P9 Financial Strategy November 2009

Examiners Answers

The Examiner's Answers for Financial Strategy

SECTION A

Answer to Question One

(a) - Calculations

(i) P/E ratios and Market Capitalisation

T Industries L Products
Current market value 670p x 120 m shares 375p x 60 million shares
= £804m = £225m

P/E ratio
(Market value/earnings) £804m/£65m £225m/£22.5m
= 12.4 = 10.0
Alternative P/E calculation: £6.70 x 120/64 £3.75 x 65/22.5
= 12.4 = 10.0

(ii) Cost of equity using CAPM - Ke = Rf + ß(Rm – Rf)

T Industries:
3% + 1.17 (9% – 3% ) = 10.02% (say, 10%)
L Products:
Workings: Value of equity £225 m
Value of debt £220 m
% Debt to Equity 97.8%

Step 1 - Ungear proxy entity

ßu = [ßg x Ve/(Ve + Vd)] + [ßd x Vd/(Vd + Ve)]
= (1.4 x 60%) + (0.2 x 40%)
= 0.84 + 0.08 = 0.92

Step 2 - Re-gear for L Products

ßg = ßu + [(ßu - ßd) x (Vd/Ve)]
= 0.92 + [(.92 - .20) x 97.8%]
= 0.92 + 0.70 = 1.62

Cost of equity using CAPM - Ke = Rf + ß(Rm – Rf)

3% + 1.62 (9% – 3% ) = 12.72% say, 13%

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(iii) Estimated value using DVM

T industries L Products
Earnings DF @ DCF Earnings DF @ DCF
£m 10% £m £m 13% £m
2010 65.0 .909 59.1 21.4 .885 18.9
2011 67.0 .826 55.3 23.5 .783 18.4
2012 + 959.3 179.6
Total 1,073.7 216.9
Workings for 2012+
(67 x 1.04) x .826/(.10 - .04) (23.5 x 1.025) x .783/(.13 - .025)

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Part (b) – Calculation of increase in value generated by combining the two entities

Value of two independent entities = £1,073.7 + £216.9 = £1,290.6

Value of combined entity if bid succeeds:

PV of Earnings 2010 + 2011 = 151.7

PV of earnings 2012+ = 1,295.7 (see below for calculation)
Total = 1,447.4

Value of two independent entities = 1,290.6

Increase in value = 156.8

Calculated: [(67.0+23.5) x 1.04] x .826/(.10 - .04)

Part (c) Report

Report to: Board of T Industries

Date 25 November 2009
Subject Evaluation of Proposed Acquisition of L Products

Introduction

The objective of this report is to provide an evaluation of the proposed acquisition of L Products
(‘L’) by T Industries (“T”). This is an acquisition opportunity that would enable us to broaden our
business base and also to acquire scarce technical expertise. However, the bid is likely to be
hostile which opens the possibility of a bidding war and, ultimately, the necessity of increasing
the bid price to unsupportable levels if we are to succeed. This is a danger we should bear in
mind when reviewing the bid terms suggested in this report.

The report contains the following sections:

1. The terms to be offered to the target company's shareholders

2. The most appropriate form of funding the bid
3. The implications of the proposed acquisition for the achievement of T’s financial
objectives

Section 1 - The range of values to be considered and a recommendation of bid terms to be

offered to the target company's shareholders

An introduction to the answer here could begin by explaining how share prices are determined
and how the stock market might evaluate the bid. The following points could be elaborated in a
good answer:

• Various methods of valuing shares e.g. technical and fundamental analysis

compared with asset valuation, which is not relevant here although some mention
could be made of intellectual capital value.
• Forms of market efficiency – very brief comments here as the question does not
require more than recognition – but some reference to how the EMH might affect
both entities could be made (i.e. full market likely to be more “efficient” than the
AIM).
• The importance of market price in a merger or acquisition situation.
• Book asset values are of no relevance here.

In the case here, both entities are listed on a stock market. The listed price provides a
benchmark as no investor would sell below the listed price unless they had knowledge that the
share price is likely to fall in the near future. As a rule of thumb acquisitions historically required
a premium of around 20% above the current market price. This premium rises to 50% in hostile

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bids before the merger or acquisition is completed. In current market conditions the premium
might be lower.

As a starting point T could offer one of the two following options, or a combination:

Share exchange of 1 T for 1.5 L (or 2 for 3).

Based on the current share price of T of 670 pence, this values L at approximately 447 pence
per share, or a 19% premium on current share price.

The increase in value generated by combining the two entities, calculated in answer to Part (b),
is £156.8 million. In theory this means T could increase the bid by this amount, as follows:

Market value: £225 million

Increase in value £157 million
Total £382 million

or 637 pence per share, implying a premium over market price of 70% and a share exchange of
around 1 T share for 1 L share. This seems excessive and gives all the future merger gains to
L’s current shareholders. The calculated value of the two entities implies T’s shares are
undervalued by the market (DVM value of £1,074m compared with market value of £804m) and
L’s shares are slightly over valued (DVM value of £217 million compared with market value of
£225 million). The possibility is that the market is expecting a bid and has assumed most of the
gains from the acquisition will be taken by L’s shareholders.

The following factors need to be considered before a formal offer is made:

• The valuations rely heavily on assumptions, especially growth rates and the value of
earnings after 2012. A sensitivity analysis based on various growth projections
could be performed to assess the impact on outcomes.
• The calculation of cost of equity for L, based as it is on a proxy entity that might not
be as similar as thought, will also affect the valuation although not to any great
extent as T is using its own cost of equity to value earnings from 2012 onwards.
• L is listed on the AIM, which is less efficient and less liquid than the main market.
• The bid will take place in a dynamic market. The market overall has fallen
substantially over the past 18 months although it is showing signs of recovery.
• It is thought L might be attractive to competitive bids. If so, a bidding war would
push up the price, usually way beyond the real worth of the target.
• If we apply the “bootstrap” principle L’s market value, based on 2009 earnings
would be £279million or 465p per share (earnings of £22.5 x T’s P/E of 12.4). This
implies a premium over current market value of £54 million, or approximately 24%,
and a share offer of 1 T for 1.44 L’s share (670p/465p). This is much more realistic
than the DVM valuation although it still assumes T can grow L’s earnings at its own
rate almost from day 1 and also that its cost of equity will not change.
• Although L’s directors might be hostile to a bid, the shareholders might be more
willing to accept an offer as they would have greater confidence of a more secure
future.
• A major benefit is the acquisition of L’s scarce technical expertise.

A recommendation is to open bidding at between 465 and 500 pence per share. Before this bid
is raised any further more detailed calculations will be possible as more information will become
available.

Section 2 - The most appropriate method of financing the bid

If the bid is a share exchange T will need to obtain authorisation for additional shares. Using 465
pence as a valuation and a share exchange of, say, 1 T shares for 1.5 L would require an issue
of an additional 40 million shares by T.

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If a cash alternative was to be offered this would require raising approximately £280 million in
new debt. The combined bank balances were only £25 million at the last balance sheet date and
this amount will be needed for working capital, if indeed it is still available.

Estimated effect on EPS

If a share exchange: If debt financed

Combined earnings for 2009: £87.5 million £87.5

Shares in issue: 160 million 120
EPS: 54.7 pence 72.9 pence

Of course, EPS in 2010 and beyond will be affected by increased interest charges if the
acquisition is debt financed and a comparison such as this is spurious. EPS will rise under both
methods of financing. With a share exchange this is because T is giving fewer shares than L
has in issue at the moment. This is an arithmetic factor and should fool no-one into thinking T
has genuinely increased EPS.

Estimated effect on gearing

Gearing (debt:debt+equity) ratios based on current market values are:

T 35.9% (450/804+450)
L 49.4% (220/225+220)
With a share exchange the ratio for the combined group would be just under 40%
(670/670+1029). If the acquisition is debt financed the ratio would rise to 48% (combined
market value as before, debt rises to £950 million). If the synergistic benefits are included the
ratio becomes 950/(1029 + 157 + 950) = 44.5%

There are many assumptions here and the gearing will be affected by how the market values
the combined group, but the principle is the same – if debt financed then gearing will rise to
possibly unacceptably high levels. If a share exchange is chosen then gearing is affected to a
much smaller extent.

Increased gearing might raise cost of equity, despite what the directors think at present, and, in
theory, reduce share price all other things remaining equal. However, the diversification effect of
acquiring another entity might go some way to mitigate this increased financial risk.

Note: Any sensible attempt at calculating the effects of the acquisition on EPS and gearing,
even if using hypothetical figures, would gain credit.

Other key factors to consider are:

ƒ From the target’s perspective a cash bid is more secure but shareholders will
then not participate in future profits of L. There might also be tax disadvantages
for L shareholders, but this is unlikely to be a key factor.
ƒ Whether T can “grow” L’s earnings at its own rate, as implied by the P/E ratio, is
difficult to determine. It depends on whether T’s managers can genuinely realise
synergistic savings and manage L’s assets better than L’s directors have done
in the past. Much also depends on economic factors largely outside the entity’s
control.
ƒ Dilution of control if share exchange. Control is almost certainly not an issue
here. (Unless there are a few institutional investors with very large
shareholdings)

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Section 3 - The implications of the proposed acquisition for the achievement of T’s financial
objectives

The objectives in principle are quite acceptable and are common for listed entities.
They have been achieved each year for the past 9 years but that period has largely been a
period of consistent growth in the stock market in general. A year on year increase of 8% in
share price and dividends combined is surely optimistic in a volatile market and the construction
industry has been particularly hard hit. However, stock markets tend to rise ahead of a general
economic upturn and the property market is seeing some improvement in the UK.

If objectives are to continue to broadly concern increases in EPS and shareholder value then
the acquisition should provide the following:

• Acquisition of L provides new markets which improves growth prospects

• Acquisition also provides some diversification of risk, which in theory should reduce
cost of equity.
• Increased asset base provides access to better funding opportunities
Financing and dividend policies

Financing policies
Theory suggests that entities should use a judicious amount of debt in their capital structure to
lower cost of capital. Debt is cheaper than equity because interest payments attract tax relief
and the return required by providers of debt is, generally, lower than expected by providers of
equity. This is because interest is (usually) secured and providers of debt do not participate in
profits. However, in a deflationary environment equity could be more attractive than debt. Some
of the reasons are as follows:

- Debt interest has to be paid out of static or falling profits, lowering return to
shareholders. Also, raising equity is safer; dividends do not have to be paid and the
shareholders do not get their money back in a liquidation.
- High inflation tends to make share prices more volatile. In periods of low or zero
inflation that volatility is reduced and the premium required by equity holders is
similarly reduced.
- In theory, the mix of debt and equity does not affect the value of the firm, other than
the value of the tax shield. When profits are falling, the value of the tax shield is
reduced.

The above reasons are valid in T’s circumstances but an issue for the directors to consider
when deciding their financing policies - both re-financing and financing the proposed acquisition
- is the “signaling” mechanism. Equity could be seen as defensive and a negative signal to the
market.

There is limited research to support the signaling effects of capital structure and the recent
dramatic changes in the global economic environment means what evidence exists might be of
no value. In particular, interest rates on borrowing are at an all time low which, combined with a
severe recession, means debt could be the preferred, and possibly only, option.

Dividend policies
In theory entities should pay no dividends and invest all earnings if they have sufficient positive
NPV investment opportunities and pay 100% dividends if they have no positive NPV investment
opportunities. Entities rarely do this as it would make for huge volatility in dividend payments
that many investors would not like. Also, unlike with capital structure, the signaling effect of
dividend policy is believed to hold. At present T pays 40% of its earnings as dividends and L
pays almost 50%. The present climate of near zero interest rates suggests that investors would
be better off allowing T to invest earnings on their behalf and reduce the dividend payout
percentage. The acceptability of this change in policy depends to some extent on shareholder
profile but given that many entities are reducing dividend payments shareholders might have
little choice but to accept.

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SECTION B

Answer to Question Two

(a)(i)

Price of new shares after 20% discount to current price of 458 cents is:
366cents (= 458cents x (1 – 20%))

So, the number of new shares required is:

8.0million (= €29.3million/3.66)
€ million
(a)(ii) 40million shares @ 458cents 183.20
8million shares @ 366cents 29.28
€212.48million
Divide by the number of new shares: €212.48/ (40 + 8) = 4.427
So T.E.R.P. is 443cents

(a)(iii) Expected trading price for the rights is the T.E.R.P. of 443cents less the discounted share
price of 366cents
So the expected trading price for the rights is 77cents each (443 – 366)

(a)(iv) Mr X will be given the right to buy 40,000 discounted shares

(New shares offered = 8/40 x current holding of 200,000 = 40,000)

Value of holding €’000

Do not take up the rights
200,000 @ T.E.R.P of 443cents: 886.0
plus payment from underwriters assumed to be
equivalent to the value of the rights, that is,
77cents x 40,000 = 30.8
Total 916.8

Take up the rights

Shareholding of 240,000 @ 443cents: 1,063.2
less cost of buying discounted shares (146.4)
(366cents x 40,000):
Total 916.8

Sell sufficient rights to provide funds to purchase

the remaining rights:

First method:
Purchase 77/443 x 40,000 = 6,953 shares

Second, alternative method:

Sell Y rights where
77 x Y = 366 (40,000 – Y)
So Y = (366 x 40,000)/(77 + 366)
= 33,047
and so take up 6,953 rights (40,000 – 33,047)

So new shareholding of 206,953 @ 443cents: 916.8

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Conclusion and discussion of other factors affecting value in practice:

The theoretical result is the same in each case. In practice, there will be variations; for example,
the payment from the underwriters will be made from the residual pool of funds that may prove
to be lower than 77 cents per share. If the rights issue was to fail and the underwriters were left
with a number of unsold rights, the residual funds could be significantly less.

Also, the actual price of the rights in the marketplace is driven by the market forces of demand
and supply and the price obtained will vary according to market sentiment towards the project
and the popularity of the rights issue itself.

(b)
Preliminary calculations
Current gearing: 30:100 = 30% (where 100 = 37 – 7 + 70)
Revised gearing: 37:100 = 37%
(where 37 = original debt of 37, equity is now 63 = 70 – 7 and so D + E = 100 = 37 + 63)

This increase in gearing would occur for both the share repurchase and the special dividend. It
would be expected to lead to a decrease in the cost of capital if the company is not approaching
debt capacity and 37% is still on the downward sloping part of the WACC curve and so does not
affect George’s choice.

Share repurchase
Advantages over special dividend:
• Enhance earnings per share (as fewer shares in circulation)
• Reduce amount of cash needed to pay future dividends
• Investors taxed as capital gains which may be lower than income tax

Special dividend
Advantages over share repurchase:
• Easier and cheaper to arrange
• No change in the balance of ownership (in cases where shareholders have the choice
whether or not to sell shares in a share repurchase scheme)

Note that both methods reduce the likelihood of unwelcome takeover bids (as less cash on the
balance sheet)

Conclusion:
The impact on gearing and hence cost of capital is the same in both cases and so does not
affect the choice. However, only the special dividend will meet George’s second objective of
keeping the balance of ownership the same and so George may prefer to use a special dividend
rather than a share repurchase. The final decision will depend on a review of the other factors
listed above and their relative importance to the entity and its shareholders. If the shares are
held by a few large shareholders, their views also need to be taken into account.

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Answer to Question Three

(a)(i)
Alternative 1:
kprefs = 4.583% = 5.5%/1.2

Alternative 2:
Use DCF to calculate the YTM which is the IRR of the cash flows under the bond.
Time Time Cash flow Discount PV of cash Discount PV of cash
£ million factor at 4% flows at 4% factor at 3% flows at 3%
Initial capital 0 10.00 1.000 10.000 1.000 10.000
Interest 1 to 9 (0.40) 7.435 (2.974) 7.786 (3.114)
Tax relief 2 to 10 0.14 7.152 (W1) 1.001 7.560 (W2) 1.058
Repayment 9 (11.00) 0.703 (7.733) 0.766 (8.426)
Total 0.294 (0.482)
5)
Workings
W1: 7.152 = 7.435 x 0.962 or 8.111 – 0.062 = 7.149
W2: 7.560 = 7.786 x 0.971 or 8.530 – 0.971 = 7.559
By interpolation: YTM = 3% + 482/(482 + 294) = 3.621%

Alternative 3
Estimated £ yield to maturity before tax deduction = 5.37% = [(1.028)(1.025) – 1] x 100.
After tax cost is 3.491% = 5.37% x (1 – 0.35)
Round up answer to 3.5% as this is only an estimated figure. A full yield to maturity calculation
would provide a more accurate figure.

Summary
Alternative After tax cost of debt
1 4.58%
2 3.621%
3 3.5% (estimate)

(a)(ii) Key issues that should be raised include:

• Foreign exchange risk. This arises from foreign currency borrowings if the exchange rate
moves unfavourably.
• Cross currency interest rate swap. The estimated cost for Alternative 3 is marginally
lower than that for Alternative 2. It might be useful to find out the cost of a cross
currency interest rate swap to fix future exchange rates and calculate the hedged YTM
on that basis to see if it is still the cheaper alternative.
• Term of the loan. This is also important – how long do we need the funds for? We have
not been told the payback of the project but it is likely to be less than 10 years and
certainly quite different from that of the preference shares which are irredeemable and
therefore have an indefinite term.
• Relative cost. As expected, the preference shares are the most costly in order to
compensate the investors for their ranking behind that of providers of debt in the face of
liquidation of the business and in the payment of interest and dividends.

Recommendation

1. If funds are required for the whole project term, Alternative 2 is the clear choice as it
provides matching of maturity and currency and is also cheaper than Alternative 1.

2. However, if the funding is only needed for 5 years and if a cross currency interest rate
swap can be arranged in association with Alternative 3 to provide finance at a lower after tax
cost of debt, then Alternative 3 may be preferable to Alternative 2.

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(b)
There are three main methods for adjusting for risk.
1. Decision trees
2. Certainty equivalents
3. Risk-adjusted discount rate

1. Decision trees are a useful tool where there are a number of possible different outcomes.

How they work:

• probabilities are applied to different outcomes
• payoffs and the probabilities of each payoff can then be computed

Usefulness to Horatio:
In the case of Horatio, this could be a useful tool if there is a risk of a project failing altogether
due to the involvement of new technology that has not been fully tried and tested on a large
scale and/or tested operationally for a 9 year period.

2. Certainty equivalents

How they work:

• Certainty equivalents are applied to different cash flows according to the results of
sensitivity analysis on a particular variable
• However there is a high level of subjective judgment involved in establishing
certainty equivalents.

Usefulness to Horatio:
Estimating certainty equivalents would be particularly difficult in the case of Horatio where the
technology is new and there is unlikely to be a sufficient track record to be able to make sound
judgments on the outcome of a particular variable in this manner.

3. Risk-adjusted discount rate

How they work:

• Different risk gradings are allocated to individual projects according to the perception of
risk in each case and this is reflected in the discount rate by adjusting it for risk.

Usefulness to Horatio:
This is likely to be useful to Horatio – the discount rate could be adjusted according to the risk
grading of this project.

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Answer to Question Four

(a)
ke = 6.2% (as given in the question)
kd (after tax) = 3.51% (= 5.4% x (1 – 0.35))
MVe = $50million (= $2.50 x 20 million)
MVd = $33million (trading at par so use nominal value)
So, WACC = ke x MVe/( MVe + MVd) + kd (after tax) x MVd/( MVe + MVd)
= (6.2% x 50/83) + (3.51% x 33/83)
= 5.13%
(b)
Firstly, calculate the value of the project profits in perpetuity at the end of year 2:
$’000
Increase annual pre-tax earnings 770.0
Deduct tax at 35% (269.5)
Increase in annual post tax profits 500.5

PV of $500,500 in perpetuity is $9.756million

(Workings: $500,500/0.0513 = 9,756,335

Time 0 Time 1
$’000 $’000
Investment (10,000)
Increased earnings 9,756
Discount factor 1.0 0.951
(= 1/1.0513)
NPV (10,000) 9,278
Net total NPV (722)

Answer: The project produces a negative NPV of $722,000

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(c)
Adjust the WACC for the NPV of the project and the additional debt:
ke = 6.2% (unchanged per question)
kd (after tax) = 3.51% (unchanged per question)
MVe = $49.3 million (= $50million - $0.722 million)
MVd = $43million (= $33million + $10million)
MVe + MVd = $92.3 million
So, WACC = ke x MVe/( MVe + MVd) + kd (after tax) x MVd/( MVe + MVd)
= 6.2% x 49.3/92.3 + 5.40 (1 – 0.35)% x 43/92.3
= 4.95%

Suitability of the current WACC in project appraisal:

Capital structure.
The WACC has fallen slightly from 5.13% to 4.95% but there is insufficient change to invalidate
the use of the current WACC in the evaluation of the project.

Risk.
There is no indication that the project has a different risk profile to that of the business as a
whole. Upgrading IT systems is in line with normal business practice for this company and this
business sector.

Conclusion
Therefore the current WACC is considered to be a suitable discount rate with which to evaluate
this project.

(d) Key issues that should be addressed in the answer include:

(i) Assessing customer requirements
• essential stage to the success of the project
• requires careful market research amongst customers and also a review of competitors’
systems
• include review of language, security, ease of use, speed of internet access of customers
• use market survey at order point – ask customers for feedback when they place an order
through the website
(ii) Drawing up an implementation plan
• timetable key processes and dates
• key tasks allocated to project manager and team members
• frequent review of progress against the plan to ensure no overrun on timing
• project manager to monitor actual costs and revenues against budget and take remedial
action to address any problems arising
• train staff
• careful testing of the system and trial run before live running
• parallel running of the new system before closing the old system (if possible)

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Answer to Question Five

01-Jan 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec

2010 2010 2011 2012 2013 2014
T$ T$ T$ T$ T$ T$
million million million million million million
Forecast A
Initial investment (D$0.38x2.1140) -150.0 40
Net T$ operating cash flows 45.0 54.0 64.8 68.7 72.8
Tax at 20% in Country T -9.0 -10.8 -13.0 -13.7 -14.6
Tax depreciation allowances (W3) 6.0 4.8 3.8 3.1 4.3
Net total remitted to Country D -150.0 42.0 48.0 55.6 58.1 102.5
Tax at 5% in Country D -2.1 -2.4 -2.8 -2.9 -3.1 (W1)
Net cash flow in T$ -150.0 39.9 45.6 52.8 55.2 99.4
Discount factor at 12% 1 0.893 0.797 0.712 0.636 0.567
NPV of T$ cash flows at 12% -150.0 35.6 36.3 37.6 35.1 56.4
Total T$ 51.0 million
Convert at 2.1145 D$ 24.1 million
Less additional logistics planning (D$ 0.4 million) assuming no tax relief
Net total PV D$ 23.7 million

Forecast B
Net cash flow in T$ (as above) -150.0 39.9 45.6 52.8 55.2 99.4
Exchange rate (W1) 2.1145 2.2287 2.3490 2.4759 2.6096 2.7505
D$ D$ D$ D$ D$ D$
million million million million million million
Net cash flow in D$ -70.9 17.9 19.4 21.3 21.2 36.1
Additional logisitics planning -0.4
Discount factor at 12% 1 0.893 0.797 0.712 0.636 0.567
NPV of cash flows in D$ at 12% -71.3 16.0 15.5 15.2 13.5 20.5
Net total PV D$ 9.4 million

W1: Tax at 5% excludes initial and residual value investment cash flows. 3.1 = 5% x (72.8
Assumption: no tax relief on 'additional logistics planning'

Examiner's Note: Full credit given if candidates made alternative assumption

on tax treatment of additional logistics planning

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Alternative approach for Forecast B, adjusting the discount rate instead

of calculating future exchange rates:

Forecast B
Net cash flow in T$ -150.0 34.2 41.0 52.8 55.2 95.1
Discount factor at 18% (W2) 1 0.847 0.718 0.609 0.516 0.437
NPV of T$ cash flows at 18% -150.0 29.0 29.5 32.2 28.5 41.6
TOTAL T$ 20.6m
Convert at 2.1145 D$ 9.7m
Less additional logistics planning (D$ 0.4m)
Net total NPV D$ 9.3 m (difference due to roundings)

So, the impact of the T$ depreciating against the D$ by 54% a year rather than staying constant at the
spot rate of 2.1145 is a reduction in the NPV of the project from D$ 23.7 million to D$ 9.4 million, a
reduction of over 60%.

Workings
W1:  Calculating future exchange rates
Date Exchange rate Workings
2009 2.1145
2010 2.2287 2.2287 = 2.1145 x 1.054
2011 2.3490 2.3490 = 2.2287 x 1.054
2012 2.4759 2.4759 = 2.3490 x 1.054
2013 2.6096 2.6096 = 2.4759 x 1.054
2014 2.7505 2.7505 = 2.6096 x 1.054

W2 :  Discount rate = 1.12 x 1.054 ‐ 1 = 18%
         which includes the investment appraisal rate of 12% and the currency depreciation of 5.4%
Pool Tax Tax
W3 : Tax depreciation  T$ all'nce impact @ 20%
allowances 150.0 30.0 6.0
2010 ‐30.0
120.0 24.0 4.8
2011 ‐24.0
96.0 19.2 3.8
2012 ‐19.2
76.8 15.4 3.1
2013 ‐15.4
61.4
2014 ‐40.0 residual value
21.4 21.4 4.3

Advice on whether to proceed

The project shows a strong positive NPV under both exchange rate scenarios.

If it considers Forecast B to be a ‘worst case scenario’, Dominique can be confident in

proceeding with the project. Indeed, this is a highly conservative assessment as it only covers a
5 year time horizon and assumes a low residual value. Taking a longer term view or assuming
a higher residual value can be expected to result in a significantly higher NPV result.

P9 14 November 2009
P9 Financial Strategy November 2009
Examiners Answers

The project would appear to fit in well with its already wide geographical spread of business.

Conclusion: advise Dominique to proceed with the project.

(b)
The Dominique group has a significant exposure to movements in both exchange rates and tax
rates because of its wide geographical spread of businesses and continued expansion into new
territories.

Exchange rates impact on:

• net investment values of subsidiaries (match currency of funding to net investment
currency to reduce exposure to exchange rate movements)
• value of repatriated profits via dividends (dividend planning and hedging of predictable
future dividend streams to protect against a relative rise in the value of the D$)
• cost of servicing foreign currency debt (try and ensure that interest streams are matched
by dividend or interest streams in the same currency)
• consolidate earnings (limited response possible – and part of the motivation behind
shareholder investment in the entity may have been to provide some exposure to a
portfolio of currencies for the countries where Dominique has operations)
• cost of goods imported in a different currency to that where the goods are to be sold (use
hedging instruments to fix currency rates on firm or predictable cash flows, hedging
back to the functional currency of the importing operation)
Tax rates:
• structure funding in tax efficient manner
• limit withholding tax by appropriate corporate structure
• generally aim to generate higher earnings in lower tax regimes
• keep informed of government plans and policies and ensure there is sufficient mark-up
and profit in any new country to reduce the risk of losses if tax rates were to increase

P9 15 November 2009
P9 Financial Strategy November 2009
Examiners Answers

The Examiner for Integrated Management offers to future candidates and to

lecturers using this booklet for study purposes, the following background and
guidance on the questions included in this examination paper.
Question 1 concerns a large entity in the construction industry. It has the opportunity to acquire
a smaller entity in a related business that has access to scarce technical resources. Both
entities’ shares are listed on a recognised Stock Exchange. The bid is likely to be hostile at the
initial approach.

The bidding entity’s financial advisors have produced estimates of future growth in the potential
target’s earnings.

Part (a) of the question evaluates the financial position of each entity prior to the acquisition.

Part (ai) requires the calculation of P/E ratios and market capitalisation for each
independent entity.

Part (aii) requires the calculation of the cost of equity for each entity, using a proxy
entity’s beta to calculate the cost for the target entity.

Part (aiii) requires the calculation of the estimated value of each entity.

Part (b) requires the calculation of the increase in value that might be generated by combining
the two entities following the acquisition.

The report section of the question, part (c), requires discussion and advice on various factors
that the bidding entity’s Board needs to consider in preparation for the bid. These include the
recommendation of an opening bid, alternative methods of financing the bid and the discussion
and evaluation of wider implications for the achievement of the broad financial objectives of the
bidding entity.

The question tests learning outcomes (LO) in the following sections of the syllabus:

Section A – Formulation of Financial Strategy

LO (i) Identify an organisation’s objectives in financial terms and evaluate their attainment.
LO (ii) Discuss the interrelationships between decisions concerning investment, financing and
dividends.

Section B – Financial Management

LO (ii) Identify and evaluate key success factors in the management of the finance function and
its relationship with other parts of the organisation and, where necessary, with external parties.

Section C – Business Valuations and Acquisitions

LO (i) Calculate values of organisations of different types, e.g. service, capital intensive.
LO (iv) Compare and recommend alternative forms of consideration for, and terms of,
acquisitions.
LO (v) Calculate post-merger or post-acquisition values of companies.

P9 16 November 2009
P9 Financial Strategy November 2009
Examiners Answers

Question 2 is in two parts.

The first part, part (a), concerns a listed entity that has announced a rights issue. Candidates
are required is to provide calculations and an evaluation of the alternative courses of action
available to a particular shareholder.

Part (b) concerns a competitor company which has cash surplus to requirements and is
considering paying across cash to its shareholders. This part requires a discussion of the
advantages of a share repurchase versus a one-off special dividend as a means of returning
surplus cash to shareholders.

The question examines learning outcomes in the following syllabus sections:

Section A – Formulation of Financial Strategy

LO (iii) Identify and analyse the impact of internal and external constraints on financial
strategy (e.g. funding, regulatory bodies, investor relations, strategy, and economic factors).

Section B – Financial Management

LO (i) Identify and describe optimal strategies for the management of working capital and
satisfaction of longer term financing requirements.

Question 3 concerns a UK-based manufacturing entity that is considering the purchase of new
equipment. It is also considering how to finance the purchase.

Part (a) of the question requires the calculation and discussion of three alternative methods of
finance and a recommendation of the most appropriate method.

Part (b) of the question requires explanation and advice about two (out of a given three)
methods of incorporating risk in the NPV project evaluation. in the context of the given scenario.
The three proposed methods are decision trees, risk adjusted discount rates and certainty
equivalents.

This question examines learning outcomes in the following syllabus sections:

Section B – Financial Management

LO (i) Identify and describe optimal strategies for the management of working capital and
satisfaction of longer term financing requirements.

Section C – Business Valuations and Acquisitions

LO (i) Calculate values of organisations of different types, e.g. service, capital intensive.

Section D– Investment Decisions and Project Control

LO (ii) Evaluate investment projects (domestic and international) taking account of potential
variations in business and economic factors.
LO (iii) Recommend methods of funding investments, taking account of basic tax
considerations.

P9 17 November 2009
P9 Financial Strategy November 2009
Examiners Answers

Question 4 concerns an entity based in Asia that is considering installing a new computer
system which would be financed by additional debt.

Part (a) of the question requires the calculation of the WACC of the entity.

Part (b) requires the evaluation of the project using the WACC calculated in part (a).

Part (c) requires the calculation of post-project WACC after adjusting for the NPV of the new
project and the increase in debt.

Part (d) of the question requires discussion of the key factors the entity should consider when
assessing customer requirements and drawing up an implementation plan.

The question examines learning outcomes in the following syllabus sections:

Section B – Financial Management

LO (i) Identify and describe optimal strategies for the management of working capital and
satisfaction of longer term financing requirements.

Section D– Investment Decisions and Project Control

LO (ii) Recommend investment decisions when capital is rationed.

Question 5 concerns a multi-national group that is considering investment in a major new

project in a different country from its head office and parent base. The entity is funded by a mix
of equity and long-term borrowings.
Part (a) of the question requires calculation and discussion of the NPV of the project cash flows
using two different exchange rate scenarios.
Part (b) of the question requires discussion of how the group’s financial strategy and
performance might be affected by movements in exchange rates and tax rates.
The question examines learning outcomes in the following syllabus sections:

Section A – Formulation of Financial Strategy

LO (iv) Evaluate current performance, taking account of potential variations in economic
and business factors.

Section D– Investment Decisions and Project Control

LO (ii) Evaluate investment projects (domestic and international) taking account of potential
variations in business and economic factors.

P9 18 November 2009