Module B

Diploma in Financial Management

Paper DB1 – Incorporating

subject areas:
– Financial Strategy
– Risk Management

Tuesday 12 June 2012

Time allowed
Reading and planning: 15 minutes
Writing: 3 hours

This paper is divided into three sections:

Section A ALL 20 questions are compulsory and MUST be attempted
Section B THREE questions in total to be attempted
and Candidates MUST attempt ONE question from
Section C Section B, ONE question from Section C and ONE
further question from either Section B or Section C
Present Value Rates are on page 2.

Do NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Present value of $1 at x%
x= 8% 9% 10%
Year 1 0·93 0·92 0·91
2 0·86 0·84 0·83
3 0·79 0·77 0·75
4 0·74 0·71 0·68

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Section A – ALL 20 questions are compulsory and MUST be attempted

Please use the space provided on the inside cover of the Candidate Answer Booklet to indicate your chosen answer to
each multiple choice question.
Each question in this section is worth 2 marks.

1 Consider the following statements concerning the cost of finance.

1. Retained earnings represent a free source of finance for a business.
2. Loan notes normally offer lower rates of return than preference shares.
3. Junk bonds normally offer lower rates of return than investment grade bonds.
4. Convertible bonds normally offer lower rates of return than non-convertible bonds.

Which TWO of the above statements are correct?

A 1 and 2
B 1 and 3
C 2 and 4
D 3 and 4

2 For the financial year just ended, Orcus Co announced earnings per share of $0·15 and a dividend cover ratio of
2·5 times. The ordinary shares of the business have a nominal value of $1 and, at the financial year end, the dividend
yield was 2·0%.

What is the price/earnings ratio of the business at the year end?

A 2·5 times
B 6·7 times
C 20·0 times
D 50·0 times

3 Rusor Co, which is committed to maximising the wealth of its owners, has the opportunity to invest in one of two
mutually-exclusive projects. The projects have the same level of risk and the expected financial outcomes for each are
as follows:
Payback Accounting Internal Net present
period rate of return rate of return value
Project Acis 5 years 22% 12% $150,000
Project Juno 6 years 21% 14% $180,000

Which project should be selected and for what reason?

A Project Acis because it has the shorter payback period
B Project Acis because it has the higher accounting rate of return
C Project Juno because it has the higher internal rate of return
D Project Juno because it has the higher net present value

4 Cardea Co, which is listed on a major stock exchange, has just made a 1-for-4 bonus issue of shares. The business
pays no dividends and will not do so for the foreseeable future.

Assuming the market is free from imperfections, which of the following will occur as a result of the issue?
A The liquidity of the business will increase
B The wealth of existing shareholders will remain the same
C Earnings per share will remain the same
D The gearing ratio will decrease

3 [P.T.O.
5 Febris Co has an item of inventory with the following characteristics:
Maximum Minimum
Daily sales demand 80 units 30 units
Supplier lead times 15 days 6 days
The economic order quantity is 1,800 units and the re-order level is 1,300 units.

What is the highest possible number of units of this inventory item that could be held?
A 1,900
B 2,620
C 2,920
D 3,100

6 The directors of Lucina Co have decided to make a 1-for-4 rights issue of ordinary shares. The current market value
of an ordinary share is $10·00 and the rights shares will be issued at a discount of 25% on this current market value.

What will be the theoretical value of the rights attached to each original ordinary share?
A $0·40
B $0·50
C $1·90
D $2·00

7 Which of the following equations describes the operating cash cycle of a wholesale business?
A Average inventories turnover period + average trade payables payment period – average trade receivables
collection period
B Average inventories turnover period + average trade receivables collection period – average trade payables
payment period
C Average inventories turnover period – average trade payables payment period – average trade receivables
collection period
D Average inventories turnover period + average trade payables payment period + average trade receivables
collection period

8 Virtus Co has 50 million $0·25 ordinary shares in issue and has just announced after-tax profits for the year just
ended of $16 million. The market capitalisation of the business is $120 million after releasing the following
information:
(i) A forecast rise in after-tax profits by 25% for the forthcoming year.
(ii) A forecast dividend payout ratio of 40% for the forthcoming year.
(iii) A forecast increase in dividends by a compound rate of 5% per year beyond the forthcoming year.

What is the expected rate of return from an ordinary share?

A 5·6%
B 6·7%
C 10·3%
D 11·7%

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9 The financial ratios of Fontus Co revealed the following results when compared with similar businesses within the
same industry:
1. A longer than average inventories turnover period
2. A shorter than average trade receivables collection period
3. A lower than average acid-test ratio
4. A lower than average sales to working capital ratio

Which TWO of the above are consistent with the problem of overtrading?
A 1 and 2
B 1 and 4
C 2 and 3
D 3 and 4

10 An investment project has an initial outlay followed by constant annual net cash inflows throughout its infinite life.
The total present value of future cash inflows is $30 million and the profitability index of the project is 2·0. The
internal rate of return is 10%.

What are the annual net cash inflows and initial outlay of the project?
Annual net Initial
cash inflows outlay
$m $m
A 0·3 3·0
B 1·5 15·0
C 1·5 150·0
D 6·0 60·0

11 The following methods may be used to hedge currency risk:

1. Matching assets and liabilities
2. Currency swaps
3. Matching receipts and payments
4. Currency futures

Which TWO of the above can be used to hedge currency risk arising from economic exposure?
A 1 and 2
B 1 and 3
C 2 and 4
D 3 and 4

12 Nox Co is financed entirely by equity. Fraus Co is financed by 40% debt and 60% equity. The two companies are
identical in every respect except for their capital structures. The tax rate is 25%.

If the beta value for the equity of Nox Co is 1·2, what is the estimated beta value for the equity of Fraus Co?
A 0·6
B 1·5
C 1·8
D 3·6

5 [P.T.O.
13 Consider the following two statements.
1. A futures contract can be tailored to the buyer’s particular requirements.
2. A forward contract can be traded on an exchange.

Which of the following combinations (true/false) is correct?

Statement
1 2
A True True
B True False
C False True
D False False

14 The following options are held by an investor at their expiry date:

1. A put option of $200,000 in exchange for euros at a strike rate of $1 = €1·15. The exchange rate at the expiry
date is $1 = €1·20.
2. A call option of 50,000 shares in Luna Co with an exercise price of $5·40 per share. The market price of a share
at the expiry date is $5·15.

Which of the following combinations (exercise/lapse) concerning the options should be undertaken?
Option
1 2
A Exercise Exercise
B Exercise Lapse
C Lapse Exercise
D Lapse Lapse

15 Consider the following statements concerning capital structure.

According to the Modigliani and Miller (with taxes) view of capital structure:
1. the cost of equity capital will increase as the level of gearing increases.
2. the weighted average cost of capital will decrease as the level of gearing increases.

Which of the following combinations (true/false) concerning the above statements is correct?
Statement 1 Statement 2
A True True
B True False
C False True
D False False

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16 Salus Co plans to fix the interest rate for a nine-month period on a loan that will be taken out in three months’ time.
The business will use a forward rate agreement to hedge interest rate risk and is quoted the following rates by a bank:
Bid Offer
3v9 5·40 5·35
3 v 12 5·55 5·50
Salus Co can borrow at 50 basis points above LIBOR and, at the fixing date, the relevant LIBOR is 5·2%.

What is the amount of interest (in percentage terms) that is payable by Salus Co to the bank as a result of the
forward rate agreement?
A 0·35%
B 0·30%
C 0·20%
D 0·15%

17 Manus Co is entirely financed by equity and its cost of capital is 12%. Consus Co is identical to Manus Co except
that it is financed 75% by equity and 25% by debt. The cost of debt is 6%, which is the risk-free rate.

Using Modigliani and Miller (without taxes), what is the weighted average cost of capital of Consus Co?
A 10·00%
B 12·00%
C 12·75%
D 21·50%

18 A colleague has stated the following about the UK Corporate Governance Code:
1. the audit committee should contain a majority of independent non-executive directors.
2. the nomination committee should contain a majority of independent non-executive directors.

Which of the following combinations (true/false) concerning the above statements is correct?
Statement 1 Statement 2
A True True
B True False
C False True
D False False

19 Mithras Co is a UK business that is due to receive €200,000 from a German customer in three months’ time. A
money market hedge will be used to manage currency risk and the following borrowing rates are available:
Country Borrowing rate
per year
Germany 16%
UK 10%
The spot rate is £1 = €1·18–1·19

What is the Sterling amount which Mithras will need to deposit now as part of the money market hedge?
A £150,060
B £161,603
C £162,973
D £163,968

7 [P.T.O.
20 The UK Corporate Governance Code sets out procedures for determining remuneration for each of the following:
(i) the chairman
(ii) the executive directors
(iii) the non-executive directors

For which of the above should the remuneration committee have responsibility for setting remuneration?
A (i) only
B (i) and (ii)
C (ii) only
D (ii) and (iii)

(40 marks)

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Section B – Candidates MUST attempt ONE question from Section B, ONE question from Section C and ONE further
question from either Section B or Section C.

1 Averna Co is a research-based engineering business that has recently developed a motor scooter operated by solar
batteries. The technology employed is highly sophisticated and so the scooter is expected to have a production life
cycle of four years. Research and development costs to date have amounted to $10·5 million.
To exploit the potential of the new product, Averna Co has two possible options:
(i) It could manufacture the scooters and then sell them through a major distributor of cars and motor scooters.
Motor scooter production would begin almost immediately and over the four-year production life cycle, sales are
forecast to be as follows:
Year 1 Year 2 Year 3 Year 4
Sales volume (No. of scooters) 2,400 5,300 8,200 8,100
Selling price per scooter $2,300 $2,100 $2,000 $1,800
Manufacturing equipment would have to be acquired immediately at a cost of $12·4 million. The equipment
would have no further use at the end of the four-year period and could be sold for an estimated $3·2 million at
that point.
An immediate injection of working capital of $2·8 million will be required, which would be released at the end
of the production period. Estimated annual manufacturing fixed costs are $5·5 million and include an annual
depreciation charge of $2·3 million. Variable costs are $400 per scooter. At the end of the four-year production
period, the production staff will be laid off and redundancy costs of $1·4 million will be incurred.
(ii) Averna Co could allow Edusa Engineering Co to manufacture the scooter under licence. It is expected that, under
this option, sales volumes will be 10% lower than the forecast figures shown above. The licence will provide for
a royalty payment to be made to Averna Co of $250 per scooter. In addition, a further royalty payment of
$2·5 million will be made to Averna Co at the end of the licence agreement. Averna Co will, however, provide
an immediate interest-free loan to Edusa Engineering Co of $2·0 million for the four-year period, at the end of
which it is repaid. Additional administration costs of $0·1 million per year will be incurred by Averna Co under
this option in order to monitor the licensing agreement.
Averna Co is financed by a mixture of ordinary shares and loan notes. The ordinary shares have a beta of 1·4. Returns
to the market are 8% and the risk-free rate is 3%. The loan notes are irredeemable and have a coupon rate of 4%.
They are currently being traded at $80 per $100 nominal value. The target capital structure of the business is 80%
ordinary shares and 20% loan notes.
Ignore taxation and inflation.

Required:
(a) Calculate
(i) the net present value; and
(ii) the discounted payback period (to nearest year)
for each option. (15 marks)

(b) Briefly state any qualifications which should be made concerning the validity of the calculations made in (a)
above. (3 marks)

(c) On the basis of the information available, which option should be chosen and why? (2 marks)

(20 marks)

9 [P.T.O.
2 Bellona Co is a small business that produces a single product – a thermostat that is used in a range of kitchen
appliances. Information relating to the thermostat is as follows:
Per thermostat
$
Selling price 10·00
Material costs (4·50)
Variable labour costs (2·50)
Fixed costs apportionment (2·00)
–––––
Profit 1·00
–––––
All sales are made to kitchen goods manufacturers on credit. Bellona Co divides its customers into three separate
categories with each having the following characteristics:
Customer category Bad debts Average settlement
% period
No. of days
A 1·0 20
B 2·5 30
C 5·0 60
A new chief executive is concerned that sales have shown no significant growth for several years and is considering
launching a marketing campaign to address the problem. A firm of marketing consultants has suggested that a focused
campaign costing $0·8 million would increase sales revenue by $4·0 million. The business has sufficient spare
capacity to accommodate this increase in sales.
It is predicted that the increased sales would be distributed among the different categories of customers as follows:
Customer category Predicted share of
increase in sales
%
A 5
B 20
C 75
Bellona Co has an overdraft and on which it pays 10% interest per year. Assume 365 days in a year.

Required:
(a) Calculate the effect on the profit of Bellona Co of launching the marketing campaign and briefly comment on
the results.
(Workings to nearest $000) (11 marks)

(b) Describe the main procedures that should be adopted for the efficient collection of amounts due from credit
customers. (6 marks)

(c) Explain why the management of trade credit can be a particular problem for small businesses such as Bellona
Co. (3 marks)

(20 marks)

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3 Lares Co operates a chain of pizza restaurants that has enjoyed considerable growth over the past five years. The
business, which is family owned, is now seeking further growth by offering a pizza delivery service in large urban
areas. To finance this growth, the board of directors is currently debating whether the business should obtain a stock
exchange listing. If a decision is made to go ahead, financial advisers to the business have suggested that a tender
offer for ordinary shares should be made when the business is floated.
Research by the financial advisers suggests that the following pattern of tender offers is likely:
Share price Number of shares
tendered (thousands)
at each share price
$2·80 790
$2·50 1,040
$2·20 1,370
$1·80 1,450
$1·60 1,480
$1·20 1,650
The financial advisers believe that an issue of four million shares should be made and the reserve price should be
$1·50.

Required:
(a) Outline three possible advantages and three disadvantages of Lares Co obtaining a stock exchange listing.
(12 marks)

(b) Explain what a tender issue involves and the advantages and disadvantages of Lares Co using a tender issue
as a means of issuing ordinary shares. (5 marks)

(c) Calculate the predicted sale proceeds from the tender issue, assuming that Lares Co issues:
(i) four million ordinary shares;
(ii) the number of shares required to maximise the funds raised. (3 marks)

(20 marks)

11 [P.T.O.
Section C – Candidates MUST attempt ONE question from Section B, ONE question from Section C and ONE further
question from either Section B or Section C.

4 Larunda Co operates a shipyard in the UK and has recently completed the building of a passenger ferry for a French
business. The ferry has successfully completed its sea trials and final payment of €20 million is due to Larunda Co
in three months’ time. The board of directors of Larunda Co will soon meet to decide whether, and if so, how, to hedge
against the currency risk to which the business will be exposed.
Over the past few months there has been considerable volatility in the currency markets. As a result, the value of the
euro has changed frequently against most major currencies, including the £ sterling. This period of volatility is set to
continue and it is by no means clear how the euro will perform against major currencies, at least in the short-term.
Faced with this uncertainty, three possible options are being explored by Larunda Co:
(i) To bear the currency risk by doing nothing.
(ii) To hedge against the risk by using a currency option. An over-the-counter option may be bought from a bank at
a premium cost of £1·10 per €100 and at an exercise price of £1 = €1·19.
(iii) To hedge against the risk by taking out a forward exchange contract. Exchange rates are:
£/€ spot 1·1705–1·1755
3-months forward €0·0065–0·0045 premium

Required:
(a) Show the financial result of each of the three options being explored, assuming that the exchange rate in
three months’ time will be:
(i) £1 = €1·1208;
(ii) £1 = €1·2432. (8 marks)

(b) Discuss the financial results calculated in (a) above. (4 marks)

(c) Outline the main advantages and disadvantages of each of the options that Larunda Co is considering.
(8 marks)

(20 marks)

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5 Morta Co is a mobile phone operator that has reported after-tax profits of $50 million for the most recent year. This
level of profit is consistent with the past performance of the business. The senior management team is keen to boost
profits in future years and is about to make a submission to the board of directors. The management team has
concluded that profits will remain at the current level unless the business is prepared to enter new markets. This,
however, would require additional finance and the management team is proposing to use retained profits to finance
this move.
The current dividend policy of the business is based on a dividend payout ratio of 60%. This would not, however, be
sustainable in future years if the board of directors agree to the proposal to enter new markets. The senior
management team has set out two mutually-exclusive strategic options for the board of directors to consider. Both
require the same initial investment but thereafter they require different levels of annual investment and are expected
to generate a different rate of annual growth. Both strategies will, however, raise the cost of equity from its current
level of 10%. The following figures relating to each strategic option have been produced to help the board in its
deliberations:
Strategic Dividend Growth rate Required return
option payout ratio in profits by shareholders
% % %
Alpha 25 12 15
Gamma 40 8 13
The board of directors is due to meet soon to discuss the proposals in detail but many directors are concerned about
changing the dividend policy that is currently in place.

Required:
(a) Provide TWO possible reasons why the senior management team may consider retained profits an attractive
source of finance. (4 marks)

(b) Discuss TWO possible reasons why the board of directors may be reluctant to make any change to the
existing dividend policy. (8 marks)

(c) Evaluate each strategic option and state, with reasons, whether it would be worthwhile to adopt either.
(8 marks)

(20 marks)

13 [P.T.O.
6 For some years Insitor Co, a public listed company, has allowed a single individual to occupy the roles of chairman
and chief executive. Following pressure from institutional shareholders, however, the board of directors has recently
decided to separate the roles. Not all board members supported this decision. A minority of directors believed that it
represented a backward step for the business.

Required:
(a) Outline the roles of chairman and chief executive. (4 marks)

(b) Discuss the benefits and problems that may arise as a result of having a separate chairman and chief
executive. (13 marks)

(c) Identify possible situations where combining the roles of chairman and chief executive may be appropriate.
(3 marks)

(20 marks)

End of Question Paper

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