PROFESSIONAL LEVEL EXAMINATION

WEDNESDAY 6 JUNE 2018

(2½ HOURS)

FINANCIAL MANAGEMENT
This exam consists of three questions (100 marks).

Marks breakdown

Question 1 35 marks
Question 2 35 marks
Question 3 30 marks

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Question 1

You work for Helvellyn Corporate Finance (HCF) and you are currently working on two tasks:

Task 1: Evans Stores Ltd (Evans) is an independent food retailer. Evans is considering an
initial public offering (IPO) of its ordinary shares on 30 June 2018 and you have been asked
to advise on a value for these shares.

Task 2: Huzzey plc (Huzzey) is a quoted conglomerate that is considering divesting itself of
one of its divisions. You have been asked to value the division.

1.1 Task 1: The Valuation of Evans’s ordinary shares

Extracts from Evans’s most recent management accounts are as follows:

Income statement Balance sheet
for the year ended as at 31 May 2018
31 May 2018
£’000 £’000
Non-current assets
Sales 280,000 53,000
Operating costs (270,000) Current assets 31,000
Depreciation (6,000) 84,000
Amortisation (500)
Profit before interest Share capital (£1 ordinary
3,500 shares) 3,000
Retained earnings
Interest (950) 12,000
Profit before tax 2,550 15,000
Taxation (at 17%) (434)
Long term loans 41,000
Profit after tax 2,116 Current liabilities 28,000
84,000

Additional information:

1. Evans’s current assets include cash balances and short-term investments, which total
£7 million.

2. The market value of Evans’s non-current assets at 31 May 2018 was estimated to be
£59 million.

3. Average multiples for a sample of listed companies in the same market sector as Evans
at 31 May 2018 are:

 Enterprise value 6.5

 Price earnings (P/E) ratio 12.1

Copyright © ICAEW 2018. All rights reserved. Page 2 of 9

Requirements

(a) Calculate the value of one Evans ordinary share at 31 May 2018 based on each of the
following methods:

 Enterprise value
 P/E ratio
 Net assets basis (historic)
 Net assets basis (re-valued) (8 marks)

(b) Recommend and justify to the board of Evans an issue price per share on 30 June 2018
for the company’s ordinary shares. Refer to the range of values calculated in part (a)
above. (4 marks)

(c) Discuss whether Shareholder Value Analysis (SVA) might be a useful additional method,
to those in part (a) above, of valuing Evans’s ordinary shares. (3 marks)

1.2 Task 2: The Divestment of the Huzzey division

Assume that the current date is 30 June 2018

At a recent board meeting of Huzzey it was decided that the company should divest itself of
its paint-manufacturing subsidiary, Supercover Ltd (Supercover). The board discussed the
following three proposed ways of carrying out the divestment:

 Proposal 1. To reduce Supercover’s operations over a period of three years and then
close it down.
 Proposal 2. To sell Supercover to another company.
 Proposal 3. To sell Supercover to a team made up of its current management.

It was decided at the board meeting that one of the criteria for choosing the best method of
divestment would be the present value of the cash flows associated with each proposal.

A suitable discount rate to assess the present value of the cash flows of all three proposals is
10%.

You should assume that corporation tax will be payable at the rate of 17% for the foreseeable
future and tax will be payable in the same year as the cash flows to which it relates.

Financial information for each proposal is as follows:

Proposal 1:

 Sales revenue for the year to 30 June 2018 was £25 million. For the three years to
30 June 2021 sales volumes are expected to decrease by 10% pa compound. Selling
prices will not change and contribution is expected to be 60% of the selling price.

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 The amount invested in working capital on 30 June 2018 was £2 million. This amount will
reduce at the end of each year in line with the reduction in sales volumes. On 30 June
2021 all remaining working capital will be recovered in full.

 On 30 June 2018 Supercover’s plant and equipment has a tax written down value of
£3 million.

 On 30 June 2021 Supercover’s plant and equipment will be sold for an estimated
£9 million (at 30 June 2021 prices).

 The plant and equipment attracts 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 plant 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.

 Redundancy payments on 30 June 2021 will amount to £0.50 million (at 30 June 2021
prices). This amount is fully allowable for tax.

Proposal 2:

All the shares in Supercover will be sold for £38 million before taxation on 30 June 2018.
Assume that this amount is fully taxable.

Proposal 3:
The management team will buy the shares of Supercover for £41 million. The £41 million will
be received in three instalments as follows:

 On 30 June 2018 £15 million

 On 30 June 2019 £13 million
 On 30 June 2020 £13 million.

Assume that all these instalments are fully taxable in the year that they are received.

Requirements

(a) Calculate the present value at 30 June 2018 of each of the three proposed ways in
which Huzzey could divest itself of Supercover. (10 marks)

(b) Identify one advantage and one disadvantage for each of the three divestment
proposals. (6 marks)

(c) Advise the board of Huzzey as to which of the three divestment proposals should be
chosen. (4 marks)

Total 35 marks

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Question 2

Assume that the current date is 30 June 2018

Mitchells is a firm of ICAEW Chartered Accountants. Mitchells has been asked to advise a
listed client, Blackstar plc (Blackstar), on the following two issues:

Issue 1: Blackstar intends to raise additional funds of £150 million to fund an expansion of
its existing operations.
Issue 2: Blackstar is concerned about its existing dividend policy.

2.1 Issue 1: Raising additional funds of £150 million

Blackstar has always maintained a policy of no gearing. Other companies in Blackstar’s

market sector have average gearing ratios (measured as debt/equity by market values) of
25%, with a maximum of 35%, and an average interest cover of 8 times, with a minimum of 6.
The finance director of Blackstar is considering raising the £150 million by either a rights
issue or by the company now borrowing and issuing debentures.

The details of the alternative sources of finance are as follows:

Rights Issue: The £150 million would be raised by a 2 for 3 rights issue, priced at a discount
on the current market value of Blackstar’s ordinary shares.

Debt issue: The £150 million would be raised by an issue of 6% coupon debentures,
redeemable at par on 30 June 2025. The gross redemption yield would be based on the
current gross redemption yield of other debentures issued by companies in Blackstar’s
market sector. One such company is Blue plc (Blue). Details for Blue’s debentures are as
follows:

 Coupon 5%
 The current market price on 30 June 2018 is £109 cum interest
 Redemption at par on 30 June 2023

Further information regarding Blackstar:

 The forecast pre-tax operating profit for the year ending 30 June 2018 is £50 million
 The corporation tax rate is 17%
 The current share price at 30 June 2018 is £7.50 ex-div
 The number of ordinary shares in issue is 60 million

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Requirements

(a) Assuming a 2 for 3 rights issue is made on 1 July 2018:

 calculate the discount the rights price represents on Blackstar’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)

(b) Alternatively, assuming debt is issued on 1 July 2018:

 calculate the issue price per debenture and total nominal value of the debentures
that will have to be issued to give a yield to redemption equal to that of Blue’s
debentures
 discuss the validity of using the yield to redemption of Blue’s debentures in the
above calculation. (7 marks)

(c) Advise Blackstar’s finance director of the advantages and disadvantages of raising the
£150 million by debt or equity or a combination of the two.
You should also discuss the likely reaction of Blackstar’s shareholders and the stock
market (you should refer to the gearing and interest cover information provided).
(12 marks)

2.2 Issue 2: Blackstar’s dividend policy

Blackstar is reviewing its dividend policy, which has been to maintain a constant payout ratio
of 30% of profits after tax. The following views were expressed by two directors at the most
recent board meeting:

Director A: “We should have a constant dividend growth policy with some growth irrespective
of whether profits after tax rise or fall. If we have surplus cash after reinvestment we can
leave it in the bank.”

Director B: “I agree with Director A, but instead of leaving surplus cash in the bank we can
pay a special dividend or repurchase some shares.”

Requirements

(a) Describe what is meant by:

 a special dividend
 a share repurchase

(b) Discuss whether Blackstar’s current dividend policy is appropriate for a listed company
and critically evaluate the alternatives suggested by Directors A and B. (4 marks)

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2.3 Mitchells is also advising Goldwing plc, which is considering making a takeover bid for
Blackstar.

Requirement

Identify the ethical issues for Mitchells regarding giving advice to both Goldwing plc and
Blackstar. Also advise Mitchells on what safeguards might be put in place.
(3 marks)

Total 35 marks

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Question 3

Assume that the current date is 30 June 2018

Tarbena plc (Tarbena) is a UK company that has a subsidiary company in Germany and also
has customers and suppliers in the USA.

At a recent board meeting of Tarbena there was a discussion about the company’s exposure
to foreign exchange rate risk (forex). In particular the following points were discussed:

 how the company’s dollar receipts and payments are hedged

 the role that interest rate parity and purchasing power parity play in relation to forex
 the likely effect on the company’s share price if it shows exchange rate losses when
translating the German subsidiary’s financial statements into sterling.
It was decided at the meeting that the finance director would make a presentation to the
board and he has asked you to prepare some notes for his presentation, including numerical
examples where appropriate.

You have the following information available to you at the close of business on
30 June 2018:

Receipts and payments

Receipts due from customers on 30 September 2018 are $6,000,000.

Payments due to suppliers on 30 September 2018 are

$10,000,000.

Exchange rates

Spot rate ($/£) 1.3078 – 1.3080

Three month forward discount ($/£) 0.0088 – 0.0092

September currency futures price

Standard contract size £62,500 $1.3096/£

Over-the-counter (OTC) currency options

September put options to sell $ are available with an exercise price of $1.3190 The premium
is £0.03 per $ and is payable on 30 June 2018.

September call options to buy $ are available with an exercise price of $1.3170. The premium
is £0.04 per $ and is payable on 30 June 2018.

Annual borrowing and depositing interest rates (%)

Dollar 6.00 – 5.80

Sterling 3.28 – 2.98

Tarbena currently has an overdraft.

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Requirements

Prepare notes for the finance director of Tarbena, which should include:

3.1 A calculation of Tarbena’s net sterling payment if it uses the following to hedge its forex:
(a) a forward contract
(b) currency futures
(c) an OTC currency option

assuming that the spot rate on 30 September 2018 will be $/£1.3167 – 1.3175 and the
September futures price will be $/£1.3171. (12 marks)

3.2 A discussion 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 is the most advantageous for Tarbena. (7 marks)

3.3 An explanation of interest rate parity together with calculations which show why the
forward rate is at a discount to the spot rate on 30 June 2018. (5 marks)

3.4 An explanation, without calculations, of purchasing power parity. (3 marks)

3.5 The likely effect on Tarbena’s share price if there are exchange rate losses when
translating the German subsidiary’s financial statements into sterling. (3 marks)

Total 30 marks

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