Financial Management - Professional Level – December 2016

MARK PLAN AND EXAMINER’S COMMENTARY

The marking plan set out below was that used to mark this examination paper. 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 four-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 version of an existing product

1.1
0 1 2 3 4
Units million 0.096 0.115 0.098 0.083
Selling price £ 299.00 299.00 299.00 299.00
Variable Costs per unit £ -164.45 -172.67 -181.3 -190.37
Contribution per unit £ 134.55 126.33 117.7 108.63
£m £m £m £m £m
Contribution 12.92 14.53 11.53 9.02
Rent -1 -1 -1 -1
Managers lump sum 0.1 -0.12
Managers Salary -0.12 -0.12 -0.12 -0.12
Consultancy saved 0.05 0.05
Contribution lost -0.24 -0.29 -0.25 -0.21
Fixed overhead -0.30 -0.31 -0.32 -0.33
Taxable -0.9 11.31 12.86 9.84 8.24
Tax @ 21% 0.19 -2.38 -2.7 -2.07 -1.73
Working capital -1 -0.2 0.18 0.15 0.87
Machinery and
equipment -24.00 4
Tax saved on CAs 0.91 0.74 0.61 0.50 1.44
Cash
flows -24.8 9.47 10.95 8.42 12.82

PV @
10% -24.8 8.61 9.05 6.33 8.76

NPV 7.95

The NPV is positive and Ribble should therefore accept the project to increase shareholder wealth.
For not including the Research and Development costs of £100,000 and allocated Fixed Overheads since
they are sunk costs and allocated costs respectively.

Units:
1. 8,000 x 12 = 96,000
2. 96,000 x 1.2 = 115,200
3. 112,200 x (1-0.15) = 97,920
4. 97,920 x (1-0.15) = 83,232

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 Financial Management - Professional Level – December 2016

working capital
cumulative Increment
0 -1 -1
1 -1.2 -0.2
2 -1.02 0.18
3 -0.87 0.15
4 0 0.87

Capital allowances and the tax saved thereon

Cost/WDV CA Tax

0 24.00 4.32 0.91

1 19.68 3.54 0.74
2 16.14 2.91 0.61
3 13.23 2.38 0.50
4 10.85
Sale 4.00 6.85 1.44

Well answered by many candidates, however the following were common errors: incorrect calcul ation of
sales and variable costs; timing errors for cash flows; only taking account of half of the relevant costs; not
stating that research and development costs should be ignored; not stating that allocated overheads
should not be included in the NPV computations.

Total possible marks 20

Maximum full marks 20

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 Financial Management - Professional Level – December 2016

1.2
Sensitivity to Sales Revenue:
1 2 3 4
£m £m £m £m
Contribution 12.92 14.53 11.53 9.02
Contribution lost -0.24 -0.29 -0.25 -0.21
Total 12.68 14.24 11.28 8.81
Total x (1-0.21) 10.02 11.25 8.91 6.96
PV @ 10% 9.11 9.30 6.69 4.75

Total PV = 29.85

Sensitivity NPV/PV
(7.95/29.85) 27%

Given the risky nature of this project the board of Ribble might consider
the project to be too sensitive to changes in the sales revenue
.

Sensitivity to the residual value of equipment:

£m
Maximum loss of scrap value 4
Increase in the balancing charge x 21% -0.84
Net cash flows 3.16

PV @ 10% 2.16

Although this represents 27% (2.16/7.95) of the overall NPV, the project is
insensitive to the residual value since there would be a substantial NPV
even if the value fell to zero.

Responses to this part of the question were mixed with many candidates not taking into account all the
relevant cash flows and many ignoring taxation. There were few candidates who made meaningful
comments regarding the sensitivity of the project to changes in the inputs.

Total possible marks 7

Maximum full marks 7

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 Financial Management - Professional Level – December 2016

1.3
Two only from those below
Ribble has:
The option to delay the project for one year to see whether the competitor launches their hoverboard onto
the market.
The option to abandon the project should sales levels be below those estimated eg if the rival company’s
hoverboard is launched and proves to be more popular than the Ribbleboard.
There is a follow on option in that Ribble could expand if the competitor’s product fails and/or sales of the
Ribbleboard are better than expected.
Candidates might also state Growth or Flexibility options .

Responses to this part of the question were good, however some candidates wasted time by mentioning
more than the two real options required to answer the question.
Total possible marks 5
Maximum full marks 5

1.4
The CEO should disregard the comments that Ribble should continue to manufacture an unsafe
hoverboard. The CEO should act with integrity and ensure that he is not corrupted by self-interest. He
should be objective and not come under the undue influence of other board members. He should act with
professional competence and exercise sound and independent judgement.

Responses to this part of the question were mixed and many did not relate to ethical issues, instead they
discussed commercial issues. Where the ethical issues were discussed a number of candidates did not
use the language of ethics.

Total possible marks 3

Maximum full marks 3

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 Financial Management - Professional Level – December 2016

Question 2

Total Marks:

This was a seven-part question that tested the candidates’ understanding of the financing options element
of the syllabus. The scenario of the question was that a corporate finance is giving advice to two clients.
Client one (2.1) is a company seeking to raise additional funds and client two (2.2) is a management
buyout team.

2.1 (a)
The cost of capital = Ke = 3 + 1.1 x (8 – 3) = 8.5%
This part of the question was well answered by the majority of candidates. However in the CAPM
equation a surprising number did not deduct the risk free rate from the market return.

Total possible marks 1

Maximum full marks 1

2.1 (b)
(i) A 1 for 2 rights issue will require 40/2 = 20 million new shares to be issued.

The price per share = £70 million / 20 million = £3.50

A discount on the current market price of: 5.00-3.50/5.00 = 30% (or £1.50)

(ii) The theoretical ex-rights price is:

Number of shares Value per share £ Number x Value £

Existing shares 2 5.00 10.00
New shares 1 3.50 3.50

Total shares 3 Total value 13.50

Theoretical ex-rights price = £13.50/3 = £4.50.

The actual share price will depend on the markets reaction to the rights issue eg fully taken up and
whether the proceeds are invested in positive net present value projects.
If we were told the net present value of the projects this could be incorporated in the theoretical ex -rights
price of £4.50 giving a more realistic estimate of the actual share price post rights issue.

This part of the question was well answered by the majority of candidates. However since the area has
been examined many times before some basic errors were made which include: incorrectly calculating the
number of new shares to be issued; although specifically asked for, not calculating the discount that the
rights price represents on the current share price of the company.
Also, many candidates were unable to comment on whether and why the actual share price might not be
equal the theoretical ex-rights share price after the rights issue.

Total possible marks 5

Maximum full marks 5

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 Financial Management - Professional Level – December 2016

2.1(c)
The yield to maturity of the Wood plc debentures is calculated as follows:

The ex interest price of the debentures = 110 - 7 = £103

Timing - Cash Flow Factors at PV Factors at PV

years £ 5% £ 10% £
0 (103) 1 (103) 1 (103)
1-4 7 3.546 24.82 3.170 22.19
4 100 0.823 82.30 0.683 68.30
4.12 (12.51)

IRR = 5 + (4.12/(4.12+12.51)x5 = 6.24% Say 6%

The issue price is:

Timing - years Cash Flow Factors at PV
£ 6.00% £

1-10 7 7.360 51.52

10 100 0.558 55.80
Issue price 107.32

The total nominal value will be: 70/(107.32/100) = £65.22million.

Wood plc has similar risk to Middleton so it may be reasonable to assume that debenture holders would
require the same yield to redemption in return for investing with either company. But how similar is
similar? Eg how comparable Wood is to Middleton in terms of gearing etc? However the Wood pl c
debentures have only four years until redemption whilst the Middleton debentures mature in ten years. It is
likely that debenture holders would require a higher yield to redemption for investing in the Middleton
debentures to compensate them for the risk of investing for a further six years.

Responses to this part of the question were mixed and, since the topic has been examined many times
before, rather disappointing. Candidates were asked to calculate the yield to redemption (YTR) of
debentures that a similar company to the client company already had in issue. They then had to use the
YTR that they had calculated to price a new debenture issue, and to calculate the total nominal value of
the new issue. Common errors included: using the cum-interest debenture price in the YTR computation;
attempting to calculate the YTR on the new issue; deducting tax from the YTR; incorrectly calculating the
total nominal value of the new issue; many mathematical errors in the YTR computations; calculating, and
using, the interest yield of the debentures rather than the YTR for the new issue, using the coupon rate to
calculate the issue price (and not arriving back at the par value!); for the new issue, using the cost of
equity to calculate the issue price.
Also comments on whether the YTR of the similar company was appropriate to use for the client company
were poor.

Total possible marks 7

Maximum full marks 7

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 Financial Management - Professional Level – December 2016

2.1(d)
The gearing and interest cover ratios of Middleton immediately after the debenture issue will be as follows:
Interest cover: Interest 65.22 x 7% = £4.57 m. Interest cover = 25.00/4.57 = 5.47 times
Gearing by market values assuming the current market price per share:
Market captialisation 40 x 5 = £200 m. Gearing (D/E) 70/200 = 35%
In time both interest cover (more operating profits) and gearing (greater equity value) are likely to improve
with the acceptance of positive NPV projects and any favourable market reaction to the issuance of debt
and its tax shield (see below)
General advantages and disadvantages of debt v equity, points that candidates might mention include:
Control issues; obligation to return capital; interest v dividends (including tax relief); issue costs; liquidation
of the investment (can the investor get out easily); risk/reward.
Note: Candidates might also comment on EPS and produce the following figures:
Current EPS 49.4p (19.75m/40m)
EPS with a rights issue 32.9p (19.75m/60m)
EPS with a debenture issues 40.4p (( 25 – 4.57)x0.79))/40m
Addressing the concerns of the board:
The company will have a gearing ratio of 35% and an interest cover of 5.47 times. Gearing is between the
industry maximum and average of 40% and 30% respectively, interest cover is between the industry
minimum and average of 5 and 6 respectively. Since this is the first time that Middleton has borrowed both
shareholders and the stock market might be concerned and prefer these ratios to be around the averages
or better. Some shareholders might be attracted to investing in Middleton because currently it has no
gearing. However if the £70 million is to be invested in positive NPV projects both shareholders and the
stock market should welcome the company borrowing.
Borrowing should reduce the current 8.5% cost of capital of the company since debt is generally less
expensive than equity because it is less risky than equity for the debt holders. Also the company receives
tax relief on the interest that it pays. Because there is increased financial risk when a company borrows
the shareholders may require a higher return but this is unlikely to offset the cheaper proportion of debt
finance. The company value should increase as a result of the cost of capital reducing and new funds
being invested in positive NPV projects.
Advice. It would be prudent for the company to restrict its borrowing to the industry average gearing level
especially since its interest cover would be near to the minimum for the industry. I would advise the
company not to borrow the full £70 million, perhaps this could be achieved by revising i ts plans for raising
the finance. For example an issue of both debt and equity to ensure that gearing and interest cover ratios
are more favourable. Or selling surplus assets.
Responses to this part of the question were extremely disappointing considering that similar questions
have been asked before. In the scenario the candidates were provided with average and maximum
gearing ratios for the industry sector that the client operated in, also a definition of gearing as debt/equity
by market values. Also the candidates were given the average and minimum interest cover for the
industry. Candidates were instructed in the question requirement to refer to this data when discussing
whether the client company should raise the finance required by debt or a rights i ssue.
Many candidates gave very generic answers to this part of the question, just brain dumping the
advantages and disadvantages of debt and equity without referring to the industry data or the sc enario of
the question. Disappointingly a large number of candidates also gave a detailed description of Modigliani
and Miller’s theory on capital structure without any reference to the traditional theory and how it might or
might not be appropriate. However it was alarming to see many candidates calculating the gearing ratio as
debt/(debt + equity) and then comparing their number with the industry data, which had been calculated in
a different way. In one instance a candidate calculated the gearing ratio using both methods and then
picked the most favourable when comparing with the industry data. This lack of understanding is not
acceptable from candidates sitting a finance examination. Also few candidates gave supported advice on
how the additional finance should be raised.
Turning to interest cover, there were some basic errors made here which included: calculating interest
cover on profits after tax; incorrect interest calculations by not using the total nominal value to be raised.

Total possible marks 14

Maximum full marks 12

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 Financial Management - Professional Level – December 2016

2.2 (a)
The source and form is typically:
The management team invest in equity (Candidates may mention that the funding for this can be raised
from various sources for example: Family; savings; sale of/refinancing of personal assets; etc.,)
A venture capital provider will invest in equity and debt
Other financiers – for example banks would provide loans

Responses to this part of the question were poor with few candidates showing an understanding of how a
management buyout is financed.

Total possible marks 3

Maximum full marks 3

2.2 (b)
The various parties who invest in the MBO will require an exit route, typically between 3 to 5 years. This
may be in the form of:
Selling the company to a third party
A secondary MBO or MBI
Floating the company on the Stock Exchange
If the company is not successful the least desirable exit would be liquidation

Responses to this part of the question were also poor and few candidates described realistic exit routes
for the financiers that contribute to the funding of a management buyout.

Total possible marks 2

Maximum full marks 2

2.2 (c)
The financial information section of the business plan will typically include:
 An historic financial analysis
 The amount and timing of the finance required
 Key risks and a contingency plan
 Anticipated gearing
 The purpose of any finance required
The following forecasts should be included:
 Cash flow in months for the first year of the plan
 Revenue forecasts in months or longer for the first year with evidence
 Financial forecasts in quarterly or annual intervals up to five years

Often a project appraisal and sensitivity analysis will be included

Responses to this part of the question were mixed and many candidates described areas, such as
business strategy, which would not appear in the financial information section of a business plan.

Total possible marks 5

Maximum full marks 5

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 Financial Management - Professional Level – December 2016

Question 3
Total Marks:

This was a four-part question that tested the candidates’ understanding of the risk management element
of the syllabus. The scenario of the question was that a company is reviewing its foreign exchange rate
risk hedging strategy.

3.1
The forward rate is: $/£ 1.4430 (1.4340+0.0090)
This is result in a sterling receipt of £3,465,003 ($5,000,000/$1.4430)
Orion should buy March sterling futures (i.e. to buy £ with $).
The number of contracts to buy is: ($5,000,000/$1,4410)/£62,500 = 55.52 contracts. Round
to 56 contracts. Slightly over hedged. (Full marks given if 55 contracts used.)
On 31 March the futures will be closed out and sold at $1.4487. This will result in a profit of:
($1.4487-$1.4410) x (£62,500 x 56) = $26,950
Sterling will be purchased on the spot market and the total receipt will be:
($5,000,000+$26,950)/$1.4490 = $3,469,255
Over the counter option:
The option premium is $5,000,000 x 3p = £150,000.
The premium with interest lost is £150,000 x (1+0.03x4/12) = £151,500
If the spot price on 31 March is $/£1,4490 Orion will exercise the options.
The sterling receipt will be ($5,000,000/$1.4390) - £151,500 = £3,323,135

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; calc ulating the futures gain in £
rather than $; treating an over the counter option like a traded option; calculating the option premium in $
rather than £; omitting interest on the option premium.
Total possible marks 11
Maximum full marks 11

3.2
The forward contract and futures contracts both lock Orion into an exchange rate and do not allow for
upside potential.
Forwards:
Tailored specifically for Orion
However there is no secondary market
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
OTC currency options:
The options are expensive
There is no secondary market
However the options allow Orion to exploit upside potential and protect downside risk
Advice:
Without hedging the sterling receipt would be £3,450,656 (5,000,000/1.4490)
The OTC option results in a much lower receipt at £3,323,135.
Both the forwards and futures result in a higher sterling receipt, however the futures are marginally better
resulting in a receipt of £3,469,255 compared to £3,465,003.
Since futures require margins and they are not a perfect hedge due to rounding and basis risk it is
recommended that a forward contract is used as it is much simpler for a similar result.
There were a lot of average responses, 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.
Total possible marks 8
Maximum full marks 8

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 Financial Management - Professional Level – December 2016

3.3
The forward rate is calculated using interest rate parity. Interest rate parity links the forward exchange rate
with interest rates in an exact relationship, because risk -free gains are possible if the rates out of
alignment. The forward rate tends to be an unbiased predictor of the future spot exchange rate.

The forward rate in 4 months is calculated as follows:

Middle spot rate x (1 + The middle US interest rate)/(1 + The middle UK interest rate) = Forward rate.

$1.4338 x (1 + 0.05 x 4/12)/(1 + 0.0315 x 4/12) = $ 1.4426

Because the dollar is depreciating against sterling it is at a discount.
The discount is $0.0088 (1.4426-1.4338). The spread increase or decrease this, in this case
$/£ 0.0086 – 0.0090

Responses to this part of the question were mixed with many candidates demonstrating a lack of
understanding of interest rate parity. Very often computations did not make sense and were very difficult to
follow.

Total possible marks 5

Maximum full marks 5

3.4
Economic risk is the risk that longer-term exchange rate movements might reduce the international
competiveness of a company. It is the risk that the present value of a company’s future cash flows might
be reduced by adverse exchange rate movements.

Orion is an importer and exporter. It buys its raw materials in euros, exports the sports nutrition products to
the USA and receives payment in dollars.
If over a period of several years the pound appreciates against the dollar and depreciates against t he euro
the sterling value of Orion’s income will fall and its cash flows decline.

Points that can be mentioned to mitigate economic exposure include:

 Diversify operations world-wide both for purchasing raw materials and selling its products.
 Market and promotional management, the company must carefully decide in which markets to
operate.

 Product management, economic exposure may mean high-risk product decisions.

 Pricing strategy must respond to the risk of fluctuations in exchange rates.
 Production management, economic exposure may influence the supply and location of production.

Few candidates gave adequate answers to this part of the question and showed little knowledge of what
economic risk is. However again there were some excellent answers.

Total possible marks 6

Maximum full marks 6

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