PROFESSIONAL LEVEL EXAMINATION

TUESDAY 6 JUNE 2017

(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

Copyright © ICAEW 2017. All rights reserved. Page 1 of 6

1. Brighton plc (Brighton) manufactures and sells various types of lock. After undertaking
market research that cost £50,000, Brighton is considering manufacturing and selling a new
type of lock for bikes. For the purposes of the initial project appraisal it can be assumed that
the locks would be manufactured in the UK. However, the board of Brighton are considering
manufacturing them overseas where labour costs and associated safety standards for
employees are much lower than in the UK. The bike lock market is highly competitive with
companies entering and leaving the market on a regular basis.

The decision on whether to introduce the new lock will be based on net present value
analysis. At a recent board meeting one of Brighton’s directors quoted from a recent financial
newspaper article that he had read:

“Shareholder wealth maximisation is the generally accepted corporate objective. Net

present value analysis is the most logical way to achieve this when used in conjunction
with Shareholder Value Analysis.”

The director felt that Brighton should be concerned with more than just the shareholders
since there are other stakeholders who also contribute to the business. However, some of the
other directors felt that if shareholder wealth is maximised they had fulfilled their obligations
and that the company should not be concerned about these other stakeholders.

The following data relates to the new bike lock

 The bike lock’s product life-cycle is estimated to be four years and the sales volume is
expected to be 5,500 units per month in the year to 30 June 2018. The sales volume is
expected to increase by 5% in the year to 30 June 2019 and then decrease at the rate of
10% pa (compound) in the two years to 30 June 2021.

 The selling price will be £100 per lock in the year to 30 June 2018 and will increase at
2% pa for the three years to 30 June 2021. The contribution per unit is expected to be
45% of the selling price.

 Fixed production overhead costs are estimated to be £0.2 million in the year to 30 June
2018. 50% of these fixed production overheads are centrally allocated. The fixed
production overheads are expected to increase by 3% pa in the three years to 30 June
2021.

 Selling and administration costs are estimated to be £0.5 million in the year to 30 June
2018 and are expected to increase by 3% pa in the three years to 30 June 2021.

 Warehousing and office space that Brighton currently owns and lets to third parties for an
annual fixed rent of £0.4 million pa, payable in advance on 30 June, will be used for the
bike lock project. The rent will not increase with inflation. At the end of the project the
warehousing and office space will be re-let to third parties.

 An investment in working capital of £1 million will be required on 1 July 2017. This will
increase at the start of each subsequent year in line with sales volume growth and selling
price increases. Working capital will be fully recoverable on 30 June 2021.

 An investment in plant and machinery costing £8 million will be required on 30 June 2017
and this will not have any scrap value on 30 June 2021. The plant and machinery will

Copyright © ICAEW 2017. All rights reserved. Page 2 of 6

 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.

At 30 June 2021, the difference between the plant and machinery’s written down value
for tax purposes and its disposal proceeds will be treated by the company either as a:

(1) balancing allowance, if the disposal proceeds are less than the tax written down
value, or
(2) balancing charge, if the disposal proceeds are more than the tax written down value.

 Assume that the rate of corporation tax will be 17% for the foreseeable future and that tax
flows arise in the same year as the cash flows that gave rise to them.

 A suitable real cost of capital to appraise the project is 7% pa and the general level of
inflation is expected to be 2.5% pa.

Requirements

1.1 Using money cash flows, calculate the net present value of the bike lock project on
30 June 2017 and advise Brighton as to whether it should proceed with the project.
(15 marks)

1.2 Ignoring the effects on working capital, calculate and comment upon the sensitivity
of the project to changes in sales revenue. (4 marks)

1.3 Outline what is meant by Shareholder Value Analysis and identify how it might be
specifically applied to the bike lock project. (6 marks)

1.4 Identify and explain two real options associated with the proposed bike lock project.
(4 marks)

1.5 Giving two examples, illustrate how conflicts may arise between the shareholders and
the other stakeholders in Brighton. (3 marks)

1.6 Outline the main elements of an ethical employment policy that Brighton could adopt if it
were to manufacture the bike locks overseas. (3 marks)

Total: 35 marks

Note: Ignore any issues relating to foreign exchange throughout this question.

Copyright © ICAEW 2017. All rights reserved. Page 3 of 6

2. Easton plc (Easton) is a listed company and a specialist retailer of pet-related products and
operates stores throughout the UK. The company is considering diversifying by opening
veterinary practices (‘the project’), which will operate from dedicated space in all of its stores.

At a board meeting of Easton it was agreed to appraise the project using net present value
analysis. However, considerable debate took place regarding the discount factor to use and
whether the company should be diversifying at all. At the meeting the finance director said:

“I will have to calculate a weighted average cost of capital (WACC) that reflects the
systematic risk of the project. I also intend to raise the capital required for the project in
such a way as to leave our existing debt:equity ratio (by market values) unchanged
following the diversification”.

Various comments made by the other attendees at the meeting were as follows:

“Why can’t we just use our current WACC?”

“I have read that the shareholders of listed companies should diversify away unsystematic
risk. But I am confused as to what systematic and unsystematic risks are.”

“I think that we should stick to what we know and not attempt to diversify. I am worried
about the stock market’s reaction to this diversification.”

“What happens if we can’t maintain our existing capital structure? How do we then
appraise the project?”

Extracts from Easton’s most recent management accounts are shown below:

Balance Sheet at 31 May 2017

£m
Ordinary share capital (1p shares) 5
Retained earnings 1,098
1,103
4% Redeemable debentures at nominal value (redeemable 2025) 200
1,303

On 31 May 2017 Easton’s ordinary shares had a market value of 252p each (cum-div). The
company declared a dividend of 10p per ordinary share during the year to 31 May 2017 and it
is expected to be paid shortly. The equity beta of Easton is 0.45. The return on the market is
expected to be 9% pa and the risk free rate 2% pa.

On 31 May 2017 Easton’s 4% redeemable debentures had a market value of £109

(cum-interest) per £100 nominal value. The debentures are due to be redeemed at par on
31 May 2025.

A listed company operating solely in the veterinary practices market had an equity beta of
0.80 and a debt:equity ratio by market values of 3:7 on 31 May 2017. It has been estimated
by the finance director that if the project goes ahead the overall equity beta of Easton will be
made up of 75% pet-related products and 25% veterinary practices.

Assume that the corporation tax rate will be 17% for the foreseeable future.

Copyright © ICAEW 2017. All rights reserved. Page 4 of 6

Requirements

2.1 Ignoring the project, calculate the current WACC of Easton on 31 May 2017 using the
CAPM. (8 marks)

2.2 Using the CAPM, calculate a cost of equity that reflects the systematic risk of the project
and explain your reasoning. (6 marks)

2.3 Assuming that the project goes ahead, estimate, using the CAPM, the overall WACC of
Easton and comment upon the implications of any permanent change in the overall
WACC. (6 marks)

2.4 Explain what is meant by systematic and unsystematic risk and give two examples of
each for Easton. (6 marks)

2.5 Discuss whether Easton should diversify its operations and how its shareholders and
the stock market might react to the proposed project. (4 marks)

2.6 Identify and describe the appropriate project appraisal methodology that should be used
if, as a result of financing the project, the current capital structure of Easton is not
maintained. Using the data relating to Easton, calculate the project discount rate that
should be used in these circumstances. (5 marks)

Total: 35 marks

PLEASE TURN OVER

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3. Assume that the current date is 30 June 2017

Lake Ltd (Lake) is a UK company that has recently started exporting leather goods to the
USA. Lake is fully aware of its exposure to foreign exchange rate risk (‘forex risk’) and the
need to hedge it. However, Lake is concerned that there may be other overseas trading risks
that it should be protecting itself against.
You work for Lake and have been asked to advise the board on how to hedge the forex risk
associated with its US trading activities. You have the following information available to you
at the close of business on 30 June 2017:
Lake is due to receive payments from its US customers in three months’ time totalling
$1,300,000. Lake currently has an overdraft.

Exchange rates

Spot rate ($/£) 1.3086 - 1.3092

Three-month forward contract discount ($/£) 0.0014 - 0.0018

September currency futures price (standard contract size £62,500): $1.3105/£

Annual borrowing and depositing interest rates

Sterling 3.20% - 3.10%

Dollar 3.70% - 3.60%

Three-month over-the-counter currency options

Call options to buy £ have an exercise price of $/£1.3200 and premium of

£0.02 per $ converted.

Put options to sell £ have an exercise price of $/£1.3100 and a premium of

£0.01 per $ converted.

Requirements

3.1 Assuming that the spot exchange rate on 30 September 2017 will be $/£1.3210 - 1.3250
and that the sterling currency futures price will be $1.3230/£, calculate Lake’s sterling
receipt if it uses the following to hedge its forex risk:

 a forward contract
 a money market hedge
 currency futures contracts
 an over-the-counter currency option (14 marks)

3.2 Describe the relative advantages and disadvantages of each of the hedging techniques
in 3.1 above and advise Lake on which would be most beneficial for hedging its forex
risk. (10 marks)

3.3 Identify and explain two overseas trading risks (other than forex risk) that Lake is
exposed to and discuss how they might be mitigated. (6 marks)

Total: 30 marks

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