Paper 3.

7
Strategic Financial
Management

PART 3

WEDNESDAY 13 DECEMBER 2006

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A BOTH questions are compulsory and MUST be

answered

Section B TWO questions ONLY to be answered

Formulae sheet, present value, annuity and standard normal

distribution tables are on pages 8, 9, 10 and 11

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination

hall

The Association of Chartered Certified Accountants

Section A – BOTH questions are compulsory and MUST be attempted

1 Stanzial plc is a UK based telecommunications company listed on the FTSE 250 index. The company is considering
the purchase of Besserlot Ltd, an unlisted company that has developed, patented and marketed a secure, medium
range, wireless link to broadband. The wireless link is expected to increase Besserlot’s turnover by 25% per year for
three years, and by 10% per year thereafter. Besserlot is currently owned 35% by its senior managers, 30% by a
venture capital company, 25% by a single shareholder on the board of directors, and 10% by about 100 other private
investors.
Summarised accounts for Besserlot for the last two years are shown below:
Profit and loss accounts for the years ended 31 March (£000)
2006 2005
Turnover 22,480 20,218
––––––– –––––––
Operating profit before exceptional items 1,302 820
Exceptional items (2,005) –
Interest paid (net) (280) (228)
––––––– –––––––
Profit before taxation (983) 592
Taxation (210) (178)
Dividend (200) (100)
––––––– –––––––
Retained earnings (1,393) 314
––––––– –––––––
Balance sheets as at 31 March (£000)
2006 2005
Fixed assets (net)
Tangible assets 5,430 5,048
Goodwill 170 200
Current assets
Stocks 3,400 2,780
Debtors falling due within one year 2,658 2,462
Debtors falling due after more than one year 100 50
Cash at bank and in hand 48 48
Creditors
Amounts falling due within one year 5,520 4,823
Net current assets 686 517
–––––– ––––––
Net assets 6,286 5,765
–––––– ––––––
Capital and reserves:
Called up share capital (25 pence par) 2,000 1,000
Profit and loss account 3,037 4,430
Other reserves 1,249 335
–––––– ––––––
Total equity shareholders funds 6,286 5,765
–––––– ––––––
Other information relating to Besserlot:
(i) Non-cash expenses, including depreciation, were £820,000 in 2005–6.
(ii) Corporate taxation is at the rate of 30% per year
(iii) Capital investment was £1 million in 2005–6, and is expected to grow at approximately the same rate as
turnover.
(iv) Working capital, interest payments and non-cash expenses are expected to increase at the same rate as
turnover.
(v) The estimated value of the patent if sold now is £10 million. This has not been included in fixed assets.
(vi) Operating profit is expected to be approximately 8% of turnover in 2006–7, and to remain at the same
percentage in future years.
(vii) Dividends are expected to grow at the same rate as turnover.

2
(viii) The realisable value of existing stocks is expected to be 70% of its book value.
(ix) The estimated cost of equity of Besserlot is 14%
Information regarding the industry sector of Besserlot:
(i) The average PE ratio of listed companies of similar size to Besserlot is 30:1
(ii) Average earnings growth in the industry is 6% per year

Required:
(a) Estimate the value of Besserlot Ltd using:
(i) Asset based valuation
(ii) PE ratios
(iii) Dividend based valuation
(iv) The present value of expected future cash flows
Discuss the potential accuracy of each of the methods used and recommend, with reasons, a value, or range
of values that Stanzial might bid for Besserlot.
State clearly any assumptions that you make.
Approximately 16 marks are available for calculations and 11 marks for discussion. (27 marks)

(b) Discuss how the shareholder mix of Besserlot and type of payment used might influence the success or
failure of the bid. (8 marks)

(c) Assuming that the bid was successful, discuss other factors that might influence the medium term financial
success of the acquisition. (5 marks)

(40 marks)

3 [P.T.O.
2 Several months ago FNDC plc, a television manufacturer, agreed to offer financial support to a major sporting event.
The event will take place in seven months’ time, but an expenditure of £45 million for temporary facilities will be
necessary in five months’ time. FNDC has agreed to lend the £45 million, and expects the loan to be repaid at the
time of the event. At the time the support was offered, FNDC expected to have sufficient cash to lend the
£45 million from its own resources, but new commitments mean that the cash will have to be borrowed. Interest rates
have been showing a rising trend, and FNDC wishes to protect itself against further interest rate rises when it takes
out the loan. The company is considering using either interest rate futures or options on interest rate futures.
Assume that it is now 1 December and that futures and options contracts mature at the relevant month end.
LIBOR is currently 4%. FNDC can borrow at LIBOR plus 1·25%
Euronext.LIFFE STIR £500,000 three month sterling futures. Tick size 0·01%, tick value £12·50
December 96·04
March 95·77
June 95·55
Euronext.LIFFE options on three month £500,000 sterling futures. Tick size 0·005%, tick value £6·25. Option
premiums are in annual %.
CALLS PUTS
December March June December March June
9400 1·505 1·630 1·670 – – –
9450 1·002 1·130 1·170 – – –
9500 0·502 0·630 0·685 – – 0·015
9550 0·252 0·205 0·285 0·060 0·115 0·165
9600 0·002 0·025 0·070 0·200 0·450 0·710

Required:
(a) Discuss the relative merits of using short-term interest rate futures and market traded options on short-term
interest rates futures to hedge short-term interest rate risk. (6 marks)

(b) If LIBOR interest rates were to increase by 0·5% or to decrease by 0·5% estimate the expected outcomes
from hedging using:
(i) an interest rate futures hedge; and
(ii) options on interest rate futures.
Briefly discuss your findings.
Note: In the futures hedge the expected basis at the close-out date should be estimated, but basis risk may
be ignored. (16 marks)

(c) Calculate and discuss the outcome of a collar hedge which would limit the maximum interest rate paid by
the company to 5·75%, and the minimum to 5·25%. (These interest rates do not include any option
premium.) (5 marks)

(d) The company has been advised that it can increase income by writing (selling) options. Discuss whether or
not this is correct, and provide a reasoned recommendation as to whether or not FNDC plc should adopt this
strategy. (3 marks)

(30 marks)

4
Section B – TWO questions ONLY to be attempted

3 The financial management team of Tampem plc is discussing how the company should appraise new investments.
There is a difference of opinion between two managers.
Manager A believes that net present value should be used as positive NPV investments are quickly reflected in
increases in the company’s share price.
Manager B states that NPV is not good enough as it is only valid in potentially restrictive conditions, and should be
replaced by APV (adjusted present value).
Tampem has produced estimates of relevant cash flows and other financial information associated with a new
investment. These are shown below:
£000
Year 1 2 3 4
Investment pre-tax operating cash flows 1,250 1,400 1,600 1,800
Notes:
(i) The investment will cost £5,400,000 payable immediately, including £600,000 for working capital and
£400,000 for issue costs. £300,000 of issue costs is for equity, and £100,000 for debt. Issue costs are not tax
allowable.
(ii) The investment will be financed 50% equity, 50% debt which is believed to reflect its debt capacity.
(iii) Expected company gearing after the investment will change to 60% equity, 40% debt by market values.
(iv) The investment equity beta is 1·5.
(v) Debt finance for the investment will be an 8% fixed rate debenture.
(vi) Capital allowances are at 25% per year on a reducing balance basis.
(vii) The corporate tax rate is 30%. Tax is payable in the year that the taxable cash flow arises.
(viii) The risk free rate is 4% and the market return 10%.
(ix) The after tax realisable value of the investment as a continuing operation is estimated to be £1·5 million
(including working capital) at the end of year 4.
(x) Working capital may be assumed to be constant during the four years.

Required:
(a) Calculate the expected NPV and APV of the proposed investment. (10 marks)

(b) Discuss briefly the validity of the views of the two managers. Use your calculations in (a) to illustrate and
support the discussion. (5 marks)

(15 marks)

5 [P.T.O.
4 You have been asked to investigate the dividend policy of two companies, Forthmate plc and Herander plc. Selected
financial information on the two companies is shown below.
Forthmate plc
Earnings after Issued ordinary Free cash flow Dividend per
Tax (£000) shares (m) to equity (£000) share (pence)
2001 24,050 100 11,400 4·8
2002 22,345 100 12,200 4·5
2003 26,460 100 (3,500) 5·3
2004 32,450 130 (2,600) 5·0
2005 35,890 130 9,200 5·5
Herander plc
Earnings after Issued ordinary Free cash flow Dividend per
Tax (£000) shares (m) to equity (£000) share (pence)
2001 8,250 50 6,100 10·0
2002 5,920 50 (4,250) 10·0
2003 9,140 50 10,300 10·3
2004 10,350 50 4,400 10·5
2005 8,220 50 3,140 10·5
A colleague has suggested that companies should try to pay dividends that are a constant percentage of a company’s
free cash flow to equity.

Required:
(a) Analyse and contrast the dividend polices of Forthmate plc and Herander plc. Include in your analysis
estimates of dividends as a percentage of free cash flow, and any other relevant calculations.
Discuss possible reasons why the companies’ dividend policies differ. (8 marks)

(b) Discuss whether or not a company should pay dividends that are equal to the free cash flow to equity.
(4 marks)

(c) In both of the last two years Herander plc has had more potential investments with positive NPV than it actually
undertook.

Required:
Discuss the implications of your findings in (a) above for the financial strategy of Herander plc. (3 marks)

(15 marks)

6
5 Kandover plc, a UK company, has recently established a subsidiary in another country, Petronia. An essential
component that is produced in the UK by Kandover plc will need to be provided to the subsidiary in Petronia. The
finance team are discussing what transfer price should be set for sales between the parent company and subsidiary.
Three suggestions have been made:
(i) Use the estimated UK market price of the component as the transfer price. This is £18 per unit.
(ii) Use fixed cost per year plus variable cost per unit.
(iii) Use a negotiated price of UK total cost plus 25%
The following is a break down of the cost structure of an important component that must be sent between parent
company and the overseas subsidiary. Annual sales are 50,000 units.
Parent company costs £
Variable costs 13 per unit
Fixed cost £120,000
Once received by the subsidiary the component undergoes further processing and is sold locally at P$250 per unit.
Costs in Petronia P$
Local variable costs 82
Local fixed cost 351,000
The current exchange rate is P$7·8/£.
The corporate tax rate in Petronia is 25%, and in the UK 30%.
A 15% withholding tax is levied on all dividend payments in Petronia.
A bilateral tax treaty exists between the UK and Petronia. This allows tax paid on income and distributions in one
country to be credited against a tax liability on the same income in the other country.
Assume that all available profits in Petronia are to be remitted back to the UK.

Required:
(a) Calculate the expected after tax profits that would result from each of the three transfer pricing methods.
(9 marks)

(b) Discuss the advantages and disadvantages of each of the methods. (6 marks)

(15 marks)

6 Two multinational companies have recently published their objectives:

Company A:
‘Our company’s objective is to focus on the maximisation of global shareholder wealth. We will use sophisticated
measures to maximise cash flow in each country in which we operate. We will also extensively outsource
internationally in order to increase profitability.’
Company B:
‘Our company’s primary objectives are to enhance our customers’ satisfaction and to grow our business. We aim to
supply our customers with the highest quality products and provide outstanding levels of sales and delivery service,
incapable of being matched by our competitors, and thereby increasing our market share.’

Required:
Discuss and contrast these objectives. Comment upon any possible ethical implications of the objectives.

(15 marks)

7 [P.T.O.
 Formulae Sheet

Ke (i) [ ]
E( r j ) = r f + E( rm ) – r f β j
D1
(ii) +g
P0

E D
WACC Keg + Kd (1 – t )
E+D E+D

⎛ Dt ⎞
or Keu ⎜1 – ⎟
⎝ E + D⎠

2 asset
portfolio
σ p = σ a2 x 2 + σ b2 (1 – x ) 2 + 2 x (1 – x ) p abσ a σ b

Purchasing i f – i uk
power parity 1 + i uk

E D(1 – t )
βa = βe + βd
E + D(1 – t ) E + D(1 – t )

Call price for a European option = Ps N( d1) – Xe – rT N( d 2 )

1n ( Ps / X ) + rT
d1 = + 0.5σ T
σ T
d 2 = d1 – σ T

Put call parity PP = PC – PS +Xe–rT

8
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10
 Standard normal distribution table

0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09

0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359
0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753
0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141
0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517
0·4 0·1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879

0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224
0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549
0·7 0·2580 0·2611 0·2642 0·2673 0·2703 0·2734 0·2764 0·2794 0·2823 0·2852
0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133
0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389

1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·3621
1·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·3830
1·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0·4015
1·3 0·4032 0·4049 0·4066 0·4082 0·4099 0·4115 0·4131 0·4147 0·4162 0·4177
1·4 0·4192 0·4207 0·4222 0·4236 0·4251 0·4265 0·4279 0·4292 0·4306 0·4319

1·5 0·4332 0·4345 0·4357 0·4370 0·4382 0·4394 0·4406 0·4418 0·4429 0·4441
1·6 0·4452 0·4463 0·4474 0·4484 0·4495 0·4505 0·4515 0·4525 0·4535 0·4545
1·7 0·4554 0·4564 0·4573 0·4582 0·4591 0·4599 0·4608 0·4616 0·4625 0·4633
1·8 0·4641 0·4649 0·4656 0·4664 0·4671 0·4678 0·4686 0·4693 0·4699 0·4706
1·9 0·4713 0·4719 0·4726 0·4732 0·4738 0·4744 0·4750 0·4756 0·4761 0·4767

2·0 0·4772 0·4778 0·4783 0·4788 0·4793 0·4798 0·4803 0·4808 0·4812 0·4817
2·1 0·4821 0·4826 0·4830 0·4834 0·4838 0·4842 0·4846 0·4850 0·4854 0·4857
2·2 0·4861 0·4864 0·4868 0·4871 0·4875 0·4878 0·4881 0·4884 0·4887 0·4890
2·3 0·4893 0·4896 0·4898 0·4901 0·4904 0·4906 0·4909 0·4911 0·4913 0·4916
2·4 0·4918 0·4920 0·4922 0·4925 0·4927 0·4929 0·4931 0·4932 0·4934 0·4936

2·5 0·4938 0·4940 0·4941 0·4943 0·4945 0·4946 0·4948 0·4949 0·4951 0·4952
2·6 0·4953 0·4955 0·4956 0·4957 0·4959 0·4960 0·4961 0·4962 0·4963 0·4964
2·7 0·4965 0·4966 0·4967 0·4968 0·4969 0·4970 0·4971 0·4972 0·4973 0·4974
2·8 0·4974 0·4975 0·4976 0·4977 0·4977 0·4978 0·4979 0·4979 0·4980 0·4981
2·9 0·4981 0·4982 0·4982 0·4983 0·4984 0·4984 0·4985 0·4985 0·4986 0·4986

3·0 0·4987 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990

This table can be used to calculate N(di), the cumulative normal distribution functions needed for the Black-Scholes
model of option pricing. If di > 0, add 0·5 to the relevant number above. If di < 0, subtract the relevant number above
from 0·5.

End of Question Paper

11