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CAP2 – SFMA – S’13 23/04/2013

CA Proficiency 2

PAPER 2 – STRATEGIC FINANCE & MANAGEMENT ACCOUNTING

SUMMER 2013 (Thursday 27th June 2013 - 9.30 a.m. to 1.20 p.m.)

INSTRUCTIONS TO CANDIDATES 1. The first 20 minutes of this examination is dedicated to reading time. During this time, candidates may refer

to their materials and make notes on this examination paper or in their own note book. Candidates are NOT permitted to open their answer books until instructed to do so. 2. Answer Question 1 in Section A. Answer ANY TWO of THREE Questions in Section B. 3. Candidates should indicate clearly whether they are answering the paper in accordance with the law and

practice of Northern Ireland or the Republic of Ireland. 4. Candidates should deem each monetary amount shown with the €/£ symbol to be stated in their relevant

currency. 5. All workings should be shown. 6. Answers should be illustrated with examples where appropriate. 7. Section A begins on Page 2 overleaf.

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CAP2 – SFMA – S’13 23/04/2013

SECTION A

CASE STUDY Answer Question 1 (Compulsory)

QUESTION 1 (Compulsory) Background Bourne plc (“BOURNE”) is an Irish based company operating in the pharmaceutical sector and was established by Ms. Olive Barry over twenty years ago. Olive currently occupies the position of Chair of BOURNE’s Board of Directors. BOURNE specialises in the research, development, production and sale (on a global basis) of a range of medications targeting certain neurological conditions. As a result of the expensive nature of the industry in which BOURNE competes, coupled with continual downward price pressures (e.g. repeated Government demands for cheaper medicines), cost control is of critical importance for BOURNE in achieving the company’s annual financial targets. Consequently, BOURNE’s newly appointed Managing Director, Mr. Ken Walsh, has been heavily incentivised by BOURNE’s Board of Directors to ensure that BOURNE achieves its 2014 profit target of €/£ 3,500,000. Performance Measurement BOURNE is organised on a divisional basis in accordance with each of the three main neurological conditions it specialises in, i.e. “Alpha”, “Beta” and “Charlie”. Each of BOURNE’s divisions is treated as an investment centre and divisional management are encouraged by the Board of Directors to pursue projects which align with BOURNE’s overall long-term strategic goals one of which is profit maximisation. Certain divisional decisions, such as, capital investment and debt financing over a predetermined monetary threshold, must be agreed in advance with the Board of Directors (via Ken as an intermediary). In terms of evaluating the annual performance of each division, BOURNE uses a combination of the following measures: return on capital employed (ROCE) and residual income (RI). Each division has recently submitted some initial 2014 budgetary data to Ken for approval. See Appendix I for the relevant budgetary data. Since the data in Appendix I was accumulated, the management of the “Beta” division have requested that Ken seek the Board of Directors approval for a major clinical trial of a new form of medication which would commence at the end of 2014; and if successful, could potentially generate significant profits for BOURNE from 2018 onwards. However, as Ken has some concerns about the proposed scale of the trial, coupled with the potential impact on his ability to achieve his annual bonuses over the next few years, he has requested that BOURNE’s Board of Directors reject the “Beta” division’s request. Transfer Pricing Proposal At a recent meeting of BOURNE’s Board of Directors, it was suggested that BOURNE seriously examine the feasibility of establishing an additional division on a particular Caribbean island noted for its low rate of corporation tax. According to the Director who made the suggestion, by using the new division to license and distribute BOURNE’s output internationally, BOURNE could potentially reduce their overall corporation tax liability, which would in turn allow BOURNE to generate additional profits for re-investment. Financial Analysis Ken has met with BOURNE’s Financial Director, Mr. Ted Moles, to discuss a proposal to acquire Dexcon Limited (“DEXCON”), a rival company, also in the pharmaceutical industry. DEXCON is attractive because its products would complement those manufactured by BOURNE. Following preliminary discussions with DEXCON’s Board of Directors, BOURNE has been provided with financial information on DEXCON (See Appendix II). Ted has informed Ken that he has some concerns about the financial performance and the management of working capital in DEXCON and wants to investigate these issues further before making any recommendation regarding the potential acquisition of the company. In order to assist Ted with his recommendations he has collected financial performance data for BOURNE’s “Charlie” division (See Appendix II). The financial performance of the “Charlie” division is very similar to the other divisions in BOURNE and Ted feels this information would prove useful in analysing DEXCON’s financial performance. Raising Capital BOURNE intends to raise additional capital to fund investment in several projects over the next year. Part of this financing plan involves a rights issue, to raise a total of €/£ 1,500,000. The issue will be announced next week on the following terms: 1 new share for 6 existing shares at a discount of 30% of BOURNE’s current share price. BOURNE’s shares are currently trading at €/£ 3.45. Ken has held preliminary discussions with BOURNE’s larger shareholders over the last few weeks about BOURNE’s plan to raise additional equity capital. Terry Neil, BOURNE’s largest shareholder, with a 9% interest in BOURNE, has told Ken he would not be in a position to subscribe to a rights issue.

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CAP2 – SFMA – S’13 23/04/2013

QUESTION 1 (Cont’d) Requirement: (a) For each of BOURNE’s three divisions, calculate the 2014 budgeted return on capital employed (ROCE) and

residual income (RI). See Appendix I for the relevant data. Assume that BOURNE expects all three divisions to generate a minimum return of 9% per annum. State clearly any assumptions that you make. 6 Marks

(b) Suggest (with reasons) what improvements you would make to BOURNE’s current system of divisional

performance evaluation. 8 Marks

(c) Outline the potential negative consequences for BOURNE as a result of Ken’s decision to recommend the

rejection of the “Beta” division’s request for a major clinical trial of a new form of medication. 7 Marks

(d) Outline FOUR potential limitations for BOURNE associated with the transfer pricing proposal as suggested by

a member of BOURNE’s Board of Directors. 8 Marks

(e) Calculate the 2012 Cash Conversion Cycle for DEXCON (using the data provided in Appendix II) and briefly

explain the significance of this number. 5 Marks

(f) Using the data provided in Appendix II, analyse the financial performance of DEXCON.

10 Marks

(g) Based on your analysis in part (f), suggest and describe FOUR actions which BOURNE should take to remedy any areas of underperformance evident in DEXCON should BOURNE proceed with the acquisition.

8 Marks (h) Calculate the theoretical ex-rights share price and outline the options open to Terry Neil if BOURNE proceeds

with the rights issue. 6 Marks

Total Marks: 58 Marks

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CAP2 – SFMA – S’13 23/04/2013

SECTION B

Answer ANY TWO of THREE Questions in this Section

QUESTION 2 Crystal Limited (“CRYSTAL”) (a user of standard costing) is an award winning firm that designs, produces and sells hand-crafted crystal ornaments globally through a network of independent retailers and via their website. As a result of ever-increasing competition mainly from low-cost producers located in the Far East, CRYSTAL’s newly appointed Production Manager, Mr. Joe Flynn, is eager to ensure that CRYSTAL’s production process (which is primarily labour based) is as efficient and cost effective as possible, whilst simultaneously maintaining CRYSTAL’s quality ethos. As a first step, Joe has accumulated the following 2012 budgeted and actual labour related information pertaining to one of CRYSTAL’s most popular ornaments, “Harp”, during which time 2,500 units (i.e. ornaments) were produced. (Note: all units of “Harp” produced by CRYSTAL require the input of all three types of labour prior to completion.)

2012 - Budgeted Information (based on 2,500 units)

Type 1 Labour 5,000 hours €/£ 25.00 per hour

Type 2 Labour 2,000 hours €/£ 35.00 per hour

Type 3 Labour 3,000 hours €/£ 18.00 per hour

2012 - Actual Information (based on 2,500 units)

Type 1 Labour 4,800 hours €/£ 27.50 per hour

Type 2 Labour 2,100 hours €/£ 34.00 per hour

Type 3 Labour 3,250 hours €/£ 17.75 per hour

Joe has since discovered that as a result of an accounting error, the standard rate of pay per hour in 2012 for all Type 2 Labour employees used in the production of “Harp” should have been €/£ 32.50. Additionally, due to an intensive in-house training programme held at the end of 2011 for all Type 2 Labour employees involved in the production of “Harp”, the standard amount of Type 2 Labour hours required to produce each unit of “Harp” in 2012 should have been 0.75 hours. Requirement: (a) In relation to CRYSTAL’s production of “Harp” in 2012 calculate the total labour mix variance and the total

labour yield variance. 6 Marks (b) From the perspective of CRYSTAL’s use of Type 2 Labour during the production of “Harp” in 2012,

calculate the following variances (all workings should be clearly shown.); (i) Labour rate variance (before adjusting for planning & operational issues) (ii) Labour efficiency (usage) variance (before adjusting for planning & operational issues) (iii) Labour rate planning variance (iv) Labour rate operational variance (v) Labour efficiency (usage) planning variance (vi) Labour efficiency (usage) operational variance 9 Marks

(c) Joe is concerned that although the hourly Type 2 Labour rate increased from €/£ 32.50 to €/£ 34.00 in

2012, labour efficiency did not improve. Consequently, Joe has suggested that the hourly labour rate be cut to €/£ 30.00 until the expected labour efficiency gains are realised.

Critically evaluate Joe’s proposal as outlined above.

6 Marks Total Marks: 21 Marks

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CAP2 – SFMA – S’13 23/04/2013

QUESTION 3 Mr. Jim Starling, the Managing Director of Starling Products Limited (“STARLING”), has become increasingly stressed recently due to the rapid expansion of the company. STARLING, which manufactures cleaning products, has grown from a small domestically focussed producer to a major player in the European market. Sales to the US and Asian markets were also increasing for STARLING. STARLING had been founded by Jim’s father, Mike Starling, in 1979 and for the first twenty five years of its existence sold all of its output to supermarket chains and hardware shops in Ireland. In 2004, Jim’s nephew Paul Neilson, developed a new chemical for cleaning windows which was dramatically more effective than any other product on the market. Jim saw an opportunity and offered Paul a 25% shareholding in STARLING in return for the sole rights to manufacture and sell this new chemical. Paul had acquired a European patent on the product at this stage. Revenues had grown from €/£ 1,600,000 in 2004 to €/£ 17,500,000 in 2012 but in many ways STARLING had not changed as it grew. Its management structure was the same in 2012 as it had been in 2000. Jim’s wife, Ellen, was STARLING’s only other director and worked part-time in STARLING with a responsibility for credit control and general working capital management. Ellen was struggling to deal with all of STARLING’s new debtors, many of whom were overseas. Jim also felt he no longer had a sense for how STARLING was performing as it had grown so big and complex. The priority right now for Jim was expanding production capacity. STARLING currently manufactures its products in a factory in the West of Ireland which is operating at maximum capacity. An adjacent site has been acquired for a new factory and Jim has now to secure funding for this new factory. Jim’s intention is to use debt to fund the factory as STARLING is currently an all equity financed company, however Jim is worried about interest rate increases in the future. Jim has read a newspaper article recently saying that interest rates “were at an all-time low and could only go in one direction.” STARLING would need to borrow €/£ 8,000,000. The 3 month Libor/Euribor rate is currently 4.5%. STARLING’s bank was very keen to lend the money and offered two financing alternatives to Jim. The two financing alternatives are detailed below. Alternatives proposed by STARLING’s bank:

1. Fixed rate, interest only, loan of €/£ 8,000,000 for 5 years. With capital repayable in 5 years. Interest rate of 6.75%. Payments would be made annually in arrears. An arrangement fee of €/£ 100,000 would be payable immediately.

2. Variable rate, interest only, loan of €/£ 8,000,000 for 5 years. Variable rate will be adjusted on a weekly basis. With capital repayable in 5 years. Interest rate of 3 month Libor/Euribor + 1.5%. This can be hedged using a swap contract where STARLING would pay a fixed rate of 6.35% and would receive 3 month Libor/Euribor + 1.5%. Payments would be made annually in arrears. A fee of 1% of the principal amount is payable immediately for arranging a swap.

Other Relevant Information

- You should ignore any interest rate exposure after the first year. - You should ignore the impact of taxation. - You should ignore the time value of money.

Requirement (a) Other than the interest rate risk associated with the proposed new borrowing, identify FOUR key risks facing

STARLING and outline how STARLING should address each of these risks. 8 Marks

(b) Outline the cumulative cash-flows which will arise in the first year from each of the two financing alternatives

proposed by STARLING’s bank assuming that: (i) immediately after borrowing Libor/Euribor falls to 2.5% and then remains unchanged

thereafter, and (ii) immediately after borrowing Libor/Euribor rises to 6% and then remains unchanged thereafter.

9 Marks (c) Advise STARLING on which of the two financing alternatives it should choose. In your answer outline the

factors you considered in making your decision. 4 Marks Total Marks: 21 Marks

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CAP2 – SFMA – S’13 23/04/2013

QUESTION 4

The Board of Directors of Hexagon Limited (“HEXAGON”) has just had a stormy meeting, where the future direction of HEXAGON was discussed at length, with no agreement reached. The Board comprises three directors; Bill O’ Brien and Michael Melvin, the founders of HEXAGON, each of whom own 33% of the equity in HEXAGON and the remaining 34% of the equity is owned by Tony Long, an investor who had bought shares in HEXAGON when it was expanding several years ago.

Tony was pushing for a stock market flotation as he has always considered his investment in HEXAGON to be a medium term one. HEXAGON had grown strongly since Tony’s investment and Tony saw the current buoyancy of the stock market as an opportunity to cash-out. Tony also argued that the three directors had all of their wealth tied up in HEXAGON and that this was not sensible. Bill, however, strongly believed that HEXAGON was going to grow rapidly over the next few years and couldn’t see the sense in sharing that growth with new investors that would buy shares at an Initial Public Offering (IPO). Hexagon wouldn’t need any funding for the foreseeable future, in fact it was generating significant profits every year, more than enough to finance any investments required. Bill saw a stock market listing as an unnecessary expense and argued that, after the listing, the three directors would no longer be able to pursue their chosen strategy for HEXAGON – they would have to satisfy the market, which was obsessed with the next year’s earnings.

Michael could see merits in the proposal to float HEXAGON but had some concerns. Michael was not convinced the directors could get a fair price for any shares sold to new investors in an IPO and was also concerned about losing control of HEXAGON and any conflict with new shareholders. The Directors agreed that they would perform a valuation of HEXAGON using the information in Appendix I below before making a decision on a stock market flotation.

Appendix I - Forecasted financial performance and investment requirements for the next five years.

30 June 2014

€/£ ’000

30 June 2015

€/£ ’000

30 June 2016

€/£ ’000

30 June 2017

€/£ ’000

30 June 2018

€/£ ’000

Sales 3,600 3,850 3,900 4,550 4,900

EBIT 900 883 1,362 1,408 1,421

Interest 285 310 310 325 350

Tax 68 60 153 198 155

Additional Information

Use the following definition of Free Cash Flow (FCF). FCF = EBIT – Tax + Depreciation – Increase in net working capital – Increase in capital investment

Depreciation is expected to be €/£ 285,000 in each of the years 2014 to 2018.

Net working capital is currently €/£ 1,120,000, which equates to 35% of 2013 sales. It is expected that this ratio of working capital to sales will be required in the future.

Annual capital investment has historically averaged 15% of annual sales.

The three directors believe a growth rate of 4% in FCF could be maintained indefinitely from 2018.

HEXAGON pays corporation tax at a rate of 20%.

HEXAGON is financed by ordinary equity and traded bonds.

The bonds were issued eight years ago at a nominal value of €/£ 100. They currently trade at €/£ 106.55. The bonds pay an annual coupon of 7.5%. This coupon will be paid in two weeks and the bonds are currently trading cum-interest. These bonds are irredeemable.

Octagon plc. (“OCTAGON”) is a publicly traded company, which is very similar to HEXAGON in most respects. OCTAGON has just paid a dividend of €/£ 0.09 per share and analysts expect OCTAGON’s dividends to grow at an annual rate of 4.5% in the future. OCTAGON’s share price closed at €/£ 1.24 yesterday.

HEXAGON’s most recent Statement of Financial Position reports values of €/£ 1,857,000 and €/£ 2,355,000 for long term debt and equity respectively.

Requirement (a) Estimate the Weighted Average Cost of Capital (WACC) of HEXAGON. (Explain any assumptions you make.)

6 Marks (b) Estimate the value of HEXAGON using a Free Cash Flow approach. (Explain any assumptions you make.)

9 Marks

(c) Critically assess the arguments each of shareholders have made for and against HEXAGON seeking a listing on the stock market. 6 Marks

Total Marks: 21 Marks