PL j17 FM Student Mark Plan Final

Financial Management - Professional Level – June 2017
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.
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:
General comments
This was a six-part question, which tested the candidates’ understanding of the investment decisions
element of the syllabus. The scenario of the question was that a company is considering launching on to
the market a new product.
1.1
0 1 2 3 4
£m £m £m £m £m
Contribution 2.97 3.18 2.92 2.68
Fixed overheads -0.10 -0.10 -0.11 -0.11
Selling and Administration -0.50 -0.52 -0.53 -0.55
Rent forgone -0.40 -0.40 -0.40 -0.40
Operating cash flows -0.40 1.97 2.16 1.88 2.02
Tax 17% 0.07 -0.33 -0.37 -0.32 -0.34
After tax operating cash

flows -0.33 1.64 1.79 1.56 1.68
New equipment -8.00

Tax saved on Cas 0.24 0.20 0.16 0.13 0.62
Working Capital -1.00 -0.07 0.09 0.08 0.90
Net cash flows -9.09 1.77 2.04 1.77 3.20
PV factors at 10% 1.00 0.909 0.826 0.751 0.683
Present value -9.09 1.61 1.68 1.33 2.19
NPV -2.28
The project has a negative NPV therefore it should not proceed.
Contribution:
1. 5,500 x 12 x £100 x 45% = £2.97m
2. 2.97 x 1.02 x 1.05 = £3.18m
3. 3.18 x 1.02 x 0.90 = £2.92m
4. 2.92 x 1.02 x 0.90 = £2.68m
Copyright © ICAEW 2017. All rights reserved Page 1 of 10

Fixed overheads only 50% incremental: £0.2m x 0.5 = £0.1m

1. 0.1
2. 0.1 x 1.03 = 0,103
3 0.103 x 1.03 = 0.106
4.0.106 x 1.03 = 0.109
Selling and administration:

1. 0.50
2. 0.50 x 1.03 = 0.515
3. 0.515 x 1.03 = 0.531
4. 0.531 x 1.03 = 0.546
Marketing costs and centrally allocated costs are a sunk costs and therefore not included.
Capital allowances and the tax

saved thereon
Cost/WDV CA Tax
0 8.00 1.44 0.24

1 6.56 1.18 0.20
2 5.38 0.97 0.16
3 4.41 0.79 0.13
4 3.62 3.62 0.62
Working Capital
Total Increment
0 -1 -1
1 -1.07 -0.07
2 -0.98 0.09
3 -0.9 0.08
4 0.9
The discount factor should be calculated as follows:
(1.07x1.025)-1 = 0. 0968 It is acceptable to round this to 0.10 (10%)
Well answered by many candidates, however the following were common errors: incorrect calculation of
sales and variable costs; timing errors for cash flows; not stating that research and development costs
should be ignored because they are a sunk cost; not stating that allocated fixed overheads should not be
included in the NPV computations.
Total possible marks 15

Maximum full marks 15

1.2
Sensitvity: £m £m £m £m
Contribution x (1-0.17) 2.47 2.64 2.42 2.22
PV factors 0.909 0.83 0.75 0.68
PV 2.25 2.18 1.82 1.52
Total PV 7.77
Sensitivity
- 2.28/7.77 = -29.3%
Sales revenue will have to increase by 29.3% to arrive at a zero NPV. The
project is therefore relatively insensitive to revenue changes.
Responses to this part of the question were mixed with many candidates basing calculations on sales
rather than contribution and many ignoring taxation. There were few candidates who made meaningful
comments regarding the sensitivity of the project to changes in the inputs.

1.3
SVA is the process of analysing the activities of a business to identify how they will result in increasing
shareholder wealth.
Answers should outline the seven drivers and relate them to the project and its negative NPV:
Sales growth rate – can this be increased, are the estimates realistic.
Operating profit margin – can the 45% contribution be improved by reducing costs.
Investment in non-current assets - can the cost of the project be reduced, perhaps by leasing plant and
machinery.
Investment in working capital - can the project operate with less investment in working capital without
causing liquidity problems.
Cost of Capital – is the cost of capital at its optimum level.
Life of projected cash flows - is the project life cycle correct and is there any value in cash flows beyond
the fourth year.
Corporation tax rate – is the company tax efficient.
Responses to this part of the question were mixed with weaker candidates merely listing the seven drivers
with no application to the scenario.


1.4
The project has a negative NPV, which signals that Brighton should reject it.
The real options are as follows (any TWO):
A follow-on option – investing into this competitive market now will allow Brighton to invest more in the
future perhaps when other competitors have left the market.
An abandonment option – Brighton might commence the project with a view to future investment.
However, if it is apparent that the sector is not going to offer future opportunities, at any time Brighton can
abandon the project eg selling out to a rival.
A timing option – Brighton could delay its investment and wait and see if competitors leave the market,
making it more attractive to invest later on.
A Growth option – As well as manufacturing overseas, Brighton also has the opportunity to expand
overseas.
A Flexibility option – Manufacturing overseas would perhaps give the flexibility to access overseas
markets more easily.
Responses to this part of the question were good, however some candidates listed all real options rather
than just stating two as per the requirement. Only the first two are marked.

1.5
The over-riding objective of companies is to create long-term wealth for shareholders. However this can
only be done if we consider the likely behaviour of other stakeholders.
For example (TWO only):
Employees- cutting their benefits in pursuit of creating short-term profits could have long-term detrimental
effects on shareholder wealth.
Creditors- delaying payments to creditors could have repercussions, which reduce longer-term
shareholder wealth.
Mangers- if managers and employees are not motivated adequately, the costs of inefficiencies will be
borne by shareholders.
Responses to this part of the question were good.

1.6
The directors of Brighton should develop an ethical policy in respect to using overseas manufacturers
where labour is cheap and safety standards for employees are low. This should relate to not using
suppliers who make use of child labour or slave labour, or who employ people in dangerous working
conditions.
.
(In relation to this students could mention the principals of: Integrity; Objectivity; Professional behaviour.)
Responses to this part of the question were good.


Question 2
Total Marks:
This was a six-part question that tested the candidates’ understanding of the financing options element of
the syllabus.
The scenario of the question was that a company is considering diversifying its activities and is calculating
the WACC that should be used to appraise the diversification. Also there is debate about whether the
company should be diversifying in the first place and how the markets and shareholders might react.
2.1
The current WACC using CAPM is calculated as follows:
Ke = 2 + 0.45 (9-2) = 5.15
Kd using linear interpolation:
The ex interest debenture price is £105 (109-4).

Timing - Cash Flow Factors at PV Factors at PV
years £ 1% £ 5% £
0 (105) 1 (105) 1 (105)
1-8 4 7.652 30.61 6.463 25.85
8 100 0.923 92.30 0.677 67.70
17.91 (11.45)
IRR = 1 + (17.91/(17.91+11.45) x 4 = 3.44%
Kd = 3.44 x (1-0.17) = 2.86%
The ex div share price is 252p – 10p = 242p.
The market value of equity is: 242p x (5m/0.01) = £1,210m
The market value of debt is: £ 200 m x (105/100) = £210 m
The debt equity ratio is: 0.15:0.85
The current WACC is: 5.15 x 0.85 + 2.86 x 0.15 = 4.81%
Responses to this part of the question were good. However a number of candidates made basic errors
when calculating the cost of debt, with a surprising number not able to carry out interpolation correctly.
Strangely some candidates correctly calculated the cost of equity using the CAPM, however they then
used this number in the DVM as growth. They then attempted to use the DVM model to calculate the cost
of equity.


2.2
The cost of equity should reflect the systematic risk of the project. An equity beta from a listed company
operating veterinary practices can be used as a surrogate in the CAPM. Since the gearing ratio of the
surrogate is materially different to Easton gearing adjustments will have to be made.
De gearing to find Ba: 0.80 = Ba (1 + (3 x 0.83)/7)

Solving for Ba. Ba = 0.59
Gearing up to reflect the gearing ratio of Easton to find Be:
Be = 0.59 (1 + (0.15 x 0.83)/0.85)

Solving for Be. Be = 0.68
The Ke to reflect the systematic risk of the project = 2 + 0.68 (9-2) = 6.76
Responses to this part of the question were disappointing. However there were some excellent answers.
Common mistakes were: degearing the company’s existing equity beta; degearing the correct beta but
regearing using book values rather than market values. Explanations of the rational for calculating the cost
of equity for the project were poor.

2.3
The overall Be of Easton will reflect the systematic risk of both per-related products and veterinary
practices.
The overall Be = 0.45 x 0.75 + 0.68 x 0.25 = 0.51
Ke = 2 + 0.51 (9-2) = 5.57%
The overall WACC =

5.57 x 0.85 + 2.86 x 0.15 = 5.16%
Easton’s WACC has increased to 5.16% from 4.81%. An increase in WACC is associated with a
reduction in value, on the other hand assuming that the project has a positive NPV this could result in an
increase in value. (Capital structure theory; max 2 marks)
Responses to this part of the question were mixed, a number of candidates did not calculate the overall
equity beta of the company and used the equity beta from part 2.2. Explanations of the affect of a rise in
the overall WACC of the company were poor.


2.4
Systematic risk is the type of risk that all companies are exposed to no matter which market sector they
operate in. Systematic risk can not be eliminated through diversification. Examples of systematic risk
include: interest rate changes; recession; oil price changes; wars.
Unsystematic risk is the risk that affects a particular market sector or individual company, most of this
risk can be diversified away by investing in a portfolio of 15-20 randomly selected securities. Examples of
unsystematic risk include: The chairman resigning; strikes by the employees of a company; changes in
regulations that affects a particular market sector.
Responses to this part of the question were poor and many candidates were confused about what the
terms systematic and unsystematic risk mean. Often students quoted the incorrect example for each risk.

2.5
Portfolio theory shows that the only logical portfolio to hold is one which is fully diversified, each groups
reactions might be:
The stock market might not welcome the diversification since diversified companies usually trade at a
conglomerate discount. The stock markets might assume that Easton does not have the expertise to
operated veterinary practices.
Shareholders who hold a well-diversified portfolio would not welcome Easton diversifying its operations ie
not doing anything that they haven’t already done for themselves, so MV might fall.
Responses to this part of the question were mixed with many candidates not able to demonstrate a good
grasp of the topic area. Few candidates mentioned that diversified companies often trade at a
conglomerate discount.

2.6
If the financing of the project results in a change in the capital structure of Easton WACC/NPV should not
be used. An alternative project appraisal technique is APV.
The project will be appraised as if it were only financed by equity to arrive at a base case NPV. The base
case NPV is then adjusted for the present value of the costs and benefits of the actual type of finance
used. For example the present value of the tax shield on interest paid.
The discount rate will be the all equity discount rate using the Ba for the project:
2 + 0.59 (9-2) = 6.13%
Responses to this part of the question were reasonable. Many candidates were able to identify APV and
describe the process. However few candidates calculated the appropriate discount rate.


Question 3
Total Marks:
This was a three-part question that tested the candidates’ understanding of the
risk management element of the syllabus.
The scenario of the question was that a company has recently started exporting to the USA and a member
of staff is asked to give advice to the board on hedging FOREX and other risks associated with overseas
trading activities.
3.1
Forward contract:
The appropriate forward rate is $/£1.3110 (1.3092 + 0.0018)
The sterling receipt will be £991,609 (£1,300,000/$1.3110)
Money market hedge:
Borrow in US$ against the receipt due in 3 months:
Borrow $1,288,085 = (1,300,000/(1+0.037/4)
Buy £ spot = £983,871 (1,288.085/1.3092)
Total receipt of £991,497 (983,871 x (1 + 0.031/4))
Currency futures:
Lake will buy September futures to hedge the $ receipt.
The number of contracts to buy is = ($1,300,000/$1.3105)/£62,500 = 15.87 round to 16
The futures contracts will be closed out on 30 September 2017 resulting in a profit of:
$12,500 ((1.3230-1.3105)x16x62,500)
The sterling receipt will be: £990,566 ((1,300,000+12,500)/1.3250)
OTC currency options:
Lake will use a call option to buy £ with an exercise price of $/£1.3200.
The premium will cost = £26,000 (1,300,000 x 0.02)
Together with interest the premium will cost £26,208 (26,000 x (1 + 0.032/4))
If the spot rate for buying £ with $ on 30 September is $/£ 1.3250 the option will be exercised.
The total receipt will = £958,640 ((1,300,000/1.3200)-26,208)
Well answered by most candidates. However some of the errors demonstrated by weaker candidates
included: calculating the number of futures contracts using the spot rate rather than the futures price;
stating that currency futures should be initially sold rather than bought; calculating the futures gain in
£ rather than $; choosing put options rather than call options; treating an over the counter option like a
traded option; calculating the option premium in US$ rather than £; omitting interest on the option
premium.


3.2
The four hedging techniques result in sterling receipts of:
Forward contract £991,609

A money market hedge £991,497
Currency futures £990,566
OTC currency option £958,640
The forward contract, money market hedge and futures contracts all lock Lake into an exchange rate. The
options however protect Heaton against the downside risk of the £ strengthening against the $ and allow
for the upside potential of the $ strengthening against the £, however the option premium is expensive.
In addition to the above some specific advantages and disadvantages include:

Forwards:
Tailored specifically for Lake
However there is no secondary market should the customers not pay Lake
Money market hedge:
The money market hedge is the same as a forward contract. However it is more difficult to arrange and
might use up Lake’s credit lines, on the other hand it does allow Lake to decrease its overdraft
immediately.
Currency futures:
Not tailored so one has to round the number of contracts
Requires a margin to be deposited at the exchange
Need for liquidity if margin calls are made
However there is a secondary market
Basis risk exists
OTC currency options:
There is no secondary market
Advice to Lake:
Spot is $1,300,000/$1.3250 = £981,132
It is unlikely that the $ is going to strengthen enough to cover the cost of the option premium, therefore it is
not recommended that the company use foreign currency options. There is very little difference receipt
using forwards, the money markets and futures and they are all better than spot.
Since there is potential for margin calls using futures and the use of credit lines using the money markets it
is recommended that Lake uses forward contracts to hedge the its foreign currency risk.
Average answers from a lot of candidates, some without any reference to the numbers calculated in part
3.1. Many candidates did not give a firm conclusion. However there were some excellent answers.


3.3
Risks that students might identify and explain are (TWO only):
Physical risk – the risk of goods being lost or stolen in transit, or the documents accompanying the goods
being lost.
Credit risk – the possibility of payment default by the customer.
Trade risk – the risk of the customer refusing to accept the goods on delivery, or cancellation of the order
in transit.
Liquidity risk – the inability to finance the credit given to customers.
Other risks that would be given marks include: Political risk and Cultural risk.
These risks may be mitigated with the help of banks, insurance companies, credit reference agencies and
government agencies such as the UK’s Export credits Guarantee Department. Other ways to reduce these
risks include risk transfer. Lake might be able to agree a contract obligating the courier to pay for losses in
excess of its statutory liability.
Responses to this part of the question were mixed with many candidates demonstrating a lack of
knowledge of overseas trading risks. Even though the requirement stated that the risks identified should
be other than FOREX a number of candidates quoted this as on of their two risks.


PL j17 FM Student Mark Plan Final

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

PL j17 FM Student Mark Plan Final

Uploaded by

Copyright:

Available Formats

Financial Management - Professional Level – June 2017

MARK PLAN AND EXAMINER’S COMMENTARY

Tax 17% 0.07 -0.33 -0.37 -0.32 -0.34

After tax operating cash

New equipment -8.00

Working Capital -1.00 -0.07 0.09 0.08 0.90

Net cash flows -9.09 1.77 2.04 1.77 3.20

PV factors at 10% 1.00 0.909 0.826 0.751 0.683

Present value -9.09 1.61 1.68 1.33 2.19

The project has a negative NPV therefore it should not proceed.

Copyright © ICAEW 2017. All rights reserved Page 1 of 10

Fixed overheads only 50% incremental: £0.2m x 0.5 = £0.1m

Selling and administration:

Capital allowances and the tax

0 8.00 1.44 0.24

The discount factor should be calculated as follows:

(1.07x1.025)-1 = 0. 0968 It is acceptable to round this to 0.10 (10%)

Total possible marks 15

Copyright © ICAEW 2017. All rights reserved Page 2 of 10

Total possible marks 4

Total possible marks 6

Copyright © ICAEW 2017. All rights reserved Page 3 of 10

Total possible marks 4

Responses to this part of the question were good.

Total possible marks 3

Responses to this part of the question were good.

Total possible marks 3

Copyright © ICAEW 2017. All rights reserved Page 4 of 10

The current WACC using CAPM is calculated as follows:

Ke = 2 + 0.45 (9-2) = 5.15

Kd using linear interpolation:

The ex interest debenture price is £105 (109-4).

Kd = 3.44 x (1-0.17) = 2.86%

The ex div share price is 252p – 10p = 242p.

The market value of equity is: 242p x (5m/0.01) = £1,210m

The market value of debt is: £ 200 m x (105/100) = £210 m

The debt equity ratio is: 0.15:0.85

The current WACC is: 5.15 x 0.85 + 2.86 x 0.15 = 4.81%

Total possible marks 8

Copyright © ICAEW 2017. All rights reserved Page 5 of 10

De gearing to find Ba: 0.80 = Ba (1 + (3 x 0.83)/7)

Gearing up to reflect the gearing ratio of Easton to find Be:

Be = 0.59 (1 + (0.15 x 0.83)/0.85)

Total possible marks 6

Ke = 2 + 0.51 (9-2) = 5.57%

The overall WACC =

Total possible marks 6

Copyright © ICAEW 2017. All rights reserved Page 6 of 10

Total possible marks 6

Total possible marks 4

Total possible marks 5

Copyright © ICAEW 2017. All rights reserved Page 7 of 10

The sterling receipt will be £991,609 (£1,300,000/$1.3110)

Money market hedge:

Borrow in US$ against the receipt due in 3 months:

Borrow $1,288,085 = (1,300,000/(1+0.037/4)

Buy £ spot = £983,871 (1,288.085/1.3092)

Total receipt of £991,497 (983,871 x (1 + 0.031/4))

Lake will buy September futures to hedge the $ receipt.

The number of contracts to buy is = ($1,300,000/$1.3105)/£62,500 = 15.87 round to 16

The sterling receipt will be: £990,566 ((1,300,000+12,500)/1.3250)

OTC currency options:

The premium will cost = £26,000 (1,300,000 x 0.02)