Financial Management - Professional Stage – December 2011

MARK PLAN AND EXAMINER’S COMMENTARY
The marking plan set out below was that used to mark this question. Markers were encouraged to use
discretion and to award partial marks where a point was either not explained fully or made by implication.
More marks were available than could be awarded for each requirement. This allowed credit to be given for a
variety of valid points which were made by candidates.

Question 1
Total Marks: 24
A question that exposed weaknesses in both technical knowledge and in the ability of candidates
to reflect accurately on the methodologies they have employed.
(a)(i)
Ordinary shares
Ke = D0 (1 + g) / P0 + g
Ke = 0.104(1 + 0.04)/(2.42 – 0.104) + 0.04
Ke = 8.7%
MVe = £138.96m (ex-div share price 231.6p x 60m)
5% irredeemable preference shares
Kp = D / P0
Kp = 5 / 103.5 x 100
Kp = 4.83%
MVp = £25.875m (£103.50 x 25m)
9% redeemable loan stock
T0
T1-7
T7

Cashflows
Ex-interest market price (117.00)
Interest (after-tax 9 x 0.72) 6.48
Repayment of capital
100.00

1%df
1
6.728
0.933

PV
(117.00)
43.60
93.30
19.90

5%df
PV
1
(117.00)
5.786
37.49
0.711
71.10
(8.41)

Kd = 0.01 + {(19.90/(19.90 + 8.41) x 0.04}
Kd = 3.8%
MVd = £23.4m
WACC
(MVe x Ke) + (MVp x Kp) + (MVd x Kd) / MVe + MVp + MVd
(12,089,520 + 1,249,763 + 889,200) / 188,235,000
WACC = 7.56%
(a) (ii) There are some problems with the DVM’s underlying assumptions, as follows:
1. Shares have value because of the dividends, which is not always true – some firms have a deliberate
policy of no or low dividend payouts, which would render any valuations using the methodology rather
unrealistic
2. Dividends do not grow or grow at a constant rate, but the former is unrealistic, and whilst the latter may
be realistic in the long term it can be subject to short-term fluctuations which undermine calculations of
the cost of equity
3. Estimates of dividend growth rates tend to be based on historic patterns rather than the actual future
facing the firm and its likely future earnings, consideration of which might produce more meaningful
cost of equity calculations
4. Share prices are constant, which is clearly not the case
In the first section, the most common error in calculating the cost of equity was failure to deduct
the dividend from the cum-dividend share price. In calculating the cost of the irredeemable
preference shares, many candidates incorrectly incorporated tax into their answers. Most
candidates coped well with the remaining sections of this part of the question.
Total possible marks
11
Maximum full marks
10

Copyright © ICAEW 2012. All rights reserved

Page 1 of 6

3. Knowledge of the cost of equity enables managers to make investment decisions that maximise shareholder value 4. according to Modigliani and Miller (with taxes) the larger loan stock issue should lower the firm’s WACC and increase shareholder wealth as the value of the additional tax relief is transferred to the shareholders However. 5. ultimately to a greater extent than the tax relief would increase it (as also evidenced in traditional theory) Appropriate reference to the following issues was also rewarded: Agency costs Tax exhaustion Generally well answered. 4. in practice.Professional Stage – December 2011 (b) 1. 2. Total possible marks Maximum full marks 4 4 (d) In theory. Managers can use knowledge of the cost of equity in their financing decisions Generally well answered. All rights reserved 8 6 Page 2 of 6 . Total possible marks 5 Maximum full marks 4 (c) 1. Total possible marks Maximum full marks Copyright © ICAEW 2012. Knowledge of the cost of equity enables managers to determine which prospective projects should be accepted and which should be rejected based on the shareholders’ minimum required rate of return 3. The cost of equity indicates the shareholders’ required rate of return and so acts as a minimum required rate of return for investment projects 2. There may be changes in future sources of finance or capital structure The new project may be in a different risk class to the firm’s existing activities The tax rate may alter during the course of the project There may be changes in the dividend growth rate in future The finance for the new investment may be project-specific The vast majority of candidates picked up the first two marks here but a much lower number went on to pick up either of the last two marks.Financial Management . financial risk may increase as the existence of greater fixed return commitments would have the effect of making returns to shareholders more variable without any alteration in business risk Taken to high levels the risk of bankruptcy could adversely affect share prices and actually lower shareholder value.

000 WDA 1. Including irrelevant costs (interest charges and the consultancy fee).6875 7.880 10.273) 8.000 Balancing allowance £96. Choosing to completely omit the effects of inflation on cash flows.100.000 Proceeds 4.Financial Management .400 2014: 5.692.722.800 (611.600. Correctly calculating capital allowances but starting them in 2013 rather than 2012.000 (20%) Tax saving (28%) £358.005.000.000) 3.593.03) = 0.072 286.636) (131.024.000.1 x 1.037.308) (106.720 2015: 4.03) = 0. All rights reserved Page 3 of 6 .414.Professional Stage – December 2011 Question 2 Total Marks: 28 Very much the question most to the liking of the majority of candidates sitting the paper.534.000 WDA 1.400 3.400. 2.262 Omission of the £168. 3.540) (127.000) Capital allowances (W2) 448.7790 4.664) 4.000) NPV 6.895 2013 2014 5.000 consultancy fee Positive NPV.873.8826 2 2014: 1/(1. it tended to be as a result of one or more of the following errors: 1. Failing to adjust the discount factors correctly to reflect the impact of inflation.000 (20%) Tax saving (28%) £448.03) = 0.290 (840.820) (111.000 x 1.120.720.552.306 (865.801 (2.000 x 1.438. increase in shareholder wealth) in order to gain full marks.880 W3: Discount factors 2013: 1/(1.096.03 3 2015: 720 x 150 x 90 = £9.090) 6.236.8826 2.03 2 2104: 720 x 125 x 90 = £8.1 x 1. positive NPV. however.000) (123.000 annual interest charges Omission of the £36.518. 4.1 x 1.157 (1.600) (103.000 2013: 6.000 WDA 1.621.000 Tax saving (28%) £26.000 (20%) Tax saving (28%) £286.962) (636. to not only state what their recommendation is (too many candidates fail to do even this). but to specifically state why (i.127) (109.000 x 1.03 W2: Capital allowances 2012: 8.623.804) 429.7790 3 2015: 1/(1. Candidates must also take care.000 26.e.280.084.561 2015 10.6875 There were very many instances of full marks on this part of the question. Where candidates did fall short of that.665 358.000 Post-tax net cash flow (7.151 0.860.017 0.233) (190.440) (236. when giving their final recommendation.240) (618.290 8. therefore accept the project W1: Sales revenue 2013: 540 x 100 x 90 = £4. Total possible marks 17 Maximum full marks 17 Copyright © ICAEW 2012.000.738 0.140 (962. (a) 2012 Revenue (W1) Port charges Administration costs Labour costs Advertising Servicing/maintenance Pre-tax net cash flow Tax (28%) Subsidy Ferry purchase/disposal (8.552.000) Discount factor (W3) 1 PV (7.029) (655.679) 250.000.311.720 5.

again.814.257.Financial Management .306 (2.800 (1.290 3.2% The PV of sales revenue could fall by 47.466 0. thereby losing half the available marks. although some candidates insisted on discussing either sensitivity analysis or NPV analysis instead of simulation.973. All rights reserved Page 4 of 6 .290 (2.665 6.624) 250. The answer was drawn directly from the learning materials and consequently rewarded those candidates who had learnt them – too many hadn’t.814.952 13. not at all sensitive to changes in the residual value of the new ship This part of the question was.647.6875 x £4m} alongside which there would be an increase in the balancing allowance of £1.7790 5.121) 429.621.895/13. Total possible marks 7 Maximum full marks 5 Copyright © ICAEW 2012.Professional Stage – December 2011 (b) (i) PV of sales revenue: Rev Tax Sub NCF df PV NPV 2013 5.514 2015 10. therefore.12m) the project would still retain a positive NPV The NPV is.616.406.012 2014 8.854.401. unlike sensitivity analysis which changes just one variable at a time It gives more information about the possible outcomes and their relative probabilities It is useful for problems which cannot be solved analytically (ie.966) 7.340 0.593.6875 5.005.518.8826 3. Total possible marks 6 Maximum full marks 6 (c) Advantages: It enables any number of variables to be amended simultaneously.401. only for obtaining more information about the possible outcomes It can be expensive and very time-consuming with or without a computer Some simulations depend on assumptions regarding probability distributions and the relationships between variables that may not be appropriate in a given scenario It is difficult in practice to implement Generally well answered. it should have been apparent that the project was not at all sensitive (in the traditional sense of generating an NPV of zero) to a fall in the estimated residual value of the ship.834 0. In the second section.012 x 100 = 47. even without making any calculations at all.154.546 Sensitivity = Project NPV/PV of the uncertain cash-flow x 100 Sensitivity = 6. those that cannot be reduced to a precise mathematical solution) Limitations: It is not a technique for making a decision. generally well answered although taxation and the subsidy were often omitted from answers to section (i).2% before the NPV = 0 (ii) Even if the residual value of the ship fell to zero (its maximum possible fall – which would reduce the project’s NPV by {0.

such that an investor would be indifferent between investing one currency at that country’s interest rate or converting the currency at spot into a second currency and investing that second currency at its country’s interest rate. Market and promotional management (balancing market risks and potential) 3.813.17475 – 1.798.000. Pricing management decisions (in response to actual and anticipated exchange rate changes) Copyright © ICAEW 2012.1745/£ (a)(iv) The real cost of the up-front premium is £100.405 (a)(v) The principle of interest rate parity holds that. a forward premium of 1.000/1.000/1.17184 = 0.000/1.530 compared to £29.000.1734/£ €35. (a)(i) €1.1172 = £31.166.009375(euro)/1.000.125 If the spot rate is €1.653.000/1. supplies and finance sources 2. not launch etc.14/£ The amount received at spot is €35.17185 ie.1760/£ x 95% = €1.01 = €34.754 compared to £29. IRP suggests 1.14 = £30.827. International diversification of sales.000/1.20/£ The amount received at the exercise price is €35.232 x (1 + 0. when foreign exchange markets are in equilibrium.328. in response to actual and anticipated exchange rate changes) 4. it polarised performance between those with a firm grasp of the material (who scored strongly) and a significant minority who have little grasp at all of the mechanics of the subject.914.000.465/1.1734 = £29.17 = £29.000.667 at spot so the option will be exercised The net receipt will be £29.29 cents Average premium in data given is 0.629 If the spot rate is €1. drop.000/29.653. although as has been the case in the past.000.000 x 1.1172/£ €35.321 (a)(ii) Bank buys € (sells £) at €1.30 so IRP very nearly holds (which is why the forward and money market hedges give similar results) (a)(vi) Economic exposure is the risk that longer-term exchange rate movements might reduce a firm’s international competitiveness or its value Translation exposure is the risk that a firm will incur exchange losses when the accounting results of its foreign branches or subsidiaries are translated into the firm’s home currency (a)(vii) 1.Financial Management . whilst selling the proceeds forward on day one Using average spot ({bid+offer/2)} and interest rates.600.738 Effective forward rate = €35.701.1760 = £29.01125 = £101. the forward premium or discount between two currencies is reflective of the interest rate differential between the two countries – differences in interest rates are offset by differences between the spot and forward rates of exchange. production.011875(UK)) = 1.0029 or 0.0026 = €1.17475 x (1.914.851 (a)(iii) Borrow €35.738 = €1. All rights reserved Page 5 of 6 .530 under the option so the option will not be exercised The net receipt will be £30. Product management decisions (launch.465 Convert €34.467.01125) = £29.Professional Stage – December 2011 Question 3 Total Marks: 28 Performance on this question was generally satisfactory.1760 – 0.798.

the bank will pay Fulton £12. value of a contract = £50. in the final part of the question too many candidates referred to standardised contract sizes (not an issue in this case) rather than basis risk (which was the issue here). number of contracts required is 48.000/50.000 Gain on futures £960.69%} x 6/12) Fulton will pay £22.69%} x 6/12) Fulton will pay £52.000 x 100 = 94. Part four however proved more of a challenge. many candidates chose to address this question as if they were dealing with a traded option rather than an over-the-counter option.5% x 6/12) Net payment on the loan is £40.000 Overall position in September: Value of portfolio £46. the majority of candidates betrayed their lack of understanding of ‘depreciation’ of a currency . Total possible marks 6 Maximum full marks 6 (c)(i) Fulton needs to use a 3–9 FRA at 2.69%) The majority of candidates knew what to do here and did it accurately.000.000/1.1% The hedge inefficiency arises due to the incidence of basis risk A surprising number of candidates calculated the value of a single contract incorrectly.980.69% If the rate is 3.5% x 6/12) Net payment on the loan is £40.350 (= 2.800 Therefore. a failure to answer the precise question asked.Financial Management . All rights reserved Page 6 of 6 . There was a very mixed response to part six – for the most part either full marks or none at all.a reduction in its purchasing power.05.000 Spot value of FTSE 100 index = 5.69%) (c)(ii) If the rate is 1.350 (= 2. which specifically asked for a calculation of interest cash flows (not merely a statement of interest rates) and/or working with full-year rather an six-month figures.5%. The vast majority of candidates also understated the premium at £100. there was a generally firm grasp of IRP theory although few scripts gained full marks due to a lack of detail and.900 In September the investor buys 960 September contracts @ 4. whilst part seven had very few good answers – too many candidates listed a range of short term measures and scored zero marks. although a small number continued to add rather than deduct the forward premium.5%-2.000 Value of each point = £10 Therefore. Fulton will pay the bank £17.000 (b)(ii) Efficiency: gain on futures/loss on portfolio = 960. Total possible marks Maximum full marks 18 18 (b)(i) Value of portfolio as at 31 December = £48.5%-2. In addition.5%.500 on its loan at the market rate (£3m x 1.000 Therefore.150 (£3m x {3. even some of the candidates who knew this area of the syllabus let themselves down by either failing to answer the question.500 on its loan at the market rate (£3m x 3.940. The second part posed less problems for candidates. very often.000 Overall position £47. failing to use the approach adopted in the learning materials.850 (£3m x {1.000.000 = 960 Futures position: In December the investor sells 960 September contracts @ 4. Total possible marks 4 Maximum full marks 4 Copyright © ICAEW 2012. The third part of the question was generally well answered. The majority of candidates also calculated the hedge efficiency incorrectly.000. However.020. In the following part. the drop in price of the FTSE index futures = 100 points Value of futures gain = 100 x £10 x 960 = £960. Disappointingly.Professional Stage – December 2011 In the first part of the question. not an increase as most candidates suggested when they multiplied the spot rate by 1.