PROFESSIONAL STAGE APPLICATION EXAMINATION

WEDNESDAY 7 SEPTEMBER 2011

(2½ hours)

FINANCIAL MANAGEMENT
This paper consists of FIFTEEN objective test (OT) questions (20 marks) and THREE written
test questions (80 marks).

1. Ensure your candidate details are on the front of your answer booklet.

2. Answer each question in black pen only.

Objective Test Questions (1 – 15)

3. Record your OT responses on the separate answer sheet provided: this must not be
folded or creased. Your candidate details are printed on the sheet.

4. For each of the FIFTEEN OT questions there are four options: A, B, C, D. Choose the
response that appears to be the best and indicate your choice in the correct box, as
shown on the answer sheet.

5. Attempt all questions: you will score equally for each correct response. There will be no
deductions for incorrect responses or omissions.

Written Test Questions (1 – 3)

6. Answers to each written test question must begin on a new page and must be clearly
numbered. Use both sides of the paper in your answer booklet.

7. The examiner will take account of the way in which answers are presented.

A Formula Sheet and Discount Tables are provided with this examination paper.

IMPORTANT

Question papers contain confidential Place your label here. If you do not have a label
information and must NOT be you MUST enter your candidate number in this
removed from the examination hall. box.

DO NOT TURN OVER UNTIL YOU

ARE INSTRUCTED TO BEGIN
WORK

Copyright © The Institute of Chartered Accountants in England and Wales 2011. Page 1 of 7
1. UGL Ltd (UGL) manufactures domestic solar panels and has a financial year end of
31 December. Its directors are now considering expanding UGL‟s scale of operations via an
initiative called „Project North‟.

If „Project North‟ is to proceed, then UGL would have to invest in new capital equipment
which would cost £1.3 million and be purchased on 31 December 2011. Because of the fast
rate of technological change in the solar panel industry, UGL‟s directors estimate that „Project
North‟ would enjoy a three-year period of competitive advantage (2012-2014).

UGL has paid for market research which produced the following estimates for „Project North‟:

(1) Year to 31 December 2012 (all figures expressed in December 2011 prices)
Total sales £2,200,000
Total variable costs £1,200,000
Total fixed costs (including interest paid of £17,000) £427,000

(2) Increase in sales volume in 2013 and 2014 10% pa

(3) Inflation rates: Sales prices 5% pa

All costs 8% pa

(4) Working capital

(to be in place at the start of each trading year) 10% of total annual sales

(5) Trade-in value of capital equipment (in December 2014 prices) £600,000

Capital allowances

UGL‟s machinery and equipment attracts capital allowances, but is and will be excluded from
the general pool. The equipment attracts 20% (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 machinery‟s written down value for tax
purposes and its disposal proceeds will be either

(i) treated by the company as an additional tax relief, if the disposal proceeds are
less than the tax written down value, or
(ii) be treated as a balancing charge to the company, if the disposal proceeds are
more than the tax written down value.

Other information

 UGL uses a post-tax money weighted average cost of capital of 14%.

 UGL‟s directors would like to assume that the corporation tax rate will be 28% for the
foreseeable future and tax will be payable in the same year as the cash flows to which
it relates.

 Unless otherwise stated all cash flows occur at the end of the relevant trading year.

Copyright © The Institute of Chartered Accountants in England and Wales 2011. Page 2 of 7
Requirements

(a) Calculate the net present value of the „Project North‟ initiative at 31 December 2011 and
advise UGL‟s directors whether they should proceed with it. (12 marks)

(b) Calculate the sensitivity of the decision in part (a) to changes in the estimated volume of
sales. Candidates should ignore the impact of working capital in this calculation.
(5 marks)

(c) Advise UGL‟s directors whether the „Project North initiative should proceed if the trade-
in value of the capital equipment at 31 December 2014 were to be £100,000 (in
December 2014 prices). (4 marks)

(d) Explain briefly your treatment of UGL‟s interest payments of £17,000 in part (a).
(2 marks)

(e) Explain Shareholder Value Analysis and identify the extent to which its principles are
employed in making the decision in part (a). (4 marks)

(27 marks)

PLEASE TURN OVER

Copyright © The Institute of Chartered Accountants in England and Wales 2011. Page 3 of 7
2. Penny Rigby Fashions plc (PRF) is a UK-based fashion clothes retailer. It has a financial
year end of 31 May. A friend of yours is a PRF shareholder and has e-mailed you recently
following his attendance at PRF‟s annual general meeting (AGM) in August. An extract from
his e-mail is shown here:

…. At the AGM a sheet of “Key Figures” was distributed to PRF shareholders. However
they weren‟t explained very well and I wondered if you could help. Here they are:

Penny Rigby Fashions plc – Key Figures at 31 May 2011

Total
Type of Nominal Value Market Post-tax
Capital (£m) Value Cost of Capital

Ordinary shares (50p) 4.0 £2.00/share ex-div 10.50% (ke)

Preference shares (25p) 0.8 £0.80/share ex-div 8.75% (kp)

Irredeemable debentures (£100) 1.4 £110% ex-int 3.60% (kd)

Weighted Average Cost of Capital (WACC) at 31 May 2011 9.748%

Retained profits for trading year to 31 May 2011 £300,000

Dividend growth in the last 3 years 0% pa

PRF‟s managing director said that when calculating these figures, PRF‟s directors had
taken account of taxation where appropriate, assuming that the corporation tax rate will
be 28% for the foreseeable future and that tax will be payable in the same year as the
cash flows to which it relates.

PRF‟s managing director also made these statements at the AGM:

1. The WACC of 9.748% represented the total return to the company‟s providers of
finance ie, the total of the after-tax interest and dividends for the trading year to
31 May 2011.

2. Unless the company exceeds the WACC „hurdle rate‟ when investing in new projects
then shareholder value will be destroyed.

3. It is possible to calculate, using the „Key Figures‟ provided, the following for PRF for
the trading year to 31 May 2011 – earnings per share, price earnings ratio, gearing
ratio and profit before interest and tax. He said something about „working backwards‟
to get these but I‟m not sure what he meant.

Copyright © The Institute of Chartered Accountants in England and Wales 2011. Page 4 of 7
Requirements

(a) Show, with workings, how PRF‟s WACC figure of 9.748% has been calculated.
Assume that the figure of 9.748% is correct. (4 marks)

(b) Calculate PRF‟s total after-tax interest and dividends for the year to 31 May 2011 and
show how these relate to its WACC figure of 9.748%. (5 marks)

(c) Explain the managing director‟s statement regarding the WACC as a „hurdle rate‟ in
your friend‟s e-mail. (4 marks)

(d) Calculate the following for PRF for the year to/at 31 May 2011:

(i) earnings per share,

(ii) price earnings ratio,
(iii) gearing ratio (based on market values) and
(iv) profit before interest and tax. (8 marks)

(e) Explain in general terms how the rate of dividend growth can be calculated and the
significance of PRF‟s dividend growth figure of 0%. (6 marks)

(27 marks)

PLEASE TURN OVER

Copyright © The Institute of Chartered Accountants in England and Wales 2011. Page 5 of 7
3. Deep Drill Supplies plc (DDS) is a UK company which manufactures and sells large-scale
components for the oil and gas industries. As the majority of its customers are international,
the DDS board is considering whether the company should be hedging its exposure to
foreign exchange risk. One of its key customers is NSDF, a Norwegian oil exploration
company.

DDS and NSDF have recently agreed a contract (DDS/12/57) for the supply of a large
consignment of components. DDS will start manufacturing these at the end of September
2011 and the work will be completed in the summer of 2012. DDS will receive the agreed
contract price, 16.75 million Norwegian kroner (NK), on 30 September 2012.

Information regarding the British and Norwegian currencies is given in the table below:

Table

(1) Recent research paid for by DDS produced the following forecast spot rates for NK/£
at 30 September 2012:
Probability
9.200 – 9.230 10%
9.300 – 9.330 10%
9.400 – 9.430 40%
9.500 – 9.530 40%

(2) Spot rate (NK/£) 9.300 – 9.325

(3) Forward rate at 30 September 2012 offered by DDS‟s bank : 0.10 – 0.13 NK discount

(4) Current interest rates Borrowing Depositing

NK 6.60% pa 5.70% pa
Sterling (£) 5.40% pa 4.30% pa

(5) DDS‟s bank has quoted the following twelve month currency over-the-counter options
each with a premium of £25,000:

A put option on 16.75 million NK at an exercise price (NK/£) of 9.300

A call option on 16.75 million NK at an exercise price (NK/£) of 9.250

Looking ahead, the DDS board has also identified a surplus of funds denominated in sterling.
It is planning to invest this in March 2012 in an interest-bearing UK deposit account for a
period of six months. It would like to investigate how it might hedge against adverse interest
rate movements.

Copyright © The Institute of Chartered Accountants in England and Wales 2011. Page 6 of 7
Requirements

(a) Assuming the current date is 30 September 2011, calculate the sterling amount
receivable by DDS on 30 September 2012 if it uses:

(i) the expected spot rate in 12 months‟ time

(ii) a forward contract
(iii) a money market hedge
(iv) an option. (10 marks)

(b) Making reference to your calculations in part (a) discuss the issues that should be taken
into account by the DDS board when it considers whether it should hedge the NSDF
receipt. (8 marks)

(c) Advise the DDS board as to the effectiveness of employing the following methods of
hedging the company‟s exposure to interest rate risk on the proposed investment of the
surplus funds in March 2012:

(i) a Forward Rate Agreement (FRA)

(ii) an interest rate future
(iii) an interest rate option
(iv) an interest rate swap. (8 marks)

(26 marks)

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