PROFESSIONAL LEVEL EXAMINATION

TUESDAY 6 DECEMBER 2016

(2½ hours)

FINANCIAL MANAGEMENT
This paper consists of THREE questions (100 marks).

1. Ensure your candidate details are on the front of your answer booklet. You will be given
time to sign, date and print your name on the answer booklet, and to enter your
candidate number on this question paper. You may not write anything else until the
exam starts.

2. Answer each question in black ballpoint pen only.

3. Answers to each question must begin on a new page and must be clearly numbered.
Use both sides of the paper in your answer booklet.

4. The examiner will take account of the way in which answers are presented.

5. When the assessment is declared closed, you must stop writing immediately. If you
continue to write (even completing your candidate details on a continuation booklet), it
will be classed as misconduct.

A Formulae Sheet and Discount Tables are provided with this examination paper.

IMPORTANT

Question papers contain confidential You MUST enter your candidate number in this
information and must NOT be removed box.
from the examination hall.

DO NOT TURN OVER UNTIL YOU

ARE INSTRUCTED TO BEGIN WORK
1. You should assume that the current date is 31 December 2016

Ribble plc (Ribble), a UK company, manufactures hoverboards and other products.

Hoverboards are a form of self-balancing scooter powered by rechargeable batteries. In the
last two years total UK sales of hoverboards have increased rapidly but major concerns have
arisen over their safety and, even though they are still in high demand, some retailers have
stopped selling them.

At a recent directors’ meeting of Ribble the chief executive officer (CEO), who is an ICAEW
Chartered Accountant, presented a research and development report (that had cost
£100,000) on a new and safer hoverboard; the Ribbleboard. The CEO stated that he believed
the new Ribbleboard could be successfully marketed for a period of four years and would
replace the company’s existing hoverboard, the Ribflyer. The directors decided that a project
appraisal should be undertaken to ascertain whether the Ribbleboard should be marketed.
Some directors felt that as there is a continuing demand for the Ribflyer, even though there
are concerns about its safety, it should still be manufactured and sold rather than taking the
risk of marketing the Ribbleboard. There was also concern that a rival company was known
to be developing a new safer hoverboard and it is likely to launch it onto the market on
31 December 2017.

The following information is available regarding the Ribbleboard project:

 The selling price will be £299 per unit in the year to 31 December 2017 and will remain
fixed in each subsequent year of the product’s life. The contribution for the year to
31 December 2017 is expected to be 45% of the selling price. The variable cost of
producing the Ribbleboard is expected to increase by 5% pa in the three years to
31 December 2020.

 The number of units sold in the year to 31 December 2017 is expected to be 8,000 per
month. For the year to 31 December 2018 the number of units sold is expected to
increase by 20%. For the remaining two years to 31 December 2020, the number of units
sold is expected to decline by 15% pa.

 The new specialist equipment required to manufacture the Ribbleboard requires more
space than Ribble currently has available. Therefore, Ribble will use factory space that it
currently owns and rents out for storage to another company for a fixed rent of £1 million
pa payable in advance on 31 December. The space will be re-let for £1 million pa at the
end of the project on 31 December 2020.

 If the project goes ahead, two managers who had already accepted voluntary
redundancy would be asked to remain employed until 31 December 2020 and manage
the project at a salary of £60,000 pa each. These managers were due to leave on
31 December 2016 and receive lump sum payments of £50,000 each at that time. They
will now receive lump sum payments of £60,000 each on 31 December 2020 when their
services will no longer be required. The managers were also due to receive consultancy
fees of £25,000 pa each for the two years ended 31 December 2017 and 2018. These
consultancy fees would not be paid to them if they remained employed to manage the
project. All of the above salaries, lump sums and fees are stated in money terms.

 It is estimated that for every ten Ribbleboards sold there will be a loss of sales of one unit
of the Ribflyer, which Ribble expects to sell at a fixed selling price of £100 and a
contribution of 25%, in each of the four years to 31 December 2020.

Copyright © ICAEW 2016. All rights reserved. Page 2 of 7

 The project will incur fixed overhead costs of £500,000 in the year to 31 December 2017
of which 40% is centrally allocated overheads. The fixed overhead costs will increase
after 31 December 2017 by 3% pa.

 Investment in working capital will be £1 million on 1 January 2017 and will increase or
decrease at the start of each year in line with sales volumes. Working capital will be fully
recoverable on 31 December 2020.

 On 31 December 2016 the project will require an investment in machinery and equipment
of £24 million, which is expected to have a realisable value of £4 million (in 31 December
2020 prices) at the end of the project. The machinery and equipment will attract 18%
(reducing balance) capital allowances in the year of expenditure and in every subsequent
year of ownership by the company, except the final year.

In the final year, the difference between the machinery and equipment’s written down
value for tax purposes and its disposal proceeds will be treated by the company either as
a:

o balancing allowance, if the disposal proceeds are less than the tax written down
value, or
o balancing charge, if the disposal proceeds are more than the tax written down value.

 Assume that the rate of corporation tax will be 21% for the foreseeable future and that tax
flows arise in the same year as the cash flows that give rise to them.

 An appropriate money cost of capital for the Ribbleboard project is 10% pa.

Requirements

1.1 Using money cash flows calculate the net present value of the Ribbleboard project at
31 December 2016 and advise Ribble’s directors whether it should be accepted.
(20 marks)

1.2 Advise Ribble’s directors as to the sensitivity of the NPV of the Ribbleboard project to:

(a) Changes in sales revenue (ignoring the effects on working capital) (4 marks)
(b) Changes in the realisable value of the machinery and equipment (3 marks)

1.3 Identify and discuss two real options available to Ribble in relation to the Ribbleboard
project. (5 marks)

1.4 Discuss the ethical issues that the CEO should consider regarding the suggestion by
some directors that only the Ribflyer hoverboard should continue to be manufactured.
(3 marks)

Total: 35 marks

Copyright © ICAEW 2016. All rights reserved. Page 3 of 7

2. You should assume that the current date is 31 December 2016

You work for Bristol Corporate Finance (BCF). Two of the clients for whom you are
responsible are Middleton plc (Middleton) and the management team of Oldham Ltd
(Oldham).

2.1 Middleton

Middleton is a listed company and is seeking to raise £70 million to invest in new projects
during 2017. Currently Middleton is financed only by equity. However, at a recent board
meeting the finance director stated that, since other companies in Middleton’s industry sector
have average gearing ratios (measured as debt/equity by market value) of 30% (with a
maximum of 40%) and an average interest cover of 6 times (with a minimum of 5 times),
perhaps the company should access the debt markets. The finance director presented the
board with two alternative sources of finance to raise the £70 million.

Equity issue: The £70 million would be raised by a 1 for 2 rights issue, priced at a discount
on the current market value of Middleton’s shares.

Debt issue: The £70 million would be raised by an issue of 7% coupon debentures,
redeemable at par on 31 December 2026. The yield to redemption of the debentures would
be equal to the yield to redemption of the debentures of Wood plc (Wood), another listed
company in Middleton’s market sector. Wood has a similar risk profile to Middleton and has
recently issued its debentures. Wood’s debentures have a coupon of 7%, will be redeemed in
four years at par and their current cum-interest market price is £110 per £100 nominal value.

There were concerns expressed by a number of board members regarding the debt issue
since it has been the long-standing policy of the company not to borrow. Their concerns were
how Middleton’s shareholders and the stock market would react and that the company’s cost
of capital would increase as a result of borrowing, leading to a fall in the company’s value.

An extract from Middleton’s most recent management accounts is shown below:

Income statement for the year ended 31 December 2016

£m
Operating profit 25.00
Taxation at 21% (5.25)
Profit after tax 19.75

Additional information:

 Middleton has an equity beta of 1.1

 The risk free rate is expected to be 3% pa
 The market return is expected to be 8% pa
 Middleton’s current share price is £5 per share ex-div
 Middleton has 40 million ordinary shares in issue.

Copyright © ICAEW 2016. All rights reserved. Page 4 of 7

 Requirements

(a) Calculate, using the CAPM, Middleton’s cost of capital on 31 December 2016. (1 mark)

(b) Assuming a 1 for 2 rights issue is made on 1 January 2017:

 calculate the discount the rights price represents on Middleton’s current share price
 calculate the theoretical ex-rights price per share
 discuss whether the actual share price is likely to be equal to the theoretical
ex-rights price. (5 marks)

(c) Alternatively, assuming debt is issued on 1 January 2017:

 calculate the issue price and total nominal value of the debentures that will have to
be issued to give a yield to redemption equal to that of Wood’s debentures

 discuss the validity of the use of the yield to redemption of Wood’s debentures in
the above calculation. (7 marks)

(d) Outline the advantages and disadvantages of the two alternative sources for raising the
£70 million, discuss the concerns of the board regarding the debenture issue (using the
gearing and interest cover information provided by the finance director) and advise
Middleton’s board on which source of finance should be used. (12 marks)

2.2 The management team of Oldham

You have been asked to make a presentation to the management team of Oldham, an
unlisted company, who are considering a management buyout (MBO) of the company. Your
presentation will cover certain aspects of the MBO process and the contents of the financial
information section of the business plan that will need to be prepared for potential financiers.

Requirements

Prepare notes for your presentation which include:

(a) An outline of the sources and forms of finance that the management team is likely to
need. (3 marks)

(b) The possible exit routes for the financiers that contribute to the funding of the MBO.
(2 marks)

(c) The content of the financial information section of the business plan. (5 marks)

Total 35 marks

Copyright © ICAEW 2016. All rights reserved. Page 5 of 7

3. You should assume that the current date is 30 November 2016

Orion plc (Orion) is a UK company that manufactures nutrition products which it exports to
the USA and receives payment in dollars. Orion imports raw materials from a number of
countries located in Europe and makes payments to suppliers in euros.

At a recent board meeting of Orion concern was expressed about several aspects of the
company’s foreign exchange rate risk (forex) hedging strategy. Below is an extract from the
minutes of the meeting:

Managing director: “We have always hedged our forex and we should continue to do so.
But I am worried that because we import our raw materials and export our finished
products, we are subject to economic risk.”

Production director: “We use derivative instruments to hedge forex and I think they are
too complicated. How do the banks calculate forward rates for example? Also can
someone explain to me what economic risk is?”

It was decided that at the next board meeting the finance director should make a presentation
to the board on the subject of forex. The finance director has asked you to prepare some
information for his presentation including an example of how receipts are hedged using
different hedging techniques.

You have the following information available to you at the close of business on 30 November
2016:

Orion currently has substantial sterling funds on deposit.

Receipts due from USA customers on 31 March 2017 are $5,000,000.

Exchange rates:

Spot rate ($/£) 1.4336 – 1.4340

Four month forward discount ($/£) 0.0086 – 0.0090

March currency futures price (standard contract size £62,500) $1.4410/£

Over-the-counter (OTC) currency option

A March put option to sell $ is available with an exercise price of $1.4390/£. The premium is
£0.03 per $ and is payable on 30 November 2016.

Annual borrowing and depositing interest rates (%)

Dollar 5.20 – 4.80

Sterling 3.30 – 3.00

Copyright © ICAEW 2016. All rights reserved. Page 6 of 7

Requirements

Provide the following information for the finance director of Orion:

3.1 A calculation of Orion’s sterling receipt using:

(a) a forward contract

(b) currency futures
(c) an OTC currency option

assuming that the spot price on 31 March 2017 is $/£ 1.4484 – 1.4490 and the March
futures price is $1.4487/£. (11 marks)

3.2 An explanation of the advantages and disadvantages of the three hedging techniques
used in 3.1 above and, using your results from 3.1 above, advice on which hedging
technique Orion should use. (8 marks)

3.3 A demonstration, with reference to theories and relevant workings, of why the forward
rate is at a discount to the spot rate at 30 November 2016. (5 marks)

3.4 An explanation of what economic risk is, a discussion of how it affects Orion and an
outline of how economic risk can be mitigated. (6 marks)

Total 30 marks

Copyright © ICAEW 2016. All rights reserved. Page 7 of 7