16014395 CIMA P9 Management Accounting Financial Strategy Solved Past Papers

The Chartered Institute of Management Accountants 2004 1

STRATEGIC LEVEL

FINANCIAL MANAGEMENT PILLAR

PAPER P9 – MANAGEMENT ACCOUNTING –FINANCIAL STRATEGY

This is a Pilot Paper and is intended to be an indicative guide fortutors and students of the style and type of questions that are likelyto appear in future examinations. It does not seek to cover the fullrange of the syllabus learning outcomes for this subject.

Management Accounting - Financial Strategy will be a three hourpaper with one compulsory section (50 marks) and one section witha choice of questions for 50 marks.

CONTENTS

Pilot Question Paper

Section A Pages 2-5

Section B: Pages 6-10

Indicative Maths Tables and Formulae Pages 11-15

Pilot Solutions Pages 16-36

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P9 PILOT PAPER 2

SECTION A – 50 MARKS

Background of companyJHC Group manufactures and distributes a wide range of food products for salethroughout Europe. It also provides advisory services to retailers. Its shares are listedand are widely held, although institutions hold the majority. The company is structuredas a group of wholly-owned subsidiaries. Each subsidiary specialises in a particularproduct or service.

Financial dataKey data for the year to 31 December 2003 is as follows:

Revenue � 1,750 millionEarnings � 215 millionShares in issue 350 millionShare price as at today � 8.31 Weighted Average Cost of Capital (WACC) for theGroup 9% (nominal net of tax rate)

Company objectivesThe company has two stated objectives:

• To increase operating cash flow and dividends per share year-on-year by at least4%, which is 2.5% above the current rate of inflation.

• To increase the wealth of shareholders while respecting the interests of ouremployees, customers and other stakeholders and operating to the highestethical standards.

Future plansThe directors are considering establishing a new subsidiary company, SP, tomanufacture and distribute health food products. The subsidiary will require a factory.The directors have identified that the factory used by a long-established subsidiary, CC,is currently operating at only 60% capacity. This factory could be converted for use bythe new subsidiary at a cost of �2.8 million. CC's annual net (after-tax) earnings are�2.2 million and are expected to remain at this level in nominal terms for theforeseeable future. This subsidiary's operations would cease immediately the decisionto proceed with SP is taken as it will take some months to convert the factory.

However, the company is aware that the European parliament is discussing legislationthat would introduce more stringent controls on the manufacture of health food productsthan are currently in operation. Industry spokesmen are attempting to argue that currentcontrols are adequate. Nevertheless, the directors of the JHC Group wish to considerthe situation should these tougher controls be introduced and two alternative methodsof equipping the new subsidiary have been proposed by the company's technicaladvisers.

The company has sufficient cash available from a recent disposal to finance the capitalcosts of the new subsidiary under either alternative.



P9 PILOT PAPER 3

Alternative 1This alternative will equip the factory to manufacture to the highest food safetystandards that new regulations might impose. It would require the purchase ofspecialised machinery, which would have to be ordered. Delivery time is approximately6 months, which would coincide with completion of the factory conversion.

Capital costsThe cost of this machinery is currently �8 million but its price is likely to rise by 5% overthe next 6 months. If an order is placed immediately (year 0), together with a 40%deposit, the supplier will hold today's price. The balance of the purchase price ispayable 6 months after installation (that is, 12 months after payment of the initialdeposit). This machinery is not likely to need replacement for at least 8 years.

RevenuesForecast revenues for SP for the first three years of operation have been provided byJHC Group’s planning department as follows. The probabilities are based on forecastsof the economies of JHC Group’s main trading areas.

Year 1(6 months ofoperating)

Year 2 Year 3

Revenues (� m) 2.5 4.5 7.4 7.5 12.5 16·5 13·5 18·5 21·5Probability 0·3 0·5 0.2 0·3 0·5 0·2 0·3 0·5 0·2

Expected revenues (�m) 4.48 11.80 17.60

The probabilities of sales for year 2 or 3 and beyond are assumed to be independent ofthe achievement of the previous year's sales revenues.

Operating and other costs/reliefs

• Cash operating costs are expected to have a fixed element of �2·5 million eachyear, plus a variable element of 35% of sales revenues. A full year's fixed costswill be charged to production in year 1. Variable costs will be much higher underthis alternative because the new regulations are likely to require more expensiveingredients in the products.

• Redundancy payments of �2.1million will be necessary for staff from the CCsubsidiary. These would be payable immediately.

• The costs of the factory conversion will be incurred during the 6 months followingthe decision to proceed but, for simplicity, it can be assumed that these are paidat the end of year 1.

• The availability of capital allowances and other tax reliefs mean that no tax islikely to be payable until year 4. For year 4 onwards, a rough estimate suggests20% of annual net cash flows (revenues less cash operating costs) will bepayable in tax.

Alternative 2To plan for a continuation of, or modest improvement to, current controls andregulations. This alternative has greater flexibility, as there is a much larger market,worldwide, for cheaper products.



P9 PILOT PAPER 4

Capital costsThe capital cost to JHC Group would also be much lower at �4.5 million. Equipment forthis alternative is readily available and can be bought when the factory conversion iscompleted.

However, the equipment is likely to need to be replaced in 6 years' time from the dateof purchase.

RevenuesThe revenues shown below are forecast using similar methods as used in Alternative 1.However, sales will be made to a wider range of customers, many in developingcountries.

Year 1(6 months ofoperating)

Year 2 Year 3

Revenues (� m) 4·5 7.5 9.5 7.1 9.4 11.1 9.5 12.5 15.6Probability 0·1 0·6 0·3 0·1 0·6 0·3 0·1 0·6 0·3

Expected revenues (� m) 7.80 9.68 13.13

Costs are as follows:

• Fixed cash operating costs will be � 1.5 million each year; variable costs will be20% of sales revenue.

• With this alternative, there will be fewer redundancies from CC and theassociated costs will be only 20% of those for Alternative 1.

• Costs of factory conversion are as Alternative 1.

• Tax relief will be similar to Alternative 1, that is, no tax will be payable until year 4when tax will become payable at 20% of annual net cash flow (revenue less cashoperating costs).

The revenues and costs for both alternatives are in nominal terms.

Required:

Assume you are JHC Group’s financial manager.

(a) (i) Calculate the net present value for the new subsidiary (SP) under each ofthe two alternatives. Make, and comment on, appropriate assumptionsabout cash flows beyond year 3, including terminal values, and the discountrate to use in the evaluation.

(15 marks)

(ii) Explain, without doing any additional calculations, on the appropriatenessand possible advantages of providing modified internal rates of return(MIRRs) for the evaluation of the two alternatives.

(5 marks)



P9 PILOT PAPER 5

(b) Write a report to the directors that discusses how the new subsidiary and the twoalternatives might contribute to the attainment of the Group's objectives andrecommends which, if either, of the alternatives should be chosen. Refer to thefigures you calculated in part (a) where appropriate. You should provide anyadditional calculations that you consider relevant to support your discussion andanalysis.

(22 marks)

(c) Discuss the option features involved in the JHC Group’s decision and explain,briefly, the benefits of including such options in the investment appraisal process.

(8 marks)

(Total = 50 marks)



P9 PILOT PAPER 6

SECTION B – 50 MARKS

ANSWER TWO QUESTIONS OUT OF FOUR

Question Two

RZ is a privately-owned textile manufacturer based in the UK with sales revenue in thelast financial year of £68 million and earnings of £4.5 million. The directors of thecompany have been evaluating a cost saving project, which will require purchasing newmachinery from the USA at a capital cost of $1.5 million. The directors expect the newmachinery to have a life of at least 5 years and to provide cost savings (includingcapital allowances) of £240,000 after tax each year. Cash flows beyond 5 years areignored by RZ in all its investment decisions. The discount rate that the companyapplies to investment decisions of this nature is its post-tax real cost of capital of 9%per annum.

RZ at present has no debt in its capital structure. The directors, who are the majorshareholders, would be prepared to finance the purchase of the new machinery via arights issue but believe an all-equity capital structure fails to take advantage of the taxbenefits of debt. They therefore propose to finance with one of the following methods:

(i) Undated debt, raised in the UK and secured on the company’s assets. Thecurrent pre-tax rate of interest required by the market on corporate debt of thisrisk is 7% per annum. Interest payments would be made at the end of each year.

(ii) A finance lease raised in the USA repayable over 5 years. The terms would be 5annual payments of US$325,000 payable at the beginning of each year. Themachinery could be bought by RZ from the finance company at the end of the fiveyear lease contract for a nominal amount of $1. Assume the whole amount ofeach annual payment is tax deductible.

(iii) An operating lease. No cost details are available at present.

Other information

• The company's marginal tax rate is 30%. Tax is payable in the year in which theliability arises.

• Capital allowances are available at 25% reducing balance

• If bought outright, the machinery is estimated to have a residual value in realcash flow terms, at the end of five years, of 10% of the original purchase price.

• The spot rate US$ to the £ is 1.58

• Interest rates in the USA and UK are currently 2.5% and 3.5% respectively.



P9 PILOT PAPER 7

Required:

(a) Discuss the advisability of the investment and the advantages and disadvantagesof financing with either (i) undated debt, (ii) a finance lease or (iii) an operatinglease compared with new equity raised via a rights issue and comment onwhether the choice of method of finance should affect the investment decision.Provide appropriate and relevant calculations and assumptions to support yourdiscussion.

(18 marks)(b) Discuss the benefits and potential problems of financing assets in the same

currency as their purchase.

(7 marks)

(Total = 25 marks)

Question Three

PCO plc operates in oil and related industries. Its shares are quoted on the LondonInternational Stock Exchange. In its retailing operations the company has concentratedon providing high quality service and facilities at its service stations rather thancompeting solely on the price of petrol. Approximately 75% of its Revenue and 60% ofits profits are from petrol, the remainder coming from other services (car wash andretail sales from its convenience stores which are available at each service station).

The company has been highly profitable in the past as a result of astute buying ofpetroleum products on the open market. The company does not enter into supplieragreements with the major oil companies except on very short-term deals. However,profit margins are now under increasing pressure as a result of intensifying competitionand the cost of complying with environmental legislation.

The managing director of the company is assessing a possible acquisition that wouldhelp the company increase the percentage of its non-petroleum revenue and profits.OT plc specialises in oil distribution from the depots owned by the major oil companiesto their retail outlets. Its shares have been quoted on the UK Alternative InvestmentMarket for the past 2 years. It operates a fleet of oil tankers, some owned and someleased. PCO plc has used its services in the past and knows it has an up to date andwell-managed fleet. However, a bid for OT plc would almost certainly be hostile and, asthe directors and their families own 40% of the shares, a successful bid is far fromassured.

Extracts from PCO plc's Balance Sheet at 31 December 2003

£mAssets Employed 105.00Cash and marketable securities 95.00Accounts receivable and inventories (75.00)

Less current liabilitiesWorking capital 125.00Property, plant and equipment 160.00Less long term liabilities (80.00)Secured loan stock 7% repayable 2009 205.00



P9 PILOT PAPER 8

Shareholders' equityStated capital(Authorised £50 million)Issued 40.00Accumulated profits 165.00Net Assets Employed 205.00

PCO plc's financial advisors have produced estimates of the expected NPV and thefirst full year post-acquisition earnings of PCO plc and OT plc:

Estimated post-acquisitionearnings in first full year

following acquisition

Estimated NPV ofcombined organisation

PCO plc plus OT plc £70 million £720 million

Summary financial statistics

Last year endPCO plc

31 December 2003OT plc

31 December 2003

Shares in issue (millions)Earnings per share (pence)Dividend per share (pence)Share price (pence)

40106 32967

24 92 211020

Book value of fixed assetsand current assets less currentliabilities (£ million)Debt ratio (outstanding debtas % of total market value)Forecast growth rate % (constant, annualised)Beta co-efficient

285

17.0

50.9

145

14.0

91.2

Required:

(a) Calculate, for PCO plc and OT plc before the acquisition:

(i) The current market value and P/E ratio.

(ii) The cost of equity using the CAPM, assuming the return on the market is8% and the return on the risk free asset is 4%.

(iii) The prospective share price and market value using the dividend valuationmodel.

(6 marks)

(b) Discuss and advise on the following issues:

(i) The price to be offered to the target company's shareholders. You shouldrecommend a range of terms within which PCO plc should be prepared tonegotiate.

(ii) The most appropriate form of funding the bid and the financial effects(assume cash or share exchange are the options).



P9 PILOT PAPER 9

(iii) The business implications (effect on existing operation, growth prospects,risk and so on).

(19 marks)

Marks are split roughly equally between sections of part (b) of the question.

(Total = 25 marks)



P9 PILOT PAPER 10

Question Four

When determining the financial objectives of a company, it is necessary to take threetypes of policy decision into account: investment policy, financing policy and dividendpolicy.

Required:

(a) Discuss the nature of these three types of decision, commenting on how they areinter-related and how they might affect the value of the firm (that is the presentvalue of projected cash flows).

(12 marks)

(b) Describe the different functions of the treasury and financial control departmentsof an organisation and comment on the relative contributions of these twodepartments to policy determination and the setting and achievement of financialobjectives.

(13 marks)

(Total = 25 marks)

Question Five

BiOs Limited (BiOs) is an unquoted company that provides consultancy services to thebiotechnology industry. It has been trading for 4 years. It has an excellent reputation forproviding innovative and technologically advanced solutions to clients’ problems. Thecompany employs 18 consultants plus a number of self employed contract staff and isplanning to recruit additional consultants to handle a large new contract. The company"outsources" most administrative and accounting functions. A problem is recruiting well-qualified experienced consultants and BiOs has had to turn down work in the pastbecause of lack of appropriate staff.

The company's two owners/directors have been approached by the marketingdepartment of an investment bank and asked if they have considered using venturecapital financing to expand the business. No detailed proposal has been made but thebank has implied that a venture capital company would require a substantialpercentage of the equity in return for a large injection of capital. The venture capitalistwould want to exit from the investment in 4-5 years' time.

The company is all-equity financed and neither of the directors is wholly convinced thatsuch a large injection of capital is appropriate for the company at the present time.

Financial informationRevenue in year to 31 December 2003 £3,600,000Shares in issue (ordinary £1 shares) 100,000Earnings per share 756pDividend per share 0Net asset value £395,000 (Note 1)

Note 1The net assets of BiOs are the net book values of purchased and/or leased buildings,equipment and vehicles plus net working capital. The book valuations are considered toreflect current realisable values.



P9 PILOT PAPER 11

Forecast

• Sales revenue for the year to 31 December 2004 - £4,250,000. This is heavilydependent on whether or not the company obtains the new contract.

• Operating costs, inclusive of depreciation, are expected to average 50% ofrevenue in the year to 31 December 2004.

• Tax is expected to be payable at 30%.

• Assume book depreciation equals capital allowances for tax purposes. Alsoassume, for simplicity, that profit after tax equals cash flow.

Growth in earnings in the years to 31 December 2005 and 2006 is expected to be 30%per annum, falling to 10% per annum after that. This assumes that no new long-termcapital is raised. If the firm is to grow at a faster rate then new financing will be needed.

This is a niche market and there are relatively few listed companies doing preciselywhat BiOs does. However, if the definition of the industry is broadened the followingfigures are relevant:

P/E RatiosIndustry Average: 18Range (individual companies) 12 to 90

Cost of EquityIndustry average 12%Individual companies Not available

BiOs does not know what its cost of equity is.

Required:

(a) Calculate a range of values for the company that could be used in negotiation witha venture capitalist, using whatever information is currently available and relevant.Make and state whatever assumptions you think are necessary. Explain, briefly,the relevance of each method to a company such as BiOs.

(15 marks)

(b) Discuss the advantages and disadvantages of using either venture capitalfinancing to assist with expansion or alternatively a flotation on the stock market in2-3 years’ time. Include in your discussion likely exit routes for the venture capitalcompany.

(10 marks)

(Total = 25 marks)

End of question paper

Maths Tables and Formulae follow on pages 11-15



P9 PILOT PAPER 12

INDICATIVE MATHS TABLES AND FORMULAE

Present value table

Present value of 1·00 unit of currency, that is ( ) nr

−−1 where r = interest rate; n =

number of periods until payment or receipt.

Interest rates (r)Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.42410 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.38611 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.35012 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.31913 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.29014 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.26315 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.23916 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.21817 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.19818 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.18019 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.16420 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Interest rates (r)Periods(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.19410 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.16211 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.13512 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.11213 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.09314 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.07815 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.06516 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.05417 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.04518 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.03819 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.03120 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026



P9 PILOT PAPER 13

Cumulative present value of 1·00 unit of currency per annum, Receivable or Payable at

the end of each year for n years rr n−+− )(11

Interest rates (r)Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.75910 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145

11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.49512 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.81413 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.10314 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.36715 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606

16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.82417 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.02218 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.20119 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.36520 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Interest rates (r)Periods(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.03110 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.32712 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.43913 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.53314 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.61115 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675

16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.73017 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.77518 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.81219 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.84320 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870



P9 PILOT PAPER 14

FORMULAE

Valuation models(i) Irredeemable preference share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div

value:

P0 =

prefk

d

(ii) Ordinary (equity) share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value:

P0 =

ek

d

(iii) Ordinary (equity) share, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 isthe ex-div value:

P0 = gk

d

−e

1 or P0 =

gk

gd

−

+

e

0][1

(iv) Irredeemable (undated) debt, paying annual after-tax interest, i [1 – t], in perpetuity, where P0 is the ex-interestvalue:

P0 =

net

][1

dk

ti −

or, without tax: P0 =

dk

i

(v) Total value of the geared firm, Vg (based on MM):

Vg = Vu + TBc

(vi) Future value of S, of a sum X, invested for n periods, compounded at r% interest:

S = X[1 + r]n

(vii) Present value of £1 payable or receivable in n years, discounted at r% per annum:

PV = n

r ][1

1

+

(viii) Present value of an annuity of £1 per annum, receivable or payable for n years, commencing in one year,discounted at r% per annum:

PV =

+

−n

rr ][1

11

1

(ix) Present value of £1 per annum, payable or receivable in perpetuity, commencing in one year, discounted atr% per annum:

PV = r

1

(x) Present value of £1 per annum, receivable or payable, commencing in one year, growing in perpetuity at aconstant rate of g% per annum, discounted at r% per annum:

PV = gr −

1

FORMULAE CONTINUE OVERLEAF



P9 PILOT PAPER 15

Cost of capital(i) Cost of irredeemable preference capital, paying an annual dividend, d, in perpetuity, and having a current ex-

div price P0:

kpref =

0P

d

(ii) Cost of irredeemable debt capital, paying annual net interest, i [1 – t], and having a current ex-interest priceP0:

kd net =

0P

ti ][1 −

(iii) Cost of ordinary (equity) share capital, paying an annual dividend, d, in perpetuity, and having a current ex-divprice P0:

ke =

0P

d

(iv) Cost of ordinary (equity) share capital, having a current ex-div price, P0, having just paid a dividend, d0, withthe dividend growing in perpetuity by a constant g% per annum:

ke = gP

d+

0

1 or ke = g

P

gd+

+

0

0]1[

(v) Cost of ordinary (equity) share capital, using the CAPM:

ke = Rf + [Rm – Rf]ß

(vi) Cost of ordinary (equity) share capital in a geared firm (no tax):

keg = k0 + [ko – kd] E

D

V

V

(vii) Cost of ordinary (equity) share capital in a geared firm (with tax):

keg = keu + [keu – kd] E

D

V

tV ][1−

(viii) Weighted average cost of capital, k0:

k0 = keg

+

++

DE

D

DE

E

VV

Vk

VV

Vd

(ix) Adjusted cost of capital (MM formula):

Kadj = keu [1 – tL] or r* = r[1 – T*L]

In the following formulae, ßu is used for an ungeared ß and ßg is used for a geared ß:

(x) ßu from ßg, taking ßd as zero (no tax):

ßu = ßg

+

DE

E

VV

V

(xi) ßu from ßg, taking ßd as zero (with tax):

ßu = ßg

−+ ][1 tVV

V

DE

E



P9 PILOT PAPER 16

Other formulae(i) Interest rate parity (international Fisher effect):

Forward rate US$/£ = Spot US$/£ x rateinterestUKnominal1

rateinterestUSnominal1

+

+

(ii) Purchasing power parity (law of one price):

Forward rate US$/£ = Spot US$/£ x rateinflationUK1

rateinflationUS1

+

+

(iii) Link between nominal (money) and real interest rates:

[1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate]

(iv) Equivalent annual cost:

Equivalent annual cost = factorannuityyear

yearsovercostsof

n

nPV

(v) Theoretical ex-rights price:

TERP = 1

1

+N [(N x cum rights price) + issue price]

(vi) Value of a right:

Value of a right = 1

priceissuepriceonRights

+

−

N

or

N

priceissuepricerightsex lTheoretica −

where N = number of rights required to buy one share.



P9 PILOT PAPER 17

SOLUTIONS TO PILOT PAPER

Note:In some cases, these solutions are more substantial and wide ranging thanwould be expected of candidates under exam conditions. They providebackground on theorists, frameworks and approaches to guide tutors andstudents in their preparation, studies and revision.

SECTION A

Answer to Question One

Requirement (a)

(i) Calculations of NPVs

Alternative 1

Item Year 0 1 2 3�m �m �m �m

Revenue 0 4.48 11.80 17.60

Less costsFactory conversion -2.80Equipment -3.20 -4·80Redundancy costs -2.10Operating costs -4.07 -6.63 -8.66Net cash flows -5·30 -7.19 5·17 8.94Discount rate @ 9% 1·000 0·917 0·842 0·772Discounted cash flows -5·30 -6.59 4·35 6.90

Net present value of cash flows for first 3 years of operations = � -0.64 million

One approach to the calculation of terminal value would be to assume, conservatively,that cash flows would only maintain for 8 years, that is until the first date the equipmentmay need to be replaced. The figures would be:

�mNPV to end year 3 -0.64PV of after-tax cash flows from year 4 to year 8 24.03 (note 1)Less opportunity cost of CC from year 1 to year 8 -12.18 (note 2)

Total NPV 11.21 million

Notes:

1. This is � 8.94 million multiplied by 80% (year 3’s after-tax cash flow) increased by4% for growth and multiplied by the appropriate year’s discount factor for each ofthe year’s 4 to 8.

2. This is � 2.2 million multiplied by the eight-year 9% cumulative present valuefactor (5.535).



P9 PILOT PAPER 18

Examiner’s NoteAn alternative approach would be to use the constant growth version of thedividend valuation model (substituting earnings for dividends) to calculatevalues beyond year 3. As JHC Group expects constant growth in earningsof 4% per annum, it might be reasonable to assume an annual 4% growthin earnings of a new venture. The NPV would then become:

�mNPV to end year 3: -0.64PV of cash flows from year 4onwards

114.84 [(8.94 x 0.8 x 1.04 x 0.772)/(0.09 - 0.04)]

Less Opportunity cost of lostrevenue from CC(Assuming no growth)

-24.44 (2.2/.09)

Total NPV (value to firm) �89.76

However, there are a lot of assumptions here and we really need estimates of thereplacement costs of the equipment to obtain a more realistic figure. A value atthe lower end of the range �11.21 million to � 89.76 million is probably moreappropriate given the finite life of the equipment.

Alternative 2

Item Year 0 1 2 3�m �m �m �m

Revenue 7.80 9.68 13.13

Less: CostsFactory conversion -2.80Equipment -4·50Redundancy costs -0·42Operating costs -3.06 -3.44 -4.13Net cash flows -4.92 1.94 6.24 9.00Discount rate @ 9% 1·000 0·917 0·842 0·772Discounted cash flows -4.92 1.78 5.26 6.95

Net present value of cash flows for first 3 years of operations = � 9.07 million

As with Alternative 1, one approach to the calculation of terminal value would beto assume that cash flows would only maintain for 6 years, that is until the firstdate the equipment is likely to need to be replaced.

Note: The capital cost is payable when factory conversion is complete, sodiscounting at the half year rate, or even the 1 year rate, given the instruction onfactory conversion costs in the question, would be acceptable.

�mNPV to end year 3 9.07PV of after-tax cash flows from year 4 to year 6 15.20 (note 1)Less opportunity cost of CC - years 1 - 6 -9.87 (note 2)Total NPV 14.40



P9 PILOT PAPER 19

Notes:

1. This is �9.00 million multiplied by 0.8 (year 3’s after tax cash flow) increased by4% growth multiplied by the appropriate year’s discount factor for each of theyear’s 4 to 6.

2. This is �2.2 million multiplied by the six-year 9% cumulative present value factor(4.486).

Examiner’s NoteAn alternative approach here also is to use the perpetuity formula tocalculate values beyond year 3. The NPV would then become:

�mNPV for years 1-3 9.07PV of cash flows from year 4onwards

115.61[(9.00 x 0.8 x 1.04 x 0.772)/(0.09 - 0.04)]

Less Opportunity cost of lostrevenue from CC

-24.44 (2.2/0.09)

Total NPV (value to firm) 100.24

A value somewhere between �14 million and �100 million is suggested. As withAlternative 1, there are a lot of assumptions here and we really need estimates ofthe replacement costs of the equipment to obtain a more realistic figure. A valueat the lower end of the range is probably more appropriate given the finite life ofthe equipment.

Examiner’s Note

Equivalent annual annuities (EAA) could also be calculated, assumingAlternative 1 ceases in year 8 and Alternative 2 in year 6:

NPV EAA�m �m

Alternative 1 11.21 2.025 (11.21/5.535)Alternative 2 14.40 3.210 (14.40/4.486)

The equivalent annual annuity (EAA) approach seeks to determine theconstant annual cash flow that offers the same present value as theproject's NPV. This is found by dividing the project's NPV by the relevantannuity discount factor. The figures here support the choice of Alternative 2that was already suggested by the NPV calculations.

Assumptions

• That the WACC is the appropriate discount rate to use in the evaluation. Thismay not be the case and is discussed further in requirement (b), the report.

• For Alternative 1, we accept the supplier’s offer to pay a 50% deposit to holdconstant the purchase price. This may not be to our advantage and is discussedfurther in requirement (b), the report.



P9 PILOT PAPER 20

• CC would continue to earn � 2.2 million a year indefinitely. This may not berealistic, but provides an estimate that can be adjusted when we fine-tune theevaluation.

• Cash flows beyond the third year of operations are estimated based on year 3’scash flows and assuming constant growth at 4%. Again, this may not be realistic,but provides a basis for discussion.

(ii)

The process for calculating MIRR is:

• An outflow in year 0 and a single inflow at the end of the project life is assumed.

• Cash flows after the initial investment are converted to a single cash inflow byassuming that the cash flows are reinvested at, usually, the cost of capital.

• MIRR is calculated by dividing the outflow by the single inflow, using PV tablesand interpolation to arrive at the discount rate, or MIRR.

MIRR is intended to address some of the deficiencies of IRR, for example:

• It eliminates the possibility of multiple rates of return;

• It addresses the reinvestment issue;

• MIRR rankings are consistent with the NPV rule, which is not always the casewith IRR.

However, there are weaknesses:

• If the reinvestment rate is greater than the cost of capital, then MIRR will under-estimate the project's true return;

• The determination of the life of the project can have a significant effect on theactual MIRR if the difference between the project's IRR and the company's cost ofcapital is large;

• The MIRR, like IRR, is biased towards projects with short payback periods;

• It does not appear to be understood or used extensively in practice;

• In the case here, we are evaluating two mutually exclusive projects with differentlife spans. The argument for using MIRR is therefore weak.



P9 PILOT PAPER 21

Requirement (b)

Report

To: Directors of JHC Group

From: Financial Manager

Subject: New subsidiary – SP

Introduction

Contents of report

(i) Estimated net present value of SP under 2 alternatives.

(ii) Contribution to attainment of group objectives and likely impact of the newsubsidiary on the Group’s share price and market value.

(iii) Recommendation of a preferred alternative.

(i) Estimated net present value for SP

Two alternatives are proposed:

Alternative 1 assesses the revenues and costs assuming we purchase advancedequipment.

Alternative 2 assumes we use “old” technology with minor improvements.

Workings for the revenues and costs for both alternatives are shown in the answer torequirement (a). In summary the financial performance of the two alternatives is asfollows (all figures in �millions):

Alternative 1 Alternative 2NPV over 6 or 8 years 11.21 14.40NPV as a "perpetuity" 89.76 100.24EAA 2.025 3.210

On the basis solely of the financial performance, alternative 2 is the better choice.

(ii) Contribution to the Group’s objectives.

OBJECTIVE 1• The new subsidiary is small and would increase Group revenue by less than 1%

in the first full year of operations under both alternatives, assuming current grouprevenue remains constant or increases. Also, loss of sales revenues by CC wouldhave to be made up before any overall increases in revenues occurred.

• In year 1, alternative 2 will make a small contribution to cash flow (but stillnegative on a cumulative basis), but alternative 1's cash flows are negative untilyear 2 and the project only begins to pay back in the second half of year 3.



P9 PILOT PAPER 22

• The loss of CC's earnings will not be compensated in the first year of operationsand so, in the immediate future, the proposal will be detrimental to the Group'sobjectives.

• The question must be asked whether the Group could not expend its resources,both financial and human, more effectively. There will be little impact on dividendsunder either alternative.

OBJECTIVE 2• Both alternatives would contribute to some extent. Using the estimated “bottom of

the range” figures in section 1 and shareholder value analysis, and assuming allother things are held constant, the effect on the company’s share price andmarket capitalisation would be as follows:

Alternative 1 Alternative 2�m �m

Current market value of the JHC Group 2908.50 2908.50Value of SP 11.21 14.40Total 2919.71 2922.90

Revised share price 8.34 8.35Current share price 8.31 8.31Increase 3 cents 4 cents

• Both alternatives would add to shareholder wealth, but the increase is negligible.However, in theory, any increase would contribute to the first part of our secondobjective, and there is little to choose between them in respect of contribution tothis objective.

• Alternative 2 would minimise the adverse effects on the workforce, but may notbe as beneficial to the other stakeholders if we assume the legislation is intendedto benefit the health of the population at large as Alternative 1.

Examiner’s Note:The effect on shareholder wealth does of course depend on theassumptions made. Any attempt using sensible assumptions would gaincredit.

(iii) Recommendation

Factors to consider:

• The two alternatives have to be weighed against the continuation of CC'soperations. This is allowed for in the valuation, but some strategic evaluation isneeded. If CC is operating at only 60% capacity and has an NPV below bothalternatives, then discontinuation of this subsidiary's operation seems a logicaldecision. No information is given on whether any action could be taken toincrease CC’s productivity. It has to be assumed that this subsidiary is in decline,but it is worth asking the question.

• The decision must take into account other factors such as relative risks and futurestrategy of the group.



P9 PILOT PAPER 23

• On the basis of the increase in shareholder wealth, Alternative 2 is to bepreferred. This also means fewer staff are made redundant. On these criteria, thisalternative contributes most to the Group’s second objective. On general healthand welfare issues, Alternative 1 would contribute more.

• Neither alternative will contribute much to the Group’s objective to increase bothoperational cash flows and dividends by 4% each year.

• In summary, the question has to be asked whether we should be putting so mucheffort into pursuing the establishment of such a small subsidiary unless there areother issues to consider, for example the effect on other subsidiaries.

Signed: Financial Manager

Requirement (c)

In the context of investment decisions, there are three options to be considered:

• The abandonment option;

• The timing option;

• The strategic option.

The abandonment option

• Major investment decisions involve heavy capital commitments and are largelyirreversible; once the initial capital expenditure is incurred, management cannotturn the clock back and act differently.

• Because management is committing large sums of money in pursuit of higher, butuncertain, payoffs, the option to abandon, or “bail out”, should things look grimcan be valuable.

• Abandonment possibilities can reduce the riskiness of a project and increase theexpected NPV of certain types of project which would otherwise produce largenegative NPVs if they could not be abandoned in the event that things do notwork out. Also, the investment could be repeated.

• In the case of SP, the company could defer payment of the equipment forAlternative 1 and risk the 5% increase in cost. This is a high price to pay for anabandonment option on an investment that will have already incurred somecapital costs, redundancy payments and loss of earnings from the closure of CC.

• In the case of Alternative 2, the equipment can be purchased any time. There willhave been some expenditure made as soon as the decision is taken, but as thefactory conversion will take six months, the company can choose to abandon thecapital expenditure at any time within those six months.

The timing option

• The example here not only introduces an abandonment option, it also raises theoption to “wait and see”. Management may have viewed the investment as a“now or never” opportunity, arguing that in highly competitive markets there is noscope for delay: money is made by staying ahead of the competition. In effect,this amounts to viewing the decision as a call option which is about to expire onthe new plant for the capital investment outlay. If a positive NPV is expected, the



P9 PILOT PAPER 24

option will be exercised, otherwise the option lapses and no investment is made.

• The option to defer the decision by, say, one year until the outcome of thegovernment's deliberations on health and safety issues becomes known, makesobvious sense. An immediate investment would yield either a negative NPV – inwhich case it would not be taken up – or a positive NPV.

• Delaying the decision by a year to gain valuable new information is a morevaluable option. This helps to understand why management sometimes does nottake up apparently wealth-creating opportunities; the option to wait and gathernew information is sufficiently valuable to warrant such delay.

The strategic investment option

• Certain investment decisions give rise to follow-on opportunities that are wealthcreating. New technology investment is particularly difficult to evaluate. Managersrefer to the high level of intangible benefits associated with such decisions -meaning that these investments offer further investment opportunities (forexample, greater flexibility).



P9 PILOT PAPER 25

SECTION B

Answer to Question Two

Requirement (a)

NPV of investmentThe investment produces a negative NPV as follows:

Capital cost $1,500,000 @ 1.58 = 949,367Cost savings @ 9% for 5 years

£240,000 x 3.89 933,600NPV -15,767

• This suggests that, as an investment evaluated at the company's post-tax cost ofequity capital over 5 years, it is not financially sustainable.

• However, the tax advantages of debt might convert the investment into a positiveNPV project.

(i) Financing with undated debtIf undated debt of, say, £950,000 is used to finance the investment there will be taxsavings in perpetuity. However, as RZ evaluates investments over 5 years, it is(arguably) reasonable to take into account only 5 years' worth of tax savings for thisparticular investment decision:

£950,000 x 7% x 30% = £19,950PV = £19,950 x 3.89 = £77,605

The adjusted NPV therefore becomes-£15,767 + £77,605 = £61,838

• This assumes the discount rate to apply to the tax savings on the interestpayments is the company’s cost of capital. There is a strong case for using theafter tax cost of debt (7% x [1 - 0.30] = 4.9%, say 5%). In this case the adjustedNPV would increase by £8,759 to £70,597 (tax savings would be £19,950 @4.329 – the cumulative discount factor for 5 years @ 5% = £86,364).

• A problem here is that long-term debt is being used to finance what the companyviews as a medium term investment. Consideration would have to be given tohow the debt would be serviced at the end of the investment's life.

Advantages• Interest payments are tax deductible.

• Does not dilute share ownership or EPS, although in the case here this isprobably not a concern.

• Probably cheaper and easier to administer.

Disadvantages• Risk of bankruptcy if interest payments not met. RZ has revenue of £68 million

and earnings of £4.5 million. Interest payments are therefore comfortablycovered.



P9 PILOT PAPER 26

(ii) Financing with a finance lease

• Leasing may be considered a direct alternative to medium term debt rather thanlong-term debt. The advantages and disadvantages of a finance lease comparedto equity are therefore similar to those for debt.

• The most appropriate method of evaluation is to compare the cash flowsassociated with debt with the cash flows associated with leasing. See attachedtable.

This shows there is a net advantage of £29,343 of buying with debt. However, much ofthis advantage is based on the estimated residual value of the machinery.

Other factors to consider are:

• An advantage of leasing might be that it is paid off in 5 years but the companyhas debt in its capital structure for much longer. Whether this is important or notis related more to the attitudes of management than economic factors. Leasing isnot "off balance" sheet - if it ever was - so there should be no effect on ratios.

• An advantage of leasing shown by empirical studies is that leasing is oftenconsidered more convenient to arrange and involves lower issue costs than eitherdebt or equity.

• The tax treatment needs more detailed consideration.

(iii) Financing with an operating lease

The main difference between a finance lease and an operating lease is who bears therisk. With a finance lease it is the lessee, with an operating lease it is (usually) thelessor. An operating lease is more akin to rental or hire purchase than to new capital.The main advantages are:

• Usually it can be cancelled at break points in the lease.

• Although commitments of the lease should be disclosed in notes to the accounts,the machines would not appear as assets in the balance sheet, which may havea favourable effect on ratios. As this is a private company and the directors aremajor shareholders, this is probably not a concern.

• Associated costs such as insurance, maintenance and so on may be wrapped upin the lease charge – this may or may not be advantageous to the lessee.

The main disadvantages are:

• Cost – more expensive than other methods of finance, although there may wellbe tax issues, which would require more information than given in the scenario toevaluate properly.

• May not be available on this type of machinery.



Year 0 1 2 3 4 5 Totals

Lease payments -325,000

Lease cash flows$ rental payments -325,000 -325,000 -325,000 -325,000 -325,000 -1,625,000In £ -205,696 -207,703 -209,729 -211,776 -213,842 -1,048,746Tax savings 61,709 62,311 62,919 63,533 64,152 314,624

Net lease cash flows -205,696 -145,994 -147,418 -148,857 -150,309 64,152 -734,122

Buy/borrowOutlay -949,367 -949,367Residual value 94,937 94,937Tax savings 71,203 53,402 40,051 30,039 61,634 256,329Net cash flows -949,367 71,203 53,402 40,051 30,039 156,571 -598,101

Net incremental cash flows -743,671 217,197 200,820 188,908 180,348 92,419 136,021PV @ 5% 1 0.952 0.907 0.864 0.823 0.784

-743,671 206,771 182,144 163,217 148,426 72,456 29,343Net advantage of purchase withdebt

29,343

Capital allowancesPurchase cost 949,367

CA @25%

Tax relief@ 30%

Year 1 allowances 237,342 71,203WDV end Year 1 712,025Year 2 allowances 178,006 53,402WDV end Year 2 534,019Year 3 allowances 133,505 40,051WDV end Year 3 400,514Year 4 allowances 100,129 30,039WDV end Year 4 300,385Residual value 94,937 0Balancing allowance 205,448 61,634Total 256,329







P9 PILOT PAPER 28

(b) Benefits and potential problems of financing assets in the same currency astheir purchase

Benefits

• Exposure to currency fluctuations is minimised as the value of the asset andthe value of the liability are matched, assuming the loan is repaid in instalmentsbroadly equal to depreciation.

• Interest payments would (presumably) be made in the foreign currency andpaid overseas which would further aid the matching principle.

• There might be cheap finance available in the overseas country to giveadvantage to US exporters.

• Debt financing is cheaper than equity wherever raised as it has tax effects andis (usually) lower risk than equity. However, the tax situation is difficult tocomment on without knowledge of detailed tax regimes and treaties betweenthe two countries.

• The decision is a matter of judgement and depends, to some extent, on howrisk averse the company is. However, hedging is an alternative option, whichwould minimise the risks.

Potential problems

• Changes in exchange rates between decision to buy and finance, unless madesimultaneously.

• Introduction of exchange controls during the life of the finance contract.

• Better finance deals may be available elsewhere, despite the currency risk.



P9 PILOT PAPER 29

Answer to Question Three

Requirement (a)

(i) – P/E Ratios and Market Values

PCO plc OT plcInformation in case (shown here for convenience)EPS - pence 106 92Share price - pence 967 1,020No of shares in issue(millions)

40 24

P/E Ratio 9.1 11.1(SP/EPS)

Market Value (£M) 386.8 244.8(No of shares * SP)

(ii) - Cost of equity using CAPMPCO plc OT plc

Ke = Rf + B(Rm - Rf)RF rate (given) 0.04 0.04Market return (given) 0.08 0.08Beta 0.9 1.2Cost of Equity 7.6% 8.8%

(iii) - Share price and market value using DVM

Po = D1/(Ke - g)

Share price - pence 1,292 n/a[(32p x 1.05)/(0.076 - 0.05)] [(21p x 1.09)/(0.088 - 0.09)]

Market value - £ million 517 n/a

Requirement (b)

Advice on price and form of funding

(i) Price to be offered

• The market value of OT plc can be determined most easily by reference to thecurrent share price.

• The constant growth version of the DVM will not work because estimatedgrowth is greater than the cost of equity. It would be possible to use anadjusted version of the model but information on future cash flows would benecessary.

• Using current market values, PCO plc is worth £387 million and OT plc, £245million, a total of £632 million before any acquisition gains.

• The financial advisors have estimated that the NPV of the combinedcompanies is £720 million, a post-acquisition gain of £88 million.

• The price to be offered will depend on the negotiating abilities of the twocompanies. Clearly, PCO plc will not be able to retain all, or possibly evenmost, of the acquisition gains.



P9 PILOT PAPER 30

• A key factor may be that it is likely to be a hostile bid. This will inevitably raisethe price to be paid and most research has shown that hostile bids result in afall in wealth for the bidder's shareholders.

• A realistic starting point may be to allocate the gains in the proportion of therelative current market values of the two companies. This would be £88 millionin the proportions 61% and 39%.

• This would mean PCO plc would take £54 million of the gain and OT plc £34million.

• The price to be offered would, therefore, be £279 million (£245 million marketvalue + £34 million share of merger gains) or 1,162 pence per share.

• PCO plc would also, presumably, take on OT plc’s outstanding debt ofapproximately £40 million, but the terms of the debt contract would need to beinvestigated.

(ii) Form of funding

CASH• PCO plc could not offer cash without raising additional debt funding.

• Assuming it was prepared to use all its cash reserves of £105 million(assuming the balance has not been used recently) this would mean anadditional £174 million debt, or £214 million if OT plc’s £40 million debt has tobe repaid under the terms of the debt contract and PCO plc is required to re-finance it.

• PCO plc’s debt ratio (debt as a proportion of market value) would then increasesubstantially – much would depend on how the share price moved following theacquisition. If the market value of the combined group is worth £632 million,then the gearing in market value terms (assuming debt trading at par) wouldrise from 17% to 29%. This might be quite acceptable, although the effect onthe cost of capital must be considered.

SHARES• The opening bid would be based on current market prices, i.e. 967 pence and

1,020 pence.

• Suggests an exchange ratio of 1.05 of a PCO plc share for every OT plc share,which would almost certainly be rejected as inadequate, as OT plc’sshareholders would have no incentive to accept the offer.

• If all the gains were to be given to OT plc’s shareholders the share price wouldbe 1,387 pence for OT plc (£333 million/24 million). This would suggest a ratioof 1.43 PCO plc shares per OT plc share, and 34.32 million new shares wouldneed to be issued to OT plc shareholders.

• If first year earnings are forecast as £70 million, this would be an EPS of 94.3pence – a decline on current EPS for PCO plc, which might not satisfyshareholders.

• A strong statement from management would be needed.

• PCO plc has only 50 million shares authorised and 40 million are issued. Ashare offer would require increasing authorised share capital. This might give asignal to the market that PCO plc might be considering a bid for a largecompany, which would have an effect on the share price. Whether this is up ordown would depend on market perceptions and sentiment towards PCO plc atthe time. If the share price rose, then this is to PCO plc's advantage in any



P9 PILOT PAPER 31

share exchange. If it fell, then a share exchange might be considered unwise.

COMBINATION• A combination offer could be considered; for example, shares plus cash or

shares plus debt.

(iii) Business implications

• It is likely to be a hostile bid, which will involve extensive advisors' costs andPCO plc will probably eventually pay all acquisition gains (and possibly more)to OT plc’s shareholders.

• Advantages include the diversification aspects of the acquisition, which is afterall why PCO plc wants to acquire another company. However, PCO plc has noexperience of the industry.

• OT plc operates in an area in which PCO plc does not have any particularexpertise, so it is difficult to see where any additional value can be created.Some synergies as a result of vertical integration might be claimed but theseare likely to be small, and accompanied by a reduction in PCO plc's flexibility tochange suppliers. It is in the oil business so, again, it does not really look like adiversification move.

• The required investment is likely to be large by PCO plc's standards. Thecompany would be taking on a substantial amount of debt in the form of OTplc's existing borrowings. A rights issue is possible, perhaps conditional uponthe bid being successful.

• A share offer would need to be a bit above one-for-one, given the currentmarket prices. This would require a prior increase in PCO plc's authorisedcapital, since only 10 million shares remain unissued, and might give a signalthat an acquisition was being considered. A possibility is a choice betweenshares in PCO plc or cash. Provided no more than half of OT plc'sshareholders opted for cash, this would leave a reasonable capital structurebut, to be comfortable, the company would still need to increase authorisedshare capital.

• An evaluation of the acquisition should look in more detail at effect on businessgrowth, risk of the company, effect on capital structure and cost of capital andso on.

• An exercise to identify other possible acquisitions targets could (should?) belaunched.



P9 PILOT PAPER 32

Answer to Question Four

Requirement (a)

Three types of decision

Investment decisions involve:• The analysis and appraisal of capital expenditure projects, acquisitions,

mergers and divestments, together with the related committal of funds.

• Decisions relating to working capital and trade investments, with the aim ofmaintaining satisfactory returns for the organisation.

Financial controllers will assess the likely cash flows of the various alternatives andidentify the one which shows the maximum NPV.

Financing decisions relate to:• The obtaining of suitable and adequate funds with which to operate the

business.

• The desired level of gearing represented by the most appropriate combinationof short, medium and long-term debt together with equity, including internallygenerated funds.

If capital needs to be raised, managers will seek the mix of sources which minimisesthe weighted average cost of capital.

Dividend decisions are: • Based in part on making payments to shareholders, which will currently satisfy

their desired long-term rate of return on investment and thereby help tomaintain the company's share price.

• Based in part on retaining sufficient profits to sustain and advance the level ofoperations to secure the shareholders' aspirations for the future.

The key decision is whether the shareholders would be better off having money nowor allowing it to be reinvested in the business to produce a higher level of cash flow inthe future.

All three types of decisions are inter-related, thus the financing decision will affect thecost of capital, and as a consequence, the net benefits obtainable from a particularproject, thereby influencing the investment decision, while the financing decisionconcerning gearing will affect both the other decisions.

The dividend decision, in determining the level of retentions, will affect the cashavailable for investment, and the extent to which external sources of funds need tobe sought in financing to optimise operations.



P9 PILOT PAPER 33

Requirement (b)

Treasury and Financial Control DepartmentsIn summary, a Treasurer handles the acquisition and custody of funds whereas theFinancial Controller has responsibility for accounting, reporting and control.

CIMA Official Terminology describes the treasury function as the function concernedwith the provision and use of finance. The main functions of such a departmentinclude:

• establishment of corporate financial objectives;

• managing the firm's liquid assets; cash, marketable securities and so on;

• management of the company's funding; determination of policies, identifyingsources and types of funds;

• corporate finance and related issues such as taxation, pension fund investmentand so on (although these functions are sometimes performed by thecontroller);

• in a multinational, dealing with currency management - dealing in foreigncurrencies, hedging currency risks and so on.

The financial control function is mainly concerned with the recording and reporting offinancial information such as:

• preparation of budgets and budgetary control;

• preparation of periodical financial statements such as monthly accounts,annual accounts;

• management and administration of activities such as paYearoll, internal audit(which in some cases may be a separate department responsible directly to theFinance Director).

It is therefore apparent that the Treasury Department has main responsibility forsetting corporate objectives and policy and Financial Control has the responsibility forimplementing policy and ensuring the achievement of corporate objectives. Thisdistinction is probably far too simplistic and, in reality, both departments will makecontributions to both determination and achievement of objectives.

There is a circular relationship in that Treasurers quantify the cost of capital, whichthe Financial Controllers use as the criterion for the deployment of funds; FinancialControllers quantify projected cash flows which in turn trigger Treasurers' decisionsto employ capital.

In smaller firms the functions of treasury and financial control may be combined andeven in larger firms the two functions often include related activities, for examplemanagement of cash. Although the Financial Controller has the main reportingresponsibilities, the Treasurer will, typically, report on cash flows and cashmanagement. In some cases who has responsibility for certain activities is not clearcut. For example credit control, taxation, insurance or pensions are sometimeshandled by the Treasury department and sometimes by the Financial Controller'sdepartment.



P9 PILOT PAPER 34

Answer to Question Five

Requirement (a)

Range of valuesThere are three basic methods we could use to value an unquoted company such asBiOs Limited (BiOs): asset value, P/E ratio basis and discounted cash flow basis.Each is discussed in turn.

Asset value• The book value of BiOs' net assets is a little under £400,000 at the last balance

sheet date.

• This value has little relevance except in specific circumstances such as aliquidation or disposal of parts of a business. In BiOs' situation it has even lessrelevance than in a company with a high level of tangible assets, as much ofthe value is in employees' expertise, or intellectual capital.

• Assuming the amount in the balance sheet does reflect realisable value thenthis is a "floor" level valuation, but of little real relevance in the circumstanceshere.

P/E Ratio• In a listed company the P/E ratio is used to describe the relationship between

the share price (or market capitalisation) and earnings per share (or totalearnings). It is calculated by dividing the price per share by the earnings pershare.

• Market capitalisation is the share price multiplied by the number of shares inissue. Market capitalisation is not necessarily the true value of a company as itcan be affected by a variety of extraneous factors, but for a listed company itprovides a benchmark that cannot be ignored.

• In the case of an unlisted company, a P/E ratio that is representative of similarquoted companies might be used as a starting point for arriving at an estimatedmarket value, based upon the present earnings of the unlisted company. Thepotential market capitalisation would be the company's latest earningsmultiplied by the benchmark P/E ratio.

• The P/E ratio can be viewed as indicative of expected growth, which is whysome companies in the industry have very high P/E ratios. A relatively high P/Ewould suggest that investors are prepared to pay a premium for the company'sshares, based upon present earnings, because they anticipate growth in futureearnings beyond growth rates expected in comparable companies.

• The potential value of BiOs using the average and range of P/Es for theindustry is as follows:

BiOs’ earnings in 2003: £756,000 (100,000 shares at 756p EPS)

P/E Ratio 12 18 90

Estimated value (£000) 9,072 13,608 68,040

• This valuation is very rough and ready and takes no real account of BiOs’specific circumstances and potential.

• It would be possible to estimate a more precise P/E ratio based on forecastgrowth rates, but this is complicated by two years of expected super-growth



P9 PILOT PAPER 35

followed by a much lower rate after that.

• The average P/E ratio of the industry applied to next year's expected earningsof £1,487,500 [Sales revenue of £4,250,000 x 50% x (1 – 0.3)] might be moreappropriate and would give an estimated market capitalisation of £26.775million.

Note: Any sensible combination of earnings and P/E ratio would be acceptable here.

Discounted Cash FlowThis method values BiOs using the directors' cash flow forecasts based on expectedsales growth and associated costs. The approach is as follows:

1. Estimate sales income.

2. Calculate earnings/cash flows for the years 2004-2006 based on yourestimates of growth. Assuming earnings equals cash flows is a simplificationfor examination purposes. In reality this would be affected by, for example:depreciation, movements in working capital, and sale and purchase of non-revenue items.

3. Calculate discounted cash flows using the industry average cost of capital of12%.

4. Estimate the present value of cash flows from 2006 to infinity using thedividend valuation model. This again is an oversimplification but provides auseful "short cut". BiOs has not in the past paid any dividends but the earningsfigure is equally acceptable: the basic form of the model assumes all earningsare paid as dividends.

5. Add the present value of all future estimated cash flows.

Estimation of earnings and cash flows for 2004-2006 (£000s)

Year to: 31 December 2004Revenue 4,250Operating costs -2,125Tax at 30% -637

Earnings/cash flow 1,488

Estimation of cash flows for 2005-2006 (£000s)

2005 = £1,488 * 1.30 = 1,9342006 = £1,934 * 1.30 = 2,514



P9 PILOT PAPER 36

Discounted cash flows for 2004-2006

Year Cash Flows Discount factor at12%

DCF£000

2004 1,488 .893 1,3282005 1,934 .797 1,5412006 2,514 .712 1,790Total 4,659

Estimation of value of cash flows from 2007 to infinity

Earnings in 2007 assuming 10% growth on 2006: £2,514 * 1.1 = £2,765In today's money, D1 = £2,765 * 0.712 = £1,969Po = D1/ke – g

= 1,969/(0.12 – 0.10) = £98,450

[Note: Any sensible attempt to calculate the value of cash flows to infinity, andrecognition that it is in fact necessary, will gain credit.]

Present value of all future estimated cash flows

2004 - 2006 = 4,6592007 onwards = 98,450Total 103,109

This method suggests a company valuation of just over £100 million.

Summary of methods and values£000s

Asset value 395P/E based value(industry average) 13,608 (or £26,775 if 2004 earnings used)DCF value 103,000

• As discussed, the asset value is largely irrelevant and the P/E basis is highlyunreliable because of difficulties in comparing one company with another. TheDCF method is the most likely to be reliable but the figures produced are veryrough and ready and assume constant growth to infinity, which is fairlyunrealistic.

• A more detailed exercise needs to be undertaken. Points to consider are:

• How is revenue to grow by rates suggested when the limiting factor isqualified staff?

• What is the true cost of capital?

• How will operating costs fall from 70% of revenue to 50% in 2004 andbeyond?

70% is calculated as:EPS of 756p x 100,000 shares = £756,000Pre-tax this is 756,000/0.7 = £1,080,000As a percentage of sales this is 1,080/3,600 x 100 = 30%Therefore, operating costs = 70%



P9 PILOT PAPER 37

Requirement (b)

Venture capital finance versus flotation• Even if a company valuation of around £100 million is accepted, this is still

relatively small for a full listing. A listing on the AIM might be an acceptablealternative and less expensive although the relative length of the "queues" forlisting (controlled by the Stock Exchange) needs to be considered.

• The main advantage of any sort of listing is that it provides a readily availablebenchmark valuation for the shares. However, the number of shares to be soldneeds serious consideration. If a small percentage of the shares is sold, thismay deter institutional investors as there may not be a ready market in theshares if they want to sell. If a high percentage is issued, control is lost.

• If venture capital finance were to be sought, control would be surrenderedanyway as these organisations require a large equity stake, high returns andan assured exit route.

• Typically, an exit route would be to sell the shares on the market either via aplacing or offer for sale or to another venture capital company. The originalowners of the firm might be able to buy back their shares via an earn-out basis.This method allows the venture capitalist to sell shares back to the owners onthe basis of the company achieving certain levels of return.

• No details of what investment would be required to allow the company to growat a faster rate is given in the question. In a company such as this, the value isin the intellectual capital and this is clearly in short supply.

• Before deciding on a course of action the directors must clarify their short andlong-term objectives. If the aim is to maximise personal wealth in the shortestpossible time, then an early flotation is probably the best alternative. If controlis important then other alternatives might be more appropriate. Other issues toconsider are:

• timing and cost of a flotation, and how many other similar companiesmight be coming to market at the same time;

• the implications of any likely changes in industry regulation.



P9 PILOT PAPER 38



P9 PILOT PAPER 39



P9 PILOT PAPER 40



The Chartered Institute of Management Accountants 2005

Financial Management Pillar

Strategic Level Paper

P9 – Management Accounting Financial Strategy

25 May 2005 – Wednesday Morning Session

Instructions to candidates

You are allowed three hours to answer this question paper.

You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, make annotations on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time.

You are strongly advised to carefully read the question requirement before attempting the question concerned. The question requirements are contained in a dotted box.

Answer the ONE compulsory question in Section A on pages 2 to 5. The question requirements are on page 5, which is detachable for ease of reference.

Answer TWO of the four questions in Section B on pages 8 to 15.

Maths Tables and Formulae are provided on pages 17 to 21. These are detachable for ease of reference.

Write your full examination number, paper number and the examination subject title in the spaces provided on the front of the examination answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close.

Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

P9 –

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P9 2 May 2005

SECTION A – 50 MARKS [the indicative time for answering this Section is 90 minutes]

READ THE SCENARIO AND ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One

Scenario Business background – The Groots Group The Groots Group (Groots) is a retailer of clothing for women and children. The group started as a single store in France in the early 1900s. The business grew by acquisition of new premises and, occasionally, by buying out small competitors. Expansion outside France started in 1955 and the group now has stores in most European cities. The parent company obtained a listing in 1968, although at that time the founding family still owned the majority of the shares. It is no longer controlled by the family although the grandson of the founder is a board member and owns 2% of the share capital. The company’s other directors and senior managers own a further 8% between them.

The style of clothing sold in the Group’s stores has changed over the years and its main theme now might be described as “ethnic”. Most of its goods are manufactured outside Europe, predominantly in India and other parts of Asia.

Corporate objectives Groots has two financial objectives and one non-financial objective. These are:

• to increase earnings and dividends per share year on year by 5% per annum;

• to maintain an optimal debt/equity ratio within the range 25-30%;

• to adhere to ethical trading policies and recognise the interests of our various stakeholder groups in all our business activities.

Proposed acquisition The directors of Groots believe they have exhausted possibilities for further expansion in Europe unless they are to diversify into different products such as men’s clothing or household goods. They have, therefore, been reviewing opportunities for investment further afield for the past year. They have identified a small group of clothing stores trading in the East Caribbean and parts of South America, Cocomos Limited (Cocomos).

Cocomos is a listed company whose shares trade on an East Caribbean Stock Exchange. It has 18 stores as outlets for its products. Twelve of them are operated by the company itself and six are operated by franchisees. The clothing is at the expensive end of the market and aimed mainly at tourists.

Cocomos has followed a policy of buying locally-made clothing from within the Caribbean, Cuba or Puerto Rico, mainly from small co-operative-type manufacturers. The advantage of this policy is that the cost base is low, allowing for a substantial mark-up to retail. The disadvantage is that the quality is variable. If the acquisition proceeds, Groots would aim to review the product sources to improve the quality and expand the range. One alternative would be to supply the stores from sources in India, which already supply some of the European stores.

The directors of Cocomos and their families own 51% of the shares. A further 15% of the shares are owned by a local pension fund. The remaining 34% are owned by a number of wealthy individual investors, including a few who live most of the time in Europe or Canada.

Cocomos’ directors are believed to be interested in opening discussions about a bid from Groots, but the franchisees are likely to be hostile. Although the franchisees are not shareholders, they will use the “stealing our national assets” argument to agitate the press, local politicians and, ultimately, the local population.



May 2005 3 P9

On the basis of published accounts, industry information and discussions with Cocomos’ directors, the Groots’ directors have forecast the following post-tax cash flows for Cocomos:

Year 1 2 3 4 Net cash flows (C$millions) 31⋅5 37⋅5 41⋅5 47⋅2

Post-tax cash flows beyond year 4 are estimated to grow at 2% per annum.

The cash flows are in real terms; that is they do not include inflation. Groots evaluates all its domestic investment decisions at a nominal, post-tax discount rate of 10%. Cocomos’ directors estimate their company’s cost of capital as 12%. However, Groots’ directors think this rate of 12% does not adequately reflect the risk of Cocomos’ cash flows.

Summary of financial statements of bidder and target companies

Income statement for the year ended 31 March 2005

Groots Group €millions

Cocomos Limited Caribbean $millions

Revenue 1,051⋅5 215⋅8 Operating profit 241⋅5 63⋅6 Finance costs (including overdraft interest) 48⋅0 15⋅0 Profit before tax 193⋅5 48⋅6 Taxation 46⋅9 11⋅5 Balance sheet as at 31 March 2005 Assets Non-current assets

Property, plant and equipment 895⋅0 245⋅0 Current assets Trade receivables and inventories 275⋅0 88⋅0 Cash and cash equivalents 45⋅0 12⋅0 Total assets 1,215⋅0 345⋅0 Equity and liabilities Equity

Share capital 245⋅0 55⋅0 (Nominal value of €1 and C$1 respectively) Retained earnings 290⋅0 100⋅0

Total equity 535⋅0 155⋅0 Non-current liabilities

Secured loan stock 7% repayable 2012 475⋅0 Secured loan stock 10% repayable 2008 135⋅0

Current liabilities

Trade and other payables 205⋅0 55⋅0 Total liabilities 680⋅0 190⋅0 Total equity and liabilities 1,215⋅0 345⋅0 Other financial information € C$ Share price today 6⋅85 6⋅95 Shares last traded on 19 May 2005 31 January 2005 High-Low share prices in past 12 months 9⋅25-6⋅25 7⋅50-5⋅50 Debt value (market) per €100 105⋅50 n/a Debt last traded on 30 December 2004 n/a

Question One continues on page 5



P9 4 May 2005

[this page is blank]



May 2005 5 P9

Question One (continued) Notes:

Exchange rate €/C$, interest and inflation rates The spot exchange rate is 0⋅30 (C$1 = €0⋅30). Forecast economic data relevant to the Caribbean, the US and the European Common Currency Area (ECCA) are as follows:

ECCA Caribbean Risk-free interest rate per annum 3⋅5% 6⋅5% Inflation rate per annum 2⋅5% 4⋅5%

You should assume the theory of interest rate parity applies when forecasting exchange rates.

Taxation Both companies will pay tax at an average of 25% from next year for the foreseeable future. Assume a double taxation treaty is in existence between France and the Caribbean country.

Debt agreement There is a clause in Cocomos’ debt agreement that says the whole of the C$135 million debt is repayable immediately in the event of a successful takeover bid.

Required: (a)

Calculate the maximum price that Groots would be prepared to pay for Cocomos based on the present value in euros of the forecast cash flows. Using appropriate discount rates, you should calculate present value using both the recognised methods of evaluating international investments.

(i)

(7 marks)Comment briefly on why, in theory, these two methods should give the same answer and why, in practice, the answers might be different.

(ii)

(3 marks)Calculate the number of shares Groots might need to issue if it offers its own shares in exchange for Cocomos using the higher of the values for the company you have calculated in (i). Comment briefly on your calculations and/or assumptions.

(iii)

(4 marks)

(Total for Part (a) = 14 Marks)

(b) Assume you are a financial manager with Groots. Write a report to the directors of Groots which should include the following:

(i) A recommendation of the maximum price to be offered to Cocomos. You should base your recommendation on the figures you calculated in part (a) and other suitable methods of company valuation.

(ii) Identify and discuss alternative methods of financing the acquisition and make a recommendation of the most appropriate method in the situation here.

(iii) An analysis of strategies for enhancing the value of the combined company following the acquisition.

(iv) Advice on the benefits and limitations of a post-completion audit and review in the context of the acquisition. Use additional calculations to support your arguments, wherever relevant and appropriate, for which up to 10 marks are available. Marks are distributed roughly equally between sections of the report.

(Total for Part (b) = 36 Marks)

(Total for Question One = 50 Marks)



P9 6 May 2005




May 2005 7 P9

Section B starts on the next page

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P9 8 May 2005

SECTION B – 50 MARKS [the indicative time for answering this Section is 90 minutes]

ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two XTA plc is the parent company of a transport and distribution group based in the United Kingdom (UK). The group owns and operates a network of distribution centres and a fleet of trucks (large delivery vehicles) in the UK. It is currently planning to expand into Continental Europe, operating through a new subsidiary company in Germany. The subsidiary will purchase distribution centres in Germany and invest in a new fleet of trucks to be based at those centres. The German subsidiary will be operationally independent of the UK parent. Alternative proposals have been put forward by Messrs A, B and C, Board members of XTA plc on how best to structure the financing of the new German operation as follows: Mr A: “I would feel much more comfortable if we were to borrow in our base currency,

sterling, where we already have long-standing banking relationships and a good reputation in the capital markets. Surely it would be much more complicated for us to borrow in euros?”

Mr B: “I am concerned about the exposure of our consolidated balance sheet and

investor ratios to sterling/euro exchange rate movements. How will we be able to explain large fluctuations to our shareholders? If we were to raise long-term euro borrowings, wouldn’t this avoid exchange rate risk altogether? We would also benefit from euro interest rates which have been historically lower than sterling rates.”

Mr C: “We know from our market research that we will be facing stiff competition in

Germany from local distribution companies. This is a high-risk project with a lot of capital at stake and we should finance this new venture by XTA plc raising new equity finance to reflect this high risk.”

Assume that today is Saturday 1 October 2005. A summary of the latest forecast consolidated balance sheet for the XTA Group at 31 December 2005 is given below. It has been prepared BEFORE taking into account the proposed German investment: £m Assets

Total assets 450 Equity and liabilities

Equity 250 Long-term borrowings 150 (there were no other non-current liabilities) Current liabilities 50 Total equity and liabilities 450



May 2005 9 P9

The proposed investment in Germany is scheduled for the final quarter of 2005 at a cost of £60m for the distribution centres and £20m for the fleet of trucks when translated from euros at today’s exchange rate of £1 = €1⋅50. There is a possibility that the euro could weaken against sterling to £1 = €2⋅00 by 31 December 2005, but it can be assumed that this will not occur until after the investment has been made. The subsidiary’s balance sheet at 31 December 2005 will only contain the new distribution centres and fleet of trucks matched by an equal equity investment by XTA plc and will only become operationally active from 1 January 2006.

Required:

(a) Write a memorandum to the Board of XTA plc to explain the advantages and disadvantages of using each of the following sources of finance:

• a rights issue versus a placing (assuming UK equity finance is chosen to

fund the new German subsidiary); and • a euro bank loan versus a euro-denominated eurobond (assuming euro

borrowings are chosen). (8 Marks)

(b) Evaluate EACH of the alternative proposals of Messrs A, B and C for financing the new German subsidiary and recommend the most appropriate form of financing for the group. Support your discussion of each proposal with

• a summary forecast consolidated balance sheet for the XTA group at

31 December 2005 incorporating the new investment; and • calculations of gearing using book values

using year end exchange rates of both £1 = €1⋅50 and £1 = €2⋅00.

(17 Marks)

(Total for Question Two = 25 Marks)

Section B continues on the next page

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P9 10 May 2005

Question Three GSD Ltd is a private UK company owned by the two families that started the business in 2000. The company produces organic food products for distribution in the domestic UK market using food products from UK farms. The company is experiencing a period of rapid growth, with revenue expected to rise by 15% in each of the following five years. The company is hoping to retain a profit margin (profit before interest and taxes divided by revenue) of 30% throughout the next five years. The ratio of working capital to revenue is expected to remain constant, where working capital is inventories plus trade receivables less trade payables. Interest is paid on the overdraft and bank loan at 6% per annum. Interest on the bank loan and overdraft is calculated on the balance outstanding at the beginning of the year. Corporation tax is paid one year in arrears at a rate of 30%, with a 100% tax allowance for capital expenditure in the year in which it is incurred. In arriving at operating profit, depreciation is charged at 25% on a reducing balance basis based on year-end balances. Extracts from the management accounts of GSD Ltd on 31 December 2004 are as follows: Balance sheet as at 31 December 2004 £m Property, plant and equipment 15 Working capital 9 24 Share capital (50p ordinary) 10 Retained earnings 4 Long-term borrowings (bank loan) 8 Short-term borrowings (overdraft) 1 Current tax payable 1 24 Income statement for the year ended 31 December 2004Revenue 45⋅0 Profit before interest and taxes 13⋅5 Dividend paid in 2004 50p a share Capital expenditure plans are for expenditure on property, plant and equipment of £10m in 2005, £10m in 2006 and £7m in each of years 2007 to 2009. No disposals of property, plant and equipment are expected in this period. Shareholders expect a year-on-year increase in dividends of 5%. Any funds deficit in the year will be funded by overdraft and any surplus funds used to reduce the overdraft. However, with the increased demands on the funds of the business to finance growth, the directors are concerned that they may exceed the overdraft limit of £1⋅5m. They may, therefore, need to negotiate an increase in the bank loan, although the bank has indicated that it would not accept gearing higher than 70% based on book values where gearing is defined as long and short term borrowings (including overdraft) divided by equity. The shareholders have indicated that they do not wish to inject any additional capital into the business.



May 2005 11 P9

Required:

(a) Construct the balance sheet, income statement and a cash flow analysis of the company for each of the years 2005 and 2006 and advise the company on the extent of any additional funding requirement in that period. In your answer, round figures to the nearest £100,000.

(16 Marks)

(b) Discuss the interrelationships between financing, investment and dividend strategies with reference to the liquidity requirements of GSD Ltd. Include in your discussion how each could be adapted to meet the company’s liquidity requirements in the years 2005 and 2006 and provide a recommendation.

(9 Marks)

(Total for Question Three = 25 Marks)


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P9 12 May 2005

Question Four FLG Inc is an airline operator based in the United States, operating a wide network of both domestic and international flights. It has recently obtained a new licence to operate direct flights to a new European destination which will necessitate the acquisition of four identical second-hand aeroplanes at a total cost of $100 million. The aeroplanes are expected to be in service for five years and each one is expected to have a residual value of $12⋅5 million at the end of the five years. However, the residual value is highly dependent on the state of the airline industry at the end of the five-year period and there is a risk that the residual value could be much lower if there is a general reduction in air travel at that time. The company has been offered a lease contract with total lease payments of $15 million per annum for five years, payable in advance, with all maintenance costs being borne by the lessee. Alternatively, the aeroplanes could be purchased outright and the bank has offered the company a five-year loan with variable interest payments payable semi-annually six months in arrears at a margin of 1% per annum above a reference six-month $ inter-bank rate. The reference six-month $ inter-bank rate is forecast to be at a flat rate of 2⋅4% for each six-month period, for the duration of the loan. The company pays tax at 30% and expects to make taxable profits in excess of the lease payments, interest charges and tax depreciation allowances arising over the next five years. Tax depreciation on the purchase of the aeroplanes can be claimed at a rate of 20% at the end of each financial year on a written-down value basis, with a delay of one year between the tax depreciation allowance arising and the deduction from tax paid.

Required:

(a) Calculate:

(i) the compound annualised post-tax cost of debt;

(ii) the NPV of the lease versus purchase decision at discount rates of both 4% and 5%;

(iii) the breakeven post-tax cost of debt at which FLG Inc is indifferent between leasing and purchasing the aeroplanes.

(10 Marks)

(b) Recommend, with reasons, whether FLG Inc should purchase with a loan or lease the aeroplanes.

Your answer should include appropriate calculations of the sensitivity of the lease versus purchase decision to changes in EACH of the following:

• the reference $ inter-bank rate for the duration of the loan;

• the residual value of the aeroplanes. (15 Marks)

(Total for Question Four = 25 Marks)



May 2005 13 P9


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P9 14 May 2005

Question Five CTC Technology College (CTC) is a non-profit making institution located in Ireland, where the national currency is the euro. The college is funded by a combination of student fees and government grants. The number of students enrolled on the part-time Information Technology course at CTC has fallen over recent years due to competition from other colleges and the wide range of different courses available. The number of students enrolling on the current course, ITS (IT Skills) has stabilised at around 150 students per annum and there are currently 20 computers surplus to requirements which CTC plans to sell for an estimated €100 each; the current book value of each computer is €200. However, this sale will not occur if the college goes ahead with its plan to replace the current ITS course with an updated course, as it is expected that a new course would result in a significant increase in student numbers. CTC realises that the financial viability of switching courses is highly dependent on the number of students that the college can attract onto the new course and has commissioned some market research, at a cost of €10,000, into the best course content and likely increase in student numbers. The results of this research indicate that an ITC (IT Competence) course would be the most popular and lead to a significant increase in student enrolments at the college. It is also estimated that there could be an additional benefit to the college of average net revenues of €20 per additional student over and above 150 as a result of those students being attracted to the college and taking other courses at the college at the same time as the ITC course. The new ITC course would be run by existing staff currently working on the ITS course at a cost of €50,000 per annum. If, however, the numbers of students on ITC were to rise above 200 per annum, an additional part-time member of staff would be needed at a cost of €10,000 per annum, payable in advance. If ITC is adopted, several computers would need to be upgraded at a total one-off cost of €15,000.

Other relevant data is as follows: ITS €

ITC €

Fee for the course (per student, payable in advance) 350 360 Directly attributable course costs (per annum, payable in arrears) 1,000 2,000 Books and consumables per student, payable in advance 50 60 Apportionment of college overheads (excluding staff costs) (per annum, charged at the end of the year)

20,000 25,000

Staff training and course development (initial set-up cost) 0 30,000 The planning horizon for the college is four years and projects are evaluated using a discount rate of 8% and on the basis of a zero terminal value at the end of the four-year period. Each course is of one year duration and student enrolments should be assumed to remain constant throughout the four-year period, with ITS attracting 150 students each year. Taxation and inflation should be ignored.



May 2005 15 P9

Required:

(a) Evaluate the number of student enrolments required on the ITC course in order for it to be financially beneficial, on a net present value of cash flow basis, for the college to replace the ITS course with the ITC course.

(15 Marks)

(b) Advise the governing body of the college on the following issues:

(i) How to monitor and control the costs and revenues of the project from the decision to introduce the new course to the start date of the course;

(5 Marks)

(ii) Options available if only 150 students enrol on the new ITC course by the enrolment deadline two weeks before the beginning of the course by which time all other course preparations will have been completed.

(5 Marks)

(Total for Question Five = 25 Marks)

(Total for Section B = 50 Marks)

End of Question Paper

Maths Tables and Formulae are on pages 17 to 21

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P9 16 May 2005




May 2005 17 P9

MATHS TABLES AND FORMULAE Present value table Present value of 1.00 unit of currency, that is (1 + r)-n where r = interest rate; n = number of periods until payment or receipt.

Interest rates (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Interest rates (r) Periods (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065 16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026



P9 18 May 2005

Cumulative present value of 1.00 unit of currency per annum, Receivable or Payable at the end of

each year for n years

−+−

rr n)(11

Interest rates (r) Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Interest rates (r) Periods

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870



May 2005 19 P9

FORMULAE Valuation models (i) Irredeemable preference share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value:

P0 = prefk

d


P0 = ek

d

(iii) Ordinary (equity) share, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 is the ex-div value:

P0 = gk

d

−e

1 or P0 = gk

gd

−

+

e

0 ][1

(iv) Irredeemable (undated) debt, paying annual after-tax interest, i [1 – t], in perpetuity, where P0 is the ex-interest value:

P0 = netd

][1

k

ti −

or, without tax: P0 = dk

i


Vg = Vu + TBc


S = X[1 + r]n

(vii) Present value of 1⋅00 payable or receivable in n years, discounted at r% per annum:

PV = nr ][1

1

+

(viii) Present value of an annuity of 1⋅00 per annum, receivable or payable for n years, commencing in one year, discounted at r% per annum:

PV =

+

− nrr ][1

11

1

(ix) Present value of 1⋅00 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum:

PV = r

1

(x) Present value of 1⋅00 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum:

PV = gr −

1

FORMULAE CONTINUE ON THE NEXT PAGE



P9 20 May 2005

Cost of capital (i) Cost of irredeemable preference capital, paying an annual dividend, d, in perpetuity, and having a current ex-div

price P0:

kpref = 0P

d

(ii) Cost of irredeemable debt capital, paying annual net interest, i [1 – t], and having a current ex-interest price P0:

kd net = 0P

ti ][1 −

(iii) Cost of ordinary (equity) share capital, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0:

ke =

0P

d

(iv) Cost of ordinary (equity) share capital, having a current ex-div price, P0, having just paid a dividend, d0, with the dividend growing in perpetuity by a constant g% per annum:

ke = gP

d+

0

1 or ke = g

P

gd+

+

0

0 ]1[


ke = Rf + [Rm – Rf]ß (vi) Cost of ordinary (equity) share capital in a geared firm (no tax):


DVV



DV

tV ][1−


k0 = keg

+

++ DE

D

DE

E

VV

Vk

VV

Vd

(ix) Adjusted cost of capital (MM formula): Kadj = keu [1 – tL] or r* = r[1 – T*L]



ßu = ßg

+ DE

E

VV

V

(xi) ßu from ßg, taking ßd as zero (with tax):

ßu = ßg

−+ ][1 tVV

V

DE

E

(xii) Adjusted discount rate to use in international capital budgeting using interest rate parity:

C$/Euro rate Spot

C$/Euro time months' 12 in rate Exchange

Euro rate discount annual1

C$ tediscountra annual1=

+

+



May 2005 21 P9

Other formulae (i) Interest rate parity (international Fisher effect):



+

+



rateinflationUS1

+

+





yearsovercostsof

n

nPV


TERP = 1

1





+

−

N

or

N





P9 22 May 2005




May 2005 23 P9



P9 24 May 2005


Strategic Level


May 2005

Wednesday Morning Session



Paper P9 – Management Accounting Financial Strategy Post Exam Guide May 2005 Exam

The Chartered Institute of Management Accountants Page 1

General Comments This was the first diet of the new syllabus, although there are many similarities to the syllabus of the old paper 13. The performance in May was very poor. The change in syllabus might account for some of the decline, but not to the extent that was observed. Many candidates demonstrated a very weak grasp of basic techniques, such as the importance of market share price in a takeover bid, the approach to calculating forward exchange rates and the calculation of break even. Many candidates also continue to suggest retained earnings are cash, and/or that issuing bonus shares will result in a cash injection. The very poor attempt at structure and presentation of some of the answers, especially of calculations, continues to give cause for concern. Many candidates, especially those in some overseas centres, were quite unable to present an investment appraisal in a format that was clear and understandable. All textbooks on the subject, including the Study System, show how an investment appraisal could be presented. Question three was the most popular of the optional questions, both in home and overseas centres. Question five was also popular in home centres with questions two and four more or less the least popular (depending on centre). Question two was more popular in overseas than in home centres. Where the marking scheme says up to 3 marks are available for each valid point, 0.5 marks are awarded for a bullet point, 1 mark for some attempt at (correct and valid) discussion, rising to 3 marks for good discussion of the point using appropriate illustrative examples. The published solutions are used as a guide. Marks are also awarded for candidates' own valid comments that might not be in the marking guide or the published solutions. Where marks are shown for calculations, the mark shown is the maximum available assuming calculations are all correct. Marks are available for recognition of correct approach and understanding. Note that in the marking scheme the sum of the marks available for specific activities may total more than the marks indicated on the question paper. This is to allow some flexibility in marking, but the maximum marks that can be awarded for a section of a question cannot exceed the number of marks indicated on the question paper.





SECTION A – 50 MARKS READ THE SCENARIO AND ANSWER THIS QUESTION. Question One(a) (i) Calculate the maximum price that Groots would be prepared to pay for Cocomos based on the

present value in euros of the forecast cash flows. Using appropriate discount rates, you should calculate present value using both the recognised methods of evaluating international investments.

(7 marks) (ii) Comment briefly on why, in theory, these two methods should give the same answer and why, in

practice, the answers might be different. (3 marks)

(iii) Calculate the number of shares Groots might need to issue if it offers its own shares in exchange

for Cocomos using the higher of the values for the company you have calculated in (i). Comment briefly on your calculations and/or assumptions.

(4 marks)

(Total for Part (a) = 14 Marks)

Rationale This question concerns a retailer of clothing for women and children. The organisation is based in France, but has extensive trading interests throughout Europe. The company believes that it has exhausted possibilities for expansion within Europe and is therefore looking to expand in other continents. It has identified a small clothing group based in the Caribbean and is interested in opening discussions with respect to an agreed takeover. The question involves investment appraisal and acquisition arithmetic. It also examines some of the non-financial issues that are raised by cross-border takeovers, particularly those that might be particularly relevant to a developing region. The question requires an evaluation of the value of the target company and a recommendation of the price to be paid. It further requires an evaluation of possible methods of financing the bid, an analysis of strategies for enhancing the value of the combined company and advice on the benefits and limitations of post-completion audit. It examines topics in all four sections of the syllabus.





Suggested Approach Part (a)(i) • Calculate forward exchange rates using interest rate parity. • Inflate C$ cash flows at 4⋅5% compound each year (NB. Those candidates who did not inflate cash

flows, but who correctly calculated a real discount rate and discounted the cash flows at that rate would have gained full credit).

For method 1: • Convert C$ cash flows to euros using the exchange rates calculated and discount at 10%. • Calculate NPV of the cash flows to year 4. For method 2: • Calculate an adjusted discount rate. • Calculate discounted cash flows and NPV to year 4 at the adjusted or estimated rate. • Convert C$ NPV to Euros at spot rate. • Calculate value of cash flows for year 4 onwards under both methods. • Deduct C$ value of Cocomos loan stock, converted at spot. • Comment on the maximum price to be offered. Part (a)(ii) • Discuss the two basic approaches to evaluating international investments. • Comment on why in theory they should be identical, but inefficiencies and imperfections in the

market will create differences. • Note the different risks applicable to international investments. Part (a)(iii) • Calculate the number of shares to be offered using the NPV calculated in part (a)(i) (or an estimated

NPV if you were unable to complete the calculations). • Calculate a share exchange ratio. Marking Guide

Marks

Exchange rates

1.5

Inflated cash flows 1 Present values at 10% and adjusted rate Up to 3 Price to pay 1.5 Comments on 2 methods Up to 3 Number of shares to issue (on “own answer” NPV) 2 Comments

2





Examiner’s Comments This question was generally poorly attempted with many candidates being unable to provide the appropriate calculations and failing to provide adequate, or any comment, as required by the question. Common Errors Part (a)(i) • Incorrect calculation of forward rates, either by using purchasing power parity instead of interest

rate parity, or by showing the Caribbean $ appreciating against the Euro instead of depreciating. The relative interest and inflation rates in the two regions give a guide as to which direction the exchange rate should be taking.

• Failure to inflate cash flows or not compounding the rate each year (or using a nominal discount rate with real cash flows).

• Failure to use two methods and/or failure to calculate or estimate an adjusted discount rate for method 2.

• Failure to calculate cash flows for year 4 onwards. • Deducting tax from cash flows which the question stated were post-tax. • When taking the repayment of debt into account, adding this to the price to be paid rather than

deducting it. • Failure to provide any comments on the maximum price, as required by the question. Part (a)(ii) • Commenting on interest rate parity and purchasing power parity as the two methods of evaluating

international investments. • Commenting that any differences were due to rounding errors. A very small amount of credit was

available for this comment, but it is not the real reason why there would be differences. • Providing no answer at all to this part of the question. Part (a)(iii) • Calculating the total number of shares to be issued using the nominal value of the shares. • Providing no comments on the calculations, as required by the question.





Question One(b) Assume you are a financial manager with Groots. Write a report to the directors of Groots which should include the following: (i) A recommendation of the maximum price to be offered to Cocomos. You should base your

recommendation on the figures you calculated in part (a) and other suitable methods of company valuation.

(ii) Identify and discuss alternative methods of financing the acquisition and make a recommendation of the most appropriate method in the situation here.

(iii) An analysis of strategies for enhancing the value of the combined company following the acquisition.

(iv) Advice on the benefits and limitations of a post-completion audit and review in the context of the acquisition.

Use additional calculations to support your arguments, wherever relevant and appropriate, for which up to 10 marks are available. Marks are distributed roughly equally between sections of the report.

(Total for Part (b) = 36 Marks)(Total for Question One = 50 Marks)

Rationale See 1(a). Suggested Approach Provide a report heading, introduction, sub headings and conclusion. Part (b)(i) • Summarise the total company value and value per share of Cocomos using the various methods of

company valuation. • Discuss the relevance of the different methods to this particular takeover bid. • Make a recommendation of the maximum price to be offered. Part (b)(ii) • Recognise that there are two basic methods of financing this bid: share exchange and cash. • Discuss the situation if shares were to be offered (based on your answer to part (a)(iii)). • Discuss the various methods available of raising cash if this is the chosen method (essentially this

means either long term borrowing or a rights issue to existing shareholders of Groots). • Calculate gearing ratios using both share exchange and borrowing and comment on the effect on

these ratios of the two different methods. • Comment on the different groups of stakeholders and their likely attitude to the different methods of

funding. Part (b)(iii) • Advise on the strategies that might be available to Groots if the acquisition is completed. • Discuss the various stakeholders’ attitudes to the strategies that might be considered.





Part (b)(iv) • Note the main purposes of a post completion audit. • Note what the major requirements are of such an audit and that the objectives of the investment

project must be clear and stated. • Discuss the main advantages of a PCA/PCR. • Discuss the main limitations of a PCA/PCR. Marking Guide

Marks

Structure and presentation of report Part (b)(i) Calculations and comments of the different methods of valuation up to a maximum of 10 marks (approximately 3-4 marks are available for calculations and 6-7 marks for comments Part (b)(ii) Up to 3 marks are available, depending on quality of discussion for discussing the key points such as (but not limited to) :

• Shares to be issued • Cash to be raised • Gearing calculations and comments • Price of new debt • Effect on WACC • Consideration of each group of shareholders • Recommendation

Part (b)(iii) Up to 3 marks are available, depending on quality of discussion for discussing the key points such as (but not limited to):

• Need for integration of strategy • Synergy/economies of scale • Staff savings • Franchising each contract • Marketing strategy • Diversification/cost of capital • Sale of non-core/redundant assets • Risks of acquisition

Part (b)(iv) Up to 3 marks are available, depending on quality of discussion for discussing the key points such as (but not limited to):

• Main purposes of PCA • Need for objectives • Main advantages

Generating information; lessons for decision making; better project planning • Limitations

Cost and time; still needs managerial judgement

Although up to 10 marks were available for discussion within each sub-section of the question, the overall maximum available for this part of the question, including structure and presentation marks, was 36 marks.

2

10

10

10

10





Examiner’s Comments Most candidates managed to provide a reasonable discussion of the benefits and limitations of post-completion audit. They were also usually able to attempt to identify and discuss alternative methods of financing, although many of these methods were not entirely appropriate for the situation here. The attempt at answering parts i and iii of this section of the question were very poorly done and, frequently, no attempt at all was made to analyse the strategies for enhancing the value of the combined company. Common Errors Part (b)(i) • Providing no or very limited discussion of the various methods of valuing the company. • Failing to recognise the importance of market values in a takeover bid situation. • Incorrect calculation of net asset value. • When calculating value using Cocomos PE basis of $10⋅3, failing to recognise they were simply

calculating the market value. Part (b)(ii) • Suggesting that retained earnings could be used to finance the acquisition. • Suggesting inappropriate methods in the circumstances, for example a venture capital company. • Providing no calculations to support a recommendation to finance with debt. For example, the

effect on gearing and the possible effect on cost of capital. • Not recognising that both companies are listed companies. • Suggesting factoring or sale and leaseback as methods of finance - methods which are quite

inappropriate in the situation here. Part (b)(iii) • No specific common errors but this part of the question was frequently poorly answered or not

attempted at all. Part (b)(iv) • Not recognising that this was a takeover situation. • Suggesting that the post completion results should be conveyed to shareholders, this is highly

unlikely.





SECTION B – 50 MARKS ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two(a) Write a memorandum to the Board of XTA plc to explain the advantages and disadvantages of using each of the following sources of finance: • a rights issue versus a placing (assuming UK equity finance is chosen to fund the new German

subsidiary); and • A euro bank loan versus a euro-denominated Eurobond (assuming euro borrowings are chosen).

(8 Marks) Rationale This question relates to a new part of the syllabus on financial management and goes beyond what would have been examined in the Finance paper on the previous syllabus as it looks at the appropriate currency of funding as well as the choice between debt and equity funding. The modelling of balance sheets based on movements in exchange rates is, I believe, new to students, and involves knowing that exchange differences on translation are posted to either profit and loss or reserves. The numbers have been kept deliberately very straightforward. Suggested Approach • Use memorandum format. • Explain the advantages and then the disadvantages of a rights issue versus a placing. • Explain the advantages and then the disadvantages of a euro bank loan versus a euro-

denominated Eurobond. Marking Guide

Marks

Advantages of rights versus placement

4

Advantages of bank loan versus Eurobond 4 Examiner’s Comments Candidates who had learnt the key features of the four sources of finance referred to in the question generally earned high marks in this section. There was a wide disparity of marks awarded in part (b) with many candidates unable to adjust the balance sheet to reflect the new investment and different financing alternatives. Common Errors • Comparing a share issue to debt or euro debt to sterling debt, neither of which was required. • Misunderstanding of the nature of a placing, incorrectly claiming that it is more expensive than a

rights issue and requires underwriting whereas a rights issue does not. • Incorrect interpretation of a euro bank loan as a bank loan sourced in euro land rather than a loan

denominated in euros.





Question Two(b) Evaluate EACH of the alternative proposals of Messrs A, B and C for financing the new German subsidiary and recommend the most appropriate form of financing for the group. Support your discussion of each proposal with • a summary forecast consolidated balance sheet for the XTA group at 31 December 2005

incorporating the new investment; and • calculations of gearing using book values Using year end exchange rates of both £1 = €1⋅50 and £1 = €2⋅00.

(17 Marks) (Total for Question Two = 25 Marks)

Rationale See 2(a). Suggested Approach • Produce summary group balance sheets under each alternative financing proposal of Messrs A, B

and C at the two outturn exchange rates provided and calculate gearing for each scenario. • Compare the extent of currency exposure and gearing levels across all three alternative financing

structures. Marking Guide

Marks

Revised balance sheets (3 marks per board member’s proposal) Gearing calculations Evaluation of board members’ suggestions (2 per proposal) Recommendation

9 3 6 2

Note: maximum of 17 marks out of 20 available for whole of part (b)

Examiner’s Comments See 2(a). Common Errors • The balance sheet was frequently only presented at one of the two exchange rates specified in the

question. • There was a widespread misconception that a sterling loan would eliminate exchange rate risk.





Question 3(a) Construct the balance sheet, income statement and a cash flow analysis of the company for each of the years 2005 and 2006 and advise the company on the extent of any additional funding requirement in that period. In your answer, round figures to the nearest £100,000.

(16 Marks)

Rationale Part (a) requires the modelling of future financial statements and cash flows and is adapted from a number of past Financial Strategy questions on the previous syllabus. Suggested Approach Adopt a structured approach by: • laying out the proforma balance sheet, income statement and cash flow analysis • inserting numbers from the base data • providing clear workings when calculating supplementary figures such as fixed asset movements

and tax payments Marking Guide

Marks

Calculation of taxes Calculation for non-current assets Revised income statement

3 2 4

Revised balance sheet Cash flow analysis Advice on additional funding requirement

2 5 2

Note: Maximum 16 marks out of 18 available for part (a)

Examiner’s Comments Candidates who attempted this question generally answered satisfactorily. Most were able to produce the required financial statements and make an attempt at the more complex calculations of cash flows and tax. Answers to part (b) were less satisfactory, with many generalised comments on financing, investment and dividend decisions and little tailoring of answers to the specific circumstances of the question. Common Errors • Incorrect calculation of the cash flows and tax, with the depreciation adjustments being most

commonly overlooked. • Ignoring the requirement stated in the question to give advice on the extent of any additional

funding required in the period.





Question Three(b) Discuss the interrelationships between financing, investment and dividend strategies with reference to the liquidity requirements of GSD Ltd. Include in your discussion how each could be adapted to meet the company’s liquidity requirements in the years 2005 and 2006 and provide a recommendation.

(9 Marks) (Total for Question Three = 25 Marks)

Rationale Part (b) tests understanding and application of the results based on principles previously examined in the Finance paper on the previous syllabus, but are tested with a stronger emphasis on application as is appropriate at Strategic Level. Suggested Approach Concentrate on: • the interrelationship of the financing, investment and dividend strategies. • how each could be adapted to meet GSD Ltd’s liquidity requirements in the years 2005 and 2006,

including a brief glance into cash flow prospects in 2007 in order to assess how long the cash shortage is likely to exist.

Marking Guide

Marks

Inter-relationship of investment/financing/dividends: discussion of key points, such as:

• Inter-dependence of the three strategies • Forecast liquidity requirement for 2007 onwards • Increase the bank loan • Reduce or delay capital expenditure • Reduce dividend, especially noting circumstances of GSD

7

Recommendation 2 Examiner’s Comments See three (a). Common Errors • Ignoring the important fact that GSD Ltd is a private company. For example, lengthy discussion on

issues such as dividend signalling are irrelevant and shareholders cannot readily sell shares to raise funds in the event of a cut in dividend levels.





Question Four(a) Calculate: (i) the compound annualised post-tax cost of debt; (ii) the NPV of the lease versus purchase decision at discount rates of both 4% and 5%; (iii) The breakeven post-tax cost of debt at which FLG Inc is indifferent between leasing and purchasing

the aeroplanes. (10 Marks)

Rationale This is a standard lease versus buy comparison, a standard approach tested on a number of occasions in past Financial Strategy questions on the previous syllabus. The individual twist here is the need to calculate the cost of debt (as frequently examined in the Finance paper on the previous syllabus). Suggested Approach Follow the guidelines given in the question closely: • First, calculate the post-tax cost of debt for use later on in comparing to the IRR calculated in part

(iii). • Second, calculate the NPV of the lease versus purchase decision using both 4% and 5% rates (part

(ii). • Third, use interpolation to calculate the breakeven cost of debt (part (iii). Marking Guide

Marks

Annualised post-tax cost of debt

2

NPV appraisal of lease versus buy Breakeven calculation

6 2

Examiner’s Comments Answers to Question four were generally quite poor. Common Errors • Few candidates could calculate the compound annual interest rate required in part (i). • Many ignored the tax on the lease payments. • Interest and loan principal cash flows were frequently erroneously included in the DCF calculations. • Residual value was often misstated as that for a single plane. • Many candidates omitted the impact of residual value in capital allowance computations.





Question four(b) Recommend, with reasons, whether FLG Inc should purchase with a loan or lease the aeroplanes. Your answer should include appropriate calculations of the sensitivity of the lease versus purchase decision to changes in EACH of the following: • the reference $ inter-bank rate for the duration of the loan; • The residual value of the aeroplanes.

(15 Marks)(Total for Question Four = 25 Marks)

Rationale Part (b) tests sensitivity of the result to changes in residual value and interest rates which has not been examined before based on these variables. Suggested Approach • To examine the impact of interest rate movements, compare the breakeven rate calculated in part

(a)(iii) with the present cost of debt calculated in part (a)(i) to assess how far interest rates could move before the lease/purchase conclusion is reversed.

• For changes in residual value, calculate the NPV of the residual value cash flows (standard decision making procedure) and compare to the NPV of the lease/purchase decision at the current cost of debt.

Marking Guide

Marks

Other factors to consider, such as:

• Sensitivity to interest rate changes o calculation (max 3 marks) o discussion (max 3 marks)

• Sensitivity to changes in residual value o calculation (max 3 marks) o discussion (max 3 marks)

• Quality/upgrade terms offered under lease • Flexibility/plans at the end of 5 years

13

Recommendation 2 Examiner’s Comments See four (a). Common Errors • Most candidates simply repeated the question, stating that potential changes to both interest rates and

residual value were important to consider. There was little quantitative or qualitative analysis of these or other relevant issues.





Question five(a) Evaluate the number of student enrolments required on the ITC course in order for it to be financially beneficial, on a net present value of cash flow basis, for the college to replace the ITS course with the ITC course.

(15 Marks) Rationale Part (a) tests standard investment appraisal using discounted cash flow. A new angle here is the calculation of a breakeven student enrolment figure. Suggested Approach • The most straight-forward approach involved the use of some very basic algebra, with “X” being the

number of students above 150. Standard discounted cash flow analysis could then be performed on incremental cash flows and the value of “X” determined where NPV(cash flows) = 0.

• The same result could be achieved on a contribution basis rather than using algebra. • Alternatively, a number of computations could be undertaken with different student numbers and the

IRR estimated by interpolation. Whichever approach was adopted, a separate adjusted calculation was required for student numbers in excess of 200 which should have included the cost of an additional part-time member of staff. Marking Guide

Marks

Calculations for NPV of: Revenues Costs Use of correct discount factor and timings Calculations assuming students >150 and N > 50 Conclusions/comments

3 5 1 2 4

Examiner’s Comments Candidates who could correctly identify and ignore sunk costs and schedule the cash flows in the correct timeframes generally performed reasonably well in this question, whichever approach they adopted. There were also some good answers to part (b), especially where candidates recognised the relevance of real options in part (ii). Common Errors A large number of candidates made basic errors by: • including sunk costs; • ignoring the knock-on benefit from students taking other courses; • misallocating cash flows to timeframes.





Question five(b) Advise the governing body of the college on the following issues: (i) How to monitor and control the costs and revenues of the project from the decision to introduce the

new course to the start date of the course; (5 Marks)

(ii) Options available if only 150 students enrol on the new ITC course by the enrolment deadline two

weeks before the beginning of the course by which time all other course preparations will have been completed.

(5 Marks)(Total for Question Five = 25 Marks)

Rationale Part (b) is based on a new topic in the syllabus relating to project control and implementation. Suggested Approach In part (i), standard budgeting and control procedures were expected, adapted to the particular circumstances of the question. Answers to part (ii) were expected to focus on the real options available to CTC in the light of under enrolment on the course. In particular, candidates were expected to re-evaluate the breakeven student number at this later point in time when additional costs such as course development expenses had already been incurred and should now be classified as sunk costs. Marking Guide

Marks

Effective monitoring and control; up to 3 marks are available for each valid point, such as:

• clear reporting line/responsibility allocated

* regular reviews/monitoring costs against budget (incl investigation of overruns & feedback into revised budget)

* fixing costs and revenues in advance where possible

Alternative options available, up to 3 marks are available for each valid point, such as: • carry on or abandon (and implications of each, for example, damage to the reputation

of the college) * implications of sunk costs/revised breakeven number

5

Examiner’s Comments See five (a). Common Errors • There were several instances where answers did not address the question set. In addition, few

candidates attempted to re-evaluate the breakeven number of students or even highlight the usefulness of such analysis.







23 November 2005 – Wednesday Morning Session



You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, make annotations on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during the reading time.

You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or sub-questions). The question requirements are highlighted in a dotted box.






P9 –

Fin

anci

al S

trat

egy

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November 2005 2 P9

SECTION A – 50 MARKS [the indicative time for answering this Section is 90 minutes] READ THE SCENARIO AND ANSWER THE QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One

Scenario

GAS plc Description of the business GAS plc is an international energy entity with a head office in the UK. Through its principal operating subsidiaries based in the UK and elsewhere in Europe, it generates electricity and supplies gas and electricity via energy supply networks across Europe. GAS plc’s strategy is to generate future growth through investment in new power stations, energy supply networks and gas storage assets. Its current focus for new investment is Bustan, a large Asian country that is in urgent need of major improvements in its electricity generation and supply systems to support the recent rapid increase in industrial production. Group profile On 31 December 2004, GAS plc had 1,200 million 50 pence ordinary shares in issue and a share price of 335 pence ex-dividend. Shareholders expect a return on equity of 9⋅4%. Dividends for GAS plc for the year ended 31 December 2004 were 14 pence a share, maintaining the 5% annual increase in dividends that has been achieved in recent years. For simplicity, dividends should be assumed to be declared and paid on 31 December each year. Investment project The new investment in Bustan has been at the planning stage since the beginning of 2004 when the government of Bustan first invited proposals for a large construction project from interested parties. The project was evaluated over a 10-year period beginning January 2005 and the project net operating cashflows in B$, the local currency of Bustan, were estimated to be as follows: B$ million Year 1 20 Year 2 150 Year 3 250 Years 4-10 300 All cash flows should be assumed to arise on 31 December of each year. It should also be assumed that annual cash flows, less tax, are paid across to the UK on the final day of each year. The cost of the initial investment in plant and other equipment at the beginning of January 2005 was B$700 million and this is subject to depreciation charged in the subsidiary accounts on a straight line basis at 5% per annum. An additional B$50 million was required to finance working capital at the beginning of January 2005.



November 2005 3 P9

Tax Bustan charges entity tax at a preferential rate of 20% for the first 10 years of such investment projects, rather than the normal rate of 40%. In Bustan, tax depreciation allowances are calculated on the same basis as accounting depreciation allowances. The tax rate in the UK is 30%, but a double tax treaty allows taxes charged in Bustan to be deducted from UK taxes charged in the same period. Assume that Bustan taxes are payable in the year in which they are incurred and that UK taxes are payable one year in arrears. Exchange rates At 31 December 2004, the spot exchange rate was £1 = B$0⋅7778. The B$ is expected to weaken against the British pound (sterling) in line with the differential in long term interest rates between the two countries over the life of the project. Long term interest rates are expected to remain stable at 4⋅8% per annum in the UK and 10% per annum in Bustan for the foreseeable future. Financing the project The total initial investment of B$750 million was funded by GAS plc at the beginning of 2005. The B$700 million investment in plant and equipment was funded by a rights issue and the B$50 million working capital requirement out of surplus cash. GAS plc evaluated the project on the basis of a realisable residual value of B$350 million for the plant and equipment and that 80% of the investment in working capital would be realised at the end of the project. Both these amounts are to be repaid in full to the UK without any taxes payable in either Bustan or the UK. Press statements In June 2004, GAS plc issued a press statement announcing its intention to submit a proposal for the project. On the same day, it announced its plans to use a 1 for 4 rights issue to fund the B$700 million capital investment in the event of the proposal being accepted. GAS plc’s proposal was accepted on 1 January 2005 and a press release issued to announce the acceptance of the proposal and GAS plc’s intention to proceed with the project without delay. The press statement also announced GAS plc’s intention to temporarily reduce dividend growth rates during the development stage of the project. Revised dividend plans are as follows: 2005-2007 Dividend per share to be frozen at December 2004 levels 2008 onwards 7% per annum growth Investment criteria Criterion 1 GAS plc requires overseas projects to generate an accounting rate of return in the overseas country, which is Bustan in this instance, of at least 25% per annum. Accounting rate of return is defined as:

investment down) (written annual averagetaxes and interest before profit accounting annual average

Criterion 2 GAS plc also assesses investment projects based on the net present value of the cashflows and applies a risk-adjusted sterling discount rate of 10⋅5% to overseas projects of this nature.

The question requirements are on page 5

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November 2005 4 P9




November 2005 5 P9

Question One

Required: (a) Show, by calculation, that the proposed investment project in Bustan met the two

minimum investment criteria set by GAS plc.

(18 marks)

(b) Discuss the major risk issues that should have been considered by GAS plc when evaluating the project.

(7 marks)

(c) The board of GAS plc has been concerned about the unusually volatile movements in the entity’s share price in 2004 and 2005 and has asked you, an external management consultant, to draft a report to the board of GAS plc that critically addresses the issues detailed below. Assume a semi-strong efficient market applies.

(i) Explain the possible reasons for the unusually volatile movements in

GAS plc’s share price in the twelve months up to and including 1 January 2005. No calculations are required.

(6 marks)

(ii) Advise what would have been a fair market price for GAS plc’s shares in January 2005 following the announcement of the acceptance of the proposal and after adjusting for the proposed rights issue. As part of your answer, calculate GAS plc’s share price on each of the bases listed below and discuss the relevance of each result in determining a fair market price for the entity’s shares:

• the theoretical ex-rights price before adjusting for the project cashflows; • the theoretical ex-rights price after adjusting for the project cashflows; • directors’ dividend forecast issued in January 2005.

(14 marks)

(iii) Advise on how and to what extent directors are able to influence their entity’s share price.

(5 marks)

(Total for requirement (c) = 25 marks)

Within the overall mark allocation, up to 4 marks are available for structure and presentation.

(Total for Question One = 50 marks)

(Total for Section A = 50 marks)

End of Section A



November 2005 6 P9

[This page is blank]



November 2005 7 P9

SECTION B – 50 MARKS [the indicative time for answering this Section is 90 minutes] ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two HG is a privately-owned toy manufacturer based in a country in the European Union, but which is not in the European Common Currency Area (ECCA). It trades internationally both as a supplier and a customer. Although HG is privately owned, it has revenue and assets equivalent in amount to some public listed companies. It has a large number of shareholders, but has no intention of seeking a listing at the present time. In fact, the major shareholders have often expressed a wish to buy out some of the smaller investors. The entity has a long history of sound, if unspectacular, profitability. The directors and shareholders are reasonably happy with this situation and are averse to adopting strategies that they think might involve a substantial increase in risk, for example, acquisition or setting up manufacturing capability overseas, as some of HG’s European competitors have done. As a consequence, HG accepts its growth rate will be relatively low, compared with some of its competitors. The entity is financed 70% equity and 30% debt (based on book values). The debt is a mixture of secured and unsecured bonds carrying interest rates of between 7% and 8⋅5% and repayable in 5 to 10 years’ time. Inflation in HG’s country is near zero and interest rates are low and possibly falling. The Company Treasurer is investigating the opportunities for, and consequences of, refinancing. HG’s main financial objective is simply to increase dividends each year. It has one non-financial objective, which is to treat all stakeholders in the organisation with “fairness and equality”. The Board has decided to review these objectives. The new Finance Director believes maximisation of shareholder wealth should be the sole objective, but the other directors do not agree and think a range of objectives should be considered, for example profits after tax and return on investment and performance improvement across a number of operational areas.

Required: (a) Evaluate the appropriateness of HG’s current objectives and the Finance Director’s

suggestion, and discuss the issues that the HG Board should consider when determining the new corporate objectives. Conclude with a recommendation.

(15 marks)

(b) Discuss the factors that the treasury department should consider when determining financing, or re-financing strategies in the context of the economic environment described in the scenario and explain how these might impact on the determination of corporate objectives.

(10 marks)

(Total for Question Two = 25 marks)

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November 2005 8 P9

Question Three FS provides industrial and commercial cleaning services to organisations throughout a country in the European Union. Its shares have been listed for 15 years and, until two years ago, the entity followed a policy of aggressive growth, mainly by acquisition. However, in the last two years, there have been few suitable takeover opportunities and, as a consequence, growth has slowed. The market has downgraded FS’s shares and they are currently trading at €3⋅57, the lowest price for five years. The market as a whole has declined in value, but not to the same extent as FS’s shares. FS’s bank has recently informed FS’s directors of a possible takeover opportunity of another of its clients, MT. This is a large private entity in the same industry as FS. MT’s directors have indicated to the bank that if the price is right they may be prepared to sell the entity. MT’s directors have made their financial forecasts and other strategic documentation available to the bank on a strictly confidential basis, requesting that this information only be released to a serious potential bidder. After much discussion between the bank and the two companies, MT agrees that FS should have the information. MT’s results for the past three years and the directors’ estimates for the current year are as follows: Year to 30 June Revenue Earnings €million €million 2003 925 55⋅5 2004 1,020 62⋅7 2005 1,150 71⋅5 2006 (forecast) 1,350 88⋅9 For 2007 onwards, growth in earnings and dividends is likely to fall to 4% per annum, according to MT’s directors. MT has paid a dividend of 50% of its earnings for the past 10 years. Summary balance sheets as at 30 June 2005 for both FS and MT are as follows: FS MT €million €million TOTAL ASSETS Non-current assets 1,944 1,040 Current assets * 796 375 2,740 1,415 EQUITY AND LIABILITIES Equity Share capital (Shares of €1) 420

(Shares of 50 cents) 220 Retained earnings 1,080 680 1,500 900 Non-current liabilities (Secured bonds, 6% 2015) 750 (Unsecured bonds, 7% 2010) 300 Current liabilities 490 215 1,240 515 2,740 1,415 * Includes cash of 250 65



November 2005 9 P9

FS’s revenues and earnings for the year ended 30 June 2005 were €2,250 million and €128⋅5 million respectively. After thoroughly examining the information on MT, financial managers in FS have identified a number of savings and potential synergies that would arise if the takeover were to go ahead. These synergies are estimated to have a net present value of €200 million. However, the FS directors believe MT’s forecast earnings are over-optimistic and think earnings growth for 2006 onwards is likely to be in the range 2% to 4%. The bank advisers disagree, but they are in a delicate situation trying to balance the interests of two clients. FS’s cost of equity is 8⋅5%. MT has not provided information on its cost of capital, but the two entity’s asset betas are likely to be the same. FS’s equity beta is quoted as 1⋅1. The expected risk free rate of return is 3% and the expected return on the market is 8%. Assume that the debt beta for both companies is 0⋅2 and that FS’s debt is trading at par. Ignore tax in your calculations.

Required:

Assume you are a Financial Manager with FS. Advise the directors of FS on

(i) the appropriate cost of capital to be used when valuing MT. Accompany your comments with a calculation of the cost of equity for MT.

(6 Marks)

(ii) a bidding strategy; that is the initial price to be offered and the maximum FS should be prepared to offer for the shares in MT. Use whatever methods of valuation you think appropriate and accompany each with brief comments on their suitability in the circumstances here. In calculations of value that require a discount rate, use the cost of equity you have calculated in (i) above. Your answer should consider the interests of both groups of shareholders.

(13 marks)

(iii) the most appropriate form of consideration to use in the circumstances. Assume the choice is either a share exchange or cash. Your answer should consider the interests of both groups of shareholders.

(6 marks)

(Total for Question Three = 25 marks)

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November 2005 10 P9

Question Four WZ is a manufacturer of specialist components for the motor trade. It is based in Zafran, a country in the Far East. The entity’s capital structure is as follows: • 5 million ordinary shares of Z$1 each, currently quoted at Z$12⋅5 per share. • 10 million preference shares of Z$1 each, currently quoted at Z$0⋅80 per share, paying a

dividend of 7% per annum. • Z$20 million, 8% undated debt, secured on the entity’s non-current assets. This debt is

currently trading at Z$90 per Z$100 nominal. To finance expansion, the directors of WZ want to raise Z$5 million for additional working capital. Cash flow from trading, before interest and tax is currently Z$15 million per annum. If the expansion goes ahead, this is expected to rise to Z$17 million. The current rate of tax, which is expected to continue for the foreseeable future, is 30%. Assume for the purposes of simplicity: • That profit after interest and tax equals cash flow; • The required rate of return on equity will remain at the current rate of 12% per annum

irrespective of type of finance raised; • There are no transaction costs. The directors of WZ are considering three forms of finance: 1 Equity via a rights issue at 15% discount to current market price; 2 9% bonds repayable in 2015 secured as a floating charge on the entity’s current assets. 3 Factoring the entity’s trade receivables. This is likely to provide a one-off release of funds

of approximately Z$5 million.

Required:

(a) Calculate for the current situation and financing alternatives 1 and 2 the expected

(i) earnings per share;

(ii) market value of equity, using the capitalisation of earnings at the cost of equity;

(iii) market value of the entity;

(iv) gearing ratios (debt to total value of the entity), using market values;

(v) weighted average cost of capital.

State whatever assumptions you consider necessary.

(12 marks)

(b) Assume you are a Financial Manager with WZ. Advise directors of WZ of the issues to be considered before deciding on which form of finance to choose, including factoring, and make your own recommendation.

(13 marks)

(Total for Question Four = 25 marks)



November 2005 11 P9


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November 2005 12 P9

Question Five RJ plc is a supplier of surgical instruments and medical supplies (excluding drugs). Its shares are listed on the UK’s Alternative Investment Market and are currently quoted at 458 pence per £1 share. The majority of its customers are public sector organisations in the UK. RJ plc is doing well and now needs additional capital to expand operations. The forecast financial statements are given below.

Extracts from the Income Statement for the year ended 31 December 2005

£000 Revenue 30,120 Costs and expenses 22,500 Operating profit 7,620 Finance costs 2,650 Profit before tax 4,970 Tax 1,491 Note: Dividends declared for 2005 are £1,392,000

Balance Sheet as at 31 December 2005

£000 £000 TOTAL ASSETS Non-current assets 14,425 Current assets Inventories 4,510 Trade receivables 3,700 Cash 198 8,408 22,833 EQUITY AND LIABILITIES Equity Share capital 8,350 Retained earnings 4,750 13,100 Non-current liabilities (Secured bonds, 6% 2008) 4,000 Current liabilities Trade payables 2,850 Other payables (tax and dividends) 2,883 5,733 22,833 You have obtained the following additional information: 1 Revenue is expected to increase by 10% per annum in each of the financial years ending

31 December 2006 and 2007. Costs and expenses, excluding depreciation, are expected to increase by an average of 5% per annum. Finance costs are expected to remain unchanged.

2 RJ plc expects to continue to be liable for tax at the marginal rate of 30%. Assume tax is

paid or refunded the year following that in which the liability or repayment arises.



November 2005 13 P9

3 The ratios of trade receivables to revenue and trade payables to costs and expenses will remain the same for the next two years. The value of inventories is likely to remain at 2005 levels.

4 The non-current assets are land and buildings, which are not depreciated in RJ plc’s

books. Capital (tax) allowances on the buildings may be ignored. All other assets used by the entity (machinery, cars and so on) are either rented or leased on operating leases.

5 Dividends will be increased by 5% each year. 6 RJ plc intends to purchase for cash new machinery to the value of £6,000,000 during

2006, although an investment appraisal exercise has not been carried out. It will be depreciated straight line over 10 years. RJ plc intends to charge a full year’s depreciation in the first year of purchase of its assets. Capital (tax) allowances are available at 25% reducing balance on this expenditure.

RJ plc’s main financial objectives for the years 2006-2007 are to earn a pre-tax return on the closing book value of equity of 35% per annum and a year-on-year increase in earnings of 10%.

Required: Assume you are a consultant working for RJ plc. Evaluate the implications of the financial information you have obtained. You should: (i) Provide forecast income statements, dividends and retentions for the two years

ending 31 December 2006 and 2007. (6 marks)

(ii) Provide cash flow forecasts for the years 2006 and 2007. Comment briefly on how RJ plc might finance any cash deficit.

(8 marks)

Note: This is not an investment appraisal exercise; you may ignore the timing of cash flows within each year and you should not discount the cash flows. You should also ignore interest payable on any cash deficit.

(iii) Discuss the key aspects and implications of the financial information you have obtained in your answer to parts (i) and (ii) of the question, in particular whether RJ plc is likely to meet its stated objectives. Provide whatever calculations you think are appropriate to support your discussion. Up to 4 marks are available for calculations in this section of the question.

(11 marks)

(Total for Question Five = 25 marks)

(Total for Section B = 50 marks)


Maths Tables and Formulae are on pages 15 to 19



November 2005 14 P9




November 2005 15 P9






November 2005 16 P9

Cumulative present value of 1.00 unit of currency per annum

Receivable or Payable at the end of each year for n years

−+−

rr n)(11

Interest rates (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514


1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870



November 2005 17 P9


P0 = prefk

d


P0 = ek

d


P0 = gk

d

−e

1 or P0 = gk

gd

−

+

e

0 ][1


P0 = netd

][1

k

ti −


i


Vg = Vu + TBc


S = X[1 + r]n


PV = nr ][1

1

+


PV =

+

− nrr ][1

11

1


PV = r

1


PV = gr −

1




November 2005 18 P9


price P0:

kpref = 0P

d


kd net = 0P

ti ][1 −


ke =

0P

d


ke = gP

d+

0

1 or ke = g

P

gd+

+

0

0 ]1[





DVV



DV

tV ][1−


k0 = keg

+

++ DE

D

DE

E

VV

Vk

VV

Vd





ßu = ßg

+ DE

E

VV

V

(xi) If ßd is not zero:

ßu = ßg

+ DE

E

VV

V + ßd

+ ED VVDV

(xii) ßu from ßg, taking ßd as zero (with tax):

ßu = ßg

−+ ][1 tVV

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November 2005 19 P9

(xiii) Adjusted discount rate to use in international capital budgeting using interest rate parity:

C$/Euro rate Spot




+

+




+

+



rateinflationUS1

+

+





yearsovercostsof

n

nPV


TERP = 1

1





+

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November 2005 20 P9




November 2005 21 P9



November 2005 22 P9



November 2005 23 P9



November 2005 24 P9




November 2005




Paper P9 – Management Accounting Financial Strategy Post Exam Guide November 2005 Exam


Examiners’ General Comments This was the second diet of the new syllabus. The performance at the first diet in May 2005 had been very disappointing and November 2005 does not show any improvement. Similar weaknesses were observed, with many candidates lacking knowledge of even quite basic financial calculations. This was clearly demonstrated in question one where many could not carry out a simple T.E.R.P. calculation, or obtain forward exchange rates from interest rates. The grasp of basic concepts was also poor, with a lack of ability to distinguish between cash flow and profit figures or calculate a simple average investment figure as part of a calculation of an average accounting rate of return in Question 1 part (a). Despite specific guidance in the Post Exam Guide after the May 2005 examination, some candidates still attempted the investment appraisal calculations in Question 1 without using a tabular format. This creates considerable confusion for candidate and marker alike and unnecessary loss of a mark for structure and presentation. The most popular optional questions were Questions 4 and 5. Question 5 proved to be a good choice with the highest average mark of any question. Candidates were generally highly competent in producing forecast income statements and cash flow forecasts from balance sheet and other data. Question 4 was less successful, with most calculating ratios such as earnings per share without first adjusting the pre-interest and tax trading cash flows for basic items such as interest and tax. Answers to the second half of the question were also poor, with few demonstrating any depth of knowledge of factoring and many answers looking surprisingly similar to those for Question 3 (iii). The least popular question was Question 3 which also had the lowest marks. In this question, candidates were required to de-gear and re-gear a beta and calculate a range of values for a given entity and there were some poor attempts at these calculations. In part (ii) of Question 3, many failed to provide much valid discussion of a bidding strategy. Some restricted their answers to calculations only, despite a high mark allocation of 13 marks indicating that more detailed analysis and discussion was expected. The inability of candidates to apply knowledge to a given case scenario was highlighted, in particular, in Question 2. In part (b) of that question, they were required to look at financing strategies “in the context of the economic environment described” which included near zero inflation and low interest rates. However, there was barely a mention of these issues in many scripts. We hope for great improvement in competence in handling financial calculations and in the ability to apply knowledge to a given case scenario in the May 2006 diet!





SECTION A Question 1 (a) Show, by calculation, that the proposed investment project in Bustan met the two minimum investment criteria set by GAS plc.

(18 marks)

Rationale This question concerns an international energy entity. The organisation is based in the UK, but has operating subsidiaries throughout Europe. The organisation is looking to expand and has focused new investment in a large Asian country, which is in urgent need of major improvements in its energy generation and supply to support increases in industrial production there. The question involves investment appraisal and discussion of the major risks to the energy entity of this new investment. It also examines concerns made by the Board of the energy entity about the unusually volatile movements in the entity’s share price recently. The question requires candidates to explain the possible reasons for the movements, advise on a fair market share price following acceptance of the project proposal by the country, after adjusting for the proposed share issue, and the extent to which the Board of the energy entity is able to influence this price. It further requires a calculation and discussion of the entity’s share price based upon three different bases. Marks are available for structure and presentation of the answer. It examines topics in all four sections of the syllabus. Suggested Approach Criterion 1 Adjust Bustan cash flows for depreciation and loss on realisation of working capital to obtain profit figures Calculate the accounting rate of return using these annual profit figures and an average investment figure calculated as 50% of the sum of the initial investment and residual value Apply Bustan tax to the annual profit figures (as capital allowances are the same as depreciation)

Criterion 2 Adjust profit figures to obtain the net cash figure repatriated to the UK Deduct UK tax and add back double tax relief Include the initial and residual investment cash flows Convert cash flows from Bustan $ to UK £ (at spot if using a discount factor adjusted for the difference in interest rates, otherwise at forward rates) Apply the appropriate discount factor to obtain the NPV of the £ cash flows. The best approach was to adjust the discount factor by the interest rates, enabling years 5 to 9 to be aggregated and a single 5 year annuity factor to be applied to the aggregated cash flows in years 5 to 9





Marking Guide

Marks

Structure and presentation of the numbers in columnar format 1 Operating cash flows 1 Loss on realisation of working capital 1 Bustan tax 2 Annual accounting profit 1 Average profit 1 Average investment 1 ARR and comment 1 UK tax including double tax relief 3 Initial investment and residual value 2 Conversion $ to £, including adjusting discount factor 3 NPV and comment 1 Examiners’ Comments Most managed to pick up enough marks to earn half marks on this part of the question. Candidates usually made a good attempt at scheduling the cash flows and calculating the NPV. The most worrying aspect was the difficulty candidates had in differentiating profit from cash flow, using profit figures to calculate the NPV and/or cash flow figures in the accounting rate of return. Many had problems with both the numerator and denominator of the ARR (see Common Errors below) despite being provided with the formula in the question. The calculation of forward rates and conversion of $ to £ was also surprisingly poor. It was very common for interest rates to be applied the wrong way round, or for candidates to multiply, rather than divide, the Bustan $ cash flow figure by the relevant exchange rate. Few spotted the significantly faster approach of adjusting the discount factor using the two interest rates provided. This eliminates the need to calculate forward exchange rates since the cash flows (or, quicker still, the final NPV figure) can be converted at spot. In addition, figures for years 5 to 9 are then identical and can be amalgamated. Common Errors Omitting the loss on realisation of working capital Not adjusting for capital allowances when calculating Bustan tax Using cash flow rather than profit figures in the numerator of the ARR calculation Deducting rather than adding the residual value of the investment to the initial value when calculating average investment for the denominator of the ARR calculation Timing problems with the UK tax calculation: applying a net 10% tax rate is only an approximation and this approach did not earn full credit Omitting UK tax altogether or applying a 30% rate and ignoring the double tax treaty





Question 1 (b) Discuss the major risk issues that should have been considered by GAS plc when evaluating the project.

(7 marks) Rationale Per 1 (a) Suggested Approach

Discuss the reliability of the cost and revenue estimates that underlie the analysis Highlight the importance of the residual value estimate to the positive NPV result and consider the numerous potential problems that might arise when attempting to sell on the plant and equipment Consider the impact of a delay in the project Discuss the impact of other factors such as: Regulator/political interference such as changes to the favourable tax treatment or restrictions on repatriation of profits Movements in exchange rates not as forecast Marking Guide

Marks

Comments should be awarded up to 3 marks each depending on quality of discussion. Key points are as below but marks should be awarded for other valid comments not included in the list.

Max 7

Reliance of result on the key estimate of realisation of plant and equipment Other cost and revenue estimates and timings Risk of regulator/political interference Exchange rates/discount factor assumptions Examiners’ Comments There were some good answers to this question and usually some attempt to apply risk issues to the scenario provided. Common Errors Few picked up the key issue of the high dependency of the result on the estimated realisable value of the plant and equipment. Many failed to even identify the reliability of cost and revenue estimates as a risk issue.





Question 1 (c) The board of GAS plc has been concerned about the unusually volatile movements in the entity’s share price in 2004 and 2005 and has asked you, an external management consultant, to draft a report to the board of GAS plc that critically addresses the issues detailed below. Assume a semi-strong efficient market applies.

(i) Explain the possible reasons for the unusually volatile movements in the entity’s share price

in the twelve months up to and including 1 January 2005. NO calculations are required.

(6 marks)

(ii) Advise what would have been a fair market price for GAS plc’s shares in January 2005 following the announcement of the acceptance of the proposal and after adjusting for the proposed rights issue. As part of your answer, calculate GAS plc’s share price on each of the bases listed below and discuss the relevance of each result in determining a fair market price for the entity’s shares:

• the theoretical ex-rights price before adjusting for the project cash flows; • the theoretical ex-rights price after adjusting for the project cash flows; • directors’ dividend forecast issued in January 2005.

(14 marks)

(iii) Advise on how and to what extent directors are able to influence their entity’s share price.

(5 marks)

Within the overall mark allocation, up to 4 marks are available for structure and presentation. Rationale Per 1 (a) Suggested Approach Part (i) Provide a brief summary of the efficient market hypothesis Consider each price-sensitive event in turn and explain the likely impact of that event on GAS plc’s share price Emphasise the importance of shareholder expectations of the profitability and risks associated with the project on the share price Explain the possible impact of general market and business conditions on the share price





Question 1 (c) (continued) Suggested Approach Part (ii) Calculate T.E.R.P. before project cash flows Calculate T.E.R.P. after project cash flow Calculate share price using the dividend growth model and based on the directors’ dividend forecast Discuss and explain the results of the above analysis Conclusion Part (iii) Explain the impact of information provided to the market by directors on the share price Advise on the need for directors to give careful consideration to the release of accurate information to the market and not to mislead shareholders or other interested parties by announcing unrealistic dividend or earnings predictions Structure and presentation Use memorandum format for your answer State purpose Use a main heading and sub-headings Summarise key comments in a conclusion Marking Guide

Marks

Comments should be awarded up to 3 marks each depending on quality of discussion. Key points are as below but marks should be awarded for other valid comments not included in the list. Part (i) Efficient market hypothesis – explanation of semi-strong form

Max 5

Impact of changes in economic or business conditions on the share price Market perception of the likely outcome of the bid and profitability of the project Extent to which the information has been anticipated by the market Part (ii) Calculation of T.E.R.P. before project cash flows (max 3)

Max 13

Calculation of T.E.R.P. after project cash flows (max 2) Calculation based on directors’ dividend forecast (max 3) Discussion of results/alternative calculations (max 6) Conclusion (max 2) Part (iii) Informing the market of developments

Max 4

Importance of accurate information/dividend predictions Structure and presentation in parts (c)(i) to (c)(iii)

Max 3





Question 1 (c) (continued) Examiners’ Comments Parts (c) (i) and (c)(iii) were generally answered well. In some cases, more detail was provided than was warranted by the mark allocation. The calculations in part (c) (ii) were less well handled (see Common Errors below) and the discussion tended to be limited to noting that one figure was higher. The figures had been deliberately chosen to ensure that the share price based on the director’s revised dividend forecast was highly unrealistic in the light of the enhanced returns as a result of the new project, but very few raised this key issue. Common Errors Part (i) No specific comments Part (ii) Inaccurate calculation of the T.E.R.P. before project cash flows. Errors included:

Using an investment value of $700 without first converting this into £ Converting the $700 initial investment value into £ by multiplying rather than dividing by the spot rate Using an assumption or estimate rather than calculating the actual rights price Basing calculation of numbers of shares on a nominal share value of £1 rather than 50p

Failing to adjust for the proceeds of the rights issues in the calculation of the T.E.R.P after project cash flows Oversimplification of the dividend growth model valuation by assuming perpetual growth, ignoring the constant 14p dividend in the first 3 years Little or no comment on the relative reliability of the market prices calculated Part (iii) Discussion of fraudulent and insider dealing activities used to influence the entity’s share price without making it clear that this is illegal and undertaking such activities is not part of your advice!





SECTION B Question 2 (a) Evaluate the appropriateness of HG’s current objectives and the Finance Director’s suggestion, and discuss the issues that the HG Board should consider when determining the new corporate objectives. Conclude with a recommendation.

(15 Marks)

Rationale Part (a) requires evaluation of the appropriateness of the current and proposed objectives of the entity described in the question. It also requires discussion of the issues arising and asks candidates to make a recommendation to the Board of the entity about these. Suggested Approach Provide a brief summary of the theoretical position Note that the entity in the scenario is a private entity and does not have a quoted share price Note the advantages and limitations of the entity’s current objectives Discuss the advantages and disadvantages of alternative objectives Make a recommendation Marking Guide

Marks

Comments should be awarded up to 3 marks each depending on quality of discussion. Key points are as below, but marks should be awarded for other valid comments not included on the list.

Theory supports maximising shareholder wealth Private company – no market value available Dividend growth as sole objective has limitations PAT and Rol – advantages and disadvantages (more than 3 marks available here for good discussion) Broader objectives – advantages and disadvantages Possible use of balanced scorecard

Recommendation and possible need for an unlisted entity to consult shareholders





Question 2 (a) (continued) Examiners’ Comments Very few managed to provide more than a marginally satisfactory answer to this question. For many, this question appeared to be a “make weight” that was attempted when none of the other optional questions (which all required calculations) was possible. It was the second least popular of the optional questions. Common Errors No specific common errors for this part of the question. The main areas of weakness were providing vague and insubstantial discussion. Many did not conclude with valid recommendations, as required by the question. Question 2 (b) Discuss the factors that the treasury department should consider when determining financing, or re-financing, strategies in the context of the economic environment described in the scenario and explain how these might impact on the determination of corporate objectives.

(10 Marks) Rationale Part (b) requires discussion of the factors to be considered by the treasury department of the entity when determining financing, or re-financing, strategies in the context of the issues currently facing the entity. Suggested Approach Provide a short introduction noting the key points that are to be addressed in the answer Note the theoretical position about debt being cheaper than equity and the reasons why this is so Discuss the arguments as to why debt might become a burden in an economic environment as described in the scenario Provide a conclusion The key points to be discussed are shown below.





Question 2 (b) (continued) Marking Guide

Comments should be awarded up to 3 marks each depending on quality of discussion. Key points are as below but marks should be awarded for other valid comments not included on the list.

Low inflation/no growth might mean cash generation in excess of investment opportunities How to deal with surplus and impact on capital structure Discussion of choices – equity v debt (more than 3 marks available here for good discussion) Theoretical effect on value of firm Refinancing options and rate of return required by shareholders Possible effect of joining ECCA Examiners’ Comments See comments in part (a) Common Errors No specific common errors for this part of the question. The main areas of weakness were in providing vague and insubstantial discussion. A common weakness was not relating the discussion of the factors to the determination of corporate objectives, as required by the question.





Question 3 (i) Assume you are a Financial Manager with FS. Advise the directors of FS on (i) The appropriate cost of capital to be used when valuing MT. Accompany your comments with a

calculation of the cost of equity for MT.

(6 Marks)

Rationale Part (i) requires candidates to advise the directors of the entity described in the question on the appropriate cost of capital to be used when valuing a potential takeover of a current client. Suggested Approach Calculate market value for FS Calculate the beta of an ungeared firm Calculate the beta of MT Calculate required return on equity for MT Provide brief comments on the appropriate cost of capital Marking Guide

Marks

Market value for FS

0.5

Bu for FS 1.5 Bg for MT 1.5 Re for MT 0.5 Comments on appropriate cost of capital 2 Examiners’ Note: Alternative, valid approaches would have gained credit

Examiners’ Comments This question was generally quite poorly attempted with many not realising the approach that was required. Common Errors Not calculating a market value for FS





Question 3 (ii) Assume you are a Financial Manager with FS. Advise the directors of FS on (ii) A bidding strategy; that is the initial price to be offered and the maximum FS should be prepared to

offer for the shares in MT. Use whatever methods of valuation you think appropriate and accompany each with brief comments on their suitability in the circumstances here. In calculations of value that require a discount rate, use the cost of equity you have calculated in (i) above. Your answer should consider the interests of both groups of shareholders.

(13 Marks)

Rationale Part (ii) requires candidates to advise on a bidding strategy, using whatever methods of valuation the candidates think appropriate, supported by comments on their suitability in the circumstances described. Suggested Approach Identify the key methods of valuation Note asset values, recognising that these will be increased by retained earnings Calculate market values using the bidding company’s PE ratio Comment on the need to do a cash flow evaluation Calculate valuation using dividend valuation model Provide comments as per the list below Marking Guide

Marks

Identifying methods of valuation

1

Asset values: 1 + for recognising retained earnings 1

Market value using P/E ratios 2 Commenting on/making adjustment 1 Comment on CAPM/cash flows 1 DVM-based method:

Comment/calculation of growth 1 Values – range 3

Comments on bidding strategy key points are : (max 6) Agreed bid/ask for more information Probable 2-stage process Recognition of synergies and value Bank’s involvement Relevance to corporate objectives

Any valid attempt at a bid price





Question 3 (ii) (continued) Examiners’ Comments This part of the question was reasonably well attempted and most managed to provide some discussion of a range of valuation methods. A minority failed to recognise that MT was a private company and therefore did not have a share listing. Common Errors Showing net assets as total assets Not recognising that the assets will be increased by retained earnings Not providing a range of valuations depending on the different growth forecasts Providing calculations but inadequate discussion Question 3 (iii) Assume you are a Financial Manager with FS. Advise the directors of FS on (iii) The most appropriate form of consideration to use in the circumstances. Assume the choice is

either a share exchange or cash. Your answer should consider the interests of both groups of shareholders.

(6 Marks)

Rationale Part (iii) requires candidates to advise on the most appropriate form of consideration (either share exchange or cash) to use in the circumstances described with particular consideration of the interests of both groups of shareholders. Suggested Approach

Discuss the key points if the bid is to be in cash, noting that insufficient cash is available at present

Discuss the advantages and disadvantages of a share exchange

Provide a recommendation





Question 3 (iii) (continued) Marking Guide

Marks

Comments should be awarded up to 3 marks each depending on quality of discussion. Key points are as below, but marks should be awarded for other valid comments not included on the list.

Cash:

Cash available per Balance Sheet Effect of debt on gearing/EPS

Shares: Calculation of an exchange rate Effect on gearing/cost of capital Would MT’s shareholders accept shares Effect on bidder if they did accept shares but then sell Other factors (cost, control etc)

Examiners’ Comments This part of the question was reasonably well attempted by well-prepared candidates, although many provided a standard discussion of share exchange versus cash without relating it to the scenario details. Common Errors Providing inadequate discussion. Providing discussion, but not supported by any calculations.





Question 4 (a) Calculate for the current situation and financing alternatives 1 and 2 the expected: (i) earnings per share;

(ii) market value of equity, using the capitalisation of earnings at the cost of equity;

(iii) market value of the entity;

(iv) gearing ratios (debt to total value of the entity), using market values;

(v) weighted average cost of capital

State whatever assumptions you consider necessary. (12 Marks)

Rationale Part (a) requires calculation of various financial indicators, based upon three different bases, pertaining to the entity described in the question. Suggested Approach

Calculate number of new shares to be issued by way of a rights issue and total number of shares in issue following the rights

For the current situation and each alternative, calculate: Earnings for equity Earnings per share Market value of equity Market value of the entity Gearing ratios Weighted average cost of capital

Marking Guide

Marks

Calculations Per alternative Total

Preliminaries: Number of new shares/total shares 1.5 Earnings for equity 0.5 1.5 (i) EPS 0.5 1.5 (ii) MV of equity 0.5 1.5 (iii) MV of entity 0.5 1.5 (iv) Gearing ratios 0.5 1.5 (v) WACC 1 3





Question 4 (a) (continued) Examiners’ Comments This part of the question was not as well answered as might have been expected, as it required fairly straightforward calculations, although most managed to obtain marginally satisfactory marks Common Errors Not recognising that the dividend on preference shares does not attract tax relief Not calculating earnings but using cash flow from trading before interest and tax Calculating the market value of equity by multiplying the number of shares in issue by the share price. The question specifically asks for the market value to be calculated using the capitalisation of earnings at the cost of equity Assuming the market value of the entity was the same as the market value of equity Not calculating the cost of preference and cost of debt in the weighted average cost of capital calculations (that is using the coupon rates instead). Question 4 (b) Assume you are a Financial Manager with WZ. Advise directors of WZ of the issues to be considered before deciding on which type of finance to choose, including factoring, and make your own recommendation.

(13 Marks) Rationale Part (b) requires candidates to advise the directors of the entity of the issues to be considered before deciding which form of financing to choose to fund its expansion and asks candidates to make a recommendation to the directors about these. Suggested Approach

Note which alternative maximises the value of equity and note the advantages and disadvantages of this alternative

Note the effect on dividends and gearing Discuss the advantages and disadvantages of financing by factoring





Marking Guide

Comments should be awarded up to 3 marks each depending on quality of discussion. Key points are as below, but marks would have been awarded for other valid comments not included on the list below.

Advise which alternative maximises value of equity and EPS Effect on required rate of return of shareholders Effect on dividends – if any Other suitable methods of finance Factoring: pros and cons/suitability Market and economic factors Examiners’ Comments In this part of the question, most understood what was required and provided a satisfactory discussion. Common Errors Providing a general discussion of the advantages and disadvantages of debt versus equity without relating it to the specific circumstances of the question Not providing any discussion, or inadequate discussion, on factoring.





Question 5 (i) Required: Assume you are a consultant working for RJ plc. Evaluate the implications of the financial information you have obtained. You should:

(i) Provide forecast income statements, dividends and retentions for the two years ending 31

December 2006 and 2007. (6 Marks)

Rationale This question requires evaluation of the implications of the financial information by the provision of forecast income statements, dividends and retentions and cash flow forecasts for the next two years based upon extracts of the income statement and balance sheet of the entity described in the question. Suggested Approach

Provide the following calculations in an income statement layout for 2006 and 2007:

Revenue, costs and expenses Depreciation Operating profit Finance costs Tax Earnings Dividends declared Retained earnings for the year

Marking Guide

Marks

For both years (2006 and 2007):

Revenue, costs and expenses (including depreciation) 1.5 Finance costs 0.5 Correct handling of depreciation 0.5 Tax, including Capital Allowances up to 2.0 Earnings 0.5 Dividends 0.5 Retained earnings

0.5





Question 5 (i) (continued) Examiners’ Comments This part of the question was generally well answered by those who attempted it. The main area of weakness was, as noted below, an inability to recognise the impact of capital allowances in the taxation figure. Common Errors Increasing costs and expenses by 10% instead of 5% Ignoring depreciation Not calculating the effect of capital allowances in the taxation figure Not completing the statement by showing retained earnings Question 5 (ii) Required: Assume you are a consultant working for RJ plc. Evaluate the implications of the financial information you have obtained. You should: (ii) Provide cash flow forecasts for the years 2006 and 2007. Comment briefly on how RJ plc might

finance any cash deficit.

(8 Marks)

Note: This is not an investment appraisal exercise; you may ignore the timing of cash flows within each year and you should not discount the cash flows. You should also ignore interest payable on any cash deficit.

Rationale See part (i)





Question 5 (ii) (continued) Suggested Approach

Provide a suitable cash flow forecast layout. Note that there is some flexibility in the method of presentation as the question asks for a cash flow forecast rather than a cash flow statement (which would need to be in published statement format).

Calculate the following Cash received Cash payable Cost of machinery Taxation payable in the year Dividends payable in the year Finance costs Net cash flow, opening and closing balances

Provide brief comments on the final closing balance Marking Guide

Marks

Cash from sales 1.0 Purchases 1.0 Machinery 0.5 Taxation (recognising timing) 0.5 Dividends (recognising timing) 0.5 Finance costs 0.5 Net cash flow and opening and closing balances 2.0 Comments 2.0 Examiners’ Comments This part of the question was also generally well answered, although, in many cases, the presentation of the figures could have been improved. Common Errors Not showing opening and closing balances Timing errors Not providing any comments





Question 5 (iii) Required: Assume you are a consultant working for RJ plc. Evaluate the implications of the financial information you have obtained. You should:

(iii) Discuss the key aspects and implications of the financial information you have obtained in your

answer to parts (i) and (ii) of the question, in particular whether RJ plc is likely to meet its stated objectives. Provide whatever calculations you think are appropriate to support your discussion. Up to 4 marks are available for calculations in this section of the question.

(11 Marks)

Rationale Part (iii) of the question requires discussion of the key aspects and implications obtained from the financial information provided and, in particular, whether the entity is likely to meet its stated objectives. Marks are available for calculations. Suggested Approach

Provide some supporting calculations, for example return on equity, earning per share increase

Discuss key points as shown in the list below Marking Guide

Marks

Calculations – up to a maximum of 4

Return on Equity EPS increase Market Value of company DPS increase

Key points 7

Return on Equity Investment and financing Increase in earnings and dividends Effect on Market Value

Examiners’ Comments No specific comments. Common Errors Providing some discussion, but no supporting calculations

















P9 –

Fin

anci

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trat

egy

TURN OVER



May 2006 2 P9


[the indicative time for answering this Section is 90 minutes]

READ THE SCENARIO AND ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One

Scenario

PM Industries plc Background PM Industries plc (PM) is a UK-based entity with shares trading on a UK Stock Exchange. It is a long established business with widespread commercial and industrial interests worldwide. It had a modest growth and profitability record until four years ago when a new Chief Executive Officer (CEO) was appointed from the United States of America (US). This new CEO has transformed the business by divesting poor performing, or non-core, subsidiaries or business units and focusing on volume growth in the remaining units. Some of this growth has been internally generated and some has come about because of financially sound acquisitions. A particular area of strength is in non-drug pharmaceutical materials such as packaging. PM now controls the largest share of this market in the UK and Europe. Financial objectives PM’s current financial objectives are:

• To increase EPS by 5% per annum; • To maintain a gearing ratio (market values of long-term debt to equity) below 30%; • To maintain a P/E ratio above the industry average.

Proposed merger The senior management of PM is currently negotiating a merger with NQ Inc (NQ), a US-based entity with shares trading on a US Stock Exchange. NQ is an entity of similar size to PM, in terms of revenue and assets, with a similar spread of commercial and industrial interests, especially pharmaceutical materials, which is why PM originally became attracted to NQ. NQ has had a less impressive track record of growth than PM over the last two years because of some poor performing business units. As a result, PM’s market capitalisation is substantially higher than NQ’s. Although this will, in reality, be an acquisition, PM’s CEO refers to it as a “merger” in negotiations to avoid irritating the NQ Board, which is very sensitive to the issue. NQ holds some software licences to products that the CEO of PM thinks are not being marketed as well as they could be. He believes he could sell these licences to a large software entity in the UK for around £100 million. He does not see the commercial logic in retaining them, as information technology is not a core business. The value of these licences is included in NQ’s balance sheet at $US125 million. Both entities believe a merger between them makes commercial and financial sense, as long as terms can be agreed. The CEO of PM thinks his entity will have the upper hand in negotiations because of the share price performance of PM over the last 12 months and his own reputation in the City. He also believes he can boost the entity’s share value if he can convince the market his entity’s growth rating can be applied to NQ’s earnings.



May 2006 3 P9

Summary of relevant financial data Extracts from the Income Statements for the year ended 31 March 2006

PM NQ £ million $ million

Revenue 1,560 2,500 Operating profit 546 750 Earnings available for ordinary shareholders 273 300 Extracts from the Balance Sheets as at 31 March 2006

PM NQ £ million $ million

Total net assets 2,000 2,100 Total equity 850 1,550 Total long term debt 1,150 550 Other data Number of shares in issue

Ordinary shares of 10 pence 950,000,000 Common stock of $1 850,000,000

Share price as at today (24 May 2006) 456 pence 450 cents High/low share price over last 12 months 475 pence/326 pence 520 cents/280 cents Industry average P/E ratio 14 13 Debt traded within last week at £105 Par

Five-year revenue and earnings record

PM (£m) NQ (US$m) Year ended 31 March Revenue Earnings Revenue Earnings 2002 1,050 225 1,850 250 2003 1,125 231 1,950 265 2004 1,250 245 2,150 280 2005 1,400 258 2,336 290 2006 1,560 273 2,500 300 The two entities’ revenue and operating profits are generated in the following five geographical areas, with average figures over the past five years as follows: PM NQ

Percentage of total: Revenue Profits Revenue Profits UK 30 28 20 17 US 22 23 75 76 Mainland Europe 20 17 5 7 Asia (mainly Japan) 18 20 0 0 Rest of World 10 12 0 0 Economic data PM’s bankers have provided forecast interest and inflation rates in the two main areas of operation for the next 12 months as follows:

Interest rates Current forecast

Inflation rate Current forecast

UK 4⋅5% 2⋅0% US 2⋅5% 1⋅5%

Terms of the merger PM intends to open the negotiations by suggesting terms of 1 PM share for 2 NQ stock units. The Finance Director of PM, plus the entity’s professional advisors, have forecast the following data, post-merger, for PM. They believe this is a “conservative” estimate as it excludes their estimate of value of the software licences. The current spot exchange rate is $US1⋅85 = £1. Market capitalisation £6,905 million EPS 31⋅65 pence

The question continues (with its requirements) on page 5 TURN OVER



May 2006 4 P9




May 2006 5 P9

Question One (continued) A cash offer as an alternative to a share exchange is unlikely, although the CEO of PM has not ruled it out should the bid turn hostile. However, this would require substantial borrowing by PM, even if only 50% of NQ’s shareholders opt for cash. Except for the potential profit on the sale of the licences, no savings or synergies from the merger have as yet been identified.

Required: Assume you are one of the financial advisors working for PM.

(a) (i) Explain, with supporting calculations, how the Finance Director and advisors of PM have

arrived at their estimates of post-merger values. (10 marks)

(ii) Calculate and comment briefly on the likely impact on the share price and market capitalisation for each of PM and NQ when the bid terms are announced. Make appropriate assumptions based on the information given in the scenario.

(4 marks) (iii) If NQ rejects the terms offered, calculate

• the maximum total amount and price per share to be paid for the entity; and

• the resulting share exchange terms PM should be prepared to agree without reducing PM’s shareholder wealth.

(6 marks)

(Total for part (a) = 20 marks)

(b) Write a report to the Board of PM that evaluates and discusses the following issues:

(i) How the merger might contribute to the achievement of PM’s financial objectives,

assuming the merger goes ahead on the terms you have calculated in (a) (iii). If you have not managed to calculate terms, make sensible assumptions;

(12 marks) (ii) External economic forces that might help and/or hinder the achievement of the merger’s

financial objectives. Comment also on the policies the merged entity could consider to help reduce adverse effects of such economic forces;

(8 marks) (iii) Potential post-merger value enhancing strategies that could increase shareholder wealth.

(10 marks)

(Total for part (b) = 30 marks)

Up to 4 marks are available for structure and presentation in Question One.


End of Section A



May 2006 6 P9




May 2006 7 P9

[Section B starts on the next page]

TURN OVER



May 2006 8 P9



ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two MNO is a private toy distributor situated in the United States of America (US) with a US customer base and local suppliers. There is a central manufacturing base and several marketing units spread across the US. The marketing units are encouraged to adapt to local market conditions, largely acting independently and free from central control. These units are responsible for all aspects of local sales, including collecting sales revenues, which are paid across to Head Office on a monthly basis. Funding is provided by Head Office as required. Figures for last year to 31 December 2005 were as follows: Revenue $10 million Gross profit margin 40% of revenue Accounts receivable days minimum 20, maximum 30 days Accounts payable days minimum 40, maximum 50 days Inventories minimum 50, maximum 80 days Non-current assets $8 million Accounts receivable, accounts payable and inventories can all be assumed to be the same on both 31 December 2004 and 31 December 2005, but fluctuate between those dates. The Financial Controller is carrying out an analysis of MNO’s working capital levels, as requested by the Treasurer. He is assuming that the peak period for accounts receivable coincides with the peak period for inventories and the lowest level of accounts payable. MNO is currently in consultation with a potentially significant new supplier in Asia, who will demand payment in its local currency.

The requirement for Question Two is on the opposite page



May 2006 9 P9

Required: (a) (i) Calculate the minimum and maximum working capital levels based on the Financial

Controller’s assumption regarding the timing of peaks and troughs in working capital variables and discuss the validity of that assumption.

(6 marks)

(ii) Using the figures calculated in (i) above, calculate and draw a chart in your answer book to show the short-term and long-term (permanent) financing requirements of MNO under each of the following working capital financing policies:

• moderate policy, where long-term financing matches permanent net current

assets;

• aggressive policy, where 30% of permanent net current assets are funded by short-term financing;

• conservative policy, where only 40% of fluctuating net current assets are funded by short-term financing.

(7 marks)

(b) Discuss the advantages and disadvantages of an aggressive financing policy and advise whether or not such a policy would be appropriate for MNO.

(6 marks)

(c) Advise MNO whether a profit or cost centre structure would be more appropriate for its treasury department.

(6 marks)


TURN OVER



May 2006 10 P9

Question Three EFG is a South American entity specialising in providing information systems solutions to large corporates. It is going through a period of rapid expansion and requires additional funds to finance the long-term working capital needs of the business. EFG has issued one million $1 ordinary shares, which are listed on the local stock market at a current market price of $15, with typical increases of 10% per annum expected in the next five year period. Dividend payout is kept constant at a leveI of 10% of post-tax profits. EFG also has $10 million of bank borrowings. It is estimated that a further $3 million is required to satisfy the funding requirements of the business for the next five-year period beginning 1 July 2006. Two major institutional shareholders have indicated that they are not prepared to invest further in EFG at the present time and so a rights issue is unlikely to succeed. The directors are therefore considering various forms of debt finance. Three alternative structures are under discussion as shown below: • Five-year unsecured bank loan at a fixed interest rate of 7% per annum;

• Five-year unsecured bond with a coupon of 5% per annum, redeemable at par and issued at a 6% discount to par;

• A convertible bond, issued at par, with an annual coupon of 4⋅5% and a conversion option in five years’ time of five shares for each $100 nominal of debt.

There have been lengthy boardroom discussions on the relative merits of each instrument and you, as Finance Director, have been asked to address the following queries: Sr. A: “The bank loan would seem to be more expensive than the unsecured bond. Is this

actually the case?”

Sr. B: “Surely the convertible bond would be the cheapest form of borrowing with such a low interest rate?”

Sr. C: “If we want to increase our equity base, why use a convertible bond, rather than a straight equity issue?”

Required:

(a) Write a response to Sr. A, Sr. B and Sr. C, directors of EFG, discussing the issues raised and advising on the most appropriate financing instrument for EFG. In your answer, include calculations of:

• expected conversion value of the convertible bond in five years’ time;

• yield to maturity (redemption yield) of the five-year unsecured bond.

Ignore tax. (18 marks)

(including up to 8 marks for calculations)

(b) Advise a prospective investor in the five-year unsecured bond issued by EFG on what information he should expect to be provided with and what further analysis he should undertake in order to assess the creditworthiness of the proposed investment.

(7 marks)




May 2006 11 P9

Question Four GHI is a mobile phone manufacturer based in France with a wide customer base in France and Germany, with all costs and revenues based in euro (€). GHI is considering expanding into the UK market and has begun investigating how to break into this market and is designing a new phone specifically for it. A small project committee has been formed to plan and control the project.

After careful investigation, the following project cash flows have been identified:

Year £million 0 (10) 1 5 2 5 3 4 4 3 5 3

The project is to be funded by a loan of €16 million at an annual interest rate of 5% and repayable at the end of five years. Loan issue costs amount to 2% and are tax deductible. GHI has a debt : equity ratio of 40 : 60 based on market values, a pre-tax cost of debt of 5⋅0% and a cost of equity of 10⋅7%. Tax on entity profits in France can be assumed to be at a rate of 35%, payable in the year in which it arises. UK tax at 25% is deductible in full against French tax in the same time period under the terms of the double tax treaty between the UK and France. The initial investment of £10 million will not qualify for any tax relief. Assume the current spot rate is £1 = €1⋅60 and sterling (£) is expected to weaken against the euro by 3% per annum (so that in year 1 it is worth only 97% of its value in euro (€) in year 0).

Required:

(a) Advise GHI on whether or not to proceed with the project based on a calculation of its adjusted present value (APV) and describe the limitations of an APV approach in this context.

(15 marks)

(b) Explain the function of the project committee of GHI in the following stages of the project: (i) determining customer requirements and an appropriate product design for

the UK market; and

(5 marks)

(ii) controlling the implementation stage of the project. (5 marks)


TURN OVER



May 2006 12 P9

Question Five RST is a publicly-owned and funded health organisation based in the Far East. It is reviewing a number of interesting possibilities for new development projects in the area and has narrowed down the choice to the five projects detailed below. RST is aware that government budget restrictions may be tighter in a year’s time and so does not want to commit to a capital budget of more than $30 million in year 1. In addition, any project cash inflows in year 1 may be used to fund capital expenditure in that year. There is sufficient capital budget remaining in year 0 to enable all projects to be undertaken. Under government funding rules, any unused capital in year 0 cannot be carried over to year 1 and no interest may be earned on unused capital. No borrowings are permitted.

RST assesses capital projects at a hurdle rate of 15% based on the equity beta of health-based companies in the private sector.

Cash outflows Cash inflows Year 0 Year 1 Project $ million $ million $ million A 9 16 4 from year 1 in perpetuity B 10 10 4 from year 2 in perpetuity C 10 12 5 in years 1 to 10 D 8 5 6 in years 3 to 7

E 9 8 2 in years 1 to 5 { 5 in years 6 to 15 Notes:

• the projects are not divisible • each project can only be undertaken once • ignore tax

Required: (a) Advise RST on the best combination of projects based on an evaluation of each

project on the basis of both:

(i) NPV of cashflows;

(ii) a profitability index for use in this capital rationing analysis.

(15 marks)

(b) Discuss

(i) whether or not capital rationing techniques based on NPV analysis are appropriate for a publicly-owned entity such as RST.

(5 marks)

(ii) as a publicly-owned entity, what other factors RST should consider and what other analysis it should undertake before making a final decision on which project(s) to accept.

(5 marks)





May 2006 13 P9

Maths Tables & Formulae are on pages 15-19



May 2006 14 P9




May 2006 15 P9






May 2006 16 P9



−+−

rr n)(11


1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514


1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870



May 2006 17 P9


P0 = prefk

d


P0 = ek

d


P0 = gk

d

−e

1 or P0 = gk

gd

−

+

e

0 ][1


P0 = netd

][1

k

ti −


i


Vg = Vu + TBc


S = X[1 + r]n


PV = nr ][1

1

+


PV =

+

− nrr ][1

11

1


PV = r

1


PV = gr −

1




May 2006 18 P9


price P0:

kpref = 0P

d


kd net = 0P

ti ][1 −


ke =

0P

d


ke = gP

d+

0

1 or ke = g

P

gd+

+

0

0 ]1[





DVV



DV

tV ][1−


k0 = keg

+

++ DE

D

DE

E

VV

Vk

VV

Vd





ßu = ßg

+ DE

E

VV

V


ßu = ßg

+ DE

E

VV

V + ßd

+ ED VVDV


ßu = ßg

−+ ][1 tVV

V

DE

E



May 2006 19 P9


C$/Euro rate Spot




+

+




+

+



rateinflationUS1

+

+





yearsovercostsof

n

nPV


TERP = 1

1



Value of a right = 1N


+

−

or

N





May 2006 20 P9




May 2006 21 P9



May 2006 22 P9



May 2006 23 P9



May 2006 24 P9




May 2006






Examiner’s General Comments The performance on Paper P9 was extremely disappointing. Many candidates appeared to have done little preparation. It was noted in the November 2005 Post Exam Guide that many candidates demonstrated poor knowledge of even quite basic financial calculations and that their grasp of many basic concepts was also limited. These weaknesses are still evident in May 2006. A further weakness was the poor presentation and structure of candidates’ solutions. Question One appeared to present candidates with particular challenges despite clues to answering the question (and (a) (i) in particular) being clearly evident in the scenario. Question Two was a standard working capital management and financing question, although it was avoided by the majority of candidates and many candidates ignored the financing aspects of the question. Question Three was even more unpopular, although it required fairly straightforward calculations of the yield to maturity of a bond and a conversion value of a convertible bond which provided readily accessible marks for the well-prepared candidate. Questions Four and Five were by far the most popular of the optional questions on this paper. Answers to Question Four were disappointing as many candidates were unable to apply the APV approach correctly and few candidates used an ungeared cost of equity in the NPV base calculation. Question Five was generally well answered with most candidates being able to make a reasonable attempt at the NPV calculations and draw basic conclusions from the results. However, few were able either to calculate appropriate PIs based on rationed cash flows, or to “stand back” from the NPV and PI results and use these to help identify the best overall combination of projects. In the sections below that explain how the marking scheme was applied, where the comment says “up to 3 marks are available for each valid point”, 0.5 marks are awarded for a bullet point, 1 mark for some attempt at (correct and valid) discussion, rising to 3 marks for good discussion of the point using appropriate illustrative examples. The published answers are used as a guide (these are available as a download from CIMA Publishing – click on the link on the CIMA website www.cimaglobal.com). Marks are also awarded for candidates' own valid comments that might not be in the marking guide or the published answers. Where marks are shown for calculations, the mark shown is the maximum available assuming calculations are all correct. Marks are available for recognition of correct approach and understanding. Note that in the marking scheme the sum of the marks available for specific activities may total more than the marks indicated on the question paper. This is to allow some flexibility in marking, but the maximum marks that can be awarded for a section of a question cannot exceed the number of marks indicated on the question paper.


http://www.cimaglobal.com




SECTION A Question One (a)

Assume you are one of the financial advisors working for PM.

(i) Explain, with supporting calculations, how the Finance Director and advisors of PM have arrived at their estimates of post-merger values.

(10 marks)

(ii) Calculate and comment briefly on the likely impact on the share price and market capitalisation for PM and NQ Inc when the bid terms are announced. Make appropriate assumptions based on the information given in the scenario.

(4 marks)

(iii) If NQ rejects the terms offered, calculate • the maximum total amount and price per share to be paid for the entity; and

• The resulting share exchange terms PM should be prepared to agree without reducing PM’s

shareholder wealth. (6 marks)


Rationale The question involves, in part (a), explaining the calculations for estimates given in the scenario relating to post-acquisition values, re-calculating these using sensible assumptions based upon information in the scenario and, finally, recalculating the exchange terms should the American entity reject the ones initially calculated and then proposed by the organisation concerned. Suggested Approach





• Calculate the number of shares to be offered to NQ and the shares that will be in issue following

the merger if the terms are accepted; • Convert NQ’s earnings into sterling and add to PM’s earnings to obtain an earnings figure for the

combined entity; • Confirm the FD’s EPS figure by dividing the total number of shares in issue into the combined

earnings figure (as calculated above); • Recognise that the P/E ratio of PM is the growth rating that should be applied to NQ’s earnings; • Confirm the FD’s post acquisition market capitalisation figure by applying PM’s P/E ratio to the

earnings figure for the combined entity (calculated above); • Provide some brief comments on the calculations; • Calculate and comment on the impact on share prices including comments on why there is no

reason for the market value to be different than PM plus NQ; • Calculate new market values and share prices attributable to PM and NQ shareholders; • Calculate maximum price to be paid and exchange terms in the following circumstances:

- value of combined entity based on FD’s post-merger values; - profit on sale of licences; - value of PM; - maximum market value and share price; - share exchange terms.

Marking Guide

Marks

Calculations of pre-acquisition values 3.5 Calculations of post-acquisition values 4 Comments 2.5 Calculations of candidate post-acquisition and market values

4

Calculations of maximum price 6

Examiner’s Comments This question was particularly poorly attempted, mainly because candidates did not read the scenario properly. Many completely misunderstood the question and assumed it was a general valuation question. They therefore calculated values for the two entities using net assets, dividend valuations models and so on, which wasted a lot of exam time. Common Errors

• Incorrect valuation methods as noted above for example net assets, dividend valuation models; • Use of industry average PE ratios to calculate the values of the two entities. PE ratios for both

entities can be calculated from the data given; • Failure to recognise the assumption of boot-strapping by the Finance Director. This was made

explicit in the question scenario on the bottom line of page 2 of the question paper: “He (the CEO of PM) also believes he can boost the entity’s share value if he can convince the market his entity’s growth rating can be applied to NQ’s earnings”

• Little or no attempt to calculate post merger share prices despite the clear requirement to “Calculate … share price and market capitalisation..” in part (ii). Many candidates simply suggested that the bidder’s share price would go down and the target’s price would go up following the announcement of the bid. This approach gained some credit, but was not what was required for satisfactory marks;

• Failure to recognise the impact of the sale of licences on the value of the merged entity.





Question One (b)

Write a report to the Board of PM that evaluates and discusses the following issues:

(i) How the merger might contribute to the achievement of PM’s financial objectives, assuming the merger goes ahead on the terms you have calculated in (a) (iii). If you have not managed to calculate terms, make sensible assumptions.

(12 marks)

(ii) External economic forces that might help and/or hinder the achievement of the merger’s financial objectives. Comment also on the policies the combined entity could consider to help reduce adverse effects of such economic forces.

(8 marks)

(iii) Potential post-merger value enhancing strategies that could increase shareholder wealth. (10 marks)

Rationale In part (b), candidates are required to write a report to the organisation’s Board evaluating and discussing how the acquisition might contribute to the organisation’s financial objectives, reducing any external economic forces that might adversely affect the achievement of these financial objectives and any value enhancing strategies that could increase shareholder wealth. Suggested Approach Part (i) Discuss how the merger will contribute to the achievement of company objectives including key points about:

• Increasing earnings per share; • Maintaining gearing below 30%; • Maintaining a PE ratio above the industry average.

Include appropriate calculations to support your discussion. Part (ii) Discuss external economic factors noting key points as follows:

• Exchange rate fluctuations; • Changes in interest rate/inflation rate; • Hedging methods to reduce these risks; • Competition controls; • Possibility of stock market crash; • Integration problems.

Part (iii) Discuss post merger value enhancing strategies. Key points include:

• Need for a position audit; • Need for an integration strategy; • Synergy/economy of scale/staff savings; • Marketing strategy; • Diversification and effect on cost of capital; • Sale of non-core/redundant assets; • Need for a communication strategy.





Marking Guide

Marks

Discussion of how the merger will contribute to achievement of company objectives 12 Discussion of impact of external economic factors 8 Discussion of post-merger value enhancing strategies 10 Includes marks for presentation and structure 3 Examiner’s Comments The attempts at part (i) of the report were generally very poor and few candidates provided any supporting calculations for their answers. Attempts at part (ii) and (iii) were, on average, of a better standard, although frequently the discussion simply listed bullet points irrespective of their relevance. Common Errors

• No supporting calculations in part (i); • Incorrect calculations of gearing; • Not recognising that this was a merger situation.

SECTION B Question Two (a)

(i) Calculate the minimum and maximum working capital levels based on the Financial Controller’s

assumption regarding the timing of peaks and troughs in working capital variables and discuss the validity of that assumption.

(6 marks)

(ii) Using the figures calculated in (i) above, calculate and draw a chart in your answer book to show the short-term and long-term (permanent) financing requirements of MNO under each of the following working capital financing policies:

• moderate policy, where long-term financing matches permanent net current assets; • aggressive policy, where 30% of permanent net current assets are funded by short-term financing; • Conservative policy, where only 40% of fluctuating net current assets are funded by short-term

financing. (7 marks)

Rationale Part (a) (i) and (ii) requires candidates to calculate minimum and maximum working capital levels based on assumptions given in the question and to discuss their validity in light of such calculations and then to calculate, and illustrate, the financing requirements for the given entity using various bases. Suggested Approach





• Calculate amount of working capital tied up in accounts receivable, accounts payable, inventories

and in total on both minimum and maximum criteria;

• Discuss the validity of the Financial Controller’s assumption;

• Calculate financing requirements;

• Provide a chart illustrating the financing requirements. Marking Guide

Marks

Calculations of working capital 4 Discussion of validity of assumption given in question 2 Calculations of financial requirements 4 Graphical illustration of financial requirements 3 Examiner’s Comments Very few candidates attempted this question. The main weaknesses in the answers of those who did were the inability to provide the calculations required by the scenario, in particular, minimum and maximum working capital levels and long-term financing requirements under each financing policy. Common Errors

• Basing calculations for accounts payables and inventories on revenue rather than cost of sales; • Failure to recognise that maximum accounts payable coincided with the minimum working capital; • Omitting to discuss the validity of the Financial Controller’s assumption regarding the timing of

peaks and troughs in working capital variables; • Making no attempt at part (a) (ii) of the question or making some attempt, but with no calculations.





Question Two (b)

Discuss the advantages and disadvantages of an aggressive financing policy and advise whether or not such a policy would be appropriate for MNO.

(6 marks)

Rationale Part (b) requires discussion of the advantages and disadvantages of a particular financing policy and its applicability to the given entity. Suggested Approach Discuss the advantages and disadvantages of an aggressive working capital financing policy, including comments on its appropriateness for MNO. Marking Guide

Marks

Discussion of pros, cons and appropriateness of “aggressive policy” 6 Examiner’s Comments Common Errors Discussing working capital management instead of financing policies for working capital.





Question Two (c)

Advise MNO whether a profit or cost centre structure would be more appropriate for its treasury department.

(6 marks)

Rationale Part (c) requires candidates to advise the given entity on the applicability of one or other different structures for its treasury department. Suggested Approach Provide a discussion of the advantages and disadvantages and features of operating a treasury department as a profit centre or a cost centre, including a conclusion about the most appropriate choice for MNO. Marking Guide

Marks

Issues relating to the choice between a profit and cost centre structure and advice on the best structure for MNO

6

Examiner’s Comments Common Errors

• Discussing centralisation rather than addressing the question, which required a discussion of the merits of establishing a treasury department as a profit centre compared with a cost centre;

• Failure to advise on the best structure for MNO.





Question Three (a)

Write a response to Sr. A, Sr. B and Sr. C, directors of EFG, discussing the issues raised and advising on the most appropriate financing instrument for EFG. In your answer, include calculations of: • expected conversion value of the convertible bond in five years’ time; • yield to maturity (redemption yield) of the five-year unsecured bond. Ignore tax.

(18 marks)(including up to 8 marks for calculations)

Rationale This question requires candidates to respond to questions raised by the directors of the entity described in the question on the most appropriate financing instrument to satisfy its funding requirements over the next few years. Marks are available for the calculations produced showing expected conversion values of the convertible bond and yield to maturity of the unsecured bond. Suggested Approach

• Calculate the expected conversion value of the convertible; • Calculate the yield to maturity of the bond; • Note that the cost of the bank loan is the interest rate; • Provide a discussion responding to each of the three board members; • Provide a recommendation on the most appropriate financing instrument for EFG.

Marking Guide

Marks

Calculations for appropriate financing instrument Up to 8 Comments in response to Board member A 3 Comments in response to Board member B 3 Comments in response to Board member C 3 Advice on most appropriate financing instrument 3 Max 18 in

total Examiner’s Comments This was the least popular question on the paper. However, those who attempted it tended to score well on the calculations, but they rarely extended the answer beyond the points identified in the scenario. Common Errors

• Incorrect or no calculations of the value of the convertible; • Incorrect calculations of yield to maturity; • No recommendation.





Question Three (b)

Advise a prospective investor in the five-year unsecured bond issued by EFG what information he would expect to be provided with and what further analysis he should undertake in order to assess the creditworthiness of the proposed investment.

(7 marks)

Rationale This part asks candidates to advise a prospective investor on what information they should expect from the given entity and what further analysis the investor should themselves undertake to assess the creditworthiness of their proposed investment. Suggested Approach

• Discuss the type of information needed to determine creditworthiness, • Discuss what other analysis should be undertaken before making a decision.

Marking Guide

Marks

Advise prospective investor 7 Examiner’s Comments Common Errors

• Weak discussion generally; • No discussion of what further analysis is required.





Question Four (a)

Advise GHI on whether or not to proceed with the project based on a calculation of its adjusted present value (APV) and describe the limitations of an APV approach in this context.

(15 marks)

Rationale This question requires candidates to advise the given entity on whether it should proceed with the project described in the question, based upon a calculation of its adjusted present value (APV) and allowing for the limitations of an APV approach. Suggested Approach Calculate base NPV:

• Cost of equity of an ungeared firm; • Forward exchange rates; • Cash flows in €; • Tax liabilities (note: alternative approaches acceptable here); • DCFs and NPV.

Calculate APV based on base NPV:

• Tax shield on debt; • Issue costs and related tax relief; • APV.

Provide a recommendation Discuss the limitations of APV Marking Guide Marks Calculation of ungeared cost of equity Calculations of base NPV Calculations of APV Advice to proceed Limitations of APV

2.5 4.5 4 1 up to 4 Max 15 in total

Examiner’s Comments





This was a very popular choice of the optional questions on the paper. Many candidates recognised that this was NPV-based, although many failed to fully understand how this progressed to an APV calculation. Common Errors NPV base calculations:

• Incorrect discount rate - an ungeared cost of equity is required in APV calculations. Many candidates simply used the geared cost of equity, ignoring the information given in the question, and others calculated the weighted average cost of capital;

• Incorrect inclusion of debt cash flows in the NPV calculation. APV calculations

• Using the cost of equity to discount the tax relief on interest costs rather than the cost of debt; • Incorrect or no calculation of the tax shield on interest costs; • Ignoring issue costs and/or their tax relief.

• Discussing the limitations of NPV rather than APV.





Question Four (b)

Explain the function of the project committee of GHI in the following stages of the project: (i) determining customer requirements and an appropriate product design for the UK market;

(5 marks)(ii) Controlling the implementation stage of the project.

(5 marks)

Rationale This part requires candidates to explain the function of the project committee, should the project go ahead, on two particularly important stages of the project. Suggested Approach

• Discuss customer requirements and product design; • Discuss control of implementation.

Marking Guide

Marks

Comments on how to determine customer requirements and an appropriate product design

5

Comments on controlling implementation 5 Examiner’s Comments Common Errors This part of the question was generally well handled although the answer to part (b) (i) tended to focus only on market research techniques rather than product design and differentiation issues. Trial implementation and evaluation and feedback controls could have been considered in more detail in part (b) (ii).





Question Five (a) Advise RST on the best combination of projects based on an evaluation of each project on the basis of both: (i) NPV of cash flows;

(ii) A profitability index for use in this capital rationing analysis.

(15 marks)

Rationale This question requires candidates, in part (a), to evaluate proposed projects using both NPV techniques and profitability indices that were appropriate for this capital rationing analysis. Candidates were also required to advise the given entity on the best combination of projects based on these evaluations. Suggested Approach

• Calculate NPV and PI for all five projects. Note that the PI should be based on net year 1 cash flows to reflect capital rationing in year 1;

• Consider all possible combinations of projects within the $30 million capital constraint in year 1 to identify the combination that produces the highest combined NPV, using PI results to assist in this exercise;

• Provide a conclusion. Marking Guide

Marks

Project NPV and PI indices 10 (1.5 marks per project for NPV and 0.5 marks per project for PI indices) Rankings by NPV and by PI index 2 Identification/recommendation of best overall combination 3 Examiner’s Comments Common Errors

• Inability to calculate the present value of cash flows in perpetuity that start in future years; • Inability to calculate a cumulative discount factor for annuities that do not start in Year 1; • Basing profitability index on Year 0 despite the question clearly stating the capital restriction was

in Year 1.





Question Five (b)

Discuss

(i) Whether or not capital rationing techniques based on NPV analysis are appropriate for a publicly-owned entity such as RST.

(5 marks)

(ii) As a publicly-owned entity, what other factors RST should consider and what other analysis it should undertake before making a final decision on which project(s) to accept.

(5 marks)

Rationale In part (b), candidates are required to discuss whether capital rationing techniques are appropriate to the entity given its current situation and, finally, to advise the given entity on other factors and/or further analysis it should consider and/or undertake prior to making a final decision. Suggested Approach

• Discuss whether such analysis is appropriate for public bodies; • Discuss what other factors should be considered and analysis undertaken.

Marking Guide

Marks

Discussion of capital rationing and the public sector 5 Discussion of other factors for consideration 5 Examiner’s Comments Common Errors

• Discussing capital rationing in general rather than in the context of the public sector; • Omitting key issues such as the reliability of the cash flow forecasts and sensitivity of the result to

changes in underlying data.

















P9 –

Fin

anci

al S

trat

egy

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November 2006 2 P9



READ THE SCENARIO AND ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One Scenario SHINE Business background SHINE is a publicly owned multinational group based in Germany with its main business centred on the production and distribution of gas and electricity to industrial and domestic consumers. It has recently begun investing in research and development in relation to renewable energy, exploiting solar, wave or wind energy to generate electricity. Corporate objectives Developing renewable energy sources is an important non-financial objective for the SHINE Group in order to protect and enhance the group’s reputation. Renewable energy projects have been given a high profile in recent investor communications and television advertising campaigns. Wind farm investment project The latest renewable energy project under consideration is the development of a wind farm in the USA. This would involve the construction of 65 wind powered electricity generators which would be owned and operated by a new, local subsidiary entity and electricity that is generated by the farm would be sold to the local electricity grid. A suitable site, subject to planning permission, has been located. Forecast operating cash flows for the project are as follows:

Year(s) US$ million Initial investment 0 200 (including working capital) Residual value 4 50 Pre-tax operating net cash inflows 1 to 4 70 Other relevant data and assumptions: • The initial investment is expected to be made on 30 November 2006 and cash flows will

arise at any point in the year;

• However, in any net present value (NPV) exercise, all cash flows should be assumed to arise on 31 December of each year;

• The local tax rate in the USA for this industry is set at a preferential rate of 10% to encourage environmentally-friendly projects rather than the normal rate of 25%;

• Tax is payable in the year in which it arises;

• No tax depreciation allowances are available;

• No additional tax is payable in Germany under the terms of the double tax treaties with the USA;

• Net cash flows are to be paid to the German parent entity as dividends at the end of each year.



P9 3 November 2006

Uncertainties affecting the outcome of the project There is some uncertainty over the US tax rate over the period of the project, with extensive discussion at local government level about raising the tax rate to 25% with immediate effect. A vote will be taken in the next six months to decide whether to retain the preferential 10% tax rate, or to increase it to 25%. Once the vote has been taken and a decision made, the tax rate will not be open for debate again for at least four years. Economic forecasters expect the value of the euro to either stay constant against the value of the US dollar for the next four years or to strengthen by 7% per annum. Assume that there is an equal probability of each of these two different exchange rate forecasts. There is also significant risk to the project from strong objections to the wind farm scheme from local farmers in the USA who are concerned about the impact of acid water run-off from boring holes for the 65 windmills. In addition, there are a number of executive holiday homes nearby whose owners are objecting to the visual impact of the windmills. Investment criteria The SHINE Group evaluates foreign projects of this nature based on a euro cost of capital of 12% which reflects the risk profile of the proposed investment. Extracts from the forecast financial statements for the SHINE Group at 31 December 2006, the end of the current financial year: € million € million ASSETS Total assets 28,000 EQUITY AND LIABILITIES Equity Share capital 3,000 (3,000 million €1 ords) Retained earnings 8,300 11,300 Non-current liabilities Floating rate borrowings 4,000 Current liabilities 12,700 28,000 Alternative financing methods The SHINE Group aims to maintain the group gearing ratio (debt as a proportion of debt plus equity) below 40% based on book values. The following alternative methods are being considered by the SHINE parent entity for financing the new investment: • Long-term borrowings denominated in euro; • Long-term borrowings denominated in US dollars.

The question requirements are on page 5, which is detachable for ease of reference

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November 2006 4 P9




P9 5 November 2006

Required: (a) Calculate the NPV of the cash flows for the proposed investment for each of the

following four possible scenarios:

• Constant exchange rate and a tax rate of 10%; • Constant exchange rate and a tax rate of 25%; • The euro to strengthen against the US dollar by 7% a year and a tax rate of 10%; • The euro to strengthen against the US dollar by 7% a year and a tax rate of 25%.

In each case, assume that the exchange rate at year 0 is US$1⋅10 = €1⋅00. (12 marks)

(b) Prepare the forecast balance sheet of the SHINE Group on 31 December 2006, incorporating the project under each of the two alternative financing structures and each of the following two exchange rate scenarios A and B:

Date Exchange rates under scenario A

Exchange rates under scenario B

30 November 2006 (date of the initial investment and arrangement of financing)

US$1⋅10 = €1⋅00 US$1⋅10 = €1⋅00

31 December 2006

(financial reporting/balance sheet date) US$1⋅10 = €1⋅00 (no change)

US$1⋅40 = €1⋅00

Assume that no other project cash flows occur until 2007. (8 marks)

(c) Write a report addressed to the Directors of the SHINE Group in which you, as Finance Director, address the following issues relating to the evaluation and implementation of the proposed wind farm project:

(i) Discuss the internal and external constraints affecting the investment decision and advise the SHINE Group how to proceed. In your answer, include reference to your calculations in part (a) above.

(9 marks)

(ii) Discuss the comparative advantages of each of the two proposed alternative financing structures and advise the SHINE group which one to adopt. In your answer include reference to your results in part (b) above, and further analysis and discussion of the impact of each proposed financial structure on the group’s balance sheet.

(9 marks)

(iii) Discuss the differing roles and responsibilities of the treasury department and finance department in evaluating and implementing the US project and the interaction of the two departments throughout the process.

(8 marks)

Marks available for structure and presentation in Question One. (4 marks)



End of Section A



November 2006 6 P9




P9 7 November 2006


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November 2006 8 P9



ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two AB is a telecommunications consultancy based in Europe that trades globally. It was established 15 years ago. The four founding shareholders own 25% of the issued share capital each and are also executive directors of the entity. The shareholders are considering a flotation of AB on a European stock exchange and have started discussing the process and a value for the entity with financial advisors. The four founding shareholders, and many of the entity’s employees, are technical experts in their field, but have little idea how entities such as theirs are valued. Assume you are one of AB’s financial advisors. You have been asked to estimate a value for the entity and explain your calculations and approach to the directors. You have obtained the following information. Summary financial data for the past three years and forecast revenue and costs for the next two years is as follows: Income Statement for the years ended 31 March Actual Forecast 2004 2005 2006 2007 2008 € million € million € million € million € million Revenue 125⋅0 137⋅5 149⋅9 172⋅0 198⋅0 Less:

Cash operating costs 37⋅5 41⋅3 45⋅0 52 59 Depreciation 20⋅0 22⋅0 48⋅0 48 48

Pre-tax earnings 67⋅5 74⋅2 56⋅9 72 91 Taxation 20⋅3 22⋅3 17⋅1 22 27 Balance Sheet at 31 March 2004 2005 2006 € million € million € millionASSETS Non-current assets Property, plant and equipment 150 175 201 Current assets 48 54 62 198 229 263 EQUITY AND LIABILITIES Equity Share capital (Shares of €1) 30 30 30 Retained earnings 148 179 203 178 209 233 Current liabilities 20 20 30 198 229 263 Note: The book valuations of non-current assets are considered to reflect current realisable values.



P9 9 November 2006

Other information/assumptions • Growth in after tax cash flows for 2009 and beyond (assume indefinitely) is expected to

be 3% per annum. Cash operating costs can be assumed to remain at the same percentage of revenue as in previous years. Depreciation will fluctuate but, for purposes of evaluation, assume the 2008 charge will continue indefinitely. Tax has been payable at 30% per annum for the last three years. This rate is expected to continue for the foreseeable future and tax will be payable in the year in which the liability arises.

• The average P/E ratio for telecommunication entities’ shares quoted on European stock

exchanges has been 12⋅5 over the past 12 months. However, there is a wide variation around this average and AB might be able to command a rating up to 30% higher than this;

• An estimated cost of equity capital for the industry is 10% after tax; • The average pre-tax return on total assets for the industry over the past 3 years has been

15%.

Required: (a) Calculate a range of values for AB, in total and per share, using methods of valuation that you consider appropriate. Where relevant, include an estimate of value for intellectual capital.

(12 marks) (b) Discuss the methods of valuation you have used, explaining the relevance of each method to an entity such as AB. Conclude with a recommendation of an approximate flotation value for AB, in total and per share.

(13 marks)


A report format is not required for this question.


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November 2006 10 P9

Question Three VCI is a venture capital investor that specialises in providing finance to small but established businesses. At present, its expected average pre-tax return on equity investment is a nominal 30% per annum over a five-year investment period. YZ is a typical client of VCI. It is a 100% family owned transport and distribution business whose shares are unlisted. The company sustained a series of losses a few years ago, but the recruitment of some professional managers and an aggressive marketing policy returned the company to profitability. Its most recent accounts show revenue of $105 million and profit before interest and tax of $28⋅83 million. Other relevant information is as follows: • For the last three years dividends have been paid at 40% of earnings and the directors

have no plans to change this payout ratio; • Taxation has averaged 28% per annum over the past few years and this rate is likely to

continue; • The directors are forecasting growth in earnings and dividends for the foreseeable future

of 6% per annum; • YZ’s accountants estimated the entity’s cost of equity capital at 10% some years ago. The

data they worked with was incomplete and now out of date. The current cost could be as high as 15%.

Extracts from its most recent balance sheet at 31 March 2006 are shown below. $ millionASSETS Non-current assets Property, plant and equipment

35⋅50

Current assets 4⋅50 40⋅00 EQUITY AND LIABILITIES Equity Share capital (Nominal value of 10 cents) 2⋅25 Retained earnings 18⋅00 20⋅25 Non-current liabilities 7% Secured bond repayable 2016 15⋅00 Current liabilities 4⋅75 19⋅75 40⋅00 Note: The entity’s vehicles are mainly financed by operating leases.



P9 11 November 2006

YZ has now reached a stage in its development that requires additional capital of $25 million. The directors, and major shareholders, are considering a number of alternative forms of finance. One of the alternatives they are considering is venture capital funding and they have approached VCI. In preliminary discussions, VCI has suggested it might be able to finance the necessary $25 million by purchasing a percentage of YZ’s equity. This will, of course, involve YZ issuing new equity.

Required:

(a) Assume you work for VCI and have been asked to evaluate the potential investment. (i) Using YZ’s forecast of growth and its estimates of cost of capital, calculate

the number of new shares that YZ will have to issue to VCI in return for its investment and the percentage of the entity VCI will then own. Comment briefly on your result.

(9 marks)

(ii) Evaluate exit strategies that might be available to VCI in five years’ time and their likely acceptability to YZ.

(6 marks) Note: Use sensible roundings in your calculations.

(Total for Requirement (a) = 15 marks)

(b) Discuss the advantages and disadvantages to an established business such as YZ of using a venture capital entity to provide finance for expansion as compared with long term debt. Advise YZ about which type of finance it should choose, based on the information available so far.

(10 marks)




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November 2006 12 P9

Question Four CD is a furniture manufacturer based in the UK. It manufactures a limited range of furniture products to a very high quality and sells to a small number of retail outlets worldwide. At a recent meeting with one of its major customers it became clear that the market is changing and the final consumer of CD’s products is now more interested in variety and choice rather than exclusivity and exceptional quality. CD is therefore reviewing two mutually exclusive alternatives to apply to a selection of its products: Alternative 1 To continue to manufacture, but expand its product range and reduce its quality. The net present value (NPV), internal rate of return (IRR) and modified internal rate of return (MIRR) for this alternative have already been calculated as follows: NPV = ₤1⋅45 million using a nominal discount rate of 9% IRR = 10⋅5% MIRR = Approximately 13⋅2% Alternative 2 To import furniture carcasses in “flat packs” from the USA. The imports would be in a variety of types of wood and unvarnished. CD would buy in bulk from its US suppliers, assemble and varnish the furniture and re-sell, mainly to existing customers. An initial investigation into potential sources of supply and costs of transportation has already been carried out by a consultancy entity at a cost of £75,000. CD’s Finance Director has provided estimates of net sterling and US$ cash flows for this alternative. These net cash flows, in real terms, are shown below. Year 0 1 2 3 US$m -25⋅00 2⋅60 3⋅80 4⋅10 £m 0 3⋅70 4⋅20 4⋅60 The following information is relevant: • CD evaluates all its investments using nominal Sterling cash flows and a nominal discount

rate. All non-UK customers are invoiced in US$. US$ nominal cash flows are converted to Sterling at the forward rate and discounted at the UK nominal rate;

• For the purposes of evaluation, assume the entity has a three year time horizon for

investment appraisals; • Based on recent economic forecasts, inflation rates in the US are expected to be constant

at 4% per annum. UK inflation rates are expected to be 3% per annum. The current exchange rate is ₤1 = US$1⋅6.

Note: Ignore taxation.

The requirement for Question Four is on the opposite page



P9 13 November 2006

Required:

Assume that you are the Financial Manager of CD.

(i) Calculate the net present value (NPV), internal rate of return (IRR) and (approximate) modified internal rate of return (MIRR) of alternative 2.

(12 marks)

(ii) Briefly discuss the appropriateness and possible advantages of providing

MIRRs for the evaluation of the two alternatives. (4 marks)

(iii) Evaluate the two alternatives and recommend which alternative the entity

should choose. Include in your answer some discussion about what other criteria could or should be considered before a final decision is taken.

(9 marks)




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November 2006 14 P9

Question Five (a) CCC is a local government entity. It is financed almost equally by a combination of central government funding and local taxation. The funding from central government is determined largely on a per capita (per head of population) basis, adjusted to reflect the scale of deprivation (or special needs) deemed to exist in CCC’s region. A small percentage of its finance comes from the private sector, for example from renting out City Hall for private functions. CCC’s main objectives are: • To make the region economically prosperous and an attractive place to live and work; • To provide service excellence in health and education for the local community. DDD is a large, listed entity with widespread commercial and geographical interests. For historic reasons, its headquarters are in CCC’s region. This is something of an anomaly as most entities of DDD’s size would have their HQ in a capital city, or at least a city much larger than where it is. DDD has one financial objective: To increase shareholder wealth by an average 10% per annum. It also has a series of non-financial objectives that deal with how the entity treats other stakeholders, including the local communities where it operates. DDD has total net assets of $1⋅5 billion and a gearing ratio of 45% (debt to debt plus equity), which is typical for its industry. It is currently considering raising a substantial amount of capital to finance an acquisition.

Required:

Discuss the criteria that the two very different entities described above have to consider when setting objectives, recognising the needs of each of their main stakeholder groups. Make some reference in your answer to the consequences of each of them failing to meet its declared objectives.

(13 marks)

(b) MS is a private entity in a computer-related industry. It has been trading for six years and is managed by its main shareholders, the original founders of the entity. Most of the employees are also shareholders, having been given shares as bonuses. None of the shareholders has attempted to sell shares in the entity so the problem of placing a value on them has not arisen. Dividends have been paid every year at the rate of 60 cents per share, irrespective of profits. So far, profits have always been sufficient to cover the dividend at least once but never more than twice. MS is all-equity financed at present although $15 million new finance is likely to be required in the near future to finance expansion. Total net assets as at the last balance sheet date were $45 million.

The requirement for Question Five part (b) is on the opposite page



P9 15 November 2006

Required: Discuss and compare the relationship between dividend policy, investment policy and financing policy in the context of the small entity described above, MS, and DDD, the large listed entity described in part (a).

(12 marks)





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November 2006 16 P9




P9 17 November 2006






November 2006 18 P9



−+−

rr n)(11


1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514


1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870



P9 19 November 2006

FORMULAE Valuation models (i) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div

value:

P0 = prefk

d

(ii) Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value:

P0 = ek

d

(iii) Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 is the ex-div value:

P0 = gk

d

−e

1 or P0 = gk

gd

−

+

e

0 ][1

(iv) Irredeemable bonds, paying annual after-tax interest, i [1 – t], in perpetuity, where P0 is the ex-interest value:

P0 = netd

][1

k

ti −


i


Vg = Vu + TBc


S = X[1 + r]n


PV = nr ][1

1

+


PV =

+

− nrr ][1

11

1


PV = r

1


PV = gr −

1




November 2006 20 P9

Cost of capital (i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current ex-div

price P0:

kpref = 0P

d

(ii) Cost of irredeemable bonds, paying annual net interest, i [1 – t], and having a current ex-interest price P0:

kd net = 0P

ti ][1 −

(iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0:

ke =

0P

d

(iv) Cost of ordinary (equity) shares, having a current ex-div price, P0, having just paid a dividend, d0, with the dividend growing in perpetuity by a constant g% per annum:

ke = gP

d+

0

1 or ke = g

P

gd+

+

0

0 ]1[

(v) Cost of ordinary (equity) shares, using the CAPM:


(vi) Cost of ordinary (equity) shares in a geared firm (no tax):


DVV



DV

tV ][1−


k0 = keg

+

++ DE

D

DE

E

VV

Vk

VV

Vd



In the following formulae, ßu is used for an ungeared ß and ßg is used for a geared ß: (x) ßu from ßg, taking ßd as zero (no tax):

ßu = ßg

+ DE

E

VV

V


ßu = ßg

+ DE

E

VV

V + ßd

+ ED VVDV


ßu = ßg

−+ ][1 tVV

V

DE

E



P9 21 November 2006


C$/euro rate Spot

C$/euro time months' 12 in rate Exchange

euro rate discount annual1

C$ rate discount annual1=

+

+




+

+



rateinflationUS1

+

+





yearsovercostsof

n

nPV


TERP = 1

1





+

−

or

N





November 2006 22 P9




P9 23 November 2006



November 2006 24 P9




November 2006






Examiner’s General Comments The performance on this paper was a marked improvement over recent previous diets and many candidates had clearly done adequate preparation of all syllabus areas. The numerical elements of the questions were generally handled well, the main weaknesses in candidates being lack of knowledge of what the calculations might mean and an inability to apply what knowledge they do have to the question scenarios. There were noticeable differences in averages and pass rates among centres. There are always some centre-specific observations in all diets but it was particularly marked in November. There is no obvious explanation for this other than to suggest that those centres that did particularly well have access to provision of good tuition. Questions Four and Five were the most popular of the optional questions, although there was no question on the paper noticeably avoided by candidates. Question Four was particularly well answered, especially part (a). Many candidates had clearly revised the topic of modified internal rate of return (MIRR) and were able to provide at least a marginally satisfactory calculation. Attempts at Question Five were, on the whole, marginally satisfactory, the main weaknesses being that the majority of candidates did not address the scenario and/or writing at length on irrelevant issues. Overseas candidates continue to have difficulty with essay-type questions. Question Two was also popular but less well answered. Question Three was the least popular question on the paper but answered reasonably well by those who attempted it. The structure and presentation of answers were also generally much improved, although some overseas centres continue to disappoint. A particular weakness that provides a great challenge to markers is those candidates who scatter answers around the answer booklet with no, or poor, indication of what part of what question is being answered. Many overseas candidates fail to tick the front page of the answer booklet with the questions they have answered, running the risk that a question is overlooked – especially if they have left many blank pages between questions. In the sections below that explain how the marking scheme was applied, where the comment says “up to 3 marks are available for each valid point”, 0.5 marks are awarded for a bullet point, 1 mark for some attempt at (correct and valid) discussion, rising to 3 marks for good discussion of the point using appropriate illustrative examples. The published solutions are used as a guide. Marks are also awarded for candidates' own valid comments that might not be in the marking guide or the published solutions. Where marks are shown for calculations, the mark shown is the maximum available assuming calculations are all correct. Marks are available for recognition of correct approach and understanding. Note that in the marking scheme the sum of the marks available for specific activities may total more than the marks indicated on the question paper. This is to allow some flexibility in marking but the maximum marks that can be awarded for a section of a question cannot exceed the number of marks indicated on the question paper.





SECTION A Question One (a)

Calculate the NPV of the cash flows for the proposed investment for each of the following four possible scenarios:

• Constant exchange rate and a tax rate of 10%; • Constant exchange rate and a tax rate of 25%; • The euro to strengthen against the US dollar by 7% a year and a tax rate of 10%; • The euro to strengthen against the US dollar by 7% a year and a tax rate of 25%.

In each case, assume that the exchange rate at year 0 is US$1⋅10 = €1⋅00. (12 marks)

Marks available for structure and presentation in Question One. (4 marks)

Rationale Question One considers various issues surrounding a proposed investment in a wind farm in the US by SHINE, a multinational energy entity based in Germany. The question falls into three sections and requires an answer, in memorandum format, addressed to the Board of the SHINE group. There are a number of internal and external constraints and uncertainties surrounding the success of the project and these are the focus of the investment appraisal exercise and ensuing discussion. The question tests topics across the syllabus in sections A, B and D as it involves investment decisions (section D), impact of constraints on financial strategy (section A), and evaluation of alternative financing structures and the role of treasury (section B). Suggested Approach Prepare schedules of the project US$ cash flows for both 10% and 25% tax rates. The most straightforward approach is probably as follows:

Calculate exchange rates for years 1 to 4 assuming that the euro strengthens by 7% a year against the US$

Convert the US$ cash flows in euro at appropriate rates and discount the euro cash flows at 12% Several shortcuts are possible, for example:

applying cumulative discount rates to year 1 to 4 cash flows, or discounting the $ cash flows at 12% and only then converting the cash flows into euro at the

appropriate rate, or for the final two scenarios, use cumulative discount rates based on a combination discount factor

of 20% which takes into account both the 12% discount factor and the 7% a year increase in the value of the euro





Marking Guide

Marks

Basic cash flows 3 Tax treatment 3 Foreign exchange rates and currency conversion 4 Discounting and present value calculations Total

2 12

This section was generally answered very well. Common Errors

incorrect tax treatment of the initial value and/or residual value the use of an average or final exchange rate for years 1 to 4 in order to apply cumulative discount

rates for the final two scenarios Question One (b)

Prepare the forecast balance sheet of the SHINE Group on 31 December 2006, incorporating the project under each of the two alternative financing structures and each of the following two exchange rate scenarios A and B:

Date Exchange rates under scenario A

Exchange rates under scenario B

30 November 2006 (date of the initial investment and arrangement of financing)

US$1⋅10 = €1⋅00 US$1⋅10 = €1⋅00

31 December 2006

(financial reporting/balance sheet date) US$1⋅10 = €1⋅00 (no change)

US$1⋅40 = €1⋅00

Assume that no other project cash flows occur until 2007. (8 marks)

Rationale Part (b) requires an analysis of the sensitivity of the entity’s results to exchange rate movements for each proposed currency of borrowing by modelling the entity’s balance sheet under different exchange rate scenarios.





Suggested Approach Prepare the simplest balance sheet first, that is, scenario A with euro denominated borrowings. Add a comment explaining that the same result is obtained under scenario A with US dollar denominated borrowings. For scenario B and assuming that borrowings are denominated in euro:

adjust the figures for Assets and Non-current liabilities to take into account the movement in exchange rates.

carry forward the unchanged figure for Current liabilities calculate the balancing figure for equity

Repeat the above steps for scenario B for borrowings denominated in US dollars. Marking Guide

Marks

Scenario A/euro borrowings Scenario A/US dollar borrowings

2 2

Scenario B/euro borrowings 2 Scenario B/US dollar borrowing 2 Total 8





Question One (c) (i)

Write a report addressed to the Directors of the SHINE Group in which you, as Finance Director, address the following issues relating to the evaluation and implementation of the proposed wind farm project:

(i) Discuss the internal and external constraints affecting the investment decision and advise the SHINE Group how to proceed. In your answer, include reference to your calculations in part (a) above.

(9 marks)

Rationale The analysis from part (a) provides information on the financial contribution of the project which forms the basis for subsequent discussion on the impact of financial and other internal and external constraints affecting the investment decision. Suggested Approach Discuss the impact of each key internal and external constraint, including:

tax rates exchange rates objections from local holiday home owners and farmers corporate objective to invest in renewable energy projects

Include reference to the potential losses resulting from unfavourable tax rates or exchange rates as calculated in part (a) of the question. Ensure that all answers are relevant in the context of a large multinational group such as SHINE where the project is largely immaterial and potential losses relatively small in comparison to total group income. Project losses may be acceptable when weighed against the potentially large public relations benefits.

Advise the SHINE group how to proceed. Key recommendations include:

wait until the final tax rate is known before proceeding further lobby local government to adopt a lower tax rate for renewable energy projects local public relations and consultation exercise research to minimise the impact of the wind farm on local holiday home owners and farmers use hedging techniques to minimise currency risk

Marking Guide

Marks

Key points include:

External constraints Uncertainty over the tax rate Uncertainty over the exchange rate

Internal constraints Need to be seen to invest in renewable energy schemes Advise how to proceed Conflict between low return renewable energy projects and positive NPV

Total 9





Examiner’s Comments The report sections for requirements (c)(i) and (c)(ii) were generally quite poor. A fundamental problem was the amount of material in the answers that appeared to have been lifted straight from study systems without applying that knowledge to the scenario provided. In addition, many candidates did not appear to realise that they were dealing with a multi-national group for which the potential losses from unfavourable tax rates or exchange rate movements were immaterial. Common Errors specific to part (c)(i):

Missing the key issue that the potential public relations benefits of the project might outweigh the potential costs.

Omitting advice on the use of hedging techniques to reduce exchange rate risk Omitting advice on how to proceed

Question One (c) (ii)


(ii) Discuss the comparative advantages of each of the two proposed alternative financing structures and advise the SHINE group which one to adopt. In your answer include reference to your results in part (b) above and further analysis and discussion of the impact of each proposed financial structure on the group’s balance sheet.

(9 marks)

Rationale This analysis (from (b)) forms the basis for subsequent discussion on the optimum currency in which to finance the project. Suggested Approach Use results from part (b) to calculate gearing and equity values under each of the four different scenarios. Analyse the results, drawing conclusions about the impact of exchange rate movements on these values for both euro denominated borrowings and US dollar denominated borrowings. Consider whether or not the exposure of group gearing and equity values to changes in exchange rates relating to the project is material. Explain that US dollar borrowings would provide a natural hedge of both US dollar cash flow and balance sheet exposures. Marking Guide

Marks

Numerical points:

Gearing calculations Changes in value of equity

Key points in discussion: US dollar borrowings provide a natural hedge of the US dollar investment Impact on gearing is negligible as the project is so small relative to the size of the entity

Conclusion





Total 9 Examiner’s Comments See part (c)(i) above. Common Errors specific to (c)(ii)

lack of understanding that the impact of exchange rate movements relating to the project is largely immaterial to group gearing levels due to the small size of the project in relation to the size of the group

misconception that US dollars would need to be borrowed in the US misconception that it would be cheaper and/or easier to raise funds in euro rather than US dollars





Question One (c) (iii)


(iii) Discuss the differing roles and responsibilities of the treasury department and finance department in evaluating and implementing the US project and the interaction of the two departments throughout the process.

(8 marks)

Rationale Part (c) (iii) considers some broader organisational issues relating to the evaluation and implementation of the wind farm project. The emphasis here is on the differing roles and responsibilities of the treasury and finance departments and their interaction throughout the evaluation and implementation process. Suggested Approach Discuss the individual roles and responsibilities of both treasury and finance at each stage of the evaluation and implementation process for the project. Discuss the interaction of treasury and finance that is required in order to fulfil their individual roles and responsibilities effectively. Marking Guide

Marks

Key points include:

Evaluating the project Treasury dept: quantify/hedging risks Finance: assess costs and revenues

Choice of finance Treasury dept: key role here

Arranging finance Treasury dept: key role here

Implementing the project itself Finance dept: set and control against budget

Interaction between the departments Total 8 Examiner’s Comments This section was generally well answered and candidates appeared to be well prepared. Common Errors

Presentation of all functions of each department, whether or not they were relevant to the evaluation and implementation of the US project.

Omitting to discuss the interaction of finance and treasury Digressing onto a discussion of the issue of centralisation versus decentralisation of the treasury

function





SECTION B Question Two (a) Calculate a range of values for AB, in total and per share, using methods of valuation that you consider appropriate. Where relevant, include an estimate of value for intellectual capital.

(12 marks)

Rationale Question Two concerns a telecommunications consultancy based in Europe, but which trades globally. It is privately owned by the founding shareholders, who are also directors and who are now considering a flotation. The financial advisor has been asked to provide a range of possible values for the entity using suitable methods of valuation. The question tests topics in section C of the syllabus – business valuations and acquisitions. Suggested Approach

Identify the four main methods of valuation. These are:

1. Asset value including intellectual capital value 2. Market capitalisation using industry average P/E 3. Dividend valuation model/earnings valuation model 4. NPV using free cash flow.

Marking Guide

Marks

Asset value – NET tangible assets 11/2 Asset values – additional marks for attempt at intellectual capital value Up to 3 Market capitalisation using industry average P/E 11/2 DVM – comment 1 NPV

Cash flow (that is using after tax profit and excluding depreciation) 2 DCF 2007 and 2008 1 DCF 2009+ 11/2 NPV 1/2

Total 12





Examiner’s Comments On average, this question was answered less well than the other optional questions. Many candidates provided too few types of valuation and/or did not calculate per share figures. Very few candidates made a serious attempt at calculating value of intellectual capital although credit was given for any valid effort. Common Errors

• Using total, and not net, assets, or average assets over 3 years. • No, or very limited, attempt at providing a value for intellectual capital. • Using the dividend valuation model without noting that there was insufficient information unless

earnings were used as a proxy. • No attempt at providing DCF/NPV calculations based on free cash flow, or confusing the various

cash flow-based methods. • No per share calculations.

Question Two (b) Discuss the methods of valuation you have used, explaining the relevance of each method to an entity such as AB. Conclude with a recommendation of an approximate flotation value for AB, in total and per share.

(13 marks)

Rationale The (financial) advisor has been asked to explain the methods of valuation to the directors and to make a recommendation of a course of action, including a possible flotation value. Suggested Approach

• Provide a summary table of the values arrived at by each of the methods used. • Discuss the various methods of valuation, identifying the key features and their

appropriateness to the scenario. • Provide a recommendation • Note the limitations of the methods that have been used.

Marking Guide Marks Up to 3 marks per valid comment. Total 13 Examiner’s Comments The level of discussion in this part of the question was weak, which is surprising given that company valuation features regularly on the paper. Common Errors

• General weakness of discussion, especially of the use of the industry price earnings ratio. • Explaining methods with little discussion of their drawbacks • No, or poorly reasoned, recommendation of a flotation value.





Question Three (a) (i) Assume you work for VCI and have been asked to evaluate the potential investment. (i) Using YZ’s forecast of growth and its estimates of cost of capital, calculate the number of new

shares that YZ will have to issue to VCI in return for its investment and the percentage of the entity VCI will then own. Comment briefly on your result.

(9 marks)

Rationale Question Three involves a venture capital entity that specialises in providing finance to small, but established, businesses. The entity is examining a potential equity investment in a medium-sized family owned transport and distribution business that is looking for additional capital to expand its operations. Part (a) (i) requires calculation of the number of shares the transport and distribution entity would need to issue to the venture capital entity to raise the necessary finance and what price these shares need to achieve to satisfy the venture capitalist’s return requirement. The question tests topics in section C of the syllabus – business valuations and acquisitions. Suggested Approach

• Calculate dividends • Calculate value using the dividend valuation model at both 10% and 15% cost of equity capital • Calculate value per share at each value • Calculate number of shares to be issued • Calculate percentage that will be owned by the venture capitalist organisation • Provide a brief comment

Marking Guide

Marks

Calculation of dividends/retained earnings 2 Valuation using DVM (at 10% and 15%) 2 Value per share 1 Shares to be issued 2 Percentage owned by VCI 1 Comment 1 Total 9 Examiner’s Comments This was the least popular question on the paper but answered fairly well by those who attempted it. The main failing was in calculating dividends although on the “own answer” principle many candidates then scored good marks. Common Errors

• Calculating incorrect dividend figure (usually by ignoring interest costs before arriving at earnings) • Calculating values and subsequent figures using only one growth rate





Question Three (a) (ii)

Assume you work for VCI and have been asked to evaluate the potential investment.

(ii) Evaluate exit strategies that might be available to VCI in five years’ time and their likely acceptability to

YZ. (6 marks)

Rationale Part (a) (ii) requires a discussion of the possible exit strategies available to the venture capital entity and their likely acceptability to the transport and distribution entity is also required. Suggested Approach Discuss the main exit strategies available, their advantages and disadvantages/likely achievement of return: MBO by YZ Flotation Third party sale

Marking Guide Marks Up to 3 marks per valid comment

Total 6 Examiner’s Comments This part of the question was generally well answered and most candidates managed to provide at least satisfactory discussion, with many very good answers being submitted. There were no specific common errors.





Question Three (b) Discuss the advantages and disadvantages to an established business such as YZ of using a venture capital entity to provide finance for expansion as compared with long term debt. Advise YZ about which type of finance it should choose, based on the information available so far.

(10 marks)

Rationale Part (b) requires a discussion of the advantages and disadvantages to an established business such as the one in the scenario of using a venture capital entity compared with raising the necessary finance through long term debt. Suggested Approach Discuss the main advantages and disadvantages of venture capital finance compared with long term debt in the circumstances of YZ and provide advice. Key points are: Advantages

Money readily available May bring useful management expertise Lowers gearing

Disadvantages May want more control than management wish to give and/or a seat on the board May push for higher risk strategies than YZ comfortable with to allow for their required rate of return and/or early flotation

May eventually sell shares to an unwanted (to YZ) buyer No tax advantages Difficulty of valuing shares – part sale

Advice Neither option ideal in current situation Need to clean up finances first

Marking Guide Marks

Up to 3 marks per valid comment 6 Total 10

Examiner’s Comments This part of the question was less well answered than part (a) with many candidates not addressing the scenario or the question as asked. Common Errors

• Discussing debt versus equity in general terms • Providing no advice • Not recognising the specific circumstances of YZ (high gearing, poor liquidity)





Question Four (i) Assume that you are the Financial Manager of CD. (i) Calculate the net present value (NPV), internal rate of return (IRR) and (approximate) modified internal

rate of return (MIRR) of alternative 2. (12 marks)

Rationale Question Four concerns a manufacturing entity based in the UK. Consumer tastes and demands are changing and the entity needs to reconsider its products and how they are manufactured and sourced. The question requires an evaluation of two alternative approaches to the continuation of how it supplies its main retailing customers with some of its products. As part of this evaluation, calculations are required of NPV, IRR and MIRR. The question tests topics in Section D of the syllabus – investment decisions and project control. Suggested Approach

• Calculate forward rates • Inflate cash flows • Convert cash flows to sterling • Calculate DCFs/NPV • Calculate internal rate of return • Calculate modified internal rate of return

Marking Guide Marks Calculating forward rates 2 Inflating cash flows 2 Ignoring sunk cost 1 Converted to sterling 1 DCFs/NPV 1 IRR (using interpolation) 2 MIRR

3

Total 12 Examiner’s Comments This was a popular question and very well answered by many candidates who attempted it. It was a fairly standard approach to investment decisions and the well prepared candidate should have been able to gain good marks. Common Errors

• Not inflating US and/or sterling cash flows • No, or incorrect, attempt at calculating modified internal rate of return • Using a financial calculator to calculate IRR (and sometimes NPV) and not showing any workings.

Very little credit could be awarded for this – marks are awarded for approach as well as correct answers.





Question Four (ii) (ii) Briefly discuss the appropriateness and possible advantages of providing MIRRs for the evaluation

of the two alternatives. (4 marks)

Rationale See question part (i) Suggested Approach Provide brief comments on the appropriateness and advantages of MIRR in the situation here. Marking Guide

Marks

Comments – up to 4 Examiner’s Comments This part of the question was very poorly answered; even candidates who had managed to calculate MIRR correctly were generally unable to explain what the calculations meant.





Question Four (iii) (iii) Evaluate the two alternatives and recommend which alternative the entity should choose. Include in

your answer some discussion about what other criteria could or should be considered before a final decision is taken.

(9 marks)

Rationale A recommendation is required, with reasons, of which alternative the entity should choose. Suggested Approach Discuss the key points, such as:

• NPV is theoretically superior to other methods

• IRR weaknesses • More evaluation needed • Cash flows beyond year 3 needed • Weaknesses of interest rate parity for forecasting forward rates • Other stakeholders’ interests • Payback could be calculated • Recommendation

Marking Scheme Marks Up to 3 marks per valid comment Total 9 Examiner’s Comments This part of the question was satisfactorily answered by many candidates who attempted it. The main faults were discussion of irrelevant issues (to the scenario) and/or a too lengthy discussion of too many “other criteria”.





Question Five (a)

Discuss the criteria that the two very different entities described above have to consider when setting objectives, recognising the needs of each of their main stakeholder groups. Make some reference in your answer to the consequences of each of them failing to meet its declared objectives.

(13 marks)

Rationale Part (a) examines the objectives of a local government entity and a large, listed entity. The requirement is a discussion of the main criteria that these two very different entities need to consider when setting objectives. The question tests topics in section A of the syllabus – formulation of financial strategy. Suggested Approach Discuss the key points, such as:

• Who are main stakeholders • Differences and similarities between stakeholder groups • Where is finance coming from and in what proportions • Do objectives need to be measurable • Will information be publicly available

Marking guide Marks Up to 3 marks per valid comment Total 13 Examiner’s Comments Many candidates provided an adequate answer to this part of the question, but there were not many strong answers and few candidates achieved high marks. Some overseas candidates politicised the question more than necessary, especially the consequences of failure, although credit was given where appropriate. Other common errors

• Poor understanding of objective setting • Not discussing consequences of failure for either entity • Not fully understanding the nature of CCC as an entity • Re-writing large chunks of the question – not an error but wastes time. • Reiterating with no application the text book/study manual





Question Five (b) Discuss and compare the relationship between dividend policy, investment policy and financing policy in the context of the small entity described above, MS, and DDD, the large listed entity described in part (a).

(12 marks)

Rationale Part (b) compares the large, listed entity described in part (a) and a small private entity. The requirement is to discuss the relationship between dividend policy, investment policy and financing policy in the context of the two entities. The question tests topics in section A of the syllabus – formulation of financial strategy. Suggested Approach Discuss the key points, such as:

• Dividend policy – part of financing decision

• Theoretical position of the relationship • Access to funds for investment • Dividend payout policy of MS • Signalling mechanism relevance to the two entities

Marking guide Marks Up to 3 marks per valid comment

Total 12 Examiner’s Comments This part of the question was generally answered less well than part (a). The main weakness was in discussing general issues of investment, finance and dividend policies with no or little focus on the entities involved. Other Common Errors

• Discussing CCC instead of MS.




Financial Management Pillar Strategic Level Paper

P9 – Management Accounting – Financial Strategy




You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during the reading time.

You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or sub-questions). The question requirements are highlighted in a dotted box.

ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking.




The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper.

Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close.


P9 –

Fin

anci

al S

trat

egy

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May 2007 2 P9



ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One SANDYFOOT Background Sandyfoot College of Higher Education (Sandyfoot) is a long-established, privately-owned college in an English-speaking country – Esco. It competes effectively with public sector universities, but on a narrower range of subjects. It operates using commercial principles although it is established as an educational trust in order to be exempt from Esco taxation. The new Chief Executive believes the college should be more aggressive in its expansion strategy in order to meet its long-term objectives of offering the same range of courses as its main public sector rivals and developing its student market internationally. He has commissioned and received a study of a potential investment overseas, but many of his senior managers and teaching staff would prefer expansion at home first. The college does not have the resources, financial or non-financial, to expand on both fronts at the same time. Investment opportunities Details about the two alternatives are as follows: Alternative 1 – “New Build” in the home country – Esco In the present facilities there is little scope for increasing student numbers or the range of courses offered. Suitable development land for expansion has been identified a few miles away. Sandyfoot has already opened discussions with the seller of the land and the local authority has been approached about outline planning permission. The land is in an area being considered by the Esco government as a development area. If this is approved there will be some financial assistance available to a purchaser such as Sandyfoot. However, a decision is not expected for at least six months. A disadvantage of this investment is the travelling that staff would be required to do between sites, as the proposed new site is not large enough to accommodate all operations, old and new. A major advantage is that it increases the catchment area for part-time students. An estimate of the additional fees from these students has been included in the figures given below. There has been a lot of interest in the land that is for sale and Sandyfoot has paid a non-refundable deposit of Esco $50,000 pending the outcome of its investment evaluation. The seller requires a decision within six months. Alternative 2 – “New Build” in a Middle Eastern Country – Midco Sandyfoot already attracts a number of full-time students from Midco and teaching staff have taught short courses there. The government of Midco is very keen to attract inward investment although it generally insists on some involvement in the investment and puts certain restrictions in contracts. For example, the government would insist on approving all courses to be taught before they could be marketed. A suitable site is available for Sandyfoot on the basis of a long-term leasehold, with an option to acquire the freehold at an unspecified price in 15 years’ time. There will be break clauses in the contract at five-year intervals whereby either party can terminate the agreement. Should Sandyfoot wish to withdraw, the entity will not be entitled to any refund of the lease premium.



P9 3 May 2007

Teaching would be done by a combination of local (Midco) tutors and tutors from Esco on two or three year contracts to work in Midco. A disadvantage would be the introduction of foreign exchange risk into the college’s finances. To require fee payments in Esco $ would be a negative factor to many students. The US$ is widely used in Midco, so Sandyfoot has decided to request fee payments in US$. All payments in Midco, with the exception of the capital costs, can also be made in US$. Cash flows for both alternatives Capital costs Alternative 1 Alternative 2 Esco $000 Midco $000 Freehold capital cost of land 6,000 Purchase of 15 year lease 20,000 Building costs 3,000 10,000 Equipment costs 1,000 5,000 Freehold land is not depreciated. Buildings and equipment for Alternative 1 will be depreciated straight line over 20 years. The total capital costs of Alternative 2 will be written off over the period of the lease. Refurbishment of buildings and replacement of equipment will be needed within the life of both investments, but these costs have not as yet been identified and have been excluded from the evaluation. Operating cash flows Alternative 1 Alternative 2 Esco $000 US $000 Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Fees 1,750 2,250 2,700 4,650 5,350 6,450 Other information • In Alternative 1, fees and costs are expected to increase by 3% per annum from year 4

indefinitely. This is approximately the expected rate of inflation in Esco. • Current spot rates are Esco $1 = Midco $6⋅5 and Esco $1 = US $1⋅8. Risk-free interest

rates are currently 4% in Esco and 5% in the US. These rates are likely to be maintained until year 3.

• In Midco, there is no official interest rate and no forecast of inflation. The Sandyfoot directors therefore assume, for convenience, that in Alternative 2 the fees receivable in year 3 in Esco $ terms will remain constant, in nominal terms, until year 15.

• Cash operating costs are assumed to be 60% of fees received each year in both alternatives.

• Assume all capital costs are incurred in year 0 and all operating cash flows are received or incurred at the end of each year.

• A survey of the land in Esco has been undertaken at a cost of Esco $10,000. A report on the Midco investment has been undertaken at a cost of Esco $20,000.

• If Alternative 1 is chosen, there will be an opportunity cost to the investment of lecturers’ “lost” time in travelling between sites. This is estimated at 1% of fees each year.

• If the investment in Midco goes ahead, fees on existing programmes in Esco are likely to fall by Esco $250,000 per annum for the duration of the investment.

• Sandyfoot has not made an investment on this scale before, but for the investment in Esco (Alternative 1) the directors believe, with justification, that 12% would be an adequate return to reflect the risks involved. A premium on the Esco rate of +4% is considered appropriate for the investment in Midco (Alternative 2).

The question continues, with its requirements, on page 5, which is detachable for ease of reference

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May 2007 4 P9




P9 5 May 2007

Method of funding Sandyfoot has accumulated cash reserves of Esco $3 million. The remaining capital costs will be funded by long-term borrowings. If Alternative 1 is chosen, it will be funded by a 20 year commercial mortgage secured on the land and buildings. Interest will be fixed at 9% per annum, payable annually. Sandyfoot currently has no other long-term borrowings. If Alternative 2 is chosen, it will be funded by one of the following methods: (i) A 15-year commercial loan taken out in Esco $ at 10% per annum interest, capital

repayable at the end of the term; (ii) A 15-year interest-free, non-repayable Midco $ government loan, but for the duration of

the loan the Midco government would take a “dividend” each year equivalent to 20% of the profits earned in Midco;

(iii) A euro-denominated Eurobond. Borrowing rates in this market appear very favourable at

the present time and are below the rates for both Esco$ bonds and US$ bonds. This option has not been investigated further at present.

Required: (a) Calculate the net present value (NPV) in Esco $ for the two alternative

investments, using the cash flows and discount rates given in the scenario.

(17 marks)

(b) Assume you are the Financial Manager for Sandyfoot. Prepare a report to the Chief Executive evaluating the investment decision and its funding. Your report should include the following sections:

(i) An evaluation of the two investments, including discussion of the key risk factors Sandyfoot should consider, the choice of discount rates used in the evaluation, and the real option features that are implied in the two investments. Discuss how these option features might impact on the investment decision being made.

(14 marks)

(ii) A discussion of the advantages and disadvantages of the three methods of funding outlined in the scenario for Alternative 2. Use appropriate calculations, where possible, to support your arguments.

(11 marks)

(iii) Recommendations about the choice of investment alternative and, if relevant, the method of funding.

(5 marks)


Additional marks for structure and presentation. (3 marks)



End of Section A



May 2007 6 P9




P9 7 May 2007


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May 2007 8 P9



ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two LEE is a manufacturing entity located in Newland, a country with the dollar ($) as its currency. LOR is a leasing entity that is also located in Newland. LEE plans to replace a key piece of machinery and is initially considering the following two approaches:

• Alternative 1 – purchase the machinery, financed by borrowing for a five-year term; • Alternative 2 – lease the machinery from LOR on a five-year operating lease.

The machinery and maintenance costs The machinery has a useful life of approximately 10 years, but LEE is aware that the industry is facing a period of intense competition and the machinery may not be needed in five years’ time. It would cost LEE $5,000 to buy the machinery, but LOR has greater purchasing power and could acquire the machinery for $4,000. Maintenance costs are estimated to be $60 in each of years 1 to 3 and $100 in each of years 4 and 5, arising at the end of the year. Alternative 1 – purchase financed by borrowing for a five year term $ interbank borrowing rates in Newland are currently 5⋅5% per annum. LEE can borrow at interbank rates plus a margin of 1⋅7% and expects $ interbank rates to remain constant over the five year period. It has estimated that the machinery could be sold for $2,000 at the end of five years. Alternative 2 – five year operating lease Under the operating lease, LOR would be responsible for maintenance costs and would charge LEE lease rentals of $850 annually in advance for five years. LOR knows that LEE is keen to lease rather than buy the machine and wants to take advantage of this position by increasing the rentals on the operating lease. However, it does not want to lose LEE’s custom and requires advice on how high a lease rental LEE would be likely to accept. Tax regulations Newland’s tax rules for operating leases give the lessor tax depreciation allowances on the asset and give the lessee full tax relief on the lease payments. Tax depreciation allowances are available to the purchaser of a business asset at 25% per annum on a reducing balance basis. The business tax rate is 30% and tax should be assumed to arise at the end of each year and be paid one year later. Alternative 3 – late proposal by production manager During the evaluation process for Alternatives 1 and 2, the production manager suggested that another lease structure should also be considered, to be referred to as “Alternative 3”. No figures are available at present to enable a numerical evaluation to be carried out for Alternative 3. The basic structure would be a five-year lease with the option to renew at the end of the five-year term for an additional five-year term at negligible rental. LEE would be responsible for maintenance costs.

The requirement for Question Two is on the opposite page



P9 9 May 2007

Required: (a) (i) Use discounted cash flow analysis to evaluate and compare the cost to LEE

of each of Alternatives 1 and 2. (9 marks)

(ii) Advise LOR on the highest lease rentals that LEE would be likely to accept

under Alternative 2. (4 marks)


(b) Discuss both the financial and non-financial factors that might affect LEE’s choice between Alternatives 1, 2 and 3. No further calculations are required in part (b).

(12 marks)



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May 2007 10 P9

Question Three STR is a well-established marketing consultancy in a country with a low interest rate. STR is a successful business which has experienced rapid growth in recent years. There are 20 million $1 ordinary shares in issue. These ordinary shares are quoted on a recognised stock exchange and 40% are owned by the founders of the business. Dividends were 40 cents per share in 2003 and grew by 5% per annum between 2003 and 2006. This pattern is expected to continue beyond 2006. Dividends are paid in the year in which they are declared. Extracts from the financial statements for the past three years are as follows: 2004 2005 2006 $million $million $million Profit before tax 21⋅6 24⋅4 26⋅7Tax expense 7⋅7 2⋅6 4⋅3 Net cash generated after deducting interest, tax and net capital expenditure, but excluding ordinary dividends

19⋅2

(7⋅1)

18⋅8

Additional information: • The opening cash balance in 2004 for cash and cash equivalents was $6 million; • The opening book value of equity in 2004 was $60 million; • Long-term borrowings remained at $50 million throughout the three years and the annual

gross interest cost on the borrowings was $1 million; • There were a number of disposals of non-current assets in 2004 and an exceptionally

high level of capital expenditure in 2005. The directors have noticed the build-up of cash and cash equivalents. They are concerned that this might not be in the best interest of the shareholders and could have an adverse effect on the share price. Various proposals have been made to reduce the level of cash and cash equivalents.

The requirement for Question Three is on the opposite page



P9 11 May 2007

Required:

(a) Calculate the following financial information for STR for each of the years 2004 to 2006: • Closing cash balance; • Closing book value of equity.

(3 marks) (b) Analyse and discuss the financial performance of the entity from the viewpoint of both the lenders and shareholders, referring to the information calculated in part (a) above and making appropriate additional calculations. Up to 6 marks are available for calculations.

(10 marks) (c) (i) Discuss the comparative advantages and disadvantages of a share

repurchase versus a one-off dividend payment. (7 marks)

(ii) Advise the directors of STR on alternative financial strategies that they could

consider that would reduce the level of surplus cash. (5 marks)

(Total for part (c) = 12 marks)



TURN OVER



May 2007 12 P9

Question Four Country Y Country Y is a large industrialised country with strong motor vehicle and construction industries. The glass industry supplies glass to these industries as well as to specialist users of glass such as contact lens manufacturers. There are five major glass manufacturing entities, each with market coverage in Country Y of between 5% and 40%. Entity Q Entity Q is a quoted entity and a major player in the glass industry. It has a market share in Country Y of approximately 35%. It is an old, well-established entity with a number of factories used to manufacture glass both locally and abroad. It has a stable, but unexciting, growth rate of 3% per annum and is facing increasing competition from new glass manufacturing entities setting up in its key markets. However, Q’s high earnings levels of earlier years have resulted in relatively low levels of debt. The head office building of Q is in the far north of Country Y in a remote geographical area. It is a considerable distance from the capital city and major centres of population in the south of the country. The building is much larger than the entity requires and several floors are unoccupied. The management team of Q is highly experienced; the majority of the senior managers have worked for Q for the whole of their working lives. The computer systems of Q were written especially for the entity, but are in need of replacement in favour of something more flexible and adaptable to changing circumstances. Entity Z Entity Z, with a market share in Country Y of 10%, is a comparatively new and small, but fast growing unquoted family-owned entity. It specialises in certain niche markets for high security and extra heat resistant glass. The patents for this specialist glass were developed by the founder owner who now acts as Managing Director. The development of the business has largely been funded by high levels of borrowings at rates of interest well above standard market rates. In addition, the directors have often been required to provide personal guarantees against personal assets. The management team of Z works in the capital city of Country Y, which is in the more prosperous southern part of the country. Z has a manufacturing base on the outskirts of the capital city. The management team of Z is enthusiastic to grow the business, but is continually frustrated by a lack of financial and human resources and marketing network that would enable Z to expand into international markets. Also, on a personal level, many of the senior managers own a substantial number of shares in Z and are keen to realise some of their capital gains and become financially more secure. The computer systems of Z consist of a basic accounting package and an internal network of PCs. Spreadsheet packages are widely used for budgeting and other financial reporting. Takeover bid The directors of Q have approached the directors of Z with a view to making a takeover bid for Z. A condition of the bid would be the retention of the current management team of Z, who have vital knowledge of the specialist manufacturing techniques required to manufacture the product range of Z. The directors of Z have been initially quite positive about the bid. Both parties are concerned that the deal may be referred to Country Y’s Competition Directorate, which regulates the country’s competition policy, for approval and that conditions may be imposed that could make the takeover less attractive.




P9 13 May 2007

Required:

(a) Explain the role of competition authorities such as Country Y’s Competition Directorate.

(6 marks)

(b) Advise the directors of Q and Z on the potential problems of merging the management structure and systems of the two entities and how these could be minimised.

(9 marks)

(c) Discuss whether the choice of capital structure for the new combined entity is likely to affect the overall value of the entity. Include references to Modigliani and Miller’s (MM’s) theory of capital structure in your answer.

(10 marks)



TURN OVER



May 2007 14 P9

Question Five GG, a large engineering and project management group, has announced plans to sell its wholly-owned telecommunications subsidiary, BB, so that it can concentrate on its core business of major infrastructure developments. HH, an entity with diverse business interests, has expressed an interest in making a bid for BB, but the directors of HH are aware that there are likely to be several other interested parties. News of the possible sale has been well received in the financial markets and GG has seen its share price rise by 15% in the last two months. HH expects to be able to use its good reputation and strong market presence to enhance the prospects of BB by improving BB’s annual earnings by 10% from the date of acquisition. Financial information as at today, 23 May 2007, ignoring any potential synergistic benefits arising from the possible acquisition of BB by HH: • Profit after tax for BB for the year ended 30 April 2007 is estimated as $1 million; • BB’s profit after tax has increased by 7% each year in recent years and this trend is

expected to continue; • The gearing level of BB can be assumed to be the same as for GG; • The business tax rate is 30%; • Estimated post-tax return on the market is 8% and the risk free rate is 3% and these rates

are not expected to change in the foreseeable future; • Assume a debt beta of zero; HH GG Proxy entity for BB

in the same industry

Number of ordinary shares in issue 8 million 4 million –

Current share price 613 cents 800 cents –

P/E ratios today 11 14 13

Dividend payout 40% 50% 50%

Equity beta 1⋅1 1⋅4 1⋅4

Gearing (debt : equity at market values) 1 : 2 1 : 2⋅5 1 : 4

Forecast earnings growth 5% 6% –

The requirement for Question Five is on the opposite page



P9 15 May 2007

Required: (a) Calculate an appropriate cost of equity for BB based on the data provided for

the proxy entity. (3 marks)

(b) (i) Calculate a range of values for BB both before and after any potential

synergistic benefits to HH of the acquisition. (8 marks)

(ii) Discuss your results in (b) (i) and advise the directors of HH on a suitable

initial cash offer for BB. (7 marks)


(c) Advise the directors of GG on both the potential benefits and potential

drawbacks arising from the divestment of its subsidiary, BB. (7 marks)





TURN OVER



May 2007 16 P9




P9 17 May 2007






May 2007 18 P9



−+−

rr n)(11


1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514


1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870



P9 19 May 2007


value:

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May 2007 20 P9


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P9 21 May 2007


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May 2007 22 P9




P9 23 May 2007

LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb.

LEARNING OBJECTIVE VERBS USED DEFINITION

1 KNOWLEDGE

What you are expected to know. List Make a list of State Express, fully or clearly, the details of/facts of Define Give the exact meaning of

2 COMPREHENSION What you are expected to understand. Describe Communicate the key features

Distinguish Highlight the differences between Explain Make clear or intelligible/State the meaning of Identify Recognise, establish or select after

consideration Illustrate Use an example to describe or explain

something

3 APPLICATION How you are expected to apply your knowledge. Apply

Calculate/compute To put to practical use To ascertain or reckon mathematically

Demonstrate To prove with certainty or to exhibit by practical means

Prepare To make or get ready for use Reconcile To make or prove consistent/compatible Solve Find an answer to Tabulate Arrange in a table

4 ANALYSIS How are you expected to analyse the detail of what you have learned.

Analyse Categorise

Examine in detail the structure of Place into a defined class or division

Compare and contrast Show the similarities and/or differences between

Construct To build up or compile Discuss To examine in detail by argument Interpret To translate into intelligible or familiar terms Produce To create or bring into existence

5 EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations.

Advise Evaluate Recommend

To counsel, inform or notify To appraise or assess the value of To advise on a course of action



May 2007 24 P9




May 2007






Examiner’s General Comments The improvement in candidates’ performance seen in November 2006 continued in May 2007 with a further increase in pass rates. There were, however, the usual marked differences in performance between and within centres. The reason for this is possibly the quality of tuition received by candidates and the associated level of preparedness. The performance of candidates in many overseas centres continues to disappoint, especially with the very poor standard of presentation of numerical answers. This problem is also apparent in many home centres. Candidates are most strongly advised to look at past exam papers and suggested solutions and practice using the structure and presentation of answers shown. A weakness that continues to be evident is mis-reading the question, or not reading it carefully. An example is in question 1 where the scenario clearly states Sandyfoot does not pay tax yet candidates frequently suggested the college should borrow in home currency debt because of the tax relief. Some discussion of its continuing tax exempt status was acceptable but this was not the point made by most candidates. Questions 4 and 5 were the most popular of the optional questions although none of them was obviously avoided by candidates. The average mark and pass rate was similar for all optional questions. In the sections below that explain how the Marking Guide was applied, where the comment says “up to 3 marks are available for each valid point”, 0.5 marks are awarded for a bullet point, 1 mark for some attempt at (correct and valid) discussion, rising to 3 marks for good discussion of the point using appropriate illustrative examples. The published solutions are used as a guide. Marks are also awarded for candidates' own valid comments that might not be in the marking guide or the published solutions. Where marks are shown for calculations, the mark shown is the maximum available assuming calculations are all correct. Marks are available for recognition of correct approach and understanding. Note that in the Marking Guide the sum of the marks available for specific activities may total more than the marks indicated on the question paper. This is to allow some flexibility in marking but the maximum marks that can be awarded for a section of a question cannot exceed the number of marks indicated on the question paper.





SECTION A Question One (a) Calculate the net present value (NPV) in Esco $ for the two alternative investments, using the cash flows and discount rates given in the scenario.

(17 marks)

Rationale Concerns a privately-owned higher education college that has two investment opportunities for consideration. The college’s resources only permit progressing one of these opportunities at present. Candidates are required to calculate the NPV of each opportunity, followed by a report evaluating the key risk factors, choice of discount rates and the real option features that might impact the decision-making process. Candidates are also required to assess the positive and negative aspects of three different methods of financing covered in the scenario and, finally, to recommend which investment opportunity should be progressed by the college. The question tests topics across the syllabus in sections A, B and D as it involves evaluation of investment decisions (section D), impact of constraints on financial strategy (section A), and evaluation of key success factors in the management of working capital and the finance function (section B). Suggested Approach Alternative 1 Calculate:

- annual cash flows (capital and operational) years 0 to 3; - DCFs using 12% discount rate years 0 to 3; - NPV for years 0 to 3; - NPV for year s 4+; - NPV for total investment period.

Alternative 2 Calculate:

- forward exchange rates for years 1 to 3 US$ to Esco$; - annual cash flows years 0 to 3 in Midco$ (capital) and Esco $ (operational); - cash flows in Esco$ years 0 to 3; - opportunity cost of lost income years 0 to 3; - net cash flows in Esco$ years 0 to 3; - DCFs using 16% (or 17% if alternative approach used) discount rate years 0 to 3; - NPV for years 0 to 3; - NPV for years 4 to 15; - NPV for total investment period.

Note that:

- Sunk costs are irrelevant and should be ignored; - Depreciation is not a cash cost; - The cost of finance is incorporated in the discount rate so interest charges should be excluded.

Credit was available for ignoring these irrelevant items.





Marking Guide

Marks

Alternative One 6.5 Alternative Two 9.5 Structure and presentation 1 Examiner’s Comments

This part of the question was answered at least satisfactorily by the majority of candidates with some very high marks being scored by the well prepared candidates. However, it was apparent that many candidates devoted too much time to this part of the question with the result that their answers to part (b) were much weaker. Common Errors Alternative 1

• Ignoring opportunity costs; • Incorrect calculation of cash flows beyond year 3 (note: assuming a 20 year investment period was an

acceptable alternative approach); • Including one or more of the costs that are irrelevant (sunk costs, depreciation or interest).

Alternative 2

• Incorrect forward rate calculation; • Incorrect calculation of opportunity costs (usually by including in wrong currency); • Incorrect calculation of cash flows beyond year 3 (usually using the wrong annuity factors); • Including one or more of the costs that are irrelevant (sunk costs, depreciation or interest).





Question One (b) Assume you are the Financial Manager for Sandyfoot. Prepare a report to the Chief Executive evaluating the investment decision and its funding. Your report should include the following sections: (i) An evaluation of the two investments, including discussion of the key risk factors Sandyfoot should

consider; the choice of discount rates used in the evaluation, and the real option features that are implied in the two investments. Discuss how these option features might impact on the investment decision being made.

(14 marks)(ii) A discussion of the advantages and disadvantages of the three methods of funding outlined in the

scenario for Alternative 2. Use appropriate calculations, where possible, to support your arguments. (11 marks)

(iii) Recommendations about the choice of investment alternative and, if relevant, the method of funding. (5 marks)


Additional marks for structure and presentation (3 marks) Suggested Approach • Provide a suitable structure for the report: heading, sub headings (following the question sections) and

an introduction that briefly explains the purpose of the report, its terms of reference and contents. Section (i) Address the three areas required: key risk factors, choice of discount rates, real option features. Evaluate in the context of Sandyfoot. • Key risk factors include:

Reliability of forecast and NPV (note NPV is heavily dependent on cash flows beyond year 3) Effects of inflation Refurbishment costs in future Exchange rate risk Level of competition, size of market etc Real costs of operating over two sites in alternative 1 and abandonment in alternative 2 Availability of lecturing staff in both alternatives Country risks – economic, political, cultural

• Key point in respect of discount rate: May be too high in alternative 2, consider diversification effect and apparent low-risk nature of the country

• Real option features – discuss each and relate to Sandyfoot Abandonment; available in alternative 2 Timing; option to delay in alternative 1 Strategic/follow on options; available in both alternatives





Suggested Approach for Question One (b) continued Section (ii) Discuss the three methods of funding and provide appropriate calculations to support discussion/recommendation. Key points for each section are: 1 Export capital from home country

- Calculate interest costs - Note risks are economic - Disadvantage is Sandyfoot does not obtain tax relief. Some discussion of its tax exempt status given

its move into highly commercial operations was acceptable.

2 Borrow in currency of host country - Calculate profits and dividend payable to Midco government - Risks are economic and, possibly, reputational - What happens if no profits? - Cheaper option but if profits much higher than expected the cost to Sandyfoot is high.

3 Borrow internationally. - Note no information to allow calculations - Advantages and disadvantages of euro debt - Sandyfoot possibly too small/unknown internationally to borrow in Eurobonds - Recognise matching advantages of borrowing; for example borrow in US$ but understand costs

associated with raising debt. Section (iii) Key points to include in recommendation:

- Re-evaluate alternatives based on discussion of key risk factors - NPVs not directly comparable - Recommend based on NPV, including method of funding if choice is alternative 1 - Relate to Sandyfoot’s objectives - Note possibility of other possibilities, for example joint venture

Suggested Approach to Question One (b) continued

Marking Guide

Marks

Evaluation of the investments, risk factors and discount rates 7 Real option features 7 Funding methods calculations 4 Comments on advantages and disadvantages of funding methods 7 Recommendations 5 Structure and presentation 3





Examiner’s Comments on Question One (b) This part of the question was, generally, not answered well. Many candidates were unable to evaluate and provided little more than a series of bullet points for section (i) of the report. Very few candidates provided calculations to support their answer about method of funding and many misunderstood the issues about borrowing in euro denominated Eurobonds. However, there were also some exceptionally good answers that provided excellent evaluation and insight into the potential risk factors involved in the investments. Common Errors Section (i) • Failing to provide adequate evaluation of the risk factors in the context of Sandyfoot; • Too much repetition of information given in the scenario; • Providing descriptive rather than analytical answers. Section (ii) • Not providing any supporting calculations. Where calculations were provided, incorrect calculation of

interest payable in method 1 (borrowing in home currency) and not adjusting cash flows before calculating the dividend payable on profits in method 2 (Midco government loan);

• Failing to recognise Sandyfoot does not pay tax; • In the discussion of borrowing in euro-denominated Eurobonds many candidates incorrectly discussed

the risks associated with investing in Eurobonds. Section (iii) • Providing a very limited recommendation, often no more than suggesting the choice should be the

alternative with the highest NPV. For 5 marks more analysis was expected.





SECTION B Question Two (a) (i) Use discounted cash flow analysis to evaluate and compare the cost to LEE of each of Alternatives 1

and 2. (9 marks)

(ii) Advise LOR on the highest lease rentals that LEE would be likely to accept under Alternative 2.

(4 marks)


Rationale Concerns a manufacturing entity planning to replace a key piece of machinery. The entity is considering whether to purchase or lease the replacement machinery it needs. Candidates are required to use DCF analysis to evaluate the cost to the entity, whether it chooses to purchase or to lease, together with the highest lease rental figure acceptable to the entity should it decide to take the leasing alternative. Candidates are also required to discuss both financial and non-financial factors that might impact the decision-making process for the entity. The question tests the learning outcome “Identify and describe optimal strategies for the management of working capital and satisfaction of longer term financing requirements.” in section B of the syllabus. Suggested Approach Part (i) Calculate the post-tax borrowing rate by: • adding the margin; • adjusting for tax. Calculate the tax depreciation allowances, including the balancing depreciation in the final year Schedule the cash flows and discount the net cash flows for both the purchase option and the lease option. Cumulative annuity factors speed up this process for the lease option. Part (ii) There were several valid approaches to the calculation of the highest acceptable lease rentals, including: • IRR approach – recalculating the lease option result using a different lease rentals figure and using

interpolation to achieve a result equal to that of the purchase option; • ratio approach – multiplying the original lease rentals figure of $850 by the ratio of the purchase option

result to the lease option result (i.e. 850 x 2876/2813 = 869). Marking Guide

Marks

(i) DCF calculations Calculation of post-tax borrowing cost 1.5 Alternative 1 4 Alternative 2 2 Conclusion 1.5 (ii) Calculations of highest acceptable lease rentals 4





Examiner’s Comments No specific comments. Common Errors • including interest or capital cash flows in the lease versus buy evaluation; • ignoring the tax deduction on maintenance payments; • allocating the tax deduction on lease rentals to years 1-5 rather than 2-6 or ignoring the time delay on

the tax deduction altogether; • invalid approaches to the calculations in part (ii) or over simplification by ignoring the time delay on the

tax deduction on lease rentals.





Question Two (b) Discuss both the financial and non-financial factors that might affect LEE’s choice between Alternatives 1, 2 and 3. No further calculations are required in part (b).

(12 marks)

Suggested Approach Plan the answer by identifying the key issues relevant to LEE Analyse each issue in turn, being careful to apply the discussion in the context of the scenario provided and distinguish those factors that have the largest potential impact.

Marking Guide Marks Examples of financial factors – key issues: maintenance costs and residual value 6 Examples of non-financial factors – key issues: useful life and risk of obsolescence 6 Examiner’s Comments There was a tendency to list “textbook” factors without applying this book knowledge to the particular business position and risk exposures of LEE. Note that the question asks for factors that might affect LEE’s choice between the alternatives – this was largely overlooked. Common Errors • no application of comments to the scenario provided; • repeating information provided in the question without any further analysis or discussion; • failing to identify the key issues involved such as useful life and risk of obsolescence.





Question Three (a) Calculate the following financial information for STR for each of the years 2004 to 2006: • Closing cash balance; • Closing book value of equity.

(3 marks)

Rationale Concerns a well-established marketing consultancy undergoing rapid growth, whose directors are seeking to reduce the level of cash and cash equivalents. This is because the directors believe that the rise in cash and cash equivalents would not be in their shareholders’ interests, accompanied by a possible adverse effect on the consultancy’s share price. Candidates are required to calculate the closing cash balance and book value of the consultancy’s equity, followed by an analysis of its financial performance from a shareholder’s perspective. Candidates are then required to discuss, and advise upon, alternative financial strategies aimed at reducing the level of the consultancy’s cash and cash equivalents. The question tests topics in section A of the syllabus – evaluation of current performance and the interrelationships between decisions concerning investment, finance and dividends. Suggested Approach Calculate: • dividend payments; • profit after tax (adjusting profit before tax for tax).

Use the results of the above to calculate: • closing cash balance; • closing book value of equity.

Marking Guide

Marks

Calculation of closing cash balance 1.5 Calculation of equity value 1.5 Examiner’s Comments These simple calculations were surprising badly done. Common Errors • inability to calculate book value of equity; • dividend cash flows allocated to the wrong year.





Question Three (b) Analyse and discuss the financial performance of the entity from the viewpoint of both the lenders and shareholders, referring to the information calculated in part (a) above and making appropriate additional calculations. Up to 6 marks are available for calculations.

(10 marks)

Suggested Approach Use the information calculated in part (a) as the basis for calculations of financial ratios such as: Relevant to shareholders: • return on equity; • ROCE; • dividend cover; • earnings per share. Relevant to lenders: • ROA; • interest cover; • gearing.

Marking Guide

Marks

Calculations – RoE, EPS, RoA and gearing 6 Issues from investors’ and lenders’ viewpoints 4 Examiner’s Comments It was disappointing how few candidates were able to identify and calculate basic financial ratios. Common Errors • confusion between ROE and ROCE; • calculation of only 2 ratios (or none at all!); • confusion over what profit figure to use in the different ratio calculations; • over-superficial discussion of the results of this analysis.





Question Three (c) (i) Discuss the comparative advantages and disadvantages of a share repurchase versus a one-off dividend

payment. (7 marks)

(ii) Advise the directors of STR on alternative financial strategies that they could consider that would

reduce the level of surplus cash. (5 marks)

(Total for part (c) = 12 marks) Suggested Approach Part (i) A short paragraph of discussion on each key advantage and disadvantage. Note that comparative detail is required – not a discussion of share repurchase or one-off dividend payments in isolation. Part (ii) As above – a short paragraph on each alternative strategy, identifying at least 4 alternatives and applying the discussion to the scenario rather than giving a “textbook” list.

Marking Guide Marks (i) Share repurchase v one-off dividend Advantages – for example target at shareholders; enhances future EPS 3.5 Disadvantages – for example treats all shareholders equally; pre-determined amount paid out 3.5 (ii) Alternative financial strategies 5.0 Example – Increase capital expenditure Example – Generic growth into new markets/products Or other applicable strategies Examiner’s Comments Again, there was a tendency towards generalised comments and “textbook” style answers out of context. Common Errors Part (i) • overlooking the requirement to compare the 2 alternatives; • narrow scope; • confusion over the impact of each alterative on earnings per share and gearing levels. Part (ii) • narrow scope of answer – often just focussing on acquisition strategies; • suggesting that surplus cash could be spent on a bonus issue of shares.





Question Four (a) Explain the role of competition authorities such as Country Y’s Competition Directorate.

(6 marks)

Rationale Concerns a takeover bid by one entity for another within the same manufacturing sector in the same country. The directors of each entity are concerned that the takeover might be referred to the country’s competition directorate for approval, with the possible consequence that the takeover might become less attractive. Candidates are required to explain the role of competition directorates, followed by the potential problems of merging the management structures, should the takeover be authorised, and then advising whether the choice of capital structure for the new combined entity is likely to affect its overall value. In doing so, candidates should refer to MM’s theory of capital structure. The question tests topics in section C of the syllabus – evaluation of the pre- and post-implications arising from mergers and acquisitions. Suggested Approach Identify the key role and different issues of interest to competition directorates. Apply these to the scenario provided. Marking Guide

Marks

Example – Public interest Example – Lessening of competition Or other applicable issues

Up to 3 marks per issue Examiner’s Comments No specific comments. Common Errors • omitting to consider the issue of public interest; • confusion with the capital market regulation.





Question Four (b) Advise the directors of Q and Z on the potential problems of merging the management structure and systems of the two entities and how these could be minimised.

(9 marks)

Suggested Approach Identifying and discussing each key issue such as: • relocation of offices; • merging management team; • merging culture; • producing an interface between the two IT systems; • planning a possible replacement IT system. Marking Guide

Marks

Example Management structure problem – present management team crucial Example Management structure solution – offer attractive salary package Example Systems problem – Incompatible systems Example Systems solution – Building an effective interface

Up to 3 marks per issue

Examiner’s Comments No specific comments. Common Errors • superficial discussion; • omitting the key issue of the importance of retaining the current management team in order to ensure

the continued success of the business; • over-concentration on just one or two of many important issues.





Question Four (c) Discuss whether the choice of capital structure for the new combined entity is likely to affect the overall value of the entity. Include references to Modigliani and Miller’s (MM’s) theory of capital structure in your answer.

(10 marks)

Suggested Approach Describe MM’s theory, both pre and post-tax. Introduce the “traditional” theory. Consider the present and future capital structure of the business and explain how the better balance of debt and equity financing is likely to increase the value of the business. Marking Guide Marks Examples Theory of Capital Structure – Under MM: (no taxes) capital structure is irrelevant (taxes) both value and debt increased until debt capacity reached Examples Application to scenario: If Q borrowing well below debt capacity, more debt would increase entity value until debt capacity reached

If Z borrowing in excess of debt capacity, reducing debt would increase entity value

Up to 3 marks per issue Examiner’s Comments There was generally a good understanding and presentation of MM’s theory. However, a large number of candidates stopped at that point, omitting to discuss the impact of potential changes in capital structure in the context of the scenario provided. Common Errors No specific comments.





Question Five (a) Calculate an appropriate cost of equity for BB based on the data provided for the proxy entity.

(3 marks)

Rationale Concerns an engineering and project management group that has announced the sale of its telecommunications subsidiary. An entity has expressed interest in bidding for the subsidiary, well aware that the subsidiary is likely to attract other bids. Candidates are required to calculate an appropriate cost of equity for the subsidiary, together with calculations of a range of values before and after any benefits to the entity should it acquire the subsidiary. Candidates are then asked to discuss the range of values calculated, followed by advice to the directors of the entity on its initial bid. Finally, candidates are asked to advise the engineering and project management group on the positive and negative aspects arising from the sale of its telecommunications subsidiary. The question tests topics in section C of the syllabus – calculation of organisational value and comparisons of alternative forms of consideration for acquisitions. Suggested Approach Ungear the beta of the proxy company. Then regear using GG’s own capital structure. Finally apply the CAPM formula, using the beta calculated above. Marking guide

Marks

Ungear beta of proxy company 1 Regear beta 1 Calculate cost of equity using CAPM 1 Examiner’s Comments No specific comments. Common Errors • Incorrect approach using formula Cost of Capital (ix) in the formula sheet; • Using the CAPM formula directly without first degearing and regearing; • Omitting to adjust debt for tax.





Question Five (b) (i) Calculate a range of values for BB both before and after any potential synergistic benefits to HH of the

acquisition. (8 marks)

(ii) Discuss your results in (b) (i) and advise the directors of HH on a suitable initial cash offer for BB.

(7 marks)


Suggested Approach Part (i) Calculate P/E valuations using: • Proxy P/E of 13; • HH’s P/E of 11. Calculate DVM valuations using: • 50% and 40% dividend payouts; • pre- and post-synergistic benefits, that is using earnings figures of both 1 and 1.1. Tabulate results Part (ii) Discuss the validity of each approach; Consider impact of any other bidders; Advise on initial cash offer – the minimum that is likely to be acceptable to GG. Marking guide Marks (i) P/E approach 3.5 DVM approach 3.5 Range of valuations 1 (ii) Validity of P/E result 2 Validity of DVM result 2 Relative bargaining power 2 Advisory cash price 1





Question Five (b) Examiner’s Comments There was generally a good standard of calculation of valuations but very limited discussion of the validity of the results obtained. Common Errors • using earnings figures in the dividend valuation model; • omitting post-synergistic calculations; • using an invalid P/E ratio; • omitting to consider possibly competing bidders; • omitting to advise on a suitable initial cash offer – or mentioning a figure but not justifying that

conclusion.





Question Five (c) Advise the directors of GG on both the potential benefits and potential drawbacks arising from the divestment of its subsidiary, BB.

(7 marks)

Suggested Approach List and discuss each possible issue – see suggested solutions.

Marking guide Marks Discussion issue – example of a benefit – concentrate on core business Up to 3 per

example Discussion issue – example of a drawback – greater vulnerability to takeovers Up to 3 per

example Examiner’s Comments This section was generally well answered – students appear to have learnt this topic thoroughly. As before, higher marks could be obtained by more application to the scenario provided and some answers focussed too narrowly on just one or two issues.












Answer TWO questions only from Section B on pages 8 to 14.

Maths Tables and Formulae are provided on pages 17 to 21. These pages are detachable for ease of reference.




P9 –

Fin

anci

al S

trat

egy

TURN OVER

© The Chartered Institute of Management Accountants 2007





ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One PT group The PT group is based in Germany and operates mail, express courier and air and ocean freight services worldwide. Its customers and operations are largely centred in Europe, but the group also operates in North America and Asia/Pacific. Currently, the largest growth area is in China, which is experiencing rapid economic development in all areas and requires increased use of express mail and freight services to support that growth. The key financial objectives of the PT group are as follows:

• to increase group earnings by an average of 10% per annum over the next three years;

• to increase earnings per share to above 110 cents within three years;

• to maintain a gearing ratio (long-term borrowings/long-term borrowings plus equity) of less than 40%.

Based on current information available about the PT group in its present form:

• group earnings are expected to increase by a compound average of 9⋅4% per annum over the next three years;

• earnings per share are expected to rise to 91 cents within three years;

• gearing is expected to remain below 40%. The PT group also has publicised the following strategic objectives:

• modernise its IT and distribution network in order to improve customer service;

• increase its worldwide coverage, particularly in rapidly growing economies of the world such as China.

The Directors of PT group are considering making an acquisition on 31 December 2007 which would help to improve its growth prospects. The Directors have been approached by the Directors of ITPT, a courier service based in Italy, who consider it to be in the best interests of the ITPT shareholders for ITPT to merge with a larger entity to take advantage of the increasing globalisation of the courier market. ITPT ITPT operates a courier service across Italy and neighbouring European countries in the eurozone. ITPT has an excellent reputation in terms of reliability and speed of delivery as well as for its efficient and friendly customer service. It is supported by an efficient, modern IT and distribution operation. Competitive pricing has also helped promote the rapid growth of the business, with earnings increasing by an average of 12% per annum in recent years. However, such a high level of growth is not considered to be sustainable indefinitely.

P9 2 November 2007



Proposed opening bid price and alternative bid structures An opening bid of €2,500 million has been proposed by the Directors of the PT group on the basis of estimated synergistic savings of the order of €60 million per annum from merging the distribution networks of the two entities. The bid is to be structured as either:

• a cash offer of €2,500 million; or

• a share-for-share offer worth €2,500 million at the PT group’s current share price. Mr A, a Director of the PT group, has suggested that all, or part, of the cost of the cash offer could be financed by the PT group by a reduction in dividend payments. Financial information for the individual entities, before taking into account the proposed acquisition Summary forecast balance sheet at 31 December 2007

PT group €million

ITPT €million

ASSETS Non-current assets Property, plant and equipment (book values) 8,626 1,021Intangible assets 7,270 0Current assets Inventories 226 42Receivables 5,867 815Cash and cash equivalents 635 72 22,624 1,950EQUITY AND LIABILITIES Equity Issued capital (€1 ordinary shares) 1,012 300Reserves 7,970 477Non-current liabilities Long-term borrowings (floating rate) 2,180 675Provisions 5,478 0Current liabilities 5,948 498 22,624 1,950 Other key financial data at 31 December 2007 Share price €4⋅80 €7⋅80Earnings per share * 69⋅5 cents 78⋅0 centsDividend per share 29⋅0 cents 34⋅0 centsCost of equity 15% 13%Current interest rate on borrowings 10% 10%Tax rate 20% 20% Forecast earnings for the years ended

€million

€million

31 December 2008 766⋅9 262⋅131 December 2009 839⋅2 293⋅531 December 2010 921⋅1 328⋅8 * (100 cents = €1) The question continues, with its requirements, on page 5, which is detachable for ease of reference.

TURN OVER

November 2007 3 P9




P9 4 November 2007



Continued from Page 3 Additional information for ITPT: • Annual growth in earnings is expected to fall to 5% per annum from 2011 onwards;

• A consistent dividend payout ratio will be maintained;

• Property, plant and equipment current replacement value is estimated as €1,500 million;

• Average return on net tangible assets over the last three years was 20%;

• Average year end net tangible assets over the last three years was €1,300 million;

• Courier industry average return on net tangible assets in the last three years was 12%;

• Courier industry average cost of capital is 15%. Note: Net tangible assets are at book values.

Required:

(a) Calculate a range of values at 31 December 2007 for:

• the intangible assets of ITPT; and

• the total value of ITPT;

and briefly interpret the significance of each result. (15 marks)

- (b) As an external consultant engaged by the Directors of the PT group to advise on

the proposed acquisition of ITPT, write a report which covers the following issues:

(i) advise whether the proposed bid price of €2,500 million appears to be appropriate.

(4 marks)

(ii) evaluate whether the acquisition of ITPT would help the PT group to meet its stated financial objectives for each of the two alternative bid structures.

(12 marks)

(iii) advise how best to structure and finance the bid offer, including a discussion of Mr A’s suggestion that part, or all, of the cost of a cash offer could be financed by a reduction in dividend payments, rather than borrowings.

(no additional calculations are required in part (iii)) (8 marks)

(iv) discuss the broader strategic implications of the proposed acquisition of ITPT

and recommend whether or not to proceed. (7 marks)

Additional marks for structure and presentation (4 marks)


End of Section A. Section B starts on page 8.

November 2007 5 P9




P9 6 November 2007



Section B starts on page 8

TURN OVER

November 2007 7 P9





ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two ABC is an entity based in the UK with diverse international interests. Its shares and debenture stock are quoted on a major international stock exchange. ABC is evaluating the potential for investment in the production and distribution of films, an area in which it has not previously been involved. This investment will require £600 million to purchase premises, equipment and provide working capital. An alternative approach would be to acquire a small entity in this field, but a preliminary search has revealed none suitable. Extracts from the most recent balance sheet of ABC are shown below: £millionASSETS Non-current assets 1,920Current assets 1,880 3,800EQUITY AND LIABILITIES Equity Share capital (Shares of £1) 300Retained earnings 1,000 1,300 Non current liabilities 8⋅4% Secured debenture repayable 2012 1,100 Current liabilities 1,400 3,800 Current share price (pence) 800Debenture price (£100) 105Equity beta 1⋅2 ABC proposes to finance the £600 million investment with a combination of debt and equity as follows:

• £260 million in debt paying interest at 8% per annum, secured on the new premises and repayable in 2014;

• £340 million in equity via a rights issue. A discount of 15% on the current share price is likely.

A marginally positive NPV of the proposed investment has been calculated using a discount rate of 15%. This is the entity’s cost of equity plus a small “premium”, a rate judged to reflect the risk of this venture. The Chief Executive of ABC thinks this is too marginal and is doubtful whether the investment should go ahead. However, there is some disagreement among the Directors about how this project was evaluated, in particular about the discount rate that has been used.

P9 8 November 2007



Director A: Suggests the entity’s current WACC is more appropriate. Director B: Suggests calculating a discount rate using data from XYZ, a quoted entity, the main

business of which is film production. Relevant data for this entity is as follows:

• Shares in issue: 400 million currently quoted at 373 pence each;

• Debt outstanding: £350 million variable rate bank loan;

• Equity beta: 1⋅6 Other relevant information

• The risk-free rate is estimated at 5% per annum and the return on the market 12% per annum. These rates are not expected to change in the foreseeable future;

• ABC pays corporate tax at 30% and this rate is not expected to change in the foreseeable future;

• Assume both ABC’s and XYZ’s debt has a beta of zero;

• Issue costs should be ignored. You are a financial advisor working for ABC’s bankers.

Required

(a) Discuss the appropriateness of the two Directors’ suggestions about the discount rate when evaluating the proposed investment and recommend an appropriate rate to use. You should support your discussion and recommendation with calculations of two separate discount rates – one for each Director’s suggestion. Show all your workings.

(18 marks) Calculations count for up to 12 marks

(b) Discuss how ABC’s market capitalisation might change during the week the

proposed investment becomes public knowledge. No calculations are required for this part of the question.

(7 marks)



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November 2007 9 P9



Question Three HIJ is a private transport and distribution entity. It is considering three investment opportunities, which are not mutually exclusive. HIJ has no cash reserves, but could borrow a maximum of $30 million at the present time at a gross interest rate of 10%. Borrowing above this amount might be possible, but at a much higher rate of interest. The initial capital investment required, the NPV and the duration of each project is as follows: Initial NPV Duration Investment $million Years $million (after tax) Project A 15⋅4 2⋅75 6 Project B 19⋅0 3⋅60 7 Project C 12⋅8 3⋅25 Indefinite Notes:

1 The projects are not divisible and cannot be postponed.

2 The discount rate considered appropriate for all three investments is 12% net of tax.

3 HIJ pays corporate tax at 30%.

4 Assume cash flows, other than the initial investment, occur evenly throughout the duration of the investments.

Required

(a)

(i) Calculate the profitability index and equivalent annual annuities for all three projects; explain the usefulness of these methods of evaluation in the circumstances here; and recommend which project(s) should be undertaken.

(10 marks)

(ii) Explain the differences between “hard” and “soft” capital rationing and which type is evident in the scenario here. Discuss, briefly, the advisability of the directors of HIJ limiting their capital expenditure in this way.

(5 marks)

(iii) You later discover that the discount rate used was nominal, but the cash flows have been calculated in real terms.

Explain, briefly, how the calculation for NPV should be adjusted and what effect the changes might have and on your recommendation. You are not required to do any calculations for this section of the question.

(4 marks) (Total for part (a) = 19 marks)

Question Three part (b) is on the opposite page

P9 10 November 2007



Required (b)

Assume that Project B, and B only, could attract Government support as follows:

• A non-repayable grant of $3⋅5 million payable as soon as the project

commenced; plus • Subsidised bank lending of 50% of the initial investment (after the government

grant), secured on the non-current assets that would be acquired for this project. The capital amount of the debt would be repayable in eight years’ time. Interest (before tax) is at the rate of 8% per annum and will be paid in equal instalments annually at the end of each year.

Discuss, with supporting calculations, whether this new information would change your recommendation using an APV approach incorporating the NPV in the scenario as the “base case”.





TURN OVER

November 2007 11 P9



Question Four UVW is a manufacturer of specialist components for the motor trade. Most of the entity’s business is “to order”; very little is manufactured for inventory. The components are sold to customers worldwide but, to date, have been manufactured solely in the UK. The Directors of UVW are reviewing the opportunity to establish a manufacturing base in Asia. There would be some loss of productivity, especially in the first year of operations, but the long-term cost savings would outweigh this. Two senior managers from the UK will be sent to the Asian country to establish the overseas operation and remain there for the first 12 months. The cost of their salaries, travel and accommodation while in Asia is budgeted at £250,000 for the year. This cost is included in the figures below. Capital equipment purchased in UK for the Asian project: £2 million Premises and equipment purchased in Asia: Asian $100 million Operating cash flows are (Year): One Two Three Costs of Asian operation (Asian $million) -70⋅0 -65⋅0 -60⋅0 Comparable costs of UK operation (£million) -1⋅5 -4⋅5 -4⋅75 Other information available: • Assume all cash flows are after tax and that operating cash flows occur at the end of each

year.

• The year three cost advantage in sterling is assumed to maintain from year four until year eight. UVW does not evaluate investments beyond eight years.

• The current spot rate is Asian $20 to £1.

• A feasibility study has been carried out in the Asian country at a cost of Asian $1⋅2 million.

• Expected inflation rate in the Asian country is 8% per annum. In the UK, it is 4% per annum. The risk free rate in the UK is 3%.

• UVW uses a discount rate of 10% for all its investment decisions. The entity’s Finance Manager does not think 10% adequately reflects the risk of this project. He believes the cost advantage of the Asian operation could fall short of the evaluated DCFs by as much as 20% in year one; 25% in year two, and 30% from year three onwards. His rough calculations suggest that, using his estimates, the project shows a substantial negative NPV.


P9 12 November 2007



Required

(a) (i) Calculate the sterling NPV of the project both with, and without, adjusting for

certainty equivalents. (12 marks)

(ii) Discuss briefly other internal factors the entity should consider before deciding

whether the project should proceed. You are NOT required to discuss external economic factors or hedging techniques. Include comments on the use of certainty equivalents and why the Finance Manager’s “rough calculations” might have been wrong.

(6 marks)

(Total for part (a) = 18 marks) Calculations count for up to 12 marks

(b) Advise the Directors of UVW whether or not the management of working capital

should be carried out in the Asian country compared with maintaining a centralised function in the UK.

(7 marks) A report format is not required for this question.


TURN OVER

November 2007 13 P9



Question Five DEF is a telecommunications entity. It provides a variety of services to the major tele-communications operators in Europe and parts of Asia. It has been trading for 10 years and has shown spectacular growth in revenue and profits over the 10-year period, although there has been some volatility year to year. Revenue for the current year is likely to be €550 million and earnings €50 million. These figures make it one of the largest private operators, but it is still much smaller than most of its customers and its nearest publicly-listed direct rival. DEF has been financed by equity provided by the original shareholders, many of whom still work in the entity, and by loans from banks. There are 50,000 shares currently in issue. The current debt : equity ratio is 80 : 20, using book values. No shares have changed hands over the past 10 years, so there has been no serious attempt to place a value on them. New investments are evaluated using a cost of capital of 10%, which is the average for the industry and also judged by DEF’s bankers and other advisors to reflect the average business risk of DEF’s operations. The average P/E for the industry is currently 14. DEF’s bankers are now suggesting an initial public offering (IPO) of DEF’s shares as most European stock markets have shown strong sustained growth over the past three or four years. The shareholders are in agreement with the suggestion in principle but have asked you, DEF’s Financial Manager, to advise them.

Required

(a) Discuss the advantages, disadvantages and challenges of pursuing an IPO in DEF’s circumstances at the present time. Conclude with a recommendation.

Calculations are not the main purpose of this question, but credit is available for calculating some simple figures to support your discussion.

(9 marks)

(b) Advise on the roles that would be played by the following organisations in DEF’s IPO:

• Investment bank; • Stockbroker; • Potential institutional investors in the issue; • DEF’s Treasury Department.

(9 marks) (c) The following methods of issuing shares are being suggested:

• Private placing; • Public offer for sale by either fixed price or tender.

Discuss the features, advantages and disadvantages of these methods and conclude with a recommendation of the preferred method of issue for DEF.

(7 marks)




P9 14 November 2007





November 2007 15 P9




P9 16 November 2007






November 2007 17 P9



Cumulative present value of 1.00 unit of currency per annum Receivable or Payable at the end of each year for n years ⎥⎦

⎤⎢⎣⎡ −+−

rr n)(11


1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514


1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

P9 18 November 2007



FORMULAE Valuation models (i) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity,

where P0 is the ex-div value:

P0 = prefk

d


P0 = ek

d


P0 = gk

d

−e

1 or P0 = gk

gd

−

+

e

0 ][1


P0 = netd

][1

k

ti −


i

(v) Total value of the geared firm, Vg (based on MM): Vg = Vu + TBc

(vi) Future value of S, of a sum X, invested for n periods, compounded at r% interest: S = X[1 + r]n


PV = nr ][1

1

+


PV = ⎥⎦

⎤⎢⎣

⎡+

− nrr ][1

11

1


PV = r

1


PV = gr −

1


November 2007 19 P9



Cost of capital (i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and

having a current ex-div price P0:

kpref = 0P

d


kd net = 0P

ti ][1 −


ke =

0P

d


ke = gP

d+

0

1 or ke = g

P

gd+

+

0

0 ]1[

(v) Cost of ordinary (equity) shares, using the CAPM: ke = Rf + [Rm – Rf]ß



DVV



DV

tV ][1−


k0 = keg ⎥⎦

⎤⎢⎣

⎡⎥⎦

⎤⎢⎣

⎡+

++ DE

D

DE

E

VV

Vk

VV

Vd




ßu = ßg ⎥⎦

⎤⎢⎣

⎡+ DE

E

VV

V


ßu = ßg ⎥⎦

⎤⎢⎣

⎡+ DE

E

VV

V + ßd

⎥⎥⎦

⎤

⎢⎢⎣

⎡

+ ED VVDV

P9 20 November 2007




ßu = ßg ⎥⎦

⎤⎢⎣

⎡−+ ][1 tVV

V

DE

E


C$/euro rate Spot




+

+




+

+



rateinflationUS1

+

+

(iii) Link between nominal (money) and real interest rates: [1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate]



yearsovercostsof

n

nPV


TERP = 1

1





+

−

or

N



November 2007 21 P9




P9 22 November 2007





1 KNOWLEDGE





something





4 ANALYSIS How you are expected to analyse the detail of what you have learned.

Analyse Categorise




5 EVALUATION How you are expected to use your learning to evaluate, make decisions or recommendations.



November 2007 23 P9






November 2007


P9 24 November 2007





Examiner’s General Comments The improvement in candidates’ performance seen in November 2006 and May 2007 was, regrettably, not continued in November 2007. The underlying reason for this may, in part, be due to an apparent preference amongst candidates for investment appraisal questions rather than merger and acquisition questions. In past examinations, entity valuation questions have not generally been answered well and Question One in this paper was no exception. Many candidates were unable to attempt many, if any, sensible calculations of valuation of entities or intangible assets. There continued to be marked differences in performance between and within centres, possibly greater differences than seen in the past. As noted in previous Post Exam Guides, the reason for this is possibly the quality of tuition received by candidates and the associated level of preparedness. However, the performance of candidates in many overseas centres appeared to improve slightly, and Question Five was particularly well attempted by candidates in some overseas centres. The standard of presentation of numerical answers continues to disappoint in all centres. Candidates are again most strongly advised to look at past exam papers and suggested solutions and practice using the structure and presentation of answers shown. No one optional question appeared to be notably the most popular although Questions Four and Five were chosen slightly more frequently than Questions Two and Three. Question Three was particularly poorly attempted and had a lower average mark than the other optional questions. In the sections below that explain how the Marking Guide was applied, where the comment says “up to 3 marks are available for each valid point”, 0.5 marks are awarded for a bullet point, 1 mark for some attempt at (correct and valid) discussion, rising to 3 marks for good discussion of the point using appropriate illustrative examples. The published solutions should be used as a guide. Marks are also awarded for candidates' own valid comments that might not be in the marking guide or the published solutions. Where marks are shown for calculations, the mark shown is the maximum available assuming calculations are all correct. Marks are available for recognition of correct approach and understanding. Note that in the Marking Guide the sum of the marks available for specific activities may total more than the marks indicated on the question paper. This is to allow some flexibility in marking but the maximum marks that can be awarded for a section of a question cannot exceed the number of marks indicated on the question paper.





SECTION A Question One (a) Calculate a range of values at 31 December 2007 for: • the intangible assets of ITPT; and • the total value of ITPT; and briefly interpret the significance of each result.

(15 marks) Rationale Concerns the proposed acquisition of a courier entity by an international business in the same industry. Due to the nature of the courier business, the prospective acquisition entity has a significant value of intangible assets and the question begins in part (a) by asking for a range of possible values for those intangible assets. Candidates are then required to value the whole entity using a variety of approaches, adding brief comments to interpret the significance of the results obtained. Suggested Approach

(i) Valuation of intangible assets • Calculate a valuation based on the difference between the book value of the net assets on

the balance sheet and the market capitalisation calculated from the share price • Repeat the above calculation using replacement values rather than book values for

property, plant and equipment • Use a Calculated Intangible Value (CIV) approach, capitalising the excess of ITPT’s

earnings over and above the industry average • Apply the PT group’s ratio of intangibles to tangible assets to ITPT’s tangible assets • Compile a summary of the results; state the range and comment on the significance of

each result

(ii) Valuation of the total entity • Calculate the market capitalisation based on the current share price • Calculate net assets based both on book values and replacement values and add one or

more valuations obtained for intangible assets • Calculate the NPV of future earnings cash flows using a 2-stage approach. Firstly use the

discrete year-by-year method for the first 3 years. Then use the DVM formula for years 4 onwards and aggregate the two results.

• Compile a summary of the results; state the range and comment on the significance of each result

Marking Guide

Marks

Valuation of intangible assets Any valid valuation method 2 each Comments 1 each Range/summary 0.5 Valuation of entire entity NPV of earnings (2-stage approach) 3 Any other valid valuation method 2 each Comments 1 each Range/summary 0.5 Max 15 marks





Examiner’s Comments on Question One (a)

As already observed, the general performance of candidates in valuing the intangible assets and the entire entity of ITPT was very poor despite the fact that these basic valuation techniques are examined in almost every diet. Many candidates made no attempt at all at valuing the intangible assets and some justified this by stating that there were no intangible assets shown in ITPT’s balance sheet. Of even more concern was that only a small minority of candidates were even able to calculate a valid net asset value for ITPT. Common errors • failing to deduct either or both long term borrowing and current liabilities from the assets shown in

the balance sheet when calculating a net asset value for ITPT • using a P/E approach to calculating market capitalisation without realising that this was simply

equivalent to the share price x number of shares in issue since the P/E ratio was derived from the same price and earnings data

• failing to realise that ITPT is a quoted entity and so the share price can be used to calculated a “floor” for the bid offer

• ignoring the CIV method or taking average annual excess earnings as the value of intangibles without capitalising this value

• applying a single growth rate of either 5% or 12% in perpetuity rather than adopting the 2-stage approach with the 12% growth rate in the first 3 years and the 5% growth rate thereafter

• generalised comments on the valuation methods themselves rather than the significance of the results to the PT group





Question One (b) A report is required in part (b), covering a wide range of issues that might influence the decision on whether or not to go ahead with the proposed acquisition. • Part (b)(i) asks for advice on a suitable bid level and a discussion of the validity of the various

different valuation results obtained in part (a). • Part (b)(ii) examines the impact of the acquisition on the financial performance of the acquiring

entity with reference to three specific financial objectives and targets relating to earnings growth, EPS and gearing level.

• Part (b)(iii) concerns how best to structure and finance the bid offer. • Part (b)(iv) concludes with a review of the broader strategic implications of, and a recommendation

on whether or not to go ahead with, the proposed acquisition. Rationale Concerns the broader issues surrounding the proposed acquisition, incorporating learning outcomes and topics from sections A and B of the syllabus. Key issues include a suitable level of bid offer, the evaluation of the likely impact on the attainment of the financial objectives of the PT group and also how best to structure and finance the bid offer. Suggested Approach Part (i)

• Explain that the base line for assessing an appropriate bid offer is the market capitalisation of ITPT based on its current share price

• Calculate the extent of the premium being offered on top of the current share price and consider whether this is likely to be:

sufficient to make the bid attractive to the shareholders of ITPT recouped by the shareholders of the PT group as a result of the expected

synergistic benefits (capitalised) • Discuss other relevant issues such as:

the impact of any possible competing bids the attractiveness to the shareholders of ITPT of acquiring shares in the PT group

(with reference to the lower growth forecast and current P/E ratio of the PT group)





Part (ii) For the cash offer: • Aggregate and adjust the combined forecast earnings figures for the PT group and ITPT

by adding in the expected annual synergistic benefits and deducting an estimated additional finance charge

• Use the above figures to calculate: average compound growth in earnings EpS in 2009

• Compute the old and new gearing ratios (using market values throughout) • Compare each result to the stated financial objectives (both pre- and post-acquisition)

For the share-for-share offer repeat the above, adjusting the calculations as follows: • Add back the additional finance charge previously deducted from combined earnings • In the EpS calculation, increase the number of shares by the number of new shares to be

issued to the shareholders of ITPT as a result of the share-for-share offer Part (iii)

Discuss the pros and cons of the cash offer versus the share-for-share offer, including: • reference to the results in part (ii) above, noting that neither finance structure enables all

financial objectives to be met • explaining that only a small proportion of the required cash offer can be funded from the

cash on the balance sheet • discussing the potential problems with each of the three alternative methods of financing

the remainder of the cash offer (reductions in dividends, new borrowings, rights issue) • concluding with a recommendation

Part (iv) Discuss the broader strategic implications of the proposed acquisition, looking at the “whole picture”, including:

• whether this strategy would assist or distract the group from its strategic objective of expanding into the high growth geographical areas such as China

• to what extent the current market advantages of ITPT (such as excellent reputation and state of the art IT systems) might be sustainable under the new group structure and they could be easily adopted by the rest of the group

• a concluding recommendation, bringing together all the key issues and recommending whether or not proceed

Marking Guide

Marks

Part (i) Up to 3 marks for discussion of each key point up to maximum available marks Key points: • comparison of proposed bid price to values calculated in part (a) above • market premium above current share price • impact of bargaining position

Max 4

Part (ii) Calculations:

• Adjusted combined earnings

4

• Earnings growth 3 • EpS 3 • Gearing 3

Assessment/conclusions 4 Max 12

Part (iii) Up to 3 marks for discussion of each key point up to maximum available marks





Key points: • Unable to meet all three financial objectives • Pros and cons of the cash offer • Pros and cons of the share-for-share offer • Choice of financing structures for the cash offer and pros and cons of each • Advice/recommendation

Max 8 Part (iv) Up to 3 marks for discussion of each key point up to maximum available marks Key points:

• Why expand in Europe rather than in China? • Can synergistic benefits be realised? • Can the PT group maintain and take advantage of ITPT’s high service

quality and up-to-date IT systems? • Overall conclusion on whether or not to proceed with the acquisition

Max 7 Up to 4 marks available for presentation

Examiner’s Comments on Question One (b) Many answers were unconvincing and failed to grasp the key issues arising from the evaluation of the proposed acquisition. Book knowledge is not sufficient at strategic level, candidates are expected to apply their book knowledge to the given scenario. For example, a general discussion on the difficulty of realising synergistic benefits without reference to the scenario earned few marks in part (iv) – candidates were expected to examine the specific issues and potential problems in adopting or even maintaining the competitive advantages that ITPT would bring in terms of superior service quality and IT systems. Common errors: Part (i)

• Failing to recognise that the current share price is the lowest bid offer that the shareholders of ITPT would consider

• Omitting to consider the proposed bid offer from the viewpoint of both PT group and ITPT shareholders

Part (ii) • Omitting to adjust combined earning figures for synergistic benefits and/or additional

finance charge (where appropriate) • Error in adjusting the number of shares in issue in the EpS calculation for the share-for-

share offer (for example, incorrectly basing the adjustment on a one-for-one share-for-share offer or on the ITPT share price)

• Calculating the gearing based on book values rather than market values or a combination of both book and market values

• In the gearing calculation, omitting to include ITPT’s borrowings and/or the new borrowings required to finance the cash offer

Part (iii) • Advising that a reduction in dividends would be a convenient method of financing the bid • Proposing the use of reserves (retained earnings) rather than cash to finance a cash offer • Omitting any reference to the results in part (ii) above • Omitting concluding advice on how best to structure and finance the bid offer

Part (iv) • Failing to stand back and see the “whole picture” and a general lack of application of

comments to the specific circumstances of this scenario • Omitting to discuss the potential problems of taking advantage of ITPT’s superior service

quality and IT systems • No concluding recommendation





SECTION B Question Two (a) Discuss the appropriateness of the two Directors’ suggestions about the discount rate when evaluating the proposed investment and recommend an appropriate rate to use. You should support your discussion and recommendation with calculations of two separate discount rates – one for each Director’s suggestion. Show all your workings. Rationale Concerns a listed, UK-based entity with diverse international interests. It is evaluating an investment into a new area of business. The entity proposes to finance the investment with a combination of debt and equity. The investment appraisal that has been conducted has revealed a marginally positive NPV, but there is disagreement among the directors as to how the project has been evaluated, with particular disagreement about the discount rate used. Part (a) requires discussion and calculations of two different methods of calculating an appropriate discount rate. The question tests topics in Section B of the syllabus. Suggested Approach DIRECTOR A Calculate current WACC, first calculating ke, kd and ratio of D:E. (Note – post-issue WACC calculations were acceptable). DIRECTOR B Calculate:

• D:E ratio for XYZ • Ungear XYZ • Regear for ABC (or use adjusted cost of capital formula) • Calculate ke and WACC • Comment on systematic risk, capital structure etc

Make a recommendation Marking Guide

Marks

Current (or post-issue) WACC 5 Comments on Director A’s suggestion 2 Calculate WACC using proxy entity data 8 Comments on Director B’s suggestion 2 Recommendation 2

Max 18 marks





Examiner’s Comments on Question Two (a) This question was, on the whole, answered satisfactorily. The main weaknesses were in the calculations of WACC using Director B’s suggestion. Common Errors Not ungearing XYZ and/or then not re-gearing for ABC Inability to calculate WACC using market values Generally poor calculations Providing no comments or recommendation





Question Two (b) Discuss how ABC’s market capitalisation might change during the week the proposed investment becomes public knowledge. No calculations are required for this part of the question.

(7 marks)A report format is not required for this question.

Rationale Part (b) requires discussion of how the entity’s market capitalisation might change when the proposed investment becomes public knowledge. The question tests topics in Section B of the syllabus. Suggested Approach Recognise the implications of the EMH. Comment on specific circumstances of this scenario (market perceptions of investment, other factors etc)

Marking Guide Marks Up to 3 points for discussion of key points. Key points:

max 7 marks

Three forms of EMH Market perception of investment Market’s calculations Dynamic market – other internal-external factors might be involved.

Note: Max marks available if EMH not mentioned were 5

Examiner’s Comments No further comment Common Errors Not mentioning EMH Discussing only EMH





Question Three (a) (i) Calculate the profitability index and equivalent annual annuities for all three projects; explain the usefulness of these methods of evaluation in the circumstances here; and recommend which project(s) should be undertaken.

(10 marks)(ii) Explain the differences between “hard” and “soft” capital rationing and which type is evident in the scenario here. Discuss, briefly, the advisability of the directors of HIJ limiting their capital expenditure in this way.

(5 marks)(iii) You later discover that the discount rate used was nominal, but the cash flows have been calculated in real terms. Explain, briefly, how the calculation for NPV should be adjusted and what effect the changes might have and on your recommendation. You are not required to do any calculations for this section of the question.

(4 marks)(Total for part (a) = 19 marks)

Rationale Concerns a private entity that is reviewing three possible investment opportunities. All three have positive NPVs but the entity has a self-imposed investment limit that means it may not be able to invest in all three. Part (a) requires calculation of profitability indexes, equivalent annual annuities of all the investments together with an explanation of the usefulness of these methods of evaluation and a recommendation. The question tests topics in Sections A and D of the syllabus. Suggested Approach Section (i) Calculate Pls and EAAs for all three projects Comment on suitability of using Pl/EAA in circumstances here Make a recommendation based on rankings of project combinations

Section (ii) Explain hard and soft capital rationing Explain which type is in evidence here Provide relevant additional comments

Section (iii) Note formula for adjusting discount rate (optional) Explain adjustment and effect on NPV Explain impact, if any, on rankings

Marking Guide

Marks

Section (i)

Calculations of PIs, EAAs 3 } Comments 4 } 10 Combination and rankings 2 } Recommendation 1 } Section (ii) Comments on hard and soft capital rationing and type in evidence here 3 } 5 Other comments 2 }





Marking Guide for Question Three (a) continued

Marks

Section (iii)

Formula and comments

4

Examiner’s Comments This question was generally very poorly answered. Many candidates could not calculate EAAs or, in some cases, Pl. Few recognised the need to combine the projects to determine rankings and many did not understand the meaning of hard and soft capital rationing. Common Errors Saying EAA can’t be calculated for project C Incorrect calculations for all projects’ EAA Suggesting capital rationing means projects are not divisible Not combining projects, often with the comment they cannot be combined because they are ‘not

divisible’. Discussing NPV instead of the appropriateness of Pl/EAA.





Question Three (b) Assume that Project B, and B only, could attract Government support as follows: • A non-repayable grant of $3·5 million payable as soon as the project commenced; plus • Subsidised bank lending of 50% of the initial investment (after the government grant), secured on the non-current assets that would be acquired for this project. The capital amount of the debt would be repayable in eight years’ time. Interest (before tax) is at the rate of 8% per annum and will be paid in equal instalments annually at the end of each year. Discuss, with supporting calculations, whether this new information would change your recommendation using an APV approach incorporating the NPV in the scenario as the “base case”.

(Total for part (b) = 6 marks)A report format is not required for this question.

Suggested Approach Calculate APV using base case NPV + grant and interest rate benefit Revise rankings Make a recommendation and comment

Marking Guide

Marks

Calculation of APV

3

Revised rankings and recommendations 3 Examiner’s Comments Very poorly answered and in many cases not even attempted Common Errors No attempt at any calculations No understanding of APV





Question Four (a) (i) Calculate the sterling NPV of the project both with, and without, adjusting for certainty equivalents.

(12 marks)(ii) Discuss briefly other internal factors the entity should consider before deciding whether the project should proceed. You are NOT required to discuss external economic factors or hedging techniques. Include comments on the use of certainty equivalents and why the Finance Manager’s “rough calculations” might have been wrong.

(6 marks)Calculations count for up to 12 marks

Rationale Concerns a specialist UK-based manufacturing entity that is considering establishing a manufacturing plant in Asia. The investment requires capital expenditure in both the UK and the Asian country although all operating costs will arise in Asia. Part (a) requires calculations of sterling NPVs, adjusted using certainty equivalents, and discussion of internal factors that should be taken into account before a decision is made. Suggested Approach Part (i) Calculate forward rates Calculate NPV using Risk Adjusted Discount Rate and Certainty Equivalents

Part (ii) Comment on other factors

Marking Guide

Marks

Part (i)

Calculations/recognition of correct cash flows 6 Calculation of NPV using RADR 2.5 Calculation of NPV using CEs 3.5

Part (ii) Discussion of key points - up to max Key points:

6

• Appropriateness of discount rate • Limitations of CE approach • Opportunity cost of managers’ time • Other potential costs • Use/usefulness of sensitivity analysis

Examiner’s Comments This was a very popular optional question and on the whole answered at least satisfactorily.

Common Errors Adding UK sterling costs to A$ costs Using 10% as a discount rate in the CE calculations instead of the risk free rate of 3% Including management costs and/or cost of feasibility study in the cash flows Discussing only financing as an ‘other factor’ Discussing method of valuation weaknesses rather than other factors





Question Four (b) Advise the Directors of UVW whether or not the management of working capital should be carried out in the Asian country compared with maintaining a centralised function in the UK.

(7 marks)A report format is not required for this question.

Rationale Part (b) requires advice on whether the management of working capital for the Asian project should be carried out in Asia or maintained as a centralised function in the UK. The question tests topics in Sections A and D of the syllabus. Suggested Approach Discuss the key factors in the management of working capital in the situation here. Advise the management of UVW on the most suitable approach.

Marking Guide

Marks

Up to 3 marks per key point

Key points to consider: Availability of staff } Max 5 Need for local inventory control } Management of Forex risk } Management of cash }

Advice/recommendation

2

Examiner’s Comments No specific comments. Common Errors Discussing aggressive vs conservative methods of financing WC. Some credit was available for this

point but it was not the main focus of the question. Not recognising that different components of WC could be managed differently.





Question Five (a) Discuss the advantages, disadvantages and challenges of pursuing an IPO in DEF’s circumstances at the present time. Conclude with a recommendation. Calculations are not the main purpose of this question, but credit is available for calculating some simple figures to support your discussion.

(9 marks)

Rationale Concerns a private telecommunications entity that provides services to telecommunication operators in Europe and parts of Asia. It is now considering a public listing of its shares. Part (a) requires discussion of the advantages, disadvantages and challenges of pursuing an IPO at the present time. The question tests topics in Sections B and D of the syllabus. Suggested Approach Provide brief calculations and preliminary comments Discuss the advantages, disadvantages and challenges Make a recommendation Ensure answer relates to DEF

Marking guide

Marks

Calculations/preliminary comments

2 } Max 9

Advantages, disadvantages, challenges – up to 9 } overall Recommendations 2 }

Examiner’s Comments Question Five was a popular choice of optional question and generally answered satisfactorily. Some overseas centres provided very good answers here. Common Errors Not discussing challenges Not making a recommendation Not relating the answer to DEF





Question Five (b) Advise on the roles that would be played by the following organisations in DEF’s IPO: • Investment bank; • Stockbroker; • Potential institutional investors in the issue; • DEF’s Treasury Department.

(9 marks)

Rationale Part (b) requires advice on the roles of various financial institutions and advisors. The question tests topics in Sections B and D of the syllabus. Suggested Approach Advise on the roles of each of the organisations in turn, relating discussion to DEF.

Marking guide Marks Comments on:

Investment bank 3 } Stockbrokers 2 } 9 Institutional investors 2 } Treasury Dept. 2 }

Examiner’s Comments No further comments Common Errors No specific common errors





Question Five (c) The following methods of issuing shares are being suggested: • Private placing; • Public offer for sale by either fixed price or tender. Discuss the features, advantages and disadvantages of these methods and conclude with a recommendation of the preferred method of issue for DEF.

(7 marks)

Rationale Requires discussion of two methods of flotation and a recommendation. The question tests topics in Sections B and D of the syllabus. Suggested Approach Discuss the features, advantages and disadvantages of the two methods Make a recommendation

Marking guide Marks Private placing

3 } Max

Offer for sale (fixed price and/or tender) 6 } 7 marks Recommendation 2 } overall

Examiner’s Comments No further comments Common Errors Not making a recommendation Assuming a private placing is done by the entity (DEF) and/or to a single investor.

















P9 –

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SECTION A – 50 MARKS [the indicative time for answering this Section is 90 minutes]

ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One Background and organisational structure Ancona International is an international advertising agency. Its shares are listed on the London Stock Exchange. Its revenue has doubled on average every four years over the past 16 years, which is satisfactory but unspectacular by industry standards. Its growth has come largely from focusing on providing high quality services and advertising products to existing clientele; its “churn” rate (the rate at which an entity replaces old customers with new ones) is low and it enjoys considerable customer loyalty. The majority of new business comes from referrals by existing customers. Ancona International usually does not bid for highly competitive, large contracts which involve very high investment costs and which, generally, have only modest chances of success. The entity has its headquarters in the UK. Operations in other countries are established as wholly-owned subsidiaries. Because of its international interests Ancona International prepares its consolidated accounts in US$. Proposals The new Vice President of the USA subsidiary, Ancona USA, is Mr de Z. He does not agree with the entity’s policy of growth through existing business and “word of mouth”. He wants to be able to tender for major advertising contracts with leading USA entities. These tenders are, typically, fiercely competitive and require substantial management time and effort to prepare. The Chief Executive Officer (CEO) of Ancona International thinks such a move would change the risk profile of the entity, although he recognises the merit of Mr de Z’s proposal. After much discussion between the main board and the management of Ancona USA a proposal has been made to allow Mr de Z and his fellow managers and other employees to take over the USA business. This proposal would require shareholder approval, but Ancona International’s CEO is confident he would get the support of most of, if not all, the institutional investors who account for 80% of the entity’s shareholders. Financial Information Balance sheets at 31 March 2008 for Ancona International and its wholly-owned US subsidiary are shown below: All figures are in US$ millions Ancona International Ancona USA (Group consolidated accounts) Non-current assets 3,975 340 Current assets 550 95 Total assets 4,525 435 Equity

Common shares of US$1 350 5 Retained earnings 1,750 170

Total equity 2,100 175 Non-current liabilities

Secured 8% bonds repayable 2025 2,050 Undated borrowings from parent at variable rate 200

Current liabilities 375 60 Total liabilities 2,425 260 Total equity and liabilities 4,525 435 Note: • Ancona International’s bonds are secured on its non-current assets. • Figures for Ancona International include those for Ancona USA.

May 2008 2 P9



After-tax earnings for Ancona International for the year ended 31 March 2008 were US$680 million. This included earnings from the US operation of US$102 million. Ancona International’s share price is currently US$18. Its debt is trading at par. If Mr de Z’s proposal goes ahead, a new entity will be established to acquire the USA interests of Ancona International to be named Zola Agencies Inc. Forecast net cash flows for Ancona USA as part of Ancona International and as a separate entity for the next five years have been prepared by the Finance Department at Ancona International and are shown below: All figures are in US$ millions Ancona USA Zola Agencies (USA operation based (USA operation as on current policies) a separate entity) 31 March 2009 2010 2011-13 2009 2010 2011-13 After-tax net cash flows 118 131 210 138 172 250 (assume = earnings)

Notes: • These forecasts are in nominal terms. • The 2011-2013 cash flows are assumed to remain constant in nominal terms each year. • Cash flows beyond 2013 are considered too uncertain and have been ignored. Other financial information • Ancona International’s weighted average after-tax cost of capital is 12% nominal

compared with an industry average of 13%. The entity with policies and risk profile most similar to those proposed for Zola Agencies is financed 100% equity and has a quoted equity beta of 2⋅5.

• The risk free rate in the USA is currently 5% and the return on the market 9%. These rates are not expected to change in the foreseeable future.

• Corporate taxes are payable at 30% in the year in which the liability arises. Assume that the directors and management of Ancona International and the proposed Zola Agencies have access to the same forecasts. Financing of the deal Information about two financing alternatives is shown below. Alternative 1 Introduce a private equity investor An investor has been identified, PE Capital. This entity will provide up to 95% of the capital required. It expects a return on its investment averaging 30% per annum compound by 31 March 2013. Its most likely exit route will be by initial public offering (IPO). PE Capital has two conditions: a director of PE sits on the board of Zola Agencies, and all earnings are to be retained in the business for five years. Mr de Z and his colleagues are able to fund 5% of the equity required. Alternative 2 Obtain a consortium of funding of equity plus debt DW bank, an investment bank based in Europe, has expressed interest in providing debt finance of up to 75% of the capital requirement. This will be a complex structure combining secured and unsecured borrowing and equity warrants, as follows: $US250 million in euro debt secured on Zola Agencies current and non-current assets. The interest rate will be 10% and the principal repayable in five years’ time. The balance of debt required will be by unsecured borrowings at a variable rate, which currently would be 11%, with equity warrants attached. The terms and conditions of the warrants have not yet been agreed. Mr de Z and his colleagues will provide 5% of the total funding required as equity, as in Alternative 1. They believe they can raise the additional 20% from a consortium of private investors, mainly friends and business associates, who would require a regular dividend of at least 20% of earnings.

May 2008 3 P9




May 2008 4 P9



Requirements (a) (i) Calculate the present value of the forecast cash flows for Ancona USA, both as

part of Ancona International, and as a separate entity (Zola Agencies), based on the information in the scenario and using discount rates that you consider appropriate. Assume in your calculations:

• Finance for a separate US entity will be all-equity; • You are conducting the valuations on 1 April 2008; • Cash flows occur on 31 March each year.

(5 marks)

(ii) Discuss briefly your choice of discount rates and explain any reasons why they might not be accurate. Support your explanation with additional calculations where necessary.

(4 marks) (b) Assume you are an independent financial adviser retained by Ancona International to advise on the sale of its USA operations. Write a report to the directors of Ancona International that: (i) Evaluates the interests of the various stakeholder groups in both Ancona

International and Ancona USA and how they might be affected by the sale of the USA operations.

(7 marks) (ii) Evaluates the economic and market factors that might impact on the negotiations

between Ancona International and Mr de Z. (7 marks)

(iii) Recommends, with reasons, an appropriate valuation for the Ancona USA

operations. You should provide a range of values on which to base your discussion, including the values calculated in part (a).

(8 marks)

(c)

Ancona International and Mr de Z eventually agree a purchase value of US$650 million and 50 million shares are issued by Zola Agencies.

(i) Calculate:

• The value that would need to be placed on Zola Agencies at 31 March 2013 if financing is as Alternative 1, and PE Capital is to receive its required return;

• The impact on earnings and earnings per share for the years ending 31 March 2009 and 2013 under Alternative 2.

(7 marks)

(ii) Evaluate the advantages and disadvantages of the two alternative methods of finance being considered by Mr de Z and recommend the most appropriate source in the circumstances. Provide additional calculations where necessary.

(9 marks)

Additional marks for structure and presentation for all of Question One (3 marks) (Total for Question One = 50 marks)

May 2008 5 P9




May 2008 6 P9




TURN OVER

May 2008 7 P9





ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two You are a financial adviser working for a large financial institution. One of your clients, Dan, has a portfolio currently worth £100,000. He has invested in good quality stocks that are spread over diversified industries with an average beta of 1⋅2; a risk profile he is happy with. He holds other assets, such as property and bank deposits, worth approximately £150,000 (excluding his own home, on which he has a 75% mortgage). He has recently inherited £40,000 which he intends to invest in equities. He has done some research himself and is considering investing in the following entities in equal proportions. Entity A is a large, listed entity in a mature industry. Dan already has 15% of his equity investments in this industry sector. Entity B is a relatively small entity whose shares have been listed on the UK’s Alternative Investment Market for the past three years. Its main area of operations is bio-technology, a sector in which Dan has no investments. Market data for the shares of the two entities are as follows: Entity Current share prices Beta P/E ratio (buy price)

A 250 pence cum rights 1⋅1 10

B 500 pence cum dividend n/a * 20 * Your financial institution estimates a return of 15⋅8% is required on this stock. Your transaction charges will be 2⋅5% of the capital amount. Financial strategies of the two entities Entity A is planning a rights issue. The terms will be 1 new share for every 4 held at a cost of 200 pence. Entity B will allow investors registered at 30 June 2008 the option of taking a dividend of 45 pence a share or a scrip dividend of 1 share for every 10 shares held. The policy of Entity B has been to offer scrip dividends as an alternative to cash dividends since its shares were first listed three years ago. The risk free rate is 5% and the return on the market is 11%. These rates are not expected to change in the foreseeable future.

May 2008 8 P9



Required: (a) Calculate the risk and expected return of Dan’s equity investment portfolio if he

goes ahead with his proposed investments. Work to a maximum of 2 decimal points in your calculations.

(5 marks)

(b)

(i) Explain the difference between systematic risk (or market risk) and unsystematic risk (or specific risk) and, briefly, the meaning of beta and how it is measured.

(4 marks)

(ii) Discuss how and to what extent the beta of Entity A and the implied beta of Entity B:

• Might affect Dan’s investment decision;

• Could be of interest to the directors of single entities such as A and B.

(6 marks)

(Total for Part (b) = 10 marks)

(c) Evaluate the implications for shareholder value of Entity A’s and Entity B’s proposed financial strategies and advise Dan on how these strategies might affect his investment decisions. Include appropriate calculations.

(10 marks) (Including up to 6 marks for calculations)


A REPORT FORMAT IS NOT REQUIRED IN THIS QUESTION


TURN OVER

May 2008 9 P9



Question Three BEN is a large, listed entity based in a country in the eurozone. Its principal activity is the manufacture and distribution of electrical consumer goods. Manufacturing operations are located in the home country but goods are sold to wholesalers worldwide, priced in the customer’s local currency. The group has experienced rapid growth in recent years and many of its IS/IT systems need upgrading to handle larger volumes and increased complexity. Group treasury is centralised at the head office and its key responsibilities include arranging sufficient long-term and short-term liquidity resources for the group and hedging foreign exchange exposures. One of the first projects is a replacement treasury management system (TMS) to provide an integrated IS/IT system. The new integrated TMS will record all treasury transactions and provide information for the management and control of the treasury operations. It replaces the current system which consists of a series of spreadsheets for each part of the treasury operations. BEN is considering the following choice of payment methods for the new integrated TMS: Method 1 • Pay the whole capital cost of €800,000 on 1 July 2008, funded by bank borrowings.

• Pay on-going consultation and maintenance costs annually in arrears; these costs will depend on the actual time spent supporting the system each year but are expected to be of the order of €60,000 in the first year and, on average, to increase by 5% a year due to inflation.

• The system is expected to have no resale value after five years although it could still be usable within the entity.

Method 2 • Enter into an operating lease with the supplier, paying a fixed amount of €250,000 a year

in advance, commencing 1 July 2008, for five years. This fee will include consultation and maintenance.

• At the end of five years there is an option to continue the lease agreement for a further three years, paying for maintenance on a time and materials basis. This has not been costed.

Other information • BEN can borrow for a period of five years at a gross fixed interest rate of 8% a year.

• The entity is liable to tax at a marginal rate of 25%, payable 12 months after the end of the year in which the liability arises (that is, a time lag of 1 year). This rate is not expected to change.

• In Method 1, tax depreciation on the capital cost is available in equal instalments over the first five years of operation.

May 2008 10 P9



Required:

(a) Calculate and recommend which payment method is expected to be cheaper for BEN in NPV terms.

(8 marks)

(b) Evaluate the benefits that might result from the introduction of the new TMS. Include in your evaluation some reference to the control factors that need to be considered during the implementation stage.

(8 marks)

(c) Advise the Directors of BEN on the following:

• The main purpose of a post-completion audit (PCA):

• What should be covered in a PCA of the TMS project;

• The importance and limitations of a PCA to BEN in the context of the TMS project. (9 marks)




TURN OVER

May 2008 11 P9



Question Four CM Limited (CM) is a private entity that supplies and distributes equipment to the oil industry in the UK. It is evaluating two potential investments. Investment 1 would expand its operations in the UK, Investment 2 would establish a base in Asia that would allow it to market and sell its products to entities in a wider geographical area. The currency in the Asian country is the $. CM does not wish to undertake both investments at the present time. Investment 1 would require less capital expenditure than Investment 2, but its operating costs would be higher. Profit forecasts for the two investments are as follows: Year: 1 2 3 Investment 1 – all figures in £000s Revenue 375 450 575 Production costs (excl. Depreciation) 131 158 201 Depreciation 267 267 266 Profit/(loss) before tax (23) 25 108 Investment 2 – all figures in A$000s Revenue 1,300 1,450 1,650 Production costs (excl. Depreciation) 260 290 330 Depreciation 967 967 966 Profit/(loss) before tax 73 193 354 Additional information: 1 The capital expenditure required for Investment 1 is £1.1 million with an expected

residual value at the end of year three of £300,000. The capital cost of Investment 2 will be A$2⋅9 million with no residual value.

2 CM depreciates the estimated net cost of its assets (initial cost less estimated residual value) straight line over the life of the investment.

3 Tax depreciation is available on the equipment purchased for Investment 1 at 40% per annum on the reducing balance basis. Capital expenditure for Investment 2 can be written off for tax purposes in the year in which it is purchased.

4 Corporate tax rate in the UK is 25%. There are tax concessions in the Asian country. The net effect is that CM would pay tax on profits generated in the Asian country at 10%. No additional tax would be payable in the UK. Tax would be refunded or paid on both investments at the end of the year in which the liability arises.

5 Investment 1 would be financed by internal funds. Investment 2 would be financed by a combination of internal funds and loans raised overseas.

6 Assume revenue and production costs excluding depreciation equal cash flows.

7 The cash flow forecasts are in nominal terms. The entity’s real cost of capital is 8% and inflation is expected to be 2⋅75% per annum constant in the UK.

8 CM evaluates all its investments over a three-year time horizon.

9 Cash flows are assumed to occur at the end of each year except the initial capital cost which is incurred in year 0.

10 Operating cash flows for Investment 2 are in A$. The current exchange rate is £1 = A$2. Sterling is expected to weaken against the A$ by 4⋅5% per annum over the next three years.

11 CM’s expected accounting return on investment is 15%, calculated as average profits after tax as a percentage of average investment over the life of the assets.

May 2008 12 P9



Required:

(a) For each of the two investments, calculate

(i) The average annual accounting return on investment using average profit after tax and average investment over the life of the assets;

(9 marks) (ii) The NPV using an appropriate discount rate calculated from the information

given in the scenario. (9 marks)

(Note: you should round the calculated discount rate to the nearest whole number).

(Total for Part (a) = 18 marks)

(b) Recommend, with reasons, which, if either, of the investments should be undertaken. Discuss any non-financial factors that might influence the choice of investment.

(7 marks)




TURN OVER

May 2008 13 P9



Question Five MAT is a manufacturer of computer components in a rapidly growing niche market. It is a private entity owned and managed by a small group of people who started the business 10 years ago. Although relatively small, it sells its products world-wide. Customers are invoiced in sterling, although this policy is being reviewed. Raw materials are purchased largely in the UK although some are sourced from overseas and paid for in foreign currencies, typically US$. As the newly-appointed Financial Manager, you are reviewing MAT’s financial records to identify any immediate or longer-term areas of risk that require immediate attention. In particular, the entity’s forecast appears to be uncomfortably close to its unsecured overdraft limit of £450,000.

Extracts from last year’s results and the forecast for the next financial year are as follows:

Last year Forecast £000 £000 Non-current assets 3,775 4,325 Current assets

Accounts receivable 550 950Inventory 475 575Cash and marketable securities 250 100Total current assets 1,275 1,625

Total assets 5,050 5,950 Total equity 3,750 4,050 Non-current liabilities

Secured bond repayable 2010 850 850Current liabilities

Accounts payable 450 625Bank overdraft 0 425Total current liabilities 450 1,050

Total equity and liabilities 5,050 5,950 Revenue 4,500 5,750Cost of goods sold 1,750 2,300Profit before tax 1,050 1,208

Required: Prepare a report to the Finance Director of MAT advising on whether the entity could be classified as “overtrading” and recommending financial strategies that could be used to address the situation. Your advice and recommendations should be based on analysis of the forecast financial position, making whatever assumptions are necessary, and should include brief reference to any additional information that would be useful to MAT at this time.


(Up to 14 marks are available for calculations)


May 2008 14 P9





May 2008 15 P9




May 2008 16 P9






May 2008 17 P9




Receivable or Payable at the end of each year for n years ⎥⎦⎤

⎢⎣⎡ −+−

rr n)(11


1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514


1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

May 2008 18 P9




value:

P0 = prefk

d


P0 = ek

d


P0 = gk

d

−e

1 or P0 = gk

gd

−

+

e

0 ][1


P0 = netd

][1

k

ti −


i


Vg = Vu + TBc


S = X[1 + r]n


PV = nr ][1

1

+


PV = ⎥⎦

⎤⎢⎣

⎡+

− nrr ][1

11

1


PV = r

1


PV = gr −

1


May 2008 19 P9




price P0:

kpref = 0P

d


kd net = 0P

ti ][1 −


ke =

0P

d


ke = gP

d+

0

1 or ke = g

P

gd+

+

0

0 ]1[





DVV



DV

tV ][1−


k0 = keg ⎥⎦

⎤⎢⎣

⎡⎥⎦

⎤⎢⎣

⎡+

++ DE

D

DE

E

VV

Vk

VV

Vd





ßu = ßg ⎥⎦

⎤⎢⎣

⎡+ DE

E

VV

V


ßu = ßg ⎥⎦

⎤⎢⎣

⎡+ DE

E

VV

V + ßd

⎥⎥⎦

⎤

⎢⎢⎣

⎡

+ ED VVDV


ßu = ßg ⎥⎦

⎤⎢⎣

⎡−+ ][1 tVV

V

DE

E

May 2008 20 P9




C$/euro rate Spot




+

+

ther formulae

) Interest rate parity (international Fisher effect):

Forward rate US$/£ = Spot US$/£ x

O (i

rateinterestUKnominal1


+

+

) Purchasing power parity (law of one price):


(ii

rateinflationUK1

rateinflationUS1

+

+

Link between nominal (money) and real interest rates:

terest rate][1 + inflation rate]

v) Equivalent annual cost:

Equivalent annual cost =

(iii)

[1 + nominal (money) rate] = [1 + real in

(i

factorannuityyear

yearsovercostsof

n

nPV

) Theoretical ex-rights price:

TERP =

(v

1

1


i) Value of a right:

Value of a right =

(v

1N+

priceissuepriceonRights −

or

N



May 2008 21 P9




May 2008 22 P9





1 KNOWLEDGE





something






Analyse Categorise







May 2008 23 P9






May 2008


May 2008 24 P9





Examiner’s General Comments The performance in this exam was satisfactory and a marked improvement over N2007 was evident, although there appeared to be fewer really strong candidates scoring very high marks. As usual, there were marked differences in the performance between centres both in the UK and overseas. Candidates in some overseas centres, notably Sri Lanka, continued to improve their performance. In particular, some overseas candidates handled Question Four better than many UK candidates. A notable improvement was the structure and presentation of answers, especially Question One where most candidates, home and overseas, provided a good report structure. Questions Three and Four were by far the most popular of the optional questions, and generally both were attempted at least satisfactorily. Question Two was the least popular, no doubt because of its technical nature, and was poorly attempted. Question Five was less frequently attempted than might have been expected given its subject matter. A weakness evident in many scripts was the general inability to apply answers to specific scenarios. It was also evident that candidates struggle to bring forward knowledge from previous syllabuses. This was especially notable in Question Five where many appeared not to understand what “overtrading” meant and also in Question Four where the accounting rate of return was frequently calculated incorrectly. In the sections below that explain how the Marking Guide was applied, where the comment says “up to 3 marks are available for each valid point”, 0.5 marks are awarded for a bullet point, 1 mark for some attempt at (correct and valid) discussion, rising to 3 marks for good discussion of the point using appropriate illustrative examples. The published solutions are used as a guide. Marks are also awarded for candidates' own valid comments that might not be in the marking guide or the published solutions. Where marks are shown for calculations, the mark shown is the maximum available assuming calculations are all correct. Marks are available for recognition of correct approach and understanding.





SECTION A Question One (a) (i) Calculate the present value of the forecast cash flows for Ancona USA, both as part of Ancona

International, and as a separate entity (Zola Agencies), based on the information in the scenario and using discount rates that you consider appropriate. Assume in your calculations:

• Finance for a separate US entity will be all-equity; • You are conducting the valuations on 1 April 2008; • Cash flows occur on 31 March each year.

(5 marks) (ii) Discuss briefly your choice of discount rates and explain any reasons why they might not be accurate.

Support your explanation with additional calculations where necessary. (4 marks)

Rationale This question concerned an International Advertising Agency that was considering allowing the Vice-President of its USA operation to buy out that entity. This buyout would have allowed the USA operation to pursue more profitable, but higher risk, ventures than the parent company had so far been willing to consider. This question tested knowledge and understanding of learning outcomes in: Syllabus Section A (iii); Syllabus Section B (ii); and Syllabus Section C (i), (iii) and (iv). In part (a), calculations of the PV of cash flows for the USA operation under two options were required. First, if it continued as part of the UK-based group, and, second if it was subject to a management buy out and continued as a separate entity. Part (a) further required discussion of the choice of discount rates to be incorporated into the evaluation. Suggested Approach ■ Calculate discount rate for Zola Agencies ■ Calculate NPV of Ancona USA and Zola Agencies using appropriate discount rates ■ Discuss choice of discount rates Marking Guide

Marks

(i) Calculations 5 (ii) Explanation and calculations

4





Examiner’s Comments on Question One (a)

Part (i) of the question was generally done very well and most candidates gained good credit. Part (ii) was less well handled and many candidates missed the main point of the question, simply describing the general limitations of CAPM. Common Errors

Use of incorrect discount rate for Ancona USA and/or Zola Agencies. Use of incorrect cumulative discount factors Lack of focus in discussion in part (ii)





Question One (b) Assume you are an independent financial adviser retained by Ancona International to advise on the sale of its USA operations. Write a report to the directors of Ancona International that: (i) Evaluates the interests of the various stakeholder groups in both Ancona International and Ancona USA

and how they might be affected by the sale of the USA operations. (7 marks)

(ii) Evaluates the economic and market factors that might impact on the negotiations between Ancona

International and Mr de Z. (7 marks)

(iii) Recommends, with reasons, an appropriate valuation for the Ancona USA operations. You should

provide a range of values on which to base your discussion, including the values calculated in part (a). (8 marks)

Rationale In part (b), candidates were required to write a report to the directors of the parent entity evaluating the proposal in terms of its effect on the various stakeholder groups, the economic and market factors that might impact on negotiations and to make a recommendation of an appropriate valuation for the US operation. Suggested Approach ■ Provide a report structure: heading, sub-headings, introduction/and or terms of reference ■ Identify and evaluate appropriate stakeholder groups ■ Identify and evaluate relevant economic and market factors ■ Calculate a range of values for Ancona USA ■ Discuss the appropriateness of each method of valuation ■ Conclude with a recommendation of a value to be placed on the US operation. Marking Guide

Marks

(i) Evaluation of stakeholders 7 (ii) Evaluation of economic and market factors 7 (iii) Recommendations – Calculations 3 (iii) Recommendations – Comments 5 Overall Structure and Presentation relating to the whole question but particularly to part (b)

3





Examiner’s Comments on Question One (b) The evaluation of stakeholder interests was generally done well and most candidates identified key groups and provided good discussion. In fact, some candidates spent far too much time on this section of the report at the expense of subsequent sections. The evaluation of economic and market factors was more poorly attempted with many candidates discussing marketing issues rather than market factors. The recommendation section of the report was typically satisfactorily answered although many candidates appeared to be short of time and provided a very brief discussion. Common Errors ■ Discussing marketing rather than economic and market factors in part (ii) ■ Inadequate discussion and evaluation, especially in parts (ii) and (iii) ■ Errors in P/E valuation in part (iii)





Question One (c) Ancona International and Mr de Z eventually agree a purchase value of US$650 million and 50 million shares are issued by Zola Agencies. (i) Calculate: • The value that would need to be placed on Zola Agencies at 31 March 2013 if financing is as

Alternative 1, and PE Capital is to receive its required return; • The impact on earnings and earnings per share for the years ending 31 March 2009 and 2013 under

Alternative 2. (7 marks)

(ii) Evaluate the advantages and disadvantages of the two alternative methods of finance being considered by Mr de Z and recommend the most appropriate source in the circumstances. Provide additional calculations where necessary.

(9 marks) Rationale In part (c), consideration of two possible methods of financing the management buyout and evaluation of the advantages and disadvantages of these two methods was required. Suggested Approach ■ Calculate value required under alternative 1 assuming 30% return required ■ Calculate impact on earnings and EPS under Alternative 2 ■ Discuss and evaluate the advantages and disadvantages of the two methods of finance being proposed ■ Make a final recommendation Marking Guide

Marks

(i) Calculations – valuation 3 (i) Calculations – impact on earnings and EPS 4 (ii) Evaluation of PE Capital alternative 4 (ii) Evaluation of Bank/Mr de Z/private investors and final recommendation 5





Examiner’s Comments on Question One (c) Part (i) was the most poorly answered, often not answered at all. Few candidates provided appropriate calculations and many appeared short of time. Part (ii) was better answered although many gave a very general explanation of the advantages of debt and equity without applying their answer to the scenario. Common Errors ■ Incorrect calculation of value, usually by applying a simple uplift of 30% and ignoring the compounding

effect. ■ Calculating EPS after dividend payments ■ Ignoring or incorrectly calculating interest payments and/or tax relief on those interest payments under

Alternative 2 ■ Using 5 million shares in Ancona USA instead of 50 million. ■ Assuming debt would have to be repaid, i.e. ignoring the possibility of re-financing. ■ Assuming retentions meant the entity would not be able to invest in positive NPV projects for 5 years.





SECTION B Question Two (a) Calculate the risk and expected return of Dan’s equity investment portfolio if he goes ahead with his proposed investments. Work to a maximum of 2 decimal points in your calculations.

(5 marks) Rationale This question concerned a financial adviser who was advising one of his clients on the investment of an inheritance of £40,000 which the client intended to invest in equities. He was considering investment in the shares of two publicly quoted entities. This question tested knowledge and understanding of learning outcomes in Syllabus Section B (i) and (ii). In part (a) calculation of the risk and expected return of the client’s equity investment portfolio if he went ahead with the proposed investment was required. Suggested Approach ■ Calculate the beta for Entity B using the CAPM ■ Calculate the average return on the proposed portfolio using either of the acceptable methods (see

published solution) Marking Guide

Marks

Calculations 5 Examiner’s Comments This was the least popular of the optional questions, probably because of its technical content. It was poorly handled by many candidates although those who had studied and fully understood the topic could achieve high marks. Common Errors ■ Calculating beta for Entity B and/or return on existing portfolio but providing no further calculations ■ Using incorrect proportions, that is ignoring transaction charges





Question Two (b) (i) Explain the difference between systematic risk (or market risk) and unsystematic risk (or specific risk)

and, briefly, the meaning of beta and how it is measured. (4 marks)

(ii) Discuss how and to what extent the beta of Entity A and the implied beta of Entity B: • might affect Dan’s investment decision; • could be of interest to the directors of single entities such as A and B.

(6 marks)

Rationale

In part (b) explanation of the difference between systematic risk and unsystematic risk was required and also discussion of how and to what extent the beta of the two entities:

• might affect the client’s investment decisions; and • might be of interest to the directors of single entities such as those being considered for investment. Suggested Approach ■ Explain the meaning of the two types of risk ■ Explain the differences between them ■ Provide a diagrammatic explanation to accompany your discussion (this was not essential but gained

credit if provided) ■ Explain the meaning of beta and how it is measured ■ Discuss the key points of how the betas affect Dan’s investment decision ■ Discuss the key points of how the betas of entities A & B could be of interest or use to their directors

Marking Guide Marks (i) Explanations 4 (ii) Dan’s investment decision 3 (ii) Directors’ viewpoint 3 Examiner’s Comments Candidates who understood the topic answered this part of the question well but many clearly lacked the knowledge to provide a satisfactory answer. Common Errors No specific common errors although some candidates muddled systematic and unsystematic risk or did not understand the relevance of betas.





Question Two (c) Evaluate the implications for shareholder value of Entity A’s and Entity B’s proposed financial strategies and advise Dan on how these strategies might affect his investment decisions. Include appropriate calculations.

(10 marks) (Including up to 6 marks for calculations)

Rationale

In part (c) evaluation of the implications for shareholder value of the two proposed investments was required, with further calculations to support the discussion.

Suggested Approach ■ Provide a brief discussion of the key points of the two entities’ financing strategies ■ Calculate TERP and value of a right for Entity A ■ Explain Dan’s situation and possible action ■ Calculate number of shares to be bought in Entity B and Dan’s dividend entitlement under the two

dividend options ■ Explain how Dan might evaluate the decision

Marking Guide Marks Calculations for Entity A 4.5 Calculations for Entity B 1.5 Comments 4 Examiner’s Comments This part of the question was very poorly attempted, although most candidates could correctly calculate TERP. Common Errors ■ Ignoring transaction charges when calculating the number of shares to be bought ■ Not recognising that in theory a rights issue should have no effect on the value of the entity ■ Not recognising that Dan could sell his rights in the market ■ Not understanding what scrip dividends are





Question Three (a) Calculate and recommend which payment method is expected to be cheaper for BEN in NPV terms.

(8 marks)

Rationale

This question concerned a large listed entity whose principal activity was the manufacturing and distribution of electrical consumer goods. The entity was now considering upgrading its information technology system to handle the larger volumes and increased complexity of its planned growth. The entity was considering two methods of paying for this new computer system. The question tested knowledge and understanding of learning outcomes in Syllabus Section D (iii) and (iv).

Suggested Approach ■ Calculate a discount rate ■ Calculate NPV for Method 1 ■ Calculate NPV for Method 2 ■ Make a recommendation of the most advantageous (i.e. least cost) method Marking Guide

Marks

Discount rate to be used 1 Calculations for Method 1 3.5 Calculations for Method 2 2.5 Recommendation 1 Examiner’s Comments This question was a very popular choice of optional question and generally done very well. Most candidates attempting it gained very high marks. Common Errors

Using 8% instead of 6% (post-tax cost of debt) as a discount rate. In Method 1, ignoring tax relief on service costs Incorrect timing of some cash flows (in both methods) Including interest cash flows





Question Three (b) Evaluate the benefits that might result from the introduction of the new TMS. Include in your evaluation some reference to the control factors that need to be considered during the implementation stage.

(8 marks)

Rationale This part of the question required evaluation of the benefits that might have resulted from the introduction of this new system together with some discussion of the control factors that need to be considered during the implementation stage. Suggested Approach ■ Discuss the key benefits that would accrue from the introduction of the TMS. ■ Include in the discussion some reference to control factors at the implementation stage

Marking Guide

Marks

Benefits 6 Control factors 2 Examiner’s Comments No further comment Common Errors No specific common errors, although some candidates provided much discussion of issues not relevant to the scenario.





Question Three (c) Advise the Directors of BEN on the following:

• The main purpose of a post-completion audit (PCA):

• What should be covered in a PCA of the TMS project;

• The importance and limitations of a PCA to BEN in the context of the TMS project. (9 marks)

Rationale Part (c) required candidates to advise the directors of the investing entity on the purpose and content of a post-completion audit. Suggested Approach ■ Explain the purpose of a PCA ■ Discuss and advise on the key features to be included in the PCA of this project ■ Discuss and advise on the key factors of importance of a PCA to BEN, including some advice on its

limitations Marking Guide

Marks

Main purpose 2 Covered in a PCA 3 Importance 2 Limitations 2 Examiner’s Comments No further comment Common Errors No specific common errors





Question Four (a) For each of the two investments, calculate (i) The average annual accounting return on investment using average profit after tax and average

investment over the life of the assets; (9 marks)

(ii) The NPV using an appropriate discount rate calculated from the information given in the scenario.

(9 marks) (Note: you should round the calculated discount rate to the nearest whole number). Rationale

This question concerned a private entity that supplied and distributed equipment to the oil industry. It was evaluating two potential investments one of which was in its home market and another which would allow it to establish a base in an Asian market. The entity did not wish to undertake both investments at the present time. The question tested knowledge and understanding of learning outcomes in Syllabus Section D (i) and (ii).

Part (a) required calculations, for both investment alternatives, of the ARR and the NPV. Suggested Approach Investment 1■ Calculate tax depreciation allowances ■ Calculate post-tax profits ■ Calculate average accounting rate of return ■ Calculate discount rate ■ Calculate NPV Investment 2■ Calculate post-tax profits ■ Calculate average accounting rate of return ■ Calculate discount rate ■ Calculate NPV in sterling (using either of the acceptable methods) Marking Guide

Marks

ARR calculations 9 NPV calculations 9





Examiner’s Comments This was a very popular optional question. There were a number of acceptable alternatives to providing the calculations and recognition of the ‘own figure’ principle was especially important in marking this question. Common Errors ■ Incorrect calculation of average investment in the ARR calculations. Less common was incorrect calculation

of average profit ■ Incorrect calculation of nominal cost of capital (or not adjusting cash flows) ■ Timing errors in the NPV calculations ■ Incorrect calculation of exchange rates by some candidates who used this approach. ■ Converting cash flows using forward exchange rates but also discounting at 11% in investment 2. Question Four (b) Recommend, with reasons, which, if either, of the investments should be undertaken. Discuss any non-financial factors that might influence the choice of investment.

(7 marks)

Rationale Part (b) required recommendations, with reasons, of which, if either, of the investments should have been undertaken, including discussion of any non-financial factors that might have influenced the entity’s choice of investment. Suggested Approach ■ Provide a summary of the ARRs and NPVs from part (a) ■ Discuss the key points and limitations of the calculations ■ Discuss non-financial factors that might influence the choice of investment ■ Conclude with a recommendation Marking Guide

Marks

Recommendations 4 Non-financial considerations 3 Examiner’s Comments No further comments Common Errors No specific common errors although under “non financial factors” some candidates discussed only the risks of trading overseas.





Question Five Prepare a report to the Finance Director of MAT advising on whether the entity could be classified as “overtrading” and recommending financial strategies that could be used to address the situation. Your advice and recommendations should be based on analysis of the forecast financial position, making whatever assumptions are necessary, and should include brief reference to any additional information that would be useful to MAT at this time. Rationale

This question concerned a private entity that manufactures computer components. It sells its products worldwide although its customers are currently invoiced in sterling. The Financial Manager is undertaking a review of a number of aspects of the entity’s finances, in particular any risk areas that need urgent attention.

Candidates were required to prepare a report advising on whether the entity could be classified as overtrading and, further, to recommend financial strategies that could be used to address the situation. The question tested knowledge and understanding of learning outcomes in Syllabus Section A (iii), (iv) and (v).

Suggested Approach ■ Provide a report structure ■ Calculate appropriate ratios ■ Calculate the operating cycle ■ Discuss these ratios indicating possible reasons for the changes from last year to forecast ■ Advise on financial strategies for redressing the overtrading situation ■ Advise on what other information might be useful at this time Marking guide

Marks

Calculations (1 mark for each calculation of the Op. Cycle and 0.5 mark for each other calculation)

14 in total

Discussion of calculations 6 Additional information and recommendations 5 Examiner’s Comments This was not as popular an optional question as was expected given that it drew heavily on knowledge gained at managerial level. However, most candidates who attempted it provided at least an adequate number of correct calculations. Common Errors

Failure to provide an operating cycle – a crucial figure. In the discussion simply putting “words round numbers” (this went up, this went down) rather than attempting an analysis of possible causes and consequences of the changes.

















P9 –

Fin

anci

al S

trat

egy

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SECTION A – 50 MARKS [the indicative time for answering this Section is 90 minutes] ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One KEN is a property development company located in country A whose currency is A$. KEN specialises in the construction of domestic housing in country A and is listed on the local stock exchange. KEN has been highly successful in recent years and has built a strong reputation based on high build quality and meeting deadlines. However, in recent months house prices have fallen and interest rates have risen, making it harder to sell houses, even at significantly lower prices. Domestic housing construction project One of KEN’s current projects is the construction of 300 houses. This project has been planned in three distinct phases, each in a self-contained plot of land. Good progress has been made with the development since work began in 2006. The position at 1 January 2009 is expected to be as follows:

Phase 1 • 80 houses • Construction completed and all houses sold and occupied.

Phase 2 • 100 houses • 30 houses were sold in 2008 • Remaining 70 houses in this Phase to be actively marketed in 2009

Phase 3 • 120 houses • Planning approval obtained but no construction work or marketing begun at

1 January 2009

Forecast figures for 2009-2011: 2009 2010 2011 House sales (number of houses) Phase 2 70 - - Phase 3 - 80 40 Cost of running the sales office (A$) Salaries and other staff costs 100,000 140,000 80,000 Other 30,000 30,000 30,000

P9 2 November 2008



Other financial information on the domestic housing project: • The forecast average selling price per house BEFORE the recent fall in house prices

was as follows: o Phase 2: A$350,000 o Phase 3: A$400,000 However, due to the recent fall in house prices in country A, the forecast average selling prices listed above are considered to be overstated by 20% on unsold houses at 1 January 2009.

• A 10% deposit is received on agreeing a house sale and the selling price is agreed at this stage. The remaining 90% is due on completion a year later.

• Construction costs are, on average, 60% of the forecast selling price. 70% of the construction costs are incurred in the year in which the sale is agreed and 30% are incurred in the following year. These costs already take into account government estimates of inflation and are not expected to be affected by the recent fall in house prices. Construction costs should therefore be calculated on the forecast selling prices before the recent fall in house prices.

• All sales office costs forecast for 2009 relate to Phase 2 and forecast costs for 2010 and 2011 relate to Phase 3.

• Business tax is 30% on profits and capital gains, payable one year in arrears.

• All cash flows should be assumed to arise at the end of the year. Strategic choices for KEN The fall in house prices has created potential liquidity problems for KEN and KEN is considering what its strategic response should be at this time. The following strategies are being considered: Strategy 1: Abandon Phase 3 and sell the land Strategy 2: Merge with another property development entity Strategy 1: Abandon Phase 3 of the domestic housing project If KEN were to abandon Phase 3 of the project, the land would be sold and the sales office staff would be made redundant. All this would be expected to take place at the end of 2009. Phase 2 of the project would continue as planned since KEN is already committed to completing this phase of the project. The land for Phase 3 was purchased in 2006 at a cost A$2⋅5 million without planning permission. Planning permission was obtained in 2006 at a cost of A$100,000 and the land could be sold in 2009, with planning permission, for A$4⋅4 million. It is estimated that it would cost A$60,000 to make the sales office staff redundant at the end of 2009. Normal running costs and salaries would be paid up to the end of 2009, at which point the sales office would be closed. Strategy 2: Merger KEN has also been approached by another property development entity located in country A that is interested in merging the businesses. Discussions are still at a very early stage but KEN is interested in investigating this possibility further. Investment appraisal KEN uses DCF to evaluate investments at an after-tax nominal discount rate of 12%.

The question requirements are on page 5, which is detachable for

ease of reference.

November 2008 3 -P9




P9 4 November 2008



Required:

(a) For Phase 2 of the project, calculate the fall in after-tax sales receipts in each of the years 2009 and 2010 as a result of the fall in house prices. Ignore the time value of money.

(4 marks)

(b) Discuss the industry, economic and market factors that affect KEN’s business cash flows and liquidity and funding issues.

(6 marks)

(c) Explain the role of the treasury function in • liquidity management, and • funding management.

(6 marks) (d) Assume you are the Finance Director of KEN and write a report to the Board

of Directors of KEN on the strategic choices facing KEN at this time.

Your report should address the following issues:

Strategy 1: (i) Calculate the net present value of the Phase 3 cash flows AFTER the

fall in house prices and compare this with the net present value of the cash flows associated with selling the land.

(17 marks) (ii) Advise whether or not to proceed with Strategy 1. As part of your

answer discuss what other real options are available to KEN, and what other factors should be taken into account.

(7 marks) Strategy 2: (iii) Identify and explain the possible reasons why KEN might consider a

merger at this time and the potential problems with such a merger.

(7 marks) Additional marks for structure and presentation in part (d) (3 marks)


November 2008 5 -P9




P9 6 November 2008




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November 2008 7 -P9





ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two BG is a privately-owned transport entity based in country B, which has the euro (€) as its currency. BG had revenue in the last financial year of €65 million and earnings of €14⋅5 million. The directors of the entity, who are also the major shareholders, have been evaluating the replacement of a number of vehicles, which will be purchased in country C, which has the C$ as its currency. BG has a number of customers based in country C. The vehicles will have a capital cost of C$1⋅6 million and the directors expect these new vehicles to provide after-tax cash flow benefits (including tax depreciation benefits) of €160,000 each year. Cash flows beyond five years are ignored by BG in all its investment decisions. The vehicles are estimated to have a resale value at the end of five years of 15% of the original purchase price. BG is currently all-equity financed. Some directors believe this should continue and the new vehicles should be financed with a rights issue (that is, they are prepared to inject more capital into the business themselves). However, the Chief Executive has suggested this capital structure fails to take advantage of the tax benefits of debt and has requested the Finance Director to evaluate two methods of financing the new vehicles. These are: 1. Debt, raised in the entity’s own country (country B) and secured on its assets

The debt would be denominated in euro and repayable in five years’ time. The current pre-tax rate of interest required by the market on corporate debt of this risk is 9⋅2% per annum. Interest payments would be made at the end of each year.

2. A finance lease raised in country C from where the vehicles will be supplied

The terms would be five annual payments of C$320,000 payable at the beginning of each year. The vehicles could be bought by BG from the finance entity at the end of the lease contract for a nominal amount of C$1. Assume the whole amount of each annual payment is tax deductible.

Other information relevant to the decision is as follows: • The discount rate that BG applies to replacement investment decisions is 12%; • BG’s marginal rate of tax is 35%. This rate is not expected to change in the

foreseeable future. Tax is payable in the year in which the liability arises and tax depreciation allowances are available at 25% per annum on a reducing balance basis;

• The spot rate C$ to the € is 2⋅45; • Interest rates are 4⋅5% per annum in country B and 3⋅5% per annum in country C.

These rates are not expected to change in the foreseeable future.

P9 8 November 2008



Required: (a) (i) Calculate the NPV of the investment in euro;

(ii) Calculate the most advantageous method of finance, if the choice is between debt repayable in five years’ time or a finance lease, and advise which is the cheaper.

Assume all cash flows and interest rates given in the question are in nominal terms.

(16 marks) (b) Assume you are the Finance Director. Advise the CEO of BG on • The advantages and disadvantages to BG of financing the vehicles with debt

or a finance lease compared with new equity raised via a rights issue;

• The reasons for the choice of discount rates used in your calculations for part (a);

• Whether the choice of method of finance should affect the investment decision.

(9 marks)

(Total for Question Two = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

TURN OVER

November 2008 9 -P9



Question Three Entity A A is a publicly listed entity operating largely in the field of training and education. Its sole financial objective is the maximisation of shareholder wealth. It has a cost of capital of 12% and evaluates all its investments using this as the discount rate. This cost of capital is typical of publicly-listed entities in this sector, although analysts believe there is a range of between 10% and 15%. Entity B B is a state-owned educational entity. A substantial proportion of its funding is provided by the government, which requires such entities to operate as commercial entities. All investments are evaluated at a standard discount rate of 7%, a rate determined by the government and applied to investments by all state-owned entities. Most of B’s objectives are qualitative, such as “provide a high quality of education to a diverse body of students”. It has no financial objective other than to stay within cash funding limits.

Required (a) (i) Discuss how the financial objective of entity A might be achieved and

measured. (5 marks)

(ii) Evaluate how the achievement of this financial objective might also benefit

other stakeholders in entity A. (8 marks)

(b) Analyse the differences between the objectives of public and private sector

entities that could explain the different discount rates between Entity A and Entity B given in the scenario.

Include in your analysis some discussion of the apparent contradiction between the government requiring state-owned entities to operate as commercial entities yet instructing them to use a discount rate substantially below that typically used by private sector entities.

(12 marks)

(Total for Question Three = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

P9 10 November 2008



[Section B continues on the next page]

TURN OVER

November 2008 11 -P9



Question Four LUG manufactures furniture for major retailers and independent customers in country D, which has the euro (€) as its currency. Until this year it sold its products only in its own country. LUG finances major changes in its investment in working capital by medium-term loans, which often result in short-term cash surpluses. Short-term cash deficits are financed by overdraft or delayed payments to creditors, usually by agreement. Assume today is 1 January 2009. Selected forecast financial outcomes (country D only) are as follows: 12 months ended 30 September 2009 €000 Revenue 2,585 Cost of goods sold 1,551 Purchases 1,034 As at 30 September 2009 €000 Accounts receivable 350 (54⋅9 days) Accounts payable 205 (72⋅4 days) Inventory 425 (Raw material = 45%, WIP = 22%, Finished goods = 33%) Operating cycle = 105 days Terms of trade of 90% of sales in country D are 30 days credit. The remaining 10% is paid by cash, debit or credit card. Card payments are considered the equivalent of cash. Sales are spread roughly evenly throughout the year. This pattern is not expected to change. New customers On 1 October 2008, LUG entered into contracts with customers in country E, whose currency is the E$. Forecast figures for the year ended 30 September 2009 will be affected as follows: • Sales to country E are likely to be affected by economic and political factors. There is a

60% probability sales will be E$750,000 and a 40% probability they will be E$950,000. All sales will be on credit, invoiced in E$, and the accounts receivable of these customers is expected to be 20% of revenue on average. Sales are spread evenly throughout the year.

• The spot rate E$ to the euro on 1 October 2008 was 1⋅43. The E$ is expected to

weaken against the euro by 3% gradually through the year. Total inventory figures are expected to be as follows to accommodate sales in country E: As at

30 September 2009 €000 Raw material 245 WIP 120 Finished goods 208

P9 12 November 2008



Required (a) (i) Calculate the revised operating cycle for the year ended 30 September 2009

to incorporate sales made to customers in country E. Assume a full year’s trading and sales spread evenly throughout the year.

(ii) Explain, briefly, the main causes of the increase in the operating cycle over

the forecast. (Total for part (a) = 12 marks)

(b) Discuss the benefits and risks of invoicing overseas customers in their own currency and explain what methods are available to help minimise the risks.

(6 marks) (c) Discuss the advantages and disadvantages of financing net current operating assets with medium-term loans compared with short-term financing, in general and as appropriate to LUG. Include in your discussion a diagrammatic explanation of aggressive and conservative working capital financing policies.

(7 marks)

(Total for Question Four = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

TURN OVER




Question Five SB plc (SB) is an unquoted entity that provides technical advisory services and human resources to the oil exploration industry. It is based in the UK, but operates worldwide. It has been trading for 15 years. The four founding directors work full time in the business. Other employees are a combination of full time technical consultants and managers, and experts retained for specific contracts. Recruiting and retaining qualified consultants is a challenge and SB has to offer very competitive remuneration packages. The market for the type of services that SB offers is growing. The large multinational oil entities are currently looking at exploration possibilities in the Caribbean. This will open up substantial new opportunities for SB which will require additional funding. However, the concessions for operating in this region are still under discussion with the various Caribbean governments and the oil multinationals have not yet started formal bidding. In recent years, SB has been informally approached by some of its competitors and also its major customers to sell out. The directors have so far rejected these approaches but are now re-considering the possibilities. An alternative also being considered is an InitiaI Public Offering (IPO), that is, a stock market flotation. Assume today is 1 January 2009 Current Financial information • Revenue in the year to 31 December 2008 was £40,250,000 and earnings (profit after

tax) were £20,188,000. There are five million shares in issue owned equally by the four directors. No dividends have been paid in any year to date.

• Net book value of buildings, equipment and vehicles plus net working capital is £22,595,000. The book valuations are considered to reflect current realisable values.

• SB is currently all equity financed. Forecast Financial information • Sales revenue for the year to 31 December 2009 is expected to be £52,250,000.

• Growth in revenue in the years to 31 December 2010 and 2011 is expected to be 20% per annum.

• Operating costs, inclusive of depreciation, are expected in the future to average 60% of revenue each year.

• Assume that book depreciation equals tax depreciation and that profit after tax equals cash flow.

• The marginal rate of tax is expected to remain at 28% per annum, payable in the year in which the liability arises.

• Assume from 2012 onwards that the 2011 pre-discounted cash flow will grow at 6% per annum indefinitely. This assumes that no new long-term capital is raised. If the entity is to grow at a faster rate then new financing will be needed.

Industry statistics The average P/E ratio for the industry, using a very broad definition, is 12 with a range of 9 to 25. The average cost of capital for the industry is 12%. Cost of capital figures by individual entity are not available.

P9 14 November 2008



Required Assume you are a financial advisor to SB. (a) (i) Calculate a range of values, in total and per share, for SB.

(ii) Advise the directors of SB on the relevance and limitations of each method of valuation to an entity such as theirs, and in the circumstances of the two alternative disposal strategies being considered.

(iii) Recommend a suitable valuation figure that could be used for a trade sale or an IPO.

Use whatever methods of valuation you think appropriate and can be estimated with the information available.

(18 marks) Note: Calculations in part (i) count for up to 10 marks. (b) Advise the directors of SB on the advantages and disadvantages of a trade sale compared with a stock market flotation at the present time, and recommend a course of action.

(7 marks)

(Total for Question Five = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION







P9 16 November 2008










Receivable or Payable at the end of each year for n years ⎥⎦⎤

⎢⎣⎡ −+−

rr n)(11


1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514


1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

P9 18 November 2008




value:

P0 = prefk

d


P0 = ek

d


P0 = gk

d

−e

1 or P0 = gk

gd

−

+

e

0 ][1


P0 = netd

][1

k

ti −


i

(v) Total value of the geared entity, Vg (based on MM):

Vg = Vu + TBc


S = X[1 + r]n


PV = nr ][1

1

+


PV = ⎥⎦

⎤⎢⎣

⎡+

− nrr ][1

11

1


PV = r

1


PV = gr −

1





Cost of capital (i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current ex-

div price P0:

kpref = 0P

d


kd net = 0P

ti ][1 −


ke =

0P

d


ke = gP

d+

0

1 or ke = g

P

gd+

+

0

0 ]1[



(vi) Cost of ordinary (equity) shares in a geared entity (no tax):


DVV

(vii) Cost of ordinary (equity) share capital in a geared entity (with tax):


DV

tV ][1−


k0 = keg ⎥⎦

⎤⎢⎣

⎡⎥⎦

⎤⎢⎣

⎡+

++ DE

D

DE

E

VV

Vk

VV

Vd





ßu = ßg ⎥⎦

⎤⎢⎣

⎡+ DE

E

VV

V


ßu = ßg ⎥⎦

⎤⎢⎣

⎡+ DE

E

VV

V + ßd

⎥⎥⎦

⎤

⎢⎢⎣

⎡

+ ED VVDV


ßu = ßg ⎥⎦

⎤⎢⎣

⎡−+ ][1 tVV

V

DE

E

P9 20 November 2008




C$/euro rate Spot




+

+

ther formulae

) Interest rate parity (international Fisher effect):


O (i

rateinterestUKnominal1


+

+

) Purchasing power parity (law of one price):


(ii

rateinflationUK1

rateinflationUS1

+

+

Link between nominal (money) and real interest rates:

nterest rate][1 + inflation rate]

v) Equivalent annual cost:

Equivalent annual cost =

(iii)

[1 + nominal (money) rate] = [1 + real i

(i

factorannuityyear

yearsovercostsof

n

nPV

) Theoretical ex-rights price:

TERP =

(v

1

1


i) Value of a right:

Value of a right =

(v

1N+

priceissuepriceonRights −

or

N







P9 22 November 2008





1 KNOWLEDGE





something






Analyse Categorise













November 2008


P9 24 November 2008





Examiner’s General Comments The overall performance was very encouraging, as shown by the high pass rate for this sitting. However, improvement was not observed across all subject areas and poor attempts in some subject areas were obscured by a strong performance in the investment appraisal evaluation in Question 1. The results for Question 2 were disappointing as this topic has been examined on a regular basis in recent examination diets. The question required a relatively straight-forward lease versus buy evaluation but with a slight “twist” at the beginning where candidates were required to evaluate the investment itself before moving on to look at the lease versus buy decision. This clearly confused many candidates who were not always able to identify the relevant cash flows to use in each calculation or choose an appropriate discount rate in each case. In Question 3, many candidates demonstrated a relatively weak understanding of the particular problems faced by the public sector when setting financial strategy. In particular, there was often a lack of understanding of how and why discount rates might be used in the public sector and why public sector entities may be expected to operate in a commercial manner. The least popular question on the paper was Question 4. It would appear that many candidates had not expected a question on financial ratios or the operating cycle and many struggled with these basic concepts. The final question, Question 5, was both popular and generally answered well. Most candidates were able to calculate a range of valuations for an unquoted company using appropriate valuation methods. There was a marked improvement in candidate performance in this area when compared with recent diets. There was a greater difference between the performance of UK and non-UK candidates than in May 2008. This was particularly evident in discursive questions where both the length and depth of answers were generally weaker for non-UK candidates. However, there were many exceptions to this general observation, with a wide disparity between centres and some non-UK centres out-performing UK exam centres. Non-UK candidates would be well advised to provide more extensive answers to discursive questions. Five line answers to five mark questions are not normally sufficient. In the sections below that explain how the Marking Guide was applied, where the comment says “up to 3 marks are available for each valid point”, 0.5 marks are awarded for a bullet point, 1 mark for some attempt at (correct and valid) discussion, rising to 3 marks for good discussion of the point using appropriate illustrative examples. The published solutions are used as a guide. Marks are also awarded for candidates' own valid comments that might not be in the marking guide or the published solutions. Where marks are shown for calculations, the mark shown is the maximum available assuming calculations are all correct. Marks are available for recognition of correct approach and understanding.





SECTION A Question One (a) For Phase 2 of the project, calculate the fall in after-tax sales receipts in each of the years 2009 and 2010 as a result of the fall in house prices. Ignore the time value of money.

(4 marks)

Rationale In part (a) candidates were required to calculate (for Phase 2) the fall in after-tax sales receipts as a result of the fall in house prices. Suggested Approach

• Calculate the value of house sales made in 2009 both before and after the fall in prices (Note that the best approach is to deduct 10% of the original sales price, that is, multiply by 90%)

• Calculate the fall in the value of house sales • Spread this figure between 2009 and 2010 to reflect the timing of sales receipts • Deduct tax at 30%

Marking Guide

Marks

Fall in total sales receipts 1.5 Correct timing of sales receipts cash flows 1.5 Tax calculation (no deduction in marks if tax delayed by one year or if tax is calculated on an alternative “profits” basis)

1.0

Total 4 Examiner’s Comments on Question One (a)

Part (a) was generally answered well. However, there were a number of candidates who only calculated the total figure for after-tax sales receipts after the fall in selling prices rather than the fall in receipts. Note that full credit was given where candidates divided the selling price by 1.10 rather than multiplying by 0.90. This alternative approach had a minor impact on the majority of figures in part (a) and also on the figures in part (d)(i). Common Errors

• Calculating the revised after-tax sales receipts rather than the fall in sales receipts • Omitting any tax calculation





Question One (b) Discuss the industry, economic and market factors that affect KEN’s business cash flows and liquidity and funding issues.

(6 marks)

Rationale In part (b) candidates were required to discuss the industry, economic and market factors that might affect KEN’s business cash flows and liquidity and funding issues.

Suggested Approach Discuss industry factors such as the high level of funding required to purchase the land and also build houses before significant sales proceeds are received and consider the implications of this on KEN’s cash flows, liquidity and funding Discuss relevant economic factors such as interest rates and the general economic climate and their impact on KEN’s cash flows, liquidity and funding Discuss relevant market factors such as house prices, the demand for new housing and competitive position and the likely impact of these factors on KEN’s cash flows, liquidity and funding. Marking Guide

Marks

Impact of:

• Industry issues such as the significant up-front funding over a long time period for purchase of land and construction of houses

2/3

• Economic factors such as interest rates and general economic confidence 2/3 • Market factors such as house prices, demand for new housing and

competitive position

2/3

Max 6 Examiner’s Comments on Question One (b) There were some excellent insightful answers to part (b). It must be assumed that this is, in part, due to the familiarity of candidates with issues surrounding liquidity due to extensive coverage in the financial press at the time of sitting this examination. Common Errors The most common error was to digress away from the scenario described in the question and discuss issues relating to the current global “credit crunch” that would not necessarily be relevant to the scenario presented. For example, there is no indication in the scenario that country A refers to the UK or the USA or that country A is facing a general economic downturn or fall in employment levels.





Question One (c) Explain the role of the treasury function in • liquidity management, and • funding management.

(6 marks)

Rationale In part (c) candidates were required to explain the role of the treasury function in two key areas of direct relevance to KEN, namely, liquidity and funding management.

Suggested Approach Definition and explanation of the scope of:

• liquidity management • funding management

in the context of KEN Marking Guide

Marks

Liquidity Sufficient liquid funds to meet obligations Working capital management

Invest surplus funds (if any) Sufficient headroom to cover unforeseen circumstances 3/4 Funding Identify suitable sources of funds Manage interest rate risks Contribute to strategic decisions concerning capital structure and dividends 3/4

Max 6 total Examiner’s Comments on Question One (c) Part (c) was generally answered very well Common Errors A number of candidates discussed all aspects of treasury management rather than restricting their answers to liquidity and funding management. A few candidates strayed in the opposite direction and focussed their answers almost entirely on issues relating to working capital management.





Question One (d) Assume you are the Finance Director of KEN and write a report to the Board of Directors of KEN on the strategic choices facing KEN at this time. Your report should address the following issues: Strategy 1: (i) Calculate the net present value of the Phase 3 cash flows AFTER the fall in house prices and compare

this with the net present value of the cash flows associated with selling the land. (17 marks)

(ii) Advise whether or not to proceed with Strategy 1. As part of your answer discuss what other real

options are available to KEN, and what other factors should be taken into account. (7 marks)

Strategy 2: (iii) Identify and explain the possible reasons why KEN might consider a merger at this time and the

potential problems with such a merger. (7 marks)

Additional marks for structure and presentation in part (d) (3 marks)

Rationale In part (d) candidates, in the role of the Finance Director, were required to write a report to the Board in which they evaluate alternative strategies 1 and 2. A full financial evaluation was required for Strategy 1 and discussion of the rationale and potential problems arising were required for Strategy 2. Suggested Approach Part (i)

• Calculate the NPV of Phase 3 after the fall in house prices • Calculate the NPV of selling the land

Part (ii) • Compare the results obtained in part (i) above and advise which is the most profitable strategy • Identify and explain other real options available to KEN • Discuss all the available options and the factors affecting the choice of strategy

Part (iii) • Identify and explain the reasons why KEN might consider a merger • Identify and explain the potential problems with a merger





Marking Guide

Marks

Part (i)

NPV of Phase 3 cash flows Sales receipts 3 Construction cash outflows for 60% 3 Sales office running costs 1 Tax (incl 1 mark for correct timing) 2 Discount factors and NPV 1 NPV of cash flows re sale of land Receipt for sale of land (and no reference to the original purchase cost etc) 0.5 Costs (redundancy costs ONLY) 2 Tax (business tax on net revenue plus capital gains tax) 3 Discount factor and NPV 1.5 Part (ii)

Total 17

Financial benefit Summary of NPV results in part (d) (i) Identify marginal benefit of proceeding with Phase 3 1 Real options

“Wait and see” what happens to house prices Possible alternative use of the land e.g. commercial development 2/3 Other factors

Reliability of cash forecasts Expected future movement in house prices 3/4 Max 7 Part (iii) Key points: Possible advantages Increased market share and ability to influence house prices Economies of scale/improved efficiency 3/4 Potential problems Competition Commission Finding a suitable merger candidate which has a sufficiently strong cash position to be able to reduce KEN’s liquidity problems

Failure to achieve expected economies of scale or other synergies 3/4 Max 7

Structure and presentation Headings and sub-heading, tabulated figures, purpose and/or conclusion

1 mark each

Total 3





Examiner’s Comments on Question One (d) The majority of candidates obtained high marks in part (d)(i) for the calculation of the NPV of the Phase 3 cash flows after the fall in house prices. The NPV of the sale of land caused more problems, with many candidates unable to identify “relevant” cash flows or make a reasonable attempt at the tax calculation. Note that full credit was awarded whatever sensible “base year” was chosen in (d)(i) as long as the same base year was used in both calculations. Parts (d) (ii) and (d) (iii) were generally answered well. However, few candidates highlighted the importance of the cash/liquidity position of the merger candidate in their answer to part (iii). Common Errors Phase III

• Miscalculation of the 10/90 split of sales receipts • Tax omitted or not delayed by a year

Land sale • Inclusion of non-relevant cash flows, such as:

o Purchase cost of land o Cost of planning permission o Office running costs

• Miscalculation of business tax by applying the 30% rate to the total net cash flows rather than just the redundancy costs

• Omission of any capital gains tax calculation • Error in calculating the capital gain and capital gains tax by excluding the cost of planning permission

from the base cost • Choice of base year for the land sale was not consistent with that used in the Phase III calculation





SECTION B Question Two (a) (i) Calculate the NPV of the investment in euro; (ii) Calculate the most advantageous method of finance, if the choice is between debt repayable in five

years’ time or a finance lease, and advise which is the cheaper. Assume all cash flows and interest rates given in the question are in nominal terms.

(16 marks) Rationale Candidates were required to calculate the NPV of the investment in euro and the most advantageous method of finance, if the choice is between medium-term debt or finance lease. Suggested Approach Part (i) • Calculate forward exchange rates • Calculate NPV of investment at 12% Part (ii) • Calculate tax depreciation allowances • Calculate after tax cost of debt to use as discount rate in lease/buy evaluation Using this discount rate: • Calculate NPV of after tax lease cash flows • Calculate NPV of purchase cash flows • Advise which method is most advantageous (i.e. is cheapest for BG) Marking Guide

Marks

Calculate forward exchange rates Calculate the NPV of the investment in euro

1.5 4.5

Calculate tax depreciation allowances Calculate the after tax cost of debt Calculate the most advantageous method of finance, if the choice is between debt repayable in five years’ time or a finance lease, and advise which is the cheaper

1.5 1.5

7.0





Examiner’s Comments This was a popular choice of the optional questions but part (a), in particular, was generally not answered well. Many candidates seemed to be thrown by the inclusion of both an investment appraisal question and a lease/buy evaluation side-by-side and were confused about which discount rate to use and which cash flows to include in each calculation. Common Errors Part (i) • wrong discount rate (e.g. 6%) • incorrect calculation of forward exchange rates • incorrect calculation of residual value • including non relevant cash flows such as tax depreciation allowances or tax deductions • confusion between the 2 currencies, aggregating C$ and cash flows Part (ii) • wrong discount rate (use of 12% or 9.2%) • misapplication of forward exchange rates • including non-relevant interest and/or capital repayment cash flows in the NPV of the “purchase”

evaluation • timing errors in lease and/or tax cash flows • not providing any advice





Question Two (b) Assume you are the Finance Director. Advise the CEO of BG on • The advantages and disadvantages to BG of financing the vehicles with debt or a finance lease

compared with new equity raised via a rights issue; • The reasons for the choice of discount rates used in your calculations for part (a); • Whether the choice of method of finance should affect the investment decision.

(9 marks) Rationale Candidates were required to advise the CEO on the advantages and disadvantages of financing the vehicles with debt or a finance lease as compared with new equity raised via a rights issue. Candidates were also required to discuss the advantages and disadvantages of financing assets in the same currency as their purchase. This question tested knowledge and understanding of learning outcomes A (i) and B (i). Suggested Approach • Provide an introductory comment • Advise on the advantages and disadvantages of debt/lease finance over equity finance • Advise on reasons for choice of discount rate • Advise on whether the choice of method of finance should affect investment decision • For a very good answer, calculate a simplified APV

Marking Guide

Marks

The advantages and disadvantages to BG of financing the vehicles with debt or a finance lease compared with new equity raised via a rights issue

3/4

The reasons for the choice of discount rates used in your calculations for part (a) 3/4 Whether the choice of method of finance should affect the investment decision 3/4

Max 9 Examiner’s Comments As a general principle, candidates should spread their time equally between subsections of a question where no detailed mark breakdown is provided. There was a marked tendency in this question for candidates to concentrate on the first part of the requirement and to the detriment of the other two parts. Common Errors • Discussing lease versus debt rather than lease or debt versus equity. • Providing a list of advantages and disadvantages with no reference to the context of the question.





Question Three (a) (i) Discuss how the financial objective of entity A might be achieved and measured.

(5 marks)(ii) Evaluate how the achievement of this financial objective might also benefit other stakeholders in entity

A. (8 marks)

Rationale Candidates were required to discuss how the financial objective of entity A might be achieved and measured and to evaluate how the achievement of this objective might also benefit other stakeholders in the entity. Suggested Approach Part (i) • Explain Entity A’s sole financial objective • Discuss how this objective could be achieved and measured Part (ii) • Identify the main stakeholder groups • Discuss how Entity A’s objective might affect each group Marking Guide

Marks

Up to three marks are available for each valid point. (i) Discussion of objectives 5 Key points: Maximisation of shareholder wealth for Entity A Measured by RoI or similar Other methods of measurement Limitation/constraint (ii) Evaluation of the achievement 8 Key points: Identification main groups of stakeholder Discussing how each group would benefit Noting conflict between groups Examiner’s Comments This was a fairly popular choice of optional question, although generally quite poorly answered. Part (ii) was generally better attempted than Part (i) Common Errors • Identifying the objective but not addressing how it might be achieved and measured • Discussing too few stakeholders in Part (ii)





Question Three (b) Analyse the differences between the objectives of public and private sector entities that could explain the different discount rates between Entity A and Entity B given in the scenario. Include in your analysis some discussion of the apparent contradiction between the government requiring state-owned entities to operate as commercial entities yet instructing them to use a discount rate substantially below that typically used by private sector entities.

(12 marks) Rationale Candidates were required to analyse the differences between the objectives of public and private sector entities that could explain the different discount rates between Entity A and Entity B given in the scenario. The question tested knowledge and understanding of learning outcome B (ii). Suggested Approach Analyse the key points as shown in the published solutions. In summary: • Objectives of two types of entity are moving closer together • Easier to define objective in private entities • Difference in definition of customer • Difference in risk characteristics and why these affect the discount rates Marking Guide

Marks

Key points: (up to 3 marks per valid point)

12

Two sectors moving closer together Who sets objectives? Risk is major difference Distinguishing characteristics

Examiner’s Comments Common Errors • Failing to recognise that key difference is one of risk • Weak understanding generally of the use of discount rates in the public sector





Question Four (a) (i) Calculate the revised operating cycle for the year ended 30 September 2009 to incorporate sales made to

customers in country E. Assume a full year’s trading and sales spread evenly throughout the year. (ii) Explain, briefly, the main causes of the increase in the operating cycle over the forecast.

(Total for part (a) = 12 marks) Rationale Candidates were required to calculate the revised operating cycle incorporating sales in country E and to provide a brief explanation of the main causes of the increase in the operating cycle over the forecast. Suggested Approach • Calculate expected sales in country E in euro • Calculate split of credit and cash sales • Calculate base figures for calculating operating cycle • Calculate operating cycle • Explain the main likely causes of the increase in the operating cycle over previous year Marking Guide

Marks

Expected sales in country E converted into euro 2 Days inventory of raw materials 1 Days accounts payable 1 Days production time (work-in-progress and finished goods) 1.5 Days accounts receivable 2.5 Operating cycle 2 Explanation that the increase is largely due to increase in accounts receivable and also some increase in inventory

2

Examiner’s Comments on Question Four (a) This was the least popular of the optional questions, and generally attempted poorly by many candidates who did choose it. There is no obvious explanation for this as it is a routine topic that has featured in previous diets. Common Errors • Incorrect calculations of sales in euro, usually by multiplying the sales in E$ by the spot rate instead

of the average during the year • Ignoring the credit/cash split in sales in Country D • Very poor attempts at calculating the basic ratio components of the operating cycle e.g. using sales

instead of purchases in calculation of Days Accounts Payable and/or instead of cost of goods sold in calculation of Days Production

• No calculation of operating cycle





Question Four (b) Discuss the benefits and risks of invoicing overseas customers in their own currency and explain what methods are available to help minimise the risks.

(6 marks)

Rationale Candidates were required to discuss the benefits and risks of invoicing overseas customers in their own currency and explain what methods are available to help minimise the risks. Suggested Approach • Comment that main benefits are likely to be market led • Identify the entity’s options • Discuss the factors to consider and the issues specific to LUG Marking Guide

Marks

Up to three marks available per valid point. Key points:

6

Benefits – marketing Explanation of risk involved External hedging option Internal hedging options (with reference to LUG) Other factors (e.g. position of competitors)

Examiner’s Comments Part (b) was generally answered well. Common Errors Lack of recognition that marketing and competitive advantage are the key drivers Omitting discussion of internal hedging methods Generalised comments without reference to LUG





Question Four (c) Discuss the advantages and disadvantages of financing net current operating assets with medium-term loans compared with short-term financing, in general and as appropriate to LUG. Include in your discussion a diagrammatic explanation of aggressive and conservative working capital financing policies.

(7 marks) Rationale Candidates were required to discuss the advantages and disadvantages of financing net current operating assets with medium-term loans compared with short-term financing. The question tested knowledge and understanding of learning outcomes A (v), B (i) and C (viii). Suggested Approach • Discuss the advantages/disadvantages of financing policies as shown in the published solution • Provide a diagrammatic explanation of aggressive and conservative working capital financing policies • Classify and explain LUG’s current financing policy Marking Guide

Marks

Explanation of advantages/disadvantages of financing policies (aggressive versus conservative) 3 Diagram(s) 3 Classification and explanation of LUG’s current financing policy 1 Total 7 Examiner’s Comments Part (c) was generally well answered. Common Errors • Not relating answers to the entity’s situation • Not providing any diagrammatic explanation





Question Five (a) Assume you are a financial advisor to SB. (i) Calculate a range of values, in total and per share, for SB. (ii) Advise the directors of SB on the relevance and limitations of each method of valuation to an entity

such as theirs, and in the circumstances of the two alternative disposal strategies being considered. (iii) Recommend a suitable valuation figure that could be used for a trade sale or an IPO. Use whatever methods of valuation you think appropriate and can be estimated with the information available.

(18 marks)Note: Calculations in part (i) count for up to 10 marks. Rationale Candidates, in the role of a financial advisor, were required to calculate a range of values, in total and per share; advise the directors on the relevance and limitations of each method of valuation in the circumstances of the two alternative disposal strategies being considered; and recommend a suitable valuation that could be used for a trade sale or an IPO. Suggested Approach • Calculate values in total and per share using a range of methods, typically: asset basis, P/E ratio, DCF/NPV • Provide advice on the relevance and limitation of each method to SB in the context of the disposal

strategies • Provide a recommendation of a valuation

Marking guide

Marks

Net asset value (calculations and comments) 2.5 P/E ratio – range of values (calculations and comments) 4.5 DCF (calculations and comments) 9.0 Recommendation Up to 3.0

Total max 18 Examiner’s Comments on Question Five (a) This was the probably the most popular of the optional questions, not surprising as it is a regularly examined topic. It was generally very well answered by candidates who chose to attempt it. Common Errors • Providing a single P/E ratio only • No calculation of ‘per share’ values • Lack of depth and/or focus in discussion of the relevance and limitation of each method • Incorrect calculation of PV of cash flows beyond 2011 • Not providing a quantified recommendation





Question Five (b) Advise the directors of SB on the advantages and disadvantages of a trade sale compared with a stock market flotation at the present time, and recommend a course of action.

(7 marks) Rationale Candidates were required to advise the directors on the advantages and disadvantages of a trade sale, as against a stock market flotation, and recommend a course of action. The question tested knowledge and understanding of learning outcome B (i). Suggested Approach • Advise on the advantages/disadvantages of the two identified methods of sale as per key points in the

published solutions • Provide a reasoned recommendation

Marking guide

Marks

Advantages & Disadvantages 5 Recommendation 2 Total 7 Examiner’s Comments No further comments Common Errors • Not recognising the key differences between a stock market flotation and a trade sale.

e.g. • failing to recognise that all ownership rights and potential to benefit from future growth would

be lost under a trade sale • confusion over which approach would be likely to value the entity more highly and why

• Not providing a reasoned recommendation of a course of action (which might be to do neither at this

point in time)



Documents

16014395 CIMA P9 Management Accounting Financial Strategy Solved Past Papers