Professional Level – Financial Management - March 2018

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. In
many cases, 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: 35

General comments
This question was generally answered well and a good majority of candidates achieved a “pass” standard.

This was a four-part question that tested the candidates’ understanding of the financing options element of
the syllabus and there was also a small section with an ethics element to it.

In the scenario a UK-listed bakery company was planning to open a number of retail outlets across the
UK. This investment would cost the company £17 million, which would be raised in such a way as to not
alter its existing gearing ratio. In part 1.1, for sixteen marks, candidates were required to calculate the
company’s current WACC from the information given, based on (1) the dividend growth model and (2) the
CAPM. Part 1.2 was worth six marks and required candidates to respond to recent comments made by
three of the company’s directors about the best discount rate to use when appraising the £17 million
investment. Part 1.3, for ten marks, tested the candidates’ understanding of (and the need for) de-gearing
and re-gearing beta within the CAPM calculation in the given scenario. Part 1.4 was worth three marks
and examined the Ethical Guide, with particular reference to the issue of confidentiality.

1.1(a)

Cost of equity (ke)

Dividend growth rate = £1.716m = 1.093 over 3 yrs so 1.0931/3-1 = 3% pa

£1.570m

Latest dividend (d0) = £1.716m £0.26

6.6m

Ex div market value per share = (£3.46 - £0.26) £3.20

Cost of equity (ke) (d1) +g (£0.26 x 1.03) + 3% 11.36%

MV (£3.20)

Cost of preference shares (k p) d £0.07 5.19%

MV £1.35

Cost of irredeemable debt (k di) (i-t) (£6 x 83%) 4.70%

MV £106

Cost of redeemable debt (kdr)

Year Cash Flow 5% factor PV 6% factor PV

0 (96) 1.000 (96.000) 1.000 (96.000)
1-3 4 2,723 10.892 2.673 10.692
1000.864 86.400 0.840 84.000
NPV 1.292 NPV (1.308)

IRR = 5% + (1.292/(1.292 + 1.308)) = 5.50%

less: Tax at 17% (5.50% x 83%) = 4.57%

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 Professional Level – Financial Management - March 2018

WACC
Total MV’s
£m £m Cost x weighting WACC
Equity (6.6m x £3.20) 21.120 11.36% x 21.120/25.470 9.42%
Pref. Shares (1m x £1.35) 1.350 5.19% x 1.35/25.470 0.28%
Irredeemable debt (£1.2m x 1.06) 1.272 4.70% x 1.272/25.470 0.23%
Redeemable debt (£1.8m x 0.96) 1.728 4.57% x 1.728/25.470 0.31%
4.350 0.82%
Total market value 25.470 10.24%

The majority of candidates did really well in part 1.1(a) and many scored full marks (14/14). Typical errors
made were (1) incorrect number of years used in the dividend growth calculation (2) not adjusting the
cum-div and cum-int market prices (3) forgetting the tax adjustment in the cost of debt and (4) not using
market values in the WACC calculation.

Total possible marks 14

Maximum full marks 14

1.1(b)

Cost of equity (ke) using the CAPM

Expected market return 10.8%

less: Expected risk-free return (2.4%)
Expected risk premium 8.4%

Applying Wells’ beta to the risk premium 1.25 x 8.4% 10.5%

plus: Expected risk-free return 2.4%
Cost of equity (ke) 12.9%

WACC
Total MV’s
£m £m Cost x weighting WACC
Equity (6.6m x £3.20) 21.120 12.90% x 21.120/25.470 10.70%
Pref. Shares (1m x £1.35) 1.350 5.19% x 1.35/25.470 0.28%
Irredeemable debt (£1.2m x 1.06) 1.272 4.70% x 1.272/25.470 0.23%
Redeemable debt (£1.8m x 0.96) 1.728 4.57% x 1.728/25.470 0.31%
4.350 0.82%
Total market value 25.470 11.52%

Part 1.1(b) was, as expected, done well by most candidates.

Total possible marks 2

Maximum full marks 2

1.2

Phil Turner – to use the cost of preference shares would be completely wrong. It’s only one element of the
firm’s total long-term finance and 7% is the coupon rate, not the current cost.

Alana Clarke and Alison Hughes – ordinary shares (cost of equity) should be taken into account. It would
make sense to use Wells’ current WACC figure for the investment appraisal if:

(1) the historical proportions of debt and equity are not to be changed
(2) the systematic business risk of the firm is not to be changed and
(3) the new finance is not project-specific.

Regarding the above, the bank borrowing will not change the gearing i.e. sufficient equity will be raised to
maintain the gearing at its current level. The systematic business risk of the firm is likely to change as it’s
moving into a different market. The finance is not project-specific e.g. cheap government loan.

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 Professional Level – Financial Management - March 2018

Overall, candidates’ answers to part 1.2 were disappointing. The comments made were rather general and
so marks will have been lost. Too few scripts considered the conditions that need to apply for the current
WACC to be used, i.e. gearing % and systematic risk to remain unchanged and any new finance is not
project-specific.

Total possible marks 7

Maximum full marks 6

1.3

New market geared beta = 1.80

New market ungeared beta = (1.80 x 77) (1.80 x 77) 1.44

(77 + (23 x 83%)) 96.09

Wells’ geared beta = 1.44 x (£21.12m + £1.35m + (£3m x 83%)) 1.70

£21.12m

So, cost of equity = (1.70 x (10.80% - 2.40%)) + 2.40 = 16.7%

Cost of debt = 8.5% x 83% 7.06%

WACC = (16.70% x £21.12m/25.47m) + (7.06% x £4.35m/£25.47m)) = 15.05%

It would be unwise to use the existing WACC as Wells’ plan involves diversification and therefore a
change in the level of systematic risk (beta rises from 1.25 to 1.70). Thus a new WACC must be
calculated. Systematic risk is accounted for by taking into account the beta of the retail bakery market and
this is then adjusted to eliminate the financial risk (level of gearing) in that market. The resultant ungeared
beta is then “re-geared” by taking into account the level of gearing of the new funds being raised.

Cost of new debt (which is higher than existing because of the increased systematic risk discussed above)
is used.

Using this, the new WACC can be calculated.

It was good to see that the numerical and discursive elements of part 1.3 were both done well by a good
number of candidates. Where candidates scored badly, it was clear from their calculations that many did
not understand the logic of de-gearing and then re-gearing. Also many were unable to explain the theory
underpinning for those calculations. This is an area of the syllabus that has been examined regularly
recently.

Total possible marks 10

Maximum full marks 10

1.4
You work for Wells and are party to confidential information which, if made public, could influence the
market price of Wells’ shares.

An ICAEW Chartered Accountant should assume that all unpublished information about a prospective,
current or previous client’s or employer’s affairs, however gained, is confidential.
That information should then:

 Be kept confidential
 Not disclosed, even inadvertently such as in a social environment
 Not be used to obtain personal advantage

Part 1.4 was, as expected, done well by most candidates.

Total possible marks 3

Maximum full marks 3

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 Professional Level – Financial Management - March 2018

Question 2

Total marks: 30

General comments
This question was had the highest percentage mark on the paper. A large majority of candidates reached
a “pass” standard in the question.

This was a six-part question which tested the candidates’ understanding of the risk management element
of the syllabus.

This question was based on a UK manufacturer of timber products. The first half of the scenario
considered the company’s need to borrow £4.5 million of short-term finance via a bank loan and its plan to
hedge the interest costs of that loan. In the second half of the question the company had agreed to
purchase €1.7 million of timber from a Finnish supplier. Candidates had to investigate the foreign
exchange risk implications of this contract for the company. In part 2.1(a) of the question, for eight marks,
candidates were required to calculate the cost to the company if it used traded sterling interest rate futures
to hedge its interest rate risk. Part 2.1(b), for three marks, required candidates to calculate the cost to the
company if it used OTC interest rate options to hedge the risk. Part 2.1(c) was worth two marks and asked
candidates to conclude, based on their calculations, which of the hedging methods should be chosen. Part
2.2(a) for seven marks asked candidates to calculate the (sterling equivalent) payment to the Finnish
supplier if (1) there was a weakening of sterling and (2) two hedging techniques were employed. In part
2.2(b), also for seven marks, candidates were required to advise the company’s board whether it should
hedge the euro payment. Finally, part 2.2(c), for three marks, asked candidates to identify the differences
between traded currency options and OTC currency options.

2.1
(a) Futures

Sell June futures

No of contracts: £4,500,000 x 6/3 = 18

£500,000

(a) (b) (c)

Interest rate 7.50% 8.00% 5.50%

Opening rate 93.2 93.2 93.2

Closing rate 92.2 91.8 94.1
Movement 1.0 1.4 (0.9)

P/L on futures 18 x £500,000 x 3/12 2,250,000 2,250,000 2,250,000

x x x
1.0% 1.4% (0.9%)
= = =
Profit/(Loss) on futures £22,500 £31,500 (£20,250)
Interest cost = £4.5m x 6/12 = £2,250,000 x 7.5% (£168,750)
8.0% (£180,000)
5.5% (£123,750)
Total cost (146,250) (148,500) (144,000)

(b) Options (a) (b) (c)

Interest rate 7.50% 8.00% 5.50%
Take up option Y Y N
Interest cost % 7.30% 7.30% 5.50%

Interest cost = £4.5m x 6/12 = £2,250,000 x 7.3% (£164,250)

7.3% (£164,250)
5.5% (£123,750)
Premium (£4,500,000 x 0.2%) (£9,000) (£9,000) (£9,000)
Total cost (£173,250) (£173,250) (£132,750)

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 Professional Level – Financial Management - March 2018

(c) If interest rates increase then futures less costly than option.
If rates fall then option is lower cost.

For part 2.1 there were many very good answers with candidates demonstrating a thorough understanding
of the techniques involved. Those areas where candidates struggled were: (1) a failure to identify that the
company would sell interest rate futures (2) charging twelve months interest rather than six (3) using six
months, rather than three months, in the futures gain/loss calculation and (4) a failure to calculate the
option premium correctly (a very common error).

Total possible marks 13

Maximum full marks 13

2.2(a)

(1) Sterling weakens by 5%

Spot rate = €1.1764 x 0.95 = €1.1176

€1,700,000/1.1176 (£1,521,144)

(2) Forward contract

€
Spot rate 1.1764
plus: Forward contract discount 0.0059
1.1823
£
(£1,700,000)/1.1823 (1,437,875)
plus: Arrangement fee (4,600)
(£1,442,475)

(3) Money Market Hedge

Lend euros now (€1,700,000) (€1,700,000) (€1,666,667)

1 + (8%/4) 1.02

Convert at spot rate €1,666,667 (£1,416,752)

1.1764

Sterling borrowed at 6.6% pa (£1,416,752) x [1 + (6.6%/4)] (£1,440,128)

Part 2.2 was, overall, done well. The calculations in part (a) were good, but typical errors included (1)
choosing the wrong exchange rate (2) strengthening rather than (as required) weakening sterling and (3)
subtracting the forward contract fee from the overall cost of the transaction.

Total possible marks 7

Maximum full marks 7

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 Professional Level – Financial Management - March 2018

2.2(b)

In summary
At spot rate (€1,700,000/ 1.1764) (£1,445,087)
Sterling weakens by 5% (£1,521,144)
Forward contract (£1,442,475)
MMH (£1,440,128)

The forward rate suggests that the euro will weaken (sterling will strengthen, rather than weaken by 5%)
over the next three months. This is good for UK importers such as Hunt, as supplies would get cheaper.

MMH gives the lowest price, based on these rates, but if sterling is likely to strengthen then perhaps don’t
hedge at all (but there are no guarantees).

General points about the various methods

Directors’ attitude to risk is important

Foreign exchange risk management is an area of the syllabus that is examined regularly and so
candidates’ answers to the discussion in part (b) were disappointing. There was a lack of depth to the
candidates’ conclusions and too many commented, erroneously, that a forward contract discount meant
that sterling would be weakening.

Total possible marks 8

Maximum full marks 7

2.2(c)

OTC’s are, typically, purchased from a bank

OTC’s are tailor-made and so will lack negotiability
Traded options are for standardised amounts and can be traded and a profit/loss made
Traded options are not available in every currency

Part (c) was answered well.

Total possible marks 4

Maximum full marks 3

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 Professional Level – Financial Management - March 2018

Question 3

Total marks: 35

General comments
This question had the lowest average mark on the paper, but most candidates achieved a “pass” standard.

This was a five-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus.

The scenario here was based around a UK property company that builds low-cost houses for sale and for
rent. The company had the opportunity to invest in a new development of 500 identical low-energy houses
on one of its vacant sites. The company planned to use a house-building firm to construct the houses over
a two year period. Part 3.1 was worth 18 marks and required candidates to make use of the information
given and calculate the NPV of the proposed investment. Parts 3.2 and 3.3, for four marks and five marks
respectively, tested candidates’ proficiency with, and understanding of, sensitivity analysis. They were
required to make sensitivity calculations and then comment on them. Part 3.4 was worth four marks and
here candidates were asked to compare the strengths and weaknesses of sensitivity analysis with those of
simulation. In part 3.5, again for four marks, candidates had to explain the concept of real options and to
identify two real options that could apply to the development in question.

3.1

2018 2019 2020 2021 2022-38

Y0 Y1 Y2 Y3 Y4-20
£’000 £’000 £’000 £’000 £’000
Construction costs (19,000) (19,000) (19,000)
Land clearance (1,400)
Sales 25,500 25,500
Rental income (W1) 1,040 2,079 2,079
Bad debts (W1) (16) (31) (31)
New staff (46) (92) (92)
Extra costs (W1) (31) (62) (62)
Tax (W2) 238 (2,882) (3,042) (322) (322)
Green machine 0 (1,200) 100
Tax on machine (W3) 0 37 30 120
Total cash flows (20,162) 2,455 4,434 1,792
1,572
6% factors (W4) 1.000 0.943 0.890 0.840
8.801
PV (20,162) 2,316 3,947 1,504 13,831
NPV 1,436

The development produces a positive NPV and so should be accepted as it will enhance shareholder
wealth.

Workings

W1 Rental income (Y2) = 175 x £5,940 = £1,039,500

Bad debts (Y2) = 1.5% x £1,039,500 = £15,592
Extra costs (Y2) = 3% x £1,039,500 = £31,185

Rental income (Y3) = 350 x £5,940 = £2,079,000

Bad debts (Y3) = 1.5% x £2,079,000 = £31,185
Extra costs (Y3) = 3% x £2,079,000 = £62,370

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 Professional Level – Financial Management - March 2018

W2 2018 2019 2020 2021 2022-38

Y0 Y1 Y2 Y3 Y4-20
£’000 £’000 £’000 £’000 £’000
Construction (75/500 x £57m) (8,550) (8,550)
Land clearance (1,400)
Sales 25,500 25,500
Rental income 1,040 2,079 2,079
Bad debts (16) (31) (31)
New staff (46) (92) (92)
Extra costs (31) (62) (62)
Taxable (loss)/profit (1,400) 16,950 17,897 1,894 1,894

Tax at 17% 238 (2,882) (3,042) (322) (322)

W3 2019 2020 2021

Y1 Y2 Y3
£’000 £’000 £’000
Green machine cost/WDV 1,200 984 807
WDA (18%)/Balancing allowance (216) (177) (707)
WDV/Sale price 984 807 100

Tax saving (17% x WDA) 37 30 120

W4
6% annuity factor for Y4-Y20 Y20 11.470 OR 10.477
Y4 (2.673) x 0.840
8.797 8.801

Part 3.1 was a difficult NPV calculation and so it was good to see that, overall, candidates did well here.
The main areas of difficulty were: (1) the tax calculation for the allowable building costs (2) the timing of
the cash flows and (3) the need to include cash flows (and then discount them) for Years 4 to 20.

Total possible marks 18

Maximum full marks 18

3.2

Y1 Y2 Total
£’000 £’000 £’000
Sales 25,500 25,500
Tax (4,335) (4,335)
Total cash flows 21,165 21,165
6% factors 0.943 0.890
PV 19,967 18,837 38,804

Sensitivity 1,436 = 3.7%

38,804

Minimum selling price = (£340,000 – 3.7%) £327,420

Part 3.2 was also done well, but some candidates used the price per house figure rather than the total
sales figure and so will have lost marks.

Total possible marks 4

Maximum full marks 4

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 Professional Level – Financial Management - March 2018

3.3

Y0 Y1 Y2 Total
£’000 £’000 £’000 £’000
Incremental construction costs (35,000) 19,000 19,000
Tax on costs (£8.55m x 3/57 x 17%) (77) (76)
Total cash flows (35,000) 18,923 18,924
6% factors 1.000 0.943 0.890
PV (35,000) 17,844 16,842 (314)

The NPV would decrease by £314,000 and so it is less likely that Bishop’s board would proceed with the
development.

Part 3.3 was a more difficult proposition and candidates’ answers here were very variable. Those who
produced a set of calculations revised from part 3.1 scored well, but too many produced a discussion
rather than calculations.

Total possible marks 5

Maximum full marks 5

3.4
Sensitivity analysis
It facilitates subjective judgment (by management for example)
It identifies areas that are critical to the success of a project, e.g. sales volume, materials price
It is relatively straightforward
But
It assumes that changes to variables can be made independently
It ignores probability
It does not point to a correct decision

Simulation
More than one variable at a time can be changed
It takes probabilities into account
But
It is not a technique for making a decision
It can be time consuming and expensive
Certain assumptions that need to be made could be unreliable
Part 3.4 was, overall, done well and a majority of candidates scored full marks.

Total possible marks 6

Maximum full marks 4

3.5

NPV analysis only considers cash flows related directly to a project. A project with a negative NPV could
be accepted for strategic reasons. This is because of (real) options associated with a project that outweigh
the negative NPV.
With regard to the Garthwick development there could be (TWO only required):
Follow-on options – future development of mixed (rental/private) developments.
Growth options – Bishop could build a few properties and then build more later, if necessary.
Flexibility options – Bishop could sell some of its rented properties rather than rent them and vice versa.
Abandonment options – Bishop could sell all the properties and quit the development after two years.
Timing options – Bishop could delay the start of the clearance and development.
In part 3.5 most candidates were able to identify examples of real options from the scenario, but too few
explained the more general issue of real options, i.e. that of turning a negative NPV into a positive one.

Total possible marks 4

Maximum full marks 4

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