
projects the £350 million 20X6 capital expenditure budget is going to be invested."
A 100 180
B 50 90
C 40 100
D 140 150
E 100 140
Requirements
15.1 Using money cash flows, calculate the net present value of the Autowater project on
31 December 20X5 and advise the board whether it should accept the project. (16 marks)
15.2 Ignoring the effects on working capital, calculate the sensitivity of the Autowater project to
changes in sales revenue and indicate whether there is a sufficient margin of safety for the
project to go ahead. (4 marks)
BBM's ordinary shares had a market value of £2.45 each (ex-div) and a beta of 0.9 on
28 February 20X4. The return on the market is expected to be 8.6% pa and the risk free rate
2.1% pa.
BBM's debentures had a market value of £110 (cum interest) per £100 nominal on 28 February
20X4 and they are redeemable at par on 28 February 20X9.
BBM's board is now considering diversifying its operations by expanding into a new market. The
average equity beta for companies already operating in this market is 1.9 with an average ratio
of equity to debt (by market values) of 83:17.
This diversification will cost BBM approximately £25 million. However, there is disagreement
amongst BBM's directors as to how the diversification should be funded and whether it should
happen at all. There are three proposals that are being considered:
Proposal 1
BBM proceeds with the diversification. It would raise the additional funding required from equity
and debt sources in such a way as to leave its existing equity: debt ratio (by market values)
unchanged following the diversification. The additional debt raised would be in the form of 8%
redeemable debentures issued at par.
Proposal 2
BBM proceeds with the diversification. It would raise all of the additional funding required in the
form of 8% redeemable debentures issued at par.
Proposal 3
BBM does not proceed with the diversification. The funds, raised as in proposal 2, are used
instead to buy back some of its ordinary shares.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Irredeemable debentures
(£100) 1.4 £110% ex-int 4.17% (kd)
PRF's managing director said that when calculating these figures, PRF's directors had taken
account of taxation where appropriate, assuming that the corporation tax rate will be 17% for
the foreseeable future and that tax will be payable in the same year as the cash flows to which it
relates.
PRF's managing director also made these statements at the AGM:
(1) The WACC of 9.791% represented the total return to the company's providers of finance ie,
the total of the after-tax interest and dividends for the trading year to 31 May 20X1.
18 Turners plc
Turners plc (Turners) is a listed company in the food retailing sector and has large stores in all
the major cities in the UK. Turners' board is considering diversifying by opening holiday travel
shops in all of its stores.
At a recent board meeting the directors were discussing how the holiday travel shops project
('the project') should be appraised. The sales director insisted that Turners' current weighted
average cost of capital (WACC) should be used to appraise the project as the majority of its
operations will still be in food retailing. The finance director disagreed because the existing cost
of equity does not take into account the systematic risk of the new project. The finance director
also said that the company's overall WACC, which reflects all of the company's activities, would
change as a result of the project's acceptance. The board were also concerned about the
market's reaction to their diversification plans. A further board meeting was scheduled at which
Turners' advisors would be asked to make a presentation on the project.
You work for Turners' advisors and have been asked to prepare information for the presentation.
You have established the following:
Turners intends to raise the capital required for the project in such a way as to leave its existing
debt:equity ratio (by market values) unchanged following the diversification.
Extracts from Turners' most recent management accounts are shown below:
Balance sheet at 31 May 20X4
£m
Ordinary share capital (10p shares) 233
Retained earnings 5,030
5,263
6% Redeemable debentures at nominal value (redeemable 20X8) 1,900
Long term bank loans (interest rate 4%) 635
7,798
19 Middleham plc
Middleham plc (Middleham) is a company involved in the production of printing inks used in a
wide range of applications in the food packaging industry. The directors of Middleham are
currently considering a £2 million investment in new production facilities. At the present time,
the company's finance director is seeking to establish an appropriate cost of capital figure for
use in the appraisal of the proposed investment. Extracts from Middleham's most recent
financial statements for the year ended 31 March 20X3 are shown below:
£'000
Ordinary share capital (50p shares) 3,200
5% irredeemable preference share capital (50p shares) 1,400
Reserves 7,000
11,600
7% debentures (at nominal value) 1,500
13,100
Current liabilities 3,700
Total equity and liabilities 16,800
£'000
Profit before taxation 3,000
Taxation (510)
Preference share dividends (70)
Ordinary share dividends (1,088)
21 Puerto plc
You should assume that it is now 1 December 20X3.
Puerto plc (Puerto) is listed on the UK stock market and operates in the vehicle leasing industry.
During a period of expansion from 20W3 to 20W7 the company funded growth by way of
convertible loans obtained from an investment bank, SM Capital (SMC). As a result of the global
economic downturn Puerto has experienced a number of trading difficulties, and the company
ceased to pay dividends to its ordinary shareholders in 20W8. Since 20W9 Puerto has embarked
on a significant restructuring of its business. Although in the current year to 30 November 20X3
the company has sustained losses, industry conditions have stabilised giving both the board of
Puerto and SMC confidence in the company's future. This confidence is also shared by the UK
stock market as Puerto's share price has been increasing over the last six months to 10p per
ordinary share on 30 November 20X3.
The board of Puerto is now considering a further restructuring that includes the purchase on
1 December 20X3 of another vehicle leasing business that in the last financial year achieved a
pre-tax operating profit of £3 million. The purchase price for this business is £24 million. The
board is confident it will be able to raise the additional borrowings required for this purchase on
1 December 20X3, particularly as SMC, as part of the restructuring, has agreed to exercise its
option to convert its convertible loans into equity on that date in order to participate in Puerto's
future growth potential. The board and SMC believe that Puerto's share price will increase
immediately on 1 December 20X3 by 35% as a result of the restructuring.
Additional information:
The SMC convertible loans amount to £68 million and the rate of interest on these loans is
3% pa. The market value of these loans, on 30 November 20X3, is equal to their nominal value
of £68 million.
SMC has the option to convert its loans into thirty ordinary shares for every £4 of loan.
Puerto also has non-convertible secured bank loans amounting to £6 million that carry an
interest rate of 7% pa.
On 30 November 20X3 Puerto had 492 million ordinary shares in issue.
£24 million of new secured borrowings at an interest rate of 6% pa will be raised from Risky
Bank plc (Risky) to finance the purchase of the vehicle leasing business. A covenant
attached to this loan requires that the gearing (debt/equity by market values) immediately
after the restructuring is not more than the industry average of 25%.
Corporation tax is 17% pa on current year profits.
Puerto has an equity beta of 2.13 which reflects Puerto's gearing on 30 November 20X3.
The risk free rate is 2.8% pa.
An appropriate market risk premium is 5% pa.
Requirements
21.1 Prepare Puerto's forecast income statement for the year ended 30 November 20X4
assuming that the restructuring goes ahead and that both the existing and newly-acquired
leasing businesses earn similar operating profits to those in the year to 30 November 20X3.
(3 marks)
21.2 Calculate Puerto's gearing ratio (debt/equity) by market values on 30 November 20X3 and
on 1 December 20X3 immediately after the restructuring. (5 marks)
21.3 Using your answer to 21.1 and 21.2, comment on the financial health of Puerto both before
and after the restructuring and whether the covenant imposed by Risky would be met if
Puerto's share price remains at 10p on 1 December 20X3. (5 marks)
21.4 Calculate (using the capital asset pricing model) the weighted average cost of capital of
Puerto on 30 November 20X3 and on 1 December 20X3 immediately after the
restructuring. (10 marks)
21.5 Discuss, with reference to relevant theories, whether the change in Puerto's capital structure
following the restructuring on 1 December 20X3 will bring about a permanent change in its
weighted average cost of capital. (6 marks)
22 Abydos plc
Abydos plc is considering a large strategic investment in a significantly different line of business
to its existing operations. The scale of the new venture is such that a significant injection of
£12.5 million of new capital will be required.
The current gearing of Abydos is 80% equity and 20% debt by market value.
The new project will require outlays immediately as follows:
£'000
Plant and equipment (purchased on first day of financial year) 10,000
Working capital 1,500
Equity issue costs (not tax allowable) 700
Debt issue costs (not tax allowable) 300
12,500
24 Newspaper articles
A friend of yours has asked you for clarification of five issues relating to newspaper articles that
he has read recently:
Issue (1) He owns 7,000 shares in Bettalot plc (Bettalot), a betting and gaming company. He
has read the following and is not sure what the implications are:
'Yesterday Bettalot announced a one for two rights issue at 95 pence per share to
raise £285 million in order to reduce its level of financial gearing. The rights issue
price represents a 24% discount on the current market value of Bettalot's ordinary
shares. The company's current p/e ratio is 9.6 and all of the money raised will be
used to redeem debenture stock with a coupon rate of 8%.'
On 30 November 20X5 BBB's ordinary shares each had a market value of 360p (cum-div) and an
equity beta of 1.10. For the year ended 30 November 20X5, the dividend declared was 10p per
ordinary share and the earnings yield (earnings per share divided by ex-div share price) was 7%.
BBB's debentures had a market value at 30 November 20X5 of £99 (cum-interest) per £100
nominal value and are redeemable at par on 30 November 20X9.
The market return is expected to be 7% pa and the risk free rate 2% pa.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Requirements
25.1 Ignoring the Climbhigh project, calculate the WACC of BBB at 30 November 20X5 using:
(a) The CAPM (8 marks)
(b) The Gordon growth model (6 marks)
25.2 Using the CAPM, calculate a WACC that is suitable for appraising the Climbhigh project
and explain the rationale for using this as the discount rate for the project. (6 marks)
25.3 By calculating an overall equity beta and using the CAPM, estimate the overall WACC of
BBB assuming that the Climbhigh project goes ahead and comment upon the implications
for the value of BBB of any change from the WACC that you have calculated in 25.1(a)
above. (6 marks)
25.4 Advise BBB on how political risk could potentially affect the value of the Climbhigh project
and how it might limit its effects where such risk exists. (6 marks)
25.5 Explain the ethical issues for the finance director in relation to the email received from the
contractor who wishes to tender for building one of the climbing walls, and briefly outline
the action that he should take. (3 marks)
Total: 35 marks
26 Cern Ltd
26.1 Cern Ltd (Cern) is an unquoted company that manufactures a range of products used in the
construction industry. Extracts from the most recent management accounts of Cern are set
out below:
Income statement for the year ended 30 September 20X2
£
Profit before interest and tax 1,080,000
Interest (180,000)
Profit before tax 900,000
Tax (17%) (153,000)
Profit after tax 747,000
Non-current assets £ £
Intangibles 900,000
Freehold land and property 1,800,000
Plant and equipment 3,600,000
Investments 900,000
7,200,000
Current assets
Inventory 540,000
Receivables 1,080,000
Cash 180,000
1,800,000
Current liabilities (1,080,000)
720,000
7,920,000
Equity and non-current liabilities
Ordinary share capital (£1 shares) 3,600,000
6% Preference shares (£1 shares) 720,000
Retained earnings 1,800,000
6,120,000
10% Debentures 1,800,000
7,920,000
The following information is also available:
(1) In the two previous financial years the profit before interest and tax was:
• year ended 30 September 20X1: £440,000.
• year ended 30 September 20X0: £1,800,000.
(2) The current market value of the preference shares has been estimated at £0.90 per
preference share.
(3) The current market value of the debentures has been estimated at £110 per £100 of
debentures.
(4) The current rental value of the freehold land and property is £270,000 pa and this
represents a 6% return.
27 Wexford plc
Wexford plc (Wexford) is a listed manufacturer of dairy products. In recent years the company
has experienced only modest levels of growth, but following the recent retirement of the chief
executive, his replacement is keen to expand Wexford's operations.
It is currently December 20X8 and the board of directors has recently agreed to support a
proposal by the new chief executive that the company purchase new manufacturing equipment
to enable it to expand its range of yoghurt-based products. The new equipment will cost
£25 million and the company is seeking to raise new finance to fund the expenditure in full.
However, the board of directors is undecided as to how the new finance is to be raised. The
directors are considering either a 1 for 5 rights issue at a price of 250p per share or a floating
rate loan of £25 million at an initial interest rate of 8% per annum. The company's bank has
agreed to provide the £25 million loan. The loan would be for a term of five years, with interest
paid annually in arrears and with the capital being repaid in full at maturity. The loan would be
secured against the company's freehold land and buildings.
You are employed by Wexford as a company accountant and have been able to obtain the
following additional information:
As a result of the investment in the new machinery, the directors aim to increase the
company's revenue by 15% per annum for the foreseeable future.
It is expected that direct costs, other than depreciation, will, on average, increase by 18% during
the year ending 30 November 20X9 due to the 'learning curve' effects associated with the new
machinery.
Indirect costs are expected to increase by £10 million in the year to 30 November 20X9.
The ratios of receivables to sales and payables to direct costs (excluding depreciation) will
remain the same as in the year to 30 November 20X8.
Depreciation on assets existing at 30 November 20X8 is forecast to be £18 million in the
year ending 30 November 20X9.
Depreciation on the new machinery will be 20% per annum on a straight line basis
commencing in the year of purchase.
Capital allowances can be assumed to be equal to the depreciation charged in a
particular year.
The company's inventory levels are expected to increase by £10 million as a result of the
increased levels of business.
Tax is payable at a rate of 17% per annum in the year in which the liability arises.
Dividends are payable the year following their declaration and the board of directors has
confirmed to the bank its intention to maintain the company's current dividend payout ratio
for the foreseeable future.
Requirements
27.1 For each of the financing alternatives being considered, prepare a forecast income
statement for the year ending 30 November 20X9 and a forecast Balance sheet at
30 November 20X9. (16 marks)
Note: Transaction costs on the issuing of new capital and returns on surplus cash invested
in the short term can both be ignored.
27.2 Write a report (including appropriate calculations) to Wexford's board of directors that fully
evaluates the two potential methods of financing the company's expansion plans.
(14 marks)
Total: 30 marks
Notes
1 These assets have been professionally valued on 28 February 20X4 as follows:
Hampton Richmond
£m £m
Non-current assets 45.2 24.1
Current assets 25.1 35.2
2 The non-current liabilities are all debentures, redeemable within the next six years, with
coupon rates as follows: Walton 7%, Hampton, 7%; Richmond, 8%. The debentures are
currently trading at: Walton £125, Hampton £110, Richmond £80.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Client Two
Jackie Wight has run a very successful fashion business, Regent Spark Ltd, for many years and is
now considering selling it and taking early retirement. She has read a recent article in the
financial press and is concerned that she won't get a fair price for her company. As a result she
has contacted Loxwood for guidance. The following is an extract from the article:
'Angel Ventures (AV) recently bid for biometrics company Praed Bio (PB), offering PB's
shareholders £5.20 a share. Maida Money (MM), a hedge fund that owns PB shares, disliked
Market research commissioned by AR's directors has estimated that the £12 million of additional
funding would increase annual turnover from September 20X3 by one fifth and that this
expansion of the company's operations would also lead to an additional £0.5 million of annual
fixed costs. The directors also expect AR's contribution to sales ratio to remain unchanged. Two
methods of raising the additional funding have been suggested:
(1) a rights issue at £2.50 per share; or
(2) an issue of 7% debentures at par.
The most recent board meeting was held on 2 September 20X3 and an extract from the minutes
of that meeting is shown here:
'Martin Cotham (Finance Director) suggested that AR should raise the £12 million via a
rights issue. The current share price is £3.10. If the issue was priced at £2.50 per share, he
thought this was sufficient a discount to be attractive to shareholders and should guarantee
a successful outcome. He said it's also good as it reduces AR's gearing and so will send the
shareholders a positive message. He felt if, after the rights issue, AR could get its share
price up above its current level, even if it's only a £0.20 per share increase, then the rights
issue looks like the best method.'
'Amy Wills (Managing Director) said that we should issue more debentures as (1) the rights
issue will dilute the value of AR's shares and (2) AR is not making enough use of the tax
shield. She also said that a rights issue might upset the shareholders, as, if they can't afford
it and don't take up the rights, they would lose money. The debentures would also put less
pressure on AR to maintain annual dividend levels and, thereby, maintain investors'
confidence in us. A slightly higher coupon rate of 7% would make the debentures more
attractive than those currently in issue. She also said we should consider other types of debt
such as convertibles and loan stock with warrants.'
Requirements
29.1 Aside from the factors already identified by Martin Cotham and Amy Wills, outline the other
factors that should be considered by a company contemplating a rights issue as a means of
raising finance. (4 marks)
29.2 Using the market research estimates above, and assuming that AR's dividend per share
remains unchanged, prepare AR's forecast income statement for the year to 31 August
20X4 if it uses:
a rights issue at £2.50 per share; or
an issue of 7% debentures at par to raise the £12 million of additional funding
required. (9 marks)
29.3 Calculate AR's earnings per share for the year to 31 August 20X3 and, for both financing
methods, its estimated earnings per share for the year to 31 August 20X4. (5 marks)
29.4 Calculate AR's gearing ratio (in book and market value terms) on 31 August 20X3 and
similarly, for both financing methods, its gearing ratio on 31 August 20X4. You should
assume that on 31 August 20X4 AR's ordinary share price is £3.30 per share and that its
debentures are quoted at par on 31 August 20X3 and 31 August 20X4. (8 marks)
30 Sennen plc
You should assume that the current date is 31 May 20X4.
Sennen plc (Sennen) is a UK listed company in the chemical industry. Morgan plc (Morgan) is a
UK listed company that has a policy of expanding by way of acquisition. As a result of financing
its acquisitions with borrowings, Morgan's gearing is high compared to its competitors.
Morgan has identified Sennen as a potential takeover target and intends to make an offer for all
of the ordinary shares of the company. The finance director of Morgan wishes to value Sennen's
ordinary shares including any synergistic benefits that may arise following the acquisition. He is
also considering the advantages and disadvantages of the different methods that can be used to
pay for the ordinary shares. The intended offer for Sennen is not public knowledge.
The Finance Director of Morgan has asked North West Corporate Finance (NWCF) to give him
advice regarding the intended offer for the ordinary shares of Sennen. You work for NWCF and
a partner in the firm has asked you to prepare a report for a meeting that he is due to attend with
the board of Morgan. You have established the following data relating to Sennen:
Sales revenue for the year ended 31 May 20X4 £20 million
Competitive advantage period 3 years
Estimated sales revenue growth for the next three years 5% pa
Estimated sales revenue growth thereafter in perpetuity 2% pa
Operating profit margin 15%
Additional working capital investment at the start of each year 1% of that year's sales revenue
Additional non-current asset investment at the end of each year 2% of that year's sales revenue
After tax synergies at the end of each year 2.5% of that year's sales
revenue
Number of ordinary shares in issue 17,000,000
Current share price 160p
Appropriate weighted average cost of capital 7% pa
Price earnings (p/e) multiple used to value recent takeovers in
the chemical industry 17
You may assume that replacement non-current asset expenditure equals depreciation in each
year.
On 31 May 20X4 Sennen had short-term investments with a market value of £2 million currently
yielding 3% pa and irredeemable debt with a market value of £10 million. The current gross yield
on Sennen's debt is 5% pa.
Assume that corporation tax will be 17% of operating profits for the foreseeable future and that
there are no other tax issues that need to be considered.
The management team of Sennen, which includes a member of the ICAEW, has been preparing
a business plan to present to potential financial backers of a management buyout (MBO) that
they intend to launch for the ordinary shares of the company. The intended MBO is not public
knowledge.
You should assume that LSL will not be purchasing or disposing of any machinery in the years
20X1-20X4 and that it would dispose of the existing pool of machinery on 28 February 20X4 at
its tax written-down value.
Printwise's board estimates that in four years' time, ie, 28 February 20X4, it could, if necessary,
dispose of LSL for an amount equal to four times its after-tax cash flow (ignoring the effects of
capital allowances and the disposal value of the machinery) for the year to 28 February 20X4.
Assume that the corporation tax rate is 17% pa.
The market values of Tower's long-term finance on 31 August 20X4 are shown below:
£1 ordinary share capital £4.20/share
6% £1 preference shares £0.80/share
5% debentures £110%
As a result of these discussions the board decided to explore the implications of making a 1 for
2 rights issue which would raise sufficient funds to purchase and cancel 60% of Tower's
debentures by market value.
In advance of the next board meeting, you have been asked by your manager, Luke Cleeve, to
prepare calculations and advice for Tower's directors. Luke pointed out to you that you should
'be careful with this information as it's potentially price sensitive and not in the public domain.'
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Requirements
32.1 Calculate Tower's theoretical ex-rights share price if a 1 for 2 rights issue were made on
1 September 20X4. (3 marks)
32.2 (a) Calculate Tower's earnings per share figure for the year ended 31 August 20X4 and for
the year ended 31 August 20X5 after the proposed rights issue (assuming no change
in profit before interest).
(b) Calculate and comment on the terms of the rights issue required if the earnings per
share figure is not to worsen by more than 10% for the year ended 31 August 20X5.
(11 marks)
32.3 Calculate Tower's gearing (debt/debt + equity) at 31 August 20X4 using both book and
market values and advise its board as to whether it has a 'gearing problem' and how its
gearing level could affect its share price. Where relevant, make reference to theories
regarding the impact of capital structure on share price. (9 marks)
32.4 Advise Tower's board as to whether the suggested change in dividend policy would have a
negative impact on the company's share price. Where relevant, make reference to theories
regarding the impact of dividend policy on share price. (9 marks)
32.5 Explain the ethical implications for an ICAEW Chartered Accountant of having access to
'price-sensitive information'. (3 marks)
Total: 35 marks
33 Brennan plc
Brennan plc is a family run business, which obtained a stock market listing around three years
ago. The board is comprised of 75% of members of the founding family. Brennan plc has a
current stock market capitalisation of £250 million and the board owns 45% of the issued shares.
The net book value of assets held by Brennan plc is £300 million.
Brennan currently enjoys competitive advantage through being a low cost producer and the
board feels that this competitive advantage is likely to continue for the next six years. The
following information relating to Brennan and the period of competitive advantage is available.
34 Fratton plc
34.1 Fratton plc (Fratton) trades extensively in Europe. The firm is due to receive €2,960,000 in
three months' time. The following information is available:
(1) The spot exchange rate is currently €1.1845 – 1.1856/£.
(2) The three-month forward rate of exchange is currently at a 0.79 – 0.59 cent premium.
(3) The prices of three-month sterling traded option contracts (premiums in cents per £
are payable up front, with a standard contract size of £62,500) are as follows:
Exercise price Calls Puts
€1.18 2.40 3.60
(4) Annual interest rates at the present time are as follows:
Deposit Borrowing
UK 1.15% 2.40%
Eurozone 0.75% 1.60%
Requirements
(a) Calculate the net sterling receipt that Fratton can expect in three months' time if it
hedges its foreign exchange exposure using:
the forward market
the money market
the options market, assuming the spot exchange rate in three months is:
– €1.1185 – 1.1200/£
– €1.1985 – 1.2000/£ (14 marks)
(b) Discuss the advantages and disadvantages of using futures contracts as opposed to
forward contracts when hedging foreign currency exposure. (7 marks)
34.2 In addition, in three months' time Fratton will be drawing down a three-month £2.5 million
loan facility which is granted each year by its bank to see the firm through its peak
borrowing period. The following information is available:
(1) The quotation for a '3–6' forward rate agreement is currently 2.60 – 1.35.
(2) The spot rate of interest today is 2.40% pa and the relevant three-month sterling
interest rate futures contract (standard contract size £500,000) is currently trading at
97.20.
Requirements
(a) Explain how Fratton could use a forward rate agreement to resolve the uncertainty
surrounding its future borrowing costs and show the effect if, in three months' time, the
spot rate of interest is 3% pa. (4 marks)
(b) Explain how Fratton could use sterling interest rate futures to hedge its exposure to
interest rate risk and show the effect if, in three months' time, the spot rate of interest is
3% pa and the price of the interest rate futures contract has fallen to 97. (5 marks)
Total: 30 marks
Call Put Call Put Call Put Call Put Call Put
Requirements
Demonstrate how FTSE 100 index options can be used by the trustees to hedge the
pension fund's exposure to falling share prices and show the outcome if, on 31 December
20X2, the portfolio's value:
(a) Rises to £6.608 million and the FTSE index rises to 5,900
(b) Falls to £4.592 million and the FTSE index falls to 4,100 (8 marks)
35.2 It is 1 December 20X2 and Sunwin's board of directors has recently agreed to purchase
machinery from a UK supplier on 28 February 20X3. The firm's cash flow forecasts reveal
that the firm will need to borrow £4 million on 28 February 20X3 for a period of nine
months. The directors are concerned that short-term sterling interest rates may rise
between now and the end of February and are considering the use of either sterling short-
term interest rate futures or traded interest rate options on futures to hedge against the
firm's exposure to interest rate rises.
The spot rate of interest on 1 December is 3% pa and March three-month sterling interest
rate futures with a contract size of £500,000 are trading at 96. Information regarding traded
interest options on futures on 1 December 20X2 is as follows:
Calls Puts
37 Stelvio Ltd
37.1 You should assume that the current date is 31 May 20X4.
Stelvio Ltd (Stelvio) imports climbing equipment from suppliers in the USA. In the past
Stelvio has not hedged its foreign exchange rate risk and has purchased foreign currency
on the spot market as and when required. The managing director of Stelvio, Fred Hughes,
has recently been reading about hedging techniques that might assist his company; in
particular he has read about the use of forwards, futures and over the counter options. Fred
is not convinced about the merits of hedging as he is of the opinion that the forward rate is
a good indication of the future spot rate. He believes he can estimate the sterling cost of the
company's future foreign currency payments with confidence, without having to use
complex derivative instruments.
Stelvio currently has a bank overdraft that costs 6% pa. It has a payment to make of
$940,000 on 30 September 20X4.
The following information is available at the close of business on 31 May 20X4:
Exchange rates:
Spot rate ($/£) 1.6025 – 1.6027
Four month forward premium ($/£) 0.0021 – 0.0020
September currency futures price (standard contract size £62,500) $1.5995/£
Over the counter currency option
A September call option to buy $ has an exercise price of $1.6100/£. The premium is 4p per
$ and is payable on 31 May 20X4.
Requirements
Produce a report for Fred Hughes which should include:
(a) A calculation of Stelvio's sterling payment if it uses each of the following to hedge its
foreign exchange rate risk:
A forward contract
Currency futures contracts
An over the counter currency option
You should assume that on 30 September 20X4 the spot exchange rate will be
$1.5002 – 1.5008/£ and that the sterling currency futures price will be $1.5005/£.
(11 marks)
39 Lambourn plc
Throughout both parts of this question you should assume that today's date is 30 June 20X2.
39.1 Lambourn plc (Lambourn) is a UK company that trades in a range of pharmaceutical
products. It buys and sells these products in the UK and also in the USA, where it trades with
three companies – Biotron Inc., Hope Inc. and USMed Inc.
Notes
1 New equipment required for the production of AP525 will cost £1,150,000 on 31 March
20X6 and will be sold on 31 March 20X9 for an agreed price of £100,000 (in 31 March 20X9
prices).
AP depreciates its equipment on a straight-line basis. A full year's depreciation is charged
in the year of purchase and none in the year of sale.
If this new equipment is purchased, existing equipment, which originally cost £120,000
many years ago and has a tax written down value of zero, will be sold on 31 March 20X6 for
£70,000.
The new equipment will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final
year. In the final year, the difference between the equipment's written down value for tax
purposes and its disposal proceeds will be treated by the company either as a:
balancing allowance, if the disposal proceeds are less than the tax written down
value; or
balancing charge, if the disposal proceeds are more than the tax written down value.
2 The new equipment will take up extra space, which will have to be rented for three years.
The rent would be at a fixed annual amount of £80,000, payable in advance, with the first
payment due on 31 March 20X6.
3 £130,000 of these fixed costs per annum are existing head office costs that will be allocated
to the project.
4 The purchase of the new equipment would be funded from an issue of debt and this
represents the interest cost on that debt.
46 Zeus plc
You should assume that the current date is 30 June 20X6.
Zeus plc (Zeus) is a large clothing retailer. Over the past five years it has built up an internet
based division, Venus, which specialises in selling to 16–24 year old female customers.
At a recent board meeting the Chief Executive Officer (CEO) of Zeus stated that:
"Venus has been successful, but we have not been able to get the value out of it that we initially
expected and the management time involved in running Venus is damaging the financial
performance of the group as a whole. Because internet-based companies have very high values
compared to non-internet companies with similar earnings, I feel that there could be more value
in Venus if it operated outside of our group. I think that we should divest ourselves of Venus and
appoint a financial advisor to assist us in the process. I wonder whether an Initial Public Offering
(IPO), where the shares are brought to the stock market for the first time, is a possibility."
The board agreed with the CEO and voted in favour of the divestment of Venus. Starr
Accountants (SA), a firm of ICAEW Chartered Accountants, has been appointed to give advice to
Zeus regarding the value of Venus and the potential IPO. In their valuation SA would like to use
net present value analysis and also a multiple of earnings. In addition to general corporate
finance work, SA also has a team that specialises in giving investment advice to clients who buy
shares in IPOs.
Extracts from Venus's most recent management accounts are shown below:
Balance sheet value of net assets at 30 June 20X6: £39 million.
Income statement for the year ended 30 June 20X6
£m
Sales 140.0
Cost of sales (56.0)
Gross profit 84.0
Selling and administration costs (72.0)
Operating profit 12.0
Taxation 17% (2.0)
Profit after tax 10.0
On 31 May 20X6 Ross's ordinary shares each had a market value of 576p (cum-div) and an
equity beta of 0.65. For the year ended 31 May 20X6, the dividend declared was 11p per
ordinary share and the earnings yield (earnings per share divided by the ex-div share price) was
6%.
Ross's 6% coupon debentures had a market value on 31 May 20X6 of £111 (cum-interest) per
£100 nominal value and are redeemable at par on 31 May 20Y0.
Requirements
47.1 Ignoring the Happytours project, calculate the WACC of Ross at 31 May 20X6 using:
(a) The Gordon growth model (12 marks)
(b) The CAPM (2 marks)
47.2 Explain the limitations of the Gordon growth model. (3 marks)
47.3 Using the CAPM, calculate a WACC that is suitable for appraising the Happytours project
and explain your rationale. (6 marks)
47.4 Assuming that £75 million is raised from the new 4% coupon debentures issued on 1 June
20X6, calculate the issue price per £100 nominal value and the total nominal value that will
have to be issued. Comment on the issue terms for these new debentures. (7 marks)
47.5 Explain what is meant by a convertible debenture and outline the advantages and
disadvantages for Ross in raising finance using this type of debt. (5 marks)
Total: 35 marks
48.3 Sheldon's managers would like an explanation regarding the time value of the FTSE 100
index options.
Requirement
Explain the three factors that will affect the time value of the FTSE 100 index options in
48.2 above. (3 marks)
Total: 30 marks
Email attachment:
Income statement for the year ended 31 August 20X6
£'000
Revenue 9,390
Working assumptions
(1) Darlo's fixed assets were revalued at 31 August 20X6 as follows:
£'000
Freehold land and buildings 3,150
Equipment 3,370
These revalued amounts have not been recognised in the balance sheet at 31 August 20X6.
(2) The average price/earnings ratio for listed businesses in Darlo's industrial sector is 10 and
the average dividend yield is 8%.
(3) A discount rate of 12% pa appropriately reflects the risk of Darlo's cash flows.
52 Ribble plc
You should assume that the current date is 31 December 20X6.
Ribble plc (Ribble), a UK company, manufactures hoverboards and other products. Hoverboards
are a form of self-balancing scooter powered by rechargeable batteries. In the last two years
total UK sales of hoverboards have increased rapidly but major concerns have arisen over their
safety and, even though they are still in high demand, some retailers have stopped selling them.
At a recent directors' meeting of Ribble the chief executive officer (CEO), who is an ICAEW
Chartered Accountant, presented a research and development report (that had cost £100,000)
on a new and safer hoverboard; the Ribbleboard. The CEO stated that he believed the new
Ribbleboard could be successfully marketed for a period of four years and would replace the
company's existing hoverboard, the Ribflyer. The directors decided that a project appraisal
should be undertaken to ascertain whether the Ribbleboard should be marketed. Some
directors felt that as there is a continuing demand for the Ribflyer, even though there are
concerns about its safety, it should still be manufactured and sold rather than taking the risk of
marketing the Ribbleboard. There was also concern that a rival company was known to be
developing a new safer hoverboard and it is likely to launch it onto the market on 31 December
20X7.
The following information is available regarding the Ribbleboard project:
• The selling price will be £299 per unit in the year to 31 December 20X7 and will remain
fixed in each subsequent year of the product's life. The contribution for the year to
31 December 20X7 is expected to be 45% of the selling price. The variable cost of
producing the Ribbleboard is expected to increase by 5% pa in the three years to
31 December 20Y0.
• The number of units sold in the year to 31 December 20X7 is expected to be 8,000 per
month. For the year to 31 December 20X8 the number of units sold is expected to increase
by 20%. For the remaining two years to 31 December 20Y0, the number of units sold is
expected to decline by 15% pa.
• The new specialist equipment required to manufacture the Ribbleboard requires more
space than Ribble currently has available. Therefore, Ribble will use factory space that it
currently owns and rents out for storage to another company for a fixed rent of £1 million pa
payable in advance on 31 December. The space will be re-let for £1 million pa at the end of
the project on 31 December 20Y0.
• If the project goes ahead, two managers who had already accepted voluntary redundancy
would be asked to remain employed until 31 December 20Y0 and manage the project at a
salary of £60,000 pa each. These managers were due to leave on 31 December 20X6 and
receive lump sum payments of £50,000 each at that time. They will now receive lump sum
payments of £60,000 each on 31 December 20Y0 when their services will no longer be
required. The managers were also due to receive consultancy fees of £25,000 pa each for
the two years ended 31 December 20X7 and 20X8. These consultancy fees would not be
paid to them if they remained employed to manage the project. All of the above salaries,
lump sums and fees are stated in money terms.
• It is estimated that for every 10 Ribbleboards sold there will be a loss of sales of one unit of
the Ribflyer, which Ribble expects to sell at a fixed selling price of £100 and a contribution
of 25%, in each of the four years to 31 December 20Y0.
Additional information:
• Middleton has an equity beta of 1.1
• The risk free rate is expected to be 3% pa
• The market return is expected to be 8% pa
• Middleton's current share price is £5 per share ex-div
• Middleton has 40 million ordinary shares in issue
Requirements
(a) Calculate, using the CAPM, Middleton's cost of capital on 31 December 20X6.
(1 mark)
(b) Assuming a 1 for 2 rights issue is made on 1 January 20X7:
• Calculate the discount the rights price represents on Middleton's current share
price.
• Calculate the theoretical ex-rights price per share.
• Discuss whether the actual share price is likely to be equal to the theoretical ex-
rights price. (5 marks)
(c) Alternatively, assuming debt is issued on 1 January 20X7:
• Calculate the issue price and total nominal value of the debentures that will have
to be issued to give a yield to redemption equal to that of Wood's debentures.
• Discuss the validity of the use of the yield to redemption of Wood's debentures in
the above calculation. (7 marks)
(d) Outline the advantages and disadvantages of the two alternative sources for raising the
£70 million, discuss the concerns of the board regarding the debenture issue (using
the gearing and interest cover information provided by the finance director) and advise
Middleton's board on which source of finance should be used. (12 marks)
54 Orion plc
You should assume that the current date is 30 November 20X6.
Orion plc (Orion) is a UK company that manufactures nutrition products which it exports to the
USA and receives payment in dollars. Orion imports raw materials from a number of countries
located in Europe and makes payments to suppliers in euros.
At a recent board meeting of Orion concern was expressed about several aspects of the
company's foreign exchange rate risk (forex) hedging strategy. Below is an extract from the
minutes of the meeting:
Managing director: "We have always hedged our forex and we should continue to do so.
But I am worried that because we import our raw materials and export our finished
products, we are subject to economic risk."
Production director: "We use derivative instruments to hedge forex and I think they are too
complicated. How do the banks calculate forward rates for example? Also can someone
explain to me what economic risk is?"
It was decided that at the next board meeting the finance director should make a presentation
to the board on the subject of forex. The finance director has asked you to prepare some
information for his presentation including an example of how receipts are hedged using
different hedging techniques.
You have the following information available to you at the close of business on 30 November
20X6:
Orion currently has substantial sterling funds on deposit.
Receipts due from USA customers on 31 March 20X7 are $5,000,000.
Exchange rates:
Spot rate ($/£) 1.4336 – 1.4340
Four month forward discount ($/£) 0.0086 – 0.0090
March currency futures price (standard contract size £62,500) $1.4410/£
Over-the-counter (OTC) currency option
A March put option to sell $ is available with an exercise price of $1.4390/£. The premium is
£0.03 per $ and is payable on 30 November 20X6.
The market values of Sentry's ordinary shares and debentures on 28 February 20X7 are:
Ordinary shares £3.44 (cum div)
7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 20X7 by either:
(1) A rights issue at £2.50 per ordinary share; or
(2) An issue of 8% debentures at par, redeemable in 20Y3.
You have been asked by the directors to assume the following for the year to 28 February 20X8:
Sales will increase by 20%
The contribution to sales ratio will remain unchanged
Fixed costs will increase by £2 million pa
The current level of dividends per share will be maintained
Corporation tax will remain at 17%
57 ST Leonard Foods
You should assume that the current date is 31 March 20X7.
ST Leonard Foods (STL) is a UK frozen food company. It buys raw vegetables and fish from its
suppliers and, following processing and freezing, sells them to its customers.
You work in STL's finance team and have been asked to prepare calculations that will help STL's
management decide on the best strategy with regard to these two issues:
Issue 1 – foreign exchange rate hedging
Earlier this year STL's management signed a contract worth €1,750,000 with one of its Spanish
suppliers and the goods arrived at STL last week. In addition, it has agreed to sell €600,000
worth of frozen goods to a new customer, a French hypermarket, and these goods will be
despatched to France in 10 days' time.
58 Brighton plc
Brighton plc (Brighton) manufactures and sells various types of lock. After undertaking market
research that cost £50,000, Brighton is considering manufacturing and selling a new type of lock
for bikes. For the purposes of the initial project appraisal it can be assumed that the locks would
be manufactured in the UK. However, the board of Brighton are considering manufacturing
them overseas where labour costs and associated safety standards for employees are much
lower than in the UK. The bike lock market is highly competitive with companies entering and
leaving the market on a regular basis.
The decision on whether to introduce the new lock will be based on net present value analysis.
At a recent board meeting one of Brighton's directors quoted from a recent financial newspaper
article that he had read:
"Shareholder wealth maximisation is the generally accepted corporate objective. Net
present value analysis is the most logical way to achieve this when used in conjunction with
Shareholder Value Analysis."
The director felt that Brighton should be concerned with more than just the shareholders since
there are other stakeholders who also contribute to the business. However, some of the other
directors felt that if shareholder wealth is maximised they had fulfilled their obligations and that
the company should not be concerned about these other stakeholders.
The following data relates to the new bike lock
• The bike lock's product life-cycle is estimated to be four years and the sales volume is
expected to be 5,500 units per month in the year to 30 June 20X8. The sales volume is
expected to increase by 5% in the year to 30 June 20X9 and then decrease at the rate of
10% pa (compound) in the two years to 30 June 20Y1.
• The selling price will be £100 per lock in the year to 30 June 20X8 and will increase at
2% pa for the three years to 30 June 20Y1. The contribution per unit is expected to be 45%
of the selling price.
• Fixed production overhead costs are estimated to be £0.2 million in the year to 30 June
20X8. 50% of these fixed production overheads are centrally allocated. The fixed
production overheads are expected to increase by 3% pa in the three years to 30 June
20Y1.
• Selling and administration costs are estimated to be £0.5 million in the year to 30 June
20X8 and are expected to increase by 3% pa in the three years to 30 June 20Y1.
• Warehousing and office space that Brighton currently owns and lets to third parties for an
annual fixed rent of £0.4 million pa, payable in advance on 30 June, will be used for the
bike lock project. The rent will not increase with inflation. At the end of the project the
warehousing and office space will be re-let to third parties.
• An investment in working capital of £1 million will be required on 1 July 20X7. This will
increase at the start of each subsequent year in line with sales volume growth and selling
price increases. Working capital will be fully recoverable on 30 June 20Y1.
• An investment in plant and machinery costing £8 million will be required on 30 June 20X7
and this will not have any scrap value on 30 June 20Y1. The plant and machinery will attract
18% (reducing balance) capital allowances in the year of expenditure and in every
subsequent year of ownership by the company, except the final year.
59 Easton plc
Easton plc (Easton) is a listed company and a specialist retailer of pet-related products and
operates stores throughout the UK. The company is considering diversifying by opening
veterinary practices ('the project'), which will operate from dedicated space in all of its stores.
At a board meeting of Easton it was agreed to appraise the project using net present value
analysis. However, considerable debate took place regarding the discount factor to use and
whether the company should be diversifying at all. At the meeting the finance director said:
"I will have to calculate a weighted average cost of capital (WACC) that reflects the
systematic risk of the project. I also intend to raise the capital required for the project in
such a way as to leave our existing debt:equity ratio (by market values) unchanged
following the diversification".
Various comments made by the other attendees at the meeting were as follows:
"Why can't we just use our current WACC?"
"I have read that the shareholders of listed companies should diversify away unsystematic
risk. But I am confused as to what systematic and unsystematic risks are."
"I think that we should stick to what we know and not attempt to diversify. I am worried
about the stock market's reaction to this diversification."
"What happens if we can't maintain our existing capital structure? How do we then appraise
the project?"
On 31 May 20X7 Easton's ordinary shares had a market value of 252p each (cum-div). The
company declared a dividend of 10p per ordinary share during the year to 31 May 20X7 and it is
expected to be paid shortly. The equity beta of Easton is 0.45. The return on the market is
expected to be 9% pa and the risk free rate 2% pa.
On 31 May 20X7 Easton's 4% redeemable debentures had a market value of £109 (cum-interest)
per £100 nominal value. The debentures are due to be redeemed at par on 31 May 20Y5.
A listed company operating solely in the veterinary practices market had an equity beta of 0.80
and a debt:equity ratio by market values of 3:7 on 31 May 20X7. It has been estimated by the
finance director that if the project goes ahead the overall equity beta of Easton will be made up
of 75% pet-related products and 25% veterinary practices.
Assume that the corporation tax rate will be 17% for the foreseeable future.
Requirements
59.1 Ignoring the project, calculate the current WACC of Easton on 31 May 20X7 using the
CAPM. (8 marks)
59.2 Using the CAPM, calculate a cost of equity that reflects the systematic risk of the project and
explain your reasoning. (6 marks)
59.3 Assuming that the project goes ahead, estimate, using the CAPM, the overall WACC of
Easton and comment upon the implications of any permanent change in the overall WACC.
(6 marks)
59.4 Explain what is meant by systematic and unsystematic risk and give two examples of each
for Easton. (6 marks)
59.5 Discuss whether Easton should diversify its operations and how its shareholders and the
stock market might react to the proposed project. (4 marks)
59.6 Identify and describe the appropriate project appraisal methodology that should be used if,
as a result of financing the project, the current capital structure of Easton is not maintained.
Using the data relating to Easton, calculate the project discount rate that should be used in
these circumstances. (5 marks)
Total: 35 marks
60 Lake Ltd
Lake Ltd (Lake) is a UK company that has recently started exporting leather goods to the USA.
Lake is fully aware of its exposure to foreign exchange rate risk ('forex risk') and the need to
hedge it. However, Lake is concerned that there may be other overseas trading risks that it
should be protecting itself against.
You work for Lake and have been asked to advise the board on how to hedge the forex risk
associated with its US trading activities. You have the following information available to you at
the close of business on 30 June 20X7:
Notes
1 Coastal's non-current assets originally cost £52.8 million. They were valued at
£37.8 million on 31 August 20X7 and its current assets were valued at £4.2 million on
the same date. Neither of these valuations is reflected in the balance sheet at
31 August 20X7.
2 Coastal's debentures were trading at £110% on 31 August 20X7.
3 Average figures for listed UK commercial radio companies:
P/E ratio 8.5
Dividend yield 5%
Enterprise value multiple 6.5
Requirements
(a) Calculate the value of one Coastal share based on each of the following methods:
Price earnings ratio
Dividend yield
Enterprise value
Net assets basis (historic cost)
Net assets basis (revalued) (12 marks)
Beyond
Year to 31 August (budgeted) 20X8 20X9 20Y0 20Y0
Sales growth 5% 3% 2% 0%
Operating profit margin 8% 9% 9% 9%
Incremental non-current asset investment
(as a % of sales increase) 6% 5% 2% 0%
Incremental working capital investment
(as a % of sales increase) 5% 5% 4% 0%
Requirements
(a) Calculate the value of Albion's equity using SVA. (12 marks)
(b) Outline the methods by which Albion's directors might raise the funds necessary for
the proposed MBO of the company. (3 marks)
Total: 35 marks
You are Ramsey's finance director and an ICAEW Chartered Accountant. At its 22 August 20X7
meeting, the board considered two proposed new investments. You were asked to prepare
workings and recommendations in advance of the next meeting regarding those two
investments, details of which are shown below:
Investment 1
Ramsey wishes to invest £9.5 million in a new computerised manufacturing system, making use of
robotic techniques. Half of this investment would be funded from Ramsey's retained earnings and
the balance via a bank loan at an agreed rate of 7.5% pa. A report was presented by the
production director at the 22 August board meeting. It concluded that this new system would
generate efficiencies that would increase manufacturing profit by 6–8% pa. At the same meeting,
one of Ramsey's other directors, Michael Bateman, said that "because the company should be
striving for a higher share price, any press releases regarding the new system should state that
profits are expected to increase by at least 15% pa."
Investment 2
Ramsey's board is considering a major change in strategy by investing in the development of
driverless cars. A driverless car is a vehicle that is capable of sensing its environment and
navigating without human input. The finance for this investment would be raised in such a way
so as not to alter Ramsey's current gearing ratio (measured as debt:equity by market values).
The debt element of the finance will come from a new issue of 9% irredeemable debentures at
par.
Ramsey's directors want to establish a cost of capital that could be used to appraise the
investment in driverless cars. They are aware that such a diversification would be very risky and is
likely to increase Ramsey's equity beta which is currently 1.25.
The following data, collected at 31 August 20X7, should be used when preparing your workings
for the next board meeting:
Driverless cars industry sector
Equity beta 2.10
Ratio of long-term funds (debt:equity) by market values 16:72
Expected risk free rate 2.25% pa
Expected return on the market 9.15% pa
64 Innovative Alarms
Assume that the current date is 31 December 20X7.
Innovative Alarms (Innovative) is a division of a major quoted company and manufactures and
sells a single alarm system to private houses and commercial premises. The financial
management department of Innovative is considering two separate issues:
Issue One: Whether to launch onto the market a new type of alarm system, the Defender, which
when triggered will not only ring a bell but also play a realistic recording of dogs barking.
Issue Two: How often the division's fleet of delivery vans should be replaced.
You are asked to provide advice on both of these issues and report to the head of the financial
management department.
64.1 Issue One: The Defender Project
The Defender is to be evaluated over a planning horizon of three years from 31 December
20X7. It has been agreed that on 31 December 20Y0 the rights to manufacture the
Defender will be sold to a team made up of the current management of Innovative (‘the
team') as by that date the Defender is expected to be Innovative's only product. The
finance director of Innovative, who is an ICAEW Chartered Accountant, will be a member of
the team and is responsible for calculating the value of the rights to manufacture the
Defender.
The following information is available regarding the Defender project:
The selling price will be £399 per unit in the year to 31 December 20X8 and the
contribution per unit is expected to be 40% of the selling price. The selling price and
variable costs per unit are expected to increase by 3% pa in the two years to
31 December 20Y0.
The number of units sold in the year to 31 December 20X8 is estimated to be 30,000
and is expected to increase by 6% pa in the two years to 31 December 20Y0.
On 31 December 20X7 the project will require an investment in working capital of
£2 million, which will increase at the start of each subsequent year in line with sales
volume growth and sales price increases. Working capital will be fully recoverable on
31 December 20Y0.
Incremental fixed costs for the year ended 31 December 20X8 are expected to be
£0.5 million and are expected to increase by 5% pa in the two years to 31 December
20Y0.
The Defender will require two hours of skilled labour per unit. Skilled labour is
expected to be in short supply over the next three years. Innovative will need to
transfer skilled labour from its existing product, which requires half the skilled labour
time per unit of the Defender. The existing product has a selling price of £175 and an
expected material and skilled labour cost of £150 in the year to 31 December 20X8.
The selling price and variable costs are expected to increase by 3% pa in the two years
to 31 December 20Y0, the end of the existing product's life cycle. Innovative's skilled
labour is paid at the rate of £15 per hour (in 31 December 20X8 prices). Any working
capital adjustments associated with the existing product can be ignored.
The number of shares in issue has not changed during the period from 1 December 20X2 to
30 November 20X7.
Additional information:
The cum-div share price on 1 December 20X7 is £2.92 per ordinary share. The special
dividend was paid in June 20X7.
The 7% debentures have a cum-interest market value of £111 per £100 nominal value.
Peel has an equity beta of 1.3.
A company that supplies domestic appliances has an equity beta of 1.1 and a debt:equity
ratio of 40:60 by market values.
The risk free rate is expected to be 3% pa.
The market risk premium is expected to be 6% pa.
Assume that the rate of corporation tax will be 17% for the foreseeable future.
Debbie has asked you to provide her with certain information so that she can prepare a
report for the board of Peel.
Requirements
65.1 Calculate Peel's WACC on 1 December 20X7 using:
(a) The dividend valuation model (dividend growth should be estimated using the earliest
and latest dividend information provided)
(b) The CAPM (10 marks)
65.2 Explain and evaluate whether either of the WACC figures calculated in 65.1 above would
be appropriate for appraising Peel's diversification into supplying domestic appliances.
(5 marks)
65.3 Determine whether the £200 million finance required should be raised from either debt or
equity sources. You should discuss the likely reaction of both shareholders and the financial
markets, and make reference to the gearing and interest cover data provided and give
advice to Debbie on which source of finance should be used. (12 marks)
65.4 Assuming that Peel raises the £200 million finance required wholly from debt, identify the
most appropriate project appraisal methodology that could be used to appraise the
diversification. Also determine the project discount rate that should be used in these
circumstances. (3 marks)
65.5 Discuss whether Peel's dividend policy over the last five years is appropriate for a listed
company. (5 marks)
Total: 35 marks
Email extract
.....................The board has managed to
keep our expansion plans very quiet so
far. Do be very careful who you share
this information with as the proposals
are likely to have an impact on the Wells
share price.....................
Assume that the corporation tax rate will be 17% for the foreseeable future.
Requirements
67.1 Ignoring the investment in retail bakery outlets, calculate Wells' weighted average cost of
capital (WACC) at 31 March 20X8 using:
(a) The dividend growth model and (14 marks)
(b) The CAPM (2 marks)
67.2 Discuss the points raised by the three directors at the 27 February 20X8 board meeting.
(6 marks)
67.3 Calculate an appropriate WACC that Wells could use when appraising the £17 million
investment in retail bakery outlets and explain the reasoning behind your approach.
(10 marks)
67.4 Identify and explain the ethical implications of Alison Hughes' email for you, as an ICAEW
Chartered Accountant. (3 marks)
Total 35 marks
Additional information:
(1) Evans's current assets include cash balances and short-term investments, which total
£7 million.
(2) The market value of Evans's non-current assets at 31 May 20X8 was estimated to be
£59 million.
(3) Average multiples for a sample of listed companies in the same market sector as Evans
at 31 May 20X8 are:
Enterprise value 6.5
Price earnings (P/E) ratio 12.1
Requirements
(a) Calculate the value of one Evans ordinary share at 31 May 20X8 based on each of the
following methods:
Enterprise value
P/E ratio
Net assets basis (historic)
Net assets basis (re-valued) (8 marks)
(b) Recommend and justify to the board of Evans an issue price per share on 30 June 20X8
for the company's ordinary shares. Refer to the range of values calculated in part (a)
above. (4 marks)
71 Blackstar plc
Assume that the current date is 30 June 20X8.
Mitchells is a firm of ICAEW Chartered Accountants. Mitchells has been asked to advise a listed
client, Blackstar plc (Blackstar), on the following two issues:
Issue 1: Blackstar intends to raise additional funds of £150 million to fund an expansion of its
existing operations.
Issue 2: Blackstar is concerned about its existing dividend policy.
71.1 Issue 1: Raising additional funds of £150 million
Blackstar has always maintained a policy of no gearing. Other companies in Blackstar's
market sector have average gearing ratios (measured as debt/equity by market values) of
25%, with a maximum of 35%, and an average interest cover of eight times, with a minimum
of six. The finance director of Blackstar is considering raising the £150 million by either a
rights issue or by the company now borrowing and issuing debentures.
The details of the alternative sources of finance are as follows:
Rights Issue: The £150 million would be raised by a 2 for 3 rights issue, priced at a discount
on the current market value of Blackstar's ordinary shares.
Debt issue: The £150 million would be raised by an issue of 6% coupon debentures,
redeemable at par on 30 June 20Y5. The gross redemption yield would be based on the
current gross redemption yield of other debentures issued by companies in Blackstar's
market sector. One such company is Blue plc (Blue). Details for Blue's debentures are as
follows:
Coupon 5%
The current market price on 30 June 20X8 is £109 cum interest
Redemption at par on 30 June 20Y3
Further information regarding Blackstar:
The forecast pre-tax operating profit for the year ending 30 June 20X8 is £50 million
The corporation tax rate is 17%
The current share price at 30 June 20X8 is £7.50 ex-div
The number of ordinary shares in issue is 60 million
Marks
1.1 Machinery 1
Tax saving 2
Tax on income 1
Working capital investment 2
Discounting and NPV 1
Recommendation 1
No market research costs 1
No fixed costs 1
Selling price 1
Raw materials 1
Variable overheads 1
Loss of contribution 3
Labour costs ignored 1
17
1.2 NPV 1
IRR 1
Advice on usefulness 4
6
1.3 Relevant discussion
6
29
1.1
March 20X3 March 20X4 March 20X5 March 20X6
£'000 £'000 £'000 £'000
Machinery (4,900.000) 980.000
Tax saving (W1) 149.940 122.951 100.820 292.690
Income (W2) 2,008.500 3,500.970 1,803.000
Tax on income (W2) (341.445) (595.165) (306.510)
Working capital investment (W3) (750.000) (22.500) (23.175) 795.675
Total cash flows (5,500.060) 1,767.506 2,983.450 3,564.855
11% factor 1.000 0.901 0.812 0.731
PV (5,500.060) 1,592.523 2,422.561 2,605.909
NPV 1,120.933
As the NPV is positive SGS should proceed with the investment as this will enhance
shareholder wealth.
No market research costs.
No fixed costs.
(2)
March
20X3
Contribution/unit £
Selling price 190
Less: Raw materials (43)
Variable overheads (45)
Loss of Boom-Boom contribution ([£99 – £28 – £35] 2) (72)
Contribution/unit 30
Marks
2.1 Calculations:
Time 0 1
Time 1 1
Time 2 1.5
Time 3 2.5
Time 4 1
PV 2
Equivalent annual cost 3
Conclusion 1
13
2.2 1½ marks per point max 4
17
Marks
3.1 (a) Calculation of capital allowances 3
Calculation of NPV 1
4
(b) Scenario 1 1
Scenario 2 4
Scenario 3 5
Scenario 4 2
12
(c) Characteristics of finance leases 3
Characteristics of operating leases 3
Reasons why leasing might be a preferred source of finance:
1 mark per valid point max 2 8
3.2 (a) Calculations for:
1 year cycle 1
2 year cycle 1
3 year cycle 1
Annual equivalent cost, 0.5 marks per cycle 1.5
Conclusion 0.5
5
(b) 1.5 marks per valid issue discussed max 6
35
Examiner's comments:
Candidates generally coped well with the calculation of capital allowances in the opening
section of part 3.1 and it was a rare script that failed to pick up full marks (where this did happen,
it was most commonly due only to arithmetical slips of the pen). With the four capital rationing
scenarios most candidates were able to identify the correct projects to pursue in scenario 1.
However, in scenario 2 there were weaker candidates who simply failed to use the ranking
methodology based on NPV per £ invested. Weaker candidates also found scenario 3 rather
challenging, overlooking the need to consider Project 5 in spite of its negative NPV in view of
the cash released in the second period. Most candidates coped well with scenario 4. Most
candidates picked up high marks on the technical knowledge part of the lease discussion, but
scored less strongly on the whole in discussing the relative merits of leasing over outright
purchase. Another notable feature was that some candidates tended to answer the question
with their 'financial reporting' hat on rather than their 'financial management' hat – the
examination is a test of candidates' knowledge of the financial management learning materials.
Most candidates found little to trouble them in the standard replacement analysis question in
part 3.2.
Marks
4.2 Information that should have been brought into the annual payment determined in 4.1
Possible information that could have been brought into the determination of the annual
payment includes the following.
The possible effect on room sales of the loss of the top floors (view and security etc).
The possible loss of sales as a result of customers not attempting to book a room
because of the likelihood that the hotel will be full.
The possible room sales to Septo if the proposal does not go ahead; Septo's staff will
have to stay somewhere locally.
The likely loss of ancillary sales eg, restaurant sales.
4.3 Discussion of the advisability of the proposal from Septo's perspective
Septo is seeking to have 'in house' an activity that most businesses would 'outsource'. It
involves Septo in an activity that seems well outside its core activity and, presumably, its
area of expertise.
This could be expensive and risky as it turns a variable type of cost (paying by room/night as
needed) into a fixed cost. How often will Septo need all 100 rooms?
Five years is a long time to commit to use a facility like this.
It also has an adverse cash flow profile, since the annual fee is payable in advance.
On the other hand, Septo has the opportunity to control quality and style. It could prove to
be much cheaper than taking rooms by the night, provided that Septo were able to make
good use of the facility.
Examiner's comments:
Generally the performance on this question, particularly on requirement 4.1, was disappointing.
This is difficult to understand because the scenario is straightforward and well defined in the
question.
In part 4.1 candidates were asked to use NPV to identify the fixed annual fee that a business
needs to pay a hotel to make the hotel owners indifferent between letting out a significant part
of the hotel as a block and letting the rooms available in the normal way.
This was generally not well answered, with relatively few correct answers. Many candidates failed
to recognise that the effective cost to BH of leasing 100 rooms to Septo, all other things being
equal, was the expected loss of room lettings. Since BH would still have 400 rooms available, it
was only its inability to meet demand above that number that would represent a cost of a deal
Marks
5.1 Best case scenario:
Plant and equipment 2
Capital allowance 2
Operating cash flow 2
Tax 1
Working capital 2
Discount factor and NPV 2
Worst case scenario:
Capital allowance 2
Operating cash flow 1
Tax 2
NPV 1
17
5.2 Discussion of uncertainty and risk 6
WORKINGS
(1) Capital Allowances (£)
20X3 Cost 1,500,000
WDA 18% 270,000 17% = 45,900
1,230,000
20X4 WDA 18% 221,400 17% = 37,638
1,008,600
20X5 WDA 18% 181,548 17% = 30,863
827,052
20X6 WDA 18% 148,869 17% = 25,308
678,183
20X7 Disposal 100,000
578,183 17% = 98,291
Examiner's comments:
The first question on the paper was a standard investment appraisal question, supplemented by
tests of technical knowledge and its practical application. For the most part, candidates scored
strongly on the first part of the question, the majority clearly being well-drilled in the quantitative
techniques involved in this part of the question. Equally apparent was that the majority of
candidates were ill-equipped in terms of simple technical knowledge to pick up full or even high
marks in the second and third parts of the question, with many scripts scoring zero or at most
very low marks on both parts.
In the first part of the question, probably the most common error was inaccurate calculation of
the inflation-adjusted discount factors. However, there were many instances of full marks.
Marks
6.1 Net present value 15
6.2 Inflation 4 max 3
6.3 Diana Marshall note 5 max 4
6.4 Real investment options 6 max 4
26
6.1
T0 T1 T2 T3
£'000 £'000 £'000 £'000
Plant (400.000) 60.000
Tax saved (W1) 12.240 10.037 8.230 27.293
Working capital (W2) (32.000) (5.000) (3.000) 40.000
Sales (W2) 320.000 370.000 400.000
Materials (52.000) (64.000) (70.000)
Labour (26.000) (32.000) (35.000)
Other variable costs (12.000) (14.000) (16.000)
Fixed overheads (11.000) (11.800) (12.700)
Tax on profit (W3) (37.230) (42.194) (45.271)
Total Cash Flows (419.760) 186.807 211.236 348.322
Discount factor (W4) 1.000 0.925 0.855 0.783
PV (419.760) 172.796 180.607 272.736
NPV 206.379
Comments:
The NPV is positive and so Frome should proceed with the investment as shareholder value is
enhanced.
WORKINGS
(1)
Cost 400.000 328.000 268.960 220.547
WDA @ 18% (72.000) (59.040) (48.413) (160.547)
WDV 328.000 268.960 220.547 60.000
(3)
Sales (W2) 320,000 370,000 400,000
Total costs (101,000) (121,800) (133,700)
Taxable profits 219,000 248,200 266,300
(4)
Discount factor (1/1.05/1.03) 0.925
(1/1.05/1.03/1.05/1.03) 0.855
(1/1.05/1.03/1.05/1.03/1.05/1.04) 0.783
6.2 Inflation has to be taken properly into account so that the correct NPV is calculated. Inflation
will have a negative effect on the real value of money and an investor will need to be
compensated for that loss of value. As a result it is important to match real cash flows with
real interest/discount rate. This method can be problematic and so it is preferable, if
possible, to match money (nominal) cash flows, ie, actual cash flows, with an inflated
discount rate. This discount rate is calculated as follows: (1 + m) = (1 + r) (1 + i), where
m = money rate, r = real rate and i = inflation rate.
6.3 The cost of capital is the cost of funds that a company raises and uses, and the return that
investors expect to be paid (commensurate with the risk exposure) for putting funds into the
company and therefore is the minimum return that a company must make on its own
investments, to earn the cash flows out of which investors can be paid their return.
If a company calculates its cost of capital at too high a figure then it is likely to reject
investment opportunities that it should be taking on (ie, would provide a positive NPV).
In contrast if it sets the cost of capital at too low a level then it is likely to take on investment
opportunities that it shouldn't be taking on (ie, those with negative NPVs).
Both of these outcomes would be detrimental to shareholder value.
6.4 Follow-on
Launching the Pink 'Un would give Frome an opportunity to launch further models at a later
date. By investing in this first model, Frome effectively has the right to 'follow-on'. It is a call
option.
Abandonment
Frome has budgeted to sell the capital equipment for £60,000 in September 20Y1. It may
be that the three year project does not go as well as hoped and the company might then
wish to abandon it and sell the assets earlier than anticipated. This would be a put option.
These two real options could be taken account of by Frome's management and would
affect their decision regarding the project, which is otherwise only appraised by calculating
its NPV.
Marks
18
7.2 Calculation of money cost of capital 1
Calculation of difference in contribution 2
Calculation of difference in working capital 3
6
24
7.1
Pessimistic Optimistic
Annual Annual
sales (units) p EV sales sales (units) p EV sales
6,000 25% 1,500 10,000 25.0 % 2,500
10,000 50% 5,000 12,800 37.5% 4,800
12,800 25% 3,200 12,800 37.5% 4,800
9,700 12,100
Optimistic
t0 t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c 14,688 12,044 9,876 44,992
Contribution (W5) 399,300 399,300 399,300
Fixed costs (140,000) (140,000) (140,000)
Tax on extra profit (W6) (44,081) (44,081) (44,081)
Working capital (50,000) 50,000
Total cash flows (515,312) 227,263 225,095 310,4211
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 206,582 185,928 232,968
NPV 110,166
53,252 +110,166
Average NPV = £28,457
2
OR
Overall expected sales = (9,700+12,100)/2=10,900 units
t0 t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c 14,688 12,044 9,876 44,992
Contribution (@£33) 359,700 359,700 359,700
Fixed costs (140,000) (140,000) (140,000)
Tax on extra profit (W7) (37,349) (37,349) (37,349)
Working capital (50,000) 50,000
Total cash flows (515,312) 194,395 192,227 277,343
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 176,705 158,780 208,285
NPV 28,458
7.2 If inflation is taken into account then money (inflated) cash flows will be matched against
NBL's money cost of capital, which is 15.5% (1.10 1.05).
(1) Contribution – there will be no effect on the NPV of the investment as both the cash
inflows (annual contribution) and the cost of capital will have been inflated by 5% per
annum, which will produce the same present value (allowing for small rounding
differences) in each relevant year.
t1 t2 t3 Total
'Real' cash flow (W2) £320,100 £320,100 £320,100
'Real' discount factor (10%) (1/1.10) (1/1.102) (1/1.103)
'Real' Present Value £291,000 £264,545 £240,496 £796,041
t1 t2 t3 Total
'Money' cash flow (inflated) £336,105 £352,910 £370,556
'Money' discount factor (1/1.155) (1/1.1552) (1/1.1553)
'Money' Present Value £291,000 £264,545 £240,496 £796,041
NPV difference 0
(2) Working capital – the NPV will be affected by the impact of inflation on the working
capital investment as there will be incremental increases to the working capital in the
three years of the project and there will be an inflated working capital figure at the end
of the project.
t0 t1 t2 t3 Total
'Real' cash flow [see (a)] (50,000) 0 0 50,000 0
'Real' discount
factor (10%) 1.000 (1/1.10) (1/1.102) (1/1.103)
'Real' Present Value (50,000) 0 0 37,566 (12,434)
t0 t1 t2 t3 Total
'Money' cash flow (50,000) (2,500) (2,625) 55,125 0
'Money' discount
factor (15.5%) 1.000 (1/1.155) (1/1.1552) (1/1.1553)
'Money' Present Value (50,000) (2,164) (1,968) 35,777 (18,355)
NPV difference (5,921)
So the total impact of 5% annual inflation on contribution and working capital will be an
NPV figure that is £5,921 lower.
Marks
8.1 Discount factor 1
Equipment cost 1
Incremental unit costs 2
Incremental salary 1
Market research fee 1
Tax 2
Writing down allowance 2
Sale proceeds 1
Price calculation – revenue 1
Price calculation – tax on revenue 1
Price calculation – equation 1
Price calculation – selling price 1
15
8.2 1 mark per point max 6
8.3 1 mark per point max 6
8.4 Existence of real options 1
Follow on options 2
Abandonment options 2
Timing option 2
Growth option 2
max 8
35
8.1 The schedule of relevant cash-flows and present values (in £) would be as follows:
Year Item CF 10% df PV
0 Equipment purchase (750,000) 1.000 (750,000)
1–5 Incremental unit costs (W1) (170,000) 3.791 (644,470)
1–5 Tax re: unit costs 28,900 3.791 109,560
1–5 Incremental salary (35,000) 3.791 (132,685)
1–5 Tax re: incremental salary 5,950 3.791 22,556
1 Market research fee (10,000) 0.909 (9,090)
1 Tax re: market research fee 1,700 0.909 1,545
0 WDA (W2) 22,950 1.000 22,950
1 WDA 18,819 0.909 17,106
2 WDA 15,432 0.826 12,747
3 WDA 12,654 0.751 9,503
4 WDA 10,376 0.683 7,087
5 WDA 38,769 0.621 24,076
5 Sale proceeds 50,000 0.621 31,050
(1,278,065)
Marks
9.1 Equipment cost and residual value 0.5
Tax saving 2
Income 0.5
Materials and labour 1
Overheads 2
Lost contribution 1
Tax on extra profit 2
Working capital 2
Discount factor 1
Conclusion 1
13
9.2 Calculation of decrease 2
Minimum value of second instalment 1
3
9.3 1 mark per point max 5
As the NPV is positive GMI should proceed with the investment as this will enhance
shareholder wealth.
WORKINGS
(1)
Year 0 Year 1 Year 2 Year 3
£'000 £'000 £'000 £'000
Cost of machinery 30,000 24,600 20,172 16,541
WDA @ 18% (5,400) (4,428) (3,631) (11,541)
WDV/sale 24,600 20,172 16,541 5,000
Tax saving @ 17% 918 753 617 1,962
(2)
Year 0 Year 1 Year 2 Year 3
£'000 £'000 £'000 £'000
Materials and labour (7,000) (8,000) (9,000)
Inflation @ 4% pa 1.04 1.042 1.043
(7,280) (8,653) (10,124)
(3)
Overheads (excluding Head office costs) (2,500) (3,000) (3,500)
Inflation @ 4% pa 1.04 1.042 1.043
(2,600) (3,245) (3,937)
(4)
£'000 £'000 £'000
Lost contribution (4,000) (4,000) (4,000)
Inflation @ 5% pa 1.05 1.052 1.053
(4,200) (4,410) (4,631)
(5)
Income 10,000 85,000
Materials and labour (7,280) (8,653) (10,124)
Overheads (2,600) (3,245) (3,937)
Lost contribution (4,200) (4,410) (4,631)
Profit/(loss) 10,000 (14,080) (16,308) 66,308
Tax @ 17% on profit/(loss) (1,700) 2,394 2,772 (11,272)
9.2 For NPV to fall to zero then the second instalment will need to fall by:
£
£5,972,000/0.794/0.83 = (9,061,940)
Estimated second instalment = 85,000,000
Minimum value of the second instalment 75,938,060
9.3 GMI's money cost of capital already takes into account GMI's estimated inflation rate. So if
the cash flows are inflated at the same rate then the correct NPV will be calculated.
If the South American inflation rates are higher than predicted then inflate further the
money cost of capital and the estimated cash flows. NPV will not be affected.
However, for the WDA, equipment resale and the second instalment, the NPV will fall as the
money discount rate rises. These are in money terms already.
9.4
£'000
Annual income from 20X6 (Year 4) 5,000
Annual costs from 20X6 (3,000)
Annual surplus from 20X6 2,000
Less tax @ 17% (340)
1,660
Perpetuity factor (1.08/1.03) 4.85%
PV of future cash flows at Year 3 [end 20X5] (£1,660/4.85%) 34,227
Discount to PV (from Year 3 [end 20X5]) 0.794
PV of future cash flows (minimum selling price of the maintenance contract) 27,176
9.5 Political risk is the risk that political action will affect the position and value of a company.
Candidates' discussion should be based on the following possible risks:
Quotas/tariffs/barriers imposed by the overseas government
Nationalisation of assets by the overseas government
Stability of the overseas government
Political and business ethics
Economic stability/inflation
Remittance restrictions
Special taxes
Regulations on overseas investors
Examiner's comments:
This question was a good discriminator between those students who have learned the
calculations and underlying theory by rote and those who really understand the topic.
In general, in part 9.1, a fairly standard NPV calculation, most candidates scored high marks. The
most common errors were made with regard to working capital investment and the corporation
tax flows.
Part 9.2 was done reasonably, but a surprising number of candidates forgot to take taxation into
account in their calculations.
Marks
10.1 Capital allowances 3
Revenue 3
Material costs 2
Lost contribution 3
Labour 2
Working capital 4
Tax 1
NPV calculation 1
Maximum 18
10.1
20X8 20X9 20Y0 20Y1 20Y2
Investment (2,000,000) 200,000
Capital allowances (W1) 61,200 50,184 41,151 33,744 119,721
DH revenue (W2) 11,725,000 14,147,000 15,561,000 15,561,000
DH material costs (W3) (6,365,000) (7,679,800) (8,447,400) (8,447,400)
Duo lost contribution
(W4) (2,500,592) (3,016,824) (3,318,208) (3,318,208)
Additional labour (W5) (167,500) (202,100) (222,300) (222,300)
New manager 35,000 (40,000) (40,000) (40,000) (60,000)
Working capital (W6) (941,700) (194,625) (113,625) 1,249,950
Taxation (17%) (5,950) (450,824) (545,407) (600,626) (597,226)
NCF (2,851,450) 2,056,643 2,590,395 2,966,210 4,485,537
df (8%) 1 0.926 0.857 0.794 0.735
DCF (2,851,450) 1,904,451 2,219,969 2,355,171 3,296,870
NPV £6,925,011
The recommendation to the directors should, therefore, be to proceed with the 'Heritage'
version of the Duo cooker.
10.2 (a) To calculate the sensitivity of changes in sales price, it is assumed sales quantity is fixed
and then the relevant cash flows from part 10.1 are considered.
20X9 20Y0 20Y1 20Y2
DH revenue 11,725,000 14,147,000 15,561,000 15,561,000
Tax on revenue (1,993,250) (2,404,990) (2,645,370) (2,645,370)
Cash flow 9,731,750 11,742,010 12,915,630 12,915,630
df (8%) 0.926 0.857 0.794 0.735
Present value 9,011,601 10,062,903 10,255,010 9,492,988
NPV = £5,413,661
IRR for this project = 8 + (6,925,011/(6,925,011 – 5,413,661))(15 – 8) = 40.1%
The cost of equity would need to increase to 40.1% (an increase of almost 400% from
its current level) before the investment decision would change.
10.3 The NPV calculated in 10.1 at £6,925,011 is for an ungeared firm.
The PV of the tax shield (interest = £2m 0.05 = £0.1m) is calculated as follows:
Time £ per annum df @ 5% PV (£)
1–4 0.1m 0.17 = 0.017m 3.546 60,282
Therefore the adjusted present value = £6,925,011 + £60,282 = £6,985,293.
10.4 The APV technique is based upon the assumptions of Modigliani and Miller with tax.
That means that issues which may affect the attractiveness of debt finance are not reflected
in the technique:
Direct and indirect costs of bankruptcy
Agency costs and covenants
Tax exhaustion
Perfect market assumptions eg, risk-free debt
Examiner's comments:
Most candidates found part 10.1 of the question to their liking. The initial calculation of expected
values proved largely unproblematic, but common errors among weaker candidates were
incorrect calculation of the lost contribution from the existing product and an inability to calculate
accurately the net working capital impact of the project. In this latter regard, a surprising number
of candidates correctly calculated the impact of the new product, but then failed to deduct the off-
setting impact of the existing product. It was also apparent that a significant number of candidates
appear to believe that it is an effective time-saving tactic not to bother with the calculation of
discount factors and/or the actual discounting of cash flows and simply to say that if the resultant
NPV was positive their recommendation would be to accept the project (or vice versa). Given that
marks were explicitly available for both the discount factors and the discounting process itself, this
was a potentially costly omission.
Section 10.3, along with section 10.4, proved to be effective discriminators between stronger
and weaker candidates. Many weaker candidates were unable to make any meaningful attempt,
some simply believing that what was required was to discount the net cash flows calculated in
section 10.1 at a discount factor of 5%. Common errors among candidates who were able to
adopt the correct approach were to use an incorrect annuity factor in the calculation or to use
the post-tax cost of debt, but for well prepared candidates this proved to be easy marks.
Section 10.4 polarised performance, although unlike in section 10.3 it was the majority rather
than the minority of candidates who struggled. The question required candidates to think
laterally across the syllabus to establish the link to underlying theory. However, many candidates
resorted simply to listing all they knew about the limitations of issues such as WACC and CAPM.
Performance overall was relatively strong on this question with the majority of candidates
scoring well in the first section, although the adjusted present value sections of the question
served to polarise performance.
Marks
11.1 Old aircraft 1
Tax cost 2
New aircraft 1
Tax saved 2
Extra profit 4
Tax 1.5
Working capital 2
Total cash flows 0.5
PV 1
Negative NPV and advise not to proceed 1
16
11.2(a) Extra income needed in Y3 2
Estimated trade-in value in Y3 1
Trade-in value required to break even 1
4
(b) Pre-tax extra profit 1
Tax 1
Discount factor and NPV 1
Sensitivity 1
Advice based on calculation 1
5
11.1
Y0 Y1 Y2 Y3
£ £ £ £
Old aircraft 760,000
Tax cost (W1) (129,200)
New aircraft (3,000,000) 600,000
Tax saved (W2) 91,800 75,276 61,726 179,198
Extra profit (W3) 566,475 594,799 624,539
Tax (W4) (96,301) (101,116) (106,172)
Working Capital (W5) (80,000) (4,000) (4,200) 88,200
Total cash flows (2,357,400) 541,450 551,209 1,385,765
8% factor 1.000 0.926 0.857 0.794
PV (2,357,400) 501,383 472,386 1,100,297
NPV (283,334)
(2) Y0 Y1 Y2 Y3
£'000 £'000 £'000 £'000
Cost/WDV 3,000.000 2,460.000 2,017.200 1,654.104
WDA @18% (540.000) (442.800) (363.096) (1,054.104)
WDV/sale 2,460.000 2,017.200 1,654.104 600.000
(3) Y0 Y1 Y2 Y3
£ £ £ £
Current profit 987,500
Estimated profit 1,527,000
Increase 539,500
1.05 566,475
1.05 = 594,799
1.05 624,539
(4) Y0 Y1 Y2 Y3
£ £ £ £
Extra profit (W3) 566,475 594,799 624,539
Tax @ 17% (96,301) (101,116) (106,172)
(5) Y0 Y1 Y2 Y3
£ £ £ £
Extra working capital £80,000 1.05
£84,000 1.05
88,200
Increment (£80,000) (4,000) (4,200) 88,200
11.2 (a)
£283,334/83%/0.794 £429,932 Extra income needed in Y3
£600,000 Estimated trade-in value in Y3
£1,029,932 Trade-in value required to break even (NPV = 0)
(b)
Y1 Y2 Y3
£ £ £
Pre-tax extra profit 566,475 594,799 624,539
less: Tax at 17% (96,301) (101,116) (106,172)
Post-tax extra profit 470,174 493,683 518,367
8% factor 0.926 0.857 0.794
PV 435,381 423,086 411,583
Thus post-tax profits would need to increase by 22.3% for the project to be taken on,
ie, where NPV = 0.
(1) Life of projected cash flows Three year projection – so relevant in part but not to
infinity
(2) Sales growth rate Not used – no growth rate other than inflation
(3) Operating profit margin Yes, relevant – margin and fixed costs used
(4) Corporate tax rate Yes, relevant
(5) Investment in non-current Not used as in usual SVA approach (% of change in sales)
assets
(6) Investment in working capital Not used as in usual SVA approach
(7) Cost of capital Yes, a discount rate of 8% was used
The value of the business is calculated from the cash flows generated by drivers 1–6 which
are then discounted at the company's cost of capital (driver 7). A terminal/residual value is
also calculated to cover the period from the end of competitive advantage to infinity. This
can create major problems with estimating a PV of future cash flows. However, SVA links a
business' value to its strategy (via the value drivers).
Practical
Some of the information in 11.1 is relevant to a SVA calculation (see relevance column in bold
above), but 11.1 is looking at a specific investment (three new aircraft) – no terminal/residual
value has been calculated, ie, the PV of future cash flows once the period of competitive
advantage lapses.
Examiner's comments
This question had the lowest average mark on the paper.
This was a three-part question that tested the candidates' understanding of the investment
decisions and valuation element of the syllabus.
In the scenario an airline company was considering whether or not to proceed with the purchase
of three new aircraft. In addition its management was concerned that the company might be the
subject of a takeover bid and wanted guidance. Part 11.1 for 16 marks was a fairly traditional
NPV calculation and required candidates to deal with capital allowances (including the trade-in
of old aircraft), incremental cash flows with regard to contribution and fixed costs, inflation and
working capital. Part 11.2 for nine marks tested candidates' ability with sensitivity analysis, ie,
how sensitive was the investment to changes in (a) the trade-in value of the aircraft and (b) the
incremental profits arising. Part 11.3 for 10 marks examined candidates' understanding of
shareholder value analysis (SVA) and to what extent the NPV calculations in part 11.1 could be
employed if the company was the subject of a takeover bid.
Part 11.1 was generally answered well, but too few candidates were able to correctly calculate
the incremental change in contribution and fixed costs. Not many candidates scored full marks
with regard to the balancing charge arising on the sale of the old aircraft. A majority of
candidates failed to calculate the working capital figures correctly.
Marks
12.1 (a) Reasoning: 1 Figures: 1 2
(b) Method and figures: 2 Ranking: 1 3
(c) Method: 1 Calculations: 2 Conclusions and reasoning: 2 5
10
12.2 Reasoning: 2 Conclusion: 1 NPV: 1 4
12.3 Calculations: 4 Limitations: 2 6
12.4 PV calculations: 3 Conclusion and reasoning: 2 5
25
12.1 (a) No capital rationing, so choose all projects with a positive NPV, ie:
NPV
£'000
Bristol 577
Swansea 2,856
Tiverton 1,664
Total 5,097
(b) Capital rationing of £8 million on 31/5/X7 (t0). Rank according to NPV/£ invested:
Bristol Cardiff Gloucester Swansea Tiverton
£'000 £'000 £'000 £'000 £'000
NPV (£'000) 577 (1,309) (632) 2,856 1,664
Investment t0 4,150 3,870 6,400 5,000 4,600
NPV/£ 0.139 n/a n/a 0.571 0.362
Rank 3 1 2
Alternatively, if Gloucester is considered and its positive t1 cash flow utilised then there is
£3,560,000 capital available (£1,790,000 + £1,770,000) at t1.
Based on the same ranking, for t1 choose 100% Swansea and use the balance (£950,000) to
fund Bristol, ie, (higher ranking than Bristol) and do 73.6% (£950/£1,290) of it. Thus the total
NPV would be:
£'000
Tiverton 1,664
Swansea (100%) 2,856
Bristol (73.6% £577,000) 425
Gloucester (632)
4,313
Thus it is preferable if the Gloucester project is taken on as this produces the higher total
NPV.
12.2 Capital rationing of £9 million in t0, but projects not divisible:
Only choose the projects with positive NPVs, ie, Bristol, Swansea or Tiverton. The highest
NPV is generated from Swansea (and is higher than Bristol and Tiverton added together).
Thus the NPV would be £2,856,000.
12.3
PV PV Eq. Ann
factor PV factor Cost
£ £ £ £
Replace vans after
one year
t0 Cost of van (12,400) 1.000 (12,400)
t1 Maintenance costs (4,300)
Resale value 9,800
5,500 0.909 5,000
(7,400) 0.909 (8,140)
Replace vans after
two years
t0 Cost of van 1.000 (12,400)
(12,400)
t1 Maintenance costs (4,300) 0.909 (3,909)
t2 Maintenance costs (4,800)
Resale value 7,000
2,200 0.826 1,818
(14,491) 1.735 (8,352)
Examiner's comments:
This question was based on (a) investment appraisal with capital rationing and (b) replacement
analysis. Both of these elements, whilst comprehensive and technical, were straightforward and
most candidates did well. In addition there was a small final part to the question which required
candidates to compare, in effect, net present value and internal rate of return.
As expected most candidates scored full marks for part 12.1(a).
Part 12.1(b) was also done well, and most candidates demonstrated how to rank the projects on
the basis of NPV/£ invested.
Part 12.1(c) was answered satisfactorily and a good number of scripts demonstrated how to deal
with capital rationing in the second year of the projects.
Part 12.2 was answered well, and most students were able to make the right decision.
Part 12.3 was also answered well and a good number of students scored full marks for it.
In the final part of the question, part 12.4, a majority of candidates gave the correct advice,
although few were able to produce the exact relevant cash flow.
Marks
13.1 Contribution 3
Fixed costs 1
Rent 1
Tax 1
Plant and equipment 1
Tax saved on CAs 2
Working capital 2
Discount factor 1
NPV 1
Negative NPV and reject 1
Not include sunk costs in NPV 1
15
13.2(a)PV of factory annual rent after tax 1
Sensitivity 1
Extent rent must fall 1
(b)IRR 2
Sensitivity 1
Sensible comments on the sensitivities 1
7
13.3 Problem if gearing changes 1
APV model is suitable 1
Base case value 1
Adjustments to base case 1
Maximum 3
Examiner's comments:
This was a five-part question that tested the candidates' understanding of the investment
decisions element of the syllabus.
The question was based on a scenario where the company was intending to launch a new
product and set up a manufacturing facility in the UK. The question covered NPV analysis,
inflation, relevant and irrelevant cash flows, working capital requirements and capital allowance
calculations. Part 13.1 for 15 marks required candidates to calculate, using money cash flows,
the net present value of the project and advise the board of the company as to whether it should
proceed. Part 13.2 for seven marks required candidates to calculate and comment upon the
sensitivity of the project to two of the inputs to the NPV analysis. Part 13.3 for three marks
required candidates to describe a different project appraisal methodology to WACC/NPV. Part
13.4 for five marks required candidates to consider the political risk of setting up the
manufacturing facility overseas and how the company might limit its effects. Part 13.5 for five
marks required candidates to identify and comment upon the 'real options' available to the
company.
Part 13.1 was well answered, however candidates did not always pay full attention to the timing
of cash flows and when they should be increased for price inflation and growth in turnover.
In part 13.2, weaker candidates had some difficulty since the project produced a negative NPV.
Candidates should be prepared to apply their knowledge to projects that have either a negative
or positive NPV.
Part 13.3 was well answered with most candidates identifying APV as the alternative
methodology to use.
In part 13.4, most candidates were able to identify political risk, however few were able to state
how to limit its effects.
In part 13.5, most candidates were able to identify the real options available to the company;
however a disappointing number of candidates did not refer to the scenario of the question.
Marks
14.1 (a)
Y0 Y1 Y2 Y3
£'000 £'000 £'000 £'000
New machine (4,500.000) 1,000.000
Tax relief (W1) 137.700 112.914 92.589 251.797
Old machine 220.000
Tax due (W2) (23.800)
Sales (W3) 8,060.000 15,926.560 7,845.926
Materials (W4) (2,756.000) (5,445.856) (2,682.801)
Unskilled labour (W5) (1,456.000) (2,877.056) (1,417.329)
Lost contribution (W6) (2,288.000) (4,521.088) (2,227.231)
Tax on extra profits (W7) (265.200) (524.035) (258.156)
Working capital (W8) (806.000) (786.656) 808.063 784.593
Total cash flows (4,972.1) 621.058 3,459.177 3,296.799
12% discount factor 1.000 0.893 0.797 0.712
PV (4,972.1) 554.605 2,756.964 2,347.321
NPV 686.790
The NPV is positive and so the investment should go ahead as it will enhance
shareholder wealth.
The market research fee is not a relevant cash flow as it is sunk/committed (candidates
needed to state this to get the mark and not just ignore).
(4)
Sales units 50,000 95,000 45,000
Material cost/unit £53 1.04 £53 1.042 £53 1.043
Materials 2,756.000 5,445.856 2,682.801
(5)
Sales units 50,000 95,000 45,000
Unskilled cost/unit £28 1.04 £28 1.042 £28 1.043
Unskilled costs 1,456.000 2,877.056 1,417.329
(6)
Sales units 50,000 95,000 45,000
Lost contribution/unit ([£96 – £74] 2) £44 1.04 £44 1.042 £44 1.043
Variable costs 2,288.000 4,521.088 2,227.231
(7)
Extra profit (sales less materials, 1,560.000 3,082.560 1,518.565
unskilled labour, lost contribution)
Tax at 17% 265.200 524.035 258.156
(8)
Sales 8,060.000 15,926.560 7,845.926
Sales increment 8,060.000 7,866.560 (8,080.634)
Working capital at 10% (806.000) (786.656) 808.063 784.593
(b)
Sales 8,060.000 15,926.560 7,845.926
Discount rate at 12% 0.893 0.797 0.712
PV of sales 7,197.580 12,693.468 5,586.299
Total PV of sales 25,477.347
less: Tax at 17% (4,331.149)
21,146.198
= 3.25%
Examiner's comments:
This question had the highest average mark on the paper. Candidate performance was very
good.
Marks
15.1
0 1 2 3 4
£m £m £m £m £m
Contribution 34.56 41.73 39.44 37.27
NPV 35.37
The project has a positive NPV, and therefore Alliance should accept it.
The contribution per unit = £800 0.40 = £320.
The annual sales in units in year one = 9,000 12 = 108,000 units.
The total contribution per year =
Year 1: 108,000 £320 = £34.56m
Year 2: £34.56m 1.15 1.05 = £41.73m
Year 3: £41.73m 0.90 1.05 = £39.44m
Year 4: £39.44m 0.90 1.05 = £37.27m
Working capital:
Year 1: 2.00 1.15 1.05 = £2.42m. Increment 2.00 – 2.42 = £(0.42)m
Year 2: 2.42 0.90 1.05 = £2.29m. Increment 2.42 – 2.29 = £0.13m
Year 3: 2.29 0.90 1.05 = £2.16m. Increment 2.29 – 2.16 = £0.13m
Year 4: Release of working capital £2.16m.
Examiner's comments:
This was a four-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario was that a UK company was considering
launching a new product on the market, and also planning additional investment into other
projects.
Part 15.1 was well answered by many candidates; common errors that weaker candidates made
were failing to calculate annual demand from monthly data, inflating cash flows which had already
been inflated because of price increases, deducting contribution from sales, treating WDAs as
outflows rather than inflows, failing to put rent in advance and using real discount rate for money
flows. All easy things, where errors should have been avoided. The hardest part was WC flows (as
expected). Part 15.2 was not well answered by the majority of candidates, with weaker candidates
using sales instead of contribution. Responses to part 15.3 were mixed and often lacked detail or
included irrelevant material (eg, advantages of sensitivity). Part 15.4(a) was well answered by many
students; however weaker candidates thought that hard versus soft capital rationing meant the
difference between indivisible and divisible projects. Part 15.4(b) had very mixed and unclear
answers, with many candidates using NPV/£ invested, which applies to divisible rather than
indivisible projects. The question clearly stated that the projects were indivisible.
Marks
(£4,977/[£65,984 – £3,484]) = r = 8%
d1 £0.0432 1.056
ke = +g + 0.056 = 7.5%
MV £2.45
BBM's geared beta for the new market = 1.62 ([84.770 + (8.944 83%)]/84.770) 1.76
BBM's current WACC figure (part 16.1 above) is 7.18% – 7.59%, depending on the method
of calculation. It would be unwise to use this figure (approx. 7%) when appraising the
diversification.
This is because the company will be working in a new market and its systematic risk (a key
tenet of the CAPM) will change. This new market has a beta of 1.9, whereas BBM currently
uses a beta of 0.9.
Were BBM to underestimate its WACC figure it would overestimate the NPV of the planned
diversification. The cost of new debt is higher.
16.4 Gearing and systematic business risk have both changed. To get WACC one needs the MV
of equity which includes the NPV of the project. To get NPV one needs WACC. So it's a
circular argument. One could use APV to overcome this.
BBM cannot use the cost of the new debt after tax as the required return of the
shareholders would be ignored. Neither can it use its risk adjusted cost of equity (as this
ignores debt finance raised).
It cannot use the risk adjusted WACC figure from part 16.3 because BBM's gearing level will
have changed (it's an all-debt issue) – the WACC to be used then depends on the reaction
to the increased gearing (U-shaped under traditional and M&M 1963 with market
imperfections). If however there was a subsequent issue of equity planned which would
re-establish the current gearing level, then the risk adjusted WACC from 16.3 could be used.
16.5 Normally a share buy-back returns money to shareholders and enables a company to use
surplus cash when there are no investment opportunities with a positive NPV available. It
does not appear to be the case here as the company is issuing debt.
If BBM made a large dividend payment then this would be contrary to company dividend
policy. It might have an adverse effect on the company's share price – uncertainty created if
larger dividend is not maintained in future.
A buy-back would reduce the number of shares in the market and this will mean that BBM's
earnings per share and market value per share may increase depending on the reaction to
the change in gearing – see below.
A buy-back could change control eg, remove the influence of an unwelcome shareholder
by buying their shares.
A share buy-back would increase BBM's gearing, which might, if BBM is below its optimal
level of gearing, lead to an increase in BBM's share price via a reduced WACC.
A buy-back gives a capital gain subject to CGT rather than a dividend subject to income tax.
Examiner's comments:
This question had the second highest average mark on the paper. Candidate performance was
very variable.
It was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus.
In the scenario a medical equipment manufacturer was planning to raise additional funding to
support a diversification into a new market. Part 16.1 for 13 marks required candidates to
calculate the company's current weighted average cost of capital (WACC) figure using (a) the
Marks
17.1
Type of Capital Market Capitalisation
£
Ordinary shares (50p) (£4m/£0.50) £2 16,000,000
Preference shares (25p) (£0.8m/£0.25) £0.80 2,560,000
Irredeemable debentures £1.4m 110/100 1,540,000
20,100,000
17.2
£
Ordinary dividends = £16m 10.5% (or 0.105 = d/2; d = 0.21 8m) 1,680,000
Preference dividends = £2.56m 8.75% (or 0.0875 = d/0.80; d = 0.07 3.2m) 224,000
Debenture interest = £1.54m 4.17% (or 0.0417 = I(1-t)/110; I(1-t) = 4.587 0.014m) 64,218
1,968,218
£1,968,218 / £20,100,000 = 9.792% (difference due to rounding)
17.3 The hurdle rate (WACC) is:
(a) the cost of funds that a company raises and uses, and the return that investors expect
to be paid for putting funds into the company; and therefore is
(b) the minimum return that a company must make on its own investments, to earn the
cash flows out of which investors can be paid their return.
If the company does not achieve this hurdle rate on its investments then it will be investing
in projects that produce a negative net present value and the value of the company (and the
wealth of the shareholders) will decline.
17.4
Earnings (see Workings below) £1,980,000
Ordinary shares in issue 8 million
Earnings per share (£1,980,000/8,000,000) £0.2475
Examiner's comments:
This question had the lowest average mark on this paper and caused problems for a large
number of students.
Most candidates scored full marks in part 17.1, but a surprising minority could not calculate the
number of shares and debentures.
Part 17.2 was poorly done although a minority of candidates did secure full marks. The majority
however were unable to work to an unknown figure which isn't the cost of capital (as this was
given in the question). This was surprising as candidates would have learnt the formulae
required or, in the case of the Dividend Valuation Model, it was given in the formulae sheet. Also
many OT's in the learning materials require candidates to work backwards towards an answer,
as was required here.
In part 17.3 many candidates knew about the desirability and impact of positive NPV's, but could
not explain what a WACC actually is, ie, a required rate of return.
Part 17.4 was in general answered very poorly indeed. Too many candidates treated retained
earnings and earnings as the same figure. A significant minority added ordinary and preference
share prices for the P/E calculation. The majority could not work backwards, up through the
income statement, despite this appearing in the learning materials.
In part 17.5 virtually no-one considered future forecasts. When past dividend growth rates and
the Gordon model were used few candidates noted the assumption that past growth = future
growth. The significance of the company's 0% dividend growth rate was poorly answered. The
question was couched in terms of returns but few candidates spotted that there would be no
capital return on the current share price.
Marks
18.1 (a) Ke 1
Kd 3
Loans 1
WACC 3
8
(b) Retentions rate 2
Shareholders' return 1.5
Growth 0.5
Ke 1
WACC 1
6
18.2 Degearing equity beta 1.5
Regear asset beta 1.5
Ke 1
State discount rate should reflect systematic risk 1
State discount rate should reflect financial risk 1
6
18.3 Weighted average beta of enlarged group 1
Ke 1
WACC of enlarged group 1
Implications 3
Capital structure theory; max 2
6
18.4 Diversification plans 5
EMH max 3
5
18.5 Project appraisal methodology and discount rate 4
35
18.1 (a) The current WACC using CAPM is calculated as follows: Ke = 2 + 0.60 (8 – 2) = 5.6%
Calculation of Kd
The cost of the debentures the cost can be calculated using linear interpolation
5% 1%
T0 (108) 1 (108) 1 (108)
T1–4 6 3.546 21.276 3.902 23.412
T4 100 0.823 82.3 0.961 96.1
(4.424) 11.512
Examiner's comments:
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was that a company was considering
diversifying its activities. The diversification was to be financed in such a way that the gearing of
the company remained unchanged. Part 18.1 of the question required candidates to calculate
the current WACC of the company using CAPM and also the Gordon growth model. Part 18.2 of
the question required candidates to calculate, using CAPM, the cost of equity to be included in
the WACC that should have been used to appraise the new project. Part 18.3 of the question
required candidates to calculate the overall WACC of the company after the diversification. Part
18.4 of the question required candidates to discuss whether the company should diversify its
operations. Part 18.5 of the question required candidates to discuss how the project should have
been appraised assuming that there was a major change in financial gearing of the company.
Also candidates were required to calculate a discount rate that should have been used in these
circumstances.
Part 18.1 (a) was designed to give a basic eight marks to build on and was set at a textbook level
with no tricks or complications. However, weaker candidates lost many of these marks by:
completely ignoring the cost of a bank loan (two marks) or not deducting tax (one mark);
incorrect calculation of the cost of the redeemable debentures, incorrect interpolation
calculations, incorrect coupon and timing (three marks), correct interpolation but no tax
adjustment (one mark); incorrect equity beta or correct beta but error in computation (one mark).
Part 18.1 (b) was a discriminator as expected, however many candidates demonstrated poor
knowledge of what a dividend yield is, many students multiplying earnings by the dividend yield.
In part 18.2, again many basic errors were made: eg, degearing using market values but
regearing using book values, even though the formulae sheet states market values on the key to
the formulae and despite the examiner's comments regarding March 2014, omitting tax
completely from the computations and poor mathematical ability using beta equations. Also no
explanation of what candidates were doing threw away two marks in this part.
Part 18.3 was well answered by many candidates. However in the discursive part of their answers
some candidates mainly discussed capital structure theory.
Part 18.4 had very mixed responses but flexible marking allowed candidates to pick up two to
three marks.
In part 18.5, most candidates mentioned APV but many did not calculate the discount rate
needed.
Marks
19.1 Earnings in 20W8 1
Dividend in 20W8 1
Dividend growth rate 1
Dividend per share in 20X2 1
Current ex-dividend share value 1
Cost of equity 1
Cost of preference shares 1
Cost of debentures – two present values calculated 2
Cost of debentures – IRR calculation 1
WACC calculation 3
13
19.2 1 mark per point max 5
Examiner's comments:
A generally very well answered question which was the second highest scoring question on the
paper.
A very common error on this relatively straightforward cost of capital question was a failure to
follow the instructions in the question – many candidates chose to use the Gordon growth model
rather than the dividend growth model – an easy way to lose marks. Other common errors were
an inability to accurately calculate the dividend growth rate from the data provided, errors in
calculating market values in the final WACC calculation and in calculating the cost of debt a
number of candidates betrayed basic misunderstanding by firstly applying one discount rate
that produced a negative NPV and then choosing a larger rather than smaller discount rate for
their second choice.
Parts 19.2 to 19.5 were generally well answered.
Marks
20.1 (a) Dividend growth rate 1
Cost of equity 1
IRR 3
Market value of equity 1
Market value of debt 1
WACC 1
20.1 (a)
Dividend per share 20Y0 (29.5m/165m) = 17.9 pence
d1 (£0.179 1.04)
Cost of equity = +g + 4% = 11%
MV £2.65
Cost of debt
Year Cash Flow 5% factor PV 10% factor PV
0 (98.00) 1.000 (98.00) 1.000 (98.00)
1–4 8.00 3.546 28.37 3.170 25.36
4 100.00 0.823 82.30 0.683 68.30
NPV 12.67 NPV (4.34)
Examiner's comments:
Most candidates scored well on this question and it had the highest average mark in the paper.
It was based on a supermarket operation and covered the topics of cost of capital and dividend
policy. Part 20.1 was worth 10 marks and required candidates to calculate the company's WACC
based on (a) the dividend growth model and then (b) the CAPM model.
Marks
22 Abydos plc
Marking guide
Marks
22.1 Capital allowances/tax saving 2
Base case NPV 3–4
Financing side effects 2–4
Give credit for technique max 10
Year 0 1 2 3 4
£'000 £'000 £'000 £'000 £'000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300
Tax @ 17% (510) (578) (646) (731)
Tax savings from capital allowances 306 251 206 169
Investment cost (11,500)
Issue costs
After tax realisable value 4,000
Net cash flows (11,500) 2,796 3,073 3,360 7,738
Discount factor 11% 1.000 0.901 0.812 0.731 0.659
Present values (11,500) 2,519 2,495 2,456 5,099
Issue costs
£1 million, because they are treated as a side-effect they are not included in this NPV
calculation.
Present value of tax shield
1 1
1– 4 = 3.312
0.08 1.08
Sales director
The sales director believes that the net present value method should be used, on the basis
that the NPV of a project will be reflected in an equivalent increase in the company's share
price. However, even if the market is efficient, this is only likely to be true if:
the financing used does not create a significant change in gearing (finance ratio
current gearing so gearing may change).
the project is small relative to the size of the company.
the project risk is the same as the company's average operating risk (but different line
of business).
Finance director
The finance director prefers the adjusted present value method, in which the cash flows are
discounted at the ungeared cost of equity for the project, and the resulting NPV is then
adjusted for financing side effects such as issue costs and the tax shield on debt interest.
The main problem with the APV method is the estimation of the various financing side
effects and the discount rates used to appraise them. The ungearing process assumes risk
free debt (5%) which it is not as it costs 8%.
Problems with both viewpoints
Both methods rely on the restrictive assumptions about capital markets which are made in
the capital asset pricing model and in the theories of capital structure. The figures used in
CAPM (risk-free rate, market rate and betas) can be difficult to determine. Business risks are
assumed to be constant.
Neither method attempts to value the possible real options for abandonment or further
investment which may be associated with the project.
Marks
23.1 Total funds calculations 1
Total geared funds 1
Gearing calculation 2
One mark per relevant point max 5
9
23.2 Rights issue calculations 2
Theoretical ex-rights price 1
Value of a right per new share 1
4
Traditional view
Loan finance is cheap because (a) it is low risk to lenders and (b) loan interest is tax
deductible. This means that as gearing increases, WACC decreases.
Shareholders and lenders are relatively unconcerned about increased risk at lower levels of
gearing.
As gearing increases, both groups start to be concerned – higher returns are demanded
and so WACC increases.
Thus, WACC decreases (value of equity increases) as gearing is introduced. It reaches a
minimum and then starts to increase again. This is the optimal level of gearing.
Modigliani and Miller (M&M) view
Shareholders immediately become concerned by the existence of any gearing.
Ignoring taxes, the cost of 'cheap' loan finance is precisely offset by the increasing cost of
equity, so WACC remains constant at all levels of gearing. There is no optimal level –
managers should not concern themselves with gearing questions. M&M '58 position Vg =
Vu.
Taking taxation into account, interest is cheap enough to cause WACC to fall despite
increasing cost of equity. This leads to an all-debt-financing conclusion. M&M '63 position
Vg = Vu + DT (Tax shield).
The earnings per share figure will fall by 7.5% (from £0.240 to £0.222).
The proposed rights issue will, as the board suggests, cause a dilution of the EPS figure as
the additional shares issued have a greater negative impact than the interest saved from the
debenture redemption. Whilst in theory (TERP) the market price of BL's ordinary shares will
fall, at least initially, it is very difficult to predict what will happen to the market value of the
shares in practice. As gearing is being reduced the market may react favourably (ie, there
would be a share price increase). However, based on market values the gearing level is
currently not high (26.2% or 35.5%), and so the market may react negatively (ie, there would
be a share price decrease) if it considers that insufficient use is being made of the tax
savings that gearing affords.
23.4 Current earnings per share (EPS) £32.4m/135m £0.240
Examiner's comments:
This question was, overall, done poorly and produced the weakest set of answers in the
examination.
In general, part 23.1 was not done well. The book value of equity often excluded retained
earnings. When calculating the market value, a majority of candidates included retained
earnings in the equity figure. Very few of them could calculate the gearing ratio correctly – far
too many included preference shares as equity. In the discursive part of the answer, some
candidates made no reference to the theories on capital structure at all and some referred to the
'Modigliani and Miller traditional theory'. Disappointingly, very few candidates made reference
to the ratios that they had calculated (high/low gearing level etc).
Answers to part 23.2 were better and the most common mistake was to confuse the market
value and the book value of debt when calculating the redemption figure.
Part 23.3 was very poorly answered. The vast majority of candidates ignored the reduction in
interest post-redemption. Also far too many candidates restricted their discussion to a
consideration of the impact of the rights issue on the shareholders' wealth. This was not relevant
to the question which was about gearing.
In part 23.4 there were some good attempts, but often candidates' answers just consisted of
identifying a 5% fall in EPS.
Marks
Total 35
(b) £
Current value of shareholding 7,000 £1.25 8,750 ½
Value of new shareholding 7,000 1.5 £1.15 12,075 ½
Less cost of taking up the rights 3,500 £0.95 (3,325) ½
8,750
Current share of earnings 7,000 £0.13 £910 ½
Examiner's comments:
In part 24.1, most candidates were able to calculate the theoretical ex-rights price correctly (and
its impact on shareholder wealth), but far too few adjusted the earnings figure to take account of
the interest savings made from the debenture redemption.
Answers to part 24.2 were reasonable, but too many candidates included a lot of theory without
application to the scenario, ie, they considered the impact of an increase in gearing, and not a
reduction as per the question.
The answers to part 24.3 were in general disappointing, and too few candidates were able to
apply their knowledge in a practical setting.
More candidates did well in part 24.4, and were able to demonstrate an understanding of the
workings of a debt for equity swap. Many candidates did not answer part 24.5; of those that did,
most struggled to work backwards from a given market rate of return to a current market price.
Marks
25.1 (a) Calculation of WACC using CAPM:
Cost of equity 1
Cost of debt:
Use of ex interest debenture price 1
PV calculation 1
IRR calculation 1
Post-tax cost of debt 1
Ex-div share price 1
Market value of equity 0.5
Market value of debt 0.5
WACC calculation 1
8
25.1 (b) Calculation of WACC using Gordon growth model:
Earnings per share 1
Proportion retained 1
Total earnings 0.5
Calculation of ARR 1.5
Growth rate 0.5
Cost of equity 1
WACC calculation 0.5
6
The accounting rate of return (r) = £447m/ [£5,153 – (1,825m £0.145)]m = 9.1%
The growth rate is: 0.091 0.59 = 0.054 or 5%
Using the Gordon growth model Ke = ((10 1.05)/350) + 0.05 = 0.08 or 8%
WACC = (8 0.76) + (5.73 0.24) = 7.46%
Examiner's comments:
This was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was that a company was considering
diversifying into a different industry sector. The diversification would have been in non-domestic
countries, some of which would be in developing countries.
Part 25.1(a) saw many basic errors, which really should not be occurring given how many times
this has been set. The errors included inability to calculate numbers correctly, incorrect use of
the CAPM equation, incorrectly calculating the number of shares in issue, not calculating the ex-
div share price and/or the ex-interest debenture price, for the cost of debt calculating positive
and negative values and interpolating outside the range calculated and no tax adjustment for
the cost of debt. Again there were many basic errors in part 25.1(b), despite very similar
questions in the revision question bank. Many had no idea at all. However there were some
good answers, but even those forgot to correctly calculate the retained profits. Many students
calculated unrealistic growth figures and blindly used them with no reality check.
Part 25.2 was often confused with part 25.3. No reality checks again, with some students clearly
demonstrating that they have a very shallow knowledge of the topic; errors included calculating
unrealistic equity betas, eg, Beta = 20.485, degearing using MV and regearing with BV despite
the formulae sheet clearly stating MV should be used, degearing and regearing with same
debt/equity ratio and ending up with a different figure from the original. Explanations were very
brief. Despite this being set before and there being a detailed example in the Study Manual,
part 25.3 saw very poor attempts by most candidates. Candidates' explanations of the
relationship between the value of the company and the discount rate were very poor.
Answers to part 25.4 were fine when they talked about political risk as required, but weaker
candidates just talked about foreign exchange and hedging, or focussed on climbing wall
regulations. Answers to part 25.5 were fine where they used the language of ethics, but many
just stated that it was unethical because it was unethical. Many candidates incorrectly thought
that this was a money laundering issue.
Marks
26.1 (a) Freehold land and property adjustment 1
Investments adjustment 1
Preference shares adjustment 1
Debentures adjustment 1
Net assets value per share 1
Calculation of dividend per share 1
Choice of yield 0.5
Valuation per share 1
Non-marketability discount 0.5
Calculation of average EBIT 1
Calculation of profit after tax 1
EPS 1
Choice of P/E ratio 0.5
Valuation per share 1
Non-marketability discount 0.5
13
(b) Basic weaknesses of net asset, dividend yield and P/E valuations 2
Other issues – 1 mark per point 5
Max 4
(c) 1 mark per point Max 4
26.2 Calculation of each possible replacement cycle – 2.5 marks 10
31
26.1 (a)
Net asset valuation: £
Intangibles 900,000
Freehold land and property 4,500,000
Plant and equipment 3,600,000
Investments 1,350,000
Inventory 540,000
Receivables 1,080,000
Cash 180,000
12,150,000
Less
Current liabilities 1,080,000
Preference shares 648,000
Debentures 1,980,000
8,442,000
£8,442,000/3,600,000 = £2.345 per share
Dividend yield valuation:
Dividend in 20X2 = £180,000
Number of shares = 3,600,000
Examiner's comments:
Whilst there were many strong responses to the valuation questions, less well-prepared
candidates were undoubtedly exposed by the question and were particularly weak in dealing
with the technicalities of both the dividend yield and price/earnings valuation techniques. In the
second section, whilst many candidates were able to list classic text-book commentary on the
respective valuation techniques, far fewer were able to augment this basic analysis with
insightful commentary on the relevance of the techniques to the specific scenario set out in the
question. The third and final section of the first part of the paper, on take-over motives, was,
however, generally very well answered across the board.
The second part of the question was, again, very well answered by the stronger candidates but
performance was somewhat polarised as those candidates who had clearly banked on there
being a traditional NPV question found their lack of a firm grasp of the replacement
methodology exposed. Even some candidates who scored well on the calculations themselves
arrived at incorrect conclusions as a result of treating the calculated figures as equivalent annual
costs rather than net revenues.
Marks
27.1 Forecast income statement 8
Forecast balance sheet 8
16
27.2 Rights issue: Up to 2 marks per valid point max 7
Floating rate loan: Up to 2 marks per valid point max 6
Report format 1
14
30
27.2 REPORT
To: The board of directors
From: Company Accountant
Date: x – x – xx
Subject: Methods of financing expansion plans
In terms of gearing, the rights issue will produce lower gearing than the floating rate loan
(ie, a lower level of financial risk), although in neither case does the proposed level of
gearing appear beyond the ability of the company to service (see interest cover below).
In terms of eps, the rights issue will produce a figure of 73.5p per share, whilst the floating
rate loan will boost eps to 84.9p per share.
In terms of interest cover, with the rights issue interest cover is a comfortable 11.6 times
against 8.3 times with the floating rate loan. In neither case, therefore, does interest cover
appear to be a cause for concern.
In terms of cost of capital, the floating rate loan may reduce the company's cost of capital as
a result of the tax shield applying to loan interest (depending on what happens to the cost
of equity as a result of the increased financial risk).
Examiner's comments:
A question which most candidates found to their liking with many scoring very strongly in the
numerical first section. The second section once again served to polarise performance between
stronger and weaker candidates.
For the most part candidates performed well on section 27.1 of the question, although there
were some common errors among weaker candidates, most notably the incorrect treatment of
both the cash and dividend figures. Weaker candidates completely overlooked the fact that cash
was the balancing figure in the whole exercise and simply chose to leave the original cash figure
unchanged. In similar fashion, the dividends were often left at their original level with no
changes incorporated to reflect profits in 20X9.
In section 27.2, stronger candidates combined relevant discussion of the two sources of finance
with the calculation of relevant calculations to underpin that discussion. However, a feature
among weaker candidates was their failure to undertake any calculations in spite of the precise
instruction in the question. Another common feature of weaker answers was a lack of breadth in
their response. For example, there was a tendency for some candidates to correctly identify the
issue of the potential impact on the firm's cost of capital but then to write at great length all they
knew on the underlying theory. Whilst this invariably earned the full marks available for this
aspect of the answer, this represented minimal reward in the context of the overall question and
was often achieved at the cost of many more marks that were available for discussion of other
relevant issues.
Marks
28.1 Total asset value 1
Total revalued assets 2
Dividend valuation 2
Earnings valuation 2
EV/EBITDA multiples 4
Profit before tax 2
Profit after tax 1
Retained profit after dividends 1
Strengths and weaknesses of each valuation method 10
25
28.2 SVA explanation 3
Problems of future cash flow and residual value 4
7
28.3 Discount at an effective 1% pa 1
Present value calculation 2
Compare to £500k offered and advise not to sell land 1
Ignore £120,000 as common to both alternatives 1
5
28.4 Professional accountants' conduct:
Be honest and truthful 1
Avoid making exaggerated claims of what they can do, and
their qualifications and experience 2
Avoid making disparaging claims of others 1
Not use confidential information from other clients in campaign 1
max 3
40
28.1
Hampton Richmond
Total asset value (historic) £21.7m £22.7m
Value per share (£21.7m/17.6m) £1.23 (£22.7m/9.8m) £2.32
Walton
£m
PBIT 36.2
Less interest (£70m 7%) (4.9)
Profit before tax 31.3
Tax at 17% (5.3)
Profit after tax / earnings 26.0
Commentary
Asset values – historic so not equal to MV and only considers tangible assets and ignores
income. Revalued figures are better as more up to date, but still have the same
disadvantages.
The P/E ratio is a better guide for Hampton as it will give the company's actual market value
at 28 February 20X4 but based only on a small number of shares changing hands at any
one time – a premium would normally be paid above MV to get control. Also, have there
been significant changes since 28 February which would affect the value?
It is a takeover bid and so, presumably, Walton will be looking forwards and intending to
generate future earnings from Hampton, not liquidate (asset strip) it as in asset values. For
Richmond (a private company) it would be reasonable to use Hampton's P/E ratio (same
market), but it will be necessary to discount (by 25% to 50%) this valuation because
Richmond's shares will be less marketable. For both companies, are the current year's
earnings reasonable ie, not distorted in any way? Synergy is also ignored in the calculations.
When it comes to the EV/EBITDA valuation, the market value of Richmond's debt (£15.44m)
will need to be deducted to obtain an equity valuation, giving a range between
£34.948 million and £53.53 million.
These figures are before any discount that might be made for the non-marketability of
Richmond's shares. If we were to apply say a 25% discount, this would give a range of
values between £26.21 million and £40.15 million.
28.2 Shareholder value analysis (SVA) concentrates on a company's ability to generate value and
thereby increase shareholder wealth. SVA is based on the premise that the value of a
business is equal to the sum of the present values of all of its activities.
The value of the business is calculated from the cash flows generated by drivers 1–6 which
are then discounted at the company's cost of capital (driver 7). SVA links a business' value
to its strategy (via the value drivers).
The seven value drivers are a key element of the SVA approach to valuing a company.
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) Cost of capital
Company projections tend to show cash flows growing steadily upwards into an indefinite
future. In the real world, economies falter, competition increases and margins decline.
The majority of a DCF value estimate comes from the 'residual value', the worth of the
company at the end of the projection period. That, naturally, depends heavily on the cash
flows estimate in the final year modelled – a result, logically, of the trend in the early years.
28.3 £60k inflating at 3% pa discounted at 4% pa is the same as £60k discounted at an effective
1% pa so:
[£60,000 9.471] + [£120,000 0.905] (assuming land sold at year 10) = £676,860 (Present
Value) vs £500,000 offered, so do not sell the land.
£120,000 ignored as common to both alternatives
28.4 When marketing themselves and their work, professional accountants should:
be honest and truthful.
avoid making exaggerated claims about (a) what they can do (b) their qualifications and
experience.
avoid making disparaging references to the work of others.
not use confidential information from other clients in the campaign.
Marks
29.1 Factors and explanations (1 mark for factor, 1 for explanation):
Issue costs 2
Shareholder reactions 2
Control 2
Unlisted companies 2
max 4
29.2 Sales 1
Variable costs 1
Fixed costs 1
Debenture interest 2
Taxation 1
Dividends 2
Retained 1
9
29.3 Current EPS 1
Extra shares 1
New shares in issue 1
EPS 2
5
29.4 Current gearing (book value) 1
Current gearing (market value) 1
Gearing ratio (book value) 3
Gearing ratio (market value) 3
8
29.5 Advice on funding 5
29.6 CLS 2
Loan stock with warrants 2
4
35
40.7p 45.1p
29.4 Based on debt/total long term funds
Current gearing (book value) 20.6% (£15.500/£75.150)
Current gearing (market value) 14.8% [£15.500/([£3.10 28.800] + £15.500)
Rights issue Debenture issue
£15.500 £15.500 + £12.000
Gearing ratio (book value) £75.150 + £12.000 + £11.664 £75.150 + £12.000 + £11.255
= 15.7% = 27.9%
Gearing ratio (market value) £15.500 £27.500
(33.600 £3.30) + £15.500 (28.800 £3.30) + £27.500
= 12.3% = 22.4%
or
Based on debt/total equity
Current gearing (book value) 26.0% (£15.500/£59.650)
Current gearing (market value) 17.4% [£15.500/([£3.10 28.800])
Rights issue Debenture issue
£15.500 £27.500
Gearing ratio (book value) £59.650 + £12.000 + £11.664 £59.650 + £11.255
= 18.6% = 38.8%
Gearing ratio (market value) £15.500 £27.500
(33.600 £3.30) (28.800 £3.30)
= 14.0% = 28.9%
Examiner's comments:
This question was generally done very well and had the highest average mark on the paper.
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus.
In the scenario a manufacturing company was planning to raise additional funding for an
expansion of its product range and was considering whether to use equity (via a share issue) or
debt (via debentures). Part 29.1 for four marks required candidates to highlight the factors to
consider when deciding between a rights issue and a debenture issue. Part 29.2 for nine marks
asked them to prepare next year's income statement using both methods of funding. In part
29.3 (five marks), they were required to calculate the resultant earnings per share figures under
both methods. Part 29.4 for eight marks asked candidates to calculate the gearing figures for
both schemes (at book value and market value). In part 29.5 (five marks) candidates had to
advise the company's directors of the merits of both schemes, based on their calculations in 29.2
to 29.4 above. Finally, for four marks, in part 29.6 they had to explain the differences between
convertible loan stock and loan stock with warrants.
There was a variable performance in part 29.1 and the weakest scripts re-hashed/embellished
existing points in the question.
Part 29.2 was very straightforward and most candidates scored full marks. The most common
errors were made with the interest and dividend calculations. A disappointing number of
students failed to increase the sales and/or variable costs figures correctly.
Part 29.3 was, again, very straightforward and the average mark here reflects that. It was good to
see that fewer candidates than previously had (incorrectly) used the retained earnings figure for
the EPS calculation.
Part 29.4 was poorly done in general. A majority of students failed to deal correctly with retained
profits in the book value and market value calculations for gearing.
Marks
£m
Present value of free cash flow years 0–3 6.68
£m
Present value years 1–3 1.45
Amount in terminal value (0.58(1 + 0.02)/(0.07 – 0.02)) 0.816 9.65
Total present value of synergies 11.10
£11.10m/£54.62 = 20.3%.
Synergies represent 20.3% of the value of debt plus equity.
Note: Credit any attempt to calculate prospective EPS rather than historic.
The share price using the p/e ratio for recent takeovers = 12.47p 17 = 212p
The p/e ratio basis is a market measure and has the advantage of valuing the shares by
comparison to other takeovers. However we do not know how comparable to Sennen
the other companies are. Also the valuation is based on historic EPS and a more
realistic measure might be a prospective EPS.
(d) The range in values is 212p – 262p.
The free cash flow valuation can be considered as a maximum value, however the
valuation is quite sensitive at 20.3% to the synergistic savings which may or may not be
made and the growth rate of sales in perpetuity.
Both measures offer a premium to the current share price of 160p and the Board of
Morgan should feel comfortable offering the shareholders of Sennen a bid premium.
(e) Students should take into account that the company is highly geared and their answers
should reflect this. They should consider both the shareholders of Sennen and Morgan
in their answers. Some areas that they may mention and expand upon for each method
are as follows:
The ability of Morgan to raise extra funds by borrowing and/or an issue of shares,
maybe a rights issue
Does Morgan have any cash reserves
Dilution of control
The tax position of Sennen's shareholders
Risk
30.2 There is a serious conflict of interest with the management team who are party to the MBO
also considering making an offer for the company. The management team should be acting
in the interests of the shareholders of Sennen and be recommending to the shareholders
the best price for their shares. It would be highly unethical for any member of the
management team who are party to the MBO to take part in negotiations with Morgan or to
make recommendations to Sennen's shareholders.
Examiner's comments:
This was a six-part question that tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that a company had
identified a takeover target.
The acquirer has had a policy of expanding by acquisition and, as a result, is highly geared
compared to its peers. Also there is a potential bid from the management of the target in the
form of a management buyout (MBO). Part 30.1(a) of the question required candidates to use
Shareholder Value Analysis (SVA) to value the target. The valuation included after tax synergies,
also candidates were required to state the strengths and weaknesses of the valuation method.
Part 30.1(b) of the question required candidates to calculate how sensitive the valuation using
SVA was to a change in the synergies. Part 30.1(c) of the question required candidates to value
Marks
REPORT
To: The board of directors
From: An Accountant
Date: x – x – xx
Subject: Possible offer for LSL
£6.5m
31.1 Net assets valuation (historic) per share £3.10
2.1m
(£6.5m + 15.5m – 11.8m + 3.0m – 3.6m)
Net assets valuation (revalued) per share £4.57
2.1m
£4.6m 9
Price earnings valuation per share £19.71
2.1m
As LSL is not a quoted company, and its shares are less marketable, this price should be
marked down (by, say, 30%), to (£19.71 – 30%) £13.80
(4 (£5.9m + £1.5m)) – (1.2 3.0)+2.8
EV/EBITDA valuation £13.71
2.1m
As LSL is not a quoted company and its shares are less marketable, this price should be
marked down (by, say, 30%) to (£13.71 – 30%) £9.60
£1.1m/6%
Dividend yield valuation per share £8.73
2.1m
As LSL is not a quoted company, and its shares are less marketable, this price should be
marked down (by, say, 30%), to (£8.73 – 30%) £6.11
£24.401m
Discounted Cash Flow valuation per share (W1) £11.62
2.1m
WORKINGS
(1) Discounted cashflow
20X1 20X2 20X3 20X4
£m £m £m £m
Pre-tax cash flows (£m) 4.600 4.300 5.200 5.700
Less corporation tax at 17% (0.782) (0.731) (0.884) (0.969)
After-tax cash flows (£m) 3.818 3.569 4.316 4.731
Tax saving – capital allowances (W2) 0.110 0.090 0.074 0.000
Disposal of pool (proceeds) 1.985
Total cash flows 3.928 3.659 4.390 6.716
14% discount factor 0.877 0.769 0.675 0.592
Present value 3.445 2.814 2.963 3.976
Examiner's comments:
This question had the lowest average % mark in the paper, but overall was done well.
The question was based around the proposed takeover of a private company by a plc. Part 31.1
for 18 marks required candidates to calculate the value (per share) of the private company using
a range of methods (six in total). Part 31.2 was worth eight marks and asked candidates to
explain the advantages/disadvantages of using each of those valuation methods. Part 31.3 was
worth six marks and it tested the candidates' understanding of the various means by which the
target company's shareholders could be remunerated for their shares.
Marks
(b) If EPS reduces by 10%, then new EPS is £0.324 (1 – 10%) £0.2916
New total shares £6.509m/£0.2916 22,322m
Current shares in issue 16.500m
New shares to be issued 5.822m
Rights issue price/share £30.855m/5.822m £5.30
As this is above the current market price (£4.20) the rights issue would not be
successful.
32.3
Gearing level (BV) £54,750/£97,670 56.1%
So gearing at MV is under 50%. Gearing would be a problem if it was causing WACC to rise
(tax advantage outweighed by debenture holders and shareholders wanting a higher
return) and MV to fall.
Gearing theory – Traditional view/Modigliani & Miller (MM) view/Modern view – balance
between tax benefits and bankruptcy costs.
32.4 Dividend policy and share price – Traditional view/MM and irrelevance theory/Modern view
– including signaling, clientele effect and agency theory.
Impact of special dividend – the market is not in favour of such dividends generally, ie, the
share price may well fall as a result, and so it seems to defeat the object of retaining profit
for investment.
32.5 Unpublished information of a price sensitive nature should remain confidential, not be
disclosed and not be used to obtain a personal advantage.
Marks
33.1 Sales calculations 1.5
Operating profit 1
Tax 1
Working capital investment 1.5
Non-current asset investment 1.5
Discount rate 1
Post year six cash flows 1.5
Short-term investments 1
Comment 3
13
33.2 1–2 marks per valid comment max 7
20
33.1
Year
1 2 3 4 5 6
Sales (£m) (W1) 212.00 224.72 238.20 252.50 267.65 283.70
Op profit (15%) 31.80 33.71 35.73 37.87 40.15 42.56
Tax at 17% (5.41) (5.73) (6.07) (6.44) (6.83) (7.24)
Working capital investment (W1) (0.84) (0.89) (0.94) (1.00) (1.06) (1.12)
Non-current asset investment (W1) (1.44) (1.53) (1.62) (1.72) (1.82) (1.93)
Free Cash Flows 24.11 25.56 27.10 28.71 30.44 32.27
Factor 9% (W2) 0.917 0.842 0.772 0.708 0.650 0.596
PV 22.11 21.52 20.92 20.33 19.79 19.23
PV of cash flows years 1–6 = £123.9m
Post year 6 cash flows (in perpetuity) = 32.27/0.09 0.596 = £213.7m
Total SVA value = £123.9m + £213.7m + £2.5m = £340.1m
The majority of the value calculated (63%) comes from the residual value, which is based on
the assumption of zero growth in cash flows from year 6. This is highly dependent on the
growth being as predicted in the period of competitive advantage.
The SVA value is significantly higher than the market capitalisation of £250 million. This may
be caused by the market assuming a lower growth rate or a higher discount rate than those
used in the SVA calculation.
WORKINGS
(1)
Year
0 1 2 3 4 5 6
Sales (increasing at 6%) 200.00 212.00 224.72 238.20 252.50 267.65 283.70
Increase in sales 12.00 12.72 13.48 14.29 15.15 16.06
Working capital (7%) 0.84 0.89 0.94 1.00 1.06 1.12
Non-current asset investment (12%) 1.44 1.53 1.62 1.72 1.82 1.93
(2) Discount factor = 3 + 0.75(11 – 3) = 9%
Marks
34.1 (a) Forward market:
Forward rate 1
Net receipt 1
Money market:
Euro borrowing 1
Sterling conversion 1
Interest 1
Option market:
Type of option 1
Number of contracts 1
Premium in euros 1
Premium in sterling 1
Scenario 1: Option not exercised 1
Scenario 1: Sterling receipt 1
Scenario 2: Option exercised 1
Scenario 2: Gain on option 1
Scenario 2: Sterling receipt 1
14
(b) Transaction costs 1
Exact date does not need to be known 2
Cannot tailor contracts 1
Hedge inefficiencies 1
Limited number of currencies 1
More complex than forwards 1
7
34.2 (a) Buy a 3–6 FRA at a fixed rate 1
Calculation of amount bank to pay Fratton 1
Payment on the underlying loan 1
Net payment on the loan 1
4
(b) Sell three-month interest rate futures 1
Number of contracts 1
Calculation of gain 1
Futures outcome 1
Payment in the spot market 1
5
30
Marks
35.1 Type of contract 1
Value of one contract 1
Number of contracts needed 1
Premium 1
If index rises – abandon 1
Outcome if index rises 1
Gain if index falls 1
Outcome if index falls 1
8
35.2 (a) Type of contract 1
Number of contracts 1
Futures outcome 1
Net outcome 1
Effective interest rate 1
Hedge efficiency 1
6
35.1 Sunwin requires an option to sell – a December put option with an exercise price of 5,000.
Portfolio value = £5.6m Exercise price = 5,000
Value of one contract = 5,000 £10 = £50,000
Number of contracts required = £5.6m/50,000 = 112 contracts
Premium: 70 points £10 per point 112 contracts = £78,400
(a) If the index rises to 5,900, the put option gives Sunwin the right to sell @ 5,000, so the
option would be abandoned (with zero value).
Overall position: £
Value of portfolio 6,608,000
Gain on option –
Less premium (78,400)
6,529,600
(b) If the index falls to 4,100, the put option gives Sunwin the right to sell @ 5,000, so the
option would be exercised (value = £9,000 {900 £10} 112 contracts = £1,008,000).
Overall position: £
Value of portfolio 4,592,000
Gain on option 1,008,000
Less premium (78,400)
5,521,600
Examiner's comments:
Following its introduction into the syllabus at the last review, this subject area was initially very
challenging for many candidates. However, at this sitting and in a reflection of an emerging
trend on the paper in more recent sittings, candidates' grasp of the material appears to get
stronger and stronger, so much so that it was this question, rather than the traditional NPV
question, that provided many candidates with the basis of their pass on the paper.
Most candidates performed strongly on part 35.1 of this question, although where errors were
made they primarily related to incorrect calculation of the number of contracts and the premium.
The only real areas of weakness in most candidates' responses to part 35.2 were in their being
unable to effectively calculate hedge efficiency (many candidates simply did not even make an
attempt to do so) and in the mis-calculation of time-period adjustments and, consequently,
premiums. However, overall candidate strength in this area of the syllabus is pleasing to see.
Marks
36.4 Option 2
FRA 2
No hedge 1
Recommendation 2
7
30
36.1
INR 200,000,000
Sterling receipt at spot rate = £2,094,394
95.4930
(a) Sterling receipt if rupee INR 200,000,000 INR 200,000,000
£2,073,658
weakens by 1% (95.4930 1.01) 96.4479
INR 200,000,000
(b) Option (@ exercise price) £2,093,145
95.5500
Less cost (£8,000)
£2,085,145
(c) Forward INR 200,000,000 INR 200,000,000
£2,089,438
contract (95.4930 + 0.2265) 95.7195
Less cost (£4,500)
£2,084,938
Option
Exercise? Indifferent Yes
Rate (4%) (4%)
Premium (0.75%) (0.75%)
(4.75%) (4.75%)
Annual interest payment (on £8.5m) (£403,750) (£403,750)
FRA
Pay at LIBOR +1 (4%) (7%)
(Payment to)/receipt from bank (0.5%) 2.5%
(4.5%) (4.5%)
Annual interest payment (on £8.5m) (£382,500) (£382,500)
No hedge
Pay at LIBOR + 1 (4%) (7%)
Annual interest payment (on £8.5m) (£340,000) (£595,000)
If LIBOR is 3% then it's better not to hedge and at 6% the FRA seems to be the cheapest
option.
It also depends on the board's attitude to risk.
The FRA eliminates down side risk (rates rising) as well as upside risk (rates falling).
Examiner's comments:
The average mark for this question was the highest in the paper, equated to a clear pass and so,
overall, was done well.
This was a four-part question that tested the financial risk element of the syllabus.
The scenario was based on a UK footwear manufacturer/exporter and included relevant
exchange rates and interest rates. The question tested (a) candidates' understanding of foreign
exchange risk management, (b) the more general risks associated with trading overseas and (c)
how to hedge against interest rate movements.
Marks
Examiner's comments:
This was a five-part question which tested the candidates' understanding of the risk
management element of the syllabus. In part 37.1 of the question the scenario was that a
company had not hedged foreign exchange rate risk before and the managing director was
considering using certain techniques to hedge. However he was not convinced that it was
necessary and felt that he could estimate his exposure by looking at forward rates. In part 37.2 of
the question candidates were required to demonstrate hedging the interest rate risk of a long-
term loan.
Part 37.1(a) was well answered by many candidates. However, it was disappointing to note the
following common errors made by a large minority of candidates on what should have been
very straightforward, well rehearsed calculations which have been examined many times before:
using the incorrect rate to calculate the number of futures contracts; making the incorrect
decision on whether to buy or sell the contracts at the current date; incorrectly using techniques
applicable to interest rate futures when dealing with currency futures; offsetting the gain on
futures in $ against the £ payment; omitting the interest on the OTC options premium, which is
payable upfront; treating the OTC option as a traded option and in some cases applying the
currency futures contract size to the OTC currency option.
Part 37.1(b) was well answered by many candidates, however easy knowledge marks were often
missed and it is estimated that two to three very basic marks were lost by weaker candidates.
In part 37.1(c), weaker candidates only described interest rate parity and purchasing power
parity and made no reference to the scenario of the question and the managing director's views.
As expected this was a discriminator.
Part 37.2(a) was well answered by many candidates but again weaker candidates lost two to
three basic marks by not being able to calculate the swap gain and revised borrowing rates.
These were basic calculations examined many times before.
Part 37.2(b) was well answered by the better candidates and was, as expected, a discriminator.
Marks
38.1 Exchange rate % change 1
Estimated spot rate 31/12/X4 1
2
38.2 (a) Sterling receipt at estimated spot rate at 31/12/X4 2
(b) Forward contract 2
Money market hedge 3
Option 3
max 9
38.3 Outcomes 3
MMH and forward contract give best outcomes 3
Advise based on whether JEK is prepared to risk £ weakening 3
max 8
38.1
Exchange rate (€/£) 30 June 20X4 1.1150 – 1.1463
30 September 20X4 1.1832 – 1.2165
Change 0.0682 – 0.0702
6.12%
% change (three months) 0.0702
1.1463
Estimated spot rate at 31/12/X4 1.2165 1.0612 1.2909
38.2 (a)
€15,109,000
Sterling receipt at estimated spot rate at 31/12/X4 £11,704,237
1.2909
(b)
€15,109,000 €15,109,000
Forward contract £12,440,510
(1.2165 – 0.0020) 1.2145
£12,410,292
Money Market Hedge
€15,109,000
Borrow in euros €14,981,655
1.0085
€14,981,655
Convert @ spot rate £12,315,376
1.2165
£12,254,083
38.3
Outcomes (in order) £
Spot rate at 30/9/X4 (as per question) 12,420,000
Money Market Hedge 12,413,899
Forward contract 12,410,292
OTC option 12,254,083
Estimated spot rate at 31/12/X4 11,704,237
The best outcome is if the current spot rate does not alter. The worst is if sterling continues
to strengthen at 2% per month and given the lower margin, the contract may make a loss as
the receipt would be significantly less than £12.42 million. However, interest rates suggest
that sterling will weaken (forward rate premium), which would be of benefit to JEK (higher
sterling receipt), but the results are all still below the £12.42 million.
The MMH and the forward contract give the best outcomes, but the latter has expensive
(fixed) costs (£0.002/€). The option has a very high fixed cost (£0.012/€), but it may be that
sterling will weaken and it could be abandoned, to JEK's benefit.
If JEK's board is prepared to risk that sterling will weaken then it would be best not to
hedge as none of the hedging methods produces £12.42 million ie, they all result in a
reduction of, or elimination of, an already low margin. If not, the MMH would be the best
option albeit with a reduced margin but hopefully this can be recovered from the follow-on
contracts potentially available.
38.4 Forward exchange contract (FC)
If JEK's bid is not successful, but the company has signed up to a forward exchange
contract, then JEK will have an obligation to sell €15.109 in three months' time. It will
therefore have to buy that sum of euros, which, if the pound has weakened, will cost an
increased amount of sterling.
Money market hedge (MMH)
JEK would have to repay the euro borrowing at 31 December 20X4, but would need to
convert this back from sterling.
Any profit or loss on FC or MMH depends on the spot rate on 31 December 20X4.
Currency option – at worst, this would not be taken up, but JEK would incur the £181,308
cost. JEK may exercise option if profitable to do so on 31 December 20X4 – this depends
on spot rate at that date.
38.5 The principle of interest rate parity (IRP) means that if an investor places money into a
currency with a high interest rate s/he will be no better off after conversion back into their
domestic currency using a forward contract than if they had left the money invested at the
domestic interest rate.
1+ Average euro interest rate
Average spot rate = Forward contract rate
1+ Average sterling insterest rate
1.0075
1.19985 = 1.1977
1.00925
Examiner's comments:
The average mark for this question was the lowest in the paper and equated to a marginal 'fail'
and so, overall, was not done well.
This was a five-part question that tested the financial risk element of the syllabus.
The scenario was based on a UK computer services company which was tendering for the sale of
a euro contract and its board was considering hedging against a weakening of the euro despite
having not yet won the tender. The question tested candidates' understanding of (a) foreign
exchange risk management and (b) the principle of interest rate parity.
Part 38.1 for two marks required candidates to estimate a future spot rate based on recent
changes. Part 38.2 for nine marks required them to calculate the company's sterling receipt from
the tender contract based on three hedging strategies. In part 38.3 for eight marks candidates
had to advise the company's board as to the advantages/disadvantages of each of the
strategies, based on their calculations in part 38.2, assuming that the tender bid was successful.
In part 38.4 they had to explain the implications for the company if the tender bid was
unsuccessful. Finally, for part 38.5 candidates were required to explain the principles of interest
rate parity, making use of the interest and forward contract rates given in the question.
Foreign exchange risk management is regularly tested in the examination, but despite this many
candidates did not get all of the calculation marks available. In part 38.1 the weaker scripts failed
to calculate the growth rate or applied it (2% per month) once, but not three times as required.
In part 38.2, as expected, most candidates did well, but quite a few used, erroneously, the
estimated spot rate from part 38.1 rather than the current spot rate given in the question. Many
candidates failed to identify the OTC currency option as a put and many also treated it as a
traded option.
Part 38.3 was not done well and too often candidates relied on textbook theory rather than
referring to the figures calculated.
In general part 38.4 was also done poorly and too few candidates were able to explain the
implications of losing the tender bid.
Overall the responses to part 38.5 were good, but many candidates used annual rather than
quarterly interest rates in their calculations.
Marks
39.1 (a) Net currency exposure 1
Forward rate 1
Cost of payment 2
39.1 (a) Lambourn's net foreign currency exposure is the net $ payment due = $1,550,000.
The sterling payments and receipts can be ignored.
The forward rate would be 1.6666 – 0.0249 = $1.6417/£.
The cost of the payment would therefore be 1,550,000/1.6417 = £944,143.
(b) The current spot rate is $1.6666/£ so Lambourn should buy December put options on
£ with a strike price of $1.67 as $1.65/£ and $1.63/£ are worse than current spot rate.
Number of contracts = $1,550,000/1.67/31,250 = 29.7 = 30 contracts
Premium = 30 31,250 0.0555 = $52,031 at spot ($1.6666) would cost £31,220
Outcome if the spot rate is $1.6400/£: Exercise the option
Option $1.67 Spot $1.64 so profit of ($0.03 30 31,250) = $28,125
Convert $1,550,000 – $28,125 = $1,521,875/1.64 = £927,973 + £31,220 = £959,193
Alternatively:
This will realise 31,250 30 $1.67 = $1,565,625
Excess $ = $15,625 which at spot would realise £9,496 (15,625/1.6454)
Cost = (31,250 30) + 31,220 – 9,496 = £959,224
(c) Sell December futures @ 1.6496
$1,550,000/1.6496 = £939,622
Therefore 939,622/62,500 = 15.03 = 15 contracts
Futures market outcome:
Sell at 1.6496
Buy at 1.6400
Profit 0.0096 15 62,500 = $9,000
Spot market outcome: Buy $1,541,000 @ $1.6400/£ = £939,634
Examiner's comments:
This risk management question produced the highest average mark of the three questions. This
reflects the fact that a firm knowledge of the techniques involved provides candidates with a
good opportunity to score highly on such questions, particularly when (as many do) they benefit
from the application of the 'follow-through' principle when such questions are marked. As usual,
however, there was very little middle ground – the failing candidates on the paper overall had
little or no grasp of the techniques involved in this question and scored poorly.
The most common errors in part 39.1 were a failure to correctly calculate the firm's net
transaction exposure, often including the sterling amounts, incorrect identification of the correct
type of option, a failure to accurately calculate the number of contracts and the use of the wrong
rate when calculating the premium.
Part 39.2 was generally well answered.
Marks
40.1 (a) Net exposure 1
Forward contract 2
Currency futures 4
Money market hedge 3
Currency options 7
17
(b) Receipt 1
Total cost 1
5
30
40.1 (a) The net exposure to FOREX should be hedged by matching payments and receipts:
$3.5 – $2.250 = $1.25 million payment.
A forward contract:
The exchange rate for the four-month forward contract is calculated by adjusting the
spot rate by the premium: $1.5154 – $0.0012 = $1.5142.
The cost of the payment in £ is: $1,250,000/1.5142 = £825,518.
This will be the cost of the payment no matter what the spot rate is on 31 March 20X4.
Currency futures:
To hedge an unexpected strengthening of the $ against the £ the March 20X4 futures
will be sold on 30 November 20X3 at $1.5148.
The number of contracts to sell is:
($1,250,000/$1.5148)/£62,500 = 13.20 Round to 13 contracts resulting in a slightly
under hedged position.
At 31 March 20X4 the currency futures contracts will be closed out and the
$1.25 million purchased on the spot market.
Closing out the contracts:
The futures price at close out is $1.5153. To buy back at this price will result in a loss on
our futures trade of: $1.5148 – $1.5153 = –$0.0005
The total loss is: $0.0005(£62,500 13) = $406.25.
The relevant spot exchange rate on 31 March 20X4 is $1.5150.
The total cost of the payment plus the loss on futures is:
($1,250,000 + $406.25)/$1.5150 = £825,351
Examiner's comments:
This was a three-part question that tested the financial risk element of the syllabus.
Part 40.1 (a) for 17 marks required candidates to calculate the results of hedging foreign
exchange rate risk using forwards, futures, the money markets and traded currency options. Part
40.1 (b) for eight marks required candidates to describe the relative advantages and
disadvantages of using various methods to hedge the FOREX.
Part 40.2 for five marks required candidates to demonstrate how an FRA can be used to hedge
interest rate risk.
Part 40.1(a) was well answered, however a number of candidates made errors when calculating
the number of futures and options contracts, also some candidates made incorrect decisions
regarding whether to buy or sell futures when setting up the hedging position. When hedging
with options some candidates chose to use calls rather than puts.
Most candidates answered part 40.1(b) well.
Part 40.2 was well answered, however a disappointing number of candidates did not show the
net interest paid by the company.
Marks
This potential gain can be split evenly, ie, 0.6% to each party, which means that SWI
would pay LIBOR + 0.4% (LIBOR + [1.0% – 0.6%] and HD would pay fixed 10.2% (10.8%
– 0.6%).
The interest rate swap would look like this:
SWI HD
Currently pays (9.2%) (LIBOR + 1.4)
HD pays SWI (bal fig) 8.8% (8.8)
SWI pays HD (LIBOR ) LIBOR
New net payment (LIBOR + 0.4) (10.2%)
Examiner's comments:
Part 41.1(a) was straightforward, but a disappointing number of candidates were unable to
calculate a 1% increase and then a 1% decrease in the value of sterling.
Parts 41.1(b) and (c) were generally well answered, although many candidates did not relate
their answers to the scenario.
Part 41.2 was answered well. The main problem area for candidates was that many of them did
not make the variable leg of the swap at LIBOR as required in the question.
Marks
Examiner's comments:
This was a six-part question that tested candidates' understanding of the risk management
element of the syllabus. The scenario was that a company had used derivative instruments to
hedge risk that locked the company into one rate or asset price. The finance director of the
company wished to know more about the use of financial options in risk management. Two risks
in particular that the finance director was concerned about were the risks associated with buying
shares and the interest rate risk associated with taking out loans.
There were many weak answers to part 42.1 of the question, but there were some excellent
answers, which demonstrated a good understanding of the characteristics of options. Part 42.2
was poorly answered, which is surprising since this has been examined before. However, again,
there were some excellent answers.
There were many weak answers to part 42.3 of the question, however there were some excellent
answers, which demonstrated a good understanding of the characteristics of options. In part
42.4, many students successfully applied the knowledge that they had acquired from their
studies of FTSE 100 index options. However basic errors included using calls instead of puts and
picking the incorrect month of exercise. Part 42.5 has been examined before, yet there were
many basic errors which included using calls instead of puts, an incorrect number of contracts,
the wrong date for the contracts and an inability to calculate an effective interest rate.
Part 42.6 was well answered by the majority of candidates.
Marks
(2)
Equipment purchase/WDV 1,150,000 943,000 773,260 634,073
WDA @ 18%/Bal.allowance (207,000) (169,740) (139,187) (534,073)
WDV/sale 943,000 773,260 634,073 100,000
Tax
(17% WDV/Bal.allowance) 35,190 28,856 23,662 90,792
(3)
Sales (March 20X6 prices) 2,600,000 700,000
Inflate at 2% pa (1.02)2 (1.02)3
"Money" sales income 2,705,040 742,846
(4)
Variable cost 1,180,000 220,000
(March 20X6 prices)
Inflate at 3% pa (1.03)2 (1.03)3
"Money" variable cost 1,251,862 240,400
(6)
Sales (W3) 2,705,040 742,846
Variable costs (W4) (1,251,862) (240,400)
Rent (80,000) (80,000) (80,000)
Fixed costs (W5) _ (164,800) (169,744) (174,836)
Trading profit/(loss) (80,000) (244,800) 1,203,434 327,610
(7)
Total working capital 0 260,000 70,000 0
1.03 (1.03)2
"Money" total working capital 0 267,800 74,263 0
£(64, 012)
% change in variable costs required 6.1%
£(1, 048, 890)
Thus, ignoring all other factors, variable costs would need to fall by 6.1% before the NPV
became positive and the AP525 was viable. This is a relatively small change required to
make the NPV positive.
43.3 With shareholder value analysis (SVA), a company's value is based on the present value of
its future cash flows, so it is forward-looking. This is theoretically the most superior valuation
method. SVA considers seven value drivers, which link to (or drive) company strategy:
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) List of capital
Predictions are very difficult, as cash flows are technically in perpetuity. Once a company's
period of competitive advantage is over then its growth rate is much slower and a terminal
(residual) value is calculated, based on its cash flows to perpetuity. This terminal value is
often the major part of the overall value of the company.
Examiner's comments:
This question had easily the highest percentage mark on the paper. Overall, the candidates'
performance was very good indeed.
This was a four-part question that tested the candidates' understanding of the investment
decisions element of the syllabus. In the scenario a pharmaceutical company was considering
the development of a new product and the possible takeover of a competitor. In part 43.1, for
18 marks, candidates were required to calculate the net present value of the proposed product
development. They were given forecast life-cycle data for the new product and had to take
account of non-relevant cash flows, inflation rates and corporation tax implications. Secondly, for
five marks, they were required to calculate the sensitivity of that decision to the variable costs of
the product. For a further six marks they were asked to outline how Shareholder Value Analysis
(SVA) could be used when valuing a target company. Finally, for six marks, candidates were
required to apply their understanding of agency theory to three specific elements of the
scenario.
Part 43.1 was very well answered by most candidates. However, common errors noted were:
no balancing charge calculated on the old equipment to be disposed of.
rental costs (fixed) were inflated and/or in arrears, not in advance.
tax savings from negative cash flows in Year 0 and Year 1 were omitted.
working capital – did not net to zero, was applied to the wrong years, the inflation
calculations were poor.
Also, many candidates lost marks for not explaining why depreciation, head office costs and
interest charges were not relevant cash flows. ‘Not relevant' was insufficient. In part 43.2 the
sensitivity calculations were generally fine. The most common errors were (a) using sales or
contribution figures rather than variable costs and (b) missing out the effect of taxation in the
calculations.
As in previous papers the candidates' understanding of SVA was generally poor. A
disappointing number of them concentrated, wrongly, on NPV rather than PV and discussed
SVA in regard to a project and not the valuation of a target company. Thus, many candidates did
not mention terminal value. Agency theory was generally answered well. The weakest area here
was candidates' explanation of the conflicts that might arise in relation to short-term versus long-
term performance appraisal in the context of the project. Too many used a takeover context
instead.
Marks
TERP = £1.5429
Value of a right = £1.5429 – £1.15 £0.3929
Current wealth 10,000 £1.70 17,000
(a) Take up rights £ £
Investment ex-rights 10,000 7/5 1.5429 21,600
Cost of extra shares 10,000 2/5 £1.15 (4,600) 17,000
(b) Sell rights
Investment ex-rights 10,000 1.5429 15,429
Sale of rights 10,000 2/5 £0.39 1,571 17,000
(c) Ignore rights
Investment ex-rights 10,000 1.5429 15,429
44.4 OW's current earnings per share (EPS) £21.12m/192.0m £0.11
OW's current p/e ratio £1.70/£0.11 15.5
[or £326.4m/£21.12m = 15.5 for 2 marks]
Examiner's comments:
This question had the lowest percentage mark on the paper. The majority of candidates
achieved a "pass" standard in the question, however.
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus and there was also a small section with an ethics element to it. It was
based around a design company which was planning to restructure its balance sheet. This would
be achieved by financing the redemption of long-term debt via a rights issue of ordinary shares.
Part 44.1 of the question, for three marks, required candidates to calculate the current gearing
levels of the company, using both book and market values. In part 44.2 for six marks, they were
asked to discuss the impact of a change in the company's gearing levels on its share price.
Candidates were expected to make reference to relevant theories and their calculations from
part 44.1. Part 44.3 for nine marks required the candidates to calculate the theoretical ex-rights
price (TERP) of the company and the impact of the proposed rights issue on the wealth of a
shareholder holding 10,000 of the company's shares. Part 44.4 (seven marks) tested candidates'
understanding of (a) the company's P/E figure and (b) the impact of the debt redemption on the
company's earnings figure. Part 44.5, again for seven marks, required candidates to apply their
understanding of dividend policy theory to the scenario. Finally, for three marks, part 44.6
required candidates to comment as an ICAEW Chartered Accountant on the ethical implications
of issuing misleading information to shareholders.
Marks
45.1 (a) Hedging strategies:
Forward contract 2
Money market hedge 3
OTC currency option 3
8
(b) Advice on hedge:
Use of spot rates to analyse costs 3
Conclusion re options 1
Effect of continually weakening rouble on spot rate 1
Advantages of options (flexibility) 2
Other factors to consider (risk attitudes, political risk) 2
9
(c) Three month forward rate:
Interest rate parity 2
Calculation of 3 month forward rate using IRP formula 2
Calculation of discount 1
5
45.2 Interest rate swap:
Calculation of interest rate differences 1
Details of swap 2
Net new rate for TC 1.5
Net new rate for SSM 1.5
Details of new interest payments 2
8
30
R145.6m
Payment in sterling would be (£1,823,419)
79.85
plus: Option premium 145.6 £90 (£13,104)
(£1,836,523)
R145.6m
(b) Sterling payment at spot rate (£1,847,481)
78.81
R145.6m
Comparative payment at earlier dates 31/12/X4 (£1,832,599)
78.81
R145.6m
31/12/X5 (£1,903,019)
78.81
Stronger sterling gives the lowest payment, and weaker sterling the highest.
The forward contract discount suggests a weakening of the rouble. It has weakened
from December 20X5 to February 20X6, so this may be a trend.
In order (lowest to highest cost)
Option (£1,836,523)
Money market hedge (£1,838,371)
Forward contract (£1,840,501)
Spot (£1,847,481)
The option gives the best outcome (it has a slightly lower cost than the money market
hedge and the forward contract). However, if the rouble continued to weaken then the
sterling cost would fall further. For example, a 1% increase in the spot value of sterling
over the next three months would make this the lowest sterling payment
(145.6mR/(78.81 1.01) = £1,829,146.
An option gives flexibility (the ability to abandon, or to take advantage of any upside)
unlike the money market hedge or forward contract (which are both fixed, binding, and
have no upside/downside).
The directors' attitude to risk is important, as is a consideration of issues such as the
potential for political risk associated with operations in Russia.
The rouble interest rates are higher than those of sterling. Using the interest rate parity
(IRP) equation above, the value of sterling against the rouble will rise. The rouble's loss
of value is called a discount.
Average UK rate 3.25% pa or 0.8125% per 3 months
Average Russian rate 6.1% pa or 1.525% per 3 months
Average spot = (90.62 – 78.81)/2) + 78.81 = 84.715
Forward = 84.715 (1.01525/1.008125) = 85.31 ie, a discount of 0.6
Average discount given = 0.59, so IRP is working
45.2
TC SSM Difference
Fixed 5.2% 6.4% 1.2%
Variable LIBOR + 1.2 LIBOR + 1.6 0.4%
Difference between differences 0.8%
This potential gain can be split evenly, ie, 0.4% to each party. This means that TC would pay
LIBOR + 0.8% (LIBOR + [1.2% – 0.4%] and SSM would pay fixed 6.0% (6.4% – 0.4%).
The interest rate swap would look like this:
TC SSM
Currently pays (5.2%) (LIBOR + 1.6)
TC pays SSM (LIBOR) LIBOR
SSM pays TC (balancing figure) 4.4% (4.4)
New net payment (LIBOR + 0.8) (6.0%)
TC and SSM would both pay at less (0.4% in each case) than their available fixed and
variable rates.
TC SSM
New net interest rate (LIBOR + 0.8) 4.3% pa 6.0% pa
£'000 £'000
Interest on £18.5m pa (795.5) (1,110.0)
Alternatively
£'000 Rate £'000 £'000 Rate £'000
Interest paid now 18,500 (5.2%) (962.0) 18,500 (5.1%) (943.5)
SSM pays TC 4.4% 814.0 (4.4%) (814.0)
TC pays SSM (3.5%) (647.5) 3.5% 647.5
New interest
payment (795.5) (1,110.0)
Marks
Examiner's comments:
This was a seven-part question, which tested candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that a company is divesting
itself of a division by offering it to the public through an Initial Public Offering.
Part 46.1 was well answered by many candidates. Common errors that weaker candidates made
were: including operating cash flows in time zero; incorrect calculation of the continuing value;
adding the 18% growth and 2% price increase figures together instead of compounding them;
omitting to explain why certain inputs were not to be included in the cash flows; applying a non-
marketability discount to the final valuation.
Part 46.2 was also well answered by the majority of candidates. However, many candidates
applied a non-marketability discount to the p/e ratio, which was inappropriate for the valuation
of an IPO. Responses to part 46.3 were mixed and often did not relate to the scenario of the
question despite the requirement specifically asking for this. Very few students submitted
correct answers to part 46.4 of the question, and often made up definitions.
Responses to part 46.5 were mixed, with a lot of candidates showing that they did not
understand what underwriting means. Responses to part 46.6 were good, although often
candidates did not consider the scenario of the question. Part 46.7 were well answered by the
majority of candidates. However, as in previous sittings, a number of candidates did not use the
language of ethics.
Marks
Examiner's comments:
This was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was that a company is expanding its
operations into a different sector of its market.
There were many basic errors in part 47.1(a), which really should not be occurring given how
many times this has been set. The errors included the inability to calculate numbers correctly;
incorrectly calculating the number of shares in issue; not calculating the ex-div share price
and/or the ex-interest debenture price; for the cost of debt calculating positive and negative
values and interpolating outside of the range calculated; no tax adjustment for the cost of debt
and using book values for the WACC calculation. In part 47.1(b) it was disappointing to see that
many candidates were deducting the risk free rate from the market risk premium. Also a number
of candidates were using the 1.3 equity beta from the sightseeing tour sector rather than Ross's
existing equity beta of 0.65.
Part 47.2 was well answered by the majority of candidates. Answers to part 47.3 were mixed and
often there were no reality checks made, with some candidates clearly demonstrating that they
have a very shallow knowledge of the topic. Errors included calculating unrealistic equity betas
(over 300 in one script); degearing using Ross's market values and regearing the gearing ratio of
the holiday and sightseeing tour sector; regearing using book values despite the formulae sheet
stating market values; degearing and regearing with the same debt/equity ratio and ending up
with a different figure from the start; when regearing changing the gearing ratio, even though
the question states that this will not change; very brief or non-existent explanations of the
rationale.
Despite part 47.4 being set before, and with a very similar detailed example in the Study
Manual, most candidates made a poor attempt. Few candidates used the redemption yield of
the existing debentures, which they had calculated in part 47.1(a); there were only brief or no
explanations of the terms of the debenture issue.
Part 47.5 were well answered by the majority of candidates, but some answers gave
explanations of Modigliani and Miller, which was not relevant to this question.
Marks
(b) Sheldon should exercise the options since the index has fallen to 5,875, which is below
the put option exercise price.
The gain on exercising the options = £962,000 ((6,525 – 5,875) £10 148)
Overall position £
Portfolio 8,695,000
Gain on options 962,000
Original value 9,657,000
Less option premium (235,320)
9,421,680
48.3 The three factors that affect the time value of the FTSE 100 options are:
Time to maturity – For example: The longer the time to maturity the more chance there
is that the option will be in the money at expiry. Also there will be a greater interest
element in the option value.
The risk free rate – For example: The level of the risk free rate will affect the interest
element in the options value. The higher it is the more interest element.
Volatility – For example: Higher volatility will increase the option value since there is
more chance of the option being in the money, or deeper in the money, at expiry.
Examiner's comments:
This was a four-part question that tested the candidates' understanding of the risk management
element of the syllabus. The scenario of the question was that a risk management company is
giving advice to two clients: to one client, on hedging foreign exchange rate risk and to the
second on hedging the fall in the value of a portfolio of FTSE 100 shares.
Part 48.1(a) was well answered by most candidates. However some of the errors demonstrated
by weaker candidates included calculating the number of futures contracts using the spot rate
rather than the futures price; stating that currency futures should be initially sold; treating an
over the counter option like a traded option; confusing puts and calls. There were average
responses from a lot of candidates to part 48.1(b), often without any reference to the numbers
calculated in part 48.1(a); however there were some excellent answers. There were some
excellent answers to part 48.2 from the majority of candidates. Weaker candidates confused
calls and puts and demonstrated that they clearly did not know the difference between the two.
There were many excellent answers to part 48.3, with a good understanding of the factors that
contribute to the time value of options. However weaker candidates tended to only give one
correct factor and then made up the other two.
Marks
49.1 FRA 2
Option 2
No hedge 1
Interest rate swap not applicable 1
Appropriate commentary 3
9
49.2 (a) Currency futures contracts 5
(b) OTC currency option 3
(c) Forward contract 2
(d) Money market hedge 3
13
49.3 Spot rate calculations 2
Appropriate commentary – 1 mark per point 6
8
30
49.1
LIBOR + 2 7% 9%
FRA
Pay at LIBOR +2 (7.00%) (9.00%)
(Payment to)/receipt from bank (0.25%) 1.75%
(7.25%) (7.25%)
Total interest payment over 12 months (on £9.5m) (£688,750) (£688,750)
Option
Exercise? Yes Yes
Rate (6.5%) (6.5%)
Premium (1.0%) (1.0%)
(7.5%) (7.5%)
Total interest payment over 12 months (on £9.5m) (£712,500) (£712,500)
No hedge
Pay at LIBOR + 2 (7%) (9%)
Total interest payment over 12 months (on £9.5m) (£665,000) (£855,000)
An interest rate swap would not be appropriate here as it is short-term and would in all
likelihood be very difficult to arrange.
If LIBOR is 5% then it would be best not to hedge. If LIBOR is 7% the FRA gives the lowest
interest figure. The figures are not conclusive, and the board's attitude to risk will be
important. The FRA eliminates downside risk (rates rising) as well as upside risk (rates
falling).
$
Cost of consignment (4,800,000)
Profit on futures 47,813
Net cost (4,752,187)
Net cost at spot rate ($4,752,187)/1.4895 (£3,190,458)
(31/1/X7)
(b) OTC currency option
If the spot rate at 31/1/X7 was $1.4895 then the option would be exercised.
A call option would be used (ie, at $1.5020/£)
Receipt in sterling would be $4.8m (£3,195,739)
1.502
plus: Option premium 4.8m £0.011 (£52,800)
(£3,248,539)
49.3
Sterling payment at spot rate 30/9/X6 $4.8m (£3,168,317)
1.5150
Sterling payment at spot rate 31/1/X7 $4.8m (£3,222,558)
1.4895
The forward contract premium suggests a strengthening of the $. A weaker £ means a
higher payment, and vice versa for a stronger £.
Order (cheapest first)
Spot at 30/9/X6 £3,168,317
Currency futures contracts £3,190,458
MMH £3,202,755
Forward contract £3,211,113
Spot at 31/1/X7 £3,222,558
OTC option £3,248,539
Examiner's comments:
This question had easily the highest percentage mark on the paper. Overall, the candidates'
performance was very good. This was a three-part question which tested the candidates'
understanding of the risk management element of the syllabus. In the scenario a UK electricity
generator was considering hedging (1) the interest costs of a large loan and (2) its exposure to
foreign exchange rate risk on a planned purchase from an American supplier. In part 49.1, for
nine marks, candidates were required to calculate the interest payments that would arise on its
planned loan were it to make use of an FRA, an option or a swap. Two different rates of LIBOR
were given to the candidates. Candidates were then required to recommend which of the
hedging techniques the company should choose at each of the LIBOR rates. Part 49.2 was worth
13 marks and asked candidates to calculate the sterling cost arising from a range of hedging
techniques applied to the American purchase. Finally in part 49.3, for eight marks, candidates
were required to advise the company's board whether it should hedge the American (dollar)
payments.
Part 49.1 was answered well by many candidates. However, common errors made were:
• candidates based their calculations on a borrowing period of six months rather than 12
(the loan was to be taken out for 12 months, starting in six months' time).
• the majority of candidates failed to calculate the implications of not hedging the borrowing
and so comparisons were difficult.
• a significant number of candidates abandoned the option when LIBOR was 5% because
they compared 5% v 6.5% instead of 7% v 6.5% ie, they failed to recognise that the
company was borrowing at LIBOR + 2% pa.
Very few candidates spotted that the swap was irrelevant because it was a short-term borrowing
(ie, 12 months). Most candidates' answers to part 49.2 were very good, but the most common
errors noted were:
• currency futures – many chose the wrong date for calculating the number of futures
contracts, bought futures instead of sold them and calculated the profit on the futures trade
in £ instead of $.
• OTC currency options – far too many candidates exercised puts rather than calls.
The forward contract calculations were generally very good as were those for the money
market hedge. The main stumbling blocks with the latter were (1) choosing the wrong
interest rate and (2) using three months rather than four. The advice given by candidates on
the foreign exchange hedging in part 49.3 was generally good, but, if candidates did not
calculate the relevant spot rates then they lost marks. The performance of overseas
candidates in this section was, overall, very poor.
Marks
50.1 (a)
Ordinary dividend per share in 20X6 (£3,797,500/15,500,000) 24.5 pence
Ordinary dividend growth rate = £0.201/£0.245, which over four years 5% p.a.
Cost of equity (ke) = (d1) + g (£0.245 1.05) 9.95%
+ 5%
MV £5.20
Cost of preference shares (kp) d (£540,000/9m) £0.06 5.55%
=
MV £1.08
50.1 (b)
Cost of equity (1.2 (9.5% – 1.9%)) + 1.9 = 11.02%
Examiner's comments:
This question had, marginally, the lowest percentage mark on the paper. The majority of
candidates achieved a 'pass' standard in the question, however.
This was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus. It was based around a UK engineering company which was planning to
diversify into the UK fracking industry. As a result various calculations regarding its current and
future cost of capital were deemed necessary. Part 50.1 of the question, for 13 marks, required
candidates to calculate the current weighted average cost of capital (WACC) of the company
using (1) the dividend growth model and (2) the CAPM. In part 50.2, for three marks, candidates
were asked to explain whether the company should continue to use its existing hurdle rate for its
decisions on large-scale investments. Part 50.3, for five marks, required candidates to explain
the underlying logic of employing the CAPM within a WACC calculation. Part 50.4 was worth
10 marks. Here, candidates were tested on their ability to re-work their CAPM calculations, which
was necessary because of the company's proposed diversification into fracking, which would
alter the level of systematic risk. Finally, in part 50.5, for four marks, candidates were asked to
explain the circumstances in which it would be appropriate to use the adjusted present value
approach to investment appraisal.
Most candidates did well in part 50.1, but common errors were:
• inaccurate (and, at times, inappropriate) calculations of the dividend growth rate.
• not using the market value (MV) when calculating the cost of preference shares.
• for the cost of redeemable debentures – not using the ex-interest MV, choosing four years
to redemption rather than three, inaccurate IRR calculation from NPV's.
• irredeemable debentures – not using the ex-interest MV, using the post-tax coupon rate as
the cost of debt.
Combining the costs of the redeemable and irredeemable debt, rather than treating them
separately.
Part 50.1(b) was done very well. Only a few candidates failed to calculate the CAPM correctly.
Part 50.2 was generally well answered and most candidates were able to identify the key issue –
ie, Roper could be making poor investment decisions. In part 50.3 too few candidates answered
the question fully and concentrated more on a discussion of de-gearing/re-gearing. In part 50.4
the de-gearing/re-gearing calculations were mostly done well, but too many candidates'
explanation of their approach here concentrated on 'how' rather than 'why' it was done. Part
50.5 was, overall, done well and candidates demonstrated a reasonable understanding of APV.
Marks
51.1 (a)
Per
share
Net Assets £4,998 £10.00
(historic cost)
500
Net Assets (£4,998 +£3,150 +£3,370 – £2,400 – £3,200) £5,918 £11.84
(revalued) 500 500
W1
WDV b/f 920 754 618
WDA @ 18%/Bal All (166) (136) (618)
WDV c/f 754 618 0
W2
Pre-tax cash profits 2,900 3,000 3,100
WDA/BA (W1) (166) (136) (618)
Taxable profits 2,734 2,864 2,482
(b) Net Assets (historic cost) – tends towards low historic values, so an undervaluation.
Intangibles are ignored. Earnings potential and future earnings are ignored.
Net Assets (revalued) – as above, except that the asset values used are current.
P/E ratio – Looks at earnings. Will it be a majority stake? If so, then control will be
gained, so shares for this controlling stake should cost more. In this scenario it gives a
much higher value than assets. However, are these earnings stable into the future? Is
the company over-reliant on the two successful games from 20X3? Future earnings –
are there new games planned? Will they be successful?
Dividend yield – this is based on dividend income and is applicable where it's to be a
minority stake. Are these dividends stable? Will there be dividend growth?
PV of future cash flows – considers cash flows not profits and estimates forwards. These
are large estimates, especially the terminal value. Is it over-reliant on the two successful
games (as above)?
Overall – a value close to £30/share should be a minimum price.
Examiner's comments:
This was a three-part question that tested the candidates' understanding of the investment
decisions element of the syllabus and there was also a small section with an ethics element to it.
In the scenario a software development company was considering investing in a company that
designs games for use on computers and mobile phones. Candidates were given financial
information relating to the target company.
Part 51.1(a) was worth 14 marks and required candidates to calculate the value of one share in
the target company using five different valuation methods. In part 51.1(b), for 10 marks,
candidates had to explain, making reference to their previous calculations, the advantages and
disadvantages of using each of the valuation methods. In part 51.2, for eight marks, candidates
were required to explain the reasoning underpinning the shareholder value analysis (SVA)
method of valuation. They also had to explain whether SVA could be used to value this particular
target company, bearing in mind the information provided. Finally, in part 51.3, for three marks,
candidates had to explain the ethical issues arising for an ICAEW Chartered Accountant who is
privy to price-sensitive information which is not in the public domain.
Generally part 51.1(a) was answered well. A surprising number of candidates were unable to
calculate the share value based on the net asset basis (historic cost), but were able to calculate it
with the net asset basis revalued. The P/E and dividend yield valuations were generally done
very well. Most candidates scored well using the PV of future cash flows method of valuation.
Candidates' discussion was limited to mainly knowledge in part 51.1(b) – few considered
whether the techniques were suitable for a majority/minority holding despite being guided in
that direction in the question. The vast majority of candidates ignored the 'elephant in the
room', ie, the fact that the target company's computer games had a limited life of three to five
years and the successful games were three years old.
In general candidates' understanding of the theory of SVA was good, but too few were able to
explain adequately whether it could be used in this particular scenario. Candidate's
understanding of the ethical issues was generally good.
Marks
52.1 Net present value calculation:
Contribution 3
Rent, managers costs, consultancy saved 4
Contribution lost 2
Fixed overhead 2
Tax, working capital, capital allowances 6
NPV and conclusion 3
20
52.2 (a) Sensitivity to sales revenue:
Contribution 1
Tax and discount factor 1.5
PV calculation 0.5
Sensitivity and conclusion 1
4
(b) Sensitivity to the residual value of equipment:
Maximum loss of scrap value 0.5
Increase in the balancing charge 1
PV calculation 0.5
Sensitivity and conclusion 1
3
52.3 Real options:
1 mark to identify, and 1.5 marks to explain
(two real options required) 2.5 2 5
35
52.1
0 1 2 3 4
Units million 0.096 0.115 0.098 0.083
Selling price £ 299.00 299.00 299.00 299.00
Variable costs per unit £ –164.45 –172.67 –181.3 –190.37
Contribution per unit £ 134.55 126.33 117.7 108.63
NPV 8.59
The NPV is positive and Ribble should therefore accept the project to increase shareholder
wealth.
Marks are awarded for not including the research and development costs of £100,000 and
allocated fixed overheads, since they are sunk costs and allocated costs respectively.
Units:
1 8,000 12 = 96,000
2 96,000 1.2 = 115,200
3 112,200 (1 – 0.15) = 97,920
4 97,920 (1 – 0.15) = 83,232
Lost contribution:
1 (96,000 units/10) £25 = £240,000
2 (115,200 units/10) £25 = £288,000
3 (97,920 units/10) £25 = £244,800
4 (83,232 units/10) £25 = £208,080
Working capital
cumulative Increment
0 –1 –1
1 –1.2 –0.2
2 –1.02 0.18
3 –0.87 0.15
4 0 0.87
Total PV = 32.08
Sensitivity NPV/PV
(8.59/32.08) 27%
Given the risky nature of this project, the board of Ribble might consider the project to be
too sensitive to changes in the sales revenue.
Sensitivity to the residual value of equipment:
£m
Maximum loss of scrap value 4
Increase in the balancing charge 17% –0.68
Net cash flows 3.32
Although this represents 26% (2.27/8.59) of the overall NPV, the project is insensitive to the
residual value, since there would be a substantial NPV even if the value fell to zero.
52.3 Ribble has:
The option to delay the project for one year to see whether the competitor launches their
hoverboard onto the market.
The option to abandon the project should sales levels be below those estimated eg, if the
rival company's hoverboard is launched and proves to be more popular than the
Ribbleboard.
There is a follow on option in that Ribble could expand if the competitor's product fails
and/or sales of the Ribbleboard are better than expected.
Candidates might also state growth or flexibility options.
52.4 The CEO should disregard the comments that Ribble should continue to manufacture an
unsafe hoverboard. The CEO should act with integrity and ensure that he is not corrupted
by self-interest. He should be objective and not come under the undue influence of other
board members. He should act with professional competence and exercise sound and
independent judgement.
Marks
Examiner's comments:
This was a seven-part question that tested the candidates' understanding of the financing
options element of the syllabus. The scenario of the question was that a corporate finance firm is
giving advice to two clients. Client one (53.1) is a company seeking to raise additional funds and
client two (53.2) is a management buyout team.
Part 53.1(a) of the question was well answered by the majority of candidates. However in the
CAPM equation a surprising number did not deduct the risk free rate from the market return.
Part 53.1(b) of the question was also well answered by the majority of candidates. However,
considering that the area has been examined many times before some basic errors were made
which included: incorrectly calculating the number of new shares to be issued; not calculating
the discount that the rights price represents on the current share price of the company (despite
this being specifically asked for).
Also, many candidates were unable to comment on whether and why the actual share price
might not be equal to the theoretical ex-rights share price after the rights issue.
Responses to part 53.1(c) of the question were mixed and, since the topic has been examined
many times before, rather disappointing. Candidates were asked to calculate the yield to
redemption (YTR) of debentures that a similar company to the client company already had in
issue. They then had to use the YTR that they had calculated to price a new debenture issue, and
to calculate the total nominal value of the new issue. Common errors included: using the cum-
interest debenture price in the YTR computation; attempting to calculate the YTR on the new
issue; deducting tax from the YTR; incorrectly calculating the total nominal value of the new
issue; many mathematical errors in the YTR computations; calculating, and using, the interest
yield of the debentures rather than the YTR for the new issue, using the coupon rate to calculate
the issue price (and not arriving back at the par value!); for the new issue, using the cost of
equity to calculate the issue price.
Also comments on whether the YTR of the similar company was appropriate to use for the client
company were poor.
Responses part 53.1(d) were extremely disappointing considering that similar questions have
been asked before. In the scenario the candidates were provided with average and maximum
gearing ratios for the industry sector that the client operated in, and also a definition of gearing
as debt/equity by market values. Also the candidates were given the average and minimum
interest cover for the industry. Candidates were instructed in the question requirement to refer
to this data when discussing whether the client company should raise the finance required by
debt or a rights issue.
Many candidates gave very generic answers to this part of the question, just brain dumping the
advantages and disadvantages of debt and equity without referring to the industry data or the
scenario of the question. Disappointingly a large number of candidates also gave a detailed
description of Modigliani and Miller's theory on capital structure without any reference to the
Marks
Examiner's comments:
This was a four-part question that tested the candidates' understanding of the risk management
element of the syllabus. The scenario of the question was that of a company reviewing its foreign
exchange rate risk hedging strategy.
Part 54.1 was well answered by most candidates. However some of the errors demonstrated by
weaker candidates included: calculating the number of futures contracts using the spot rate
rather than the futures price; stating that currency futures should be initially sold rather than
bought; calculating the futures gain in £ rather than $; treating an over the counter option like a
traded option; calculating the option premium in $ rather than £; omitting interest on the option
premium.
There were a lot of average responses to part 54.2, some without any reference to the numbers
calculated in part 54.1. Many candidates did not give a firm conclusion. However there were
some excellent answers.
Responses to part 54.3 were mixed, with many candidates demonstrating a lack of
understanding of interest rate parity. Very often computations did not make sense and were very
difficult to follow.
Few candidates gave adequate answers to part 54.4, and showed little knowledge of what
economic risk is. However again there were some excellent answers.
Marks
55.1
Rights issue Debt issue
£m £m
Sales (£78.5m 1.20) 94.200 94.200
Variable costs (72% sales) (67.824) (67.824)
Fixed costs (£13.85m + £2m) (15.850) (15.850)
Profit before interest 10.526 10.526
Interest (Workings) (1.421) (3.021)
Profit before tax 9.105 7.505
Tax @ 17% (1.548) (1.276)
Profit after tax 7.557 6.229
Dividends payable (4.920) (3.000)
Retained earnings 2.637 3.229
55.2
Rights issue Debt issue
£m £m
Ordinary share capital (additional 8m shares) 20.500 12.500
Share premium (8m new shares £1.50) 12.000 0.000
Retained earnings 13.923 14.515
46.423 27.015
Debentures 20.300 40.300
Total long term funds 66.723 67.315
£0.369 £0.498
30.4% 59.9%
55.3
Current EPS £5.568m £0.445m
12.500
£0.445m
20.500
Target earnings £9.123m
Add back tax (17%) ÷ 83%
Target profit before tax £10.992m
Add back interest 1.421m
Add back fixed costs 15.850m
Target contribution £28.263m
Contribution/sales ratio ÷ 28%
Target sales £100.939m
55.4 Sentry's current earnings per share figure is 44.5p. The predicted EPS are 36.9p (rights
issue) and 49.8p (debt issue). So the rights issue leads to a lower EPS whilst the debt issue
increases EPS and may, for this reason, be favoured by shareholders.
Rights issue:
As would be expected, the level of gearing is much lower than under the debenture issue
option (30.4% compared to 59.9%). It's also lower than Sentry's current level of gearing
(46.0% [£20,300/44.086]).
Examiner's comments:
This question was, generally answered well and most candidates achieved a 'pass' standard.
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus and there was also a small section with an ethics element to it.
Marks
56.1 (a) Relevant money cash flows
Newcastle sales & contribution 2
Tax on profit 0.5
Factory closure 0.5
Tax on closure 0.5
Working capital 0.5
Machinery sale 0.5
Tax saving on machinery 1
Lease cancellation 0.5
Tax saving 0.5
Newcastle working capital 1.5
Discount factor 1
Irrelevant costs: lease, head office, fixed 2
11
London sales 1
London variable costs 1
London fixed costs 1
Tax on profit 0.5
Factory closure 0.5
Tax on closure 0.5
Lease payments 0.5
Tax saved on lease 0.5
Machinery sale 0.5
Tax saving 1.5
London working capital 1.5
Discount factor 1
10
56.1 (b) Advice 1
W1
Newcastle sales £1.3m 1.02 1,326.000
£1.5m 1.02 1.03 1,575.900
W2
Newcastle contribution
(sales 65%) 861.900 1,024.339
W3
WDV 3,100.000
Balancing Allowance (1,400.000)
Sale 1,700.000
W4
Working capital (132.600) (157.590) 0.000
Balance b/f 0.000 132.600 157.590
Increment (132.600) (24.990) 157.590
W1
London sales £7.2m 1.02 7,344.000
£5.5m 1.02
1.03 5,778.300
W2
London fixed costs £1.4m 1.02 (1,428.000)
£1.4m 1.02
1.03 (1,470.840)
W3
London contribution (sales 60%) 4,406.400 3,466.980
less: London fixed costs (1,428.000) (1,470.840)
London 'profit' 2,978.400 1,996.140
W4
WDV 3,100.000 2,542.000 2,084.440
WDA (558.000) (457.560) (1,484.440)
WDV/sale 2,542.000 2,084.440 600.000
W5
Working capital (734.400) (577.830) 0.000
Balance b/f 800.000 734.400 577.830
Increment 65.600 156.570 577.430
56.1(b) White should choose March 20X9 for closure of the London factory as it has the higher
NPV and will enhance shareholder wealth the most.
Indivisible projects
1 2 3 4 Total
£'000 £'000 £'000 £'000
Invested 6,000 4,700 3,850 14,550
NPV 621 869 622 2,112
1 2 3 4 Total
£'000 £'000 £'000 £'000
Invested 4,500 4,700 3,850 13,050
NPV 563 869 622 2,054
The highest NPV is achieved via the combination of projects 1, 3 and 4. This would
generate an NPV of £2,112,000.
56.3 The efficient markets hypothesis (EMH) holds that stock markets are considered in the main
to be efficient, ie, all share prices are 'fair'. Investment returns are those expected for the
risks undertaken. Information is rapidly and accurately incorporated into share values.
When share prices at all times rationally reflect all available information, the market in which
they are traded is said to be efficient. In efficient markets investors cannot make consistently
above-average returns other than by chance.
An efficient market is one in which share prices reflect all of the information available. There
are three levels of efficiency:
Weak form – prices only change when new information about a company is made available.
There are no changes in anticipation of new information. Information arrives in a random
manner (the random walk theory) and so the chartist theory (technical analysis) will not hold
up here. The market is efficient in the weak form if past prices cannot be used to earn
consistently abnormal profits.
Examiner's comments:
This question had the lowest percentage mark on the paper. The majority of candidates
achieved a 'pass' standard in the question, however.
This was a three-part question that tested the candidates' understanding of the investment
decisions element of the syllabus.
It was based around a UK cosmetics manufacturing company which has three factories (in
London, Newcastle and Manchester). In part 56.1 of the question, for 22 marks, the company
had decided to close the London factory and relocate some of its production to the Newcastle
factory. Its board is not sure of the best closure date (20X7 or 20X9). Candidates were given
financial information about the two factories and were asked to calculate the relevant money
cash flows associated with closing the London factory (a) in 20X7 and (b) in 20X9. From these
calculations candidates were required to calculate the NPV for each scenario. Part 56.2, for six
marks, considered the Manchester factory and tested candidates' understanding of capital
rationing. Part 56.3, for seven marks, required candidates to explain the key principles of the
Efficient Market Hypothesis and the influence of behavioural factors.
As expected, parts 56.1(a) and 56.1(b) were a very effective discriminator. A good number of
candidates did really well here, but a significant minority really struggled and were unable to
identify the relevant cash flows adequately. This was largely due to an inability to stand back and
think the scenario through carefully before diving in and doing the calculations. Typical errors
made were:
The inclusion of opportunity costs (despite instructions to the contrary)
Including irrelevant cash flows, eg, leases, head office costs, fixed costs
Inaccurate inflation adjustments
Poor working capital calculations
Too many candidates mixed together the London and Newcastle sales/contribution figures
Many candidates considered only 20X7 cash flows for the 20X7 closure date and will have
lost marks
Most candidates scored well in part 56.2 and the most common error was a failure to apply the
trial and error approach for the indivisible projects.
Part 56.3 was answered well by most candidates.
Marks
57.1 Net payment due 1
No hedge 2
OTC option 3
Money market hedge 3
Forward contract 2
11
57.2 Hedging advice comparing the methods
under each exchange rate 8
57.1
Net payment due at 30/6/X7 = €1,750,000 – €600,000 €1,150,000
(£917,065) (£902,315)
plus: Premium cost
(€1,150k/€100 £0.70) (8,050) (8,050)
Total cost (£925,115) (£910,365)
Forward contract
Sterling payment €1,150,000 1,150,000 (£913,133)
(1.2652 – 0.0058) 1.2594
At the lower LIBOR rate it is best not to hedge, but with LIBOR at 6% the option is slightly
cheaper than the FRA.
Examiner's comments:
Most candidates demonstrated a good understanding of this area of the syllabus and this
question had the highest average mark on the paper
This was a four-part question which tested the candidates' understanding of the risk
management element of the syllabus.
In the scenario a UK frozen food company was considering hedging its exposure to (a) foreign
exchange rate risk on a planned €1.15 million (net) payment (three months ahead) and (b)
interest rate risk on a £4.2 million loan from its bank (also three months ahead).
Part 57.1 was worth 11 marks and asked candidates to calculate, at two spot rates, the sterling
cost arising from a list of hedging techniques that could be applied to the euro payment. In part
57.2, for eight marks, candidates were required to advise the company's board whether it
should hedge the euro payment. In part 57.3, for seven marks, candidates were required to
calculate the annual interest payments that would arise on its planned loan were it to make use
of an FRA, an option or to not hedge at all. Two different rates of LIBOR were given to the
candidates. From these calculations, candidates were then required to recommend which of the
hedging techniques the company should choose at each of the LIBOR rates given. Finally in part
57.4, for four marks, candidates were asked to explain how FRA's differ from interest rate
futures.
Part 57.1 was generally answered well. However, a minority of candidates added the euro
receipt to the euro payment or kept them separate and so will have lost marks. One disturbing
error, which occurred too frequently, was that candidates calculated two different MMH and
forward contract results using the two future spot rates given, rather than a single result for each,
based on the current spot rate. Also, many wasted time by recalculating the correct MMH and
forward contract results for the second set of spot data, rather than just stating 'no change'. The
examining team has no explanation for this as many similar questions have been set in the past
without these issues occurring. With the currency option, the most common errors were (a)
choosing a put rather than a call option and (b) using a traded option rather than an OTC.
Overall, part 57.2 was disappointing in that too few candidates went beyond only comparing the
best outcome at each spot rate. Most answers here needed to demonstrate a deeper
understanding of the issues involved.
In part 57.3 many candidates scored full marks, which was good to see. However, a number of
candidates lost marks as they were confused by the timings in the scenario. Rather than calculate
the annual interest cost as required, they calculated, incorrectly, a three month cost, ie, between
now and when the loan is to be taken out.
Overall, part 57.4 was answered well.
Marks
58.1
0 1 2 3 4
£m £m £m £m £m
Contribution 2.97 3.18 2.92 2.68
Fixed overheads –0.10 –0.10 –0.11 –0.11
Selling and administration –0.50 –0.52 –0.53 –0.55
Rent forgone –0.40 –0.40 –0.40 –0.40
Operating cash flows –0.40 1.97 2.16 1.88 2.02
After tax operating cash flows –0.33 1.64 1.79 1.56 1.68
Working capital
Total Increment
0 –1 –1
1 –1.07 –0.07
2 –0.98 0.09
3 –0.9 0.08
4 0.9
The discount factor should be calculated as follows:
(1.07 1.025) –1 = 0. 0968 It is acceptable to round this to 0.10 (10%).
Total PV 7.77
Sensitivity
– 2.28/7.77 = –29.3%
Sales revenue will have to increase by 29.3% to arrive at a zero NPV. The project is therefore
relatively insensitive to revenue changes.
58.3 SVA is the process of analysing the activities of a business to identify how they will result in
increasing shareholder wealth.
Answers should outline the seven drivers and relate them to the project and its negative
NPV:
Sales growth rate – can this be increased, are the estimates realistic.
Operating profit margin – can the 45% contribution be improved by reducing costs.
Investment in non-current assets – can the cost of the project be reduced, perhaps by
leasing plant and machinery.
Investment in working capital – can the project operate with less investment in working
capital without causing liquidity problems.
Cost of Capital – is the cost of capital at its optimum level.
Life of projected cash flows – is the project life cycle correct and is there any value in cash
flows beyond the fourth year.
Corporation tax rate – is the company tax efficient.
58.4 The project has a negative NPV, which signals that Brighton should reject it. The real options
are as follows (any TWO):
A follow-on option – investing into this competitive market now will allow Brighton to invest
more in the future, perhaps when other competitors have left the market.
An abandonment option – Brighton might commence the project with a view to future
investment. However, if it is apparent that the sector is not going to offer future
opportunities, Brighton can abandon the project at any time eg, by selling out to a rival.
A timing option – Brighton could delay its investment and wait and see if competitors leave
the market, making it more attractive to invest later on.
A growth option – As well as manufacturing overseas, Brighton also has the opportunity to
expand overseas via acquistion.
A flexibility option – Manufacturing overseas would perhaps give the flexibility to access
overseas markets more easily.
58.5 The over-riding objective of companies is to create long-term wealth for shareholders.
However this can only be done if we consider the likely behaviour of other stakeholders. For
example (TWO only):
Employees – cutting employee benefits in pursuit of creating short-term profits could have
long-term detrimental effects on shareholder wealth, for example if the company has high
staff turnover which affects productivity or service levels.
Examiner's comments:
This was a six-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was a company considering
launching a new product on to the market.
Part 58.1 was well answered by many candidates, however the following were common errors:
incorrect calculation of sales and variable costs; timing errors for cash flows; not stating that
research and development costs should be ignored because they are a sunk cost; not stating
that allocated fixed overheads should not be included in the NPV computations.
Responses to part 58.2 were mixed, with many candidates basing calculations on sales rather
than contribution, and many ignoring taxation. There were few candidates who made
meaningful comments regarding the sensitivity of the project to changes in the inputs.
Responses to part 58.3 were also mixed, with weaker candidates merely listing the seven drivers
with no application to the scenario.
Responses to part 58.4 were good, but some candidates listed all real options rather than just
stating two as per the requirement. Only the first two are marked. Responses to parts 58.5 and
58.6 were also good.
Marks
59.1 Cost of equity 1
Cost of debt 4
MV equity 1
MV debt 1
WACC 1
8
59.2 Explanation 2
De-gearing 1.5
Re-gearing 1.5
Cost of equity associated with the project 1
6
59.3 Overall equity beta 1.5
Cost of equity 1
WACC 1.5
Commentary 2
6
59.1 The current WACC using CAPM is calculated as follows: Ke = 2 + 0.45 (9 – 2) = 5.15%
Kd using linear interpolation:
The ex-interest debenture price is £105 (109 – 4).
Timing Cash Flow Factors at PV Factors at PV
Years £ 1% £ 5% £
0 (105) 1 (105) 1 (105)
1–8 4 7.652 30.61 6.463 25.85
8 100 0.923 92.30 0.677 67.70
17.91 (11.45)
IRR = 1 + (17.91/(17.91 + 11.45) 4 = 3.44%
Kd = 3.44 (1 – 0.17) = 2.86%
The ex div share price is 252p – 10p = 242p.
The market value of equity is: 242p (5m/0.01) = £1,210m. The market value of debt is:
£200m (105/100) = £210m. The debt equity ratio is: 0.15:0.85
The current WACC is: (5.15% 0.85) + (2.86% 0.15) = 4.81%
59.2 The cost of equity should reflect the systematic risk of the project. An equity beta from a
listed company operating veterinary practices can be used as a surrogate in the CAPM.
Since the gearing ratio of the surrogate is materially different to Easton, gearing
adjustments will have to be made.
De gearing to find Ba: 0.80 = Ba (1 + (3 0.83)/7) Solving for Ba. Ba = 0.59
Gearing up to reflect the gearing ratio of Easton to find Be: Be = 0.59 (1 + (0.15 0.83)/0.85)
Solving for Be. Be = 0.68
The Ke to reflect the systematic risk of the project = 2 + 0.68 (9 – 2) = 6.76%
59.3 The overall Be of Easton will reflect the systematic risk of both pet-related products and
veterinary practices.
The overall Be = (0.45 0.75) + (0.68 0.25) = 0.51
Ke = 2 + 0.51 (9 – 2) = 5.57%. The overall WACC = (5.57% 0.85) + (2.86% 0.15) = 5.16%
Easton's WACC has increased to 5.16% from 4.81%. An increase in the WACC is associated
with a reduction in value, but assuming that the project has a positive NPV this could result
in an increase in value.
Examiner's comments:
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was a company considering diversifying its
activities, and calculating the WACC that should be used to appraise the diversification. Also
there is debate about whether the company should be diversifying in the first place, and how the
markets and shareholders might react.
Responses to part 59.1 were good. However a number of candidates made basic errors when
calculating the cost of debt, with a surprising number not able to carry out interpolation
correctly. Strangely, some candidates correctly calculated the cost of equity using the CAPM, but
then used this number in the DVM as growth. They then attempted to use the DVM model to
calculate the cost of equity.
Responses to part 59.2 were disappointing, but there were some excellent answers.
Common mistakes were: de-gearing the company's existing equity beta; de-gearing the correct
beta but re-gearing using book values rather than market values. Explanations of the rationale
for calculating the cost of equity for the project were poor.
Responses to part 59.3 were mixed. A number of candidates did not calculate the overall equity
beta of the company, and used the equity beta from part 59.2. Explanations of the effect of a rise
in the overall WACC of the company were poor. Responses to part 59.4 were poor, and many
candidates were confused about what the terms systematic and unsystematic risk mean. Often
students quoted incorrect examples of each risk.
Responses to part 59.5 were also mixed, with many candidates not able to demonstrate a good
grasp of the topic area. Few candidates mentioned that diversified companies often trade at a
conglomerate discount.
Responses to part 59.6 were reasonable. Many candidates were able to identify APV and
describe the process. However, few candidates calculated the appropriate discount rate.
Marks
60.1 Forward contract 2
Money market hedge 3
Currency futures 4
OTC currency options 5
14
60.2 Implications of hedging techniques 3
Advantages and disadvantages 5
Recommendation 2
10
60.3 2 marks for each risk identified and explained 4
Ways to mitigate the risks 2
6
30
Examiner's comments:
This was a three-part question that tested the candidates' understanding of the risk management
element of the syllabus. The scenario of the question was a company that has recently started
exporting to the US, and a member of staff is asked to give advice to the board on hedging
FOREX, and other risks associated with overseas trading activities.
Part 60.1 was well answered by most candidates. However some of the errors demonstrated by
weaker candidates included: calculating the number of futures contracts using the spot rate
rather than the futures price; stating that currency futures should be initially sold rather than
bought; calculating the futures gain in £ rather than $; choosing put options rather than call
options; treating an over the counter option like a traded option; calculating the option premium
in US$ rather than £; omitting interest on the option premium.
There were average answers to part 60.2 from a lot of candidates, some without any reference to
the numbers calculated in 60.1. Many candidates did not give a firm conclusion, but there were
some excellent answers.
Responses to part 60.3 were mixed, with many candidates demonstrating a lack of knowledge of
overseas trading risks. Even though the requirement stated that the risks identified should be
other than FOREX, a number of candidates quoted this as one of their two risks.
Marks
61.1 (a) Valuation:
P/E ratio 2
Dividend yield 2
EBITDA 5.5
Net assets at historic cost 1
Net assets revalued 1.5
12
(b) 1 point per valid point on each of the valuation methods 7
Advice on price range 1
8
61.2 (a) SVA:
Sales and operating margin 2
Tax and depreciation 2
Non-current assets 2
Working capital 1
Terminal value 2.5
Present values 0.5
Short term investments 1
Long term debt 1
12
(b) Methods to fund MBO – 1 mark per point 3
35
61.1 (a)
(b) Asset valuations are the lowest. They are historic figures and balance sheet-based, with
no intangibles. Merikan is buying Coastal to run it, not to break it up.
P/E and enterprise value are the most relevant as they are forward-looking and based
on profits/earnings.
Using the dividend yield is acceptable, but it is a 100% purchase and the yield
calculation is only relevant for minority interests. Also, this method ignores growth. So
a price range of £12 to £16 per share looks reasonable.
61.2 (a)
Terminal
20X7 20X8 20X9 20Y0 value
£m £m £m £m £m
Sales 70.0 73.5 75.7 77.2 77.2
Operating margin 5.9 6.8 6.9 6.9
Tax (17%) (1.0) (1.2) (1.2) (1.2)
Depreciation 1.5 1.5 1.5 1.5
Operating cash flows 6.4 7.2 7.3 7.3
Replacement non-current assets (1.5) (1.5) (1.5) (1.5)
Incremental non-current assets (0.2) (0.1) 0.0 0.0
Incremental working capital (0.2) (0.1) (0.1) 0.0
Free cash flows 4.5 5.4 5.7 5.8
Discount factor (8%) 0.926 0.857 0.794 0.794
4.6
/8%
Present values 4.2 4.7 4.5 57.2
Total present value 70.6
plus: Short-term investments 0.7
less: Long-term debt
(£10m £95%) (9.5)
Market value of equity 61.8
So GB's equity is worth approximately £61.8m
Examiner's comments:
This question was generally answered poorly and a very slim majority of candidates achieved a
pass standard. It was a four-part question that tested the candidates' understanding of
investment decisions. In the scenario a UK-listed media group is planning to (1) purchase an
unquoted commercial radio company and (2) sell all of its shares in an unquoted newspaper
company via a Management Buy Out (MBO).
Many candidates did well in part 61.1(a) and some scored full marks. However, overall this was
not answered as well as expected. A considerable number of candidates were unable to
calculate the company's net assets and/or earnings figures, which was very disappointing. The
enterprise value (EV) calculation was a recent addition to the syllabus. Overall this was answered
reasonably well, but many candidates did not attempt it at all. Part 61.1(b) was, overall, done
well, but to score high marks here candidates needed to consolidate valuation theory with the
figures that they had calculated.
For part 61.2(a) there was a wide range of answers. Some candidates did really well here, whilst
others produced very little. The figures themselves were not difficult, and a methodical approach
would have generated a good mark. There was evidence of time pressure, as there were many
incomplete answers. Part 61.2(b) was done well by most candidates. A similar question to this
was set recently, but many candidates did poorly because they failed to concentrate their
answers on the directors behind the MBO, rather than the company itself.
Marks
62.1
(£275 83%)
Cost of irredeemable debt (kdi) = 3.80%
£6,000
Marks
Lend @ UK 3,132,907
1.007 3,154,837
(d) Strengthening £
1.6385 1.05 = 1.7204 £5,200,000 3,022,509
1.7204
63.2
Conversion at spot rate £5,200,000 £3,173,634
1.6385
If £ strengthens 3,022,509
Option 3,161,985
Forward 3,139,056
Money market hedge 3,154,837
The current spot rate gives best result.
The worst result is from the strengthening £, and the forward contract discount predicts a
strengthening of the £.
C$ is depreciating, and £ strengthening, which is bad for UK exporters. The forward contract
provides certainty, as does the money market hedge.
An option gives flexibility, but it is expensive.
63.3 Jenson's imports are purchased mostly in euros. If exports were, for example, mostly in
Canadian dollars then Jenson would be disadvantaged by both a strong euro and a weak
dollar (as in 63.1 and 63.2 above).
63.4 Advantages of using currency futures over forward contracts:
Lower transaction costs
The exact date of receipt or payment does not have to be known
Examiner's comments:
Most candidates demonstrated a reasonable understanding of this area of the syllabus and this
question had the highest average mark on the paper. It was a six-part question which tested the
candidates' understanding of the risk management element of the syllabus.
The scenario was centred on a UK-based manufacturer of industrial pumps. The company was
considering hedging its exposure to (1) foreign exchange rate risk on a C$5.2 million receipt
(three months ahead) from a Canadian customer and (2) a fall in the value of a large quoted
shareholding.
Foreign exchange risk is a regular topic in this examination, and part 63.1 was generally
answered well. However, many candidates lost marks unnecessarily, eg, choosing a call rather
than a put option, failing to deal with fees correctly, or choosing the wrong interest rates for the
MMH. Over half of the candidates believed that strengthening sterling meant getting less
foreign currency.
Marks
64.1 (a) NPV calculation:
Contribution/contribution lost 5
Fixed overheads 1
Tax charge 1
Sale proceeds 2
Working capital 2
Machinery and equipment 1
Tax saved on capital allowances 2
PV and recommendation 2
16
64.1 (b) Disadvantages of sensitivity analysis 3
Simulation 3
Total possible marks 6
Marks available 4
64.1 (a)
Units pa 30,000
0 1 2 3
Units 000's
( 1.06) 30.00 31.80 33.71
Selling price £ ( 1.03) 399.00 410.97 423.30
The Defender project has a positive NPV, which will increase shareholder wealth. The
project should therefore be accepted.
Working capital
Year Cumulative Increment
£'000 £'000
0 (2,000.00) (2,000.00)
1 (2,183.60) (183.60)
2 (2,384.05) (200.45)
3 2,384.05
Contribution lost
The contribution of the other product is:
£
Selling price 175
Materials and skilled labour (150)
Contribution 25
Examiner's comments
This was a five-part question, which tested candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that of a company launching
a new product onto the market, and also considering how often it should replace its fleet of
delivery vans. 64.1(a) was well answered by many candidates, but there were common errors:
incorrect calculation of contribution; timing errors for cash flows; incorrect calculations of the
contribution lost; incorrect calculations of the value of the rights at the end of the project and in
some cases ignoring it altogether; not explaining why the project should be accepted; not
providing workings so no marks could be awarded when the figure presented was incorrect.
Responses to 64.1(b) were mixed, with many candidates not able to adequately explain the
disadvantages of sensitivity analysis. The question only asked for disadvantages, but many
candidates wasted time by stating advantages. The explanations of simulation as an alternative
to sensitivity analysis were poor. Responses to 64.1(c) and (d) were good. However some
candidates did not read the question and stated real options which did not apply at the end of
the project. Responses to question 64.2 were mixed.
Marks
65.1 Dividend valuation model:
Ordinary dividend growth 1.5
Ex-div share price 1
Cost of equity 0.5
Cost of debt 4
WACC calculation 2
CAPM 1
10
65.2 Systematic risk unchanged 2.5
Explanation 2.5
5
65.3 Calculations (max 3 marks if no use made of historic information) 6
Discussion and advice 6
12
65.4 Identification and explanation of APV 2
Calculation of discount rate 1
3
65.5 Identification of 50% payout ratio over time 2
Appropriate discussion 3
5
35
Examiner's comments
This was a five-part question that tested understanding of financing options. The scenario of the
question was that of a company diversifying its operations and raising finance by either debt or
equity. Candidates were also asked to discuss the company's dividend policy. Responses to part
65.1 were mixed. Many candidates did not consider whether their answers were reasonable, for
example using a cost of equity of 50% in their WACC computations. There were basic errors in
many calculations.
Answers to 65.2 were disappointing, with many candidates demonstrating that they do not know
the basic assumptions regarding the use of WACC. Hardly any candidates mentioned that since
the company is raising a large amount of capital by either debt or equity the gearing might not
remain constant and that, because of its size, the project could not be considered marginal.
Most candidates centred their discussion of systematic risk, which they assumed would change.
However if some very basic calculations were carried out it could be seen that the systematic risk
of the new project was the same as existing projects.
Responses to 65.3 were extremely disappointing despite an almost identical question being
asked in a recent past paper. The question gave industry gearing and interest cover figures, so
that candidates could perform analysis looking at current gearing and interest cover, and then
gearing and interest cover after raising the new finance by either debt or equity. Five years'
historic information was also given to calculate interest cover figures. It was very disappointing
that a large number of candidates did not use this information or calculated the gearing in a
different way to that specified, or used book values despite the question stating market values
had been used. In addition many candidates did not consider the likely reaction of shareholders
and markets to the finance being raised by either debt or equity. Finally, a large number of
candidates wasted time explaining the theories of M & M when theory was not asked for in the
question.
Responses to 65.4 were mixed, with many candidates identifying APV as an alternative to
WACC/NPV. However few candidates calculated the discount rate that should be used in APV.
Again this has been examined many times before. Responses to 65.5 were also mixed, with
many candidates not able to demonstrate a good understanding of dividend policy. Few
candidates used the historic information to establish the company's current dividend policy.
Many repeated theory, despite this not being required.
Marks
66.1 (a) Forward rate and resulting receipt 2
OTC option 4
6
66.1 (b) Advantages and disadvantages of each 2.5
Advice and recommendation 2.5
Total possible marks 5
Marks available 4
66.2 (b) Reasons why hedge is not efficient (1 mark per point) 2
66.1 (a) The forward rate is: $/£ 1.2526 (1.2492 + 0.0034)
This results in a sterling receipt of £6,386,716 ($8,000,000/$1.2526)
Over the counter option:
The option premium is $8,000,000 2p = £160,000.
The premium with interest lost is £160,000 (1+0.03 4/12) = £161,600.
If the spot price on 31 March is $/£1.2700, Orion will exercise the options.
The sterling receipt will be ($8,000,000/$1.2400) – £161,600 = £6,290,013.
(b) The forward contract locks Jewel into an exchange rate and does not allow for upside
potential.
Forwards:
Tailored specifically for Jewel.
There is no secondary market.
OTC currency options:
The options are expensive.
There is no secondary market.
However, the options allow Jewel to exploit upside potential and protect
downside risk.
Examiner's comments
This was an eight-part question that tested the candidates' understanding of the risk
management element of the syllabus.
Part 66.1(a) was well answered by most candidates. However some of the errors demonstrated
by weaker candidates included: using the incorrect spot rate; deducting the forward discount;
not including interest on the option premium, or including interest but taking a whole year;
treating the OTC option as a traded option.
Part 66.1(b) produced average answers from a lot of candidates, some without any reference to
the numbers calculated in part 66.1(a). Many candidates did not give a firm conclusion.
Responses to question 66.1(c) were good.
Responses to 66.2(a) and (b) were also good, however some candidates made some basic
errors as follows: incorrect calculation of the number of contracts and the value of one contract
by using the current index price and not the current futures price; incorrect computation of the
loss on the portfolio; stating that contracts should be initially bought not sold; incorrect
computation of the gain on futures by using the current index price and not the futures price.
Responses to 66.3 were good, but many candidates did not read the question when they
demonstrated the cash flows that would typically occur when the swap was implemented.
Marks
67.1 (a) Cost of equity (dividend valuation model) 3
Cost of preference shares 1
Cost of irredeemable debt 2
Cost of redeemable debt 4
WACC calculation 4
14
67.1 (b) Cost of equity (CAPM) 1
WACC calculation 1
2
67.2 Appropriate discussion of directors' views 6
£1.716m
Latest dividend (d0) = £0.26
6.6m
Ex div market value per share = (£3.46 – £0.26) = £3.20
(d1) (£0.26 1.03)
Cost of equity (ke) +g + 3% 11.36%
MV (£3.20)
d1 £0.07
Cost of preference shares (kp) 5.19%
MV £1.34
(i – t) (£6 83%)
Cost of irredeemable debt (kdi) 4.70%
MV £106
Cost of redeemable debt (kdr)
Year Cash Flow 5% factor PV 6% factor PV
0 (96) 1.000 (96.000) 1.000 (96.000)
1–3 4 2,723 10.892 2.673 10.692
3 100 0.864 86.400 0.840 84.000
NPV 1.292 NPV (1.308)
WACC
Total MVs
£m £m Cost weighting WACC
Equity (6.6m £3.20) 21.120 12.90% 21.120/25.470 10.70%
Pref. Shares (1m £1.35) 1.350 5.19% 1.35/25.470 0.28%
Irredeemable debt (£1.2m 1.06) 1.272 4.70% 1.272/25.470 0.23%
Redeemable debt (£1.8m 0.96) 1.728 4.57% 1.728/25.470 0.31%
4.350 0.82%
Total market value 25.470 11.52%
67.2 Phil Turner – to use the cost of preference shares would be completely wrong, as it is only
one element of the firm's total long-term finance and 7% is the coupon rate, not the current
cost.
Alana Clarke and Alison Hughes – ordinary shares (cost of equity) should be taken into
account. It makes sense to use Wells' current WACC figure for the investment appraisal if:
(1) the historical proportions of debt and equity will not change.
(2) the systematic business risk of the firm will not change.
(3) the new finance is not project-specific.
Regarding the above, the bank borrowing will not change the gearing as sufficient equity
will be raised to maintain the gearing at its current level. The systematic business risk of the
firm is likely to change as it is moving into a different market. The finance is not project-
specific.
67.3 New market geared beta = 1.80
Examiner's comments
This was a four-part question that tested candidates' understanding of the financing options
element of the syllabus, and there was also a small section on ethics. In the scenario a UK-listed
bakery company was planning to open a number of retail outlets across the UK. This investment
would cost the company £17 million, which would be raised in such a way as to not alter its
existing gearing ratio. In part 67.1, for 16 marks, candidates were required to calculate the
company's current WACC from the information given, based on (1) the dividend growth model
and (2) the CAPM. The majority of candidates did really well in part 67.1(a) and many scored full
marks. Typical errors made were (1) incorrect number of years used in the dividend growth
calculation (2) not adjusting the cum-div and cum-int market prices (3) forgetting the tax
adjustment in the cost of debt and (4) not using market values in the WACC calculation.
Part 67.2 was worth six marks and required candidates to respond to recent comments made by
three of the company's directors about the best discount rate to use when appraising the
£17 million investment. Overall, candidates' answers to part 67.2 were disappointing. The
comments made were rather general and so marks will have been lost. Too few scripts
considered the conditions that need to apply for the current WACC to be used, ie, gearing and
systematic risk to remain unchanged, and any new finance is not project-specific.
Part 67.3, for 10 marks, tested the candidates' understanding of (and the need for) de-gearing
and re-gearing beta within the CAPM calculation in the given scenario. It was good to see that
the numerical and discursive elements of part 67.3 were both done well by a good number of
candidates. Where candidates scored badly, it was clear from their calculations that many did
not understand the logic of de-gearing and then re-gearing. Also many were unable to explain
the theory underpinning for those calculations. This is an area of the syllabus that has been
examined regularly recently. Part 67.4 was worth three marks, with particular reference to the
issue of confidentiality and it was answered well.
Marks
68.1 (a) Sell June futures 1
Number of contracts 1
Profit/loss on futures 4
Interest cost 1
Total cost 1
8
68.1 (b) Options cost – 1 mark for each scenario 3
£4,500,000
No of contracts: 6/3 = 18
£500,000
(a) (b) (c)
Interest rate 7.50% 8.00% 5.50%
(c) If interest rates increase, then futures are less costly than options.
If rates fall, then options are lower cost.
68.2 (a) (1) Sterling weakens by 5%
Examiner's comments
This question was based on a UK manufacturer of timber products. The first half of the scenario
considered the company's need to borrow £4.5 million of short-term finance via a bank loan and
its plan to hedge the interest costs of that loan. In the second half of the question the company
had agreed to purchase €1.7 million of timber from a Finnish supplier. Candidates had to
investigate the foreign exchange risk implications of this contract for the company. In part
68.1(a) of the question, for eight marks, candidates were required to calculate the cost to the
company if it used traded sterling interest rate futures to hedge its interest rate risk. Part 68.1(b),
for three marks, required candidates to calculate the cost to the company if it used OTC interest
rate options to hedge the risk. Part 68.1(c) was worth two marks and asked candidates to
conclude, based on their calculations, which of the hedging methods should be chosen. For part
68.1 there were many very good answers with candidates demonstrating a thorough
understanding of the techniques involved. Those areas where candidates struggled were: (1) a
failure to identify that the company would sell interest rate futures (2) charging 12 months
interest rather than six (3) using six months, rather than three months, in the futures gain/loss
calculation and (4) a failure to calculate the option premium correctly (a very common error).
Part 68.2(a) for seven marks asked candidates to calculate the (sterling equivalent) payment to
the Finnish supplier if (1) there was a weakening of sterling and (2) two hedging techniques were
employed. In part 68.2(b), also for seven marks, candidates were required to advise the
company's board whether it should hedge the euro payment. Finally, part 68.2(c), for three
marks, asked candidates to identify the differences between traded currency options and OTC
currency options. Part 68.2 was, overall, done well. The calculations in part (a) were good, but
typical errors included (1) choosing the wrong exchange rate (2) strengthening rather than (as
required) weakening sterling and (3) subtracting the forward contract fee from the overall cost of
the transaction. Foreign exchange risk management is an area of the syllabus that is examined
regularly and so candidates' answers to the discussion in part (b) were disappointing. There was
a lack of depth to the candidates' conclusions and too many commented, erroneously, that a
forward contract discount meant that sterling would be weakening.
Marks
69.1 Construction costs and land clearance 1.5
Sales 1
Rental income 2
Bad debts 1
New staff 1
Extra costs 1
Tax 1.5
Green machine and tax 3
Net cash flows 2
Discount factors 2
PVs 1
NPV 1
18
69.1
20X8 20X9 20Y0 20Y1 20Y2-Z8
Y0 Y1 Y2 Y3 Y4–20
£'000 £'000 £'000 £'000 £'000
Construction costs (19,000) (19,000) (19,000)
Land clearance (1,400)
Sales 25,500 25,500
Rental income (W1) 1,040 2,079 2,079
Bad debts (W1) (16) (31) (31)
New staff (46) (92) (92)
Extra costs (W1) (31) (62) (62)
Tax (W2) 238 (2,882) (3,042) (322) (322)
Green machine 0 (1,200) 100
Tax on machine (W3) 0 37 30 120
Total cash flows (20,162) 2,455 4,434 1,792
1,572
6% factors (W4) 1.000 0.943 0.890 0.840
8.801
PV (20,162) 2,316 3,947 1,504 13,831
NPV 1,436
The development produces a positive NPV and so should be accepted as it will enhance
shareholder wealth.
WORKINGS
(3)
20X9 20Y0 20Y1
Y1 Y2 Y3
£'000 £'000 £'000
Green machine cost/WDV 1,200 984 807
WDA (18%)/Balancing allowance (216) (177) (707)
WDV/Sale price 984 807 100
(4)
6% annuity factor for Y4 – Y20 Y20 11.470 or 10.477
Y4 (2.673) 0.840
8.797 8.801
69.2
Y1 Y2 Total
£'000 £'000 £'000
Sales 25,500 25,500
Tax (4,335) (4,335)
Total cash flows 21,165 21,165
6% factors 0.943 0.890
PV 19,967 18,837 38,804
1, 436
Sensitivity = 3.7%
38,804
The NPV would decrease by £314,000, and so it is less likely that Bishop's board would
proceed with the development.
Examiner's comments
The scenario was based around a UK property company that builds low-cost houses for sale and
for rent. The company had the opportunity to invest in a new development of 500 identical low-
energy houses on one of its vacant sites. The company planned to use a house-building firm to
construct the houses over a two year period. Part 69.1 was worth 18 marks and required
candidates to make use of the information given and calculate the NPV of the proposed
investment. It was a difficult NPV calculation and so it was good to see that, overall, candidates
did well here. The main areas of difficulty were: (1) the tax calculation for the allowable building
costs (2) the timing of the cash flows and (3) the need to include cash flows (and then discount
them) for Years 4 to 20. Parts 69.2 and 69.3, for four marks and five marks respectively, tested
candidates' proficiency with, and understanding, of sensitivity analysis. Part 69.2 was also done
well, but some candidates used the price per house figure rather than the total sales figure and
so will have lost marks. Part 69.3 was a more difficult proposition and candidates' answers here
were very variable. Those who produced a set of calculations revised from part 69.1 scored well,
but too many produced a discussion rather than calculations. Part 69.4 was worth four marks and
here candidates were asked to compare the strengths and weaknesses of sensitivity analysis with
those of simulation. Part 69.4 was, overall, done well and a majority of candidates scored full
marks. In part 69.5, again for four marks, candidates had to explain the concept of real options
and to identify two real options that could apply to the development in question. In part 69.5
most candidates were able to identify examples of real options from the scenario, but too few
explained the more general issue of real options, ie, that of turning a negative NPV into a
positive one.
Marks
70.1 (a) Enterprise value 4.5
P/E ratio 1.5
Net assets historic 1
Net assets revalued 1
8
70.1 (b) Discussion of asset v income based measures 3
Recommendation 1
4
70.1 (c) Discussion of SVA, including drivers and problems 3
Examiner's comments
The scenario of the question was consideration of two tasks for a firm of corporate financiers:
Task 1 The valuation of a company that is considering an IPO.
Task 2 A quoted conglomerate is considering divesting itself of one of its subsidiaries.
Part 70.1 was well answered by many candidates, however the following were common errors:
for enterprise value: incorrect EBITDA; no deduction of debt and addition of cash to arrive at the
value of the shares; using the incorrect multiple; calculating a negative share price and making
no comment that this is not possible. For P/E ratio: using profits before tax. For net assets
(historic): using gross assets; using gross assets and only deducting long-term debt. For net
assets basis (re-valued): many candidates re-valued the non-current assets and then made the
same errors as for the net assets (historic) computations.
Overall a large number of candidates reduced their valuations to take into account non-
marketability. Since this is an IPO, such adjustments were not necessary.
Responses to question 70.1(b) were mixed. Many candidates only referred to their range of
values and did not recommend an issue price. The justification of the price was quite poor.
Responses to question 70.1(c) were good. However poorer candidates only stated what the
seven value drivers in SVA are, with no further explanation of the methodology. Responses to
70.2(a) were generally good. However a large number of candidates attempted to calculate the
Marks
71.1 (a) The number of new shares to be issued = 40 million (60 2/3)
The price per share = £3.75 (150/40)
This represents a discount on the current share price of 50% or £3.75. (3.75/7.50)
The theoretical ex rights price is:
Number of shares Value per share Number value
£ £
Existing shares 3 7.50 22.50
New shares 2 3.75 7.50
Examiner's comments
The scenario of the question involves giving advice to a listed client on two issues:
Issue 1 Whether to raise additional funding by debt or equity.
Issue 2 A review of dividend policy and also an ethical situation.
Marks
72.1 Net payment 1
Forward rate 1.5
Sterling equivalent 0.5
Sell September futures 1
Number of contracts 1
Loss on futures on closeout 2
Dollar purchase 1
Call options to buy dollars 1
Option calculations 3
12
72.2 Advantages and disadvantages of hedging techniques 5
Advice 2
7
Examiner's comments
The scenario of the questions is that of a board wanting some clarification on forex issues. Part
72.1 was well answered by most candidates. However some of the errors demonstrated by
weaker candidates included: using the incorrect spot rate; deducting the forward discount;
incorrect computation for the number of futures contracts; making the incorrect decision of
whether to sell or buy futures; assuming that the futures loss was in £; choosing the put option
and not the call option; not including interest on the option premium, or including interest but
taking a whole year; treating the OTC option as a traded option; not netting receipts and
Marks
73.1 Revised Economic Value:
Sales correct in summary calculation 1
Sales workings
Y1 Expected Value 1
Y1 Inflation 1
Y2 Expected Value 1
Y2 Inflation 1
Y3 Expected Value 1
Y2 Inflation 1
Variable Cost 1
Fixed Cost 2
Close down costs 1
Tax 1
Sale of Plant and Machinery 1
Tax saved on Plant and Machinery 2
Working capital 1
Discounting 1
Economic Value 1
18
73.2 Revised Economic Value:
Scrap value 1
Tax rebate 1
Discounting 1
New economic value 1
4
73.3 Ethics and fundamental principles:
Behave with integrity 1
Behave objectively with no conflict of interest 1
Behave professionally 1
3
73.4 Impact of real options:
Explain impact of real option on – NPV 1
Identify abandon real option and explain using scenario 2
Identify growth real option and explain using scenario 2
5
73.5 Shareholder Value Added (SVA)
Explain SVA 1
Advantage of SVA 1
Explain seven drivers of SVA 2
Disadvantage of predicting 1
Disadvantage of terminal value on SVA 1
Adjust SVA with short terms investments and debt 1
7
Max 5
35
WORKINGS
1
Y1 Y2 Y3
£'000 £'000 £'000 £'000
Sales (£7m 0.7) 4,900 (£5m 0.6) 3,000 2,500
(£4.5m 0.3) 1,350 (£4m 0.4) 1,600 (1.02)3
6,250 4,600 0.7 3,220 2,653
1.02 (£4m 0.4) 1,600
6,375 (£3m 0.6) 1,800
3,400 0.3 1,020
4,240
(1.02)2
4,411
2
£'000
Annual fixed cost cash flows = (£1.7m – £0.6m) £1.1m 1.02 1,122 (Y1)
£1.1m (1.02)
2
Depreciation excluded as not a cash flow 1,144 (Y2)
£1.1m (1.02)
3
1,167 (Y3)
Close down costs = £0.6m (1.02)
3
3 £637,000
4
Y1 Y2 Y3
£'000 £'000 £'000
Sales 6,375 4,411 2,653
VCs (1,913) (1,323) (796)
FCs (1,122) (1,144) (1,167)
Close down costs (637)
Taxable profit 3,340 1,944 53
Tax payable @ 17% 568 330 9
73.3 An ICAEW member is being asked to falsify the economic value of Snowdog and thus
mislead potential buyers, ie, Snowdog's directors. To do so would break the principles of
the ICAEW Ethical Guide which states, inter alia:
A member should behave with integrity – ie, be honest and truthful. The member's
advice and work should not be influenced by the interests of other parties, which
would be the case here were s/he to overvalue Snowdog.
A member should strive for objectivity in all professional and business judgements – ie,
there should be no bias, conflict of interest or undue influence of others. The member
has a conflict of interest here. S/he is being asked to act with bias in favour of one party
(Rumsey's directors) over another (Snowdog's directors).
A member should behave professionally – ie, avoid any action that discredits the
profession. If the member falsified the valuation of Snowdog then the ICAEW's
reputation is at risk.
73.4 NPV analysis only considers cash flows related directly to a project. However, a project with
a negative (or low) NPV could be accepted for strategic reasons. This is because of (real)
options associated with a project that outweigh the poor NPV.
With regard to Snowdog two real options are:
abandonment – if there is no MBO Snowdog could be closed before the three years
are up.
growth (calling it follow on or timing also ok) – if Snowdog performs better than
expected it could be kept open longer than three years.
73.5 With SVA a company's value is based on the PV of its future cash flows, so it is forward-
looking.
The advantage is that this is theoretically the most superior valuation method compared
with earnings (which may be manipulated) or assets (which don't focus on the income
generated).
SVA considers seven value drivers, which link to (or drive) company strategy:
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) Cost of capital
Examiner's comments:
This question had the highest percentage mark on the paper. The vast majority of candidates
achieved a 'pass' standard in this question.
This was a five-part question that tested the candidates' understanding of the investment
decisions element of the syllabus.
The scenario was based on a UK manufacturer of computer hardware. The company's board has
decided to close down one of its subsidiary companies in three years' time. This is due to the
latter's recent poor performance. The board has learned that the subsidiary's senior
management would like to investigate the possibility of a management buy-out (MBO). The
board has decided that the subsidiary's buy-out price would be its current economic value,
based on predicted trading results for the next three years. Question 73.1 was worth 18 marks
and required candidates to make use of the information given and calculate the subsidiary's
economic value, based on discounted future cash flows. In question 73.2, for four marks,
candidates were asked to re-work their figures from question 73.1 because of a change in the
data provided. This tested their understanding of sensitivity analysis. Question 73.3 was worth
three marks and examined the Ethical Guide, with particular reference to the issues of integrity,
objectivity and professional behaviour. Question 73.4, for five marks, tested candidates'
understanding of real options and asked them to identify two real options that could apply to
the subsidiary as alternatives to the MBO. Finally, in question 73.5, again for five marks,
candidates had to explain the shareholder value analysis (SVA) approach to company valuation,
with its advantages and disadvantages.
For 73.1 the majority of candidates produced good answers. Relevant cash flows were, in the
main, correctly identified. However, the expected sales calculations did cause many candidates
problems. Common errors made by candidates were:
poor expected value (EV) calculations for Year 2. Some candidates showed no real
understanding by producing an EV higher than any of the individual sales figures.
no explanation of why depreciation is ignored in the cash flows.
closure costs were ignored as irrelevant when they were not.
the tax written down value brought forward was treated as a cash outlay.
an extra writing down allowance was included in Year 0.
the money discount rate (given) was increased by the inflation rate in the question.
73.2 was answered very well by most candidates. They demonstrated a good understanding of
the key factors involved in the sensitivity analysis.
Answers for 73.3 were very variable. Candidates who scored well will have explained why the
key ethical issues (integrity, objectivity and professional behaviour) are under threat in the given
scenario. Many candidates failed to do this and produced a 'shopping list', without explanation.
In addition a lot of candidates rolled integrity and objectivity into one issue rather than two.
73.4 was done well by the majority of candidates, but it was disappointing to see a number of
scripts where the candidate did not know the definition of a real option. Also, many candidates
did not apply their real option knowledge to the actual scenario. Instead, they listed many (some
irrelevant) options. Finally, some candidates gave more than the two options required in the
question.
Marks
74.2 Gordon's Growth Model (GGM) is also known as Earnings Retention Model. Dividend
growth based on proportion of dividends that are retained and the rate of return on those
retained profits. Thus g = rb. The GGM is based on the premise that these profits are the
only source of funds. Growth is achieved by re-investing earnings. This is then put into the
Dividend Valuation Model to get the cost of equity, assuming the value of a share = PV of
growing future dividends.
CAPM – specific/unsystematic risk can be diversified away by investors, so it is assumed that
investors are rational and that they have a diversified portfolio. Systematic risk can't be
diversified away – macro-economic factors. A company's beta is calculated from the
performance of its share price against the market average and is taken as a measure of the
market's view of the risk attached to the security in question. The higher the perceived risk,
then the higher the beta figure and thus the higher the equity return required by investors.
74.3 When using WACC to appraise projects the following assumptions are implied:
(1) Heath's historic proportions of debt and equity are not to be changed (which they are –
see below).
(2) Heath's systematic business risk is not to be changed (it does not change as it's still the
same industry).
(3) The finance is not project-specific (eg, cheap government loans, which it is not).
In this case the finance is very substantial, ie, 42% of total funds at market value
(£10m/£24m) and as it would be borrowed money then this will affect the company's
gearing level significantly (it is only just over 12% at present and would increase to 38% @
MV).
APV – increased gearing may lead to a fall in WACC because of the tax shield on loan
interest. To find the new WACC requires the new MV of the company's shares. However this
requires the NPV of the proposed investment to be known, which needs the new WACC.
So:
(1) Calculate a base case value
(2) Calculate the PV of the tax shield
(3) Adjust for issue costs
Total up 1, 2 and 3 to give APV – if positive then proceed with investment.
Examiner's comments:
This question had the second highest percentage mark on the paper. A large majority of
candidates reached a 'pass' standard in the question.
This was a four-part question which tested the candidates' understanding of the financing
options element of the syllabus.
The question was centred on an online retailer of baby products which is based in the UK. The
company's market share has been falling and its board is investigating the possibility of
establishing a small chain of shops across the UK, at a cost of £10 million. This expansion could
be funded by a bank loan, thereby taking advantage of current low interest rates. An alternative
view within the board is that the company should invest in a completely different type of
business, in this case a chain of care homes. In question 74.1, for 20 marks, candidates were
required to calculate the company's current WACC figure, based on (a) Gordon's Growth Model
and (b) the CAPM. Question 74.2, for five marks, required candidates to compare and contrast
the two valuation methods above. In question 74.3 (six marks) candidates were asked to advise
the company's board whether the existing WACC figure (from question 74.1) should be used in
when appraising the proposed investment in shops. The candidates' understanding of the APV
technique was also tested here. Finally, question 74.4, for four marks, required candidates to
explain the portfolio effect and discuss the validity of the proposal to invest in a completely
different type of business.
The requirements of question 74.1 have been examined regularly in recent examinations.
Accordingly, many candidates produced very good answers, scoring heavily. As expected, for
candidates the most difficult element here was the calculation of the dividend growth rate
(based on g = b r). It was clear that some candidates had no idea how to approach the
calculation of g = b r. In addition many candidates calculated unrealistically high figures for g,
b and r (and then the cost of equity) without question. Elsewhere, it was disappointing to see a
number of candidates (wrongly) deducting the ordinary dividend for their preference share
calculations and using the ordinary dividend growth rate with preference dividends. Also, a
surprising number of candidates used 5% (the coupon rate) as the pre-tax irredeemable cost of
debt, omitting to take the current market value of the debt into account. Most candidates' IRR
calculations for the cost of redeemable debt were good. However, too many showed a lack of
understanding from here and produced an illogical IRR calculation from NPV figures that were
correct. The CAPM calculation for cost of equity was very straightforward and the vast majority of
candidates scored full marks. However a significant number did not put the right numbers in to
the CAPM and so did not calculate the correct cost of equity.
The overall standard of answers given for question 74.2, 74.3 and 74.4 (theory and advice) was
disappointing when compared to the accuracy of (most of) the calculations in question 74.1.
Whilst many scripts scored well in question 74.2, far too many were unable to explain the basics
of Gordon's Growth Model and the CAPM.
Marks
75.1 Hedging strategies:
No hedge 2
FTC outcome 1
FTC fee 1
MMH: Borrow 1
MMH: Convert 1
MMH: Lend and result 1
Option: strategy 1
Option: no of contracts 1
Option: cost of option premium 2
Option: decision 1
Option: gain 1
Option: due from customer 1
Option: convert to £'s 1
Option: net receipt 1
16
75.2 Advice on hedge:
Summary of hedging outcomes 1
Best outcome at $1.3350 2
Best outcome at $1.4050 2
Impact on Eddyson if dollar ($) strengthens 1
6
75.3 Interest rate parity:
State and explain interest rate parity 2
Average UK and US three month rates 1
Average spot rate 1
Calculation of forward rate/average premium 1
5
75.4 Economic risk:
96% UK sales so little exposure 1
Increase in economic risk as US sales increase 1
Weaker $ would be bad for Eddyson 1
3
30
£1,722,846 £1,637,011
Forward contract (FC)
1.3775 – 0.0044 = 1.3731 $2,300,000 £1,675,042
1.3731
Fee $2,300,000 (£6,900)
= 23,000 £0.30
$100 £1,668,142
So with spot rate at 1.3350 (weakening £ and strengthening $) the best outcome for
Eddyson is not to hedge the dollar receipt.
With the spot rate at 1.4050 (strengthening £ and weakening $) the best outcome is to
hedge the dollar receipt via the traded option. The FC and the MMH both give a fixed
sterling receipt – the MMH produces a slightly higher figure. The FC and MMH are safest
techniques to use for a risk-averse board.
The £/$ interest rates and the forward contract premium indicate that the market is
expecting the dollar to strengthen (sterling to weaken). This would be good for Eddyson, an
exporter, as sterling receipts would be higher. The board's attitude to risk will be important
here.
75.3
1+ Average dollar interest rate (3 mos.)
Average spot rate = Average forward rate
1+ Average sterling interest rate (3 mos.)
The dollar interest rates are lower than those of sterling. Using the interest rate parity (IRP)
equation above (which shows that differences in interest rates can not be exploited as
forward rate will adjust to offset any gains), the value of sterling against the dollar will fall.
The dollar's gain in value is called a premium. So, using the data in the question:
Average UK rate 5.10% pa or 1.01275% per three months.
Average US rate 3.6% pa or 1.009% per three months.
Average spot rate = 1.3715
Forward rate = 1.3715 1.009/1.01275 = 1.3664 ie, a premium of $0.0051/£
Average premium given = $0.0052/£ so IRP is working
75.4 Currently very little economic risk as the majority of Eddyson's sales are in the UK (96%).
However if more sales are to the US then economic risk would increase – $ sales and €
purchases.
A weakening $ and a strengthening € would both be bad for Eddyson.
Examiner's comments:
This question had the lowest average mark on the paper, but most candidates achieved a 'pass'
standard.
This was a four-part question that tested the candidates' understanding of the risk management
element of the syllabus.
The scenario here involved a UK manufacturer of home and garden appliances. The company
has recently received a large order from an American customer. Its board is considering whether
or not to hedge the foreign exchange rate risk. Question 75.1, for 16 marks, required candidates
to calculate the net sterling receipt for each of four possible strategies. These were (a) no hedge,
(b) a forward contract, (c) a money market hedge and (d) sterling traded currency options.
Question 75.2 was worth six marks and required candidates to advise the company's board,
based on their previous calculations. In question 75.3 (five marks) candidates needed to
demonstrate their understanding of interest rate parity. Question 75.4 was worth three marks.
1 1
The annuity factor: AF1 n = 1 –
r (1+ r)n
D(1 – T)
(d) e = a 1+
E
Your ratings, comments and suggestions would be appreciated on the following areas of
this Question Bank