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Financial Management - Professional Stage - September 2010

PROFESSIONAL STAGE - FINANCIAL MANAGEMENT OT EXAMINER’S COMMENTS

The following table summarises how well candidates answered each syllabus content area.

How well candidates answered each syllabus area

Syllabus area Number of questions Well answered Poorly answered*

1 8 8 0

2 3 2 1

3 4 4 0

Total 15 14 1

* If 40% or more of the candidates gave the correct answer, then the question was classified as “well answered”.

There was one question with a facility of less than 40%:

A company had to pay in euros for a delivery from an overseas supplier. The company expected the exchange rate
prevailing on the future payment date to be such as to make it indifferent between taking out a forward contract and
being exposed to the exchange rate risk. Candidates were given the forward exchange rate and the forward
exchange transaction cost. They were asked to calculate the expected spot rate on payment day. Most candidates
who answered the question incorrectly failed to take account of the transaction cost correctly.

© The Institute of Chartered Accountants in England and Wales 2010 Page 1 of 10


Financial Management - Professional Stage - September 2010

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. In many cases,
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: 29

General comments
This question had the second highest average mark on the paper and was mostly done well.
It tested the investment decisions element of the syllabus and was based on a manufacturing company’s
proposal to expand one product line whilst closing another.
In part (a) for 20 marks candidates were presented with a lot of information and from this they had to calculate
the NPV of the proposal. To do well they would have needed to demonstrate, inter alia, a good understanding
of relevant cash flows with regard to revenues, costs and the purchase and sale of machinery. Part (b) for
four marks required a calculation (with advice) of the impact on the NPV of a change in the estimated scrap
value of a machine. Part (c) was worth five marks and tested candidates’ understanding of Shareholder Value
Analysis (SVA) and how it could be applied to the company in the scenario.

1(a)
Cease Domestic Tool (DT) production now
t0 t1 t2 t3
£ £ £ £
New machine (m/c) (4,200,000) 0
Tax on new m/c (W1) 235,200 188,160 150,528 602,112

Old m/c scrap 250,000


Old m/c tax saved (W2) 165,200
Old m/c foregone scrap (50,000)
Old m/c foregone tax (W3) (47,040) (37,632) (30,106) (106,422)

DT contribution foregone (W4) (1,566,000) (1,566,000) (1,566,000)


Boiler contribution gain (W5) 3,900,000 3,510,000 3,000,000
Fixed costs increase (W6) (200,000) (200,000) (200,000)
Tax on profit (597,520) (488,320) (345,520)
Working capital (W7) (1,600,000) 800,000 700,000 100,000
Total cash flows (5,196,640) 2,487,008 2,076,102 1,434,170
Discount 1.000 0.935 0.873 0.816
PV (5,196,640) 2,325,352 1,812,437 1,170,283
NPV 111,432

Marks were awarded for ignoring sales growth of bought-in tools

Positive NPV. Shareholder wealth increased. Therefore proceed with expansion.

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Financial Management - Professional Stage - September 2010

Alternative answer as two separate NPVs

Expand boilers
t0 t1 t2 t3
£ £ £ £
New machine (m/c) (4,200,000) 0
Tax on new m/c (W1) 235,200 188,160 150,528 602,112

Old m/c scrap 250,000


Old m/c tax saved (W2) 165,200

Boiler contribution (W5) 8,520,000 8,130,000 7,620,000


Fixed costs (W6) (2,100,000) (2,100,000) (2,100,000)
Tax on profit (1,797,600) (1,688,400) (1,545,600)
Working capital (W7) (4,700,000) 800,000 700,000 3,200,000
Total cash flows (8,249,600) 5,610,560 5,192,128 7,776,512
Discount 1.000 0.935 0.873 0.816
PV (8,249,600) 5,245,874 4,532,728 6,345,633
NPV 7,874,635

Don’t expand boilers


t0 t1 t2 t3
£ £ £ £

Old m/c scrap 50,000


Old m/c tax (W3) 47,040 37,632 30,106 106,422

DT contribution (W4) 1,566,000 1,566,000 1,566,000


Boiler contribution (W5) 4,620,000 4,620,000 4,620,000
Fixed costs (W6) (1,900,000) (1,900,000) (1,900,000)
Tax on profit (1,200,080) (1,200,080) (1,200,080)
Working capital (W7) (3,100,000) 3,100,000
Total cash flows (3,052,960) 3,123,552 3,116,026 6,342,342
Discount 1.000 0.935 0.873 0.816
PV (3,052,960) 2,920,521 2,720,291 5,175,351
NPV 7,763,203

Marks were awarded for ignoring sales growth of bought-in tools OR putting it into both NPVs

Positive NPV difference of £111,432. Shareholder wealth increased. Therefore proceed with expansion.

Workings
W1 t0 t1 t2 t3
£ £ £ £
WDV 4,200,000 3,360,000 2,688,000 2,150,400
WDA (840,000) (672,000) (537,600) (2,150,400)
WDV 3,360,000 2,688,000 2,150,400 0,000
Tax 235,200 188,160 150,528 602,112

W2 Sell now
WDV b/f 840,000
Current scrap value (250,000)
Balancing allowance (BA) 590,000

Tax saving on BA @28% 165,200

© The Institute of Chartered Accountants in England and Wales 2010 Page 3 of 10


Financial Management - Professional Stage - September 2010

t0 t1 t2 t3
£ £ £ £
W3 Sell Y3
WDV 840,000 672,000 537,600 430,080
WDA (168,000) (134,400) (107,520) (380,080)
WDV 672,000 537,600 430,080 50,000
Tax saving on WDA @ 28% 47,040 37,632 30,106 106,422

W4 DT sales 8,700,000
Contribution @ 18% 1,566,000

W5 Boiler sales now 16,500,000


Boiler contribution @ 28% 4,620,000
Boiler sales new 28,400,000 27,100,000 25,400,000
Boiler contribution @ 30% 8,520,000 8,130,000 7,620,000
Boiler increased contribution 3,900,000 3,510,000 3,000,000

W6 Fixed costs (700,000) (2,100,000) (2,100,000) (2,100,000)


(1,200,000)
Increase (200,000) (200,000) (200,000)

W7 Working Capital 900,000 4,700,000 3,900,000 3,200,000


2,200,000
Increase (1,600,000) 800,000 700,000

Part (a) was hard work with a lot of information to work through. However a well organised candidate (n.b.
poor layout let a lot of candidates down) with a good understanding of the basic investment appraisal
techniques will have scored high marks. Capital allowances were generally done well, but many candidates
failed to correctly calculate the balancing allowances available. Too many candidates included figures for
Industrial Bought-in Tools – there was no need to do so. A good number of candidates were unable to deal
correctly with the fixed costs and/or the working capital elements within the question.

Total possible marks 20


Maximum full marks 20

1(b)
Impact of scrap value of £500,000 £
Scrap value 500,000
Reduction in BA (500,000 x 28%) (140,000)
Net increase in cash flow (Y3) 360,000

PV of Y3 additional cash (£360,000 x 0.816) 293,760

Thus the NPV of the proposed scheme would increase by £293,760 and makes it more attractive.
This was generally done well and most candidates were able to deal correctly with the reduction in the
balancing allowance and the need to then discount the net increase in cash flow.

Total possible marks 4


Maximum full marks 4

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Financial Management - Professional Stage - September 2010

1(c)
Shareholder value analysis (SVA) concentrates on a company’s ability to generate value and thereby
increase shareholder wealth. SVA is based on the premise that the value of a business is equal to the sum of
the present values of all of its activities. SVA posits that a business has seven value drivers:

1. Life of projected cash flows


2. Sales growth rate
3. Operating profit margin
4. Corporate tax rate
5. Investment in non-current assets
6. Investment in working capital
7. Cost of capital

The value of the business is calculated from the cash flows generated by drivers 1-6 which are then
discounted at the company’s cost of capital (driver 7).

In the case of Britton, all of the seven SVA value drivers are relevant and are used in the calculation. Britton’s
(three year) strategy of expanding its boiler market will increase the value of the firm.
The theoretical aspects of SVA were generally well done, but too few candidates applied the concept of SVA
to the Britton scenario.

Total possible marks 6.5


Maximum full marks 5

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Financial Management - Professional Stage - September 2010

QUESTION 2 Total marks: 25

General comments
This question had the lowest average mark on the paper.

It tested candidates’ understanding of financing decisions and was divided into five sections, based around
extracts from fictional newspaper articles.

Part (a) was numerical (nine marks) and required candidates to calculate the impact of a rights issue on a
company’s earnings figure and a shareholder’s wealth. The proceeds of the rights issue were to be used to
reduce the company’s level of gearing (debentures). Part (b) for five marks required candidates to explain the
implications of financial gearing on the value of the company’s shares. Parts (c) and (d) were worth three
marks and four marks respectively and tested candidates’ understanding the rights of debenture holders in a
company in financial distress. Finally, in part (e) for four marks candidates were given the current after-tax cost
of redeemable debenture stock and asked to calculate its current cum-interest market price.

2(a)
(i) Shares (m) Market value (£) £m
Current situation 600 1.25 750
Rights issue 300 0.95 285
Ex rights 900 1.15 1,035

£m
Current total earnings £750m/9.6 78,125
plus: Interest saved on redeemed debenture stock 285m x 8% x 72% 16,416
New total earnings 94,541

New Earnings per Share (EPS) £94,541m/900m £0.105


Current Earnings per Share £1.25/9.6 £0.130
Decrease in EPS 19.2%

(ii) £
Current value of shareholding 7,000 x £1.25 8,750

Value of new shareholding 7,000 1.5 x £1.15 12,075


less: Cost of taking up the rights 3,500 x £0.95 (3,325)
8,750

Current share of earnings 7,000 x £0.13 £910


New share of earnings 10,500 x £0.105 £1,103

In this part most candidates were able to calculate the theoretical ex-rights price correctly (and its impact on
the shareholder’s wealth), but far too few adjusted the earnings figure to take account of the interest savings
made from the debenture redemption.

Total possible marks 9


Maximum full marks 9

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Financial Management - Professional Stage - September 2010

2(b)
(i) Reduced gearing will cut the financial risk. The impact of gearing is that there will be (a) regular interest
payments and (b) the need at some future date to repay the capital sum that has been borrowed. The
implication of the cut in gearing is that it is regarded as too high at the moment by Bettalot and beyond its
optimal level.
(ii) As gearing increases/decreases then financial risk does the same.
The traditional view and M&M 1963 allowing for market imperfections is that the cost of equity moves in
the same direction as the level of gearing. Thus by repaying some of its outstanding debt, Bettalot will cut
its cost of equity (reduced financial risk/financial distress) and as a result, all else being equal, its share
price would increase.
The M&M 1963 view suggests two opposing effects on the share price from a reduction in gearing – a fall
from a reduction in the tax shield on debt and a rise from a reduction in the cost of equity through lower
financial risk.
The answers to part (b) were reasonable, but too many candidates included a lot of theory without application
to the scenario, i.e. they considered the impact of an increase in gearing and not a reduction as per the
question.

Total possible marks 5


Maximum full marks 5
2(c)
With the companies in financial distress there is a real chance that they will default on interest payments
and/or the repayment of sums due on redemption. If they do default then if the debentures are secured then
assets could be sold which would put the companies’ future in doubt. Thus debenture holders would have far
greater influence/control over company policy than is the norm.
The answers to this part were in general disappointing and too few candidates were able to apply their
knowledge in a practical setting.

Total possible marks 3


Maximum full marks 3
2(d)
In a debt for equity swap lenders are given shares in the company in exchange for the cancellation of some
(or all) of their debt.

The alternative outcome for lenders (i.e. if no swap takes place) could be that they lose their money
altogether, as the company concerned in a swap will be suffering liquidity problems.

If the debt equity swap went ahead there would now be more shares in issue. The gearing level would fall and
any tax advantages of gearing would be lost. These two combined are likely to cause a fall in the share price.
More candidates did well in this part and were able to demonstrate an understanding of the workings of a
debt for equity swap.

Total possible marks 4


Maximum full marks 4

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Financial Management - Professional Stage - September 2010

2(e)
Year Cash Flow (£) 5% factor PV (£)
1-3 4.32 2.723 11.763
3 100 0.864 86.400
Total Present Value 98.163

The PV of the future cash flows is £98.163, which would be the ex interest price in Year 0.

Thus the cum interest price would be (£98.163 + £6) £104.163

Factors: market interest rates, tax rate, risk (linked to any security, amount of other debt).
Many candidates didn’t answer part (e) and of those that did most struggled to work backwards from a given
market rate of return to a current market price.

Total possible marks 4


Maximum full marks 4

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Financial Management - Professional Stage - September 2010

QUESTION 3 Total marks: 26

General comments
Most candidates scored well on this question and it had the highest average mark in the paper.
The question tested candidates’ understanding of managing financial risk and was divided into two main
sections – foreign exchange and an interest rate swap.
Part (a) was worth 15 marks and required candidates to calculate and discuss the potential benefits of
hedging (via a forward contract or a money market hedge) a large receipt of euros from a customer. In part
(b) for 11 marks candidates were given details of two companies’ loans – one at fixed rate, the other at
variable – and were asked to construct and comment on an interest rate swap that would benefit both parties.

3(a)(i)
Strengthening of sterling = 1.1084 x 1.01 = €1.1195/£

€3,500,000/1.1195 = £3,126,396

Weakening of sterling = 1.1084 x 0.99 = €1.0973/£

€3,500,000/1 0973 = £3,189,647

This was straightforward, but a disappointing number of candidates were unable to calculate a 1% increase
and then a 1% decrease in the value of sterling.

Total possible marks 3


Maximum full marks 3
3(a)(ii)
Forward contract Spot rate 1.1084
less: Premium (0.0040)
1.1044

Sterling receivable €3,500,000/1.1044 £3,169,142

Money market hedge Euro borrowing rate (3 months) 3.4%/4 = 0.85%

€3,500,000 x 1/1.0085 €3,470,501

At spot rate (€3,470,501/1.1084) £3,131,091


plus: Interest earned (sterling rate – 3.9%/4) £30,528
Total sterling receivable £3,161,619

This part was well answered and most candidates scored good marks.

Total possible marks 6


Maximum full marks 6

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Financial Management - Professional Stage - September 2010

3(a)(iii)
Spot rate gives a sterling value of £3,157,705 (€3,500,000/1.1084). Strengthening of sterling would reduce
receipt to £3,126,396, whilst weakening of sterling increases sterling receipt to £3,189,647. So it would be
preferable if sterling depreciated. Interest rates (and thus forward rate premium) suggest a weakening of
sterling in the three months ahead. The forward contract is preferable to the money market hedge (£7,523
higher). Management’s attitude to risk is important here. If sterling is expected to weaken then perhaps ignore
hedge and go with the spot rate. Alternatively as margins are low, the forward gives more security as the rate
of depreciation is not guaranteed.
Although many candidates produced good answers here, a lot scored poorly because their discussions of the
hedging possibilities were far too general and not sufficiently applied to the scenario.
Total possible marks 6
Maximum full marks 6
3(b)(i)
SWI HD Difference
Fixed 9.2% 10.8% 1.6%
Variable LIBOR + 1.0 LIBOR + 1.4 0.4%
Difference between differences 1.2%

This potential gain can be split evenly, i.e. 0.6% to each party, which means that SWI would pay LIBOR +
0.4% (LIBOR + [1.0% - 0.6%] and HD would pay fixed 10.2% (10.8% - 0.6%).

The interest rate swap would look like this:


SWI HD
Currently pays (9.2%) (LIBOR + 1.4)
HD pays SWI (bal fig) 8.8% (8.8)
SWI pays HD (LIBOR ) LIBOR
New net payment (LIBOR + 0.4) (10.2%)

SWI and HD would both pay at less (0.6% in each case) than their available fixed and variable rates.

New net interest rate (LIBOR + 0.4) 8.8% pa 10.2% pa


Interest on £24m pa £2,112k £2,448k

Alternatively
£’000 Rate £’000 £’000 Rate £’000
Interest paid now 24,000 (9.2%) (2,208) 24,000 (9.8%) (2,352)
HD pays SWI 8.8% 2,112 (8.8%) (2,112)
SWI pays HD (8.4%) (2,016) 8.4% 2,016
New interest payment (2,112) (2,448)

This was answered well. The main problem area for candidates was that many of them did not make the
variable leg of the swap at LIBOR as required in the question.

Total possible marks 8


Maximum full marks 8
3(b)(ii)
Counterparty risk – counterparty defaults before completion
Position or market risk – unfavourable market movements once swap established
Transparency risk – accounts become misleading
Again this was answered well.

Total possible marks 3


Maximum full marks 3

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