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Financial Management - Professional Stage – September 2011

PROFESSIONAL STAGE - FINANCIAL MANAGEMENT OT EXAMINER’S COMMENTS

The following table summarises how well candidates answered each syllabus content area.

How well candidates answered each syllabus area

Syllabus area Number of questions Well answered Poorly answered*

1 6 6 0

2 3 3 0

3 6 4 2

Total 15 13 4

* If 40% or more of the candidates gave the correct answer, then the question was classified as “well
answered”.

Details of the two questions with facilities of less than 40% are shown here:

1. Candidates were given a list of the costs (including lost contribution) for a company’s proposal to build a
new extension to its factory. They were also given the cost for the extension as per a quote from an external
contractor. They were asked to calculate the net gain or loss if the company did its own construction work.
The majority of those candidates who answered the question wrongly failed to deal correctly with the lost
contribution figure.

2. Candidates were given the details of two mutually exclusive three-year projects - initial investment in
equipment, scrap value of the equipment, cost of capital and NPV. They were asked to calculate the
sensitivity of the scrap value as regards which project to chose. Most candidates who answered the
question incorrectly failed to (i) deal with the impact of discounting correctly or (ii) tested the sensitivity of the
scrap value against the wrong variable.

© The Institute of Chartered Accountants in England and Wales 2011 Page 1 of 8

539.018 983.200) 433.355) 308.102) Fixed costs (W4) (442.805) (41.000 Tax saving @ 28% 72.300. Markers were encouraged to use discretion and to award partial marks where a point was either not explained fully or made by implication.000 2. Question 1 Total marks: 27 General comments This question had the highest average mark on the paper and most candidates did very well.310. Parts (b) and (c).000 0.600 WDA @ 20% (260.000 Tax saved on equipment (W1) 72.769 0.040.699 473.081.400) (65. 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.000) (166.240 46. Markers make every effort to read even the worst presentation. Financial Management .050) (206. The scenario was fairly standard and in part (a) for 12 marks candidates had to advise the directors of the company in question whether to proceed with a planned investment in capital equipment.040. asked candidates to calculate the sensitivity of their calculations in part (a).354 364.936) (182.000 832.458 14% factor 1.000 665. they would have had to show an understanding of the impact of taxation.296.300. Workings W1 2011 2012 2013 2014 £ £ £ £ WDV b/f 1. General point about candidates’ handwriting There were a number of instances in the scripts where the markers found it extremely difficult to read the candidates’ handwriting.000 665.224) (516.877 0.160 Total cash flows (1. In many cases.456.050 3.368 © The Institute of Chartered Accountants in England and Wales 2011 Page 2 of 8 .592 18. 1(a) 2011 2012 2013 2014 £ £ £ £ Capital equipment cost (1.365 1. To do well here.Professional Stage – September 2011 MARK PLAN AND EXAMINER’S COMMENTARY The marking plan set out below was that used to mark this question.084) Working Capital (W6) (231.000) (208.598 Variable costs (W3) (1. but if a marker is unable to read what has been written then no marks can be awarded for the passage in question. Part (e) for 4 marks required candidates to explain the theory behind Shareholder Value Analysis (SVA) and how SVA could be applied to the scenario.800 58. which were worth 9 marks in total.368 Sales (W2) 2.000 832. Part (d) for 2 marks asked candidates to demonstrate their knowledge of theory by asking for explanations of their treatment of interest in the NPV calculation.281 The NPV is positive and so UGL’s management should proceed with the proposed investment as it will enhance shareholder value.000) 600.458.109 NPV 269.000 1. It was a five-part question that tested the candidates’ understanding of the investment decisions element of the syllabus.458.800 58.000) (1.000) (35.829.482) Taxation on extra profit (W5) (159.800) (478. based on an NPV calculation.592 18.648) (1. capital allowances and the discount rate on their original figures.668.200) 380.240 46.675 PV (1.600 600.600) WDV/sale 1.

687) Net cash flow 730.000 x 1.178 736. the NPV will be negative and UGL should not proceed with the investment.281 = 14. forgetting to include the variable costs and taxation were the most common errors.050 x 1.050 3.014 Tax on extra profit @ 28% 159.936 182.10 2.081.224 £478.598 6.539.355) 308.668.699) (728.648) (1.Professional Stage – September 2011 W2 2011 2012 2013 2014 £ £ £ £ Sales £2.805) (41. Total possible marks 12 Maximum full marks 12 1(b) 2012 2013 2014 PV £ £ £ £ Sales 2.402 1.767 Sensitivity of sales volume is £269.668.4% £1.252.310.05 x 1.050 206.449 901.05 x 1.08 x 1.157.539.000 1.648) (1.050 x 10% 266. if sales volumes are 14. Total possible marks 5 Maximum full marks 5 © The Institute of Chartered Accountants in England and Wales 2011 Page 3 of 8 .829.280 624.668.10 3.Working Capital Total £2.797 Discount factor 0.873.296. Otherwise.829.769 0.598 x 10% 308.08 442.050 x 1.877 0.310.000 x 1. The most common errors were (i) to ignore the volume change for sales and variable costs or (ii) just the latter plus including the interest charge.598 W3 VC’s £1.296.08 478.310.648 £2.128.081.805 £3.668.10 1.496 2.000 £2.000) (35.000 2.310.800 £442.668.225) Contribution 1.767 So.08 1. ignoring the impact on working capital.555.800) (478.675 Total PV 640.668.080 812.000 £2.102 W4 FC’s (£427.454 less: Taxation (283. early mistakes made were not unduly detrimental.296.10 1.920) (315.102) FC’s (W4) (442.713 1.08 516.800 x 1.000 2.102) (3.4% lower than estimated. because the markers apply the “follow through” rule.081.000) (1.482 W5 Sales (W2) 2.050 £2.000) x 1.773 608.050 3.000 x 10% 231.000 £1.000 x 1. Financial Management .598 VC’s (W3) (1.310. In this part many candidates scored full marks.482) Extra profit 571.160 Change in working capital (231.000 x 1.£17.829.08 x 1.873.200 650.200.160 Here most candidates scored high marks and.000) (1.953) (350.224x 1.200.679 Variable costs (1.602.224) (516.084 W6 .081.05 2.014.539.296.000 .

000 £ Loss of scrap value (500. Cost of capital The value of the business is calculated from the cash flows generated by drivers 1-6 which are then discounted at the company’s cost of capital (driver 7).675) 243. This was not done well and far too many candidates did not know why the interest charge should have been excluded.000) Increase in balancing allowance (£500.000 and this means that the amended NPV would be £26. but candidates scored low marks if SVA was not adequately explained or if SVA’s value drivers were not related to part (a).000 Net decrease in cash flow (Y3) (360. Thus the interest payments will be dealt with as part of the WACC and so. UGL’s (three year) strategy of expanding its solar panel market will increase the value of the firm. In the case of UGL. Corporate tax rate 5. Investment in working capital 7. Sales growth rate 3. interest paid on funds borrowed. SVA posits that a business has seven value drivers: 1. Total possible marks 4 Maximum full marks 4 1(d) The process of discounting takes account of the time value of money. Total possible marks 4 Maximum full marks 4 © The Institute of Chartered Accountants in England and Wales 2011 Page 4 of 8 . Financial Management . to avoid double counting.281 – so a much more marginal decision for the UGL directors. SVA is based on the premise that the value of a business is equal to the sum of the present values of all of its activities. Operating profit margin 4. This was also generally done well. all of the seven SVA value drivers are relevant and are used in the calculation. This part was answered reasonably overall.g. it is necessary to ignore specific interest payments. e. Life of projected cash flows 2.000 x 28%) 140. but in the poorer scripts candidates forgot to take account of the impact of the balancing allowance on the new NPV figure.000) PV of loss of cash flow in 2014 (£360. Total possible marks 2 Maximum full marks 2 1(e) Shareholder Value Analysis (SVA) concentrates on a company’s ability to generate value and thereby increase shareholder wealth.000 x 0.000 Thus the NPV of the proposed scheme would decrease by £243.Professional Stage – September 2011 1(c) Impact of scrap value of £100. Investment in non-current assets 6.

21 x 8m) 1.50% x £16.4m x 110/100 1.5% (or 0. for 6 marks.000 20. d = 0.Professional Stage – September 2011 Question 2 Total marks: 27 General comments This question had the lowest average mark on this paper and caused problems for a large number of students It was a five-part question that tested the sources of finance and cost of capital elements of the syllabus.2m) 224. but a surprising minority could not calculate the number of shares and debentures.000 Preference dividends = £2. Finally.560. Total possible marks 5 Maximum full marks 5 © The Institute of Chartered Accountants in England and Wales 2011 Page 5 of 8 .014m) 55.100.80.000 Debenture interest = £1.56m x 8.000 Ordinary shares 10.560/£20. rather than being asked to calculate the company’s WACC.000 = 9.6% (or 0. For 4 marks in part (c) candidates were asked to explain the meaning of WACC as a hurdle rate.25) x £0.0875 = d/0. In part (a) for 4 marks.000 Irredeemable debentures £1. it was given in the formulae sheet. It was a good discriminator in that its structure will have caused candidates to plan their approach carefully. Also many OT’s in the learning materials require candidates to work backwards towards an answer. in the case of the Dividend Valuation Model.748% Part (b) was poorly done although a minority of candidates did secure full marks.114% Irredeemable debentures 3. as was required here.440 1. This was surprising as candidates would have learnt the formulae required or.358% Preference shares 8.000 Preference shares (25p) (£0. Part (d) for 8 marks required candidates to rebuild the company’s most recent Income Statement from the information available to them.75% x £2. in part (e) candidates had to explain the factors surrounding the company’s rate of dividend growth.100 1.000/£20.036 = I(1-t)/110.07 x 3.60% x £1.276% Weighted Average Cost of Capital 9.100.540/£20. candidates were given that figure and asked to prove it.959.75% (or 0. Financial Management .000.680. Total possible marks 4 Maximum full marks 4 2(b) £ Ordinary dividends = £16m x 10.540. 2(a) Type of Capital Market Capitalisation (£) Ordinary shares (50p) (£4m/£0.959. The majority however were unable to work to an unknown figure which isn't the cost of capital (as this was given in the question).100 0. d = 0. In part (b) for 5 marks candidates had to calculate the total annual interest and dividends payable and reconcile this to the WACC calculation in part (a).100 8.440 £1.748% Most candidates scored full marks here.54m x 3.440 / £20.50) x £2 16. In the scenario a shareholder is asking for an explanation of information given out at a company’s recent AGM. I(1-t) = 3.96 x 0.80 2.105 = d/2.8m/£0.

strategy.980.4% Total Long term Capital £20. but could not explain what a WACC actually is.000/8.00/£0.204.000 Ordinary shares in issue 8 million Earnings per share (£1. Total possible marks 6 Maximum full marks 6 © The Institute of Chartered Accountants in England and Wales 2011 Page 6 of 8 . i.72) (77.56m + £1. up through the Income Statement. The majority could not work backwards.980.000 less: Ordinary dividends (£16m x 10.Professional Stage – September 2011 2(c) The hurdle rate (WACC) is: (a) the cost of funds that a company raises and uses.000) £0. Total possible marks 8 Maximum full marks 8 2(e) Key points regarding dividend growth: It should be future growth – forecasts.2475 8. If the company does not achieve this hurdle rate on its investments then it will be investing in projects that produce a negative net present value and the value of the company (and the wealth of the shareholders) will decline. a required rate of return. Too many candidates treated retained earnings and earnings as the same figure. to earn the cash flows out of which investors can be paid their return. despite this appearing in the learning materials. Past dividends per share or The Gordon growth model 0% growth means constant share price with no capital growth.56m x 8. A significant minority added ordinary and preference share prices for the P/E calculation.000 This was in general answered very poorly indeed.6% / 0. retentions etc – but often use past i. Here virtually no-one considered future forecasts. In this part many candidates knew about the desirability and impact of positive NPV’s.000 less: Preference dividends (£2. Financial Management . When past dividend growth rates and the Gordon model were used few candidates noted the assumption that past growth = future growth.2475 Price earnings Ratio £2.000. The significance of the company’s 0% dividend growth rate was poorly answered. The question was couched in terms of returns but few candidates spotted that there would be no capital return on the current share price.000 x 28/72) (857.e.138.08 Gearing ratio = Fixed Return Capital £2.1m Profit before interest and tax – see Workings below Workings (working upwards) £ Profit before interest and tax 3.204.54m 20.000) Profit before tax 3.000) Earnings 1.111 less: Interest (£1.000) Retained Profits (given) 300.111) Profit after tax 2.061.680.e.111 less: Corporation Tax (£2.54m x 3. The return is just dividend yield. and the return that investors expect to be paid for putting funds into the company and therefore is (b) the minimum return that a company must make on its own investments.5%) (1. Total possible marks 5 Maximum full marks 4 2(d) Earnings (see Workings below) £1.75%) (224.980.

772 9.034 9. In part (c) for 8 marks candidates had to advise the company’s management as to the effectiveness of each of four techniques for hedging interest rate risk.775.774.230 x 10% 0.Professional Stage – September 2011 Question 3 Total marks: 26 General comments This question had a good average mark and was generally done well.000 x 1.75m NK 1.034 x (1 + 4.75m NK 15.455 (iii) Money market hedge NK borrowed now 16. spot rate at 30/9/12) 16.712.000 Most students scored high marks in this part.043 (assumed on deposit) (26.075) Sterling receipt .300 less: Premium cost £25.490 (iv) Option Put option (sell NK) exchange rate is 9.e.801.3%) £1.6%) 1.685. 3(a) (i) Expected spot rates at 30 September 2012 9. It was a three-part question that tested the financial risk elements of the syllabus.771.net £1.325 + 0.685.757.075 9.430 x 40% 3.13) 9. Financial Management .300 NK/£ Sterling receipt 16. Part (b) was worth 8 marks and required candidates to explain the issues that arose for the company’s management from the calculations made in part (a).933 9.945 NK (1 + 6.530 x 40% 3.066 Sterling receipt. converted at spot rate 15.325 Sterling invested at 4.812 Expected spot rate at 30 September 2012 (NK/£) 9. the most common mistake was to use a call option instead of a put option.440 So sterling receipt if no hedging (i.75m NK £1.364 9.712. The scenario was that of a company (i) due a large receipt of foreign exchange and (ii) having a surplus of funds (sterling) to invest.75m NK £1.330 x 10% 0.75m NK 16.75m NK 16. Candidates were asked to give advice. Total possible marks 10 Maximum full marks 10 © The Institute of Chartered Accountants in England and Wales 2011 Page 7 of 8 . In part (a) for 10 marks candidates had to calculate the outcome of employing four different forex hedging techniques.549 (9.945 NK £1.923 9.440 (ii) Forward contract Sterling receipt: 16.3% pa £1. However.

246.757. DDS would buy traded call options. but these are for standardised amounts. Upside potential is therefore removed. produces a higher sterling receipt than the money market hedge. for more flexibility.774.e. worse than the forward contract. (iv) Interest rate swap – it would be impractical as a long term hedge for a large deposit.796. Few candidates spotted that an interest rate swap would be inappropriate as it is a long term strategy. Sterling receipt with current spot rate (9.608 i. Total possible marks 8 Maximum full marks 8 3(c) (i) FRA – this would fix the rate of interest receivable by DDS. However. If the research paid for is accurate then it would be better to not hedge at all as the spot rate in twelve months’ time will produce a sterling receipt of £1. (ii) Interest rate future – DDS would buy interest rate futures. 364. but these are for standardised amounts and may not be suitable. although there were some very good answers. It would be difficult to find a counterparty.775.075) £1. So. It can be tailored to the exact amount to be invested by DDS.23 (as per the question) the option would be abandoned with a receipt of (£1. March 2012. Total possible marks 9 Maximum full marks 8 © The Institute of Chartered Accountants in England and Wales 2011 Page 8 of 8 .30NK/£ produces an attractive amount of sterling £1. Here the better answers identified what needed to be done with the FRA.75m NK £1.660. At a future spot rate of 9. (iii) Interest rate option – DDS would have the right to deal at an agreed interest rate at maturity date.e. DDS could purchase a tailored over the counter (OTC) option.325NK/£) 16. if the future spot rate is 9. Financial Management .246 9. If the current spot rate remains constant (unlikely bearing in mind the comparative interest rates in the UK and Norway) this would produce an even higher sterling receipt of £1.325 The forward contract (assuming that there is no arrangement fee).Professional Stage – September 2011 3(b) The directors’ attitude to risk will be an important factor. which could be impractical. too few candidates were able to apply theory to practice i. The put option at the strike price of 9. The hedge is only for six months.000 premium and also have the chance to benefit from a low exchange rate in September 2012.796.e. raise issues pertinent to the scenario.788. Both of these hedging methods will produce a fixed sterling amount. known at the start of the hedging period.814. In part (b).000 and management might consider paying the £25.735 – 26.53 (as per the question) the receipt is only £1. i. the future and the option rather than just describing them.