PROFESSIONAL LEVEL EXAMINATION

WEDNESDAY 13 MARCH 2019

(2.5 HOURS)

FINANCIAL MANAGEMENT
This exam consists of three questions (100 marks).

Marks breakdown

Question 1 35 marks
Question 2 35 marks
Question 3 30 marks

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Question 1

Assume that the current date is 28 February 2019

Palace Parade Furniture plc (PPF) is a UK-based furniture manufacturer. It has been trading
since 1992. PPF makes domestic furniture, such as chairs and beds, which is sold to retailers
across Europe. This market is very competitive and PPF’s board is considering diversifying
its product range. One means of diversification would be the purchase of the majority of the
shares in Turner Pring Ltd (TP), a UK-based kitchen manufacturer.

TP has traded since 1998 and makes a wide range of kitchen units which are sold to
specialist UK retailers. TP’s two founders, Violet Turner and Arthur Pring, own 65% of the
company’s shares. PPF’s board has been informed that Violet and Arthur wish to sell all of
their shares. The senior managers of TP have expressed an interest in a management buy-
out (MBO), but Violet and Arthur would also consider offers from other parties.

You work in PPF’s finance team. You have been asked by PPF’s board to prepare a range of
valuations for Violet and Arthur’s shares, supported by guidance on the methods by which
PPF could pay for those shares.

Extracts from TP’s most recent management accounts are shown below:

Income statement for the year to 28 February 2019

£’000
Sales 64,200
Profit before interest 7,200
Interest (1,800)
Profit after interest 5,400
Corporation tax at 17% (918)
Profit after tax 4,482
Dividends (2,890)
Retained profits 1,592

Balance sheet as at 28 February 2019

£’000 £’000
Land and buildings 15,600
Plant and machinery 19,200
Vehicles 1,400
36,200
Current assets 8,110
44,310

Ordinary share capital (£1 shares) 8,500

Retained earnings 8,580
17,080
7.5% Redeemable debentures 24,000
Current liabilities 3,230
44,310

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Other information

1. Four UK listed companies in the same industry sector as TP have the following P/E
ratios and dividend yields:

Allex plc Tagg plc Gresty plc Joanz plc

P/E ratio 8.1 10.7 9.5 9.3
Dividend yield 7.0% 8.3% 8.0% 7.5%

2. TP’s profit before interest figures for the five trading years to 28 February 2019 were:

2015 2016 2017 2018 2019

£’000 £’000 £’000 £’000 £’000
3,600 11,800 3,800 4,800 7,200

PPF wishes to use this information to derive an average earnings figure for use in a P/E
valuation of TP.

3. TP has paid a constant dividend per share since 2014. TP’s last issue of ordinary
shares was in 2013.

4. TP’s debentures are redeemable in 2020.

5. TP’s non-current assets are independently valued at:

£’000
Land and buildings 23,200
Plant and machinery 20,800
Vehicles 1,150

These values are not reflected in TP’s balance sheet at

28 February 2019.

6. You should assume that the corporation tax rate has been and will remain at 17%.

Requirements

1.1 Prepare a report for PPF’s board that

 calculates the value of one share in TP at 28 February 2019 using the P/E, dividend
yield and asset-based valuation methods (13 marks)
 comments on the strengths and weaknesses of the three valuation methods used
and (10 marks)
 outlines two methods by which PPF could pay for Violet and Arthur’s shares.
(4 marks)

1.2 Identify how the shareholder value analysis (SVA) approach to company valuation
differs from the valuation methods used in part 1.1 above. (4 marks)

1.3 Explain how an MBO works and the means by which the managers could finance it.
(4 marks)
Total 35 marks

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Question 2

Assume that the current date is 28 February 2019

Edencatt Packaging plc (EP) is a UK listed manufacturer. It has a financial year-end of

28 February. The company started trading in 1996, making a limited range of bespoke plastic
shopping bags for small retailers. Since then EP has expanded via organic growth and the
acquisition of other companies. It now supplies plastic bags and bottles to manufacturers
across Europe, mainly in the food, chemicals and agricultural sectors.

There is public concern with the environmental impact of plastic products. In response, EP’s
board is investigating the possible purchase of the entire share capital of Marshgreen Ltd
(Marshgreen), a manufacturer of glass bottles and paper bags and wrapping. It would cost
EP £13 million to purchase Marshgreen.

Minutes taken at EP’s most recent board meeting included the following comment made by
Josie Hatton, EP’s production director:

“If we are to proceed with our appraisal of the investment in Marshgreen then we should
make sure that we use an accurate hurdle rate in our NPV calculations. We’ve been using
a cost of capital figure of 8% for at least three years now. The danger here is that by using
a hurdle rate that’s too high or too low we will be destroying shareholder wealth. Surely
our objective is to maximise shareholder wealth?”

You work in EP’s finance team and have been asked to advise the board on a suitable cost
of capital for appraising the possible Marshgreen investment.

Extracts from EP’s most recent management accounts are shown below:
Income statement for the year ended 28 February 2019

£’000
Profit before interest and tax 7,330
Interest (290)
7,040
Corporation tax at 17% (1,197)
5,843
Preference dividend (160)
5,683
Ordinary dividend (4,455)
Retained profit 1,228

Balance sheet as at 28 February 2019

Non-current assets 19,600

Net current assets 1,300
20,900

Ordinary shares (£1 par) 5,500

Retained earnings 8,200
13,700
8% Preference shares (£1 par) 2,000
5% Redeemable debentures (see note) 2,200

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6% Irredeemable debentures 3,000
20,900

Note
The 5% debentures are redeemable at par on 28 February 2022.

Other information:

Market values of EP’s long-term funds at 28 February 2019

Ordinary shares £9.06 cum div

Preference shares £1.24 ex div
5% Redeemable debentures £97% ex int
6% Irredeemable debentures £97% cum int

EP’s ordinary dividend has been increasing at a steady rate over the past five years. In 2014
the ordinary dividend per share was £0.735. There have been no changes to the number of
ordinary shares in issue since 2014.

CAPM data
EP’s equity beta 1.20
Expected risk-free return 3.6% pa
Expected return on the market portfolio 9.8% pa
Average equity beta for Marshgreen’s sector 1.65
Ratio of long-term funds (equity:debt by market values)
for Marshgreen’s sector 88:12

If EP were to purchase Marshgreen’s shares it would raise the necessary funds via the issue
of both ordinary shares and 8% redeemable debentures. The funds would be raised in such a
way as to preserve EP’s existing gearing ratio (equity:debt by market values).

Assume that the corporation tax rate will be 17% for the foreseeable future.

Requirements

2.1 Calculate EP’s weighted average cost of capital (WACC) at 28 February 2019 using

(a) The dividend growth model and (16 marks)

(b) The CAPM (2 marks)

2.2 Determine an appropriate WACC that EP could use when appraising the £13 million
investment in Marshgreen and explain the reasoning behind your approach. (10 marks)

2.3 Explain how the APV technique works and the circumstances under which it is
applicable. (4 marks)

2.4 Comment on Josie Hatton’s view that maximisation of shareholder wealth should be the
objective of EP’s board.
(3 marks)

Total 35 marks

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Question 3

Assume that the current date is 1 March 2019

Cool Sports Ltd (CS) is a UK retailer of sportswear. It purchases its goods in bulk to take
advantage of quantity discounts. These goods are held in three main warehouses and from
there they are distributed to CS’s chain of large retail outlets across the UK. Currently 70% of
CS’s purchases are imported from southern Europe with the remainder coming from India.
You are an ICAEW Chartered Accountant and you work in CS’s finance team.

CS’s board is considering the following two issues:

1. Whether to hedge against exchange rate movements in the Indian currency (rupees).

2. Whether to establish a production facility overseas which would enable CS to take

advantage of lower labour costs and less rigorous health and safety regulations.

To date CS has not hedged against the exchange rate risk of any of its Indian imports.
However, with the possibility of an increased level of purchases from India, you have been
asked to investigate the implications of hedging that risk.

CS has recently signed the contract for a large consignment of goods from its main Indian
supplier, BDC. The goods will arrive on 30 April 2019. The agreed price is 145 million Indian
rupees (R) and CS will pay that sum to BDC on 31 May 2019.

You have collected the following data at the close of business on 1 March 2019:

Spot rate (R/£) 91.07 – 91.89

Three-month forward contract discount (R/£) 0.62 – 0.78
Forward contract arrangement fee
(per one million rupees converted) £95
Three-month OTC call option on rupees,
exercise price (R/£) 94.25
Three-month OTC put option on rupees,
exercise price (R/£) 95.50
OTC option premium (per one million rupees converted) £250
Relevant currency futures contract price
(standard contract size £62,500) R/£ 92.12
Sterling interest rate (lending) 2.8% pa
Sterling interest rate (borrowing) 3.8% pa
Rupee interest rate (lending) 6.0% pa
Rupee interest rate (borrowing) 6.8% pa

Requirements

3.1 Calculate for CS’s board the sterling cost of the BDC consignment if it uses the
following hedging instruments to hedge its exchange rate risk:

 A forward contract
 An OTC currency option
 Currency futures contracts
 A money market hedge

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 You should assume that on 31 May 2019 the sterling currency futures price will be R/£
92.88 and the spot exchange rate will be R/£ 92.45 – 93.32. (13 marks)

3.2 Advise CS’s board whether it should hedge its Indian rupee payment to BDC. You
should refer to your calculations in part 3.1 above and the sterling cost of not hedging.
(9 marks)

3.3 Explain the principle of interest rate parity (IRP). Given the information provided above,
calculate the forward rate of exchange on 31 May 2019 using IRP, commenting on your
result. You should use the average current spot and borrowing/lending rates for the
purposes of this calculation. (5 marks)

3.4 Outline the main elements of an ethical employment policy that CS could adopt if it were
to establish a production facility overseas. (3 marks)

Total 30 marks

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