F3 Nov 2010 Exam Paper

8/6/2019 F3 Nov 2010 Exam Paper

1/28

The Chartered Institute of Management Accountants 2010

F

3

FinancialStra

tegy

Financial Pillar

F3 Financial Strategy

25 November 2010 Thursday 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 beginsduring which you should read the question paper and, if you wish, highlightand/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 useyour calculator during this reading time.

You are strongly advised to carefully read ALL the question requirementsbefore attempting the question concerned (that is all parts and/or sub-questions).

ALL answers must be written in the answer book. Answers written on thequestion paper will not be submitted for marking.

You should show all workings as marks are available for the method you use.

The pre-seen case study material is included in this question paper on pages2 to 7. The unseen case study material, specific to this examination, isprovided on pages 8 and 9.

Answer the compulsory question in Section A on page 11. This page isdetachable for ease of reference.

Answer TWO of the three questions in Section B on pages 14 to 19.

Maths tables and formulae are provided on pages 21 to 25.

The list of verbs as published in the syllabus is given for reference on page27.

Write your candidate number, the paper number and examination subject titlein the spaces provided on the front of the answer book. Also write yourcontact ID and name in the space provided in the right hand margin and sealto close.

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


2/28

November 2010 2 Financial Strategy

DEF Airport

Pre-seen case study

OverviewDEF Airport is situated in country D within Europe but which is outside the Eurozone. The local

currency is D$. It is located near to the town of DEF. It began life in the 1930s as a flying cluband was extended in 1947, providing scheduled services within central Europe. A group of fourlocal state governments, which are all in easy reach of the airport (hereafter referred to as theLSGs), took over the running of the airport in 1961. The four LSGs are named North (NLSG),South (SLSG), East (ELSG) and West (WLSG). These names place their geographical locationin relation to the airport. In the early 1970s flights from the airport to European holidaydestinations commenced with charter flights operated by holiday companies. In 1986, the firsttransatlantic flight was established and the airport terminal building was extended in 1987.

By 1989 the airport was handling 500,000 passengers per year which is forecast to increase to3.5 million for both incoming and outgoing passengers in the current financial year to 30 June2011. The airport mainly serves holidaymakers flying to destinations within Europe and only 5%of the passengers who use the airport are business travellers.

DEF Airport was converted into a company in 1990 and the four LSGs became theshareholders, each with an equal share. The company is not listed on a stock exchange. Theairport has undertaken extensive development since 2000, with improvements to its singleterminal building. The improvements have mainly been to improve the airports cateringfacilities and to increase the number of check-in desks. There has also been investment in theaircraft maintenance facilities offered to the airlines operating out of the airport.

GovernanceThe Board of Directors has four Executive directors: the Chief Executive, the Director ofFacilities Management, the Finance Director and the Commercial Director. In addition there is aCompany Secretary and a Non-Executive Chairman. In accordance with DEF Airports Articlesof Association, the Non-Executive Chairman is drawn from one of the four LSGs. The Non-

Executive Chairman is the sole representative of all four LSGs. The Chairmanship changesevery two years with each of the four LSGs taking turns to nominate the Chair.

The four LSGs have indicated that they may wish to sell their shareholdings in the airport in thenear future. If any LSG wishes to sell its shares in the airport it must first offer them to the otherthree LSGs. Any shares that are not purchased by the other LSGs may then be sold on theopen market. A local investment bank (IVB) has written to the Chairman expressing an interestin investing in the airport in return for a shareholding together with a seat on the Board.

Mission statementThe Board of Directors drew up a mission statement in 2008. It states At DEF Airport we aimto outperform all other regional airports in Europe by ensuring that we offer our customers arange of services that are of the highest quality, provided by the best people and conform to the

highest ethical standards. We aim to be a good corporate citizen in everything we do.

DEF Airport development planThe Board of Directors produced a development plan in 2009. The Board of Directors consultedwith businesses in the area and followed central government airport planning guidelines. It wasassumed that the views of other local stakeholders would be represented by the four LSGswhich would feed comments to the Board through the Chairman.

The plan relates to the development of DEF Airport and its forecast passenger growth for thenext two decades. The Board proposed that future development of the airport will be phasedand gradual in order to avoid unexpected consequences for the local communities and industry.


3/28

Financial Strategy 3 November 2010

Strategic objectivesThe following strategic objectives have been established in the development plan:

1. Create a planning framework which enables DEF Airport to meet the demands of theforecast passenger numbers;

2. Reduce to a minimum the visual and audible impacts of the operation of the airport on

the local environment;3. Ensure that the airport is financially secure;4. Improve land based access to the airport;5. Minimise the pollution effects of the operation of the airport.6. Maintain / increase employment opportunities for people living close to the airport.

By the year ending 30 June 2015, DEF Airport is expected to support about 3,000 local jobsand have a throughput of 5 million passengers per year, an increase of 1.5 million from the 3.5million passengers forecast for the current financial year ending 30 June 2011. In order toaccommodate the forecast increased number of passengers and attain the developmentobjectives, it will be necessary for the airport to extend its operational area to the east of theland it currently occupies.

Financial objectivesExtracts from DEF Airports forecast income statement for the year ending 30 June 2011 andforecast statement of financial position as at that date are presented in the Appendix. The fourLSGs have made it clear to the Board of Directors that the airport must at least achievefinancial self-sufficiency. The financial objectives of the airport are to ensure that:

1. The airport does not run at a loss;2. All creditors are paid on time;3. Gearing levels must not exceed 20% (where gearing is defined as debt to debt plus

equity) and any long-term borrowings are financed from sources approved by the fourLSGs.

Corporate Social Responsibility

A key feature of DEF Airports development plan is to develop Sustainable Aviation initiativesin order to reduce the effects of flying on the environment. One effect on the environment is thatthe airport is subject to specific planning restrictions affecting flights between the hours of 11p.m. (2300 hours) and 7 a.m. (0700 hours) to reduce aircraft noise. Flights are permittedbetween these times, but must be specially authorised. Typically, flights between these timeswould be as a result of an emergency landing request.

A leading international consultancy, QEG, which specialises in auditing the corporate socialresponsibility (CSR) issues of commercial enterprises, has offered to provide a CSR audit toDEF Airport free of charge. QEG is based in the USA and hopes to expand by offering itsservices to European enterprises.

DEF Airports competitors

TUV Airport is located about 100 kilometres away from DEF Airport and serves a highlypopulated industrial city. The Board of Directors of DEF Airport considers TUV Airport to be itsmain competitor. There are another three competing airports within 80 kilometres of DEFAirport. TUV Airport purchased one of these three competitor airports and subsequentlyreduced services from it in order to reduce the competitive threat to itself.

AirlinesAirlines are keen to negotiate the most cost effective deal they can with airports. DEF Airportapplies a set of standard charges to airlines but is aware that some of its competitor airportshave offered inducements to airlines in order to attract DEFs business.

Airlines across the world are facing rising fuel and staff costs as well as strong competition fromwithin the industry. There has been an overall increase in customer demand for air travel in

recent years and low-priced airlines have emerged and are threatening the well-established,


4/28


traditional airlines. Consequently, the traditional airlines have begun to cut the number ofdestinations to which they fly.

There are several low-priced airlines that serve DEF Airports competitors, but only one, S, alsooperates out of DEF Airport. S is exploring ways in which it might increase its flights to andfrom DEF Airport.

DEFs Board of Directors has been approached by a North American airline that wishes tooperate services from DEF Airport. This airline specialises in flights for business and first classpassengers. However, this airline insists that it would pay DEF Airport in US$. This is contraryto the airports policy of accepting payment only in D$, which is the local currency.

Analysis of revenue by business segmentThe forecast split of total revenue of D$23.4 million by business segment for the currentfinancial year ending 30 June 2011 is:

%Aviation income 48Retail concessions at the airport 20Car Parking 15

Other income 17(Other income includes income from property rentals, and other fees and charges.)

DEF Airport offers discounts for prompt payment.

Aviation incomeIn addition to the standard charges, which are set out below, there is a range of surchargeswhich are levied on airlines for such items as noisy aircraft (charged when aircraft exceed theGovernment limits for acceptable noise levels), recovery of costs and expenses arising fromcleaning or making safe any spillages from aircraft and extraordinary policing of flights (forexample, arrests made as a result of anti-social behaviour on aircraft).

Standard charges made by DEF Airport to the airlines:

Charges per aircraft

Landing charges large aircraft: D$300Landing charges medium aircraft: D$170

Parking charges for the first two hours are included in the landing charge. Thereafter, a chargeof D$200 per hour is imposed for each large aircraft and D$250 per hour for each mediumaircraft. The parking charge is lower for large aircraft because they take at least two hours toclean and refuel, so they almost always have to pay for an hours parking, and also becausethere is less demand for the parking areas used for large aircraft. Medium aircraft tend to takeoff again within one hour of landing. Approximately 10% of medium sized aircraft landingsresult in the airline incurring parking charges for one hour. This is normally either because their

scheduled departure time requires them to park or because of delays imposed by air trafficrestrictions, technical malfunctions or problems with passengers.

Charges per passengerPassenger Load:

Flights to European destinations:Flights outside Europe:

D$1.60 per departing passengerD$4.00 per departing passenger

Passenger security D$1.20 per passenger arriving or departing


5/28


Retail concessionsDEF Airport provides the facilities for a range of shops, bureau de change (dealing in foreignexchange currency transactions for passengers), bars and cafes for the budget consciouspassenger.

DEF Airport has a monopoly in the provision of retail concessions and therefore faces no

competition.

Car parkingCar parking is an important source of DEF Airports revenue. The airport has extended its owncar parking facilities for customers over recent years. Car parks occupy a large area of whatwas green belt land (that is land which was not previously built on) around its perimeter. Theland was acquired by the airport specifically for the purpose of car parking. A free passengerbus service is provided to take passengers to and from the car parks into the airport terminalbuilding.

Competitors have established alternative car parking facilities off-site and provide bus servicesto and from the airports terminal. The parking charges made by the competitors are lower thanthose levied by the airport. Competitor car park operators offer additional services to

passengers, such as car maintenance and valeting, which are undertaken while the car is left intheir care.

DEF Airport does not have a hotel on its premises. There is a hotel within walking distance ofthe airport which offers special rates for passengers to stay the night before their flight and thento park their cars at the hotel for the duration of their trip.

Other incomeThis heading contains a mixture of revenue streams. The Commercial Director reported thatsome have good growth prospects. Property rental income is likely to decline though as therehas been much building development around the airport perimeter.

DEF Airport security

Passengers and their baggage are required to go through rigorous security checks. There is afast track service provided which can be accessed by all passengers at an extra charge. This isintended to speed up the security process. However, on some occasions this leads topassengers on the normal route becoming frustrated because they are required to wait inlengthy queues to pass through the security checks. Airport security staff are required by law tosearch all departing passengers and their baggage for suspicious or dangerous items. On thevery rare occasions that they discover anything they report their concerns to the police. Thereare always several police officers on patrol at the airport at any given time and so the policecan respond to any report very quickly.

In addition to passenger and baggage screening, DEF Airport security staff are responsible forthe security of parked aircraft and airport property. They do this primarily by monitoring allarriving and departing vehicles and their drivers and by monitoring the many closed circuit

television cameras that cover the airport.

The airport has had a good record with regard to the prevention of theft from passengerbaggage. This is frequently a serious matter at other airports, but DEF Airport has received veryfew complaints that baggage has been tampered with. DEF Airports Head of Security regardsthe security of baggage as very low risk because of this low level of complaints.

The Head of Security at DEF Airport was appointed to his current role in 1990, when the airportwas very much smaller than it is today. He was a police sergeant before he joined the airportstaff. Immediately before his appointment he was responsible for the front desk of DEF townsmain police station, a job that involved managing the day-to-day activities of the other policeofficers on duty. He was happy to accept the post of Head of Security because the policeservice was starting to make far greater use of computers. He had always relied on a

comprehensive paper-based system for documenting and filing reports.


6/28


The Head of Security is directly responsible for all security matters at DEF Airport. In practice,he has to delegate most of the actual supervision of staff to shift managers and team leadersbecause he cannot be expected to be on duty for 24 hours per day or to manage the securityarrangements in great detail while administering the security department. The overallresponsibilities of the Head of Security have not been reviewed since his appointment.

Strategic optionsThe Board of Directors is now actively considering its strategic options which could beimplemented in the future in order to meet the strategic objectives which were set out in theairports development plan.


7/28


APPENDIX 1

Extracts of DEF Airports forecast income statement for the year ending 30 June2011 and statement of financial position as at 30 June 2011

Forecast income statement for the year ending 30 June 2011

Note D$000

Revenue 23,400Operating costs 1Net operating loss

(25,450)(2,050)

Interest income 70Finance costs (1,590)Corporate income tax expenseLOSS FOR THE YEAR

(130)(

3,700)

Forecast statement of financial position as at 30 June 2011

ASSETSD$000

Non-current assets 150,000Current assetsInventories 400Trade and other receivables 9,250Cash and cash equivalentsTotal current assets

3,030

Total assets12,680

162,680

EQUITY AND LIABILITIESEquityShare capital 2 17,700

Share premium 530Revaluation reserve 89,100Retained earningsTotal equity

23,200130,530

Non-current liabilitiesLong term borrowings 3 22,700Current liabilitiesTrade and other payablesTotal liabilities

9,450

Total equity and liabilities32,150

162,680

Notes:

1. Operating costs include depreciation of D$5.0 million.2. There are 17.7 million ordinary shares of D$1 each in issue.3. The long-term borrowings comprise a D$6.3 million loan for capital expenditure which

is repayable on 1 July 2015 and D$16.4 million owed to the 4 LSGs. This has no fixedrepayment schedule and is not expected to be repaid in the next year.

End of Pre-seen MaterialThe unseen material begins on page 8

TURN OVER


8/28


SECTION A 50 MARKS

[You are advised to spend no longer than 90 minutes on this question]

ANSWER THIS QUESTION

Question One

Unseen case material

Background

Todays date is 25 November 2010.

The Directors of DEF Airport have recently received information that TUV Airport, a competitorairport located approximately 100 kilometres from DEF, is interested in acquiring the company.

TUV Airport is privately owned and has the overall financial objective of maximising shareholderwealth. Its strategic objectives support this financial objective by focussing on opportunities for

growth, both internally and by expansion through acquisition.

The Directors of DEF Airport have informed the four LSGs about the potential takeover bid andthe Directors and the LSGs have been discussing the implications of the sale of their shares toTUV Airport. On the one hand, the potential takeover bid appears quite attractive becauserunning the airport has proved to be very challenging in recent months due to a globaleconomic downturn. On the other hand, the LSGs are reluctant to give up direct control overlocal air transport and the interest income received on funds which the LSGs advanced to DEF.

The most likely date for the proposed takeover is considered to be 1 July 2011.

DEF Airports forecast financial statements for the year ending 30 June 2011 are set out in thepre-seen material on page 7. Financial and strategic objectives can be found on page 3.

Financial information for DEF Airport

Forecast revenue for the year ending 30 June 2011 can further be analysed by businesssegment as follows:

% D$ millionAviation income 48 11.23Retail concessions 20 4.68Car parking 15 3.51Other income 17 3.98TOTAL 100 23.40

Forecast total operating costs for the year ending 30 June 2011 are D$25.45 million.

Years ending 30 June 2012 and 30 June 2013

The total number of passengers is estimated to be 3.5 million in the year ending30 June 2011 and to grow by 5% in the year ending 30 June 2012 and then by 8% inthe year ending 30 June 2013.

Aviation income should be assumed to be directly related to the number of passengers.The average aviation income per passenger in the year ending 30 June 2011 isforecast to be D$3.21 and this is expected to increase at a rate of 4% a year in each ofthe years ending 30 June 2012 and 30 June 2013.

Car parking income should be assumed to be directly related to the number ofpassengers. The average car parking income per passenger is forecast to be D$1.00in the year ending 30 June 2011 and this is expected to increase at a rate of 10% a

year in each of the years ending 30 June 2012 and 30 June 2013.


9/28


Retail concessions and other income are expected to increase by 7% a year in each ofthe years ending 30 June 2012 and 30 June 2013 and are not dependent on passengernumbers.

Operating costs excluding depreciation are expected to increase by 4% a year ineach of the years ending 30 June 2012 and 30 June 2013. Operating costs are notdependent on passenger numbers.

Depreciation is expected to remain constant at D$5 million in each of the years ending30 June 2012 and 30 June 2013. No capital expenditure or disposals of non-currentassets are planned for either of these two financial years.

Working capital is expected to remain constant. The interest rate payable on borrowings is 7%. No repayments of long-term borrowings

are due in each of the years ending 30 June 2012 and 30 June 2013. Interest of 4% isreceived on cash and cash equivalents. Interest should be calculated on the openingbalances of borrowings and cash and cash equivalents in each year.

Corporate income tax is charged at 30% on taxable profits and is paid at the end of theyear in which the taxable profit arises. No tax refunds are available on losses for taxpurposes as these are carried forward to be offset against future taxable profits.

Tax depreciation allowances are available on a reducing balance basis at a rate of 25%per annum. On 1 July 2011, the opening balance of non-current assets that qualify fortax depreciation allowances can be assumed to be D$3 million.

Operating cash flows can be assumed to equate to operating profit or loss afteradjusting for the non-cash items specified above.

Year ending 30 June 2014 onwards

For the financial years ending 30 June 2014 to 30 June 2016, assume annual profits after tax ofD$6 million, D$8 million and D$9 million respectively and that these are equivalent to cashflows.

For the year ending 30 June 2017 onwards, assume annual profits after tax (that is, cash) growby 5% a year in perpetuity.

Valuation of DEF Airport

The Directors of DEF Airport consider 11% to be an appropriate after tax discount rate to use indiscounting future cash flows. All cash flows should be assumed to arise at the end of the year.

In the event of the acquisition going ahead, TUV Airport is expected to be able to benefit from aone-off synergistic benefit of D$3 million (after tax) in the year ending 30 June 2012. It payscorporate income tax at a rate of 30% and expects to be able to obtain tax relief on any futurelosses for tax purposes arising from DEF Airport by offsetting against taxable profits elsewherein the group in the same year..

The requirement for Question One is on page11 which isdetachable for ease of reference

TURN OVER


10/28


This page is blank


11/28


Required:

(a) Construct, for each of the financial years ending 30 June 2012 and 30 June 2013:

A forecast of the net cash flow for the year;

A statement of opening and closing balances for cash and cash equivalents

and long term borrowings.

(13 marks)

(b) Assume you are an external consultant engaged by the Board to prepare a report on thefactors that need to be considered should a takeover bid be received from TUV Airport.

Write a report addressed to the Board in which you:

(i) Calculate a range of values for DEF Airport as at 1 July 2011. Discuss your

results and advise on an appropriate valuation for use in negotiations withTUV Airport.

(Up to 7 marks are available for calculations)

(14 marks)

(ii) Explain the main differences in the financial objectives of public and private sector

organisations, illustrating your answer by reference to the stated financial

objectives of both DEF Airport and TUV Airport.

(8 marks)

(iii) Discuss the strategic implications of the proposed sale of the business for the

LSGs and also for each of the other major stakeholder groups. Advise the LSGs

whether or not to negotiate a sale of the business to TUV Airport.

(12 marks)

Additional marks available for structure and presentation: (3 marks)

(Total for Question One = 50 marks)

(Total for Section A = 50 marks)

End of Section ASection B starts on page 14

TURN OVER


12/28


Section B starts on page 14


13/28


Section B starts on page 14

TURN OVER


14/28


SECTION B

[You are advised to spend no longer than 45 minutes on each question in this section]

ANSWER TWOOF THE THREE QUESTIONS 25 MARKS EACH

Question Two

Todays date is 25 November 2010.

GUC provides gas utility products and services in South America. Its functional currency is P$.The Board is considering raising additional finance to provide capital for future acquisitions.

Three alternative sources of finance are being considered:

1) New equity by means of a rights issue at a 15% discount to current share price.

2) A five year bond with a yield of 0.5% below the industry average yield for comparable bonds.

3) A convertible bond issued at par with a coupon rate of 3%. The bond would beconvertible into ordinary shares in five years time at the ratio of 11 ordinary shares perP$100 nominal of the bond.

Extracts from the financial statements of GUC for the year ended 30 September 2010 and otherrelevant financial information are shown below:

Revenue P$4,500 million

Earnings P$ 864 million Number of equity shares in issue (par value 50 cents) 785 million Share price as at 30 September 2010 P$8.20

Share price as at 25 November 2010 P$7.70 Industry average P/E ratio 8.4 Gearing ratio (debt:debt+equity, current market values) 34% Industry average gearing ratio 45% Corporate income tax rate 30%

GUC forecasts that the share price will grow in line with the expected growth in earnings anddividends of 6% per annum. The yield to maturity for bonds without conversion rights, issuedby utility companies of similar size to GUC, is currently 6.5%

The shareholder profile is as follows:

Institutions (such as pension funds etc) 72%

Small individual non-employee investors 15%Employees and directors 13%


15/28


Required:

(a) Calculate:

(i) GUCs current cost of equity(ii) The gross yield to maturity of the convertible bond up to and including

conversion, assuming the convertible bond is issued on 25 November 2010.

State any assumptions made.

(10 marks)

(b) Evaluate the THREE alternative methods of finance being considered by GUC andadvise which method might be most appropriate.

(15 marks)

(Total for Question Two = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

Section B continues on the next page

TURN OVER


16/28


Question Three

PEI is a privately-owned college of higher education in the UK. It competes directly with otherprivate and government-funded schools and colleges. The college directors are considering twoinvestment opportunities that would allow the college to expand in the UK (known as Projects Aand B) and a third opportunity to set up a satellite training centre in a foreign country (known as

Project C). Ideally, it would invest in all three projects but the company has only GBP 25 millionof cash available (where GBP is British Pounds). PEI currently has borrowings ofGBP 50 million and does not wish to increase indebtedness at the present time. PEIs sharesare not listed.

The initial capital investment required (on 1 January 2011) and likely net operating cash inflowsarising from the investments in each project are as follows.

InitialInvestmentGBPmillion Net Operating Cash inflows (after tax)

Project A 15.50 GBP 1.75 million each year from year 1 indefinitely.Project B 10.20 GBP 1.15 million in year 1, and GBP 3.10 million a year in years 2 to 7.Project C 9.50 A$ 9.30 million each year for years 1 to 5.

Notes:

1. The projects are not divisible.

2. Project B has a residual value of GBP 2.5 million. The other projects are expected tohave no residual value.

3. Projects A and B are to be discounted at 8%. The Finance Director considers that a GBPdiscount rate of 9% is more appropriate for Project C as it carries slightly greater risk.

4. The GBP/A$ exchange rate is expected to be GBP/A$ 2.00 on 1 January 2011 (that is,GBP 1 = A$ 2.00). The A$ is expected to weaken against GBP by 1.5% per annum forthe duration of the project.

5. Assume cash flows, other than the initial investment, occur at the end of each year.


17/28


Required:

(a)(i) Calculate the NPV and PI of each of the THREE projects based on the

GBP cash flows.(8 marks)

(ii) Evaluate your results and advise PEI which project or combination ofprojects to accept.

(7 marks)

(b) Explain the alternative method of evaluating Project C using an A$ discount rate,illustrating your answer with a calculation of an appropriate A$ discount rate.

(4 marks)

(c) Discuss the key financial factors, other than the NPV decision, that should beconsidered before investing in a project located in a foreign country rather thanthe home country.

(6 marks)

(Total for Question Three = 25 marks)


Section B continues on the next page

TURN OVER


18/28


Question Four

ADS operates a number of large department stores based in a developed country in Asia. Itsshares are listed on an Asian stock exchange. It has shown year-on-year growth in earningsand dividends every year since it became a listed company in 2000. Some years have shown

better growth than others but even in a relatively poor year earnings in real terms have beenhigher than in the previous year. It is currently all-equity financed. Approximately half of itsshareholders are institutional investors; the other half is made up of large holdings by theoriginal founding family members and small investors including many employees of ADS.

The directors of ADS are proposing to raise A$250 million to invest in new, smaller stores. Thisinvestment will carry similar risk to ADSs current business. It is proposed that the investmentwill be financed by an issue of an undated bond carrying 5% interest pre-tax. This rate isdeemed to reflect the returns required by the market for the risk and duration of the bond.Some of the directors are reluctant to agree to debt finance as they think it will lower the valueof equity and this might be a matter of concern for shareholders. The investment is planned forthe end of 2010.

The following information is relevant:

Earnings for ADS are forecast to be A$127.1 million in 2011. This forecast assumesthat the new stores are already fully operational at the start of 2011. From the year2012 onwards, earnings are expected to increase at a rate of 4% per annumindefinitely.

The corporate income tax rate is 25%. This is not expected to change.

The cost of equity for ADS as an all-equity financed company is 9%.

There are 300 million shares in issue, currently quoted at A$8.50.

One of ADSs directors has recently read an article about company valuation and thedifferences between Modigliani and Miller (MM) models and the traditional view.


19/28


Required:

(a) Discuss:

How the MM models, both with and without corporate taxes, differ from thetraditional view of the relationship between gearing and cost of capital.Accompany your discussion with appropriate graphical illustrations.

The limitations of MM models in real world situations.

(10 marks)

(b)

(i) Calculate the value of ADSs equity using discounted cash flow techniques,

assuming that the new stores are financed by equity.

(2 marks)

(ii) Calculate, assuming that the new stores are financed by the undated bond andusing the MM model with corporate taxes, the following:

The value of ADSs equity; The expected cost of equity; The weighted average cost of capital (WACC).

(6 marks)

(c) Explain your results in (b) above and advise the directors whether their concernabout lowering the value of equity is valid.

(7 marks)

(Total for Question Four = 25 marks)


(Total for Section B = 50 marks)

End of Question Paper

Maths Tables and Formulae are on Pages 21 25


20/28


Maths Tables and Formulae are on Pages 21 25


21/28


22/28


Cumulative present value of 1.00 unit of currency per annum

Receivable or Payable at the end of each year for nyears

+

r

r n)(11

Periods(n)

Interest rates (r)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 1.7363 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.4874 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.1705 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 4.3557 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.8688 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.3359 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 6.49512 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 7.824

17 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

Periods(n)

Interest rates (r)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 0.8332 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.5283 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.1064 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.5895 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 3.3267 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 3.8379 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 4.32712 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


23/28


FORMULAE

Valuation models

(i) Irredeemable preference shares, paying a constant annual dividend,d, in perpetuity, where P0

P

is the ex-div value:

0

prefk

d=

(ii) Ordinary (equity) shares, paying a constant annual dividend,d, in perpetuity, where P0

P


0

ek

d=

(iii) Ordinary (equity) shares, paying an annual dividend,d, growing in perpetuity at a constant rate, g, whereP0

P


0

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

P

is the ex-interestvalue:

0

netd

][1

k

ti =

or, without tax: P0dk

i=

(v) Total value of the geared entity, Vg

V

(based on MM):

g = Vu

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

+ TB

S = X[1 + r]

(vii) Present value of 100 payable or receivable in nyears, discounted at r% per annum:

n

PV=n

r][1

1

+

(viii) Present value of an annuity of 100 per annum, receivable or payable for nyears, commencing in oneyear, discounted at r% per annum:

PV=

+

n

rr ][1

11

1

(ix) Present value of 100 per annum, payable or receivable in perpetuity, commencing in one year,discounted at r% per annum:

PV=r

1

(x) Present value of 100 per annum, receivable or payable, commencing in one year, growing in perpetuity ata constant rate of g% per annum, discounted at r% per annum:

PV=gr

1


24/28


Cost of capital

(i) Cost of irredeemable preference shares, paying an annual dividend,d, in perpetuity, and having a currentex-div price P0

k

:

pref

0P

d=

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

k

:

dnet

0P

ti ][1 =

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

k

:

e =

0P

d

(iv) Cost of ordinary (equity) shares, having a current ex-div price,P

0, having just paid a dividend, d0

k

, with thedividend growing in perpetuity by a constant g% per annum:

e = gP

d

+0

1

or ke = gP

gd

+

+

0

0]1[

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

ke = Rf +[Rm Rf

]

(vi) Cost of ordinary (equity) share capital in a geared entity :

keg = keu + [keu kdE

D

V

tV ][1]

(vii) Weighted average cost of capital, k0

WACC= k

or WACC

++

+

DE

D

DE

E

VV

V

tVV

V

dk ][1e

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

Kadj = keu

[1 tL] or r*= r[1 T*L]

(ix) Ungear :

u =

+ ][1 tVV

V

DE

Eg +

+ ][1

][1

tVV

tV

DE

Dd

(x) Regear :

g = u+ [u dE

D

V

tV ][1]

(xi) Adjusted discount rate to use in international capital budgeting (International Fisher effect)

A$/B$rateSpot

timemonths'12inA$/B$ratespotFuture

A$ratediscountannual1

B$ratediscountannual1=

+

+

where A$/B$ is the number of B$ to each A$


25/28


Other formulae

(i) Expectations theory:

Future spot rate A$/B$ = Spot rate A$/B$ x

rateinterestnominal1

rateinterestnominal1

countryA

countryB

+

+

where:

A$/B$ is the number of B$ to each A$, and

A$ is the currency of country A and B$ is the currency of country B

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

Future spot rate A$B$ = Spot rate A$/B$ xrateinflation1

rateinflation1

countryA

countryB

+

+

(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[(Nx cum rights price) + issue price]

(vi) Value of a right:

N

priceissuepricerightsexlTheoretica

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


26/28


This page is blank


27/28


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 foreach question in this paper.

It is important that you answer the question according to the definition of the verb.

LEARNING OBJECTIVE VERBS USED DEFINITION

Level 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

Level 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 or

purpose of

Identify Recognise, establish or select afterconsideration

Illustrate Use an example to describe or explainsomething

Level 3 APPLICATION

How you are expected to apply your knowledge. Apply

Calculate

Put to practical use

Ascertain or reckon mathematically

Demonstrate Prove with certainty or to exhibit by

practical means

Prepare Make or get ready for use

Reconcile Make or prove consistent/compatible

Solve Find an answer to

Tabulate Arrange in a table

Level 4 ANALYSISHow 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 Build up or compile

Discuss Examine in detail by argument

Interpret Translate into intelligible or familiar terms

Prioritise Place in order of priority or sequence for action

Produce Create or bring into existence

Level 5 EVALUATION

How are you expected to use your learning to

evaluate, make decisions or recommendations.

Advise

Evaluate

Recommend

Counsel, inform or notify

Appraise or assess the value of

Advise on a course of action


28/28

Financial Pillar

Strategic Level Paper

F3 Financial Strategy

November 2010

Thursday Morning Session

Documents

F3 Nov 2010 Exam Paper