ICAEW Professional Level Financial Management Question & Answer Bank March 2016 To March 2020

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PROFESSIONAL LEVEL EXAMINATION
TUESDAY 8 MARCH 2016
(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 2016. All rights reserved. Page 1 of 7

1. Aranheuston Pharma plc (AP) is a large listed UK pharmaceuticals company and its financial
year end is 31 March. Its directors have decided to invest in new products on a regular basis
in order to keep pace with the global trading environment. In order to help grow the company
more quickly, AP’s directors are also investigating the possible takeover of a competitor.
Considerable development time is required for the production of new pharmaceutical

products and so net cash inflows from sales often lag well behind the development costs
required.
Forecast life-cycle data for a new product (AP525) that is under consideration are provided
below:
Year to Year to Year to Year to

31/3/16 31/3/17 31/3/18 31/3/19
£’000 £’000 £’000 £’000
Depreciation (note 1) (350) (350) (350) -
Rent (note 2) - (80) (80) (80)
Fixed costs (notes 3 & 5) - (290) (290) (290)
Interest (note 4) - (60) (60) (60)
Sales (note 5) - 0 2,600 700
Variable costs (note 5) - 0 (1,180) (220)
Profit/(loss) (350) (780) 640 50
Total working capital required (note 5) 0 260 70 0
Note 1
New equipment required for the production of AP525 will cost £1,150,000 on 31 March 2016
and will be sold on 31 March 2019 for an agreed price of £100,000 (in 31 March 2019 prices).
AP depreciates its equipment on a straight-line basis. A full year’s depreciation is charged in

the year of purchase and none in the year of sale.
If this new equipment is purchased, existing equipment, which originally cost £120,000 many
years ago and has a tax written down value of zero, will be sold on 31 March 2016 for
£70,000.
The new equipment will 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. In the final year, the difference between the equipment’s written down value for tax
purposes and its disposal proceeds will be treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value, or
 balancing charge, if the disposal proceeds are more than the tax written down value.
Note 2
The new equipment will take up extra space, which will have to be rented for three years. The
rent would be at a fixed annual amount of £80,000, payable in advance, with the first
payment due on 31 March 2016.

Note 3
£130,000 of these fixed costs per annum are existing head office costs that will be allocated
to the project.
Note 4
The purchase of the new equipment would be funded from an issue of debt and this
represents the interest cost on that debt.
Note 5
Unless otherwise stated, all of the above figures are in 31 March 2016 prices. The following
inflation rates are expected for the years ended 31 March 2017-2019:
 Sales: 2% pa
 Variable and fixed costs and working capital: 3% pa
Other information
Corporation tax will be payable at the rate of 21% pa for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant year.
An appropriate money cost of capital for the project is 8% pa.
Requirements:
1.1 Using money cash flows, calculate the net present value of the AP525 product at
31 March 2016 and advise AP’s directors whether the company should proceed with it.
(18 marks)
1.2 Calculate the sensitivity of your advice in part 1.1 to changes in the variable costs of the
AP525 product and comment on your result. (5 marks)
1.3 For the purposes of the possible takeover of a competitor, outline the Shareholder
Value Analysis (SVA) approach to company valuation for AP’s directors, identifying its
advantages and disadvantages. (6 marks)
1.4 Agency theory highlights the potential conflicts that may occur between a company’s
shareholders and its directors.
(a) Explain how these conflicts might arise in AP in relation to the potential takeover of
a competitor.
(b) Assuming that the AP525 product goes ahead, explain how these conflicts might
arise in AP in relation to:
 debt levels
 short-term versus long-term performance appraisal. (6 marks)
Total: 35 marks

2. You should assume that the current date is 1 March 2016
Oliphant Williams plc (OW) is a large UK design company that has traded since 1994. Its
capital structure at 29 February 2016 is shown below:
Par Value Market Value Total market

value
£m (ex-div / ex-int) £m
Ordinary share capital 96 £1.70/share 326.4
Preference share capital 28 £1.80/share 50.4
3.5% debentures (redeemable at par 160 £105% 168.0
in 2019)
Note 1: OW’s retained earnings at 29 February 2016 were £43.8 million.
Note 2: OW’s earnings for the year to 29 February 2016 were £21.12 million. Earnings are
not expected to change significantly in the next two years.
Note 3: OW’s ordinary dividend for the year to 29 February 2016 was £0.09 per share.
You are an ICAEW Chartered Accountant and the managing director of OW. The following
comments were made at OW’s most recent board meeting:
Finance director
“The company’s level of debt is too high and its balance sheet needs restructuring. Why don’t
we raise more equity and pay off some of the debt? This would reduce gearing and have a
positive impact on the price of ordinary shares. A reasonably priced rights issue is probably
the best way forward and should not dilute OW’s earnings per share excessively.”
Marketing director
“Our dividend is similar, in terms of the payout ratio, to previous years, but I think that this
policy of paying high dividends is an unnecessary drain on our resources. I think that our
shareholders would react positively if we reduce the dividend in future.”
Production director
“Whilst we don’t expect our earnings to change much in the next two years, surely it would be
better for our share price if we predict some growth when we communicate with our
shareholders?”
In response to the finance director’s concerns, OW’s board is considering the redemption of
one half of its debentures. The debentures would be redeemed at an agreed price of
£110.40%. The redemption would be funded by a 2 for 5 rights issue.
Assume that the corporation tax rate will be 21% pa for the foreseeable future.

Requirements
2.1 Calculate OW’s gearing ratio (debt / debt + equity) at 29 February 2016, using both
book and market values. (3 marks)
2.2 Discuss, with reference to relevant theories and your calculations in 2.1 above, the
finance director’s view that a reduction in OW’s gearing would have a positive impact on
the company’s share price. (6 marks)
2.3 Assuming that the debenture redemption and rights issue goes ahead on 1 March 2016
as outlined above, calculate the theoretical ex-rights price of one OW ordinary share.
Show the financial impact of the proposed rights issue on an OW shareholder who owns
10,000 ordinary shares and who
(a) takes up all of the rights

(b) sells all of the rights
(c) does nothing. (9 marks)
2.4 Calculate, and comment upon, the actual price of an ordinary OW share after the rights
issue is made, assuming that OW’s current P/E (price/earnings) ratio remains
unchanged. (7 marks)
2.5 Making reference to relevant theories, discuss whether the marketing director is correct
that a reduction in OW’s ordinary dividend would affect the price of its ordinary shares.
(7 marks)
2.6 Comment on the ethical implications of the production director’s suggestion for you as
an ICAEW Chartered Accountant. (3 marks)
Total: 35 marks

3.1 You should assume that the current date is 29 February 2016
Tully Carlisle Ltd (TC) is a UK construction firm. Most of its suppliers are UK-based.
However, since 2014 it has been purchasing steel girders from a Russian company, GSL.
At a recent board meeting one of TC’s directors commented:
“With our GSL purchases, we’ve never hedged against adverse exchange rate movements.
I think that we should as we’re now buying a lot of steel from GSL. The orders are made
three months ahead of delivery and payment. A lot could happen to the exchange rate in
those three months.”
TC’s next order from GSL, at a price of R145.6 million (R = roubles, the Russian currency)
will be paid for in three months’ time on 31 May 2016. You are a member of TC’s finance
team and have been asked to advise the board of the implications of hedging this purchase.
You have collected the following information:
Spot exchange rate at 31 December 2014 (R/£) 79.45 – 91.34

Spot exchange rate at 31 December 2015 (R/£) 76.51 – 87.95
Spot exchange rate at 29 February 2016 (R/£) 78.81 – 90.62
Three-month forward contract discount (R/£) 0.55 – 0.63
Forward contract arrangement fee (per one million roubles converted) £40
Three-month over the counter (OTC) put option on roubles, exercise price (R/£) 91.83
Three-month OTC call option on roubles, exercise price (R/£) 79.85
Relevant OTC option premium (per one million roubles converted) £90
Sterling interest rate (borrowing) 3.6% pa
Rouble interest rate (borrowing) 6.6% pa
Sterling interest rate (lending) 2.9% pa
Rouble interest rate (lending) 5.6% pa
Requirements
(a) Calculate the sterling cost of TC’s payment to GSL on 31 May 2016 if it uses the
following to hedge its exchange rate risk:
 a forward contract
 a money market hedge
 an OTC currency option (8 marks)
(b) With reference to your calculations in (a) above and the spot exchange rates provided,
advise TC’s board whether to hedge the payment to GSL. (9 marks)
(c) Explain, with relevant workings, why the three-month forward rate is expressed at a
discount to the spot rate on 29 February 2016. (5 marks)

3.2 TC borrowed £18.5 million last year at a fixed rate of 5.2% pa and this loan is repayable in
March 2019. Anticipating a fall in interest rates, TC’s board has asked its finance team to
investigate the possibility of arranging an interest rate swap. TC’s bank has offered the
company a variable rate loan at LIBOR plus 1.2% pa.
Saunders Southgate Media (SSM), a company with a similar sized loan to TC (at a variable
rate of LIBOR plus 1.6% pa), is keen to swap its loan for one at a fixed rate. SSM has been
offered a fixed rate of 6.4% pa by its bank. LIBOR is currently 3.5% pa.
Requirement
Prepare workings for TC’s board that show how an interest rate swap that is equally
beneficial to both companies could be set up. The variable leg of the swap should be set at
LIBOR. Your workings should include a calculation of the total annual interest payable by
each company once the swap has been made. (8 marks)
Total: 30 marks

Professional Level and Stage – Financial Management - March 2016
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.
General point about candidates’ handwriting
As in previous papers, there were a number of instances in the scripts where the markers found it extremely
difficult to read the candidates’ handwriting. If a marker is unable to read what has been written then no marks
can be awarded for the passage in question.
QUESTION 1
Total marks: 35
General comments
This question had easily the highest percentage mark on the paper. Overall, the candidates’ performance
was very good indeed.
This was a four-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus. In the scenario a pharmaceutical company was considering the development of a
new product and the possible takeover of a competitor. In part (1), for 18 marks, candidates were required
to calculate the net present value of the proposed product development. They were given forecast life-
cycle data for the new product and had to take account of non-relevant cash flows, inflation rates and
corporation tax implications. Secondly, for five marks, they were required to calculate the sensitivity of that
decision to the variable costs of the product. For a further six marks they were asked to outline how
Shareholder Value Analysis (SVA) could be used when valuing a target company. Finally, for six marks,
candidates were required to apply their understanding of agency theory to three specific elements of the
scenario.
1.1

31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
Old equipment - Sale 70,000
Tax due (W1) (14,700)
New equipment cost/sale (1,150,000) 100,000
Tax relief on equipment (W2) 43,470 35,645 29,229 112,155
Sales (W3) 2,705,040 742,846
Variable costs (W4) (1,251,862) (240,400)
Rent (80,000) (80,000) (80,000)
Fixed costs (W5) (164,800) (169,744) (174,836)
Taxation (W6) 16,800 51,408 (252,721) (68,798)
Working capital (W7) 0 (267,800) 193,537 74,263
Net cash flow after taxation (1,114,430) (425,547) 1,173,479 545,230
8% factor 1.000 0.926 0.857 0.794
PV (1,114,430) (394,057) 1,005,672 432,913
NPV (69,902)
Ignore depreciation as it’s not a cash flow.

Ignore HO costs as they are allocated – not incremental cash flows therefore
Ignore interest as it’s part of the cost of capital
AP 525 produces a negative NPV and so should not be taken on as it would reduce shareholder wealth.

Workings

31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
W1
WDV b/f 0
Balancing charge 70,000
WDV/sale 70,000
Tax (21% x balancing charge) 14,700
W2
Equipment purchase/WDV 1,150,000 943,000 773,260 634,073
WDA @ 18%/Bal.allowance (207,000) (169,740) (139,187) (534,073)
WDV/sale 943,000 773,260 634,073 100,000
Tax
(21% x WDV/Bal.allowance) 43,470 35,645 29,229 112,155
W3
Sales (March 2016 prices) 2,600,000 700,000
2 3
Inflate at 2% pa x (1.02) x (1.02)
“Money” sales income 2,705,040 742,846
W4
Variable cost
(March 2016 prices) 1,180,000 220,000
2 3
Inflate at 3% pa x (1.03) x (1.03)
“Money” variable cost 1,251,862 240,400
W5
Fixed costs
(March 2016 prices) 290,000 290,000 290,000
less: HO cost allocation (130,000) (130,000) (130,000)
160,000 160,000 160,000
2 3
Inflate at 3% pa x1.03 x (1.03) x (1.03)
“Money” fixed costs 164,800 169,744 174,836
W6
Sales (W3) 2,705,040 742,846
Variable costs (W4) (1,251,862) (240,400)
Rent (80,000) (80,000) (80,000)
Fixed costs (W5) (164,800) (169,744) (174,836)
Trading profit/(loss) (80,000) (244,800) 1,203,434 327,610
Tax reclaim/(payable) @ 21% 16,800 51,408 (252,721) (68,798)
W7
Total working capital 0 260,000 70,000 0
2
x1.03 x (1.03)
“Money” total working capital 0 267,800 74,263 0
Incremental working capital 0 (267,800) 193,537 74,263

Part (1) was very well answered by most candidates. However, common errors noted were:
 No balancing charge calculated on the old equipment to be disposed of.
 Rental costs (fixed) were inflated and/or in arrears not in advance.
 Tax savings from negative cash flows in Year 0 and Year 1 were omitted.
 Working capital – did not net to zero, was applied to the wrong years, the inflation calculations were
poor.
Also, many candidates lost marks for not explaining why depreciation, head office costs and interest
charges were not relevant cash flows. ‘Not relevant’ was insufficient.
Total possible marks 18

Maximum full marks 18
1.2
PV of variable costs
31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
Variable costs (1,251,862) (240,400)
Taxation @ 21% 262,891 50,484
Net cash flow after taxation (988,971) (189,916)
8% factor 0.857 0.794
PV (847,548) (150,793)
Total PV of variable costs (£847,548 + £150,793) £(998,341)
% change in variable costs required £(69,902) 7%

£(998,341)
Thus, ignoring all other factors, variable costs would need to fall by 7% before NPV became positive and
AP 525 was viable. This is a relatively small change required to make the NPV positive.
In part (2) the sensitivity calculations were generally fine. The most common errors were (a) using sales or
contribution figures rather than variable costs and (b) missing out the effect of taxation in the calculations.

1.3
With SVA a company’s value is based on the PV of its future cash flows, so it is forward-looking. This is
theoretically the most superior valuation method. SVA considers seven value drivers, which link to (or
drive) company strategy:
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
Predictions are very difficult as cash flows are technically in perpetuity. Once a company’s period of
competitive advantage is over then its growth rate is much slower and a terminal (residual) value is
calculated, based on its cash flows to perpetuity. This terminal value is often the major part of the overall
value of the company.
Once the total value of the company has been calculated, based on the future cash flows and value
drivers, then, to calculate the value of equity, it is necessary to add the value of any short-term
investments held and deduct the market value of any debt held.
As in previous papers the candidates’ understanding of SVA was generally poor. A disappointing number
of them concentrated, wrongly, on NPV rather than PV and discussed SVA in regard to a project and not
the valuation of a target company. Thus, many candidates didn’t mention terminal value.


1.4
Apply agency theory to the question
(a) A takeover - e.g. empire building by directors, making acquisitions which are not in the shareholders’
best interest (negative NPV). Or, alternatively, a takeover might lead to the directors being made
redundant, so they would avoid a takeover which would have been in the shareholders’ best interest
(positive NPV).
(b)
 Debt levels – it’s an all-debt financed equipment purchase here, but the directors are likely to be
cautious over risk and may prefer lower levels of debt than would be at the optimal level (share price
maximised) for the shareholders.
 Time horizons – directors may take a short-term view of the firm as their performance is usually judged
in the short-term. However, shareholder wealth is affected by the long-term performance of the
company. Thus directors might turn down a possible investment that has short-term losses, but a
long-term positive NPV. However, this wouldn’t occur in the case of AP525 as it has a negative NPV.
Agency theory was generally answered well. The weakest area here was candidates’ explanation of the
conflicts that might arise in relation to short-term versus long-term performance appraisal in the context of
the project. Too many used a takeover context instead.


QUESTION 2
Total marks: 35
General comments
This question had the lowest percentage mark on the paper. The majority of candidates achieved a “pass”
standard in the question, however.
This was a six-part question that tested the candidates’ understanding of the financing options element of
the syllabus and there was also a small section with an ethics element to it. It was based around a design
company which was planning to restructure its balance sheet. This would be achieved by financing the
redemption of long-term debt via a rights issue of ordinary shares. Part (1) of the question, for three
marks, required candidates to calculate the current gearing levels of the company, using both book and
market values. In part (2) for six marks, they were asked discuss the impact of a change in the company’s
gearing levels on its share price. Candidates were expected to make reference to relevant theories and
their calculations from part (1). Part (3) for nine marks required the candidates to calculate the theoretical
ex-rights price (TERP) of the company and the impact of the proposed rights issue on the wealth of a
shareholder holding 10,000 of the company’s shares. Part (4) – seven marks - tested candidates’
understanding of (a) the company’s P/E figure and (b) the impact of the debt redemption on the company’s
earnings figure. Part (5), again for seven marks, required candidates to apply their understanding of
dividend policy theory to the scenario. Finally, for three marks, part (6) required candidates to comment as
an ICAEW Chartered Accountant on the ethical implications of issuing misleading information to
shareholders.
2.1
Long term finance Book value (£m) Market value (£m)
Ordinary share capital 96.0 326.4
retained earnings (RE) 43.8 n/a
Preference share capital (PSC) 28.0 50.4
3.5% debentures 160.0 168.0
327.8 544.8
Total fixed return capital (debs + PSC) 188.0 218.4
Gearing % 188.0 57.4% 218.4 40.1%

327.8 544.8
Many candidates’ answers to part (1) were disappointingly weak. Typical errors were: (a) not including
preference shares as debt (contra to the study manual and past questions) and (b) ignoring retained
earnings in their book value calculations, but including it in their market value calculations.

2.2
Main theories of gearing and market value - traditional view, M&M 1958 and 1963.
The modern view is that the optimum gearing level (maximisation of company value) is a balance between
the benefits of the tax shield and bankruptcy costs. The impact on OW’s WACC (and value) depends on
where its optimum gearing level is.
OW’s gearing (at book value) is over 57%, so rather high and this may depress OW’s market value.
However, gearing (at market value) is 40%, i.e. much lower, and this may have a positive effect on the
value of OW’s shares.
Hard to say where OW’s gearing level is likely to be as there are no industry comparisons.
If OW’s gearing level is currently above its optimal level, then a reduction in its gearing will have a positive
effect on its share price and vice versa.
In part (2) many candidates only scored three marks by focussing just on the theory of gearing and
company value. Those scoring higher marks noted that there was a lack of industry comparison available
in the question and, better still, noted the importance of where the company is now in relation to its
optimum gearing level.


2.3
Total funds needed for debenture redemption = £160m x 50% x 110.40/100 £88.32m
Shares (m) £m
Currently 192.0 £1.70 326.400
Rights issue (2 for 5) 76.8 £1.15 88.320
268.8 £1.5429 414.72
TERP = £1.5429
Value of a right = £1.5429 - £1.15 £0.3929
Current wealth 10,000 x £1.70 17,000
(a) Take up rights £ £

Investment ex-rights 10,000 x 7/5 x 1.5429 21,600
Cost of extra shares 10,000 x 2/5 x £1.15 (4,600) 17,000
(b) Sell rights

Investment ex-rights 10,000 x 1.5429 15,429
Sale or rights 10,000 x 2/5 x £0.39 1,571 17,000
(c) Ignore rights

Investment ex-rights 10,000 x 1.5429 15,429
In part (3) a significant number of candidates calculated a TERP in excess of the current market value –
clearly this is wrong. This was mainly because they assumed that the par value of ordinary shares was £1
(not 50p) and insisted that the share price was £3.40, not £1.70, as given in the question. Many
candidates didn’t calculate the correct debenture redemption figure. Most candidates did well with the
impact of the rights issue on the shareholder’s wealth, but many calculated a large increase in wealth
when it should be zero or a loss from doing nothing.

2.4
OW’s current earnings per share (EPS) £21.12m/192.0m £0.11
OW’s current p/e ratio £1.70/£0.11 15.5

[or £326.4m/£21.12m = 15.5 for 2 marks]
£m
OW’s current earnings 21.120
plus: Interest saved (after tax) £160m/2 x 3.5% x 79% 2.212
OW’s new earnings 23.332
OW’s new earnings per share (EPS) £23.332m/268.8m £0.0868
OW’s MV/share post-rights £0.0868 x 15.5 £1.35
Thus if OW’s P/E ratio remains unchanged post-rights, its market value will fall (from
£1.70/share) by approx. £0.35/share (20.6%). This fall has been caused by a dilution in the EPS figure
(the extra shares have outweighed the impact of the debenture interest saved).
However the debenture redemption will cause a fall in gearing. This decline in gearing may prompt an
increase in OW’s p/e ratio (lower financial risk).
Candidates’ performance in part (4) was very variable indeed and was probably the weakest set of
answers on the whole paper. Very few candidates adjusted the company’s earnings figure for saved
interest (less tax). A disappointing number calculated the P/E ratio, wrongly, as follows: £1.70/£21.12m.


2.5
Reference to main dividend policy theory:
M&M theory - share value is determined by future earnings and the level of risk. The amount of dividends
paid will not affect shareholder wealth providing the retained earnings are invested in profitable investment
opportunities (positive NPV’s). Any loss in dividend income will be offset by gains in share price.
Traditional theory - shareholders would prefer dividends today rather than dividends or capital gains in
future. Cash now is more certain than in the future.
Supplementing these main theories:

 Impact of signalling
 Clientele effect
A change in dividend policy may have a negative impact on OW’s share price. So it’s important that if
dividends are cut, then shareholders are given clear reasons for the change, i.e. communication with them
is good.
Part (5) was answered very well, as expected.

2.6
The ICAEW provides ethical guidance that will ensure that recipients of corporate finance
advice can rely on the objectivity and integrity of advice given to them by members. The other
ethical principle at risk here is that of professional behaviour.
Part (6), also, was answered well, but a high number of candidates included money laundering in their
answers – not relevant here.


QUESTION 3
Total marks: 30
General comments
The average mark for this question was very good and most candidates demonstrated a good
understanding of this area of the syllabus.
This was a four-part question which tested the candidates’ understanding of the risk management element
of the syllabus. In the scenario a construction company was investigating firstly how it might manage its
exposure to foreign exchange rate risk and then whether a proposed interest rate swap on borrowed funds
was worthwhile. Part (1a) for eight marks required candidates to calculate the sterling cost arising from a
range of hedging techniques applied to a large Russian purchase contract. In part (1b) for nine marks,
candidates were required to advise the company’s board whether it should hedge the Russian (rouble)
payments. Part (1c) for five marks required candidates to explain, with relevant workings, the concept of
interest rate parity (IRP). In part (2), for eight marks, the company was planning to swap its borrowings
from a fixed rate to a variable rate of interest and candidates were asked to provide workings for the board
demonstrating how the swap would work and calculating the resultant annual interest payments.
3.1(a)
Forward contract
Payment in sterling would be R145.6m R145.6m (£1,834,677)
(78.81 + 0.55) 79.36
plus: Arrangement fee 145.6 x £40 (£5,824)
(£1,840,501)
Money market hedge
Payment in sterling would be R145.6m R145.6m R143,589,740 lent
[1 + (5.6%/4)] 1.014
Converted at spot rate R143,589,740 (£1,821,9743)

78.81
Borrowed at 3.6% p.a. £1,821,974 x (3.6%/4) (£16,398)

(£1,838,371)
OTC currency option

A call option would be used (i.e. at 79.85R/£)
Payment in sterling would be R145.6m (£1,823,419)

79.85
plus: Option premium 145.6 x £90 (£13,104)

(£1,836,523)
Most candidates’ answers to part (1a) were very good, but the most common error noted was that a
minority of candidates used the wrong approach with regard to the call option.


3.1(b)
Sterling payment at spot rate R145.6m (£1,847,481)
78.81
Comparative payment at earlier dates 31/12/14 R145.6m (£1,832,599)

79.45
31/12/15 R145.6m (£1,903,019)

76.51
A stronger £ gives the lowest payment and vice versa for a weaker £
The FC discount suggests a weakening of the rouble, and it has weakened from December 2015 to
February 2016, so maybe a trend.
In order (lowest to highest cost)

Option (£1,836,523)
MMH (£1,838,371)
FC (£1,840,501)
Spot (£1,847,481)
The option gives best outcome (it’s slightly lower than the MMH & the FC). However, if the rouble
continued to weaken then the sterling cost would fall further. For example, a 1% increase in the spot value
of sterling over the next three months would then make this the lowest sterling payment
(145.6mR/(78.81 x 1.01) = £1,829,146.
Option gives flexibility (abandon, upside) unlike MMH or FC (fixed, binding, no upside/downside)
Directors’ attitude to risk is important.
Other relevant points e.g. political uncertainty in Russia
(1b) was not as good as hoped. Too many candidates discussed recent spot movements OR forward
contract v MMH v option rather than both.

3.1(c)
Avge. spot rate x 1 + Average rouble interest rate (3 mos.) = Fwd contract rate (3 mos.)
1 + Average sterling interest rate (3 mos.)
The rouble interest rates are higher than those of sterling. Using the interest rate parity (IRP) equation
above, the value of sterling against the rouble will rise. The rouble’s loss of value is called a discount.
Average UK rate 3.25% pa or 0.8125% per 3 mos.

Average Russian rate 6.1% pa or 1.525% per 3 mos.
Average spot = 84.715
Forward = 84.715 x 1.01525/1.008125 = 85.31 i.e. a discount of 0.6
Average discount given = 0.59 so IRP is working
The concept of IRP was, in most cases, answered well, but many candidates used twelve-month rather
than three-month figures. A minority of candidates didn’t mention IRP and so scored zero.


3.2
TC SSM Difference
Fixed 5.2% 6.4% 1.2%
Variable LIBOR + 1.2 LIBOR + 1.6 0.4%
Difference between differences 0.8%
This potential gain can be split evenly, i.e. 0.4% to each party. This means that TC would pay
LIBOR + 0.8% (LIBOR + [1.2% - 0.4%] and SSM would pay fixed 6.0% (6.4% - 0.4%).
The interest rate swap would look like this:

TC SSM
Currently pays (5.2%) (LIBOR + 1.6)
TC pays SSM (LIBOR) LIBOR
SSM pays TC (balancing figure) 4.4% (4.4)
New net payment (LIBOR + 0.8) (6.0%)
TC and SSM would both pay at less (0.4% in each case) than their available fixed and
variable rates.
TC SSM
New net interest rate (LIBOR + 0.8) 4.3% pa 6.0% pa
£’000 £’000
Interest on £18.5m pa (795.5) (1,110.0)
Alternatively
£’000 Rate £’000 £’000 Rate £’000

Interest paid now 18,500 (5.2%) (962.0) 18,500 (5.1%) (943.5)
SSM pays TC 4.4% 814.0 (4.4%) (814.0)
TC pays SSM (3.5%) (647.5) 3.5% 647.5
New interest payment (795.5) (1,110.0)
The interest rate swap was done very well and most candidates scored maximum marks here. The
weakest area was with the initial overall saving on interest cost (0.8%), which a small percentage of
candidates didn’t calculate correctly.


TUESDAY 7 JUNE 2016
(2½ hours)
exam starts.
IMPORTANT

Copyright © ICAEW 2016. All rights reserved.
ICAEW\J16 221371
1. You should assume that the current date is 30 June 2016
Zeus plc (Zeus) is a large clothing retailer. Over the past five years it has built up an internet
based division, Venus, which specialises in selling to 16-24 year old female customers.
At a recent board meeting the Chief Executive Officer (CEO) of Zeus stated that:
“Venus has been successful, but we have not been able to get the value out of it that we
initially expected and the management time involved in running Venus is damaging the
financial performance of the group as a whole. Because internet-based companies have very
high values compared to non-internet companies with similar earnings, I feel that there could
be more value in Venus if it operated outside of our group. I think that we should divest
ourselves of Venus and appoint a financial advisor to assist us in the process. I wonder
whether an Initial Public Offering (IPO), where the shares are brought to the stock market for
the first time, is a possibility.”
The board agreed with the CEO and voted in favour of the divestment of Venus. Starr
Accountants (SA), a firm of ICAEW Chartered Accountants, has been appointed to give
advice to Zeus regarding the value of Venus and the potential IPO. In their valuation SA
would like to use net present value analysis and also a multiple of earnings. In addition to
general corporate finance work, SA also has a team that specialises in giving investment
advice to clients who buy shares in IPOs.
Extracts from Venus’s most recent management accounts are shown below:
Balance sheet value of net assets at 30 June 2016: £39 million.
Income Statement for the year ended 30 June 2016

£m
Sales 140.0
Cost of sales (56.0)
Gross profit 84.0
Selling and administration costs (72.0)
Operating profit 12.0
Taxation (2.5)
Profit after tax 9.5
Note: Selling and administration costs include depreciation of £2 million.
Additional information relating to Venus:
 An analyst has estimated that, for the four years to 30 June 2020, the volume of sales will
grow by 18% pa and selling prices will increase by 2% pa. Because of volume discounts,
the gross profit percentage will increase to 66%.
 Selling and administration costs, excluding depreciation, are estimated to increase by 5%

pa for the four years to 30 June 2020.
 Venus will require an additional investment in working capital on 1 July 2016 of

£26 million. 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 2020.
ICAEW\J16 Page 2 of 7
 On 30 June 2016 Venus will need to invest in a new warehouse management system
that will cost £10 million and will not have any scrap value on 30 June 2020. The
warehouse management system will 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 2020, the difference between the warehouse management system’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.
 SA intends to include in the net present value analysis a continuing value at the end of
four years that will represent the value of the net cash flows after tax beyond the fourth
year. This will be calculated by treating the after-tax operating cash flows for the year
ended 30 June 2020 as a growing perpetuity with a growth rate of 1% pa.
 An appropriate money discount rate to reflect the risk of Venus is 10% pa.
 SA would like to assume that the rate of corporation tax will be 21% for the foreseeable
future and that tax flows arise in the same year as the cash flows that gave rise to them.
 The average price earnings (P/E) ratio of companies similar to Venus is 55.
 Unless otherwise stated assume that all cash flows arise at the end of the year to which
they relate.
Requirements
1.1 Using money cash flows, calculate the value of Venus on 30 June 2016 using net
present value analysis. (15 marks)
1.2 Calculate the value of Venus on 30 June 2016 using a multiple of current earnings.
(2 marks)
1.3 Summarise the advantages and disadvantages of the two valuation methods used in
parts 1.1 and 1.2 and identify any concerns you have in respect of using them to value
Venus. (5 marks)
1.4 In relation to the potential IPO, explain the difference between an offer for sale and an
offer for subscription (also known as a direct offer). (2 marks)
1.5 Outline the advantages and disadvantages of underwriting and advise the board of
Zeus as to whether the potential IPO should be underwritten. (4 marks)
1.6 Explain two methods, other than an IPO, by which Zeus could divest itself of Venus.
(4 marks)
1.7 Identify any ethical issues that SA may have in relation to the potential Venus IPO and
state how they might be resolved. (3 marks)
Total: 35 marks
2. Ross Travel plc (Ross) provides public transport services in the UK. Ross is planning to set
up a new division called “Happytours” and to expand into a different sector of the
transportation industry by operating holiday and sightseeing tours. The Chief Executive
Officer (CEO) of Ross believes that the expansion will cost £500 million and that the finance
can be raised in such a way as to leave the existing debt:equity ratio, by market values, of
the company unchanged after the expansion.
The CEO of Ross would like the finance director of the company to advise him of how the
company’s current weighted average cost of capital (WACC) can be adjusted to take into
account the risk of expanding into the new sector. The debt proportion of the new finance will
be raised in the form of redeemable debentures. However, the CEO would also like to know
the advantages and disadvantages of Ross issuing convertible debentures.
The finance director has established the following:
 The debt proportion of the £500 million finance to be raised on 1 June 2016 will be in the
form of new 4% coupon debentures, which will be redeemed on 31 May 2021 at par. The
redemption yield of the new debentures will be equal to the redemption yield of Ross’s
existing debentures.
 An appropriate equity beta for a company that operates in the holiday and sightseeing
tour sector is 1.3 at a debt:equity ratio, by market values, of 1:1.
 The market risk premium is expected to be 5% pa and the risk free rate 2% pa.
 The corporation tax rate will be 21% for the foreseeable future.
The following information relates to Ross without the Happytours project
Extracts from Ross’s most recent management accounts are as follows:
Balance Sheet at 31 May 2016
£m
Ordinary share capital (5p shares) 32
Retained earnings 3,072
3,104
6% Redeemable debentures at nominal value 608
3,712
On 31 May 2016 Ross’s ordinary shares each had a market value of 576p (cum-div) and an
equity beta of 0.65. For the year ended 31 May 2016, the dividend declared was 11p per
ordinary share and the earnings yield (earnings per share divided by the ex-div share price)
was 6%.
Ross’s 6% coupon debentures had a market value on 31 May 2016 of £111 (cum-interest)
per £100 nominal value and are redeemable at par on 31 May 2020.
Requirements
2.1 Ignoring the Happytours project, calculate the WACC of Ross at 31 May 2016 using:
 the Gordon growth model (12 marks)

 the CAPM (2 marks)
2.2 Explain the limitations of the Gordon growth model. (3 marks)
2.3 Using the CAPM, calculate a WACC that is suitable for appraising the Happytours
project and explain your rationale. (6 marks)
2.4 Assuming that £75 million is raised from the new 4% coupon debentures issued on
1 June 2016, calculate the issue price per £100 nominal value and the total nominal
value that will have to be issued. Comment on the issue terms for these new
debentures. (7 marks)
2.5 Explain what is meant by a convertible debenture and outline the advantages and
disadvantages for Ross in raising finance using this type of debt. (5 marks)
Total 35 marks
3.1 You should assume that the current date is 31 May 2016
Heaton Risk Management (HRM) is an authorised financial advisor and provides investment
and risk management advice. You work for HRM and currently you are advising two clients,
Orchid Cars Ltd (Orchid) and Sheldon Investments (Sheldon).
Orchid is a UK company that manufactures sports cars. Orchid’s main market is the UK but it
also exports cars to the USA.
Currently Orchid uses forward contracts to hedge its foreign exchange rate risk. However,
Orchid’s managing director has recently been considering using foreign currency futures and
over-the-counter foreign currency options. You have been asked to make a comparison of
the results of hedging using the three different techniques.
Orchid is due to receive $2,500,000 on 30 September 2016.
The following data is available to you at the close of business on 31 May 2016:
Exchange rates:
Spot exchange rate ($/£) 1.5398 – 1.5402

Four-month forward premium ($/£) 0.0015 – 0.0010
September currency futures price (standard contract size £62,500): $1.5379/£
Four-month over-the-counter currency options:
Call options to buy £ have an exercise price of $1.5300/£. The premium is £0.03 per $ to be
converted and is payable on 31 May 2016.
Put options to sell £ have an exercise price of $1.5200/£. The premium is £0.01 per $ to be
converted and is payable on 31 May 2016.
Orchid has surplus cash funds on which it receives interest at 3.60% pa.
Requirements
(a) Assuming that the spot exchange rate on 30 September 2016 will be $/£1.5315 –
1.5325 and that the sterling currency futures price will be $1.5320/£, calculate Orchid’s
net sterling receipt if it uses the following to hedge its foreign exchange rate risk:
 currency futures contracts
 an over-the-counter currency option.
(11 marks)
(b) Discuss the relative advantages and disadvantages of each hedging technique and
advise Orchid on which would be most beneficial for hedging its foreign exchange rate
risk.
(9 marks)
3.2 Sheldon holds a portfolio of FTSE 100 shares and the current market value on 31 May 2016
is £9,657,000. The managers at Sheldon are worried that over the next three months the
FTSE 100 will fall in value due to economic uncertainty in Europe and Asia. The managers at
Sheldon do not want to sell the company’s portfolio and wish to protect its current value
against a potential fall in the FTSE 100.
The FTSE 100 index is 6,525 on 31 May 2016 and you have the following information
available to you regarding traded index option premiums:
FTSE 100 INDEX OPTIONS: £10 per full index point (points per contract)
6,450 6,525 6,600

Calls Puts Calls Puts Calls Puts
July 155 51 87 85 70 135
August 215 120 171 159 120 213
Option contracts expire at the end of the month.
Requirement
Demonstrate how FTSE 100 index options can be used by Sheldon to hedge its portfolio of
shares against a fall in the FTSE 100 and show the outcome if, on 31 August 2016, the
portfolio’s value:
(a) Rises to £10,471,000 and the FTSE 100 index rises to 7,075;
(b) Falls to £8,695,000 and the FTSE 100 index falls to 5,875. (7 marks)
3.3 Sheldon’s managers would like an explanation regarding the time value of the FTSE 100
index options.
Requirement
Explain the three factors that will affect the time value of the FTSE 100 index options in 3.2
above. (3 marks)
Total 30 marks
Financial Management - Professional Level – June 2016
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: 35
General comments
This was a seven-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 divesting itself of a division by
offering it to the public through an Initial Public Offering.
1.1
0 1 2 3 4
£m £m £m £m £m
Gross profit 111.21 133.85 161.10 193.90
Selling and Administration (73.50) (77.18) (81.04) (85.09)
Operating cash flows 37.71 56.67 80.06 108.81
Tax
21% (7.92) (11.90) (16.81) (22.85)
After tax operating cash flows 29.79 44.77 63.25 85.96
New equipment (10.00)
Tax saved on Ca's 0.38 0.31 0.25 0.21 0.95
Working Capital (26.00) (5.29) (6.37) (7.67) 45.33
Continuing value 964.66
Net cash flows (35.62) 24.81 38.65 55.79 1096.9
PV factors at 10% 1.00 0.91 0.83 0.75 0.68
Present value (35.62) 22.55 31.92 41.90 749.20
NPV 809.95
Gross profit = £92.4 million (140 x 66%)

Gross profit year:
1 = 92.4 x 1.18 x 1.02 = £111.21 million
2 = 111.21 x 1.18 x 1.02 = £133.85 million
3 = 133.85 x 1.18 x 1.02 = £161.10 million
4 = 161.10 x 1.18 x 1.02 = £193.90 milion
Selling and administration £70 million (72-2) increasing at 5%pa as depn not a cash flow.
Continuing value = (85.96 x 1.01)/(0.10 – 0.01) = £964.66 million
Ignoring BS asset values (valuing income assets generate)
Capital allowances and the tax saved thereon

Cost/WDV CA Tax
£m £m £m
0 10.00 1.80 0.38
1 8.20 1.48 0.31
2 6.72 1.21 0.25
3 5.51 0.99 0.21
4 4.52 4.52 0.95
Copyright © ICAEW 2016. All rights reserved Page 1 of 10

Working Capital
Total Increment
£m £m
0 (26) (26)
1 (31.29) (5.29)
2 (37.66) (6.37)
3 (45.33) (7.67)
4 45.33
Well answered by many candidates, however common errors that weaker candidates made were:
including operating cash flows in time zero; incorrect calculation of the continuing value; adding the 18%
growth and 2% price increase figures together instead of compounding them; omitting to explain why
certain inputs were not to be included in the cash flows; applying a non-marketability discount to the final
valuation.

1.2
Profits after tax at 30 June 2016 = £9.5 million.

The value of Venus based on the mean p/e ratio = £522.5 million (9.5 x 55)
Well answered by the majority of candidates however many candidates applied a non-marketability
discount to the p/e ratio, which was inappropriate for the valuation of an IPO.

1.3
The advantages of the NPV valuation are that it values the future cash flows of the company and takes
into account both risk and the time value of money. However the disadvantages are that the inputs into the
model are critical in arriving at a reliable estimate of the value of Venus.
The major advantage of the multiples valuation is that it values Venus by comparison to its peers and
reflects the future growth potential of the market. However the disadvantages are that no company is truly
comparable and establishing a maintainable earnings figure is problematic.
In relation to Venus reservations include:
For the NPV valuation: Is 18% growth realistic for the next four years, how has this figure been
estimated; does the 10% discount factor truly reflect the risk of the company; is it reasonable to calculate
the continuing value by treating the fourth year after tax operating cash flow as a growing perpetuity and
how has the 1% growth figure been calculated; is it reasonable to assume that the gross profit percentage
will increase by 10%;
For the multiples valuation: The p/e ratio of 55 is the mean of a sample of comparable companies, what
is the spread of p/e ratios and have outliers been excluded; Is taking historic earnings realistic, should
prospective earnings be calculated.
Responses to this part of the question were mixed and often did not relate to the scenario of the question
despite the requirement specifically asking them to.


1.4
With an offer for sale shares in Venus would be sold to an issuing house which would then offer the
shares for sale to the general public.
With an offer for subscription (or direct offer) the shares in Venus would be offered directly to the public i.e
not through an issuing house.
Very few students submitted correct answers to this part of the question and often made up definitions.

1.5
The danger for Zeus of not using a underwriter for the IPO is that there might be insufficient demand for all
the securities to be issued. This is especially important when a fixed issue price is set in advance of the
issue date and the market is volatile. The market appetite for Venus’s stocks might be less than expected,
especially with the value placed on the company, which depends on high future growth.
Underwriting is a form of insurance, which ensures that all securities are sold and Zeus can be certain of
obtaining the funds required.
The major disadvantage of underwriting is the cost. The cost depends on the characteristics of the
company issuing the security and the state of the market. With a company such as Venus the cost is likely
to be at the upper end of the scale. Usually fees range from 1% to 2% of the total finance to be raised.
Another disadvantage of underwriting is that it may signal that the company is not confident in the issue
being fully taken up.
The advice of whether or not to underwrite the IPO must be supported.
Responses to this part of the question were mixed with a lot of candidates showing that they did not
understand what underwriting means.

1.6
A management buy-out is possibility. However due to the value and risk of Venus it is more likely that a
private equity firm would be interested in being involved in a management buy-in. Private equity firms
have access to large amounts of debt.
Zeus could sell-off Venus to another internet company that is involved in the fashion industry and is
seeking to expand.
With an MBO, MBI or Sell-off Zeus would receive cash but there may be difficult negotiations regarding
the price. Also the shareholders of Zeus would not be able to participate in the future growth of Venus.
Zeus could spin-off (or demerge) Venus; the existing shareholders would then hold shares in the
demerged company as well as in the remaining group. Shareholders could then participate in the growth
of Venus as an independent company.
Liquidation or selling of the assets to generate cash. This would be a last resort measure.
Responses to this part of the question were good although often candidates did not consider the scenario
of the question.


1.7
For SA there is an issue of confidentiality here and a potential conflict of interest. This can be resolved by:
 The use of different partners and teams for different clients.

 All necessary steps to be taken to prevent the leakage of confidential information between
different teams and sections within the firm “Chinese Walls”.
 Regular review of the situation by a senior partner or compliance officer not personally involved
with either client.
 Advising clients to seek additional independent advice, where it is appropriate.
Well answered by the majority of candidates. However , as in previous sittings, a number of candidates did
not use the language of ethics.


Question 2
Total Marks: 35
General comments
This was a five-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 expanding its operations into a different
sector of its market.
2.1
WACC using the Gordon growth model:
The growth rate = g = r x b Where r = the current accounting rate of return

b = the proportion of profits after tax retained
The profits after tax = the current ex-div share price x the earnings yield x the number of shares in issue.
The ex-div share price = 565p (576p – 11p)
The number of shares in issue =640m (£32m/£0.05)
The total earnings = £216.96m (565p x 0.06 x 640m)
Total dividends = £70.40m (11p x 640m)
Retentions = £146.56m (£216.96m-£70.40m) b = 67.55% (£146.56m/£216.96m)
r = Earnings/Opening Equity Capital Employed = £216.96/(£3,104m-£146.56m) = 7.33%
g = 7.33% x 67.55% = 4.95% say 5%
ke = (d1/MV)+g = (11p(1.05)/565p)+0.05 = 7%
The cost of debt (kd) =
Year Cash Flow 1% PV 5% PV
0 (105) 1 (105.00) 1 (105.00)

1–4 6 3.902 23.41 3.546 21.28
4 100 0.961 96.10 0.823 82.30
14.51 (1.42)
The yield to maturity is a little under 5% = 1 + ((14.51/(14.51+1.42) x (5-1)) = 4.64%
kd = 3.67% (4.64x(1-0.21))
Market values:
Equity = £3,616m (565p x 640m)
Debt = £638.4m (£608mx1.05)
WACC =(7% x 3,616 + 3.67% x 638.4)/(3,616+638.4) = 6.5%
Many basic errors, which really shouldn’t be occurring given how many times this has been set. The errors
included: the inability to number crunch correctly; incorrectly calculating the number of shares in issue; not
calculating the ex-div share price and/or the ex-interest debenture price; for the cost of debt calculating
positive and negative values and interpolating outside of the range calculated; no tax adjustment for the
cost of debt; using book values for the WACC calculation.


2.1
WACC using the CAPM:

ke = 2 + 0.65 x 5 = 5.25%
kd = 3.67%
WACC = (5.25% x 3,616 + 3.67% x 638.4)/(3,616+638.4) = 5%
It was disappointing to see that many candidates were deducting the risk free rate from the market risk
premium. Also a number of candidates were using the 1.3 equity beta from the sightseeing tour sector
rather than Ross’s existing equity beta of 0.65.

2.2
Particular issues are:
The model relies on accounting profits; it assumes that b and r are constant; it can be distorted by
inflation; it relies on historic information; it assumes that all new finance is from equity or gearing is held
constant.
Well answered by the majority of candidates.

2.3
The discount rate to appraise the Happytours project must reflect its systematic risk. Ross operates in the
public transport sector; the holiday and sightseeing sector of the transportation industry is likely to have a
higher systematic risk since it relies more on discretionary spending than the public transportation sector.
The discount rate should also reflect the financial risk of Ross; in this case the finance will be raised in
such proportions that the market value gearing will remain constant.
A beta factor from a company operating in the new sector should be selected to reflect the systematic risk.
However gearing adjustments are likely to be necessary.
Equity beta of the new sector = 1.3.
Degear the beta factor: 1.3 x (1/(1 + (1 x 0.79)) = 0.73.
Regear the beta factor using Ross’s capital structure:

0.73 x ((3,616 + (638.4 x 0.79)/3,616) = 0.83.
Observation: Ross’s current equity beta is 0.65 and the equity beta for the new industry sector is 0.83,
which reflects its higher systematic risk.
ke becomes = 2 + 0.83 x 5 = 6.15%
WACC = (6.15% x 3,616 + 3.67% x 638.4)/(3,616 + 638.4) = 5.78%

Responses were mixed and often there were no reality checks made with some candidates clearly
demonstrating that they have a very shallow knowledge of the topic, errors included: calculating unrealistic
equity betas (over 300 in one script); degearing using Ross’s market values and regearing the gearing
ratio of the holiday and sightseeing tour sector; regearing using book values despite the formulae sheet
stating market values; degearing and regearing with same debt/equity ratio and ending up with a different
figure from the start; when regearing changing the gearing ratio, even though the question states that this
will not change; very brief or non-existent explanations of the rationale.


2.4
The issue price of the new debentures is arrived at by discounting their cash flows at an appropriate yield
to maturity. The yield to maturity that investors in the debentures will require should reflect the riskiness of
the debentures, the coupon rate and the maturity date. The new debentures have a longer maturity date
and a lower coupon rate than Ross’s current debentures. Therefore it is likely that investors in the new
debentures will require a higher yield to maturity than investors in the existing debentures.
Using the yield to maturity of the current debentures 4.64% the issue price will be:
Annuity factor for five years at 4.64% = (1 – (1 + 0.0464)^-5))/0.0464 = 4.373

(Note: If an annuity factor and discount factor at 5% are used, full marks should be given)
The issue price per £100 nominal value = 4 x 4.373 + 100 x 1/1.0464)^5 = £97.20
The total nominal value that will have to be issued to raise £75 million = £75m/0.972 = £77.16 million.
Despite this being set before and with a very similar detailed example in the study manual, most
candidates made a poor attempt. Few candidates used the redemption yield of the existing debentures,
which they had calculated in part 2.1; brief or no explanation of the terms of the debenture issue.

2.5
Convertible debentures are fixed return securities and can be either secured or unsecured. They may be
converted, at the option of the holder (and sometimes the company) into ordinary shares in the same
company at a future date, or a series of future dates. The coupon on convertible debentures is normally
lower than on redeemable debentures because of the value of the conversion rights.
Advantages for Ross include:

 Obtaining finance at a lower rate of interest than on redeemable debentures.
 Encouraging possible investors with the prospect of a future share in profits.
 Introducing an element of short-term gearing.
 Avoiding the problem of redemption if the conversion rights are taken up.
 Being able to issue equity cheaply if the debentures are converted
Disadvantages for Ross include:

 Dilution of control if the conversion rights are taken up.
 Uncertainty as to whether the conversion rights will be taken up and the debentures have to be
redeemed in cash.
Well answered by the majority of candidates however some answers gave explanations of Modigliani and
Miller, which was not relevant to this question.
Total possible marks 6.5


Question 3
Total Marks: 30
General comments
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 risk management
company is giving advice to two clients. To one client on hedging foreign exchange rate risk and to the
second on hedging the fall in the value of a portfolio of FTSE 100 shares.
3.1 (a)
Forward contract:
The appropriate forward rate = $/£ 1.5392 (1.5402-0.0010)
This will result in a sterling receipt of = £1,624,220 ($2,500,000/$1.5392)
Currency futures:
HRM will buy September futures to hedge the $ receipt, the number of
contracts = ($2,500,000/$1.5379)/£62,500 = 26.01. Round to 26 contracts.
The futures contracts will be closed out on 30 September 2016 resulting in a loss of:
$9,588 ((1.5379-1.5320) x 26 x £62,500).
The sterling receipt will be: £1,625,065 (($2,500,000 - $9,588)/£1.5325))
OTC currency options:
Ross will use a call option to buy £ with an exercise price of $1,5300.
The premium will cost: £75,000 ($2,500,000 x £0.03)
The cost including interest lost on surplus cash deposits = £75,900 (£75,000 x (1+ 0.36 x 4/12))
If the spot rate for buying £ on 30 September 2016 is $/£1.5325, Ross will exercise the options and buy £
at $/£1.5300.
The sterling receipt will = £1,633,987 ($2,500,000/$1.5300)
The net receipt after taking the option premium and interest lost into account =
£1,558,087 (£1,633,987 - £75,900)
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; treating an over the counter option like a traded
option; confusing puts and calls.

3.1 (b)
The sterling receipt for each of the three hedging techniques:
Forward contract £1,624,220

Currency futures £1,625,065
OTC currency option £1,558,087
The forward contract and futures contracts both lock Heaton into an exchange rate and do not allow for
the upside potential of the $ strengthening against the £ more than expected.
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 HRM
However there is no secondary market should the customers not pay HRM
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

There is no secondary market
Advice to HRM: 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, £845, between the receipt using forwards or futures.
Since there is potential for margin calls using futures it is recommended that HRM use forward contracts to
hedge the its foreign currency risk.
Average responses from a lot of candidates without any reference to the numbers calculated in part 3.1
(a), however there were some excellent answers.

3.2
To protect the current value of the portfolio over the next three months Sheldon should hold August put
options with and exercise price equal to the current FTSE 100 index of 6,525.
The number of contracts = 148 (£9,657,000/6,525 x £10)
The premium will cost = £235,320 (159 x £10 x 148)
(a) Sheldon should let the options lapse since the Index has gone up and is higher, at 7,075, than the
exercise price of the put option.
Overall position £
Portfolio value 10,471,000
Less option premium (235,320)
10,235,680
(b) Sheldon should exercise the options since the index has fallen to 5,875, which is below the put option
exercise price.
The gain on exercising the options = £962,000 ((6,525 – 5,875) x £10 x 148)
Overall position £
Portfolio 8,695,000
Gain on options 962,000
Original value 9,657,000
Less option premium (235,320)
9,421,680
Some excellent answers from the majority of candidates. Weaker candidates confused calls and puts and
demonstrated that they clearly did not know the difference between the two.


3.3
The three factors that affect the time value of the FTSE 100 options are
 Time to maturity – For example: The longer the time to maturity the more chance there is that the
option will be in the money at expiry. Also there will be a greater interest element in the option
value.
 The risk free rate – For example: The level of the risk free rate will affect the interest element in
the options value. The higher it is the more interest element.
 Volatility – For example: Higher volatility will increase the option value since there is more chance
of the option being in the money, or deeper in the money, at expiry.
Many excellent answers with a good understanding of the factors that contribute to the time value of
options. However weaker candidates tended to only give one correct factor and then made up the other
two.


TUESDAY 6 SEPTEMBER 2016
(2½ hours)
exam starts.
3. Answers to each question must begin on a new page and must be clearly numbered.
IMPORTANT


1. You should assume that the current date is 30 September 2016
Northern Energy Ltd (Northern) is a UK electricity generator. On 31 March 2017 it has

contracted to borrow £9.5 million for a year at an interest rate of LIBOR + 2% pa. The loan
will be used to finance the construction of a new rail terminal at one of its power stations.
Northern’s board is now worried that interest rates may well increase over the next six
months and would like to investigate how it might hedge against any adverse movements.
Northern’s bank has offered the company either a Forward Rate Agreement (FRA) at
7.25% pa or an option at 6.5% pa plus a premium of 1% of the sum borrowed. The board
would also like to consider the possibility of an interest rate swap.
Northern’s three power stations are coal-fired and the company has for many years imported
coal from China and India, with payment made to suppliers at the time of the order.
Northern’s board is concerned that in recent months the Indian and Chinese exchange rates
have become more volatile. As a result Northern’s board is considering buying coal from the
USA.
Earlier this month Northern’s purchasing team started discussions with ACT Inc (ACT), an
American coal mining company. ACT has informed Northern that, because of the logistical
issues involved, the first consignment of coal would arrive in three months’ time on
31 December 2016. Northern has agreed to pay for the coal one month later on 31 January
2017. Northern’s board is keen to establish whether it is worth hedging its dollar exchange
rate risk.
ACT has quoted Northern a price of $4.8 million for this first consignment. You work in
Northern’s finance team and have been asked to prepare workings to help Northern’s board
to decide on a hedging strategy. You have collected the following data at the close of
business on 30 September 2016:
Spot rate ($/£) 1.5150 - 1.5260
Relevant currency futures contract price (standard contract size £62,500) $1.5095/£
OTC currency option Four-month put option on dollars ($/£) 1.5110

Four-month call option on dollars ($/£) 1.5020
Premium (per $ converted) £0.011
Forward contract Four month forward premium ($/£) 0.0112 - 0.0094

Arrangement fee (per $ converted) £0.004
Interest rates US dollar interest rate (lending) 3.6% pa

US dollar interest rate (borrowing) 4.5% pa

Requirements
1.1 Assuming that on 31 March 2017 LIBOR will be:
(a) either 5% pa
(b) or 7% pa
prepare suitable interest payment calculations for each eventuality and recommend to
Northern’s board whether it should hedge against interest rate movements using a FRA,
an option or an interest rate swap. (9 marks)
1.2 Calculate Northern’s sterling cost of the ACT consignment if it uses the following to
hedge its exchange rate risk:
(a) Currency futures contracts

(b) An OTC currency option
(c) A forward contract
(d) A money market hedge
You should assume that on 31 January 2017 the spot exchange rate will be
$1.4895 – 1.4956/£ and that the sterling currency futures price will be $1.4945/£.
(13 marks)
1.3 With reference to your calculations in 1.2 above, explain to Northern’s board the
implications of hedging or not hedging the payment to ACT. (8 marks)
Total: 30 marks

2. Roper Newey plc (Roper) is a UK engineering company that operates in the oil industry
providing support services on oil rigs and at oil terminals. It started trading in 1999 and it has
a financial year end of 31 August.
For a number of years Roper has used a weighted average cost of capital (WACC) figure of
7% pa as its hurdle rate when appraising large-scale investments. At Roper’s most recent
board meeting it was decided to investigate the possibility of the company diversifying into
the UK fracking industry. Fracking involves extracting oil and gas from beneath the ground
via the high pressure injection of water and sand. It is a very controversial industry in the UK,
not least because of concerns about its impact on the natural environment.
Roper’s board is considering supplying services to the fracking industry. The finance for this
investment would be raised in such a way so as not to alter Roper’s current gearing ratio
(measured by market values). The debt element of the finance will come from a new issue of
6% irredeemable debentures at par.
Roper’s directors are aware that many American companies have been very successful
financially when investing in fracking, but are concerned that such a diversification by Roper
in the UK would be excessively risky. As a result Becky Challoner, Roper’s finance director,
has agreed to present relevant figures and advice at the next board meeting. Becky has
asked you, as a member of Roper’s finance team, to work with her on this.
Details of Roper’s capital structure at 31 August 2016 are shown below:
Total nominal value Market Value

£m
Ordinary share capital (£1 shares) 15.5 £5.20/share (ex-div)
Preference share capital (£1 shares) 9.0 £1.08/share (ex-div)
4% redeemable debentures (Note 1) 6.5 £107% (cum-int)
5% irredeemable debentures 10.0 £101% (cum-int)
Roper’s most recent dividend payments and the interest payments due in the near future are
shown below:
Ordinary dividends (Note 2) £3,797,500 Paid in August 2016

Preference dividends (Note 2) £540,000 Paid in August 2016
4% redeemable debentures interest £260,000 To be paid in September 2016
5% irredeemable debentures interest £500,000 To be paid in September 2016
Note 1
These are redeemable at par on 31 August 2019.
Note 2
Ordinary and preference dividends are paid once a year. Ordinary dividend payments have
increased at a steady annual rate since August 2012 at which time the ordinary dividend per
share was £0.201. There have been no issues of ordinary shares since August 2012.
Additional information at 31 August 2016

Roper equity beta 1.2
Risk free rate (pa) 1.9%
Market return (pa) 9.5%

Fracking industry – market data at 31 August 2016
Average equity beta 1.9
Ratio of long–term funds (equity:debt) by market values 90:25
Assume that corporation tax will be payable at the rate of 21% for the foreseeable future and
tax will be payable in the same year as the cash flows to which it relates.
Requirements
2.1 Ignoring the investment in fracking services, calculate Roper’s WACC at 31 August
2016 using:
(a) The dividend growth model and

(b) The CAPM
(13 marks)
2.2 Ignoring the investment in fracking services, advise Roper’s board, giving reasons,
whether it should continue using 7% as its hurdle rate when appraising large-scale
investments. (3 marks)
2.3 Explain the underlying logic for using the CAPM when calculating a company’s WACC.
(5 marks)
2.4 Calculate the WACC that Roper should use when appraising its proposed investment in
fracking and explain the reasoning behind your approach. (10 marks)
2.5 With reference to the information provided, explain the circumstances in which it would
be appropriate to use the adjusted present value approach to investment appraisal.
(4 marks)
Total: 35 marks

3. Darlo Games Ltd (Darlo) is a UK company which was formed in 2005 by Michelle Cartmel
and Rob Orton. Darlo produces games for use on computers and mobile devices such as
phones. Its financial year end is 31 August. Michelle and Rob own 70% of Darlo’s issued
share capital and are part of its executive management team. The remainder of Darlo’s
share capital is owned by Michelle and Rob’s friends and family. Darlo has been particularly
successful in the past three years as two of its games introduced in late 2013 have
generated very high levels of sales. A game has a typical lifespan of 3-5 years.
NSL plc (NSL) is a listed software development company based in the UK and is actively
seeking to invest in other companies. You are an ICAEW Chartered Accountant and work in
Darlo’s finance team. You have received an email from your manager, Jackie Tann, an
extract from which is shown below:
From: Jackie Tann

Date: 1 September 2016
A member of the board has told me, in confidence, that NSL is considering buying
shares in Darlo. I’m not sure at this stage if they want to buy all of them or just a
minority holding. We need some guidance on what a reasonable share price might be.
I’ve extracted the key figures from our most recent management accounts in the
document attached to this email. I’ve also provided you with some working assumptions.
Could you please prepare a range of prices for the Darlo board to consider? Also I’m
keen to know if we could value Darlo using Shareholder Value Analysis (SVA).
Email attachment:
Income Statement for the year ended 31 August 2016

£’000
Revenue 9,390
Profit before interest and tax 2,849

Interest (30)
Profit before taxation 2,819
Corporation tax at 21% (592)
Profit after taxation 2,227
Dividends paid (740)
Retained profit 1,487
Balance Sheet at 31 August 2016

£’000
Freehold land and buildings (original cost £2.8 million) 2,400
Equipment (original cost £4.5 million) 3,200
5,600
Working capital 148
5,748
4% debentures (redeemable in 2023) at nominal value (750)
4,998
Ordinary shares of £1 each 500

4,998

Working assumptions
(1) Darlo’s fixed assets were revalued at 31 August 2016 as follows:
£’000
Freehold land and buildings 3,150
Equipment 3,370
These revalued amounts have not been recognised in the balance sheet at
31 August 2016.
(2) The average price/earnings ratio for listed businesses in Darlo’s industrial sector
is 10 and the average dividend yield is 8%.
(3) A discount rate of 12% pa appropriately reflects the risk of Darlo’s cash flows.
(4) Darlo’s pre-tax net cash inflows (after interest) for the next three years are
estimated to be:
£’000
Year to 31 August 2017 £2,900
Projecting forward from 31 August 2019 and taking a prudent view, our estimated
net cash inflows (after interest, capital asset replacement and all necessary tax
adjustments) will be £2 million pa.
(5) On 31 August 2016 Darlo’s equipment had a tax written down value of £920,000.
Assume that we will scrap it (i.e. dispose of it for zero income) on 31 August 2019.
The equipment attracts 18% (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 equipment’s written down
value for tax purposes and its disposal proceeds will be treated by the company
either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down
value, or
 balancing charge, if the disposal proceeds are more than the tax written down
value.
(6) Corporation tax will be payable at the rate of 21% for the foreseeable future and that
tax will be payable in the same year as the cash flows to which it relates.

Requirements
3.1 Prepare a report for Darlo’s board which:
(a) Calculates the value of one share in Darlo based on each of these methods:
 net asset basis (historic cost)

 net asset basis (revalued)
 price/earnings ratio
 dividend yield
 present value of future cash flows
(14 marks)
(b) Explains, with reference to your calculations and the information provided, the
advantages and disadvantages of using each of the five valuation methods in
(a) above. (10 marks)
3.2 Explain how the SVA approach works and whether the information provided by Jackie
Tann is sufficient to value Darlo using SVA (calculations are not required). (8 marks)
3.3 Explain the ethical issues that you should consider as an ICAEW Chartered Accountant
arising from Jackie Tann’s email. (3 marks)
Total: 35 marks

Professional Level – Financial Management - September 2016

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.
difficult to read the candidates’ handwriting. If a marker is unable to read what has been written then no
marks can be awarded for the passage in question.
Question 1
Total marks: 30
General comments
This question had easily the highest percentage mark on the paper. Overall, the candidates’ performance
was very good.
This was a three-part question which tested the candidates’ understanding of the risk management
element of the syllabus. In the scenario a UK electricity generator was considering hedging (1) the interest
costs of a large loan and (2) its exposure to foreign exchange rate risk on a planned purchase from an
American supplier. In part 1.1, for nine marks, candidates were required to calculate the interest payments
that would arise on its planned loan were it to make use of an FRA, an option or a swap. Two different
rates of LIBOR were given to the candidates. Candidates were then required to recommend which of the
hedging techniques the company should choose at each of the LIBOR rates. Part 1.2 was worth 13 marks
and asked candidates to calculate the sterling cost arising from a range of hedging techniques applied to
the American purchase. Finally in part 1.3, for eight marks, candidates were required to advise the
company’s board whether it should hedge the American (dollar) payments.
1.1
LIBOR + 2 7% 9%
FRA
Pay at LIBOR +2 (7.00%) (9.00%)
(Payment to)/receipt from bank (0.25%) 1.75%
(7.25%) (7.25%)
Total interest payment over 12 months (on £9.5m) (£688,750) (£688,750)
Option
Exercise? Yes Yes
Rate (6.5%) (6.5%)
Premium (1.0%) (1.0%)
(7.5%) (7.5%)
No hedge
Pay at LIBOR + 2 (7%) (9%)
If LIBOR is 5% then it would be best not to hedge. If LIBOR is 7% the FRA gives the lowest interest figure.
So the figures are not conclusive and the board’s attitude to risk will be important.
The FRA eliminates downside risk (rates rising) as well as upside risk (rates falling).
An interest rate swap would not be appropriate here as it is short-term and would in all likelihood be very
difficult to arrange.

Part 1.1 was answered well by many candidates. However, common errors made were:
 Candidates based their calculations on a borrowing period of six months rather than twelve (the loan
was to be taken out for 12 months, starting in 6 months’ time).
 The majority of candidates failed to calculate the implications of not hedging the borrowing and so
comparisons were difficult.
 A significant number of candidates abandoned the option when LIBOR was 5% because they
compared 5% v 6.5% instead of 7% v 6.5% i.e. they failed to recognise that the company was
borrowing at LIBOR + 2% pa.
Very few candidates spotted that the swap was irrelevant because it was a short-term borrowing
(i.e. 12 months).

1.2
(a) Currency futures contracts
Dollars will be purchased. Therefore sell £ on futures exchange.
Contracts to be sold = £4.8m/1.5095/£62,500 = 50.9, (round to 51 [or 50])
At 31/1/17 Buy futures at 1.4945

Sell futures at 1.5095
Profit 0.015 x 51 x $62,500 $47,813
$
Cost of consignment (4,800,000)
Profit on futures 47,813
Net cost (4,752,187)
Net cost at spot rate (31/1/17) ($4,752,187)/1.4895 (£3,190,458)
(b) OTC currency option

If the spot rate at 31/1/17 was $1.4895 then the option would be exercised.
A call option would be used (i.e. at $1.5020/£)
Receipt in sterling would be $4.8m (£3,195,739)

1.502
plus: Option premium 4.8m x £0.011 (£52,800)

(£3,248,539)
(c) Forward contract

Payment in sterling $4.8m $4.8m (£3,191,913)
(1.5150 – 0.0112) 1.5038
plus: Arrangement fee 4.8m x £0.004 (£19,200)

(£3,211,113)
(d) Money market hedge

Payment in sterling would be $4.8m $4.8m $4,743,083 lent
[1 + (3.6%/3)] 1.012
Converted at spot rate $4,743,083 (£3,130,748)

1.5150
Borrowed at 6.9% p.a. £3,130,748 x (6.9%/3) (72,007)

(£3,202,755)

Most candidates’ answers to part 1.2 were very good, but the most common errors noted were:
 Currency futures – many chose the wrong date for calculating the number of futures contracts, bought
futures instead of sold them and calculated the profit on the futures trade in £ instead of $.
 OTC currency options – far too many candidates exercised puts rather than calls.
The forward contract calculations were generally very good as were those for the money market hedge.
The main stumbling blocks with the latter were (1) choosing the wrong interest rate and (2) using three
months rather than four.

1.3
Sterling payment at spot rate 30/9/16 £4.8m (£3,168,317)

1.5150
Sterling payment at spot rate 31/1/17 £4.8m (£3,222,558)

1.4895
The forward contract premium suggests a strengthening of the $. A weaker £ means a higher payment
and vice versa for a stronger £.
Order (cheapest first)

Spot at 30/9/16 £3,168,317
Currency futures contracts £3,190,458
MMH £3,202,755
Forward contract £3,211,113
Spot at 31/1/17 £3,222,558
OTC option £3,248,539
Thus three of the four hedging results lie between the two spot rates.
The futures contracts give gives best outcome (lower than the MMH, FC and OTC). However, if the dollar
were to weaken by January 2017 (against expectations) then it might be best to not hedge at all.
Option gives flexibility (abandon, upside) unlike MMH or FC (fixed, binding, no upside/downside). Futures
contracts can be cheaper (lower transaction costs), but contracts cannot be tailored to user’s exact
requirements.
The directors’ attitude to risk is important.
The advice given by candidates on the foreign exchange hedging in part 1.3 was generally good, but, if
candidates did not calculate the relevant spot rates then they will have lost marks. The performance of
overseas candidates in this section was, overall, very poor.


Question 2
Total marks: 35
General comments
This question had, marginally, the lowest percentage mark on the paper. The majority of candidates
achieved a “pass” standard in the question, however.
the syllabus. It was based around a UK engineering company which was planning to diversify into the UK
fracking industry. As a result various calculations regarding its current and future cost of capital were
deemed necessary. Part 2.1 of the question, for 13 marks, required candidates to calculate the current
weighted average cost of capital (WACC) of the company using (1) the dividend growth model and (2) the
CAPM. In part 2.2, for three marks, candidates were asked to explain whether the company should
continue to use its existing hurdle rate for its decisions on large-scale investments. Part 2.3, for five marks,
required candidates to explain the underlying logic of employing the CAPM within a WACC calculation.
Part 2.4 was worth ten marks. Here, candidates were tested on their ability to re-work their CAPM
calculations, which was necessary because of the company’s proposed diversification into fracking, which
would alter the level of systematic risk. Finally, in part 2.5, for four marks, candidates were asked to
explain the circumstances in which it would be appropriate to use the adjusted present value approach to
investment appraisal.
2.1(a)
Ordinary dividend per share in 2016 (£3,797,500/15,500,000) 24.5 pence

Ordinary dividend growth rate = £0.201/£0.245, which over four years 5% p.a.
Cost of equity (ke) = (d1)+g (£0.245 x 1.05) + 5% 9.95%

MV £5.20
Cost of preference shares (k p) d = (£540,000/9m) £0.06 5.55%

MV £1.08
Cost of redeemable debt (kdr)

Year Cash Flow 2% factor PV 3% factor PV
0 (103.00) 1.000 (103.00) 1.000 (103.00)
1-3 4.00 2,884 11.54 2.829 11.32
3 100.00 0.942 94.20 0.915 91.50
NPV 2.74 NPV(0.18)
IRR = 3% - (0.18/(2.74 + 0.18)) = 2.94%
less: Tax at 21% (2.94% x 79%) = 2.32%
Cost of irredeemable debt (k di) £5 x 79% 4.11%

£96
WACC
Total MV’s
£’000 Cost x weighting WACC
Equity 15.5m x £5.20 80,600 9.95% x 80,600/106,615 7.52%
Pref. shares 9m x £1.08 9,720 5.55% x 9,720/106,615 0.51%
Red. debt £6.5m x 103/100 6,695 2.32% x 6,695/106,615 0.15%
Irred. debt £10.0m x 96/100 9,600 4.11% x 9,600/106,615 0.37%
26,015 1.03%
Total market value 106,615 8.55%

Most candidates did well in part 2.1, but common errors were:
 Inaccurate (and, at times, inappropriate) calculations of the dividend growth rate.
 Not using the market value (MV) when calculating the cost of preference shares.
 For the cost of redeemable debentures - not using the ex-interest MV, choosing four years to
redemption rather than three, inaccurate IRR calculation from NPV’s.
 Irredeemable debentures - not using the ex-interest MV, using the post-tax coupon rate as the cost of
debt.
 Combining the costs of the redeemable and irredeemable debt, rather than treating them separately.

2.1(b)
Cost of equity (1.2 x (9.5%-1.9%)) + 1.9 = 11.02%
Weighted cost of equity 11.02% x 80,600/106,615 8.33%

Weighted cost of debt (as above) 1.03%
WACC 9.36%
This part was done very well. Only a few candidates failed to calculate the CAPM correctly.

2.2
Roper is using 7% as its hurdle rate. In fact a more accurate figure would be 8.55% (say 9%) or 9.36%
(say 10%). This means it could be making poor investment decisions. If it takes on a project with an IRR of
8% this will be destroying shareholder value as the IRR is < the company’s cost of capital.
Part 2.2 was generally well answered and most candidates were able to identify the key issue – i.e. Roper
could be making poor investment decisions.

2.3
CAPM theory:
Systematic vs unsystematic risk and portfolio theory
Beta – a measure of systematic risk against market average
CAPM gives an alternative cost of equity which is used to calculate the WACC
In part 2.3 too few candidates answered the question fully and concentrated more on a discussion of de-
gearing/re-gearing.


2.4
New market geared beta = 1.9
New market ungeared beta = 1.9 x 90 (1.9 x 90) 1.56

(90 + (25 x 79%)) 109.75
Better Deal’s geared beta = 1.56 x (£80.600m + 9.720 + (£16.295m x 79%)) 2.00
£80.600m
So, cost of equity = (2.00 x (9.5%-1.9%)) + 1.9 = 17.1%
Cost of debt = 6% x 79% 4.74%
WACC = (17.1% x £80,600/106,615)) + (4.74% x £26,015/£106,615)) = 14.09%
It would be unwise to use the existing WACC (9.36%) as Roper’s plan involves diversification and
therefore a change in the level of systematic risk. Thus a new WACC must be calculated. Systematic risk
is accounted for by taking into account the beta of the petroleum market and this is then adjusted to
eliminate the financial risk (level of gearing) in that market. The resultant ungeared beta is then “re-
geared” by taking into account the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased risk discussed above) is used.
Using this, the new WACC can be calculated.
In this part the de-gearing/re-gearing calculations were mostly done well, but too many candidates’
explanation of their approach here concentrated on “how” rather than “why” it was done.

2.5
Adjusted PV (APV) – if the capital structure changes maybe the cost of capital will as well (M&M 63). If
new debt is raised to finance/part-finance a new investment, what is the new cost of capital? To find this
one needs to know the new MV of the company’s shares and to know this one needs to know the NPV.
This can’t be calculated without the new cost of capital. So it’s a conundrum unless a simplifying
assumption is made as in this question i.e. the finance is issued in such a way as to leave the gearing
unchanged.
Thus use the APV approach:
1. Calculate the base cost of the project – assume that the company is not geared.
2. Calculate the PV of the tax shield (tax saved via interest payments)
Combine 1 and 2. If APV is positive, then proceed and vice versa.
Part 2.5 was, overall, done well and candidates demonstrated a reasonable understanding of APV


Question 3
Total marks: 35
General comments
Most candidates demonstrated a good understanding of this area of the syllabus.
This was a three-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus and there was also a small section with an ethics element to it. In the scenario a
software development company was considering investing in a company that designs games for use on
computers and mobile phones. Candidates were given financial information relating to the target company.
Part 3.1 was worth 14 marks and required candidates to calculate the value of one share in the target
company using five different valuation methods. In part 3.2, for ten marks, candidates had to explain,
making reference to their previous calculations, the advantages and disadvantages of using each of the
valuation methods. In part 3.3, for eight marks, candidates were required to explain the reasoning
underpinning the shareholder value analysis (SVA) method of valuation. They also had to explain whether
SVA could be used to value this particular target company, bearing in mind the information provided.
Finally, in part 3.4, for three marks, candidates had to explain the ethical issues arising for an ICAEW
Chartered Accountant who is privy to price-sensitive information which is not in the public domain.
3.1(a)
Per share
Net Assets (historic cost) £4,998 £10.00
500
Net Assets (revalued) (£4,998 + £3,150 + £3,370 – £2,400 – £3,200) £5,918 £11.84
500 500
P/E ratio (£2,227 x 10) £22,270 £44.54

500 500
Less (say) 30% for lack of marketability of shares £31.18
Dividend yield (£740/8%) £9,250 £18.50

500 500
Less (say) 30% for lack of marketability of shares £12.95
PV of future cash flows y/e 2017 y/e 2018 y/e 2019 Total
£’000 £’000 £’000 £’000 £’000
Pre-tax cash profits 2,900 3,000 3,100
Tax at 21% (W2) (574) (601) (521)
Net cash flow 2,326 2,399 2,579
x x x
12% factor 0.893 0.797 0.712
PV 2,077 1,912 1,836 5,825
Post 2019 net cash inflows 2,000

Discounted to infinity x 1/12%
£16,667
Discounted to PV from 2019 x 0.712
11,867
Total PV of future cash flows 17,692
17,692/500 £35.38
W1
WDV b/f 920 754 618
WDA @ 18%/Bal All (166) (136) (618)
WDV c/f 754 618 0

W2
Pre-tax cash profits 2,900 3,000 3,100
WDA/BA (W1) (166) (136) (618)
Taxable profits 2,734 2,864 2,482
Tax due at 21% (574) (601) (521)
Generally this was answered well. Common errors noted were:

 A surprising number of candidates were unable to calculate the share value based on the net asset
basis (historic cost), but were able to calculate it with the net asset basis revalued).
 The P/E and dividend yield valuations were generally done very well.
 Most candidates scored well using the PV of future cash flows method of valuation.

3.1(b)
Net Assets (historic cost) – tends towards low historic values, so an undervaluation. Intangibles are
ignored. Earnings potential and future earnings are ignored.
Net Assets (revalued) – as above except that the asset values used are at least current.
P/E ratio - Looks at earnings. Will it be a majority stake? If so, then control will be gained, so shares for
this controlling stake should cost more. In this scenario it gives a much higher value than assets.
However – are these earnings stable into the future? Is the company over-reliant on the two
successful games from 2013? Future earnings - are there new games planned? Will they be
successful?
Dividend yield – this is based on dividend income and is applicable where it’s to be a minority stake. Are
these dividends stable? Will there be dividend growth?
PV of future cash flows - considers cash flows not profits and estimates forwards. These are large
estimates, especially the terminal value. Is it over-reliant on the two successful games (as above)?
Overall - a value close to £30/share should be a minimum price.
Candidates’ discussion was limited to mainly knowledge – few considered whether the techniques were
suitable for a majority/minority holding despite being guided in that direction in the question. The vast
majority of candidates ignored the “elephant in the room”, i.e. the fact that the target company’s computer
games had a limited life of three to five years and the successful games were three years old.

3.2
SVA is an alternative method of calculating the value of a company, based on future cash flows & seven
“value drivers”. These value drivers can, in most cases, be managed by the company and so the influence
of company strategy will be evident.
Value driver Information available

Length of project Yes
Sales growth rate Implied
Profit margin Implied
Fixed assets investment Implied
Working capital investment No
Tax rate Yes
Discount rate Yes
In general candidates’ understanding of the theory of SVA was good, but too few were able to explain
adequately whether it could be used in this particular scenario.


3.3
An ICAEW Chartered Accountant should assume that all unpublished information about a prospective,
current or previous client’s or employer’s affairs, however gained, is confidential. That information should
then:
 Be kept confidential
 Not disclosed, even inadvertently such as in a social environment
 Not be used to obtain personal advantage
Candidate’s understanding of the ethical issues was generally good.


TUESDAY 6 DECEMBER 2016
(2½ hours)
exam starts.
3. Answers to each question must begin on a new page and must be clearly numbered.
IMPORTANT

1. You should assume that the current date is 31 December 2016
Ribble plc (Ribble), a UK company, manufactures hoverboards and other products.

Hoverboards are a form of self-balancing scooter powered by rechargeable batteries. In the
last two years total UK sales of hoverboards have increased rapidly but major concerns have
arisen over their safety and, even though they are still in high demand, some retailers have
stopped selling them.
At a recent directors’ meeting of Ribble the chief executive officer (CEO), who is an ICAEW
Chartered Accountant, presented a research and development report (that had cost
£100,000) on a new and safer hoverboard; the Ribbleboard. The CEO stated that he believed
the new Ribbleboard could be successfully marketed for a period of four years and would
replace the company’s existing hoverboard, the Ribflyer. The directors decided that a project
appraisal should be undertaken to ascertain whether the Ribbleboard should be marketed.
Some directors felt that as there is a continuing demand for the Ribflyer, even though there
are concerns about its safety, it should still be manufactured and sold rather than taking the
risk of marketing the Ribbleboard. There was also concern that a rival company was known
to be developing a new safer hoverboard and it is likely to launch it onto the market on
31 December 2017.
The following information is available regarding the Ribbleboard project:
 The selling price will be £299 per unit in the year to 31 December 2017 and will remain
fixed in each subsequent year of the product’s life. The contribution for the year to
31 December 2017 is expected to be 45% of the selling price. The variable cost of
producing the Ribbleboard is expected to increase by 5% pa in the three years to
31 December 2020.
 The number of units sold in the year to 31 December 2017 is expected to be 8,000 per
month. For the year to 31 December 2018 the number of units sold is expected to
increase by 20%. For the remaining two years to 31 December 2020, the number of units
sold is expected to decline by 15% pa.
 The new specialist equipment required to manufacture the Ribbleboard requires more
space than Ribble currently has available. Therefore, Ribble will use factory space that it
currently owns and rents out for storage to another company for a fixed rent of £1 million
pa payable in advance on 31 December. The space will be re-let for £1 million pa at the
end of the project on 31 December 2020.
 If the project goes ahead, two managers who had already accepted voluntary
redundancy would be asked to remain employed until 31 December 2020 and manage
the project at a salary of £60,000 pa each. These managers were due to leave on
31 December 2016 and receive lump sum payments of £50,000 each at that time. They
will now receive lump sum payments of £60,000 each on 31 December 2020 when their
services will no longer be required. The managers were also due to receive consultancy
fees of £25,000 pa each for the two years ended 31 December 2017 and 2018. These
consultancy fees would not be paid to them if they remained employed to manage the
project. All of the above salaries, lump sums and fees are stated in money terms.
 It is estimated that for every ten Ribbleboards sold there will be a loss of sales of one unit
of the Ribflyer, which Ribble expects to sell at a fixed selling price of £100 and a
contribution of 25%, in each of the four years to 31 December 2020.

 The project will incur fixed overhead costs of £500,000 in the year to 31 December 2017
of which 40% is centrally allocated overheads. The fixed overhead costs will increase
after 31 December 2017 by 3% pa.
 Investment in working capital will be £1 million on 1 January 2017 and will increase or
decrease at the start of each year in line with sales volumes. Working capital will be fully
recoverable on 31 December 2020.
 On 31 December 2016 the project will require an investment in machinery and equipment
of £24 million, which is expected to have a realisable value of £4 million (in 31 December
2020 prices) at the end of the project. The machinery and equipment will 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.
In the final year, the difference between the machinery and equipment’s written down
value for tax purposes and its disposal proceeds will be treated by the company either as
a:
o balancing allowance, if the disposal proceeds are less than the tax written down
value, or
o balancing charge, if the disposal proceeds are more than the tax written down value.
 Assume that the rate of corporation tax will be 21% for the foreseeable future and that tax
flows arise in the same year as the cash flows that give rise to them.
 An appropriate money cost of capital for the Ribbleboard project is 10% pa.
Requirements
1.1 Using money cash flows calculate the net present value of the Ribbleboard project at
31 December 2016 and advise Ribble’s directors whether it should be accepted.
(20 marks)
1.2 Advise Ribble’s directors as to the sensitivity of the NPV of the Ribbleboard project to:
(a) Changes in sales revenue (ignoring the effects on working capital) (4 marks)
(b) Changes in the realisable value of the machinery and equipment (3 marks)
1.3 Identify and discuss two real options available to Ribble in relation to the Ribbleboard
project. (5 marks)
1.4 Discuss the ethical issues that the CEO should consider regarding the suggestion by
some directors that only the Ribflyer hoverboard should continue to be manufactured.
(3 marks)
Total: 35 marks

2. You should assume that the current date is 31 December 2016
You work for Bristol Corporate Finance (BCF). Two of the clients for whom you are
responsible are Middleton plc (Middleton) and the management team of Oldham Ltd
(Oldham).
2.1 Middleton
Middleton is a listed company and is seeking to raise £70 million to invest in new projects
during 2017. Currently Middleton is financed only by equity. However, at a recent board
meeting the finance director stated that, since other companies in Middleton’s industry sector
have average gearing ratios (measured as debt/equity by market value) of 30% (with a
maximum of 40%) and an average interest cover of 6 times (with a minimum of 5 times),
perhaps the company should access the debt markets. The finance director presented the
board with two alternative sources of finance to raise the £70 million.
Equity issue: The £70 million would be raised by a 1 for 2 rights issue, priced at a discount
on the current market value of Middleton’s shares.
Debt issue: The £70 million would be raised by an issue of 7% coupon debentures,
redeemable at par on 31 December 2026. The yield to redemption of the debentures would
be equal to the yield to redemption of the debentures of Wood plc (Wood), another listed
company in Middleton’s market sector. Wood has a similar risk profile to Middleton and has
recently issued its debentures. Wood’s debentures have a coupon of 7%, will be redeemed in
four years at par and their current cum-interest market price is £110 per £100 nominal value.
There were concerns expressed by a number of board members regarding the debt issue
since it has been the long-standing policy of the company not to borrow. Their concerns were
how Middleton’s shareholders and the stock market would react and that the company’s cost
of capital would increase as a result of borrowing, leading to a fall in the company’s value.
An extract from Middleton’s most recent management accounts is shown below:
Income statement for the year ended 31 December 2016
£m
Operating profit 25.00
Taxation at 21% (5.25)
Profit after tax 19.75
Additional information:
 Middleton has an equity beta of 1.1

 The risk free rate is expected to be 3% pa
 The market return is expected to be 8% pa
 Middleton’s current share price is £5 per share ex-div
 Middleton has 40 million ordinary shares in issue.

Requirements
(a) Calculate, using the CAPM, Middleton’s cost of capital on 31 December 2016. (1 mark)
(b) Assuming a 1 for 2 rights issue is made on 1 January 2017:
 calculate the discount the rights price represents on Middleton’s current share price
 calculate the theoretical ex-rights price per share
 discuss whether the actual share price is likely to be equal to the theoretical
ex-rights price. (5 marks)
(c) Alternatively, assuming debt is issued on 1 January 2017:
 calculate the issue price and total nominal value of the debentures that will have to
be issued to give a yield to redemption equal to that of Wood’s debentures
 discuss the validity of the use of the yield to redemption of Wood’s debentures in
the above calculation. (7 marks)
(d) Outline the advantages and disadvantages of the two alternative sources for raising the
£70 million, discuss the concerns of the board regarding the debenture issue (using the
gearing and interest cover information provided by the finance director) and advise
Middleton’s board on which source of finance should be used. (12 marks)
2.2 The management team of Oldham
You have been asked to make a presentation to the management team of Oldham, an
unlisted company, who are considering a management buyout (MBO) of the company. Your
presentation will cover certain aspects of the MBO process and the contents of the financial
information section of the business plan that will need to be prepared for potential financiers.
Requirements
Prepare notes for your presentation which include:
(a) An outline of the sources and forms of finance that the management team is likely to
need. (3 marks)
(b) The possible exit routes for the financiers that contribute to the funding of the MBO.
(2 marks)
(c) The content of the financial information section of the business plan. (5 marks)
Total 35 marks

3. You should assume that the current date is 30 November 2016
Orion plc (Orion) is a UK company that manufactures nutrition products which it exports to
the USA and receives payment in dollars. Orion imports raw materials from a number of
countries located in Europe and makes payments to suppliers in euros.
At a recent board meeting of Orion concern was expressed about several aspects of the
company’s foreign exchange rate risk (forex) hedging strategy. Below is an extract from the
minutes of the meeting:
Managing director: “We have always hedged our forex and we should continue to do so.
But I am worried that because we import our raw materials and export our finished
products, we are subject to economic risk.”
Production director: “We use derivative instruments to hedge forex and I think they are
too complicated. How do the banks calculate forward rates for example? Also can
someone explain to me what economic risk is?”
It was decided that at the next board meeting the finance director should make a presentation
to the board on the subject of forex. The finance director has asked you to prepare some
information for his presentation including an example of how receipts are hedged using
different hedging techniques.
You have the following information available to you at the close of business on 30 November
2016:
Orion currently has substantial sterling funds on deposit.
Receipts due from USA customers on 31 March 2017 are $5,000,000.
Exchange rates:
Spot rate ($/£) 1.4336 – 1.4340

Four month forward discount ($/£) 0.0086 – 0.0090
March currency futures price (standard contract size £62,500) $1.4410/£
Over-the-counter (OTC) currency option
A March put option to sell $ is available with an exercise price of $1.4390/£. The premium is
£0.03 per $ and is payable on 30 November 2016.
Annual borrowing and depositing interest rates (%)
Dollar 5.20 – 4.80

Sterling 3.30 – 3.00

Requirements
Provide the following information for the finance director of Orion:
3.1 A calculation of Orion’s sterling receipt using:
(a) a forward contract

(b) currency futures
(c) an OTC currency option
assuming that the spot price on 31 March 2017 is $/£ 1.4484 – 1.4490 and the March
futures price is $1.4487/£. (11 marks)
3.2 An explanation of the advantages and disadvantages of the three hedging techniques
used in 3.1 above and, using your results from 3.1 above, advice on which hedging
technique Orion should use. (8 marks)
3.3 A demonstration, with reference to theories and relevant workings, of why the forward
rate is at a discount to the spot rate at 30 November 2016. (5 marks)
3.4 An explanation of what economic risk is, a discussion of how it affects Orion and an
outline of how economic risk can be mitigated. (6 marks)
Total 30 marks

Financial Management - Professional Level – December 2016
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

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

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.


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.


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.
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.


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.

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.


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.


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.


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.

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.

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.


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
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.
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:
The options are expensive
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.

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.

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.


(2½ hours)
This paper consists of three questions (100 marks).
exam starts.
IMPORTANT


BLANK PAGE

1. You should assume that the current date is 28 February 2017
Sentry Underwood plc (Sentry) is a large, listed UK drinks manufacturer. Sentry’s recent
profitability has deteriorated because of increased competition and a volatile consumer
market. As a result, Sentry’s board is considering a major change in the company’s trading
strategy which will cost £20 million to implement. The board has decided that this investment
will be funded either via a rights issue or an issue of debentures. Jenna Helier is Sentry’s
finance director and she is an ICAEW Chartered Accountant. Sentry’s other directors have
asked her to provide information to help them decide on the source of funding for the new
investment.
Extracts from Sentry’s most recent management accounts are shown below:
Income Statement for the year to 28 February 2017

£’000
Sales 78,500
Variable costs (56,520)
Fixed costs (13,850)
Profit before interest 8,130
Debenture interest (1,421)
Profit before tax 6,709
Taxation at 17% (1,141)
Profit after tax 5,568
Dividends proposed (3,000)
Balance Sheet at 28 February 2017

£’000
Ordinary share capital (£1 shares) 12,500
Retained profits 11,286
23,786
7% debentures (redeemable July 2019 to December 2020) 20,300
44,086
The market values of Sentry’s ordinary shares and debentures on 28 February 2017 are:
Ordinary shares £3.44 (cum div)

7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 2017 by either:

1. A rights issue at £2.50 per ordinary share or
2. An issue of 8% debentures at par, redeemable in 2023
You have been asked by the directors to assume the following for the year to 28 February
2018:
 Sales will increase by 20%
 The contribution to sales ratio will remain unchanged
 Fixed costs will increase by £2 million pa
 The current level of dividends per share will be maintained
 Corporation tax will remain at 17%

At last week’s board meeting the following comments were made by two of Sentry’s other
directors:
Matthew Girvan: “We could decrease the amount of new capital that we have to raise by
reducing the annual dividend. Our payout ratio has been excessive for a
number of years now. Why not halve it?”
Roger Smyth: “We need to be very careful with this issue of shares or debentures.
There’s a danger that our earnings per share (EPS) figure will be diluted,
which could cause a fall in our share price. To avoid any problem with
our share price, I suggest it would be better to tell our shareholders that
we expect sales to increase by 30%-35% next year, rather than the 20%
we are forecasting.”
Requirements
1.1 For both the rights issue and the debenture issue, prepare forecast income
statements for Sentry for the year to 28 February 2018. (6 marks)
1.2 For both the rights issue and the debenture issue, calculate Sentry’s forecast
 EPS figure for the year to 28 February 2018 and

 Gearing ratio (book value of long-term borrowings/long-term funds) as at
28 February 2018. (6 marks)
1.3 For the rights issue only, calculate the increase in annual sales required for the year
to 28 February 2018 in order that Sentry’s EPS figure remains the same as in the
current year. (6 marks)
1.4 Making reference to your calculations in 1.1, 1.2 and 1.3 above, discuss the
implications for Sentry’s shareholders of the company using a rights issue or a
debenture issue to fund its proposed £20 million investment. (8 marks)
1.5 Discuss Matthew Girvan’s proposal that dividends should be cut, making reference to
relevant theories. (6 marks)
1.6 Discuss the ethical issues for Jenna Helier that would be caused by Roger Smyth’s
suggestion. (3 marks)
Total: 35 marks

2. White Rock plc (White), a UK listed company, manufactures a range of cosmetics at three
factories: lipsticks (London), mascara (Newcastle) and foundation products (Manchester).
White’s financial year end is 31 March.
At its most recent board meeting the following matters were discussed:
(1) Closure of the London factory.

(2) Investment priorities at the Manchester factory.
(3) The impact of (1) and (2) above on White’s share price.
2.1 Closure of the London factory
The cosmetics industry is very competitive and products can quickly become unfashionable.
Falling demand for White’s lipsticks and the high costs of operating in London have meant
that the company’s directors have decided to close the London factory. Instead, White will
manufacture a smaller range of lipsticks at its Newcastle factory which currently only makes
mascara, but does have spare capacity. Manufacture of this smaller range of lipsticks would
commence in Newcastle as soon as the London factory is closed. White’s directors are
unsure whether to close the London factory on 31 March 2017 or on 31 March 2019, when its
lease expires.
You work in White’s finance team and have been asked to provide information to aid the
directors’ decision on the date of the factory closure. Information to support your task is
shown below:
Sales and contribution

London Newcastle
factory factory
Estimated lipstick sales (all at 31 March 2017 prices)
Year to 31 March 2018 £7.2m £1.3m
Year to 31 March 2019 £5.5m £1.5m
Contribution to sales ratio 60% 65%
Leases
The London factory lease costs £1.8 million pa and expires on 31 March 2019. The annual
lease cost is fixed and is payable on 1 April. If the factory is closed on 31 March 2017 then
White would pay a tax allowable cancellation charge of £3 million on that date to cancel the
lease. The Newcastle factory lease costs a fixed £0.8 million pa which is payable on 1 April.
Other fixed costs

London Newcastle
factory factory
Factory-wide fixed costs pa (at 31 March 2017 prices) £1.4m £1.2m
Allocated head office costs pa (at 31 March 2017 prices) £1.6m £1.3m
Working capital
The London factory has a working capital balance on 31 March 2017 of £0.8 million. White’s
policy is that at the start of each financial year, there should be working capital in place that is
equivalent to 10% of the estimated sales for that year.

Tax allowable London factory closure payments
Closure payments if closure is on 31 March 2017 £1.6m

Closure payments if closure is on 31 March 2019 (at 31 March 2019 prices) £2.3m
London factory machinery
Machinery tax written down value at 1 April 2016 £3.1m

Resale value of machinery at 31 March 2017 £1.7m
Resale value of machinery at 31 March 2019 (at 31 March 2019 prices) £0.6m
The factory machinery attracts 18% (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 treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value,
or
Inflation rates (applicable to all sales and costs unless otherwise indicated)
Year to 31 March 2018 2%

Year to 31 March 2019 3%
Other information
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant year.
White uses a money cost of capital of 11% for investment appraisal purposes.
Requirements
(a) Calculate the relevant money cash flows associated with closing the London factory on:
(1) 31 March 2017

(2) 31 March 2019
and use these to calculate the net present value at 31 March 2017 of each of these
possible closure dates.
In both of these calculations you should ignore any opportunity cash flows associated
with the alternative closure date. (21 marks)
(b) Advise White’s directors as to the preferred closure date of the London factory.
(1 mark)

2.2 Investment priorities at the Manchester factory
The Manchester factory has a capital expenditure budget of £15 million for the financial year
to 31 March 2018. White’s board needs to choose which of the available projects would
maximise shareholder wealth. Details of the four projects available are shown below:
Project 1 2 3 4
£’000 £’000 £’000 £’000
Investment required 6,000 4,500 4,700 3,850
Net Present Value 621 563 869 622
Requirement
Prepare calculations showing the combination of projects that will maximise White’s
shareholders’ wealth if the four projects are assumed to be either (1) divisible or
(2) indivisible. (6 marks)
2.3 White’s managing director has stated that once the London closure date and the Manchester
investment plans are announced to the stock market, White’s share price will adjust to reflect
this information accurately. However, the finance director has pointed out that there are
behavioural factors that may mean that this is not the case.
Requirement
Explain the key principles underlying the Efficient Market Hypothesis and how behavioural
factors question the validity of that hypothesis. (7 marks)
Total 35 marks

3. You should assume that the current date is 31 March 2017
ST Leonard Foods (STL) is a UK frozen food company. It buys raw vegetables and fish from
its suppliers and, following processing and freezing, sells them to its customers.
You work in STL’s finance team and have been asked to prepare calculations that will help
STL’s management decide on the best strategy with regard to these two issues:
Issue 1 - foreign exchange rate hedging
Earlier this year STL’s management signed a contract worth €1,750,000 with one of its
Spanish suppliers and the goods arrived at STL last week. In addition, it has agreed to sell
€600,000 worth of frozen goods to a new customer, a French hypermarket, and these goods
will be despatched to France in ten days’ time.
Both of these contracts are due to be settled in three months’ time on 30 June 2017. STL’s
management is keen to explore whether it is worth hedging against movements in the value
of the euro between now and then. Four possible strategies are under consideration by the
board:
 Do not hedge
 Use an over-the-counter (OTC) currency option
 Use a money market hedge
 Use a forward contract
The following data has been collected at the close of business on 31 March 2017:
Spot rate (€/£) 1.2652 – 1.2744

Euro interest rate (lending) 2.2% pa
Euro interest rate (borrowing) 3.4% pa
Three-month OTC call option on € – exercise price 1.2540/£
Three-month OTC put option on € – exercise price 1.2650/£
Three month forward contract premium (€/£) 0.0058 – 0.0042
Cost of relevant OTC option £0.70 per €100 converted
Arrangement fee for forward contract £5,500
Issue 2 - interest rate hedging
STL has recently signed a contract with its bank to borrow £4.2 million on 1 July 2017 to help
fund the construction of a new factory. The loan is for three years at an interest rate of
LIBOR + 1% pa. STL’s management is concerned that interest rates will rise before 1 July
and wishes to explore whether it should hedge its borrowing cost. Its bank has offered STL a
Forward Rate Agreement (FRA) at 5.8% pa or an option at 5.2% pa plus a premium of 0.5%
of the sum borrowed.

Requirements
3.1 For Issue 1, show the net sterling payment for the four possible strategies under
consideration, assuming that on 30 June 2017 the spot exchange rate will be:
(a) €1.1875 – 1.1960/£
(b) €1.2745 – 1.2860/£

(11 marks)
3.2 For Issue 1, with reference to your calculations in 3.1 above, advise STL’s board
whether it should hedge against movements in the value of the euro. (8 marks)
3.3 For Issue 2, assuming that on 1 July 2017 LIBOR will be:
(a) 4% pa
(b) 6% pa
calculate the annual interest rate payment if STL chooses an FRA, an option or no
hedging instrument and advise STL’s management as to its best strategy. (7 marks)
3.4 Explain briefly how FRAs differ from interest rate futures. (4 marks)
Total: 30 marks

Professional Level – Financial Management - March 2017

difficult to read the candidates’ handwriting. If a marker is unable to read what has been written then no
marks can be awarded for the passage in question.
Question 1
Total marks: 35
General comments
This question was, generally answered well and most candidates achieved a “pass” standard.
the syllabus and there was also a small section with an ethics element to it.
In the scenario a listed UK drinks manufacturer planned to raise £20 million to finance a major change in
the company’s trading strategy. This additional funding would be raised either via a rights issue or a
debenture issue. In part 1.1, for six marks, candidates were required to prepare a forecast income
statement for both of these methods of funding. Part 1.2 was also worth six marks and asked candidates
to calculate (a) the EPS and (b) the gearing ratio for both methods of funding. Part 1.3, for six marks,
tested sensitivity analysis – what level of sales would be necessary to maintain the EPS at its current
level. Part 1.4 was worth eight marks. It brought together the three parts above and required candidates to
discuss the implications for the shareholders of the two funding methods. Part 1.5, for six marks, tested
candidates’ understanding of dividend theory. Finally, in part 1.6, for three marks, candidates had to
explain the ethical issues arising for an ICAEW Chartered Accountant who is aware of a plan to overstate
the company’s forecast sales figures.
1.1
Rights issue Debt issue

£m £m
Sales (£78.5m x 1.20) 94.200 94.200
Variable costs (72% x sales) (67.824) (67.824)
Fixed costs (£13.85m + £2m) (15.850) (15.850)
Profit before interest 10.526 10.526
Interest (Working 1) (1.421) (3.021)
Profit before tax 9.105 7.505
Tax @ 17% (1.548) (1.276)
Profit after tax 7.557 6.229
Dividends payable (4.920) (3.000)
Retained earnings 2.637 3.229
Working 1
£20,3m x 7% 1.421 1.421
£20.0m x 8% 1.600
1.421 3.021
Most candidates did very well in part 1.1 and the majority scored full marks. The most common errors
occurred with the estimated variable costs, interest charges and dividend payments. A small minority of
candidates were unable to calculate the number of new shares issued via the rights issue and used,
erroneously, a 1 for 1 issue (rather than dividing £20m by the issue price of £2.50).


1.2

£m £m
Ordinary share capital 20.500 12.500
Share premium 12.000 0
Retained earnings 13.923 14.515
46.423 27.015
Debentures 20.300 40.300
Total long term funds 66.723 67.315
EPS £7.557 £6.229

20.500 12.500
£0.369 £0.498
Gearing £20.300 £40.300

£66.723 £67.315
30.4% 59.9%
Part 1.2 was generally well answered, but a number of candidates were unable to identify the earnings
figure from the Income Statement and used the retained profit figure instead. A significant number of
candidates were unable to calculate the correct gearing ratios. Typical errors here were: (a) calculating
debt/equity instead of debt/debt+equity, despite instructions to the contrary, (b) omission of forecast
retained profits, (c) addition of par value of new shares rather than sum raised and (d) using market values
rather than book values, again contrary to the instruction given.

1.3
Current EPS £5.568m £0.445m

12.500
£0.445m
x
20.500
Target earnings £9.123m
Add back tax (17%) ÷83%
Target profit before tax £10.992m
Add back interest 1.421m
Add back fixed costs 15.850m
Target contribution £28.263m
Contribution/sales ratio ÷28%
Target sales £100.939m
Current sales £78.500m

Target sales/current sales (£100.939m/£78.500m) 1.286
Thus sales would need to increase by 28.6% or £22,439m
Part 1.3 was a good discriminator and, whilst many candidates were able to work backwards to a forecast
sales figure, a large minority scored very poorly here.


1.4
Sentry’s current earnings per share figure is 44.5p. The predicted EPS are 36.9p (rights issue) and 49.8p
(debt issue). So the rights issue leads to a lower EPS whilst the debt issue increases EPS and may, for
this reason, be favoured by shareholders.
Rights issue:
As would be expected, the level of gearing is much lower than under the debenture issue option (30.4%
compared to 59.9%). It’s also lower than Sentry’s current level of gearing (46.0% [£20,300/44.086]).
However if one takes the market value into account then the current gearing figure (34.5%) is much lower.
Current MV of equity = 40.000m (£3.20 x 12.5m). Current MV of debt = £21.112m (1.04 x £20.3m).
(£21.112/[£21.112 + £40.000]) = 34.5%
The interest cover ratio of 7.4 is higher than that for the debenture issue (3.5) and existing (5.7).
The rights issue (£20m) represents 50% Sentry’s current market capitalisation (£3.20 x 12.500 = £40m).
This could deter current shareholders from investing and so there might be a dilution of shareholders (and
control).
Debenture issue:
this creates a very high level of gearing (59.9%) and the interest cover is 3.5 (compared to the current
cover figure of 5.7). So the extra financial risk taken on might concern the shareholders.
It would need sales to increase by 29% for the EPS under the rights issue to remain at its current level – is
this achievable? Roger Smyth’s comments suggest otherwise.
Other issues to consider:

Current debentures are due to be repaid in 2019-2020. Additional financial pressure therefore.
Issue costs – the cost of issuing debentures is likely to be cheaper.
Tax shield – the debenture issue would give Sentry more chance to take advantage of the tax shield and
its WACC may fall accordingly, unless the gearing level was then deemed by investors to be too high.
Overall the answers to part 1.4 were disappointing. Too many candidates said little beyond the fact that
EPS and gearing would move up/down, depending on the funding method chosen. Very few considered
the impact on interest cover or the required size of the equity issue. The discussion of financial risk was,
generally, limited and too many candidates spent too much time on M&M theories.


1.5
Reference to main dividend policy theory:
M&M theory - share value is determined by future earnings and the level of risk. The amount of dividends
paid will not affect shareholder wealth providing the retained earnings are invested in profitable investment
opportunities (positive NPV’s). Any loss in dividend income will be offset by gains in share price.
Traditional theory - shareholders would prefer dividends today rather than dividends or capital gains in
future. Cash now is more certain than in the future.
Supplementing these main theories:
 Impact of signalling
 Clientele effect
A change in dividend policy may have a negative impact on Sentry’s share price. So it’s important that if
dividends are cut, then shareholders are given clear reasons for the change, i.e. communication with them
is effective.
Part 1.5 was, overall, answered very well, although some candidates discussed capital structure theory
here.

1.6
The ICAEW provides ethical guidance that will ensure that shareholders can rely on the objectivity and
integrity of information given to them by members. The other ethical principle at risk here is that of
professional behaviour.
Part 1.6 was, in general, answered very well.


Question 2
Total marks: 35
General comments
This question had the lowest percentage mark on the paper. The majority of candidates achieved a “pass”
standard in the question, however.
This was a three-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus.
It was based around a UK cosmetics manufacturing company which has three factories (in London,
Newcastle and Manchester). In part 2.1 of the question, for 22 marks, the company had decided to close
the London factory and relocate some of its production to the Newcastle factory. Its board is not sure of
the best closure date (2017 or 2019). Candidates were given financial information about the two factories
and were asked to calculate the relevant money cash flows associated with closing the London factory (a)
in 2017 and (b) in 2019. From these calculations candidates were required to calculate the NPV for each
scenario. Part 2.2, for six marks, considered the Manchester factory and tested candidates’ understanding
of capital rationing. Part 2.3, for seven marks, required candidates to explain the key principles of the
Efficient Market Hypothesis and the influence of behavioural factors.
2.1(a)
2017 2018 2019

y0 y1 y2
£m £m £m
Newcastle sales (W1) 1,326.000 1,575.900
Newcastle VC's (sales x 35%) (464.100) (551.565)
Tax on profit (W2) (146.523) (174.137)
Factory closure (1,600.000)
Tax on closure (@ 17%) 272.000
WC reversal 800.000
Machinery sale 1,700.000
Tax saving on machinery (W3) 238.000
Lease cancellation (3,000.000)
Tax saving on cancellation 510.000
Newcastle working capital (W4) (132.600) (24.990) 157.590
Total cash flows (1,212.600) 690.387 1,007.788
Discount 1.000 0.901 0.812
PV (1,212.600) 621.970 817.943
NPV 227.314
Newcastle lease will be paid anyway, so the cost is irrelevant.

Allocated Head Office costs are irrelevant as they are not incremental.
Newcastle factory-wide fixed costs are irrelevant as they’re incurred anyway.
W1
Newcastle sales £1.3m x 1.02 1,326.000
£1.5m x 1.02 x 1.03 1,575.900
W2
Newcastle contribution (sales x 65%) 861.900 1,024.339
Tax @ 17% 146.523 174.137
W3
WDV 3,100.000
Balancing Allowance (1,400.000)
Sale 1,700.000
Tax saved (17% x £1,400,000) 238.000

W4
Working capital (132.600) (157.590) 0.000
Balance b/f 0.000 132.600 157.590
Increment (132.600) (24.990) 157.590

2.1(b)
2017 2018 2019

y0 y1 y2
£m £m £m
London sales (W1) 7,344.000 5,778.300
London variable costs (sales x 40%) (2,937.600) (2,311.320)
London fixed costs (W2) (1,428.000) (1,470.840)
Tax on profit (W3) (506.328) (339.344)
Factory closure (2,300.000)
Tax on closure 391.000
Lease payments (1,800.000) (1,800.000)
Tax saved on lease 306.000 306.000
Machinery sale 600.000
Tax saving on machinery (W4) 94.860 77.785 252.355
London working capital (W5) 65.600 156.570 577.830
Total cash flows (1,639.540) 1,212.427 1,483.981
Discount 1.000 0.901 0.812
PV (1,639.540) 1,092.277 1,204.432
NPV 657.169
This is the higher NPV and so White should choose this date (2019) for closure of the London factory. This
will enhance shareholder wealth the most.
W1
London sales £7.2m x 1.02 7,344.000
£5.5m x 1.02 x 1.03 5,778.300
W2
London fixed costs £1.4m x 1.02 (1,428.000)
£1.4m x 1.02 x 1.03 (1,470.840)
W3
London contribution (sales x 60%) 4,406.400 3,466.980
less: London fixed costs (1,428.000) (1,470.840)
London “profit” 2,978.400 1,996.140
Tax on “profit” @ 17% (506.328) (339.344)
W4
WDV 3,100.000 2,542.000 2,084.440
WDA (558.000) (457.560) (1,484.440)
WDV/sale 2,542.000 2,084.440 600.000
Tax saved (WDA x 17%) 94.860 77.785 252.355
W5
Working capital (734.400) (577.830) 0.000
Balance b/f 800.000 734.400 577.830
Increment 65.600 156.570 577.430

As expected, parts 2.1(a) & 2.1(b) were a very effective discriminator. A good number of candidates did
really well here, but a significant minority really struggled and were unable to identify the relevant cash
flows adequately. This was largely due to an inability to stand back and think the scenario through
carefully before diving in and doing the calculations. Typical errors made were:
 The inclusion of opportunity costs (despite instructions to the contrary)

 Including irrelevant cash flows, e.g. leases, head office costs, fixed costs
 Inaccurate inflation adjustments
 Poor working capital calculations
 Too many candidates mixed together the London and Newcastle sales/contribution figures
 Many candidates considered only 2017 cash flows for the 2017 closure date and will have lost marks

2.2
Project 1 2 3 4 Total
£’000 £’000 £’000 £’000 £’000
Investment required (£m) 6,000 4,500 4,700 3,850 19,050
Net Present Value 621 563 869 622
NPV/£ invested £0.104 £0.125 £0.185 £0.162

Ranking 4 3 1 2
Divisible projects 1 2 3 4 Total

£’000 £’000 £’000 £’000
Invested 1,950 4,500 4,700 3,850 15,000
NPV 202 563 869 622 2,256
Funds used 32.5% 100% 100% 100%

of of of of
P1 P2 P3 P4
Indivisible projects
Using trial and error:

1 2 3 4 Total
£’000 £’000 £’000
Invested 6,000 4,500 3,850 14,350
NPV 621 563 622 1,806
1 2 3 4 Total
£’000 £’000 £’000
Invested 6,000 4,700 3,850 14,550
NPV 621 869 622 2,112
1 2 3 4 Total
£’000 £’000 £’000
Invested 4,500 4,700 3,850 13,050
NPV 563 869 622 2,054
The highest NPV is achieved via the combination of projects 1, 3 and 4. This would generate an NPV of
£2,112,000.
Most candidates scored well in part 2.2 and the most common error was a failure to apply the trial and
error approach for the indivisible projects.


2.3
The efficient markets hypothesis (EMH) holds that stock markets are considered in the main to be efficient,
i.e. all share prices are “fair”. Investment returns are those expected for the risks undertaken. Information
is rapidly and accurately incorporated into share values. When share prices at all times rationally reflect all
available information, the market in which they are traded is said to be efficient. In efficient markets
investors cannot make consistently above-average returns other than by chance.
An efficient market is one in which share prices reflect all of the information available. There are three
levels of efficiency:
Weak Form - prices only change when new information about a company is made available. There
are no changes in anticipation of new information. Information arrives in a random manner (the
random walk theory) and so the chartist theory (technical analysis) will not hold up here. The market is
efficient in the weak form if past prices CANNOT be used to earn consistently abnormal profits.
Semi Strong Form - prices reflect all information about past price movements and all knowledge that is
publicly available/anticipated. The market can anticipate price changes before new information is formally
announced. The market is efficient in the semi-strong form if publicly available information (e.g. historical
share prices, dividend announcements) CANNOT be used to earn consistently abnormal profits.
Strong Form - share prices reflect all information about past price movements, all knowledge that is
publicly available/anticipated and from insider knowledge available to specialists or experts. The market is
efficient in the strong form if all information (private and public) CANNOT be used to earn consistently
abnormal profits.
Behavioural finance questions the validity of the EMH and posits that investors’ irrational behaviour may
affect share price movements. Examples of irrational behaviour are:
Overconfidence Representativeness Narrow framing

Miscalculation of probabilities Ambiguity aversion Positive feedback
Cognitive dissonance Availability bias Conservatism
Part 2.3 was answered well by most candidates and the weaker scripts just listed behavioural factors,
without significant introduction or explanation.


Question 3
Total marks: 30
General comments
Most candidates demonstrated a good understanding of this area of the syllabus and this question had the
highest average mark on the paper
of the syllabus.
In the scenario a UK frozen food company was considering hedging its exposure to (a) foreign exchange
rate risk on a planned €1.15m (net) payment (three months ahead) and (b) interest rate risk on a £4.2m
loan from its bank (also three months ahead).
Part 3.1 was worth 11 marks and asked candidates to calculate, at two spot rates, the sterling cost arising
from a list of hedging techniques that could be applied to the euro payment. In part 3.2, for eight marks,
candidates were required to advise the company’s board whether it should hedge the euro payment. In
part 3.3, for seven marks, candidates were required to calculate the annual interest payments that would
arise on its planned loan were it to make use of an FRA, an option or to not hedge at all. Two different
rates of LIBOR were given to the candidates. From these calculations, candidates were then required to
recommend which of the hedging techniques the company should choose at each of the LIBOR rates
given. Finally in part 3.4, for four marks, candidates were asked to explain how FRA’s differ from interest
rate futures.
3.1
Net payment due at 30/6/17 = €1,750,000 - €600,000 €1,150,000
Spot rate @ 30/6/17 Spot rate @ 30/6/17

€1.1875-1.1960/£ €1.2745-1.2860/£
Do not hedge €1,150,000 (£968,421) €1,150,000 (£902,314)

1.1875 1.2745
OTC option €1.1875-1.1960 €1.2745-1.2860

Call option
Exercise option Yes No
Rate 1.2540 1.2745
Sterling payment €1,150,000 €1,150,000

1.2540 1.2745
(£917,065) (£902,315)
plus: Premium cost
(€1,150k/€100 x £0.70) (8,050) (8,050)
Total cost (£925,115) (£910,365)
Money market hedge

Lend euros now €1,150,000 €1,150,000 €1,143,709
1 + (2.2%/4) 1.0055
Convert at spot rate €1,143,710 (£903,975)

1.2652
Sterling borrowed at 4.6% pa 903,975 x [1 + (4.6%/4)] (£914,370)
Forward contract
Sterling payment €1,150,000 1,150,000 (£913,133)

(1.2652 - 0.0058) 1.2594

Arrangement fee (5,500)

(£918,633)
Part 3.1 was generally answered well. However, a minority of candidates added the euro receipt to the
euro payment or kept them separate and so will have lost marks. One disturbing error, which occurred too
frequently, was that candidates calculated two different MMH and forward contract results using the two
future spot rates given, rather than a single result for each, based on the current spot rate. Also, many
wasted time by recalculating the correct MMH and forward contract results for the second set of spot data,
rather than just stating “no change”. The examining team has no explanation for this as many similar
questions have been set in the past without these issues occurring. With the currency option, the most
common errors were (a) choosing a put rather than a call option and (b) using a traded option rather than
an OTC.

3.2
In summary
Spot rate - €1.1875/£ Spot rate - €1.2745
Do not hedge (£968,421) (£902,314)
OTC option (£925,115) (£910,365)
MMH (£914,370) (£914,370)
Forward contract (£918,633) (£918,633)
Sterling payment @ current spot rate €1.150m/1.2652 (£908,947)
The forward rate suggests that the euro will strengthen (sterling will weaken) over the next three months.
STL would prefer sterling to be stronger (purchases then cheaper).
With an exchange rate of €1.1875/£

Sterling much weaker and the MMH and FC produce the lowest sterling payments.
With an exchange rate of €1.2745/£

Sterling much stronger and the option and no hedge produce the lowest sterling payments. Once the
exchange rate exceeds €1.2577/£ (€1.150,000/£914,370) then the option produces a lower payment than
the MMH (and also, therefore, the FC)
Directors’ attitude to risk important

General points about the various methods
Overall, part 3.2 was disappointing in that too few candidates went beyond only comparing the best
outcome at each spot rate. Most answers here needed to demonstrate a deeper understanding of the
issues involved.


3.3
LIBOR 4% LIBOR 6%
FRA Option No hedge FRA Option No hedge
Pay (5.0%) (5.0%) (5.0%) (7.0%) (5.2%) (7.0%)
(Pay)/refund (0.8%) 1.2%
Premium (0.5%) (0.5%)
Total (5.8%) (5.5%) (5.0%) (5.8%) (5.7%) (7.0%)
£’000 £’000 £’000 £’000 £’000 £’000

Annual interest (243.6) (231.0) (210.0) (243.6) (239.4) (294.0)
At lower rate for LIBOR it’s best not to hedge, but with LIBOR at 6% the option is slightly cheaper than the
FRA.
In part 3.3 many candidates scored full marks, which was good to see. However, a number of candidates
lost marks as they were confused by the timings in the scenario. Rather than calculate the annual interest
cost as required, they calculated, incorrectly, a three month cost, i.e. between now and when the loan is to
be taken out.

3.4
FRA’s allow lenders/borrowers to fix a rate of interest. The bank will pay/receive any difference between
the agreed rate and the actual rate paid/received (see workings in 3.3 above).
Interest rate futures are similar to FRA’s in that they are contracts on an interest rate, but the terms,
amounts and periods are standardised.
Entitlement to interest rate receipts is bought with futures and the promise to make to interest rate
payments is sold with futures.
The pricing of an interest rate futures contract is calculated as (100-r), so if the rate in a futures contract is
5% then the contract will be priced at 95. Profits/losses on the buying and selling of futures are offset
against the moves in interest rates.
Overall, part 3.4 was answered well.


TUESDAY 6 JUNE 2017
(2½ hours)
exam starts.
IMPORTANT


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

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:
value, or
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.

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
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.

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

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:
 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

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

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.


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.)


Question 2
Total Marks:
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)
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)
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.

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:
Basis risk exists
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.


TUESDAY 12 SEPTEMBER 2017
(2½ HOURS)
1. Please read the instructions on this page carefully before you begin your exam. If you
have any questions, raise your hand and speak with the invigilator before you begin.
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anything which is not in direct response to the examination questions.
5. Ensure that all of your responses are visible on screen and are not hidden within cells.
Your answers will be presented to the examiner as they appear on screen.

1. Merikan Media plc (Merikan) is a large listed media group based in the UK. It currently owns
a controlling interest in 35 companies worldwide. Merikan’s board is considering altering its
UK investment portfolio via:
(1) the purchase of all of the shares in a commercial radio company and
(2) the disposal of all of its shares in a newspaper company.
You work in Merikan’s finance team and have been asked to prepare valuations and
supporting notes for the board. Details of the two proposed transactions are shown below.
1.1 Purchase of all of the shares in a commercial radio company
Coastal Radio Ltd (Coastal) was formed in 2003 and has been a very successful radio
station. Its listener numbers have increased steadily, as have advertising revenue and annual
profits. Extracts from Coastal’s most recent management accounts (together with supporting
notes) are shown here:
Income Statement Balance Sheet

for the year ended 31 August 2017 at 31 August 2017
£’000 £’000
Sales 28,400 Non-current assets 36,310
Operating costs (15,600) Current assets 4,316
Depreciation (3,500) 40,626
Amortisation (1,200)
Profit before interest 8,100 £1 ordinary shares 3,500
Debenture interest (400) Retained earnings 27,206
Profit before tax 7,700 5% debentures 8,000
Taxation (at 17%) (1,309) Current liabilities 1,920
Profit after taxation 6,391 40,626
Dividends paid (1,750)
Notes:
1. Coastal’s non-current assets originally cost £52.8 million. They were valued at
£37.8 million on 31 August 2017 and its current assets were valued at £4.2 million on
the same date. Neither of these valuations is reflected in the balance sheet at 31 August
2017.
2. Coastal’s debentures were trading at £110% on 31 August 2017.
3. Average figures for listed UK commercial radio companies:
P/E ratio 8.5

Dividend yield 5%
Enterprise value multiple 6.5

Requirements
(a) Calculate the value of one Coastal share based on each of the following methods:
 Price earnings ratio

 Dividend yield
 Enterprise value
 Net assets basis (historic cost)
 Net assets basis (revalued) (12 marks)
(b) Justify and advise the board of the price range within which it should make an offer for
Coastal’s shares. Refer to your calculations in part (a) above. (8 marks)
1.2 Disposal of all of its shares in a newspaper company
Merikan has owned all of the share capital of Albion Newspaper Group Ltd (Albion) since
2005. Recently Albion’s directors have informed Merikan’s board that they are willing to make
a management buy-out (MBO) of Albion. Accordingly, Merikan’s board wishes to value Albion
using the shareholder value analysis method (SVA). Merikan’s board estimates that Albion
has a three-year competitive advantage over its competitors (to 31 August 2020) and the
following data regarding Albion’s value drivers and additional financial information has been
collected:
Sales for the current year (to 31 August 2017) £70.0 million
Annual depreciation
(equal to annual replacement non-current asset expenditure) £1.5 million
Par value of 6% debentures in issue (current market value £95%) £10.0 million
Short-term investments held £0.7 million
Corporation tax rate 17%
Current WACC 8%
Beyond
Year to 31 August (budgeted) 2018 2019 2020 2020
Sales growth 5% 3% 2% 0%
Operating profit margin 8% 9% 9% 9%
Incremental non-current asset investment
(as a % of sales increase) 6% 5% 2% 0%
Incremental working capital investment
(as a % of sales increase) 5% 5% 4% 0%
Requirements
(a) Calculate the value of Albion’s equity using SVA. (12 marks)
(b) Outline the methods by which Albion’s directors might raise the funds necessary for the
proposed MBO of the company. (3 marks)
Total: 35 marks

2. You should assume that the current date is 31 August 2017
Ramsey Douglas Motors plc (Ramsey) is a UK-listed, UK-based motor car manufacturer
which was formed in 1984. Ramsey’s financial year end is 31 August.
Details of Ramsey’s long term-finance at 31 August 2017 and its total dividend and
interest payments for the year to 31 August 2017 are shown in the table below:
Table
Dividends Interest
Market Nominal paid in paid in
value at value at year to year to
31/8/17 31/8/17 31/8/17 31/8/17
£’000 £’000 £’000 £’000

£1 ordinary shares (note 1) 65,600 32,000 5,440
£0.50 preference shares 10,800 2,000 640
£100 irredeemable debentures 6,000 5,000 275
£100 redeemable debentures 4,200 4,000 240
(note 2)
Notes:
1. Ordinary share dividends have been growing at 3% pa for the past four years.
2. The redeemable debentures are redeemable at par on 31 August 2020.
3. All dividends and interest for the year to 31 August 2017 have been paid in full.
You are Ramsey’s finance director and an ICAEW Chartered Accountant. At its 22 August
2017 meeting, the board considered two proposed new investments. You were asked to
prepare workings and recommendations in advance of the next meeting regarding those two
investments, details of which are shown below:
Investment 1
Ramsey wishes to invest £9.5 million in a new computerised manufacturing system, making
use of robotic techniques. Half of this investment would be funded from Ramsey’s retained
earnings and the balance via a bank loan at an agreed rate of 7.5% pa. A report was
presented by the production director at the 22 August board meeting. It concluded that this
new system would generate efficiencies that would increase manufacturing profit by 6-8%
pa. At the same meeting, one of Ramsey’s other directors, Michael Bateman, said that
“because the company should be striving for a higher share price, any press releases
regarding the new system should state that profits are expected to increase by at least
15% pa.”
Investment 2
Ramsey’s board is considering a major change in strategy by investing in the development of
driverless cars. A driverless car is a vehicle that is capable of sensing its environment and
navigating without human input. The finance for this investment would be raised in such a
way so as not to alter Ramsey’s current gearing ratio (measured as debt:equity by market
values). The debt element of the finance will come from a new issue of 9% irredeemable
debentures at par.

Ramsey’s directors want to establish a cost of capital that could be used to appraise the
investment in driverless cars. They are aware that such a diversification would be very risky
and is likely to increase Ramsey’s equity beta which is currently 1.25.
The following data, collected at 31 August 2017, should be used when preparing your
workings for the next board meeting:
Driverless cars industry sector

Equity beta 2.10
Ratio of long-term funds (debt:equity) by market values 16:72
Expected risk free rate 2.25% pa

Expected return on the market 9.15% pa
The board also discussed the possible negative impact of this risky investment on Ramsey’s
share price. One director, Laura Young, commented “It’s okay. Markets are efficient. Even if
it does fall, the share price will soon adjust to its normal level.”
Other information
You should assume that corporation tax will be payable at the rate of 17% for the
foreseeable future and tax will be payable in the same year as the cash flows to which it
relates.
Requirements
2.1 Using the information in the table, calculate Ramsey’s WACC at 31 August 2017.
(10 marks)
2.2 Calculate, and briefly comment upon, the impact on the market value of Ramsey’s
redeemable debentures of a rise in their gross redemption yield to 5% pa. (3 marks)
2.3 Advise, with reasons, whether Ramsey should use the WACC figure calculated in part
2.1 above when appraising Investment 1. (5 marks)
2.4 Explain the ethical implications for you, as an ICAEW Chartered Accountant, arising
from Michael Bateman’s suggestion regarding the press releases for Investment 1.
(3 marks)
2.5 Calculate an appropriate WACC that Ramsey could use when appraising Investment 2
and explain the reasoning behind your approach. (10 marks)
2.6 Evaluate briefly Laura Young’s comments regarding Investment 2’s effect on Ramsey’s
share price. (4 marks)
Total: 35 marks

3. You should assume that the current date is 31 August 2017
Jenson Grosvenor plc (Jenson) is a UK-based manufacturer of industrial pumps. The

majority of the raw materials and component parts used in the manufacture of Jenson’s
pumps are imported from EU countries and are invoiced in euros.
You work in Jenson’s finance team and have been asked to provide guidance on two issues
to be discussed at the next board meeting.
Issue 1 – AZS Oil contract
Jenson’s directors recently signed a contract with a Canadian oil company, AZS Oil (AZS).
This contract is for the supply of a large consignment of specialised oil pumps for use by AZS
at its oilfields in northern Canada. The contract is valued at 5.2 million Canadian dollars (C$).
The pumps will be dispatched on 31 October 2017 and Jenson will receive the C$5.2 million
from AZS on 30 November 2017.
You have been given the following information at the close of business on 31 August 2017:
Spot rate (C$/£) 1.6305 – 1.6385

Three-month forward contract discount (C$/£) 0.0045 – 0.0085
Arrangement fee for forward contract £0.35 per C$100 converted
Canadian dollar interest rate (lending) 4.4% pa
Canadian dollar interest rate (borrowing) 5.2% pa
Three-month OTC call option on C$ – exercise price 1.6090/£
Three-month OTC put option on C$ – exercise price 1.6245/£
Cost of relevant OTC option £0.75 per C$100 converted
In relation to the AZS contract, you are aware that at the next board meeting Jenson’s
directors will discuss (a) the implications of an increase in the value of sterling and (b) the
foreign exchange hedging techniques that Jenson might employ.
Issue 2 – Shareholding in Callella plc
Jenson owns 50,000 shares in Callella plc (Callella). The company has never used any
hedging techniques to protect it from a fall in the value of this investment and the board now
wishes to remedy that. As a first step, the directors will consider how traded options work at
the next board meeting.
The market price of one Callella share at 31 August 2017 is 365p. Traded options on Callella
shares at the same date are available as follows (all figures are in pence):
Calls Puts
Exercise price September October September October
355 11.0 21.0 2.0 13.5
370 3.5 14.0 9.0 20.5

Requirements
3.1 For Issue 1, calculate Jenson’s sterling receipt from the AZS contract if it:
(a) uses an OTC currency option
(b) uses a forward contract
(c) uses a money market hedge
(d) does not hedge the Canadian dollar receipt and sterling strengthens by 5% by
30 November 2017 (9 marks)
3.2 With reference to your calculations in part 3.1, advise Jenson’s board whether or not it
should hedge its Canadian dollar receipt from the AZS contract. (7 marks)
3.3 Explain why Jenson’s imports and exports might expose the company to economic risk.
(3 marks)
3.4 Explain the advantages and disadvantages of using currency futures rather than a
forward contract to manage foreign exchange risk. (4 marks)
3.5 For Issue 2, calculate the intrinsic value and the time value of each of the options on
Callella’s shares at 31 August 2017. (4 marks)
3.6 For Issue 2, explain briefly the three factors that affect the time value of the options on
Callella’s shares. (3 marks)
Total: 30 marks


Question 1
Total marks: 35
General comments
This question was, generally answered poorly and a very slim majority of candidates achieved a “pass”
standard.
In the scenario a UK-listed media group is planning to (i) purchase an unquoted commercial radio
company and (ii) sell all of its shares in an unquoted newspaper company via a Management Buy Out
(MBO). In part 1.1(a), for twelve marks, candidates were required to calculate the value of the target
company, using five different methods. Part 1.1(b) was worth eight marks and asked candidates to advise
on a suitable price range for the purchase of the target company. Part 1.2(a), for twelve marks, tested
shareholder value analysis (SVA). Candidates were asked to calculate the value of the newspaper
company’s equity using SVA analysis. Finally, for three marks, part 1.2(b) required candidates to outline
how management could raise funds for an MBO.
1.1(a)
Total Value
Value per share
£’000 £
P/E ratio £6,391,000 x 8.5 = 54,324 /3,500 15.52
Lower marketability (25% discount, say) 11.64
Dividend yield £1,750,000/5% = 35,000 /3,500 10.00

Enterprise value £’000

Profit before interest & tax 8,100
Depreciation 3,500
Amortisation 1,200
EBITDA 12,800 x 6.5 = 83,200
less: Debt at MV 8,000 x £110% = (8,800)
74,400 /3,500 21.26
Net Assets – historic cost

Ordinary share capital 3,500
30,706 /3,500 8.77
Net Assets – revalued

Historic cost (as above) 30,706
Non current assets (£37,800 - £36,310) 1,490
Current assets (£4,200 – £4,316) (116)
Debentures (£8,000 - £8,800) (800)
31,280 /3,500 8.94

Many candidates did well in part 1.1(a) and some scored full marks. However, overall this was not
answered as well as expected. Four of the five valuation methods asked for have been tested regularly
and the calculations were not at all difficult (i.e. there were no ‘tricks’). A considerable number of
candidates were unable to calculate the company’s Net Assets and/or Earnings figures, which was very
disappointing. The Enterprise Value (EV) calculation was a recent addition to the syllabus. Overall this
was answered reasonably well, but many candidates did not attempt it at all. The question itself followed
the examples in the study materials very closely.

1.1(b)
Asset valuations are the lowest. They are historic figures - Balance Sheet-based, no intangibles. Merikan
is buying Coastal to run it, not break it up
P/E and EV are most relevant – forward-looking and based on profits/earnings.
Dividend yield is OK, but it is a 100% purchase and the yield calculation is only relevant for minority
interests. Also it ignores growth.
So a price range of £12 to £16 per share looks about right
Part 1.1(b) was, overall, done well, but to score high marks here candidates needed to consolidate
valuation theory with the figures that they had calculated.

1.2(a)
Terminal
2017 2018 2019 2020 Value
£m £m £m £m £m
Sales 70.0 73.5 75.7 77.2 77.2
Operating margin 5.9 6.8 6.9 6.9
Tax (17%) (1.0) (1.2) (1.2) (1.2)
Depreciation 1.5 1.5 1.5 1.5
Operating cash flows 6.4 7.2 7.3 7.3
Replacement non-current assets (1.5) (1.5) (1.5) (1.5)
Incremental non-current assets (0.2) (0.1) 0.0 0.0
Incremental working capital (0.2) (0.1) (0.1) 0.0
Free cash flows 4.5 5.4 5.7 5.8
Discount factor (8%) 0.926 0.857 0.794 0.794
4.6
/8%
Present values 4.2 4.7 4.5 57.2
Total present value 70.6
plus: Short-term investments 0.7
less: Long-term debt (£10m x £95%) (9.5)
Market value of equity 61.8
So GB’s equity is worth approximately £61.8m

For part 1.2(a), as in the two previous parts, there was a wide range of answers. Some candidates did
really well here, whilst others produced very little. The figures themselves were not that difficult and a
methodical approach (bear in mind that SVA has been examined before) would have generated a good
mark. There was evidence of time pressure i.e. there were many incomplete answers (more than the
previous occasion that this topic had been set).


1.2(b)
Methods by which management might fund its MBO:
From management’s equity.
From venture capitalists – via equity and debt.
Borrowing from bank(s) - debt.
Part 1.2(b) was done well by most candidates. A similar question to this was set recently, but many
candidates did poorly because they failed to concentrate their answers on the directors behind the MBO,
rather than the company itself.


Question 2
Total marks: 35
General comments
This question was poorly done and had the lowest percentage mark on the paper. The majority of
candidates failed to reach a “pass” standard in the question.
It was based around a UK-listed car manufacturer. The company was considering investing in (i) a
computerised manufacturing system and (ii) the development of driverless cars. In part 2.1 of the question,
for ten marks, candidates were required to calculate the company’s current WACC figure. Part 2.2, for
three marks, tested candidates’ understanding of the pricing of debentures and asked them to calculate
the current market value of redeemable debt when given a yield figure. Part 2.3, for five marks, tested
candidates’ understanding of which WACC to use in the appraisal of the first investment. Part 2.4
examined the Ethical Guide and was worth three marks. Part 2.5, for ten marks, examined the CAPM.
Candidates had to demonstrate that they understood how (and why) to calculate a cost of capital figure
when a company is diversifying. Finally, for four marks, candidates were required to explain the basic
tenets of the Efficient Market Hypothesis within the scenario given.
2.1
Cost of equity (ke) = (d1) +g (£5,440 x 1.03) + 3% 11.54%
MV £65,600
Cost of preference shares (k p) d £640 5.93%

MV £10,800
Cost of irredeemable debt (k di) (£275 x 83%) 3.80%

£6,000
Year Cash flow 4% factor PV 5% factor PV

£’000 £’000 £’000
0 (4,200) 1.000 (4,200.0) 1.000 (4,200.0)
1-3 240 2,775 666.0 2.723 653.5
3 4,000 0.889 3,556.0 0.864 3,456.0
NPV 22.0 NPV (90.5)
IRR = 4% + (22/(22 + 90.5)) = 4.20%
less: Tax at 17% (4.20% x 83%) = 3.48%
WACC
Total MV’s Cost x weighting WACC
£’000 £’000
Equity 65,600 11.54% x 65,600/86,600 8.74%
Pref. shares 10,800 5.93% x 10,800/86,600 0.74%
Irredeemable debt 6,000 3.80% x 6,000/86,600 0.26%
Redeemable debt 4,200 3.48% x 4,200/86,600 0.17%
21,000 1.17%
Total market value 86,600 9.91%
There were many very good answers to part 2.1 and candidates secured the full (ten) marks available.
The calculation of WACC has been examined frequently. However, in this exam candidates were, nor for
the first time, given total figures, rather than unit figures, to work with. This flummoxed a considerable
number of candidates, i.e. many candidates, when given the total nominal value and the nominal value per
share or debenture, were incapable of deducing the number of shares or debentures in issue. Also a
significant number of them altered the share and debt values to make them ex-div, despite the fact that the
question stated that all dividends and interest due for the year had already been paid.


2.2
From 2.1 above
Year Cash flow 5% factor PV

£’000 £’000
1-3 240 2.723 653.5
3 4,000 0.864 3,456.0
Present value 4,109.5
Thus current market value would be £4,109.5/£4,000 = £102.74%

Yield increases to 5% and market value falls to £102.74%, i.e. it’s an inverse relationship.
Part 2.2 was a good test of candidates’ understanding of the market price and yield of redeemable debt.
Generally, it was answered very poorly. Many candidates commented that if the redemption yield of the
debt were to increase then so would the price of that debt, thus totally misunderstanding the relationship
between required return and value. This topic has been tested a number of times in recent exams.

2.3
When using WACC to appraise projects the following assumptions are implied:
1. Ramsey’s historic proportions of debt and equity are not to be changed

2. Ramsey’s systematic business risk is not to be changed
3. The finance is not project-specific (e.g. cheap government loans)
In this case the finance is of a material size, i.e. 11% of total funds at market value (£9.5m/£86.6m) and
the historic gearing does not appear to be met (it’s 50:50 ignoring project NPV). The systematic business
risk, as far as we’re aware, does not change as it’s still the same industry. It’s not project-specific finance.
Therefore unwise to use existing WACC but after-tax cost of bank loan isn’t WACC either as it ignores the
required returns of shareholders.
Candidates’ responses to part 2.3 were also very disappointing. Too many candidates restricted their
answers to a discussion about the impact on the company’s gearing levels, without taking into account the
wider aspects of when to employ the current WACC figure. Again, this topic has been examined frequently
in the past.

2.4
Ethical guidance – key areas of ethical concern regarding the press release
Integrity – members need to show honesty, fair dealing, truthfulness.
Objectivity – members must not succumb to the undue influence of others.
Interest of shareholders and owners must be taken into account – members must not let their own self-
interest influence their actions.
Part 2.4, as expected, was answered well.


2.5
New market ungeared beta = (2.10 x 72) = (2.10 x 72) 1.77

(72 + (16 x 83%)) 85.28
Ramsey’s geared beta = 1.77 x (£65.6m + £10.8m + (£10.2m x 83%)) 2.29

£65.6m
So, cost of equity = (2.29 x (9.15% - 2.25%)) + 2.25 = 18.05%
Cost of debt = 9% x 83% 7.47%
WACC = (18.05% x £65.6m/86.6m) + (7.47% x £21.0m/£86.6m)) = 15.48%
It would be unwise to use the existing WACC (9.91%) as Ramsey’s plan involves
diversification and therefore a change in the level of systematic risk (beta rises to 2.29 from
1.25). Thus a new WACC must be calculated. Systematic risk is accounted for by taking into
account the beta of the driverless cars market and this is then adjusted to eliminate the
financial risk (level of gearing) in that market. The resultant ungeared beta is then “re-geared”
by taking into account the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased risk discussed
above) is used.

Part 2.5 has been examined on a number of occasions recently and candidates should be well used to the
approach that is required. Most candidates scored well with the de-gearing and re-gearing calculations,
but only a few were able to work through to the end of the calculations, which was disappointing.

2.6
Markets set prices based on information available. If the market “takes fright” at the proposed investment
into driverless cars then the MV of Ramsey’s shares will fall and may not recover. It all depends on the
market’s view of the company’s likely future success.
Efficiency does not mean that prices return to a “normal level”. Markets have no memory. Efficiency
means that shares cannot be bought cheaply and then sold quickly at a profit. Share prices are “fair” and
investment returns are those expected for the risks undertaken.
Part 2.6 caught out the majority of candidates here - they were unable to apply EMH theory to this
practical example. Responses that centred on the three forms of efficiency and/or behavioural aspects will
have scored poorly.


Question 3
Total marks: 30
General comments
Most candidates demonstrated a reasonable understanding of this area of the syllabus and this question
had the highest average mark on the paper
This was a six-part question which tested the candidates’ understanding of the risk management element
of the syllabus.
The scenario was centred on a UK-based manufacturer of industrial pumps. The company was
considering hedging its exposure to (i) foreign exchange rate risk on a C$5.2 million receipt (three months
ahead) from a Canadian customer and (ii) a fall in the value of a large quoted shareholding. Part 3.1 was
worth nine marks and asked candidates to calculate the sterling receipt arising from a list of hedging
techniques that could be applied to the Canadian dollar receipt. In part 3.2, for seven marks, candidates
were required to advise the company’s board whether it should hedge the dollar receipt. Part 3.3, for three
marks, required candidates to explain, from the given scenario, economic risk. In part 3.4 (four marks)
candidates were required to explain the advantages and disadvantages of using currency futures rather
than a forward contract to manage foreign exchange risk. Part 3.5, for four marks, asked candidates, with
reference to its large quoted shareholding, to calculate the intrinsic value and time value of traded options,
for which various prices were given. Finally in part 3.6, for three marks, candidates were asked to explain
the three factors that affect the time value of traded options.
3.1
£ £
(a) OTC currency option
Put option
C$5,200,000 3,200,985
1.6245
Cost C$5,200,000 = 52,000 x £0.75 (39,000)

100 3,161,985
(b) Forward contract

1.6385 + 0.0085 = 1.6470 C$5,200,000 3,157,256
1.6470
Fee C$5,200,000 = 52,000 x £0.35 (18,200)

100 3,139,056
(c) Money market hedge

Borrow C$ C$5,200,000 £5,133,268
1.013
Convert @ spot £5,133,268 3,132,907

1.6385
Lend @ UK 3,132,907
x
1.007 3,154,837
(d) Strengthening £
1.6385 x 1.05 = 1.7204 C$5,200,000 3,022,509
1.7204
Foreign exchange risk is a regular topic in this examination. As expected part 3.1 was generally answered
well. However, many candidates lost marks unnecessarily, e.g. choosing a call rather than a put option,
failing to deal with fees (a cost) correctly, choosing the wrong interest rates for the MMH. Over half of the
candidates believed that a strengthening £ meant getting less foreign currency.


3.2
Conversion at spot rate C$5,200,000 £3,173,634
1.6385
If £ strengthens 3,022,509
Option 3,161,985
Forward 3,139,056
MMH 3,154,837
The current spot rate gives best result.

The worst result is from the strengthening £ and the forward contract discount predicts a
strengthening of the £.
C$ is depreciating, £ strengthening, which is bad for UK exporters.
Forward contract is certain.
MMH is certain.
Option gives flexibility but is expensive.
Generally part 3.2 was answered adequately, but bearing in mind how frequently this is examined, it was
disappointing. Too few candidates went beyond only comparing the best outcome at each rate. Most
answers here needed to demonstrate a deeper understanding of the issues involved. Many candidates
stated, wrongly, that interest rates indicated that sterling would weaken. Also too few commented on the
(negative) impact of a stronger pound on an exporter (as per the question).

3.3
Jenson's imports are purchased mostly in euros. If exports were, for example, mostly in Canadian dollars
then Jenson would be disadvantaged by both a strong euro and a weak dollar (as in 3.1 and 3.2 above).
In part 3.3 few candidates scored full marks. Those that did, explained how a strengthening pound
(against the Canadian dollar) when exporting and a weakening pound (against the euro) when importing
would both be bad for the company in question.

3.4
Advantages of using currency futures over forward contracts:
 Lower transaction costs.
 The exact date of receipt or payment does not have to be known.
Disadvantages of using currency futures over forward contracts:

 The contracts cannot be tailored to user’s exact requirements.
 Hedge inefficiencies (whole number of contracts and basis risk) may occur.
 Limited number of currencies can make use of futures contracts.
 If neither currency is $US then this can complicate matters.
Part 3.4 was generally answered well, but many candidates just listed the advantages/disadvantages of
currency futures and/or a forward contract rather than answer the question as set.


3.5
Intrinsic value
Only options that are in the money have an intrinsic value.
For the call options:

The call options with an exercise price of 355p are in the money and have an intrinsic value of
10p (365p-355p).
The call options with an exercise price of 370p are out of the money and have a zero intrinsic
value.
For the put options:

The put options with an exercise price of 370p are in the money and have an intrinsic value of
5p (370p-365p).
The put options with an exercise price of 355p are out of the money and have a zero intrinsic
value.
Time value
The time value is calculated by deducting the intrinsic value from the option premium:
Calls Puts
Sept Oct Sept Oct
355 1.0 11.0 2.0 13.5
370 3.5 14.0 4.0 15.5
Part 3.5 has been examined before, albeit rarely. A minority of candidates answered it well and scored full
marks, but most were unable to calculate the values required.

3.6
The time value of the options will be affected by:
 The time period to expiry of the options.
 The volatility of the market price of the underlying item.
 The general level of interest rates.
Part 3.6 was answered well and most candidates scored full marks.


TUESDAY 5 DECEMBER 2017
(2½ HOURS)
This exam consists of three questions (100 marks).
4. The examiner will take account of the way in which answers are structured. Do not
include anything which is not in direct response to the exam questions.
Your answers will be presented to the examiner exactly as they appear on screen.
A Formulae Sheet and Discount Tables are provided with this exam paper.

1. Assume that the current date is 31 December 2017.
Innovative Alarms (Innovative) is a division of a major quoted company and manufactures

and sells a single alarm system to private houses and commercial premises. The financial
management department of Innovative is considering two separate issues:
Issue One: Whether to launch onto the market a new type of alarm system, the Defender,
which when triggered will not only ring a bell but also play a realistic recording of dogs
barking.
Issue Two: How often the division’s fleet of delivery vans should be replaced.
You are asked to provide advice on both of these issues and report to the head of the
financial management department.
1.1 Issue One: The Defender Project
The Defender is to be evaluated over a planning horizon of three years from 31 December
2017. It has been agreed that on 31 December 2020 the rights to manufacture the Defender
will be sold to a team made up of the current management of Innovative (‘the team’) as by
that date the Defender is expected to be Innovative’s only product. The finance director of
Innovative, who is an ICAEW Chartered Accountant, will be a member of the team and is
responsible for calculating the value of the rights to manufacture the Defender.
The following information is available regarding the Defender project:
 The selling price will be £399 per unit in the year to 31 December 2018 and the
contribution per unit is expected to be 40% of the selling price. The selling price and
variable costs per unit are expected to increase by 3% pa in the two years to
31 December 2020.
 The number of units sold in the year to 31 December 2018 is estimated to be 30,000 and
is expected to increase by 6% pa in the two years to 31 December 2020.
 On 31 December 2017 the project will require an investment in working capital of

£2 million, which will increase at the start of each subsequent year in line with sales
volume growth and sales price increases. Working capital will be fully recoverable on
31 December 2020.
 Incremental fixed costs for the year ended 31 December 2018 are expected to be
£0.5 million and are expected to increase by 5% pa in the two years to 31 December
2020.
 The Defender will require two hours of skilled labour per unit. Skilled labour is expected
to be in short supply over the next three years. Innovative will need to transfer skilled
labour from its existing product, which requires half the skilled labour time per unit of the
Defender. The existing product has a selling price of £175 and an expected material and
skilled labour cost of £150 in the year to 31 December 2018. The selling price and
variable costs are expected to increase by 3% pa in the two years to 31 December 2020,
the end of the existing product’s life cycle. Innovative’s skilled labour is paid at the rate of
£15 per hour (in 31 December 2018 prices). Any working capital adjustments associated
with the existing product can be ignored.

 New equipment will be required to manufacture the Defender, which will cost £8 million
on 31 December 2017 and will have an estimated scrap value of £2 million on
31 December 2020 (in 31 December 2020 prices). The new equipment will attract 18%
(reducing balance) capital allowances in the year of expenditure, except in the final year.
At 31 December 2020, the difference between the equipment’s written down value for tax
purposes and its disposal proceeds will be treated by the company as a:
value, or
(2) balancing charge, if the disposal proceeds are more than the tax written down
value.
 The finance director calculated the value of the rights to manufacture the Defender as
three times the net contribution after tax for the year to 31 December 2020.
 A suitable money cost of capital to appraise the project is 10% pa.
Requirements
(a) Using money cash flows, calculate the net present value of the Defender project on
31 December 2017 and advise whether Innovative should proceed with the project.
(16 marks)
(b) Outline the disadvantages of sensitivity analysis for the head of the financial
management department and how simulation might be a better way to assess the risk of
the Defender project. (4 marks)
(c) Describe two real options that are available at the end of the project on 31 December
2020 as an alternative to selling the rights to manufacture the Defender. (4 marks)
(d) Identify and discuss the ethical issues in relation to the sale of the rights to manufacture
the Defender. (3 marks)

1.2 Issue Two: Replacing the fleet of delivery vans
Innovative would like to decide upon a policy for replacing its fleet of delivery vans, since no
formal policy exists at the present time. A new delivery van costs £30,000. The following
information is available:
Interval between Trade-in Maintenance cost

replacement value (paid at the end of the year)
(years) £ £
1 22,500 500
2 17,000 2,500
3 12,000 3,500
A suitable cost of capital for evaluating the replacement policy is 15% pa.
Requirement
Calculate the optimal replacement policy for the delivery vans and advise the head of the
financial management department of the limitations of the approach used.
Note: Ignore inflation and taxation when determining the optimal replacement policy
(8 marks)
Total: 35 marks

2. Assume that the current date is 1 December 2017
Peel Kitchens plc (Peel) is a quoted wholesaler of kitchen cabinets and worktops and has a
financial year end of 30 November.
The board of Peel is considering diversifying into the supply of domestic appliances and
would need to raise finance of £200 million during 2018 should the diversification go ahead.
The finance director of Peel, Debbie Harris (Debbie), needs to calculate the weighted
average cost of capital (WACC) that will be used to appraise the potential diversification.
She is also considering whether the finance required should be raised by debt in the form of
6% debentures issued at par or by equity in the form of an issue of 100 million ordinary
shares. Debbie is particularly concerned about how the financial markets and the company’s
shareholders might react to the impact the additional £200 million finance may have on the
company’s capital structure.
The board of Peel is also contemplating its dividend policy beyond 2017. Extracts from Peel’s
management accounts are produced below:
Year ended 30 November

2013 2014 2015 2016 2017
£m £m £m £m £m
Profits before interest and 81.03 78.86 87.54 85.37 94.04
tax
Interest (33.32) (33.32) (33.32) (33.32) (33.32)
47.71 45.54 54.22 52.05 60.72
Taxation (8.11) (7.74) (9.22) (8.85) (10.32)
Profits after tax 39.60 37.80 45.00 43.20 50.40
Ordinary dividends 19.80 18.90 22.50 21.60 25.20

Special dividend - - - - 9.00
Total dividends 19.80 18.90 22.50 21.60 34.20
Capital at 30 November 2017 £m

Ordinary shares (50p nominal value) 90.00
Retained earnings 256.50
346.50
7% Debentures at nominal value
(redeemable at par on 30 November 2022) 476.00
822.50
The number of shares in issue has not changed during the period from 1 December 2012 to
30 November 2017.
 The cum-div share price on 1 December 2017 is £2.92 per ordinary share. The special
dividend was paid in June 2017.
 The 7% debentures have a cum-interest market value of £111 per £100 nominal value.

 Peel has an equity beta of 1.3.
 A company that supplies domestic appliances has an equity beta of 1.1 and a debt:equity
ratio of 40:60 by market values.
 The risk free rate is expected to be 3% pa.
 The market risk premium is expected to be 6% pa.
 Assume that the rate of corporation tax will be 17% for the foreseeable future.
 An analyst has calculated the gearing ratios (measured as debt/equity by market values)
and interest cover for companies that operate in Peel’s market sector as follows:
Maximum Minimum Average

Gearing ratio 135% 80% 100%
Interest cover 3 2 2.4
Debbie has asked you to provide her with certain information so that she can prepare a
report for the board of Peel.
Requirements
2.1 Calculate Peel’s WACC on 1 December 2017 using:
(a) The dividend valuation model (dividend growth should be estimated using the
earliest and latest dividend information provided).
(b) The CAPM. (10 marks)
2.2 Explain and evaluate whether either of the WACC figures calculated in 2.1 above would
be appropriate for appraising Peel’s diversification into supplying domestic appliances.
(5 marks)
2.3 Determine whether the £200 million finance required should be raised from either debt
or equity sources. You should discuss the likely reaction of both shareholders and the
financial markets, and make reference to the gearing and interest cover data provided
and give advice to Debbie on which source of finance should be used. (12 marks)
2.4 Assuming that Peel raises the £200 million finance required wholly from debt, identify
the most appropriate project appraisal methodology that could be used to appraise the
diversification. Also determine the project discount rate that should be used in these
circumstances. (3 marks)
2.5 Discuss whether Peel’s dividend policy over the last five years is appropriate for a listed
company. (5 marks)
Total: 35 marks

3. Assume that the current date is 30 November 2017
Jewel House Investments Ltd (Jewel) is an investment company based in the UK. You work
for Jewel and at a recent meeting with the company’s finance director it was agreed that you
would work on three specific tasks:
Task One: Hedging foreign exchange rate risk for receipts from foreign investors.
Task Two: Hedging a portfolio of investments.
Task Three: Arranging an interest rate swap for a loan that the company has recently taken
out.
3.1 Task One: Jewel is due to receive an investment of $8 million from a client in the USA on
31 March 2018. It was agreed with the client that Jewel would hedge the foreign exchange
rate risk associated with the $ receipt and invest the sterling equivalent of the $8 million on
behalf of the client.
You have the following information available to you on 30 November 2017:
Exchange rates:
Spot rate ($/£) 1.2490 – 1.2492

Four-month forward contract discount ($/£) 0.0031 – 0.0034
Over-the-counter (OTC) currency option
A put option to sell $ is available with an exercise price of $1.2400. The premium is £0.02 per
$ and is payable on 30 November 2017.
Jewel has funds on deposit which earns interest of 3% pa.
Requirements
(a) Calculate the amount of sterling to be invested on behalf of the US client using:
 an OTC currency option
assuming that the spot price on 31 March 2018 is $/£ 1.2697 – 1.2700 (6 marks)
(b) Using your results from 3.1 (a) above, explain the advantages and disadvantages of the
two hedging techniques used and advise which hedging technique would be the more
beneficial for Jewel’s client. (4 marks)
(c) Outline whether currency futures would have been more advantageous than using a
forward contract to hedge the foreign exchange rate risk associated with the $8 million
receipt. (2 marks)

3.2 Task Two: One of Jewel’s investments is a portfolio of UK FTSE 100 shares, which is worth
£100 million on 30 November 2017. The finance director of Jewel is concerned about a
potential fall in value of the portfolio over the next four months.
You have the following information available to you on 30 November 2017:
 The FTSE 100 index is 7,261
 The price for a March 2018 FTSE 100 index future is 7,195
 The face value of a FTSE 100 index futures contract is £10 per index point
Requirements
(a) Calculate the outcome of hedging Jewel’s £100 million portfolio using March 2018 FTSE
100 index futures. Assume that on 31 March 2018 both the FTSE 100 index and the
FTSE 100 index futures price are 7,010 and that the portfolio value changes exactly in
line with the change in the FTSE 100 index. (6 marks)
(b) Explain why the hedge in 3.2 (a) above will not be 100% efficient. (2 marks)
3.3 Task Three: Jewel recently bought new premises and borrowed £50 million for a period of
ten years. The loan is at a floating rate of LIBOR + 4% pa. LIBOR is currently 0.36% pa. The
finance director of Jewel believes that interest rates are going to rise and he would like to
protect the company against interest rate risk.
The finance director of Jewel identified Nevis plc (Nevis), which is a company that would like
to swap £50 million of its 5% pa fixed rate loans to a floating rate. Jewel and Nevis agreed to
enter into an interest rate swap with any benefits from the swap being shared equally
between the two companies. Jewel can borrow at a fixed rate of 6.5% pa and Nevis can
borrow at a floating rate of LIBOR + 3.5% pa.
Requirements
(a) Demonstrate how the interest rate swap between Jewel and Nevis would be
implemented, with the floating rate leg of the swap set at LIBOR. (4 marks)
(b) Calculate
 the initial difference in annual interest rates for Jewel if it enters into the interest rate
swap with Nevis.
 the amount to which LIBOR would have to rise for the cost of Jewel’s floating rate
borrowing to equal the fixed rate achieved through the interest rate swap.
(2 marks)
(c) Identify four advantages for Jewel of entering into an interest rate swap with Nevis.
(4 marks)
Total: 30 marks

Professional Level – Financial Management – December 2017
Question 1
Total Marks: 35
General comments
This was a five-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 launching a new product onto
the market and also considering how often it should replace its fleet of delivery vans.
1.1 (a)
Units pa 30,000
0 1 2 3
Units 000's
(x 1.06) 30.00 31.80 33.71
Selling price £
(x 1.03) 399.00 410.97 423.30
Contribution per unit £ 159.6 164.39 169.32

(see skilled)
£000's £000's £000's £000's
Contribution 4788.00 5227.6 5707.78
Contribution lost -1500.00 -1637.7 -1788.15
Fixed overhead -500.00 -525.00 -551.25
Taxable 0 2788.00 3064.90 3368.38
Tax @ 17% 0 -473.96 -521.03 -572.62
Sale proceeds 9759.88
Working capital -2000.00 -183.60 -200.45 2384.05
Machinery and equipment -8000.00 2000.00
Tax saved on CAs 244.80 200.74 164.60 409.86
Cash flows -9755.2 2331.18 2508.02 17349.55
PV @ 10% -9755.2 2119.25 2072.74 13034.97
NPV 7471.76
The Defender project has a positive NPV, which will increase shareholder wealth. The project should
therefore be accepted.
Working capital
Year cumulative Increment

0 -2000 -2000
1 -2183.6 -183.6
2 -2384.05 -200.45
3 2384.05

Year Cost/WDV CA Tax
0 8000.00 1440.00 244.80

1 6560.00 1180.80 200.74
2 5379.20 968.26 164.60
3 4410.94
Sale -2000.00 2410.94 409.86
Contribution Lost
The contribution of the other product is:
£
Selling price 175
Materials and skilled Labour -150
Contribution 25
Contribution lost per unit of the defender -50
Year 1 = -50 x 30 = -1500.00

Year 2 = -50 x 1.03 x 31.80 = 1637.70
Year 3 = -50 x 1.03^2 x 33.71 = 1788.15
NB the skilled labour cost of £15 per hour is common to both alternatives so may be ignored by students.
In year 1 the contribution on the Defender is £189.6 ignoring labour. The contribution lost is £40x2=£80
ignoring labour. The net gain is £189.6-80=£109.60 per Defender. If labour costs are included in the
figures as above the net gain is the same ie £159.6-50=£109.60.
If the gross figures are used in the NPV then they are as follows;
Defender 5688 6210 6781

Lost contn 2400 2620 2861
Which nets to the same as shown in the NPV calc above
Sale proceeds £000's

Contribution 5707.78
Contribution lost -1788.15
Net Contribution 3919.63
Net contribution x 3 x (1-0.17) 9759.88
Well answered by many candidates, however the following were common errors: incorrect calculation of
contribution; timing errors for cash flows; incorrect calculations of the contribution lost; incorrect
calculations of the value of the rights at the end of the project and in some cases ignoring it altogether; not
explaining why the project should be accepted; not providing workings so no marks could be awarded
when the figure presented was incorrect.


1.1 (b)
The disadvantages of sensitivity analysis are:
 It assumes that changes to variables can be made independently.

 It ignores probability. It only identifies how far a variable needs to change to result in a zero NPV,
it does not look at the probability of such a change.
 It is not an optimising technique and does not point directly to a correct decision.
Simulation goes some way to address the weaknesses of sensitivity analysis. The main advantage is that
it allows the effect of more than one variable changing at the same time to be assessed. This gives more
information about the possible outcomes and their relative probabilities and it is useful for problems that
can not be solved analytically. However it should be noted that simulation is also not an optimising
technique and does not point directly to a correct decision.
Responses to this part of the question were mixed with many candidates not able to adequately explain
the disadvantages of sensitivity analysis. The question only asked for disadvantages but many candidates
wasted time by stating advantages. The explanations of simulation as an alternative to sensitivity analysis
were poor.

1.1 (c)
Abandonment option: If the defender project is not successful it is unlikely the team will buy the rights to
manufacture the new alarm system. Therefore Innovative has the option to abandon and sell the assets.
Follow on option: Rather than sell the rights to manufacture the new alarm system there might be the
opportunity to launch a second (and third and so on) version, which could be highly profitable, or could
lose money, for Innovative.
(Note: Students might mention growth options rather than follow on options. If so award marks)
Responses to this part of the question were good. However some candidates did not read the question
and stated real options which did not apply at the end of the project.

1.1 (d)
There is a clear conflict of interest regarding the computation of the sale proceeds of the rights to
manufacture the Defender after the time horizon of three years.
Since the finance director will be a member of the team he should act with integrity and have the interests
of shareholders in mind. In these circumstances he should not be involved in negotiating the price that the
team will buy the rights for. He should be objective and demonstrate professional behaviour.
Responses to this part of the question were generally good.


1.2
Replacement after one year (£):
(30,000) + (22,500 - 500)/1.15 = (10,870) Annual equivalent cost (AEC) = (10,870)/0.870 =

(12,494)
Replacement after two years (£):
(30,000) + (500)/1.15 + (17,000 – 2,500)/(1.15)^2 = (19,471) AEC = (19.471)/1.626 = (11,975)
Replacement after three years )£)
(30,000) + (500)/1.15 + (2,500)/(1.15)^2 + (12,000 – 3,500)/(1.15)^3 = (26,736)

AEC = (26,736)/2.283 = (11,710)
The optimal replacement period is that which gives the lowest AEC, in this case replacing the vans after
three years is preferable.
Limitations include:
Changing technology, leading to obsolescence, changes in design

Inflation – affecting estimates and the replacement cycles
How far ahead can estimates be made and with what certainty
Ignoring taxation.
Note: Students were instructed to ignore inflation in 1.2.
Responses to this part of the question were mixed, it was apparent that some candidates had not revised
this area of the syllabus. However we did see some very good attempts.


Question 2
Total Marks: 35
General comments
the syllabus. The scenario of the question was that a company is diversifying its operations and raising
finance by either debt or equity. Also candidates were asked to discuss the company’s dividend policy.
2.1
(a) Growth can be estimated by past ordinary dividend growth for the past four years excluding special
dividend as it’s a one-off:
Growth = (25.2/19.80)(1/4) -1 = 0.0621 or 6.21%
Shares in issue = 180m (90 x 2)
2017 dividends per share = 14p (25.20/180)
Ex div share price = 278p (292-14)
Ke = (14(1.0621)/278) + 0.0621 = 0.1156 or 11.56%
Kd is calculated as the YTM of the 7% debentures x (1-t):
The ex interest debenture price is £104 (111 – 7)
Years Cash Flow Factors PV Factors PV

£ 5% 10%
0 -104.00 1 -104.00 1 -104.00
1 to 5 7.00 4.329 30.30 3.791 26.54
5 100.00 0.784 78.40 0.621 62.10
4.70 -15.36
The YTM = 5 + (4.7/(4.7 + 15.36) x 5) = 6.17%
Kd = 5.12 (6.17 x (1-0.17))
The market value of debt and equity =
Debt £495.04 (476 x 1.04). Equity £500.40 (278p x 180m) Total debt and equity = £995.44m
WACC = (11.56 x 500.40 + 5.12 x 495.04)/995.44 = 8.35%
(b) Using the CAPM
Ke = 3 + 1.3 x 6 = 10.80%
WACC = (10.80 x 500.40 + 5.12 x 495.04)/995.44 = 7.98%
Responses to this part of the question were mixed. Many candidates did not consider whether their
answers were reasonable, for example using a cost of equity of 50% in their WACC computations. Also
many candidates made some very basic errors as follows:
When calculating the cost of equity using the dividend valuation model: when calculating the growth rate
from past dividends including the special dividend, also calculating to the 5 th root and not the 4th root;
incorrect calculations of the ex-div share price; incorrect calculations of the number of shares in issue.
When calculating the cost of debt: using the cum-interest price for the debentures; incorrect number of
years; using the total amount of debentures in issue for the capital flows and for the annual interest flows
using an individual debenture’s interest; not taking tax into account; incorrect interpolation.

When calculating the cost of equity using the CAPM many candidates deducted the risk free rate from the
market risk premium.
When calculating the WACC: using book values rather than market values.
In all calculations: not providing workings

2.2
Ungear existing activities 1.3 = Ba(1+50(1-0.17)/50) Ba = 0.71

New activity ungeared 1.1 = Ba(1+40(1-0.17)/60) Ba=0.71
So systematic business risk doesn’t change which may mean existing WACC calculated in 2.1 applies.
However, the use of WACC/NPV assumes that, over the life of the project the gearing ratio of Peel will
remain constant and that the project is marginal. Peel is considering financing a diversification that
represents 20% (200/995) of the company’s total market value of debt and equity, which can hardly be
considered to be marginal, by either debt or equity. As gearing is likely to change existing WACC cannot
be used. Finance is not project specific (eg cheap government loan) so that condition for using the existing
WACC is met.
Generally responses to this part of the question were disappointing with many candidates demonstrating
that they do not know the basic assumptions regarding the use of WACC. Hardly any candidates
mentioned that since the company is raising a large amount of capital by either debt or equity the gearing
might not remain constant and that, because of its size, the project cannot be considered to be marginal.
Most candidates centred their discussion of systematic risk, which they assumed would change. However
if some very basic calculations were carried out it could be seen that the systematic risk of the new project
was the same as existing projects.

2.3
Gearing (D/E by market values):
The current gearing ratio is 99% (495,04/500.40)
Gearing if the finance is raised with debt = 139% ((200+495.04)/500.40)
Gearing if the finance is raised with equity = 71% (495.04/(200+500.40))
(Note: Assuming no change in the share price as a result of the diversification. In the longer term a
positive NPV would affect the ratios calculated.)
Interest cover: best and worst case as PBIT varies.
Current:
2014 2017
£m £m
EBIT 78.86 94.04
Interest 33.32 33.32
Int cover 2.37 2.82
Interest cover if debt is raised:
Total interest will equal £45.32m (33.32 + 200 x 6%)

2014 2017
£m £m
EBIT 78.86 94.04
Interest 45.32 45.32
Int cover 1.74 2.08
[EPS (although not explicitly required students may also calculate and comment on EPS)
Current: 2014 37.8/180=21p

2017 50.4/180=28p
Equity: 2014 37.8/280=13.5p

2017 50.4/280=18p
Debt: 2014 (78.86-45.32)0.83/180=15.5p

2017 (94.04-45.32)0.83/180=22.5p]
The decision to raise the finance wholly by debt or equity will radically change Peel’s gearing ratio and
interest cover.
Interest Cover: Since 2013 Peel has been operating with an interest cover between the average of 2.4 and
maximum of 3 for the industry sector that it operates in. Currently Peel has an interest cover of 2.82, which
is near the maximum. Interest cover will be unchanged if Peel raises equity, however if debt is raised the
interest cover would have been 2.08, which is near to the minimum of 2 for the industry sector, also in
previous years interest cover would have been below the minimum.
Gearing ratio: Peel is currently operating with a gearing ratio of 99%, which is around the average for the
industry of 100%. If the company raises debt finance the gearing ratio will rise to 139%, which is above the
industry maximum of 135%, and if equity is raised the gearing ratio will fall to 71%, which is below the
industry minimum of 80%.
Given the above the likely reaction of the financial markets is likely to be unfavourable if Peel raises the
finance by an issue of debentures. The share price could fall and also the cost of debt increase.
Shareholders are also likely to be concerned if the finance is raised by debt and it is unlikely that they
would approve the diversification if it were financed in such a way.
On the other hand raising the finance by equity would make the company much safer in terms of financial
risk. However shareholders might be concerned about potential control issues unless the funds are raised
by way of a rights issue. Also the financial markets might consider that the company is not using spare
debt capacity.
Advice. Given the potential financial risks involved it would be prudent for Peel to raise the finance by an
issue of shares or a combination of debt and equity to keep gearing ratio and interest cover more in line
with the 2017 figures.
Responses to this part of the question were extremely disappointing despite an almost identical question
being asked in a recent past paper. The question gave industry gearing and interest cover figures so that
the candidates could perform analysis looking at current gearing and interest cover, and then gearing and
interest cover after raising the new finance by either debt or equity. Also five years’ historic information
was given to calculate interest cover figures. It was very disappointing that a large number of candidates
did not use this information or calculated the gearing in a different way to that specified or used book
values despite the question stating market values had been used. In addition many candidates did not
consider the likely reaction of the shareholders and markets to the finance being raised by either debt or
equity. Finally, a large number of candidates wasted time explaining the theories of M & M, theory was not
asked for in the question.


2.4
If the finance is raised by either debt or equity the gearing of Peel will radically change. In these
circumstances WACC/NPV is not a suitable investment appraisal technique to use. An alternative
technique would be Adjusted Present Value (APV), which assumes in the first that the project is financed
purely by equity. The resultant NPV of cash flows is then adjusted for the actual benefits and costs of the
actual finance used. A suitable all equity discount rate, which reflects the systematic risk of the project
would be:
Taking the beta equity of a company in the domestic appliance sector we calculate the asset beta and use
it in the CAPM (2.2 above)
The all equity discount rate using CAPM = 7.26% (3 + 0.71 x 6)
Responses to this part of the question were mixed, with many candidates identifying APV as an alternative
to WACC/NPV. However few candidates calculated the discount rate that should be used in APV. Again
this has been examined many times before.

2.5
Since dividends are rising and falling with profits it would appear that Peel has a policy of maintaining a
constant dividend payout ratio. The dividend payout ratios have been:
2013 2014 2015 2016 2017

£m £m £m £m £m
Profits after tax 39.60 37.80 45.00 43.20 50.40
Ordinary dividend 19.80 18.90 22.50 21.60 25.20
Payout ratio 50% 50% 50% 50% 50%
(Note: Candidates are not required to calculate the payout ratio for all years. However a clear identification
of 50% payout across the period given is required.)
A listed company seeks to give ordinary shareholders a constant dividend with some growth. This cannot
be achieved by have in a policy of maintaining a constant payout ratio since dividends rise and fall with
profits. Peels current dividend policy is not usually considered appropriate for a listed company and may
lead to a fluctuating share price (signalling effect).
understanding of dividend policy. Few candidates used the historic information to establish the company’s
current dividend policy. Many repeated theory, despite this not been required.


Question 3
Total Marks:
General comments
This was an eight-part question that tested the candidates’ understanding of the risk management element
of the syllabus. The scenario of the question was that you work for an investment company and you are
working on three specific tasks.
3.1 (a)

This is result in a sterling receipt of £6,386,716 ($8,000,000/$1.2526)
Over the counter option:

If the spot price on 31 March is $/£1.2700 Orion will exercise the options.
The sterling receipt will be ($8,000,000/$1.2400) - £161,600 = £6,290,013
included: using the incorrect spot rate; deducting the forward discount; not including interest on the option
premium, or including interest but taking a whole year; treating the OTC option as a traded option.

3.1 (b)
The forward contract locks Jewel into an exchange rate and does not allow for upside potential.
Forwards:
Tailored specifically for Jewel
However the options allow Jewel to exploit upside potential and protect downside risk.
Advice:
Without hedging the sterling receipt would have been £6,299,213 ($8,000,000/$1.2700)
The currency option results in a sterling receipt of £6,290,013, which is marginally worse than the spot rate
on 31 March 2018. However the forward contract results in a higher sterling receipt of £6,386,716.
It is recommended that a forward contract is used to hedge any unanticipated fall in the value of the $.

3.1 (c)
Futures are possibly not appropriate since they have the following disadvantages:
Basis risk exists
However there is a secondary market and if the client decides not to invest it would be possible to close
out the position, which could result in a gain or loss on the futures trade.


3.2 (a)
The value of one contract = 7,195 x £10 = £71,950
March contracts will be sold.
The number of contracts = £100,000,000 / £71,950 = 1,389.85. Round to 1390.
On 31 March the portfolio value will fall to:
£100,000,000 (7,010/7,261) = £96,543,176. A fall of £3,456,824.
Since there is a loss on the portfolio there will be a gain on the futures contracts.
The futures position will be closed out and the gain will =
(7,195-7,010) x £10 x 1390 = £2,571,500.
Responses to this part of the question were good however some candidates made some basic errors as
follows: incorrect calculation of the number of contracts and the value of one contract by using the current
index price and not the current futures price; incorrect computation of the loss on the portfolio; stating that
contracts should be initially bought not sold; incorrect computation of the gain on futures by using the
current index price and not the futures price

3.2 (b)
The hedge is not 100% efficient due to:

Basis risk i.e. the futures price at 30 November is not the same as the FTSE 100.
The rounding of the number of contracts.

3.3 (a)
First it is necessary to calculate the interest rate differentials:
Jewel Nevis Differentials

Fixed rates 6.5% 5.0% 1.5%
Floating rates LIBOR + 4% LIBOR + 3.5% 0.5%
Net differential 1.0%
This net differential will be shared 0.50% each
The interest rates that can be achieved through the swap are:
Jewel Nevis
Fixed market rate 6.5% ----
Floating market rate ---- LIBOR + 3.5%
Less the differential 0.5% 0.5%
Rates achieved through the swap 6.0% LIBOR + 3.0%
Cash flows would typically be: LIBOR from Nevis to Jewel and fixed of 2.0% from Jewel to Nevis.

Responses to this part of the question were good however many candidates did not read the question
when they demonstrated the cash flows that would typically occur when the swap was implemented.

3.3 (b)
Jewel is paying 4.36% (0.36 + 4) on its floating rate borrowings and would be paying a fixed rate of 6%
through the swap. The initial difference in interest rates is = 1.64% (6.00 – 4.36)
For the floating rate to equal the fixed rate of 6% achieved through the swap LIBOR would have to rise to
2% (1.64 + 0.36).
Responses to this part of the question were generally good.

3.3 (c)
The advantages to Jewel of an interest rate swap include:
 The arrangement costs are significantly less than terminating an existing loan and taking out a new
one.
 Interest rate savings are possible either out of the counterparty or out of the loan markets by using the
principle of comparative advantage.
 They are available for longer periods than the short-term methods of hedging such as FRAs, futures
and options.
 They are flexible since they can be arranged for tailor-made amounts and periods. Also they are
reversible.
 Obtaining the type of interest rate, fixed or floating, that the company wants.
 Swapping to a fixed interest rate for Jewel will assist in cash flow planning.


(2½ HOURS)
4. The examiner will take account of the way in which answers are structured. Do not
include anything which is not in direct response to the examination questions.
Your answers will be presented to the examiner as they appear on screen.

1. Assume that the current date is 31 March 2018
Wells Bakers plc (Wells) is a UK bakery firm that has been trading since 1983. It
manufactures and sells its own branded products to UK supermarkets and its financial year
end is 31 March.
Wells’ board is considering a change in the company’s strategy with the opening of a number
of retail bakery outlets across the UK. This would be a major investment for the company.
The £17 million required for this investment would be raised in such a way as not to alter the
company’s existing gearing ratio (equity:debt by market values). Wells’ bank, London &
Edinburgh plc (L&E), is aware of the company’s plans and has stated that it is prepared to
provide the debt element of the £17 million at an interest rate of 8.5% pa, with repayment due
in ten years’ time.
Wells has always used a discount rate of 7% when assessing potential investments. The
following comments made by directors regarding the planned £17 million investment were
recorded in the minutes of the board meeting held on 27 February 2018:
Phil Turner: “Let’s carry on using 7% as the discount rate. We’re being prudent here, as
7% represents the most costly source of finance that we have, i.e.
preference shares. At least that’s a fixed cost, unlike the ordinary shares.”
Alana Clarke: “I don’t think we can ignore the ordinary shares. Can’t we average out the
costs of the various types of capital and use that?”
Alison Hughes: “We should use 8.5% as our discount rate as that’s what L&E would
charge us for funding the retail expansion.”
The board wants to determine the appropriate discount rate to use when assessing the
investment in retail bakery outlets. You work in Wells’ finance team and are an ICAEW
Chartered Accountant. You have been asked to provide workings for the board to consider
when it meets next month. You have collected the following data as at 31 March 2018:
Balance Sheet extract Nominal value Market value

(£’000)
£1 ordinary shares (note 1) 6,600 £3.46/share cum-div
7% £1 preference shares 1,000 £1.35/share ex-div
6% Irredeemable debentures 1,200 £106% ex-int
4% Redeemable debentures (note 2) 1,800 £100% cum-int
Notes
(1) Wells will pay its ordinary dividend (£1.716 million) for the year to 31 March 2018 in
early April 2018. Its annual dividend has been growing steadily every year since April
2015, at which time the dividend totalled £1.570 million.
(2) The 4% debentures are redeemable at par in 2021.

CAPM data
Wells’ equity beta 1.25

Expected risk-free return 2.4% pa
Expected return on the market portfolio 10.8% pa
Average equity beta for bakery retailers 1.80
Ratio of long-term funds (equity:debt by market values) for bakery retailers 77:23
Two days ago, Alison Hughes sent you an email about Wells’ proposed investment. An
extract from her email is shown below:
Email extract
.....................The board has managed to keep our

expansion plans very quiet so far. Do be very
careful who you share this information with as the
proposals are likely to have an impact on the Wells
share price.....................
Requirements
1.1 Ignoring the investment in retail bakery outlets, calculate Wells’ weighted average cost
of capital (WACC) at 31 March 2018 using
(a) The dividend growth model and (14 marks)

(b) The CAPM (2 marks)
1.2 Discuss the points raised by the three directors at the 27 February 2018 board meeting.
(6 marks)
1.3 Calculate an appropriate WACC that Wells could use when appraising the £17 million
investment in retail bakery outlets and explain the reasoning behind your approach.
(10 marks)
1.4 Identify and explain the ethical implications of Alison Hughes’ email for you, as an
ICAEW Chartered Accountant. (3 marks)
Total 35 marks

2. Assume that the current date is 31 March 2018
Hunt Trading plc (Hunt) is a UK supplier of timber products. It imports timber in large
quantities and manufactures a range of products for sale to builders’ merchants and garden
centres in the UK. You work in Hunt’s finance team and have been asked to provide advice
on two issues.
2.1 Issue one: interest rate risk
The company has been very successful recently with demand for its products growing
steadily. At its March meeting, Hunt’s board identified a need for £4.5 million of short term
finance to fund additional machinery and increasing levels of working capital. A £4.5 million
bank loan would be required for a six-month period from 1 June 2018 until 30 November
2018. The board is concerned that the current cost of borrowing, 6.4% pa, will increase
before 1 June and would like to investigate how it might hedge this risk using either traded
sterling interest rate futures or over-the-counter (OTC) interest rate options.
You have collected the following information on 31 March 2018:
Traded sterling interest rate futures OTC interest rate options
June 3-month futures price = 93.2 Strike rate = 7.3% pa plus

a premium of 0.2% of the sum borrowed
Standard contact size = £500,000
Requirements
(a) Calculate the cost to Hunt of borrowing £4.5 million for six months if it uses traded
sterling interest rate futures to hedge its interest rate risk and if by 1 June 2018:
 Interest rates increase to 7.5% pa and the futures price moves to 92.2
 Interest rates increase to 8.0% pa and the futures price moves to 91.8
 Interest rates decrease to 5.5% pa and the futures price moves to 94.1 (8 marks)
(b) Calculate the cost to Hunt of borrowing £4.5 million for six months if it uses OTC interest
rate options to hedge its interest rate risk and if by 1 June 2018:
 Interest rates increase to 7.5% pa

 Interest rates increase to 8.0% pa
 Interest rates decrease to 5.5% pa (3 marks)
(c) Based on your calculations in (a) and (b) above, advise Hunt’s board as to the preferred
method of hedging its interest rate risk. (2 marks)

2.2 Issue two: foreign exchange rate risk
The majority of Hunt’s timber suppliers are based in Scotland and Wales. However, Hunt’s
board is concerned that those suppliers’ delivery lead times are lengthening as they struggle
to keep pace with increasing demand. The board has a contract with a Finnish supplier for a
very large consignment of timber costing €1.7 million. This is due to arrive at Hunt’s factory
on 31 May 2018, with payment due on 30 June 2018. There is concern amongst board
members that sterling might weaken against the euro before the end of June and they would
like to explore the implications of hedging the foreign exchange risk of the Finnish purchase.
You have been asked to advise Hunt’s board and have collected the following information at
the close of business on 31 March 2018:
Spot rate (€/£) 1.1764 – 1.1808

Three-month forward contract discount (€/£) 0.0059 – 0.0081
Arrangement fee for forward contract £4,600
Euro interest rate (lending) 8.0% pa
Euro interest rate (borrowing) 9.2% pa
Requirements
(a) Calculate Hunt’s sterling payment if it:
 Does not hedge the euro payment and sterling weakens by 5% by 30 June 2018.
 Uses a forward contract
 Uses a money market hedge (7 marks)
(b) With reference to your calculations in 2.2 part (a) above, advise Hunt’s board whether it
should hedge its euro payment. (7 marks)
(c) Identify the differences between traded currency options and OTC currency options.
(3 marks)
Total 30 marks

3. Bishop Homes Ltd (Bishop) is a UK property company that started trading in 2008. It has a
financial year-end of 31 March. Bishop builds low-cost houses for sale and for rent. It
currently owns and collects rent from 12,500 rental properties.
Bishop has the opportunity to invest in a new development of 500 identical low-energy
houses on one of its vacant sites called Garthwick. Once the land has been cleared then
Bishop will employ Piper Hardwick plc (Piper), a UK house-building firm, to construct the
houses over a two year period. You work in Bishop’s finance department and have been
asked to provide information on the viability of the Garthwick development for Bishop’s board.
You have been provided with the following details:
Land clearance
This will cost £1.4 million, payable on 31 March 2018.
Construction cost
The total contract price for the 500 houses is £57 million, which will be payable to Piper in
three equal annual instalments starting on 31 March 2018. Only the construction costs
relating to the houses for sale are an allowable expense for tax purposes. Those construction
costs are allowable for tax in the year of sale (see building schedule below).
Building schedule
Of the 500 houses built, 150 will be sold and 350 will be rented. Houses built for sale are sold
in the year of construction whereas houses built for rent are not rented out until the year after
construction.
Year to 31 March
2019 2020 2021
Houses constructed in year 250 250 0
Houses sold in year 75 75 0
Houses rented in year 0 175 350
Houses for rent

The rent per property will be £5,940 pa. Bishop estimates that bad debts amount to 1.5% of
rental income.
Houses for sale

The selling price of a house will be £340,000.
New staff
Bishop will need to employ two new full-time employees to manage the additional rented
houses in the year to 31 March 2020 and then two more employees will be employed in the
year to 31 March 2021. The average salary per employee will be £23,000 pa.
Other costs
In addition to the new employees, it is estimated that the new houses for rent will lead to an
increase in general costs equal to 3% of their rental income before bad debts.
New machinery

Bishop will need to purchase specialist equipment to check the low-energy specifications of
the new houses. This will be purchased on 31 March 2019 at a cost of £1.2 million. Because
this equipment has a high rate of obsolescence, Bishop estimates that it will be sold on
31 March 2021 for £100,000.
The equipment attracts 18% (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 equipment’s written down value for tax purposes and its
disposal proceeds will be treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value, or
Assumptions to be used in calculations

 Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will
be payable in the same year as the cash flows to which it relates.
 All income will be liable to corporation tax.
 Unless indicated otherwise, all costs will be allowable for corporation tax.
 Inflation can be ignored throughout.
 A suitable cost of capital is 6%.
 All cash flows occur at the end of the relevant financial year.
Investment appraisal
Bishop appraises its capital investments using the net present value approach. For new
developments Bishop discounts its future income and costs over a 20-year period.
6% annuity factors
Year 3 = 2.673
Year 17 = 10.477
Year 20 = 11.470
Requirements
3.1 Calculate the net present value of the Garthwick development at 31 March 2018 and
advise Bishop’s board whether the company should proceed with it. (18 marks)
3.2 Calculate the sensitivity of the decision in 3.1 above to changes in the selling price per
house sold and hence the minimum selling price per house sold that Bishop should
accept for the Garthwick development to proceed. (4 marks)
3.3 Determine the impact on your advice in 3.1 above if Piper offers to accept a revised
contract price of £54 million payable in full on 31 March 2018. (5 marks)
3.4 Compare the strengths and weaknesses of sensitivity analysis with those of simulation.
(4 marks)
3.5 Explain what is meant by the term ‘real options’ and identify two real options that could
apply to the Garthwick development. (4 marks)
Total 35 marks


Question 1
Total marks: 35
General comments
This question was generally answered well and a good majority of candidates achieved a “pass” standard.
This was a four-part question that tested the candidates’ understanding of the financing options element of
In the scenario a UK-listed bakery company was planning to open a number of retail outlets across the
UK. This investment would cost the company £17 million, which would be raised in such a way as to not
alter its existing gearing ratio. In part 1.1, for sixteen marks, candidates were required to calculate the
company’s current WACC from the information given, based on (1) the dividend growth model and (2) the
CAPM. Part 1.2 was worth six marks and required candidates to respond to recent comments made by
three of the company’s directors about the best discount rate to use when appraising the £17 million
investment. Part 1.3, for ten marks, tested the candidates’ understanding of (and the need for) de-gearing
and re-gearing beta within the CAPM calculation in the given scenario. Part 1.4 was worth three marks
and examined the Ethical Guide, with particular reference to the issue of confidentiality.
1.1(a)
Cost of equity (ke)
Dividend growth rate = £1.716m = 1.093 over 3 yrs so 1.0931/3-1 = 3% pa

£1.570m
Latest dividend (d0) = £1.716m £0.26

6.6m
Ex div market value per share = (£3.46 - £0.26) £3.20
Cost of equity (ke) (d1) +g (£0.26 x 1.03) + 3% 11.36%

MV (£3.20)
Cost of preference shares (k p) d £0.07 5.19%

MV £1.35
Cost of irredeemable debt (k di) (i-t) (£6 x 83%) 4.70%

MV £106

0 (96) 1.000 (96.000) 1.000 (96.000)
1-3 4 2,723 10.892 2.673 10.692
1000.864 86.400 0.840 84.000
NPV 1.292 NPV (1.308)
IRR = 5% + (1.292/(1.292 + 1.308)) = 5.50%
less: Tax at 17% (5.50% x 83%) = 4.57%

WACC
Total MV’s
£m £m Cost x weighting WACC
Equity (6.6m x £3.20) 21.120 11.36% x 21.120/25.470 9.42%
Pref. Shares (1m x £1.35) 1.350 5.19% x 1.35/25.470 0.28%
Irredeemable debt (£1.2m x 1.06) 1.272 4.70% x 1.272/25.470 0.23%
Redeemable debt (£1.8m x 0.96) 1.728 4.57% x 1.728/25.470 0.31%
4.350 0.82%
Total market value 25.470 10.24%
The majority of candidates did really well in part 1.1(a) and many scored full marks (14/14). Typical errors
made were (1) incorrect number of years used in the dividend growth calculation (2) not adjusting the
cum-div and cum-int market prices (3) forgetting the tax adjustment in the cost of debt and (4) not using
market values in the WACC calculation.

1.1(b)
Cost of equity (ke) using the CAPM
Expected market return 10.8%

less: Expected risk-free return (2.4%)
Expected risk premium 8.4%
Applying Wells’ beta to the risk premium 1.25 x 8.4% 10.5%

plus: Expected risk-free return 2.4%
Cost of equity (ke) 12.9%
WACC
Total MV’s
Equity (6.6m x £3.20) 21.120 12.90% x 21.120/25.470 10.70%
Pref. Shares (1m x £1.35) 1.350 5.19% x 1.35/25.470 0.28%
4.350 0.82%
Part 1.1(b) was, as expected, done well by most candidates.

1.2
Phil Turner – to use the cost of preference shares would be completely wrong. It’s only one element of the
firm’s total long-term finance and 7% is the coupon rate, not the current cost.
Alana Clarke and Alison Hughes – ordinary shares (cost of equity) should be taken into account. It would
make sense to use Wells’ current WACC figure for the investment appraisal if:
(1) the historical proportions of debt and equity are not to be changed
(2) the systematic business risk of the firm is not to be changed and
(3) the new finance is not project-specific.
Regarding the above, the bank borrowing will not change the gearing i.e. sufficient equity will be raised to
maintain the gearing at its current level. The systematic business risk of the firm is likely to change as it’s
moving into a different market. The finance is not project-specific e.g. cheap government loan.

Overall, candidates’ answers to part 1.2 were disappointing. The comments made were rather general and
so marks will have been lost. Too few scripts considered the conditions that need to apply for the current
WACC to be used, i.e. gearing % and systematic risk to remain unchanged and any new finance is not
project-specific.

1.3
New market ungeared beta = (1.80 x 77) (1.80 x 77) 1.44

(77 + (23 x 83%)) 96.09
Wells’ geared beta = 1.44 x (£21.12m + £1.35m + (£3m x 83%)) 1.70

£21.12m
So, cost of equity = (1.70 x (10.80% - 2.40%)) + 2.40 = 16.7%
Cost of debt = 8.5% x 83% 7.06%
WACC = (16.70% x £21.12m/25.47m) + (7.06% x £4.35m/£25.47m)) = 15.05%
It would be unwise to use the existing WACC as Wells’ plan involves diversification and therefore a
change in the level of systematic risk (beta rises from 1.25 to 1.70). Thus a new WACC must be
calculated. Systematic risk is accounted for by taking into account the beta of the retail bakery market and
this is then adjusted to eliminate the financial risk (level of gearing) in that market. The resultant ungeared
beta is then “re-geared” by taking into account the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased systematic risk discussed above)
is used.
It was good to see that the numerical and discursive elements of part 1.3 were both done well by a good
number of candidates. Where candidates scored badly, it was clear from their calculations that many did
not understand the logic of de-gearing and then re-gearing. Also many were unable to explain the theory
underpinning for those calculations. This is an area of the syllabus that has been examined regularly
recently.

1.4
You work for Wells and are party to confidential information which, if made public, could influence the
market price of Wells’ shares.
current or previous client’s or employer’s affairs, however gained, is confidential.
That information should then:
 Not be used to obtain personal advantage
Part 1.4 was, as expected, done well by most candidates.


Question 2
Total marks: 30
General comments
This question was had the highest percentage mark on the paper. A large majority of candidates reached
a “pass” standard in the question.
This was a six-part question which tested the candidates’ understanding of the risk management element
of the syllabus.
This question was based on a UK manufacturer of timber products. The first half of the scenario
considered the company’s need to borrow £4.5 million of short-term finance via a bank loan and its plan to
hedge the interest costs of that loan. In the second half of the question the company had agreed to
purchase €1.7 million of timber from a Finnish supplier. Candidates had to investigate the foreign
exchange risk implications of this contract for the company. In part 2.1(a) of the question, for eight marks,
candidates were required to calculate the cost to the company if it used traded sterling interest rate futures
to hedge its interest rate risk. Part 2.1(b), for three marks, required candidates to calculate the cost to the
company if it used OTC interest rate options to hedge the risk. Part 2.1(c) was worth two marks and asked
candidates to conclude, based on their calculations, which of the hedging methods should be chosen. Part
2.2(a) for seven marks asked candidates to calculate the (sterling equivalent) payment to the Finnish
supplier if (1) there was a weakening of sterling and (2) two hedging techniques were employed. In part
2.2(b), also for seven marks, candidates were required to advise the company’s board whether it should
hedge the euro payment. Finally, part 2.2(c), for three marks, asked candidates to identify the differences
between traded currency options and OTC currency options.
2.1
(a) Futures
Sell June futures
No of contracts: £4,500,000 x 6/3 = 18

£500,000
(a) (b) (c)

Interest rate 7.50% 8.00% 5.50%
Opening rate 93.2 93.2 93.2

Closing rate 92.2 91.8 94.1
Movement 1.0 1.4 (0.9)
P/L on futures 18 x £500,000 x 3/12 2,250,000 2,250,000 2,250,000

x x x
1.0% 1.4% (0.9%)
= = =
Profit/(Loss) on futures £22,500 £31,500 (£20,250)
Interest cost = £4.5m x 6/12 = £2,250,000 x 7.5% (£168,750)
8.0% (£180,000)
5.5% (£123,750)
Total cost (146,250) (148,500) (144,000)
(b) Options (a) (b) (c)

Interest rate 7.50% 8.00% 5.50%
Take up option Y Y N
Interest cost % 7.30% 7.30% 5.50%
Interest cost = £4.5m x 6/12 = £2,250,000 x 7.3% (£164,250)

7.3% (£164,250)
5.5% (£123,750)
Premium (£4,500,000 x 0.2%) (£9,000) (£9,000) (£9,000)
Total cost (£173,250) (£173,250) (£132,750)

(c) If interest rates increase then futures less costly than option.
If rates fall then option is lower cost.
For part 2.1 there were many very good answers with candidates demonstrating a thorough understanding
of the techniques involved. Those areas where candidates struggled were: (1) a failure to identify that the
company would sell interest rate futures (2) charging twelve months interest rather than six (3) using six
months, rather than three months, in the futures gain/loss calculation and (4) a failure to calculate the
option premium correctly (a very common error).

2.2(a)
(1) Sterling weakens by 5%
Spot rate = €1.1764 x 0.95 = €1.1176
€1,700,000/1.1176 (£1,521,144)
(2) Forward contract

€
Spot rate 1.1764
plus: Forward contract discount 0.0059
1.1823
£
(£1,700,000)/1.1823 (1,437,875)
plus: Arrangement fee (4,600)
(£1,442,475)
(3) Money Market Hedge
Lend euros now (€1,700,000) (€1,700,000) (€1,666,667)

1 + (8%/4) 1.02
Convert at spot rate €1,666,667 (£1,416,752)

1.1764
Sterling borrowed at 6.6% pa (£1,416,752) x [1 + (6.6%/4)] (£1,440,128)
Part 2.2 was, overall, done well. The calculations in part (a) were good, but typical errors included (1)
choosing the wrong exchange rate (2) strengthening rather than (as required) weakening sterling and (3)
subtracting the forward contract fee from the overall cost of the transaction.


2.2(b)
In summary
At spot rate (€1,700,000/ 1.1764) (£1,445,087)
Sterling weakens by 5% (£1,521,144)
Forward contract (£1,442,475)
MMH (£1,440,128)
The forward rate suggests that the euro will weaken (sterling will strengthen, rather than weaken by 5%)
over the next three months. This is good for UK importers such as Hunt, as supplies would get cheaper.
MMH gives the lowest price, based on these rates, but if sterling is likely to strengthen then perhaps don’t
hedge at all (but there are no guarantees).
General points about the various methods

Directors’ attitude to risk is important
Foreign exchange risk management is an area of the syllabus that is examined regularly and so
candidates’ answers to the discussion in part (b) were disappointing. There was a lack of depth to the
candidates’ conclusions and too many commented, erroneously, that a forward contract discount meant
that sterling would be weakening.

2.2(c)
OTC’s are, typically, purchased from a bank

OTC’s are tailor-made and so will lack negotiability
Traded options are for standardised amounts and can be traded and a profit/loss made
Traded options are not available in every currency
Part (c) was answered well.


Question 3
Total marks: 35
General comments
This question had the lowest average mark on the paper, but most candidates achieved a “pass” standard.
This was a five-part question that tested the candidates’ understanding of the investment decisions
The scenario here was based around a UK property company that builds low-cost houses for sale and for
rent. The company had the opportunity to invest in a new development of 500 identical low-energy houses
on one of its vacant sites. The company planned to use a house-building firm to construct the houses over
a two year period. Part 3.1 was worth 18 marks and required candidates to make use of the information
given and calculate the NPV of the proposed investment. Parts 3.2 and 3.3, for four marks and five marks
respectively, tested candidates’ proficiency with, and understanding of, sensitivity analysis. They were
required to make sensitivity calculations and then comment on them. Part 3.4 was worth four marks and
here candidates were asked to compare the strengths and weaknesses of sensitivity analysis with those of
simulation. In part 3.5, again for four marks, candidates had to explain the concept of real options and to
identify two real options that could apply to the development in question.
3.1
2018 2019 2020 2021 2022-38

Y0 Y1 Y2 Y3 Y4-20
£’000 £’000 £’000 £’000 £’000
Construction costs (19,000) (19,000) (19,000)
Land clearance (1,400)
Sales 25,500 25,500
Rental income (W1) 1,040 2,079 2,079
Bad debts (W1) (16) (31) (31)
New staff (46) (92) (92)
Extra costs (W1) (31) (62) (62)
Tax (W2) 238 (2,882) (3,042) (322) (322)
Green machine 0 (1,200) 100
Tax on machine (W3) 0 37 30 120
Total cash flows (20,162) 2,455 4,434 1,792
1,572
6% factors (W4) 1.000 0.943 0.890 0.840
8.801
PV (20,162) 2,316 3,947 1,504 13,831
NPV 1,436
The development produces a positive NPV and so should be accepted as it will enhance shareholder
wealth.
Workings
W1 Rental income (Y2) = 175 x £5,940 = £1,039,500

Bad debts (Y2) = 1.5% x £1,039,500 = £15,592
Extra costs (Y2) = 3% x £1,039,500 = £31,185
Rental income (Y3) = 350 x £5,940 = £2,079,000

Bad debts (Y3) = 1.5% x £2,079,000 = £31,185
Extra costs (Y3) = 3% x £2,079,000 = £62,370

W2 2018 2019 2020 2021 2022-38

Y0 Y1 Y2 Y3 Y4-20
£’000 £’000 £’000 £’000 £’000
Construction (75/500 x £57m) (8,550) (8,550)
Land clearance (1,400)
Sales 25,500 25,500
Rental income 1,040 2,079 2,079
Bad debts (16) (31) (31)
New staff (46) (92) (92)
Extra costs (31) (62) (62)
Taxable (loss)/profit (1,400) 16,950 17,897 1,894 1,894
Tax at 17% 238 (2,882) (3,042) (322) (322)
W3 2019 2020 2021

Y1 Y2 Y3
£’000 £’000 £’000
Green machine cost/WDV 1,200 984 807
WDA (18%)/Balancing allowance (216) (177) (707)
WDV/Sale price 984 807 100
Tax saving (17% x WDA) 37 30 120
W4
6% annuity factor for Y4-Y20 Y20 11.470 OR 10.477
Y4 (2.673) x 0.840
8.797 8.801
Part 3.1 was a difficult NPV calculation and so it was good to see that, overall, candidates did well here.
The main areas of difficulty were: (1) the tax calculation for the allowable building costs (2) the timing of
the cash flows and (3) the need to include cash flows (and then discount them) for Years 4 to 20.

3.2
Y1 Y2 Total
£’000 £’000 £’000
Sales 25,500 25,500
Tax (4,335) (4,335)
Total cash flows 21,165 21,165
6% factors 0.943 0.890
PV 19,967 18,837 38,804
Sensitivity 1,436 = 3.7%

38,804
Minimum selling price = (£340,000 – 3.7%) £327,420
Part 3.2 was also done well, but some candidates used the price per house figure rather than the total
sales figure and so will have lost marks.


3.3
Y0 Y1 Y2 Total
£’000 £’000 £’000 £’000
Incremental construction costs (35,000) 19,000 19,000
Tax on costs (£8.55m x 3/57 x 17%) (77) (76)
Total cash flows (35,000) 18,923 18,924
6% factors 1.000 0.943 0.890
PV (35,000) 17,844 16,842 (314)
The NPV would decrease by £314,000 and so it is less likely that Bishop’s board would proceed with the
development.
Part 3.3 was a more difficult proposition and candidates’ answers here were very variable. Those who
produced a set of calculations revised from part 3.1 scored well, but too many produced a discussion
rather than calculations.

3.4
Sensitivity analysis
It facilitates subjective judgment (by management for example)
It identifies areas that are critical to the success of a project, e.g. sales volume, materials price
It is relatively straightforward
But
It assumes that changes to variables can be made independently
It ignores probability
It does not point to a correct decision
Simulation
More than one variable at a time can be changed
It takes probabilities into account
But
It is not a technique for making a decision
It can be time consuming and expensive
Certain assumptions that need to be made could be unreliable
Part 3.4 was, overall, done well and a majority of candidates scored full marks.

3.5
NPV analysis only considers cash flows related directly to a project. A project with a negative NPV could
be accepted for strategic reasons. This is because of (real) options associated with a project that outweigh
the negative NPV.
With regard to the Garthwick development there could be (TWO only required):
Follow-on options – future development of mixed (rental/private) developments.
Growth options – Bishop could build a few properties and then build more later, if necessary.
Flexibility options – Bishop could sell some of its rented properties rather than rent them and vice versa.
Abandonment options – Bishop could sell all the properties and quit the development after two years.
Timing options – Bishop could delay the start of the clearance and development.
In part 3.5 most candidates were able to identify examples of real options from the scenario, but too few
explained the more general issue of real options, i.e. that of turning a negative NPV into a positive one.


WEDNESDAY 6 JUNE 2018
(2½ HOURS)
Marks breakdown
Question 1 35 marks
Question 2 35 marks
Question 3 30 marks
2. Please alert the invigilator immediately if you encounter any issues during the delivery
of the exam. The invigilator cannot advise you on how to use the software. If you
believe that your performance has been affected by any issues which occurred, you
must request and complete a candidate incident report form at the end of the exam; this
form must be submitted as part of any subsequent special consideration application.
5. The examiner will take account of the way in which answers are structured. Respond
directly to the exam question requirements. Do not include any content or opinion of a
personal nature. A student survey is provided post-exam for feedback purposes.
A Formulae Sheet and Discount Tables are provided with this exam.

Question 1
You work for Helvellyn Corporate Finance (HCF) and you are currently working on two tasks:
Task 1: Evans Stores Ltd (Evans) is an independent food retailer. Evans is considering an
initial public offering (IPO) of its ordinary shares on 30 June 2018 and you have been asked
to advise on a value for these shares.
Task 2: Huzzey plc (Huzzey) is a quoted conglomerate that is considering divesting itself of
one of its divisions. You have been asked to value the division.
1.1 Task 1: The Valuation of Evans’s ordinary shares
Extracts from Evans’s most recent management accounts are as follows:

Income statement Balance sheet
for the year ended as at 31 May 2018
31 May 2018
£’000 £’000
Non-current assets
Sales 280,000 53,000
Operating costs (270,000) Current assets 31,000
Depreciation (6,000) 84,000
Amortisation (500)
Profit before interest Share capital (£1 ordinary
3,500 shares) 3,000
Retained earnings
Interest (950) 12,000
Profit before tax 2,550 15,000
Taxation (at 17%) (434)
Long term loans 41,000
Profit after tax 2,116 Current liabilities 28,000
84,000
1. Evans’s current assets include cash balances and short-term investments, which total
£7 million.
2. The market value of Evans’s non-current assets at 31 May 2018 was estimated to be
£59 million.
3. Average multiples for a sample of listed companies in the same market sector as Evans
at 31 May 2018 are:
 Enterprise value 6.5

 Price earnings (P/E) ratio 12.1

Requirements
(a) Calculate the value of one Evans ordinary share at 31 May 2018 based on each of the
following methods:
 Enterprise value
 P/E ratio
 Net assets basis (historic)
 Net assets basis (re-valued) (8 marks)
(b) Recommend and justify to the board of Evans an issue price per share on 30 June 2018
for the company’s ordinary shares. Refer to the range of values calculated in part (a)
above. (4 marks)
(c) Discuss whether Shareholder Value Analysis (SVA) might be a useful additional method,
to those in part (a) above, of valuing Evans’s ordinary shares. (3 marks)
1.2 Task 2: The Divestment of the Huzzey division
Assume that the current date is 30 June 2018
At a recent board meeting of Huzzey it was decided that the company should divest itself of
its paint-manufacturing subsidiary, Supercover Ltd (Supercover). The board discussed the
following three proposed ways of carrying out the divestment:
 Proposal 1. To reduce Supercover’s operations over a period of three years and then
close it down.
 Proposal 2. To sell Supercover to another company.
 Proposal 3. To sell Supercover to a team made up of its current management.
It was decided at the board meeting that one of the criteria for choosing the best method of
divestment would be the present value of the cash flows associated with each proposal.
A suitable discount rate to assess the present value of the cash flows of all three proposals is
10%.
You should assume that corporation tax will be payable at the rate of 17% for the foreseeable
future and tax will be payable in the same year as the cash flows to which it relates.
Financial information for each proposal is as follows:
Proposal 1:
 Sales revenue for the year to 30 June 2018 was £25 million. For the three years to
30 June 2021 sales volumes are expected to decrease by 10% pa compound. Selling
prices will not change and contribution is expected to be 60% of the selling price.

 The amount invested in working capital on 30 June 2018 was £2 million. This amount will
reduce at the end of each year in line with the reduction in sales volumes. On 30 June
2021 all remaining working capital will be recovered in full.
 On 30 June 2018 Supercover’s plant and equipment has a tax written down value of
£3 million.
 On 30 June 2021 Supercover’s plant and equipment will be sold for an estimated
£9 million (at 30 June 2021 prices).
 The plant and equipment attracts 18% (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 plant and equipment’s written
either as a:
value, or
 Redundancy payments on 30 June 2021 will amount to £0.50 million (at 30 June 2021
prices). This amount is fully allowable for tax.
Proposal 2:
All the shares in Supercover will be sold for £38 million before taxation on 30 June 2018.
Assume that this amount is fully taxable.
Proposal 3:
The management team will buy the shares of Supercover for £41 million. The £41 million will
be received in three instalments as follows:
 On 30 June 2018 £15 million

 On 30 June 2019 £13 million
 On 30 June 2020 £13 million.
Assume that all these instalments are fully taxable in the year that they are received.
Requirements
(a) Calculate the present value at 30 June 2018 of each of the three proposed ways in
which Huzzey could divest itself of Supercover. (10 marks)
(b) Identify one advantage and one disadvantage for each of the three divestment
proposals. (6 marks)
(c) Advise the board of Huzzey as to which of the three divestment proposals should be
chosen. (4 marks)
Total 35 marks

Question 2
Mitchells is a firm of ICAEW Chartered Accountants. Mitchells has been asked to advise a
listed client, Blackstar plc (Blackstar), on the following two issues:
Issue 1: Blackstar intends to raise additional funds of £150 million to fund an expansion of
its existing operations.
Issue 2: Blackstar is concerned about its existing dividend policy.
2.1 Issue 1: Raising additional funds of £150 million
Blackstar has always maintained a policy of no gearing. Other companies in Blackstar’s

market sector have average gearing ratios (measured as debt/equity by market values) of
25%, with a maximum of 35%, and an average interest cover of 8 times, with a minimum of 6.
The finance director of Blackstar is considering raising the £150 million by either a rights
issue or by the company now borrowing and issuing debentures.
The details of the alternative sources of finance are as follows:
Rights Issue: The £150 million would be raised by a 2 for 3 rights issue, priced at a discount
on the current market value of Blackstar’s ordinary shares.
Debt issue: The £150 million would be raised by an issue of 6% coupon debentures,
redeemable at par on 30 June 2025. The gross redemption yield would be based on the
current gross redemption yield of other debentures issued by companies in Blackstar’s
market sector. One such company is Blue plc (Blue). Details for Blue’s debentures are as
follows:
 Coupon 5%
 The current market price on 30 June 2018 is £109 cum interest
 Redemption at par on 30 June 2023
Further information regarding Blackstar:
 The forecast pre-tax operating profit for the year ending 30 June 2018 is £50 million
 The corporation tax rate is 17%
 The current share price at 30 June 2018 is £7.50 ex-div
 The number of ordinary shares in issue is 60 million

Requirements
(a) Assuming a 2 for 3 rights issue is made on 1 July 2018:
 calculate the discount the rights price represents on Blackstar’s current share price
 calculate the theoretical ex-rights price per share
 discuss whether the actual share price is likely to be equal to the theoretical ex-
rights price. (5 marks)
(b) Alternatively, assuming debt is issued on 1 July 2018:
 calculate the issue price per debenture and total nominal value of the debentures
that will have to be issued to give a yield to redemption equal to that of Blue’s
debentures
 discuss the validity of using the yield to redemption of Blue’s debentures in the
above calculation. (7 marks)
(c) Advise Blackstar’s finance director of the advantages and disadvantages of raising the
£150 million by debt or equity or a combination of the two.
You should also discuss the likely reaction of Blackstar’s shareholders and the stock
market (you should refer to the gearing and interest cover information provided).
(12 marks)
2.2 Issue 2: Blackstar’s dividend policy
Blackstar is reviewing its dividend policy, which has been to maintain a constant payout ratio
of 30% of profits after tax. The following views were expressed by two directors at the most
recent board meeting:
Director A: “We should have a constant dividend growth policy with some growth irrespective
of whether profits after tax rise or fall. If we have surplus cash after reinvestment we can
leave it in the bank.”
Director B: “I agree with Director A, but instead of leaving surplus cash in the bank we can
pay a special dividend or repurchase some shares.”
Requirements
(a) Describe what is meant by:
 a special dividend
 a share repurchase
(b) Discuss whether Blackstar’s current dividend policy is appropriate for a listed company
and critically evaluate the alternatives suggested by Directors A and B. (4 marks)

2.3 Mitchells is also advising Goldwing plc, which is considering making a takeover bid for
Blackstar.
Requirement
Identify the ethical issues for Mitchells regarding giving advice to both Goldwing plc and
Blackstar. Also advise Mitchells on what safeguards might be put in place.
(3 marks)
Total 35 marks

Question 3

Tarbena plc (Tarbena) is a UK company that has a subsidiary company in Germany and also
has customers and suppliers in the USA.
At a recent board meeting of Tarbena there was a discussion about the company’s exposure
to foreign exchange rate risk (forex). In particular the following points were discussed:
 how the company’s dollar receipts and payments are hedged

 the role that interest rate parity and purchasing power parity play in relation to forex
 the likely effect on the company’s share price if it shows exchange rate losses when
translating the German subsidiary’s financial statements into sterling.
It was decided at the meeting that the finance director would make a presentation to the
board and he has asked you to prepare some notes for his presentation, including numerical
examples where appropriate.
You have the following information available to you at the close of business on
30 June 2018:
Receipts and payments
Receipts due from customers on 30 September 2018 are $6,000,000.
Payments due to suppliers on 30 September 2018 are

$10,000,000.
Exchange rates
Spot rate ($/£) 1.3078 – 1.3080

Three month forward discount ($/£) 0.0088 – 0.0092
September currency futures price
Standard contract size £62,500 $1.3096/£
Over-the-counter (OTC) currency options
September put options to sell $ are available with an exercise price of $1.3190 The premium
is £0.03 per $ and is payable on 30 June 2018.
September call options to buy $ are available with an exercise price of $1.3170. The premium
Dollar 6.00 – 5.80
Tarbena currently has an overdraft.

Requirements
Prepare notes for the finance director of Tarbena, which should include:
3.1 A calculation of Tarbena’s net sterling payment if it uses the following to hedge its forex:
(b) currency futures
(c) an OTC currency option
assuming that the spot rate on 30 September 2018 will be $/£1.3167 – 1.3175 and the
September futures price will be $/£1.3171. (12 marks)
3.2 A discussion of the advantages and disadvantages of the three hedging techniques
used in 3.1 above and, using your results from 3.1 above, advice on which hedging
technique is the most advantageous for Tarbena. (7 marks)
3.3 An explanation of interest rate parity together with calculations which show why the
forward rate is at a discount to the spot rate on 30 June 2018. (5 marks)
3.4 An explanation, without calculations, of purchasing power parity. (3 marks)
3.5 The likely effect on Tarbena’s share price if there are exchange rate losses when
translating the German subsidiary’s financial statements into sterling. (3 marks)
Total 30 marks

Professional Level – Financial Management – June 2018
Question 1
Total Marks:
General comments
The scenario of the question was that you work for a firm of corporate financiers and you are working on
two tasks:
Task 1 The valuation of a company that is considering an IPO.

Task 2 A quoted conglomerate is considering divesting itself of one of its subsidiaries.
1.1 (a)
Enterprise Value
EBITDA = £10,000 (3,500 + 6,000 + 500)

Enterprise value = £65,000 (10,000 x 6.5)
Net Debt = £34,000 (41,000 - 7,000)
The total value of equity = £31,000 (65,000 - 34,000)
The value of one share = £10.33 (31,000/3,000)
Price earnings ratio
EPS = 70.53p (2116/3000)

The value of one share = £8.53 (70.53 x 12.1)
Net assets (historic)
The value of one share = £5 (15,000/3000)
Net assets (re-valued)
The value of one share = £7 ((15,000 + 59,000 - 53,000)/3,000)
Well answered by many candidates, however the following were common errors: For enterprise value:
incorrect EBITDA; no deduction of debt and addition of cash to arrive at the value of the shares; using the
incorrect multiple; calculating a negative share price and making no comment that this is not possible. For
P/E ratio: using profits before tax. For net assets (historic): using gross assets; using gross assets and
only deducting long-term debt. For net assets basis (re-valued): many candidates re-valued the non-
current assets and then made the same errors as for the net assets (historic) computations.
Overall a large number of candidates reduced their valuations to take into account non-marketability.
Since this is an IPO such adjustments were not necessary.


1.1 (b)
The range of values is from £5 to £10.33.

It is unlikely that the board of Evans would be happy with an issue price based on net assets, either
historic or re-valued. The major problem with asset valuations is that they do not reflect the earning
capacity of the assets. The board is more likely to be happy with an issue price based on income, either
p/e ratio or enterprise value, which range from £8.53 to £10.33.
So an issue price in this range is likely to be acceptable.
I would suggest an issue price of £10 per share. (Candidates may suggest a different price, any
supported price given marks)
Responses to this part of the question were mixed. Many candidates only referred to their range of values
and did not recommend an issue price. The justification of the price was quite poor.

1.1 (c)
SVA would be a useful additional valuation methodology since it is based on the future free cash flows that
the company generates. The free cash flows are forecasted using seven value drivers (sales growth;
operating profit margin; tax rate; investment in non-current assets; cost of capital; life of cash flows). The
cash flows will be forecast over a planning horizon, typically 3 to 5 years, and then a terminal value
calculated.
However problems with this technique include: estimating the inputs into the model; estimating growth; the
length of the planning horizon; the terminal value dominates the valuation.
Responses to this part of the question were good. However poorer candidates only stated what the seven
value drivers in SVA are with no further explanation of the methodology.

1.2 (a)
Proposal 1
2019 2020 2021

£ millions £ millions £ millions
Sales 22.50 20.25 18.23

Contribution 13.50 12.15 10.94
Redundancy (0.50)
Pre-tax 10.44
Tax @ 17% (2.30) (2.07) (1.78)
Working capital 0.20 0.18 1.62
Plant and equipment 9.00
WDAs 0.09 0.08 (1.19)
Total 11.49 10.34 18.09
Factors @ 10% 0.909 0.826 0.751
Present value 10.44 8.54 13.59
Total present value = £32.57 million
Working capital
2019 2 x 0.10 = 0.20

2020 1.8 x 0.10 = 0.18
2121 1.62

WDAs
3000
(540)@17%=0.09
2460
(443)@17%=0.08
2017
9000
6983@17%=(1.19)
Proposal 2
Sale proceeds net of tax = £31.54 million (38 x (1-0.17))
Proposal 3
The present value of the payments = 15 + 13/(1.1) + 13/(1.1)2 = £37.56 million
After tax = £31.18 million (37.56 x (1-0.17)
Responses to this part of the question were generally good. However a large number of candidates
attempted to calculate the Net Present Values and not the Present Values of each of the proposed
divestment methods.

1.2 (b)
Winding down operations

Advantages include: Keeping control; should the company decide to keep Supercover in business it can
do.
Disadvantages include: Estimates of sales and resale values; The operations may take longer than three
years to wind down.
Selling to another company

Advantages include: Being paid upfront; no long term involvement.
Disadvantages include: Finding a buyer; the buyer may wish to buy Supercover for a cheaper price.
MBO
The main advantage is that Huzzey has a buyer.
The disadvantage is that the sale proceeds are to be paid over two years. If Supercover goes into
liquidation or has cash flow difficulties the full sale proceeds may not be received.
Responses to this part of the question were mixed with candidates often struggling to state sensible
advantages and disadvantages.

1.2 (c)
The present values are:
Winding down operations £32.57 million

Selling to another company £31.54 million
MBO £31.18 million
To maximise shareholder wealth Huzzey should wind down operations since it produces the highest
present value. However the present value relies upon a number of assumptions about sales volume, the
release of working capital and the proceeds of selling plant and equipment. The present value is not
sufficiently high to choose it over the other two proposals as the figures are pretty similar.

In present value terms there is little to choose between selling to another company or an MBO. Since it
might be difficult to find a buyer for Supercover the preferred proposal would be for the current
management team of the company to buy it.
(Marks awarded for other conclusions as long as they are supported)
Responses to this part of the question were mixed; many candidates simply picked the highest present
value with little other consideration


Question 2
Total Marks:
General comments
the syllabus.
The scenario of the questions is that you work for a firm of ICAEW Chartered Accountants and you are
giving advice to a listed client on two issues:
Issue 1 Whether to raise additional funding by debt or equity.

Issue 2 A review of dividend policy and also an ethical situation.
2.1 (a)
The number of new shares to be issued = 40 million (60 x 2/3)
The price per share = £3.75 (150/40)
This represents a discount on the current share price of 50% or £3.75. (3.75/7.50)
The theoretical ex rights price is:
Number of shares Value per share £ Number x value £

Existing shares 3 7.50 22.50
New shares 2 3.75 7.50
Total shares 5 Total value 30.00

The theoretical ex rights price = £6.00 (30/5)
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. The net present value of the
projects could be incorporated in the theoretical ex-rights price of £6.00 giving a more realistic estimate of
the actual share price post rights issue.
Responses to this part of the question were quite good with many candidates scoring full marks. However
weaker candidates made some of the following mistakes: confusing a 2 for 3 rights issue for a 3 for 2
rights issue; not calculating the discount the rights issues represented on the current share price;
inadequate discussions on whether the actual share price is likely to be equal to the theoretical ex-rights
price.

2.1 (b)
The yield to maturity of Blue’s debentures is:
The ex interest price of Blue’s debentures is £104 (109 – 5)
Timing Cash Flow Factors @ PV £ Factors @ PV £

years 1% 5%
0 (104) (104) (104)
1-5 5 4.853 24.27 4.329 21.65
5 100 0.951 95.10 0.784 78.40
15.37 (3.95)
IRR (Yield to maturity) = 1 + (15.37/(15.37+3.95)) x 4 = 4.18% Say 4%

The issue price of Blackstar’s debentures will be:
The annuity factor for seven years (2018 to 2025) = (1 – (1.04)-7)/0.04 = 6.002
The seven year present value factor at 4% = 1/(1.04)7 = 0.760
The issue price = 6 x 6.002 + 100 x 0.760 = £112.01
The total nominal value of the debentures to be issued = 150/1.1201 = £133.91 million. Say £134 million.
Blackstar and Blue are in the same industry sector so it is reasonable to assume that the yield to
redemption of 4% is acceptable. However the financial risk of Blue might be different to Blackstar and this
should be reflected in the yield to redemption.
Also Blue’s debentures mature in five years and Blackstar’s debentures mature in seven years. It is likely
that investors in Blackstar’s debentures would require a higher yield to redemption than 4%.
Generally responses to this part of the question were disappointing, however there were some excellent
responses. Poorer candidates made some of the following mistakes: using the new debt issues terms to
calculate the YTM rather than Blue’s; using the cum interest debenture price in YTM computations;
deducting tax from the YTM when calculating the issue price for the new debenture issue; when
interpolating arriving at two negative NPVs by discounting at 5% and 10%, then arriving at a YTM of more
than 5%; incorrect calculations when calculating the nominal value of the new issue.

2.1 (c)
The gearing and interest cover ratios of Blackstar immediately after the debenture issue will be as follows:
Interest cover: Interest 134 x 6% = £8.04 m. Interest cover = 50.00/8.04 = 6.21 times
Gearing by market values assuming the current market price per share:
Market captialisation 60 x 7.5 = £450 m. Gearing (D/E) 150/450 = 33%
Current EPS 69.2p (50(1-0.17)/60)

EPS with a rights issue 41.5p (50(1-0.17)/100m)
EPS with a debenture issues 58p (50-8.04)(1-0.17)/60m
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.
Analysis:
The company will have a gearing ratio of 33% and an interest cover of 6.21 times. Gearing is between the
industry maximum and average of 35% and 25% respectively, but near to the maximum; interest cover is
between the industry minimum and average of 6 and 8 respectively, but near to the minimum.
Since this is the first time that Blackstar 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 Blackstar because currently it has no gearing. However if the £150 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 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 £150 million, perhaps this could be achieved by revising its 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 despite an almost identical questions
being asked in a recent past papers. The question gave industry gearing and interest cover figures so that
the candidates could perform analysis looking at the gearing and interest cover should the company
decide to borrow. It was very disappointing that a large number of candidates did not use this information
or calculated gearing in a different way to that specified. In addition many candidates did not consider the
likely reaction of the shareholders and markets to the finance being raised by either debt or equity.
Finally, a large number of candidates wasted time explaining the theories of M & M, theory was not asked
for in the question.

2.2 (a)
A special dividend is a “one off” dividend payment in addition to the ordinary dividend.
A share repurchase is an alternative to dividend payments. Instead of paying dividends a company may
consider using the cash to repurchase issued shares.
Responses to this part of the question were mixed, with a surprising number of candidates not knowing
what a special dividend is. Also the explanations of a share repurchase were poor. However there were
some excellent responses.

2.2 (b)
Blackstar’s current dividend policy is unlikely to be appropriate for a listed company since dividends will
rise and fall with profits and may cause signalling issues.
It is more usual for a listed company to pay a constant dividend with some growth. So both directors A and
B are correct in stating that Blackstar should do this. However shareholders are unlikely to be happy with
the company leaving surplus cash in the bank where returns will be lower than the company’s cost of
capital. Surplus cash should be returned to shareholders in the form of a special dividend or share
repurchase.
understanding of dividend policy. Many candidates did not identify that the policy of maintaining a constant
payout ratio means that dividends will rise and fall with profits. Also comments on the views of the two
directors were often confused and hard to follow. However, again, there were some excellent responses.


2.3
Professional accountants in public practice should be aware of the danger of a conflict in interest.
In its dealings with Goldwing and Blackstar Evans could implement the following safeguards:
 Use different partners and teams for the two clients.

 Take all steps to ensure that there is no leakage of confidential information between the two teams.
 Ensure that there is a regular review of the situation by a senior partner or compliance officer who is
not personally involved with either client.
 Advise the clients to seek additional independent advice where appropriate.
Candidates might mention the following principles: Integrity; Objectivity; Confidentiality;
This part of the question was well answered however a large number of candidates did not recognise that
there was a conflict of interest for Mitchells.


Question 3
Total Marks:
General comments
This was a five part question that tested the candidates’ understanding of the
The scenario of the questions is that at a recent board meeting of a company the subject of its forex was
discussed. As a result there are some points that the board would like clarification on.
3.1
The net payment = $4,000,000 (10,000,000 – 6,000,000)

This is result in a sterling payment of £3,038,129 ($4,000,000/$1.3166)
Tarbena should sell Sept sterling futures (i.e. to buy $ with £).
The number of contracts to sell is: ($4,000,000/$1.3096)/£62,500 = 48.87 contracts. Round
to 49 contracts. Slightly over hedged. (Full marks given if 48 contracts used.)
On 30 September the futures will be closed out and bought at $1.3171. This will result in a loss of:
($1.3096-$1.3171) x (£62,500 x 49) = $(22,969)

Dollars will be purchased on the spot market and the total payment will be:
($4,000,000+$22,969)/$1.3167 = $3,055,342
Over the counter option, call options to buy $ will be used:

If the spot price on 30 September is $/£1.3167 Tarbina will exercise the options.
The sterling payment will be ($4,000,000/$1.3170) + £161,312 = £3,198,518
included: using the incorrect spot rate; deducting the forward discount; incorrect computation for the
number of futures contracts; making the incorrect decision of whether to sell or buy futures; assuming that
the futures loss was in £; choosing the put option and not the call option; not including interest on the
option premium, or including interest but taking a whole year; treating the OTC option as a traded option;
not netting receipts and payments and presenting calculation on both transactions.

3.2
The forward contract and futures contracts both lock Tarbena into an exchange rate and do not allow for
upside potential.
Forwards:
Tailored specifically for Tarbena
Currency futures:


However the options allow Tarbena to exploit upside potential and protect downside risk
Advice:
Without hedging the sterling payment would be £3,037,898 (4,000,000/1.3167)
The OTC option results in a higher payment of £3,198,518.
Both the forwards and futures result in a lower sterling payment of £3,038,129 and £3,055,342, which are
not materially different.
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.
Candidates may also mention Taberna’s attitude to risk.

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.
Middle rates:
Spot $/£1.3079 ((1.2078+1.3080)/2)
Interest rates: $ 5.9% ((6 + 5.8)/2); £ 3.13% ((3.28 + 2.98)/2)
The forward rate = $1.3079 x (1 + 0.059 x 4/12)/(1 + 0.0313 x 4/12) = $ 1.3169

Because the dollar is depreciating against sterling it is at a discount.
The discount is $0.0090 (1.3079-1.3169). The spread increase or decrease this, in this case
$/£ 0.0088 – 0.0092
Responses to this part of the question were mixed with some good explanations of interest rate parity.
However many candidates did not perform computations or their computations were incomplete.

3.4
Purchasing power parity (PPP) is the theory that in the long-term exchange rates between currencies will
tend to reflect the relative purchasing power of the currency of each country.
The theory is based on the idea that a basket of goods in one country will, after the effect of the exchange
rate, cost the same no matter where it is traded. It is sometimes called the law of one price.
The impact of different inflation rates in different countries will cause prices to change at different speeds.
So even if parity is achieved disequilibrium will be created. PPP predicts that the disequilibrium will be
remover by changes in the exchange rate.
Responses to this part of the question were poor with many candidates displaying no knowledge of what
purchasing power parity is.


3.5
There are opposing arguments as to whether translation exposure is important. The arguments centre on
whether the reporting of a translation loss will affect the company’s share price.
There is an argument that, to the extent that cash flows are not affected, translation exposure can be
ignored. Therefore there will be no affect on Tarbena’s share price.
On the other hand, those who believe that accounting results are an important determinant of the share
price argue that translation losses should be reduced to a minimum. Therefore
showing translation losses could reduce Tarbena’s share price.
Responses to this part of the question were poor and displayed no knowledge of what translation
exposure is or the likely effects are.


WEDNESDAY 12 SEPTEMBER 2018
(2½ HOURS)
Marks breakdown
Question 1 35 marks
Question 2 35 marks
Question 3 30 marks
2. The invigilator cannot advise you on how to use the software, but please alert them
immediately if you encounter any issues during the delivery of the exam. If you believe
that your performance has been affected by any issues which occurred, you must
request and complete a candidate incident report form at the end of the exam. This form
must be submitted as part of any subsequent special consideration application.

Question 1
Assume that the current date is 31 August 2018
The Thomas Rumsey Group plc (Rumsey) is a UK company which was founded in 2001 and
has a financial year end of 31 August. Rumsey manufactures computer hardware and also
supplies information technology (IT) support services. Since its formation the group has
expanded via organic growth and the acquisition of other companies.
Snowdog Printers Ltd (Snowdog) is a UK company that manufactures computer printers.

Rumsey has owned 100% of Snowdog’s ordinary shares since 2009.
Snowdog’s sales and profits have fallen in each of the last two years. Rumsey’s board met in
July 2018 and decided to wind down Snowdog’s operations and that Snowdog will cease
trading in three years’ time, on 31 August 2021.
Following the July 2018 meeting, Snowdog’s directors informed the Rumsey board that they
would like to investigate a management buy-out (MBO) of 100% of Snowdog’s share capital.
You are an ICAEW Chartered Accountant and you work in Rumsey’s finance team. You have
been asked to provide guidance on the MBO for Rumsey’s board.
The Snowdog MBO was discussed at the Rumsey board meeting on 15 August 2018. Three
key issues discussed at that meeting are summarised below:
 It was agreed that the buy-out price for Snowdog would be its economic value to Rumsey,
assuming that it remained in the group until 31 August 2021. The economic value would
be the expected net present value of Snowdog’s projected cash flows over the next three
years, discounted at Rumsey’s WACC. The forecast data for this calculation is shown
below.
 One of Rumsey’s directors asked “Couldn’t we add a premium to the MBO price? The
cash flows are only estimates after all. I’m sure that we could inflate the cash inflows or
alter the WACC figure in our favour. Snowdog’s directors would be unaware of this and
they seem very keen to buy the company.”
 Another director asked whether Shareholder Value Analysis (SVA) could be used as an
alternative to the expected NPV to calculate the value of Snowdog.
Forecast data
(1) Sales in the year to 31 August 2020 will be dependent on the level of sales in the year
to 31 August 2019 as shown in the table below:
y/e August 2019 y/e 31 August 2020

Sales (£m) Probability Sales (£m) Probability
5.0 0.6
7.0 0.7
4.0 0.4
4.0 0.4
4.5 0.3
3.0 0.6
Sales in the year to 31 August 2021 will be £2.5 million. The expected value of annual
sales is to be used in the NPV calculation.

(2) Variable costs will be 30% of sales.
(3) Fixed costs (including depreciation of £600,000 pa) will be £1.7 million pa.
(4) Closure costs on 31 August 2021 will be £600,000.
(5) All of the figures in (1) – (4) above are in 31 August 2018 prices. The inflation rate for
sales and costs is 2% pa.
(6) The tax written down value at 31 August 2018 of Snowdog’s plant and machinery is
£3.3 million. It is estimated that this will have a scrap value of £1.5 million (in 31 August
2021 prices) on 31 August 2021. The plant and machinery attracts 18% (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 equipment’s written down value for tax purposes and its disposal proceeds
will be treated by the company either as:
a balancing allowance, if the disposal proceeds are less than the tax written down
value, or
a balancing charge, if the disposal proceeds are more than the tax written down
value.
(7) Snowdog’s working capital on 31 August 2018 totalled £1.8 million. It is planned to
reduce this by £0.2 million on 31 August 2019 and £0.3 million on 31 August 2020. The
outstanding balance will be released on 31 August 2021. All working capital figures are
given in money terms.
Other information
Rumsey’s money WACC is 11% pa.
Requirements
1.1 Calculate the expected NPV of Snowdog’s money cash flows at 31 August 2018.
(18 marks)
1.2 Calculate the effect on this expected NPV if the scrap value of Snowdog’s plant and
machinery on 31 August 2021 is £1 million. (4 marks)
1.3 Comment on the ethical implications for you as an ICAEW Chartered Accountant of the
Rumsey director’s suggestion regarding the MBO premium. (3 marks)
1.4 Explain what is meant by the term ‘real options’ and identify for Rumsey’s board two
real options that could apply to Snowdog as alternatives to the MBO. (5 marks)
1.5 Outline the Shareholder Value Analysis (SVA) approach to company valuation,
identifying its advantages and disadvantages. (5 marks)
Total: 35 marks

Question 2
Assume that the current date is 1 September 2018
Heath Care plc (Heath) is a listed UK company that sells baby products. The company was
founded in 1995 and it has a financial year end of 31 August.
All of Heath’s customers are based in the UK. They order goods online and these are then
delivered by a national courier company from Heath’s central warehouse. Despite not having
any physical shops, Heath was initially very successful. However, in the past two years the
market for baby products has become much more competitive and the company’s market
share has fallen as a result. This has led to a 15% decline in the price of its ordinary shares.
You work in Heath’s finance team and have been asked to provide guidance for the
company’s board following its most recent meeting. At that meeting the following suggestions
were made by two of Heath’s directors:
Janine Barrowland – “We could establish a number of Heath shops across the UK. This
would give more visibility to our brand. I estimate it would cost us £10 million for ten
shops. I can see from the management accounts that we’ve not got sufficient cash to
make that sort of investment, but I see no reason why we shouldn’t borrow the £10
million. Interest rates are still very low and we could probably borrow it from our bank at
a maximum cost of 4% pa. Our WACC wouldn’t alter by much, which would make any
investment decision very straightforward.”
Chris Sinnott – “Why not invest in a completely different type of business? We know that
people in the UK are living longer and I know of an established care home business that
is for sale and it may well be a good investment for us.
There’s a steady net cash inflow and we’d own a number of valuable properties. Yes, it’s
risky, but diversification like this would be good for our investors as we’d be making
positive use of the portfolio effect.”
An extract from Heath’s balance sheet at 31 August 2018 is shown below:

£’000
Retained earnings (note 1) 2,520
9% Preference share capital (£1 shares) 750
4% Redeemable debentures (note 2) 680
5% Irredeemable debentures 1,240
11,490
Note 1
Earnings for the year to 31 August 2018 were £1,050,000 and an ordinary dividend of
£630,000 for the year to 31 August 2018 has been proposed.

Note 2
These debentures are redeemable at par on 1 September 2021.
The market prices of Heath’s long-term finance on 1 September 2018 are:
Ordinary shares £3.45/share (cum div)

Preference shares £1.62/share (cum div)
Redeemable debentures £103% (cum interest)
Irredeemable debentures £94% (ex interest)
Additional information
Heath’s equity beta 1.4

Expected risk free rate 3.35% pa
relates.
Note: In the earnings retention model g = rb.
Requirements
2.1 Calculate Heath’s WACC on 1 September 2018 using:
(a) Gordon’s growth model (earnings retention model)

(17 marks)
(b) CAPM (3 marks)
2.2 Compare and contrast Gordon’s growth model with the CAPM as alternative means of
calculating the cost of equity. (5 marks)
2.3 Advise Heath’s directors whether they should use the existing WACC figure calculated
in part 2.1 above when appraising the investment suggested by Janine Barrowland.
Your advice should include specific reference to the use of the APV technique and the
circumstances under which it is applicable. (6 marks)
2.4 From the point of view of a shareholder, explain the portfolio effect and discuss the
validity of Chris Sinnott’s proposal that Heath should purchase a care home business.
(4 marks)
Total: 35 marks

Question 3
Eddyson Cordless Ltd (Eddyson) is a UK-based company that designs and manufactures
battery-powered home and garden appliances. It was formed in 2010 and an analysis of its
sales and purchases, by value, over the past 12 months shows the following:
UK Eurozone
Sales 96% 4%
Purchases of raw materials 74% 26%
Recently, a very large US electrical wholesale company, Timba Inc (Timba), placed an order
with Eddyson worth $2.3million. The goods will be exported to the US next week and Timba
will pay for them on 30 November 2018.
Eddyson’s board is considering whether it is worth hedging the foreign exchange rate risk
associated with the sale to Timba. Four possible strategies have been proposed:
 Do not hedge
 Use a forward contract
 Use a money market hedge
 Use sterling traded currency options
You work in Eddyson’s finance team and have been asked to provide calculations and
guidance for the board. You have collected the following information at the close of business
on
1 September 2018:

Three-month forward contract premium ($/£) 0.0060 – 0.0044
Arrangement fee for forward contract £0.30 per $100 converted
US dollar interest rate (borrowing) 4.0% pa
US dollar interest rate (lending) 3.2% pa
Sterling traded currency options (standard contract size £31,250) are priced as follows on
1 September 2018 (premiums are quoted in cents per £):
September November
2018 2018
contracts contracts
Exercise price ($/£) Calls Puts Calls Puts

1.351.08 2.36 1.99 3.70

Requirements
3.1 Calculate Eddyson’s net sterling receipt for each of the four proposed strategies under
consideration, assuming that on 30 November 2018 the spot exchange rate will be:
(a) $/£ 1.3240 – 1.3350

(b) $/£ 1.3935 – 1.4050
Note: Interest on option premiums should be ignored. (16 marks)
3.2 With reference to your calculations in 3.1 above, advise Eddyson’s board whether it
should hedge against movements in the value of the US dollar. (6 marks)
3.3 Explain, with relevant workings, why the three-month forward rate is expressed at a
premium to the spot rate on 1 September 2018. (5 marks)
3.4 Briefly discuss whether any future sales to Timba might expose Eddyson to economic
risk. (3 marks)
Total: 30 marks


Question 1
Total marks: 35
General comments
This question was had the highest percentage mark on the paper. The vast majority of candidates
achieved a “pass” standard in this question.
The scenario was based on a UK manufacturer of computer hardware. The company’s board has decided
to close down one of its subsidiary companies in three years time. This is due to the latter’s recent poor
performance. The board has learned that the subsidiary’s senior management would like to investigate the
possibility of a management buy-out (MBO). The board has decided that the subsidiary’s buy-out price
would be its current economic value, based on predicted trading results for the next three years. Question
1.1 was worth 18 marks and required candidates to make use of the information given and calculate the
subsidiary’s economic value, based on discounted future cash flows. In question 1.2, for four marks,
candidates were asked to re-work their figures from question 1.1 because of a change in the data
provided. This tested their understanding of sensitivity analysis. Question 1.3 was worth three marks and
examined the Ethical Guide, with particular reference to the issues of integrity, objectivity and professional
behaviour. Question 1.4, for five marks, tested candidates’ understanding of real options and asked them
to identify two real options that could apply to the subsidiary as alternatives to the MBO. Finally, in
question 1.5, again for five marks, candidates had to explain the shareholder value analysis (SVA)
approach to company valuation, with its advantages and disadvantages.
1.1
Y1 Y2 Y3
Year to 31/8/19 31/8/20 31/8/21
£’000 £’000 £’000
Sales (W1) 6,375 4,411 2,653
VCs (30%) (1,913) (1,323) (796)
FCs (W2) (1,122) (1,144) (1,167)
Close down costs (W3) (637)
Tax (W4) (568) (330) (9)
P&M sale 1,500
P&M tax saving (W5) 101 83 122
Working capital 200 300 1,300
Net cash flows 3,073 1,997 2,966
11% factors 0.901 0.812 0.731
PV 2,769 1,622 2,168
Economic value 6,559
Workings
W1 Y1 Y2 Y3
£’000 £’000 £’000 £’000
Sales (£7m x 0.7) 4,900 (£5m x 0.6) 3,000 2,500
(£4.5m x 0.3) 1,350 (£4m x 0.4) 1,600 x (1.02)3
6,250 4,600 x 0.7 3,220 2,653
x 1.02 (£4m x 0.4) 1,600
6,375 (£3m x 0.6) 1,800
3,400 x 0.3 1,020
4,240
x (1.02)2
4,411

W2 £’000
Annual fixed cost cash flows = [£1.7m – £0.6m] £1.1m x 1.02 1,122 (Y1)
Depreciation excluded as not a cash flow £1.1m x (1.02)2 1,144 (Y2)
£1.1m x (1.02)3 1,167 (Y3)
W3
Close down costs = £0.6m x (1.02)3 £637,000
W4 Y1 Y2 Y3
£’000 £’000 £’000
Sales 6,375 4,411 2,653
VCs (1,913) (1,323) (796)
FCs (1,122) (1,144) (1,167)
Close down costs (637)
Taxable profit 3,340 1,944 53
Tax payable @ 17% 568 330 9
W5 Y1 Y2 Y3
£’000 £’000 £’000
WDV b/f 3,300 2,706 2,219
WDA @ 18%/Balancing Allowance (BA) (594) (487) (719)
WDV/sale 2,706 2,219 1,500
Tax saving (WDA/BA x 17%) 101 83 122

The majority of candidates produced good answers. Relevant cash flows were, in the main, correctly
identified. However, the expected sales calculations did cause many candidates problems. Common
errors made by candidates were:
 Poor expected value (EV) calculations for Year 2. Some candidates showed no real understanding by
producing an EV higher than any of the individual sales figures.
 No explanation of why depreciation is ignored in the cash flows.
 Closure costs were ignored as irrelevant when they weren’t.
 The tax written down value brought forward was treated as a cash outlay.
 An extra writing down allowance was included in Year 0.
 The money discount rate (given) was increased by the inflation rate in the question.

1.2
£’000
Scrap value = £1 million, therefore loss of cash = £1.5m - £1.0m 500
Tax rebate (balancing allowance) x 83%
Discounted to Y0 x 0.731
Economic value decreases by 303
New economic value = £6,559 – £303 6,256

This was answered very well by most candidates. They demonstrated a good understanding of the key
factors involved in the sensitivity analysis.

1.3
An ICAEW member is being asked to falsify the economic value of Snowdog and thus mislead potential
buyers, i.e. Snowdog’s directors. To do so would break the principles of the ICAEW Ethical Guide which
states, inter alia:
A member should behave with integrity – i.e. be honest and truthful. The member’s advice and work
should not be influenced by the interests of other parties, which would be the case here were s/he to
overvalue Snowdog.
A member should strive for objectivity in all professional and business judgements – i.e. there should be
no bias, conflict of interest or undue influence of others. The member has a conflict of interest here. S/he

is being asked to act with bias in favour of one party (Rumsey’s directors) over another (Snowdog’s
directors).
A member should behave professionally – i.e. avoid any action that discredits the profession. If the
member falsified the valuation of Snowdog then the ICAEW’s reputation is at risk.
Answers here were very variable. Candidates who scored well will have explained why the key ethical
issues (integrity, objectivity and professional behaviour) are under threat in the given scenario. Many
candidates failed to do this and produced a “shopping list”, without explanation. In addition a lot of
candidates rolled integrity and objectivity into one issue rather than two.

1.4
NPV analysis only considers cash flows related directly to a project. However, a project with a negative (or
low) NPV could be accepted for strategic reasons. This is because of (real) options associated with a
project that outweigh the poor NPV.
With regard to Snowdog two real options are:

Abandonment – if there is no MBO Snowdog could be closed before the three years are up
Growth (calling it follow on or timing also ok) – if Snowdog performs better than expected it could be kept
open longer than three years
This was done well by the majority of candidates, but it was disappointing to see a number of scripts
where the candidate did not know the definition of a real option. Also, many candidates did not apply their
real option knowledge to the actual scenario. Instead, they listed many (some irrelevant) options. Finally,
some candidates gave more than the two options required in the question.

1.5
With SVA a company’s value is based on the PV of its future cash flows, so it is forward-looking.
The advantage is that this is theoretically the most superior valuation method compared with earnings
(which may be manipulated) or assets (which don’t focus on the income generated).
SVA considers seven value drivers, which link to (or drive) company strategy:

7. Cost of capital
The disadvantage is that predictions are very difficult as cash flows are technically in perpetuity. Once a
company’s period of competitive advantage is over then its growth rate is much slower and a terminal
(residual) value is calculated, based on its cash flows to perpetuity. This terminal value is often the major
part of the overall value of the company.
Once the total value of the company has been calculated, based on the future cash flows and value
drivers, then, to calculate the value of equity, it is necessary to add the value of any short-term
investments held and deduct the market value of any debt held.
SVA has been examined many times recently and, as expected, most candidates produced very good
answers. Typical errors here were: (a) not knowing the seven value drivers and (b) applying SVA as if this
was an investment appraisal, rather than a company valuation.


Question 2
Total marks: 35
General comments
This question was had the second highest percentage mark on the paper. A large majority of candidates
reached a “pass” standard in the question.
This was a four-part question which tested the candidates’ understanding of the financing options element
of the syllabus.
The question was centred on an online retailer of baby products which is based in the UK. The company’s
market share has been falling and its board is investigating the possibility of establishing a small chain of
shops across the UK, at a cost of £10 million. This expansion could be funded by a bank loan, thereby
taking advantage of current low interest rates. An alternative view within the board is that the company
should invest in a completely different type of business, in this case a chain of care homes. In question
2.1, for 20 marks, candidates were required to calculate the company’s current WACC figure, based on (a)
Gordon’s Growth Model and (b) the CAPM. Question 2.2, for five marks, required candidates to compare
and contrast the two valuation methods above. In question 2.3 (six marks) candidates were asked to
advise the company’s board whether the existing WACC figure (from question 2.1) should be used in
when appraising the proposed investment in shops. The candidates’ understanding of the APV technique
was also tested here. Finally, question 2.4, for four marks, required candidates to explain the portfolio
effect and discuss the validity of the proposal to invest in a completely different type of business.
2.1
(a)
Ke Dividend growth (g = br)
Opening equity capital employed = £2,520 – (£1,050 - £630) £2,100
r= £1,050 12.5%
(£6,300 + £2,100)
b= £420 0.4
£1,050
g=rxb 12.5% x 0.4 5%
ke = d1+ g (£630/6,300) x 1.05 + 5% 8.13%

MV (£3.45 - £0.10)
Kp = d/mv £1 x 9% £0.09 5.89%

(£1.62- £0.09) £1.53
Kdr Yr Cash Flow (£) 4% PV (£) 5% PV (£)

0 (99) 1.000 (99.00) 1.000 (99.00)
1-3 4 2.775 11.10 2.723 10.89
3 100 0.889 88.90 0.864 86.40
1.00 (1.71)
IRR = approx 4.4%

Kdr = 4.4% x 83% 3.65%
Kdi = i/mv £5 x 83% 4.41%

£94
WACC
MV (£’000) Cost Weighting WACC
Ord. shares (6,300 x £3.35) 21,105.0 8.13% x 21,105.0/24,091.3 7.1
Pref. shares (750 x £1.53) 1,147.5 5.89% x 1,147.5/24091.3 0.3
Redeemable debs (680 x £99%) 673.2 3.65% x 673.2/24,091.3 0.1
Irredeemable debs (1,240 x £94%) 1,165.6 4.41% x 1,165.6/24,091.3 0.2
24,091.3 7.7%

(b)
Ke via CAPM = (8.25% – 3.35%) x 1.4 = 6.86%
3.35%
10.21%
MV (£’000) Cost Weighting WACC

Ord. shares (6,300 x £3.35) 21,105.0 10.21% x 21,105.0/24,091.3 8.9%
Pref. shares (750 x £1.53) 1,147.5 5.89% x 1,147.5/24091.3 0.3%
Redeemable debs (680 x £99%) 673.2 3.65% x 673.2/24,091.3 0.1%
Irredeemable debs (1,240 x £94%) 1,165.6 4.41% x 1,165.6/24,091.3 0.2%
24,091.3 9.5%
The requirements of question 2.1 have been examined regularly in recent examinations. Accordingly,
many candidates produced very good answers, scoring heavily. As expected, for candidates the most
difficult element here was the calculation of the dividend growth rate (based on g = b x r). It was clear that
some candidates had no idea how to approach the calculation of g = b x r. In addition many candidates
calculated unrealistically high figures for g, b and r (and then the cost of equity) without question.
Elsewhere, it was disappointing to see a number of candidates (wrongly) deducting the ordinary dividend
for their preference share calculations and using the ordinary dividend growth rate with preference
dividends. Also, a surprising number of candidates used 5% (the coupon rate) as the pre-tax irredeemable
cost of debt, omitting to take the current market value of the debt into account. Most candidates’ IRR
calculations for the cost of redeemable debt were good. However, too many showed a lack of
understanding from here and produced an illogical IRR calculation from NPV figures that were correct.
The CAPM calculation for cost of equity was very straightforward and the vast majority of candidates
scored full marks. However a significant number did not put the right numbers in to the CAPM and so did
not calculate the correct cost of equity.

2.2
Gordon’s Growth Model (GGM) is also known as Earnings Retention Model. Dividend growth based on
proportion of dividends that are retained and the rate of return on those retained profits. Thus g = rb. The
GGM is based on the premise that these profits are the only source of funds. Growth is achieved by re-
investing earnings. This is then put into the Dividend Valuation Model to get the cost of equity, assuming
the value of a share = PV of growing future dividends.
CAPM - specific/unsystematic risk can be diversified away by investors, so it’s assumed that investors are
rational and that they have a diversified portfolio. Systematic risk can’t be diversified away – macro-
economic factors. A company’s beta is calculated from the performance of its share price against the
market average and is taken as a measure of the market’s view of the risk attached to the security in
question. The higher the perceived risk, then the higher the beta figure and thus the higher the equity
return required by investors. .
The overall standard of answers given for question 2.2, 2.3 and 2.4 (theory and advice) was disappointing
when compared to the accuracy of (most of) the calculations in question 2.1. Whilst many scripts scored
well in question 2.2, far too many were unable to explain the basics of Gordon’s Growth Model and the
CAPM.


2.3
When using WACC to appraise projects the following assumptions are implied:
1. Heath’s historic proportions of debt and equity are not to be changed (which they are – see below)
2. Heath’s systematic business risk is not to be changed (it does not change as it’s still the same
industry)
3. The finance is not project-specific (e.g. cheap government loans, which it isn’t)
In this case the finance is very substantial, i.e. 42% of total funds at market value (£10m/£24m) and as it
would be borrowed money then this will affect the company’s gearing level significantly (it’s only just over
12% at present and would increase to 38% @ MV).
APV – increased gearing may lead to a fall in WACC because of the tax shield on loan interest. To find the
new WACC requires the new MV of the company’s shares. However this requires the NPV of the
proposed investment to be known, which needs the new WACC. So
1. Calculate a base case value
2. Calculate the PV of the tax shield
3. Adjust for issue costs
Total up 1, 2 & 3 to give APV - if positive then proceed with investment.
Too few candidates explained the three conditions required to use the existing WACC and then apply
them to the given scenario. Generally, there was a good understanding of the APV technique, but typical
errors here were choosing the wrong cost of equity (it should be ungeared) and then deducting (rather
than adding) the PV of the tax shield.

2.4
A portfolio is a combination of investments. Many investors attempt to reduce their risks by holding a
portfolio. The idea is that by investing in different securities they are “not putting all of their eggs in one
basket”. It is better to spread investment risks.
Investors can spread the risk themselves (via their investment strategy) and don’t need managers to do it
for them. Indeed managers may want to diversify in order to protect their own jobs – which aren’t
diversified. This creates agency conflict.
Heath’s managers may well not know anything about running a care home (conglomerate discount) and
so it may be dangerous for investors to allow this investment.
Some of Heath’s investors may not be diversified or may be unable to purchase certain investments
because they are private companies.
Most candidates showed a good understanding of portfolio theory. However, too many failed to distinguish
between company and investor portfolios in the scenario.


Question 3
Total marks: 30
General comments
This question had the lowest average mark on the paper, but most candidates achieved a “pass” standard.
This was a four-part question that tested the candidates’ understanding of the risk management element
of the syllabus.
The scenario here involved a UK manufacturer of home and garden appliances. The company has
recently received a large order from an American customer. Its board is considering whether or not to
hedge the foreign exchange rate risk. Question 3.1, for 16 marks, required candidates to calculate the net
sterling receipt for each of four possible strategies. These were (a) no hedge, (b) a forward contract, (c) a
money market hedge and (d) sterling traded currency options. Question 3.2 was worth six marks and
required candidates to advise the company’s board, based on their previous calculations. In question 3.3
(five marks) candidates needed to demonstrate their understanding of interest rate parity. Question 3.4
was worth three marks. Here, candidates were asked to explain whether, taking into account the
information provided, additional sales to the USA might expose the company to economic risk.
3.1
No hedge Spot rate Spot rate
1.3350 1.4050
$2,300,000 $2,300,000
1.3350 1.4050
£1,722,846 £1,637,011
Forward contract (FC)
1.3775 - 0.0044 = 1.3731 $2,300,000 £1,675,042

1.3731
Fee $2,300,000 = 23,000 x £0.30 (£6,900)

$100 £1,668,142
Money market hedge (MMH)

Borrow $ $2,300,000 $2,277,228
1.01
Convert @ spot £2,277,228 £1,653,160

1.3775
Lend @ UK £1,653,160
x
1.0115 £1,672,171
Option
Buying £s, so a November call option
No. of contracts = $2,300,000 £1,703,704 54.52 55 contracts

$1.35 £31,250
Cost of option 55 x 0.0199 x 31,250 $34,203 £25,048

1.3655
Future spot rate 1.3350 1.4050

Bought for (1.3500) (1.3500)
(Loss)/Profit (0.0150) 0.0550

So therefore Abandon option Take up option
Gain on option $0.0550

x 31,250
x 55
$94,531
Due from customer $2,300,000 $2,300,000

Gain on option 0 94,531
Due from customer $2,300,000 $2,394,531
Converted to £ ($2.3m/1.3350) £1,722,846 ($2,394,531/1.4050) £1,704,293

less: Cost of option (25,048) (25,048)
Net receipt £1,697,798 £1,679,245
For most elements candidates scored well. Forward contracts (FC) and money market hedges (MMH) are
examined regularly and most candidates accrued full marks here. Candidates need to make the best use
of the spreadsheet provided in the examination. In a number of instances candidates reduced their
exchange rates to two decimal places, thus losing marks unnecessarily. One common error amongst
candidates was to add, rather than subtract, the forward contract fee. It was disappointing to see that
some candidates used the two future spot rates given to calculate alternative sterling receipts for the FC
and then also for the MMH. Both of these hedging techniques produce one, fixed sterling figure each. As
expected candidates found the currency options element of the question more difficult. Whilst many of
them scored well, common errors noted were:
 Choosing a put rather than a call option and then getting the exercise/abandon decision wrong as well.
 Calculating the wrong number of contracts, by failing to use the option exercise price.
 Calculating the profit on exercising the option in sterling rather than in $.
 Treating it as an OTC option rather than a sterling traded currency option.

3.2
Spot rate Spot rate
1.3350 1.4050
No hedge £1,722,846 £1,637,011
FC £1,668,142 £1, 668,142
MMH £1,672,171 £1,672,171
Option £1,697,798 £1,679,245
So with spot rate at 1.3350 (weakening £ and strengthening $) the best outcome for Eddyson is not to
hedge the dollar receipt.
With the spot rate at 1.4050 (strengthening £ and weakening $) the best outcome is to hedge the dollar
receipt via the traded option. The FC and the MMH both give a fixed sterling receipt – the MMH produces
a slightly higher figure. The FC and MMH are safest techniques to use for a risk-averse board.
The £/$ interest rates and the forward contract premium indicate that the market is expecting the dollar to
strengthen (sterling to weaken). This would be good for Eddyson, an exporter, as sterling receipts would
be higher. The board’s attitude to risk will be important here.
More general points on the various hedging techniques.

This was answered reasonably well, but too many scripts made rather general points. Too few candidates
recognised that the FC premium suggests that sterling will be weakening, which is good news for a UK
exporter.


3.3
Average spot rate x 1 + Average dollar interest rate (3 mos.) = Average forward rate
1 + Average sterling interest rate (3 mos.)
The dollar interest rates are lower than those of sterling. Using the interest rate parity (IRP) equation
above (which shows that differences in interest rates can’t be exploited as forward rate will adjust to offset
any gains), the value of sterling against the dollar will fall. The dollar's gain in value is called a premium.
So, using the data in the question:
Average UK rate 5.10% pa or 1.01275% per 3 mos.

Average US rate 3.6% pa or 1.009% per 3 mos.
Average spot rate = 1.3715
Forward rate = 1.3715 x 1.009/1.01275 = 1.3664 i.e. a premium of $0.0051/£
Average premium given = $0.0052/£ so IRP is working
Interest rate parity (IRP) has been examined fairly regularly and many candidates did well here. However
there were quite a few poor scripts and some candidates used twelve months rather than three months
when trying to prove that the IRP was working in this scenario.

3.4
Currently very little economic risk as the majority of Eddyson’s sales are in the UK (96%).
However if more sales are to the USA then economic risk would increase - $ sales and € purchases
A weakening $ and a strengthening € would both be bad for Eddyson.
This produced a very varied set of answers. Whilst many candidates scored full marks here, many scored
zero, as they had no understanding of economic risk, frequently mentioning (wrongly) the impact of tariffs,
quotas and political unrest.


WEDNESDAY 5 DECEMBER 2018
(2½ HOURS)
Marks breakdown
Question 1 35 marks
Question 2 30 marks
Question 3 35 marks
must request and complete a candidate incident report form at the end of the exam; this
form must be submitted as part of any subsequent special consideration application.
Copyright © ICAEW 2018. All right reserved.

Question 1
Assume that the current date is 31 December 2018.
Physiotec plc (Physiotec) is listed on the London Stock Exchange (LSE) and is a major
supplier to physiotherapy clinics. One of the products that Physiotec supplies is elastic
therapeutic tape (ETT). This is used to treat pain sustained in athletic injuries. Physiotec has
incurred £0.5 million of research and development costs relating to a new type of ETT. The
research has been successful and Physiotec intends to market the new type of ETT called
Supertape. Physiotec is aware that in one year’s time, on 31 December 2019, another
supplier is likely to launch a product similar to Supertape onto the market.
The finance director of Physiotec, who is an ICAEW Chartered Accountant, intends to

appraise the Supertape project using expected net present value. Because the ETT market is
very competitive he intends to evaluate the project over a three year time horizon.
A marketing analyst has provided the following estimates of sales of packs of Supertape, with
associated probabilities, for the year to 31 December 2019.
Number of packs sold Probability
4 million 50%
2 million 30%
1 million 20%
Sales volumes for the two years to 31 December 2021 are forecast to be at the expected
volume of sales in the year to 31 December 2019, adjusted for growth of 5% pa.
The sales director of Physiotec suggested to the finance director that a public announcement
is made to the LSE about the Supertape project, in order to increase the company’s share
price. He believes that the announcement should state that sales of Supertape are going to
be 4 million packs pa. The sales director feels that this is reasonable considering the
probability distribution provided by the marketing analyst.
Additional information relating to the Supertape project:
 Each pack of Supertape will be sold for £5 in the year to 31 December 2019. The
contribution is expected to be 60% of the selling price. The selling price and variable
costs per pack are expected to increase by 3% pa in the two years to 31 December 2021.
 A marketing campaign will cost £0.8 million, payable on 31 December 2018.
 Selling and administration expenses for the year to 31 December 2019 are estimated to
be £2 million and are expected to increase by 4% pa in the two years to 31 December
2021.
 Fixed production costs for the year to 31 December 2019 are estimated to be £0.75
million and are expected to remain constant in the two years to 31 December 2021.

 Physiotec will use existing factory space to manufacture Supertape. This factory space is
currently let to a third party at a fixed annual rent, which is payable in advance on
31 December, of £1 million pa. The rent will not increase with inflation. At the end of the
project the factory space will be re-let to third parties.
 On 31 December 2018 the project requires an investment in working capital of £3 million,

which will increase at the start of each year in line with sales volume growth and sales
price increases. Working capital will be fully recoverable on 31 December 2021.
 On 31 December 2018 the project will require an investment in plant and equipment of £4
million. It is estimated that on 31 December 2021 the plant and equipment will have a
value of £0.5 million (in 31 December 2021 prices).
 The plant and equipment will attract 18% (reducing balance) capital allowances in the
year of expenditure and in every subsequent year of ownership by the company, except
in the final year.
At 31 December 2021, the difference between the equipment’s written down value for tax
purposes and its disposal proceeds will be treated by the company as a:
value, or
 A suitable real cost of capital to appraise the Supertape project is 7% pa and the general
level of inflation is expected to be 2.4% pa.
Requirements
1.1 Using money cash flows, calculate the expected net present value of the Supertape
project on 31 December 2018 and advise Physiotec’s board whether it should proceed
with the project. (19 marks)
1.2 Ignoring the effects on working capital, calculate the sensitivity of the Supertape
project to changes in sales volume and discuss this sensitivity with reference to the
estimates provided by the marketing analyst. (5 marks)
1.3 Describe two advantages and two disadvantages of using expected values when
appraising the Supertape project. (4 marks)
1.4 Describe two real options that are available to Physiotec in relation to the Supertape
project. (4 marks)
1.5 Identify the ethical and legal issues for the finance director of Physiotec regarding the
suggestion made by the company’s sales director about the public announcement of the
Supertape project to the LSE. (3 marks)
Total: 35 marks

Question 2
Assume that the current date is 30 November 2018.
North American Cars Ltd (NAC) is a UK based company that imports classic North American
cars into the UK. NAC sells the cars in both the UK and the Eurozone. There are three issues
that the board of NAC is currently considering.
You are the finance director of NAC and have been asked to report to the board on these
three issues.
2.1 Issue 1
NAC is buying a new warehouse to store the cars and has arranged to borrow £800,000 for
one year from 30 April 2019 at an interest rate of LIBOR + 3%. The board of NAC is
concerned that LIBOR might increase over the next five months from its current level of 1%
pa. However, one member of the board is of the opinion that LIBOR will fall.
A bank has offered NAC a forward rate agreement (FRA) at 4.5% pa or an interest rate
option at 4% pa plus a premium of 1% of the sum borrowed.
Requirements
(a) Calculate the interest cost of the £800,000 loan using the FRA and the option assuming
that LIBOR on 30 April 2019 will be:
 either 1.25% pa
 or 0.60% pa (6 marks)
(b) Recommend to the board of NAC whether it should hedge interest rate movements
using the FRA or the interest rate option. (3 marks)
2.2 Issue 2
On 31 March 2019 NAC is due to pay $1,250,000 to its US suppliers for a shipment of fifty
cars. The board of NAC would like to establish the most appropriate hedging strategy to
protect the company against foreign exchange rate (forex) risk.
The following data is available at the close of business on 30 November 2018:

4-month forward contract discount ($/£) 0.0052 – 0.0058
Annual borrowing and depositing interest rates:
Dollar 4.80% – 4.40%

Sterling 3.75% – 3.25%

4-month over-the-counter (OTC) currency options:
 Call options to buy $ have an exercise price of $/£1.4025 and a premium of £0.006
per $ converted.
 Put options to sell $ have an exercise price of $/£1.4028 and a premium of £0.002
per $ converted.
Option premiums are payable on 30 November 2018. NAC currently has an overdraft.
Requirements
(a) Calculate NAC’s sterling cost of the $1,250,000 payment using:
Assume that the spot exchange rate will be $/£1.3980 – 1.3990 on 31 March 2019.
(9 marks)
(b) Discuss the relative advantages and disadvantages of each of the hedging techniques
in 2.2 (a) above and advise NAC’s board on which technique would be the most
beneficial for hedging its forex risk. (8 marks)
2.3 Issue 3
The board is concerned about NAC’s exposure to economic risk as it imports cars from the
USA and sells some of them to customers in the Eurozone.
Requirement
Explain how economic risk affects NAC. (4 marks)
Total 30 marks

Question 3
Assume that the current date is 30 November 2018.

Continental plc (Continental) is a major international hotel operator. At a recent board
meeting it was decided that the company should diversify by opening gymnasiums and health
spas in or near to all of its hotels at a cost of £1,000 million. The following are extracts from
the board minutes relating to this diversification:
 The board discussed which discount rate to use to appraise the diversification. Some
directors felt that the company’s existing weighted average cost of capital (WACC)
should be used. Others felt that the rate should reflect the systematic risk of the
diversification.
 The board discussed how the finance would be raised for this diversification as
Continental’s current gearing (measured as debt/equity by market values) is close to the
hotel market average. Some directors felt that gearing is irrelevant and wanted all the
finance to be raised from debt. Others were less sure and expressed concern that the
company’s credit rating would fall, affecting Continental’s cost of debt and the market
value of its debentures. They preferred a mix of equity and debt or even all equity finance.
 Several board members felt that the £296 million proposed special dividend for the year
to 30 November 2018 should be cancelled and used to partly fund the diversification.
The finance director of Continental was asked to prepare a report on the above issues for
presentation at the next board meeting.
An extract from Continental’s most recent management accounts is shown below:

Balance sheet at 30 November 2018
£m
Ordinary share capital (£1 shares) 190
6,190
4% Redeemable debentures at nominal value 1,500
7,690
On 30 November 2018 Continental’s ordinary shares each had a market value of £46 (ex-div).
Continental’s debentures are redeemable at par (£100) in four years’ time and the current
price of the debentures is £94
(ex-interest).
Profits and dividends for the years to 30 November:
2014 2015 2016 2017 2018

£m £m £m £m £m
Profits after tax 372 391 1,222 414 433
Ordinary dividends 105 93 110 137 141

Proposed special
dividend -- -- -- -- 296
Total dividends 105 93 110 137 437

Other information and assumptions:
 The number of Continental’s ordinary shares in issue has not changed in the last five
years.
 Continental’s equity beta on 30 November 2018 is 0.74.
 Other companies operating in similar areas to Continental and its proposed diversification:
Total
Total debt
equity by
Company Main Equity by market market
name activity beta value value
£m £m
Fitgroup plc Operating
gymnasiums and 0.56 434 150
health spas
Bowlright plc Operating bowling
alleys and 0.85 75 23
gymnasiums
The Local plc Operating bars and
hotels 0.62 1,221 797
 The market return is expected to be 9% pa.
 Corporation tax is at the rate of 17% for the foreseeable future.
 An analyst estimated the following:
(1) If Continental were to fund the £1,000 million diversification entirely by borrowing,
the market value of its existing debentures would fall by 5%.
(2) If Continental were to fund the £1,000 million diversification entirely by equity, the
market value of its existing debentures would rise by 5%.
(3) The price of the company’s ordinary shares would stay the same whether the
project is funded entirely by debt or entirely by equity.
Requirements
3.1 Calculate on 30 November 2018:

(a) Continental’s WACC using the dividend valuation model (dividend growth should
be estimated using the earliest and latest dividend information provided).
(b) Continental’s cost of equity using the CAPM.
(11 marks)
3.2 Using the CAPM and assuming that the current gearing of Continental remains
unchanged after the diversification, calculate a cost of equity that reflects the
systematic risk of the diversification and also explain your reasoning.
(8 marks)

3.3 Assuming the £1,000 million finance required is raised on 1 December 2018, calculate
Continental’s gearing (measured as debt/equity by market values) if it comes entirely
from:
(a) debt or
(b) equity (4 marks)
3.4 Discuss whether the £1,000 million finance required for the diversification should be
raised from debt, equity or a combination of debt and equity sources. You should make
reference to:
 relevant theories
 Continental’s current gearing
 your calculations in 3.3 above
 other relevant practical issues. (12 marks)
Total: 35 marks

Question 1
Total Marks: 35
General comments
The scenario of the question was that a company is launching a new product onto the market.
Part 1.1 of the question covered ENPV (expected NPV) analysis using probabilities.
Part 1.2 of the question required sensitivity calculations and discussion.
Part 1.3 of the question required knowledge of using expected values.
Part 1.4 of the question discussed the real options available to the company.
Part 1.5 of the question discussed an ethical issue.
1.1
The Supertape Project

0 1 2 3
£ £ £ £
millions millions millions millions
Contribution 8.40 9.08 9.82
Initial marketing -0.80
Selling and admin -2.00 -2.08 -2.16
Fixed costs -0.75 -0.75 -0.75
Rent forgone -1.00 -1.00 -1.00
Operating cash flows -1.80 4.65 5.25 6.91
Tax 17% 0.31 -0.79 -0.89 -1.17
After tax operating cash flows -1.49 3.86 4.36 5.74
Plant and equipment -4.00 0.50
Tax saved on Cas 0.12 0.10 0.08 0.29
Working Capital -3.00 -0.25 -0.27 3.52
Net cash flows -8.37 3.71 4.17 10.05
PV factors at 10% 1.00 0.909 0.826 0.751
Present value -8.37 3.37 3.44 7.55
ENPV 5.99
Research cost of £0.5 million should be ignored since they are a sunk cost.
The project should be accepted since it has a positive ENPV, which will increase
shareholder’s wealth.

The discount rate: ((1.07) x (1.024))-1 = 0.09568. Round to 10%
Sales and Contribution

Sales @ £5 Prob x
per Pack Sales
Packs
Probability m £m £m
0.5 4 20 10.00
0.3 2 10 3.00
0.2 1 5 1.00
Expected Sales 14.00
Contribution Y1 = £8.40 m (14.00 x 0.60)
The contribution will be increase each year by volume and sales price increase:
Y2: 8.4 x 1.05 x 1.03 = 9.08

Y3 9.08 x 1.05 x 1.03 = 9.82

Cost/WDV CA Tax
4.00 0.72 0.12

3.28 0.59 0.10
2.69 0.48 0.08
2.21
-0.5 1.71 0.29
Working capital:
Y1 (3.0 x 1.05 x 1.03) -3 =(0.25)

Y2 (3.25 x 1.05 x 1.03) – 3.25 = (0.27)
Y3 3.52.
Most of the attempts at this question were good however common errors were: Not stating why the
research costs should be ignored i.e that they are sunk costs; incorrect timing of cash flows; inflating cash
flows when it is stated that they remain constant; inflating the net cash flows by the general level of
inflation; not using the Fisher formulae to calculate the nominal cost of capital and merely adding the
general level of inflation to the real cost of capital; discounting money net cash flows by the real cost of
capital.

1.2
The sensitivity of the Supertape project to changes in sales revenue:
Contribution X (1-0.17) 6.97 7.54 8.15
PV factors at 10% 0.909 0.826 0.751
Present Value 6.34 6.23 6.12

Sensitivity 5.99/18.69 32.05%
A fall in sales from £14 million to: 14(1-0.3205) = £9.51 million will
result in a zero NPV.
There is a 50% chance that sales will be £10 m or less and the management of Physiotec will
have to consider whether it is willing to accept this level of risk. Especially since this is a very
competitive market and it is possible that another product similar to Supertape might be
marketed by a rival company.
Mainly well answered however the examiners observed an error that has not occurred in past sensitivity
questions. Some candidates attempted to calculate sensitivity using units (rather than £ contribution),
going as far as taxing them and discounting them. Some other, common, errors were: calculating
sensitivity using sales rather than contribution; ignoring tax; inverting the sensitivity calculation; inadequate
narrative and not referring to the probabilities provided.

1.3
Advantages:
 The information is reduced to a single number for assessing the Supertape project rather than a
range of outcomes.
 Easily understood.
Disadvantages:
 The probabilities of the different sales levels may not be accurate.
 The expected sales of £14 million may not correspond to any of the possible expected sales
levels.
 The expected sales of £14 million will not be achieved unless the project is run many times.
 The expected sales of £14 million are an average and it does not consider the spread of possible
results. It therefore ignores risk.
Quite poorly answered with many candidates clearly making up answers and showing little understanding
of the advantages and disadvantages of using expected values.

1.4
The option to delay. Since a competitor is likely to enter into the market in one year’s time it might be
prudent to start the project in one year rather than now on 31 December 2018. The product might be not
as good as Supertape or it might be better. Physiotec can make a more informed decision when it knows
what the competitor is intending.
The option to abandon. Since expected values are being used to estimate sales if the worst case
scenario occurs, sales of only 1 million, Physiotec can abandon the project.
Follow on options. Producing Supertape might allow Physiotec to develop future products, which can be
marketed after 31 December 2021, even if the lower level of sales of 1 million occurs and the project
initially has a negative NPV.
Growth options. Physiotech could develop new markets for Supertape eg overseas which may turn a
negative NPV project (initial sales 1 million) into a positive.
A lot of very good answers, however poorer candidates did not refer to the scenario. The examiners would
like to emphasise that this is very important to gain high marks. Also many candidates provided a list of
every real option that they could think of. Candidates should be aware when two real options are asked for
only the first two are marked.


1.5
The finance director of Physiotec should disregard the sales director’s suggestion since this would be
misleading shareholders and the markets. The finance director would not be acting in an ethical manner if
he tried to hide the fact that the sales level of 4 million is not certain and that there is only a 50%
probability of that level occurring. He would be breaching the fundamental principles of Integrity,
Objectivity, Professional competence and due care and Professional behaviour.
There are also legal considerations to consider since the professional accountant must be aware of and
comply with current legislative and regulatory measures. Therefore, as well as being unethical, making
this announcement would be illegal.
Good answers however many candidates omitted the legal aspects.


Question 2
Total Marks: 30
This was a five part question that tested the candidates’ understanding of the
The scenario of the question was that a company imports goods from the USA and sells them in the UK.
Part 2.1 (a) required computations regarding hedging short-term interest rate risk.
Part 2.1 (b) required discussion regarding the techniques used to hedge the short-term interest rate risk.
Part 2.2 (a) required computations regarding FOREX.
Part 2.2 (b) required advice regarding the techniques that have been used to hedge the FOREX.
Part 2.3 required a discussion regarding economic risk.
and the Eurozone. Also the company was taking out a loan to buy a new warehouse.
2.1 (a)
LIBOR 1.25% 0.60%

LIBOR + 3 4.25% 3.60%
FRA Pay to lenders 4.25% 3.60%

Pmt to bank 0.25% 0.90%
FRA rate 4.50% 4.50%
Interest cost for 12 months £36,000 £36,000
Option - Exercise Yes No

Pay interest at 4.00% 3.60%
Premium 1.00% 1.00%
Effective rate 5.00% 4.60%
Interest cost for 12 months £40,000 £36,800
Responses to this part of the question were quite good with many candidates scoring almost full marks.
However weaker candidates made some of the following mistakes: calculating interest payable for a five
month period and misreading the question which states that the borrowing will be for one year and will
take place on 30 April 2019, which is five months from 30 November 2018; lack of understanding of FRAs,
which are OTC and treating them like futures; treating the OTC interest rate option as an option on interest
rate futures

2.1 (b)
If LIBOR increases to 1.25% the FRA is better than the option by £4,000.
If LIBOR decrease to 0.60% the FRA is slightly better than the option by £800.
The decision on whether to hedge depends on the board’s attitude to risk as for both the interest rates
given not hedging is cheaper.
If LIBOR does fall (one board member) the option allows upside potential and could be cheaper than the
FRA but would never be cheaper than not hedging.
But given that the overall view of the board is that LIBOR will rise it would depend on how far the board
believes it would rise. LIBOR would need to rise to over 1.5% before the FRA is cheaper than doing
nothing and by over 2% before the option is cheaper.
Reasonable answers however common errors include: no recommendation given and just advantages and
disadvantages; no consideration of not hedging as an alternative.


2.2 (a)
This is result in a sterling payment of ($1,250,000/$1.4017) = £891,774
Using the money markets, NAC will invest in $, $ at the spot rate and borrow in £.
Invest $1,250,000/(1+0.044x4/12) = $1,231,932
Buy $ spot $1,231,932/$1.3965 = £882,157
Borrow in £ to give total cost £882,157 x (1+0.0375x4/12) = £893,184
Over the counter option. Using a call option to buy $:

Exercise price $1.4025. If spot is $1.3980 exercise the option.
The option premium is $1,250,000 x £0.006 = £7,500.
The premium with interest is £7,500 x (1+0.0375x4/12) = £7,594
The sterling payment will be ($1,250,000/$1.4025) + £7,594 = £898,860
Responses to this part of the question were mainly good but common errors were: for the forward contract
using the incorrect exchange rate and deducting instead of adding the forward discount; for the money
market hedge choosing the incorrect interest rates, incorrect apportionment of the annual interest and
using the incorrect spot rate; for the OTC option choosing the put rather than the call, not taking account
of the interest on the option premium, treating the OTC option as a traded option and incorrect exercise or
abandon decisions.

2.2 (b)
Results of hedging using various methods:
Forward £891,774
Money market £893,184
Option £898,860
If no hedge the payment will cost: $1,250,000/$1.3980 = £894,134,
The forward contract and money market hedge lock NAC into an exchange rate. The options however
protect NAC against the downside risk of the £ weakening more than expected against the $ and allow for
the upside potential of the $ weakening against the £, however the option premium is expensive.

Forwards:
Tailored specifically for NAC
However there is no secondary market. .
Money market hedge:
The money market hedge is more difficult to arrange than a forward contract and might use up NAC’s
credit lines.
It is unlikely that the $ is going to weaken enough to cover the cost of the option premium, therefore it is
not recommended that the company use OTC foreign currency options. The forward contact and money
market hedge are both better than the spot rate, however the forward is the cheapest. It is recommended
that NAC use a forward contract to hedge the forex.
Responses to this part of the question were mixed, with quite a few candidates not giving advice.


2.3
NAC is an importer and exporter. It buys cars in $, exports some to the Eurozone and receives payment in
€. If over a period of several years the pound weakens (although the data in the question indicates that it
is strengthening) against the dollar and appreciates against the euro the sterling value of NAC’s income
will fall and its net cash flows decline. This will reduce the value of the business (PV of future cash flows).
Responses to this part of the question were poor with quite a lot of candidates showing a lack of
understanding of what economic risk is and how it affected the company.


Question 3
Total Marks: 35
This was a four 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 diversifying its operations and raising finance by either
debt or equity.
Part 3.1 required cost of capital computations before the diversification.
Part 3.2 required computations regarding a cost of capital appropriate for the diversification.
Part 3.3 required gearing calculations if the diversification is financed by debt or equity.
Part 3.4 required a discussion of from what source (debt, equity or a combination) the finance required for
the diversification should be raised.
3.1
(a) Growth can be estimated by past ordinary dividend growth for the past four years
excluding special dividend as it’s a one-off:
Growth = (141/105)(1/4) -1 = 0.0765 or 7.7%
Shares in issue = 190m
2017 dividends per share = 74p (141/190)
Ex div share price = 4600p
Ke = (74(1.077)/4600) + 0.077 = 0.0943 or 9.43%
Kd =
Time Cash flow Factors at PV Factors at PV
£ 5% £ 10% £
0 (94) 1 (94) 1 (94)
1-4 4 3.546 14.18 3.170 12.68
4 100 0.823 82.30 0.683 68.30
2.48 (13.02)
YTM = 5 + ((2.48/(2.48+13.02))5) = 5.8%
Kd = 5.8 (1-0.17) = 4.81%
Market values:
Equity 190m x £46 = £8,740m
The total market value of debt = 1,500 x 0.94 = £1,410
WACC = (9.43 x 8740 + 4.81 x 1410)/(8740 + 1410) = 8.79%
(b) Using CAPM.

Ke = 3 + 0.74(9 – 3) = 7.44%
This area has been examined many times before and there are adequate examples in the learning
materials. However this part of the question was not well answered and common errors were: not stating
that the special dividend should be ignored when calculating growth from past dividends; calculating
growth from past dividends and using the 5th root rather than the 4th root; inverting the growth computation;
confusion of digits between £ and pence; incorrect market value computations; when calculating the IRR
of the debentures incorrect computations with two negative NPVs, incorrect IRR computation and omitting
tax: when using the CAPM for ke using the market return and not the market risk premium.


3.2
The cost of equity will have to reflect the systematic business risk of the diversification and the financial
risk. An appropriate equity beta will have to be selected. Bowlright’s beta is affected by its diversification
into bowling alleys and gyms. The Local does not operate in the gym market sector. The choice of equity
beta is therefore that from Fitgroup, which is 0.56.
We will have to consider whether the Fitgroup equity beta should be adjusted for financial risk. The
gearing of Continental is:(1410/8740) = 16% and Fitgroups gearing is: 150/434) = 35%. The two gearing
ratios are material different and gearing adjustments will have to be made:
Degear: 0.56 = Ba (1+ ((150 x 0.83)/434)) = 0.44
Regear: Be = 0.44 (1+ ((1410 x 0.83)/8740)) = 0.50
Ke = 3 + 0.50 (9 – 3) = 6%
Answers to this part of the question were often weak common errors were: inadequate narrative on why
an equity beta should be chosen from the samples of comparative companies given; choosing the
incorrect comparator; using an average of all three or just two of the comparators; incorrect computations
when degearing the equity beta, in some cases ending up with a higher asset beta than the equity beta;
regearing the asset beta using Continental’s book values; using clearly impossible equity betas in the
CAPM, for example an equity beta of 28.

3.3
(a) If the diversification is financed by debt the price of the debentures will fall to:
94 (1-0.05) = 89.3
The market value of existing debt will now become: 1500 x 0.893 = £1339.5m
Total debt will be: 1339.5 + 1000 = £2339.5m
Gearing will be: 2339.5/8740 = 27%
(b) If the diversification is finance by equity the price of the debentures will rise to:
94 (1+0.05) = 98.7
The market value of debt will now become: 1500 x 0.987 = 1480.5
The market value of equity will be: 8740 + 1000 = £9740m
Gearing will be: 1480.5/9740 = 15%
Note: These gearing figures are approximate since it is unlikely that the market value of existing
equity will in reality remain the same after the diversification.
Disappointing answers and common errors were: not recalculating the value of the existing debt; using a
combination of book and market values; using just book values; using the incorrect measure of gearing i.e
debt/debt + equity instead of debt/equity (despite the question stating, twice, that market values and
debt/equity should be used).

3.4
Gearing:
Current Gearing If financed by debt If financed by equity

16% 27% (from 3.3 above) 15% (from 3.3 above)
The view of the board member that gearing is irrelevant has practical and theoretical implications as
follows:

Practical Considerations:
Equity:
Continental currently has gearing around the market average at 16% and financing the diversification by
equity will change this to 15%, which is not materially different. Shareholders and the markets should not
be worried about this change. However unless the equity is raised by way of a rights issue there might be
control issues. Even if there is a rights issue there will be control issues for shareholders who do not wish
to take up their rights. To ensure that a rights issue would be fully subscribed it is likely to be underwritten
which will incur a cost. Dividends do not have to be paid unlike interest. If some of the equity comes from
cutting the special dividend then this may upset shareholders and have an adverse impact on the value of
the equity (signalling).
Debt:
Financing the diversification by debt will materially increase the gearing from 16% to 27%, it would be
useful to know the maximum gearing in Continentals market sector. This increase may cause
shareholders and the markets concern and it could have adverse implications for raising future debt
finance. Debt interest has to be paid.
Combination of Debt and Equity:

Perhaps the most prudent way to finance the diversification would be to use both debt and equity in
proportions that will maintain Continentals current gearing of 16% ie more equity than debt within the
£1,000 million raised.
Theoretical Considerations:
As stated above from a practical viewpoint as stated above gearing does have implications. However from
a theoretical point of view it is useful to look at the views of Modigliani and Miller (M&M).
In 1958 M&M showed that in a no tax world there is no advantage for firms to issue debt. There is
therefore no optimal capital structure. However one of the main advantages of issuing debt is that the
company gets tax relief on the interest. In 1963 M&M showed that, in the presence of corporation tax, it is
advantageous for companies to issue debt.
The effect of interest being allowable against tax means that the higher the gearing the less tax a
company will pay. This implies that Continental should not consider financing the diversification by equity
at all and should only consider debt financing.
M&M stated that a company that has gearing is worth more than one that does not. This increase in value
being due to the tax shield on debt. Since debt is cheaper than equity this implies that WACC will fall as
gearing rises, hence increasing the value of the firm. Continental will therefore increase its value if it
borrows the £1,000 million. In the extreme M&M 1963 suggests that the optimal gearing is 100%, however
this is impractical and Continental would certainly risk bankruptcy if it were to gear up to this level.
The traditional theory (aka trade-off theory) suggests there is an optimal capital structure with a minimum
WACC (and maximum firm value). If the 16% industry gearing is considered optimal by the market then
both methods of finance move the company away from the optimal, increasing the WACC and reducing
the company’s value (more so in the case of debt).
Conclusion:
Although there is merit in what M&M state it would be prudent for Continental to consider the practical
implications of financing the diversification as stated above and use a mix of debt and equity.
Given that the question set out four areas that should be addressed answers were disappointing in that
not all the area were covered. Answers tended to be general and not related to the scenario of the
question. The scenario stated that Continental’s current gearing is near to the industry average and yet
few candidates referred to this in their answers, nor calculated the current gearing. The question asked for
theory but this should be related to the scenario and not just a mind dump of the theory.

WEDNESDAY 13 MARCH 2019
(2.5 HOURS)
Marks breakdown
Question 1 35 marks
Question 2 35 marks
Question 3 30 marks
2. The invigilator cannot advise you on how to use the software, but please alert them
immediately if you encounter any issues during the delivery of the exam. If you believe
that your performance has been affected by any issues which occurred, you must
request and complete a candidate incident report form at the end of the exam. This form
must be submitted as part of any subsequent special consideration application.
6. You must make sure your answers are clearly visible when you submit your exam. Your
answers will be presented to the examiner exactly as they appear on screen: the
examiner will not be able to review your formulae, or expand rows or columns where
content is not visible.
Copyright © ICAEW 2019. All rights reserved

Question 1
Assume that the current date is 28 February 2019
Palace Parade Furniture plc (PPF) is a UK-based furniture manufacturer. It has been trading
since 1992. PPF makes domestic furniture, such as chairs and beds, which is sold to retailers
across Europe. This market is very competitive and PPF’s board is considering diversifying
its product range. One means of diversification would be the purchase of the majority of the
shares in Turner Pring Ltd (TP), a UK-based kitchen manufacturer.
TP has traded since 1998 and makes a wide range of kitchen units which are sold to
specialist UK retailers. TP’s two founders, Violet Turner and Arthur Pring, own 65% of the
company’s shares. PPF’s board has been informed that Violet and Arthur wish to sell all of
their shares. The senior managers of TP have expressed an interest in a management buy-
out (MBO), but Violet and Arthur would also consider offers from other parties.
You work in PPF’s finance team. You have been asked by PPF’s board to prepare a range of
valuations for Violet and Arthur’s shares, supported by guidance on the methods by which
PPF could pay for those shares.
Extracts from TP’s most recent management accounts are shown below:
Income statement for the year to 28 February 2019
£’000
Sales 64,200
Profit before interest 7,200
Interest (1,800)
Profit after interest 5,400
Corporation tax at 17% (918)
Dividends (2,890)
Retained profits 1,592
Balance sheet as at 28 February 2019
£’000 £’000
Land and buildings 15,600
Plant and machinery 19,200
Vehicles 1,400
36,200
Current assets 8,110
44,310

17,080
7.5% Redeemable debentures 24,000
Current liabilities 3,230
44,310

Other information
1. Four UK listed companies in the same industry sector as TP have the following P/E
ratios and dividend yields:
Allex plc Tagg plc Gresty plc Joanz plc

P/E ratio 8.1 10.7 9.5 9.3
Dividend yield 7.0% 8.3% 8.0% 7.5%
2. TP’s profit before interest figures for the five trading years to 28 February 2019 were:
2015 2016 2017 2018 2019

£’000 £’000 £’000 £’000 £’000
3,600 11,800 3,800 4,800 7,200
PPF wishes to use this information to derive an average earnings figure for use in a P/E
valuation of TP.
3. TP has paid a constant dividend per share since 2014. TP’s last issue of ordinary
shares was in 2013.
4. TP’s debentures are redeemable in 2020.
5. TP’s non-current assets are independently valued at:
£’000
Land and buildings 23,200
Plant and machinery 20,800
Vehicles 1,150
These values are not reflected in TP’s balance sheet at

28 February 2019.
6. You should assume that the corporation tax rate has been and will remain at 17%.
Requirements
1.1 Prepare a report for PPF’s board that
 calculates the value of one share in TP at 28 February 2019 using the P/E, dividend
yield and asset-based valuation methods (13 marks)
 comments on the strengths and weaknesses of the three valuation methods used
and (10 marks)
 outlines two methods by which PPF could pay for Violet and Arthur’s shares.
(4 marks)
1.2 Identify how the shareholder value analysis (SVA) approach to company valuation
differs from the valuation methods used in part 1.1 above. (4 marks)
1.3 Explain how an MBO works and the means by which the managers could finance it.
(4 marks)
Total 35 marks

Question 2
Assume that the current date is 28 February 2019
Edencatt Packaging plc (EP) is a UK listed manufacturer. It has a financial year-end of

28 February. The company started trading in 1996, making a limited range of bespoke plastic
shopping bags for small retailers. Since then EP has expanded via organic growth and the
acquisition of other companies. It now supplies plastic bags and bottles to manufacturers
across Europe, mainly in the food, chemicals and agricultural sectors.
There is public concern with the environmental impact of plastic products. In response, EP’s
board is investigating the possible purchase of the entire share capital of Marshgreen Ltd
(Marshgreen), a manufacturer of glass bottles and paper bags and wrapping. It would cost
EP £13 million to purchase Marshgreen.
Minutes taken at EP’s most recent board meeting included the following comment made by
Josie Hatton, EP’s production director:
“If we are to proceed with our appraisal of the investment in Marshgreen then we should
make sure that we use an accurate hurdle rate in our NPV calculations. We’ve been using
a cost of capital figure of 8% for at least three years now. The danger here is that by using
a hurdle rate that’s too high or too low we will be destroying shareholder wealth. Surely
our objective is to maximise shareholder wealth?”
You work in EP’s finance team and have been asked to advise the board on a suitable cost
of capital for appraising the possible Marshgreen investment.
Extracts from EP’s most recent management accounts are shown below:
Income statement for the year ended 28 February 2019
£’000
Interest (290)
7,040
Corporation tax at 17% (1,197)
5,843
Preference dividend (160)
5,683
Ordinary dividend (4,455)
Balance sheet as at 28 February 2019
Non-current assets 19,600

Net current assets 1,300
20,900
Ordinary shares (£1 par) 5,500

13,700
8% Preference shares (£1 par) 2,000
5% Redeemable debentures (see note) 2,200

6% Irredeemable debentures 3,000
20,900
Note
The 5% debentures are redeemable at par on 28 February 2022.
Other information:
Market values of EP’s long-term funds at 28 February 2019
Ordinary shares £9.06 cum div

Preference shares £1.24 ex div
5% Redeemable debentures £97% ex int
6% Irredeemable debentures £97% cum int
EP’s ordinary dividend has been increasing at a steady rate over the past five years. In 2014
the ordinary dividend per share was £0.735. There have been no changes to the number of
ordinary shares in issue since 2014.
CAPM data
EP’s equity beta 1.20
Expected return on the market portfolio 9.8% pa
Average equity beta for Marshgreen’s sector 1.65
Ratio of long-term funds (equity:debt by market values)
for Marshgreen’s sector 88:12
If EP were to purchase Marshgreen’s shares it would raise the necessary funds via the issue
of both ordinary shares and 8% redeemable debentures. The funds would be raised in such a
way as to preserve EP’s existing gearing ratio (equity:debt by market values).
Requirements
2.1 Calculate EP’s weighted average cost of capital (WACC) at 28 February 2019 using
(a) The dividend growth model and (16 marks)

2.2 Determine an appropriate WACC that EP could use when appraising the £13 million
investment in Marshgreen and explain the reasoning behind your approach. (10 marks)
2.3 Explain how the APV technique works and the circumstances under which it is
applicable. (4 marks)
2.4 Comment on Josie Hatton’s view that maximisation of shareholder wealth should be the
objective of EP’s board.
(3 marks)
Total 35 marks

Question 3
Assume that the current date is 1 March 2019
Cool Sports Ltd (CS) is a UK retailer of sportswear. It purchases its goods in bulk to take
advantage of quantity discounts. These goods are held in three main warehouses and from
there they are distributed to CS’s chain of large retail outlets across the UK. Currently 70% of
CS’s purchases are imported from southern Europe with the remainder coming from India.
You are an ICAEW Chartered Accountant and you work in CS’s finance team.
CS’s board is considering the following two issues:
1. Whether to hedge against exchange rate movements in the Indian currency (rupees).
2. Whether to establish a production facility overseas which would enable CS to take

advantage of lower labour costs and less rigorous health and safety regulations.
To date CS has not hedged against the exchange rate risk of any of its Indian imports.
However, with the possibility of an increased level of purchases from India, you have been
asked to investigate the implications of hedging that risk.
CS has recently signed the contract for a large consignment of goods from its main Indian
supplier, BDC. The goods will arrive on 30 April 2019. The agreed price is 145 million Indian
rupees (R) and CS will pay that sum to BDC on 31 May 2019.
You have collected the following data at the close of business on 1 March 2019:
Spot rate (R/£) 91.07 – 91.89

Three-month forward contract discount (R/£) 0.62 – 0.78
Forward contract arrangement fee
(per one million rupees converted) £95
Three-month OTC call option on rupees,
exercise price (R/£) 94.25
Three-month OTC put option on rupees,
exercise price (R/£) 95.50
OTC option premium (per one million rupees converted) £250
Relevant currency futures contract price
(standard contract size £62,500) R/£ 92.12
Rupee interest rate (lending) 6.0% pa
Rupee interest rate (borrowing) 6.8% pa
Requirements
3.1 Calculate for CS’s board the sterling cost of the BDC consignment if it uses the
following hedging instruments to hedge its exchange rate risk:
 A forward contract
 An OTC currency option
 Currency futures contracts
 A money market hedge

You should assume that on 31 May 2019 the sterling currency futures price will be R/£
92.88 and the spot exchange rate will be R/£ 92.45 – 93.32. (13 marks)
3.2 Advise CS’s board whether it should hedge its Indian rupee payment to BDC. You
should refer to your calculations in part 3.1 above and the sterling cost of not hedging.
(9 marks)
3.3 Explain the principle of interest rate parity (IRP). Given the information provided above,
calculate the forward rate of exchange on 31 May 2019 using IRP, commenting on your
result. You should use the average current spot and borrowing/lending rates for the
purposes of this calculation. (5 marks)
3.4 Outline the main elements of an ethical employment policy that CS could adopt if it were
to establish a production facility overseas. (3 marks)
Total 30 marks

Professional Level – Financial Management – March 2019

Question 1
Total marks: 35
General comments
This question had (marginally) the lowest percentage mark on the paper. Most candidates achieved a
“pass” standard in this question.
The scenario was based around a large UK-listed furniture manufacturer. This company was considering
diversifying its operations via the purchase of a controlling interest in a (non-listed) kitchen manufacturer.
Candidates were cast as an employee of the bidding company and given summarised financial statements
and other relevant data of the target company. In part 1.1a, for 13 marks, candidates were asked to
calculate a range of values for the target company. These were based on P/E, dividend yield and assets.
Part 1.1b, for ten marks, required candidates to comment on their findings and to summarise the strengths
and weaknesses of the valuation methods employed. In part 1.1c, for four marks, candidates were asked
to outline two methods by which the bid company could pay for the target’s shares. Part 1.2, for four
marks, examined SVA as a valuation method. Candidates were asked to explain the rationale that
underpins SVA. Finally, part 1.3, also for four marks, asked candidates to explain the workings of an MBO
and the methods by which the management involved could raise the funding required.
1.1a
P/E values:
[If candidates don’t use data to get average Earnings as instructed then:
Average P/E of listed companies (8.1+10.7+9.5+9.3)/4 = 9.4
2019 Earnings (TP) £4.482m
Average P/E x 2019 Earnings 9.4 x £4.482m £42.131m
Value/share £42.131m/8.5m £4.96
Mark-down for lower marketability (non-listed shares) at, say, 70% £3.47]
If they do use data to get average Earnings as instructed then:

£m
Average PBIT for TP [£m] (3.6+11.8+3.8+4.8+7.2)/5 = 6.240
less: Interest (£24m x 7.5%) (1.800)
Average PBT for TP 4.440
less: Tax @ 17% (0.755)
Average Earnings for TP 3.685
Average P/E as above = 9.4
Average P/E x Average Earnings 9.4 x £3.685m £34.639m

Value/share £34.639m/8.5m £4.08
Mark-down for lower marketability (non-listed shares) at, say, 70% £2.86
Dividend yield values:

Average yield of listed companies (7.0%+8.3%+8%+7.5%)/4 = 7.7%
2019 Dividend (TP) £2.890m
2019 Dividend/Average yield £2.890m/7.7% £37.532m
Value/share £37.532m/8.5m £4.42

Mark-down for lower marketability (non-listed shares) at, say, 70% £3.09
Asset-based values:
Net Assets (per Balance Sheet) £17.080m
Value per share £17.080m/8.5m £2.01
Revalued Net Assets (£17.080m - £36.2m + £23.2m + £20.8m + £1.15m) 26.030m

Value per share £26.030m/8.5m £3.06
Part 1.1a was generally done well, but many students scored very low marks and showed little
understanding of the figures given and how to use them for valuation. The most common errors with the
P/E valuation were (i) ignoring the averaging instruction given in the paper and (ii) using PBIT rather than
the earnings figure. Excluding the “outliers” (2016, 2019) was acceptable if explained, but several
candidates just did it, without explanation and will have lost marks. The dividend yield calculations were in
general done well. The most common error was to multiply the current dividend by 7.7% rather than divide
it. The asset values were the weakest calculations overall because a very large minority of candidates
used assets and not net assets.

1.1b
 Based on the above figures the price range is approximately £2 to £3.50 per share.
 This is an offer for 65% of TP’s shares. So PPF would then have control of TP – thus a premium would
be payable.
 The P/E ratio is normally a better guide as it considers the earnings creating potential of the company
rather than just the value of its assets. However 2015-2019 earnings are erratic, so it is prudent to
consider past earnings as well as current. How typical are 2016 and 2019 for example? This suggests
a degree of risk with TP’s earnings – so should PPF offer a lower price? Earnings can be manipulated
by accounting policies.
 PPF will be looking forwards and intending to generate future earnings from TP, not liquidate (asset
strip) it as in asset values. It will be necessary to discount (by, say 30%) this P/E valuation because
TP’s shares will be less marketable.
 The dividend yield approach is most effective when an investor is looking for dividend income rather
than control. This is not the case here and future earnings will be of more relevance to PPF’s directors,
acting on behalf of its shareholders. As with P/E it will be necessary to discount (by, say 30%) the yield
valuation because TP’s shares will be less marketable. Growth is ignored.
 Asset values – historic so not equal to MV and only considers tangible assets and ignores income.
Revalued figures are better as they are more up to date, but they still have the same disadvantages.
 Debentures are redeemable very soon in 2020 – this could have a negative impact on the price
payable.
The discussion here was disappointing. Most candidates did not discuss the three key issues (purchasing
a controlling interest, the variable earnings and the imminent [2020] redemption of debentures). These
elements certainly distinguished between good candidates and those just learning and churning.

1.1c
Paying in cash
This is more attractive to the target shareholders as the value is certain. There may be personal tax
implications.
This may cause liquidity problems for the bidding firm and so it may be necessary to increase its gearing.
Lower transaction costs will arise with a cash purchase.
Paying with shares

There are no liquidity problems
There are no immediate tax issues
There will be a dilution of ownership and any gains made will now be shared with the target shareholders.

Paying with loan stock

This avoids dilution of ownership
There is an assured return for stock holders
This could cause gearing problems
Many answers here were poor. Candidates showed a lack of understanding of the scenario by suggesting
a rights issue or a debenture issue. Also, too many candidates suggested using retained earnings rather
than cash.

1.2
Shareholder value analysis (SVA) is an income measure (not asset-based) and 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 (PV) of the cash flows
generated by all of its activities rather than the earnings or dividends. 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). SVA links a business’ value to its strategy (via the value drivers).
The seven value drivers are a key element of the SVA approach to valuing a company.
7. Cost of capital
The majority of a DCF value estimate comes from the “residual value”, the worth of the company at the
end of the projection period. That, naturally, depends heavily on the cash flows estimate in the final year
modelled – a result, logically, of the trend in the early years.
SVA has been examined regularly in recent exams and candidates, as expected, did well here. The most
common error was to misunderstand a key issue of SVA’s purpose, namely to establish a PV, not an NPV.

1.3
MBO - existing management buys the company from the existing shareholders
Methods by which management might fund its MBO:
From management’s equity
From venture capitalists – via equity and debt
Borrowing from bank(s) – debt
Most candidates scored at least three marks out of the (maximum) four that were available.


Question 2
Total marks: 35
General comments
This question was had the second highest percentage mark on the paper. A good majority of candidates
reached a “pass” standard in the question.
This was a four-part question that tested the candidates’ understanding of the financing options element of
the syllabus.
In the scenario a UK-listed packing manufacturer was considering diversifying via the purchase of the
entire share capital of a manufacturer of eco-friendly packaging materials. Candidates were given data to
aid them in preparing informed advice for the bidding company’s board.
Part 2.1 was worth 18 marks and required candidates to calculate the bid company’s current WACC
figure, using (i) the Dividend Growth Model and (ii) the CAPM. For ten marks, part 2.2 asked candidates to
determine and explain the appropriate WACC to use when appraising the purchase of the target company.
Part 2.3, for four marks, required candidates to explain when and how to employ the Adjusted Present
Value technique. Finally, for three marks, part 2.4 asked candidates to comment on whether maximisation
of shareholder wealth should be the objective of a company’s board.
2.1a
Cost of equity (ke)
Latest dividend (d0) £4.455m/5.5m = £0.81
Dividend growth rate = £0.0810 = 1.102 over 5 yrs. so 1.1021/5-1 = 2% pa

£0.0735

MV (£8.25)
Cost of preference shares (kp) d £0.08 6.5%

MV £1.24

0 (97) 1.000 (97.000) 1.000 (97.000)
1-3 5 2,723 13.615 2.486 12.430
3 100 0.864 86.400 0.751 75.100
NPV 3.015 NPV (9.470)
IRR = 5% + (5% x (3.015/(3.015+ 9.470))) = 6.2%
less: Tax at 17% (6.2% x 83%) = 5.1%

MV £91
WACC
Total MV’s
Equity (5.5m x £8.25) 45.375 12.0% x 45.375/52.719 10.3%
Preference shares (2m x £1.24) 2.480 6.5% x 2.480/52.719 0.03%
Redeemable debt (£2.2m x 0.97) 2.134 5.1% x 2.134 /52.719 0.02%
7.344 0.08%

It was good to see that many candidates scored full marks here, i.e. 16 out of 16. Amongst the weaker
answers, common errors noted with the cost of equity were (i) treating the 2014 dividend (73.5p/share) as
the most recent dividend (2019), (ii) using simple averages for the annual growth rate rather than a
compound average, (iii) using g=br instead of the compound rate - which gave a growth rate way in
excess of what really happened, (iv) using four years’ growth years not five. With the cost of preference
shares and irredeemable debt, too many candidates used only the coupon rate and ignored the market
value. Typical errors with the cost of redeemable debt were (i) using the wrong current market value
and/or the wrong discount factors (ii) incorrect use of NPV’s to calculate the IRR (iii) using book, rather
than market, value for the WACC calculation.

2.1b

Applying EP’s beta to the risk premium 1.20 x 6.2% 7.4%

WACC
Total MV’s
Equity (5.5m x £8.25) 45.375 11.0% x 45.375/52.719 9.5%
Preference shares (2m x £1.24) 2.480 6.5% x 2.480/52.719 0.03%
Redeemable debt (£2.2m x 0.97) 2.134 5.1% x 2.134 /52.719 0.02%
7.344 0.08%
Total market value 52.719 10.3
Here, a few candidates were unable to calculate the cost of equity using the CAPM, which was a surprise.


2.2
New market ungeared beta = (1.65 x 88) (1.65 x 88) 1.48

(88 + (12 x 83%)) 97.96
EP’s geared beta = 1.48 x (£45.375m+ £2.48m + (£4.864 x 83%)) 1.70

£45.375m
So, cost of equity = (1.70 x 6.2%) + 3.60 14.1%
Cost of debt = 8% x 83% 6.6%
WACC = (14.1% x 45.375m/£52.719m) + (6.6% x £7.344m/£52.719m)) 13.1%
It would be unwise to use the existing WACC as EP’s plan involves a degree of diversification
and therefore a change in the level of systematic business risk (beta rises from 1.20 to 1.70).
Thus a new WACC must be calculated. Systematic risk is accounted for by taking into
account the beta of the glass/paper market and this is then adjusted to eliminate the financial
risk (level of gearing) in that market. The resultant ungeared beta is then “re-geared” by
taking into account the level of gearing of the new funds being raised which remains the
same i.e. financial risk for EP is constant. Higher cost of debt because of the higher
systematic business risk.
Whilst there were some very good answers to part 2.2, the average score for it was approximately 5 out of
10, i.e. below pass standard. Too many candidates were unable to de-gear and re-gear properly and
many calculated a geared beta and/or cost of equity that were well in excess of reality. Not many
candidates calculated the after-tax cost of the new debt and then the new WACC, which was based (only)
on the new debt and the new cost of equity. The written section of this part was generally poor, even
though this topic has been set regularly in recent examinations.

2.3
Adjusted Present Value (APV)
Increased gearing may lead to a fall in WACC because of the tax shield on loan interest. To find the new
WACC requires the new MV of the company’s shares. However this requires the NPV of the proposed
investment to be known, which needs the new WACC. To avoid this circular argument one would use APV
which:
1. Calculates a base case value
2. Calculates the PV of the tax shield
3. Adjusts for issue costs
Add 1, 2 and 3 to give APV - if it is positive then proceed with investment.
This was answered well and most candidates demonstrated a good understanding of APV.


2.4
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:
Managers will have their own objectives (pay, security, power) which could lead to agency problems
Employees/Unions – staff morale and job security are important
Lenders/Creditors – will they receive their expected returns/settlements?
Government – a firm should behave legally, pay its taxes on time
Regulators - a firm should follow the relevant regulations
Society will be interested in, for example, pollution levels
Part 2.4 was problematic for many candidates. Most of them answered a different question to that set, i.e.
they discussed the errors that could be made in investment appraisal if the wrong discount rate is used. It
would appear that they were seduced by a comment made in the scenario rather than reading the
requirement carefully.
Total possible marks 3.5

Question 3
Total marks: 30
General comments
This question had the highest average mark on the paper and a large majority of the candidates achieved
a “pass” standard.
of the syllabus and there was also a small section with an ethics element to it.
The company in this question was a UK retailer of sportswear. It imports goods from suppliers in Europe
and India. The company’s board was planning to increase the proportion of its imports that originate in
India. As a result, the board was considering whether to (i) hedge against exchange rate movements on
Indian imports and (ii) establish a production facility in India. Candidates were cast as an employee in the
company’s finance team. In Part 3.1, for 13 marks, candidates were instructed to calculate, using four
different hedging instruments, the sterling cost of a large consignment of Indian goods. Part 3.2, for nine
marks, required candidates to advise the company’s board whether to hedge the consignment. In part 3.3,
for five marks, candidates were asked to explain the principle of interest rate parity and, using data given
in the scenario, to show how it works. Part 3.4 was worth three marks. Here, candidates were required to
outline the main elements of an ethical employment policy that the company could adopt were it to open a
production facility in India.
3.1
R
Spot rate 91.07
91.69
£
Translation of rupees R145m/91.69 (1,581,416)
plus: Arrangement fee R145m/1m x £95 (13,775)
(£1,595,191)
(2) OTC Option
CS will buy rupees so it’s a call option

Exercise at 94.25 (vs. spot @ 92.45)
Purchases of rupees R145m/94.25 (1,538,462)
plus: Option fee R145m/1m x £250 (36,250)
(£1,574,712)
(3) Currency futures
Buy rupees. Sell £.
No of contracts R145m 1,574,034 25.2 contracts

92.12 62,500
Say 25 contracts
At 31/5/19 Buy (92.88)

Sell 92.12
Loss on futures (0.76) x 25 x 62,500 R1,187,500
Contract price R145,000,000
Total R146,187,500
Converted at spot rate on 31/5/19 R146,187,500 (£1,581,260)

92.45


Invest in rupees now R145m R145m R142,857,100
1 + (6%/4) 1.015
Convert at spot rate R142,857,100 (£1,568,652)

91.07
Sterling borrowed at 3.8% pa (£1,568,652) x [1 + (3.8%/4)] (£1,583,554)

Many candidates scored full marks here and showed a really good understanding of the various hedging
techniques involved. Typical errors within the weaker answers were (i) deducting, rather than adding, the
forward rate discount (ii) deducting, rather than adding, the arrangement fees (iii) not identifying the
option/futures correctly, i.e. put/sell (iv) the futures loss (or gain) was shown in £ and not rupees.

3.2
Current spot At spot rate 1/3/19 R145m
91.07 (1,592.182)
3-month spot At spot rate 31/5/19 R145m

92.45 (1,568.415)
SUMMARY STERLING COSTS £

3-month spot (1,568.415)
Option (1,574.712)
Future (1,581,260)
MMH (1,583.554)
Current spot (1,592.182)
Forward contract (FC) (1,595.191)
From these figures, no hedge looks the cheapest option. The option is cheapest hedge.
MMH, futures & FC will give fixed amounts. Option allows upside but expensive premium.
Other general comments re various methods.
What is the management’s attitude to risk?
The forward discount suggests that the rupee should lose value. This would be good news for
CS as an importer (strengthening sterling).
This was done well by many candidates, but a lot of answers were too general. So there was discussion of
the strengths/weaknesses of various hedging techniques, but little advice given that related to the
scenario.


3.3
Av spot rate x Av rupee rate (3 mos.) = Av f’wd rate = Av discount
Av sterling rate (3 mos.) given in question
91.48 x 1.01600 = 92.18 0.70 OK

1.00825
Theory IRP links currency & money markets (MM).

MM interest rates explain difference between forward and spot rates
No gain can be made on interest rates of different currencies
In part 3.3 a good number of candidates were able to explain IRP and demonstrate it working from the
data given. Key reasons for lower scores here were (i) weak definitions of IRP and (ii) using 12-month
averages rather than three months.

3.4
An ICAEW accountant should behave with integrity and s/he should behave in a professional manner.
With this in mind an ethical employment policy is needed and it could include:
Commitment to work within the rules and regulations of the Indian government
No forced labour
No child labour
Employees should have the right to join a trade union
Employees should receive a living wage in cash
Reasonable working hours
Employees should have an employment contract
Employees should have equal opportunities
Health and Safety standards should be in line with regulations
This was, in general, answered well.


WEDNESDAY 12 JUNE 2019
(2.5 HOURS)
Marks breakdown
Question 1 35 marks
Question 2 35 marks
Question 3 30 marks
must request and complete a candidate incident report form at the end of the exam.
This form must be submitted as part of any subsequent special consideration
application.

Question 1
Assume that the current date is 30 June 2019.
Optical Answers plc (OA) manufactures a range of eyewear and eyewear accessories. The
finance director of OA is undertaking the following two tasks.
1.1 Task One – Handyspecs project
The project involves the launch of a range of compact folding reading glasses called
“Handyspecs”. A market research consultant has produced a report, costing £250,000, which
estimated that the product life cycle will be three years. The report also identified a rival firm
which is contemplating launching a similar product range on the market sometime in the next
12 months.
The following information is available regarding Handyspecs.
 The selling price will be £18.50 per unit for the year to 30 June 2020 and will then
increase by 3% pa. Contribution is expected to be 70% of the selling price.
 Demand is estimated to be 10,000 units per month in the year to 30 June 2020 and then
decline by 10% pa in the two years to 30 June 2022.
 Selling and administration costs are estimated to be £100,000 for the year to 30 June
2020 and are expected to increase by the general level of inflation in the two years to 30
June 2022.
 Fixed costs, 50% of which are centrally allocated, are estimated to be £80,000 in the year
to 30 June 2020. These fixed costs are expected to increase by the general level of
inflation in the two years to 30 June 2022.
 OA will rent factory space to manufacture Handyspecs at a cost of £50,000 pa, payable
in advance on 30 June. The rent is not subject to inflationary increases.
 Investment in working capital will be £250,000 on 30 June 2019 and will increase or
decrease at the start of each year in line with sales volume and sales price changes.
Working capital will be fully recoverable on 30 June 2022.
 On 30 June 2019 investment in plant and equipment costing £2 million will be required.
This will have an estimated scrap value of £200,000 on 30 June 2022 (in 30 June 2022
prices).
 The plant and equipment attracts 18% (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 plant and equipment’s written
either as a:
value, or

 Assume that corporation tax will be payable at the rate of 17% for the foreseeable future
and tax will be payable in the same year as the cash flows to which it relates.
 A suitable real discount rate to assess the net present value of the project is 7%. The
general level of inflation is expected to be 2.5% pa.
Requirements
(a) Using money cash flows, calculate the net present value of the Handyspecs project at
30 June 2019 and advise OA’s board as to whether it should proceed with the project.
(b) Ignoring the effects on working capital, calculate and comment upon the sensitivity
of the project’s NPV to changes in sales volume.
(4 marks)
(c) Identify and explain two real options associated with the proposed Handyspecs project.
(4 marks)
(d) Outline how shareholder value analysis (SVA) could be used to evaluate the
Handyspecs project. (3 marks)
1.2 Task two – Capital budget
OA has other projects that it has already appraised using NPV analysis. The company has no
difficulty in raising funds from the capital markets. However, the capital expenditure budget
(excluding the Handyspecs project) has been set at a maximum of £10 million for the year to
30 June 2019. The £10 million will be allocated to projects, excluding Handyspecs, on the
basis of maximising shareholder wealth.
The indivisible projects available for investment of the £10 million are as follows:
Project Initial expenditure NPV

£m £m
A 2.0 0.5
B 4.0 1.5
C 3.0 1.0
D 2.0 (0.5)
E 6.5 2.5
Requirements
(a) Determine the combination of projects that will maximise shareholder wealth.
(4 marks)
(b) State the difference between hard and soft capital rationing and identify the type of
capital rationing that is being employed by OA. Also discuss whether the type of
rationing being employed by OA is appropriate for maximising shareholder wealth.
(5 marks)
Total: 35 marks

Question 2
Assume that the current date is 31 May 2019.
Stable plc (Stable) operates department stores and has an accounting year ending 31 May.
Because of a decline in sales and profits, Stable is seeking to diversify and has identified
another quoted company, Exito plc (Exito), as a likely takeover target. Stable’s finance
department has estimated that Exito could be purchased for £300 million. The £300 million
purchase price represents the present value of Exito’s free cash flows discounted using an
appropriate risk adjusted WACC. The finance to purchase Exito would be raised in such a
way as to leave Stable’s existing gearing (measured as debt:equity by market values)
unchanged after the acquisition.
The CEO of Stable would like the finance director (who is an ICAEW Chartered Accountant)
to address the following points raised at a recent board meeting:
 The board would like an explanation of how the WACC used to establish the purchase
price of Exito was calculated and why this differs from Stable’s current WACC.
 The board would like to know at what price the debt proportion of the £300 million finance
required for the Exito purchase should be issued.
 The sales director suggested that since Stable is going to make a bid for Exito, it would
be financially advantageous for board members to buy shares in Exito before the bid is
publicly announced.
 The production director asked whether it would be a good idea to partly finance the
acquisition of Exito by Stable not paying dividends in the next financial year.
The finance director of Stable has the following information available to him to address the
above points raised at the board meeting:
 Stable has in issue £40 million nominal of ordinary shares, each with a par value of 10p
and a market value of 405p(ex div) on 31 May 2019. The number of ordinary shares has
not changed in the last five years.
 On 31 May 2019 Stable has in issue £395 million nominal of 5% redeemable debentures
with a market price of £109 (cum interest) per £100 nominal value. The debentures are
redeemable in four years’ time at par.
 Stable has an equity beta of 0.5.
 Exito as an equity beta of 1.2 and a debt:equity ratio, by market values, of 40:60.
 The debt proportion of the £300 million finance to be raised on 1 June 2019 will be in the
form of new 3% coupon debentures redeemable on 31 May 2024 at par. The redemption
yield of the new debentures will be equal to the redemption yield of Stable’s existing 5%
debentures.
 The market risk premium is expected to be 5% pa and the risk free rate 2% pa.
 The corporation tax rate will be 17% for the foreseeable future.

 Stable’s dividends during the past four years ending 31 May were as follows:
Type of 2016 2017 2018 2019

dividend £m £m £m £m
Ordinary 43 45 46 48
Special 4 1 -- --
Total 47 46 46 48
Requirements
2.1 Ignoring the acquisition of Exito, calculate the cost of equity of Stable at 31 May 2019
using:
 the dividend valuation model (dividend growth should be estimated using the
earliest and latest dividend information provided) (3 marks)
 the CAPM (1 mark)
2.2 Ignoring the acquisition of Exito and using the CAPM, calculate the current WACC of
Stable at 31 May 2019.
(6 marks)
2.3 Using the CAPM, calculate the risk adjusted WACC that Stable will have used to find
the present value of Exito’s free cash flows. Explain why this is different to Stable’s
current WACC that you have calculated in 2.2 above.
(8 marks)
2.4 Assuming that £80 million is raised from the new 3% coupon debentures issued on 1
June 2019, calculate the issue price per £100 nominal value and the total nominal value
that will have to be issued to give a redemption yield equal to that of Stable’s current 5%
debentures. Also comment upon whether it is appropriate to use the redemption yield
on the current debentures to establish the new issue’s price. (6 marks)
2.5 Making reference to relevant theories and practical considerations, evaluate whether it
would be appropriate for Stable to not pay a dividend next year to part fund the
acquisition of Exito. (8 marks)
2.6 Discuss the ethical and legal implications for the finance director and the advice he
should give to the board regarding the suggestion made by the sales director. (3 marks)
Total: 35 marks

Question 3
Assume that the current date is 30 June 2019.
Technical Equipment Ltd (TE) is based in the UK. TE has recently secured a contract to
import products from a major manufacturer of outdoor equipment based in the Eurozone and
payment will be made to them in euro. TE intends to sell the equipment to customers in the
UK and the USA.
TE’s board has no experience of hedging foreign exchange rate (forex) risk and has asked a
firm of consultants to provide advice. The advice will cover hedging instruments and
economic risk.
You work for the consultants and have the following information available to you at the close
of business on 30 June 2019:
TE has estimated that it will receive $6 million in three months’ time from its American
customers.
TE currently has funds on deposit.
Exchange rates
Spot rate ($/£) 1.3155 – 1.3159

Three month forward discount ($/£) 0.0037 – 0.0055
September currency futures
Standard contract size £62,500. Price $1.3200/£
Over-the-counter (OTC) currency options
September put options to sell $ are available with an exercise price of $1.3210. The premium
September call options to buy $ are available with an exercise price of $1.3190. The premium
Dollar 6.20 – 5.90

Requirements
3.1 Calculate TE’s sterling receipt if it uses the following to hedge its forex risk:

(b) a money market hedge
(c) currency futures
(d) an OTC currency option
Assume that the spot rate on 30 September 2019 will be

$/£ 1.3192 – 1.3220 and the September futures price will be $/£ 1.3206. (15 marks)
3.2 Identify the advantages and disadvantages of the four hedging techniques used in 3.1
above and advise TE’s board as to which hedging technique it should use to hedge its
forex risk. (9 marks)
3.3 Briefly explain to TE’s board what economic risk is, how it affects TE and how it can be
reduced. (6 marks)
Total: 30 marks

Question 1
Total Marks: 35
General comments
This was a six-part question, which tested the candidates’ understanding of the investment decisions
The scenario of the question was that a company is launching a new product onto the market.
Part 1.1a of the question covered NPV analysis.

Part 1.1b of the question required sensitivity calculations and discussion.
Part 1.1c of the question discussed options available to the company.
Part 1.1d of the question discussed SVA applied to project appraisal.
Part 1.2a of the question required calculations in a capital rationing situation.
Part 1.2b of the question required a discussion regarding capital rationing.
Note: Some candidates were not showing workings, which is bad practice and which is explicitly warned
against in the CBE software.
1.1 (a)
0 1 2 3
£000s £000s £000s £000s
Sales 2220.00 2057.94 1907.71
Contribution 70% 1554.00 1440.56 1335.40
Selling and admin (100.00) (102.50) (105.06)
Fixed costs (40) (41) (42.03)
Rent (50.00) (50.00) (50.00)
Operating cash flows (50.00) 1364.00 1247.06 1188.31
Tax 17% 8.50 (231.88) (212.00) (202.01)
After tax operating cash flows (41.50) 1132.12 1035.06 986.30

Plant and equipment (2000.00) 200.00
Tax saved on CAs 61.20 50.18 41.15 153.47
Working Capital (250.00) 18.25 16.92 214.83
Net cash flows (2230.30) 1200.55 1093.13 1554.60
PV factors at 10% 1.00 0.909 0.826 0.751

Present value (2230.30) 1091.30 902.93 1167.50
NPV 931.43
Market research should be ignored since it is a sunk cost. 50% of fixed costs should be ignored since
they are centrally allocated.

The project should be accepted since it has positive NPV which will increase shareholder’s wealth.
Discount factor (1.07 x 1.025 )-1 = 9.7% Round to 10%
Sales
Year 1 18.5 x 10 x 12 = 2220
Year 2 2220 x 1.03 x 0.90 = 2057.94
Year 3 2057.94 x 1.03 x 0.90 = 1907.71
Working capital
Year 1 250 x 1.03 x 0.9 = 231.75 Increment 18.25
Year 2 231.75 x 1.03 x 0.9 = 214.83 Increment 16.92
Year 3 214.83.
Capital allowances and the tax saved
Cost/WDV CA Tax
£000s £000s £000s
2000.00 360.00 61.20
1640.00 295.20 50.18
1344.80 242.06 41.15
1102.74
(200) 902.74 153.47
Most of the attempts at this question were good however common errors were: Not stating why the
research costs should be ignored i.e that they are sunk costs; not stating the reason why 50% of the fixed
costs should be ignored i.e. that they are centrally allocated; inflating cash flows when it is stated that they
remain constant; incorrect timing of cash flows; inflating the net cash flows by the general level of inflation;
not using the Fisher formulae to calculate the nominal cost of capital and merely adding the general level
of inflation to the real cost of capital; discounting money net cash flows by the real cost of capital.

1.1 (b)
Sensitivity
£000s £000s £000s
Contribution 1554.00 1440.56 1335.40
Contribution X (1-0.17) 1289.82 1195.66 1108.38
PV factors at 10% 0.909 0.826 0.751
Present Value 1172.45 987.62 832.39
Sensitivity 931.43/2992.46 31.13%
A fall in sales from £2220 million to: 2220(1-0.3113) = £1529.01 million. OA will have to consider whether
this is an acceptable risk. 31% is a large change so not that sensitive to volume changes.

Some candidates attempted to calculate sensitivity using units (rather than £ contribution), going as far as
taxing them and discounting them. This is an error that has appeared in recent examination diets. Other,
common, errors were: calculating sensitivity using sales rather than contribution; ignoring tax; inverting the
sensitivity calculation; inadequate narrative and not stating whether the project is or is not sensitive to
changes in volume.

1.1 (c)
Timing options. The option to delay the project and see whether the competitor does launch a similar
product to Handyspecs.
Follow on options; producing Handyspecs could give OA the opportunity to produce a similar product at
the end of the product life cycle of three years, particularly if the competitor does not enter the market or
does but fails.
(Mention of Growth options also acceptable.)
Abandonment options. If sales decline more than expected eg because the competitor enters the market
OA has the option to abandon the project.
Quite poorly answered with many candidates not referring to the scenario of the question and just giving
generic answers

1.1 (d)
SVA is useful to highlight the key drivers of value, namely: Cost of capital; Life of projected cash
flows’;Sales growth rate; Investment in working capital; Investment in non-current assets; Corporation tax
rate; Operating profit margin. This enables managers to set targets of achieving value-enhancing
strategies in each area. It helps to focus mangers on value enhancement to ensure that shareholder’s
wealth is the primary objective.
Quite poorly answered with many candidates outlining company valuation rather than project appraisal
and referencing to the scenario of the question.

1.2 (a)
Since the projects are indivisible the combination that will maximise shareholder wealth will have to be
identified by trial and error.
Project D should not be considered since it has a negative NPV.
The possible combinations are:
Projects Cost £m NPV £m

ABC 2+4+3=9 0.5 + 1.5 + 1 = 3
AE 2 + 6.5 = 8.5 0.5 + 2.5 = 3
CE 3 + 6.5 = 9.5 1 + 2.5 = 3.5
B and E is not possible since the expenditure exceeds £10 million.
The combination that will maximise shareholder’s wealth and keep within the capital expenditure budget of
£10 million is C and E.

Some good answers however many candidates assumed, incorrectly, that the projects were divisible
despite an explicit statement that they were indivisible. Some candidates allocated projects to the capital
budget using NPV per £ invested, instead of trial and error.

1.2 (b)
Hard rationing is where external capital markets limit the supply of funds to a company
Soft rationing is where internally the firm imposes its own constraints on the amount of funds raised and
used to finance projects.
Since OA has no difficulty in raising funds on the capital markets the company is applying soft capital
rationing. However this might not maximise shareholder’s wealth since all projects except D have positive
NPVs and should be accepted. The limit of £10 million also excludes the combination of projects B and E
that would cost £10.5 million and produce the highest combined NPV of £4 million.
Some good answers however poorer candidates clearly had not revised this topic and confused hard and
soft rationing with indivisible and divisible projects.


Question 2
Total Marks: 35
General comments
This was a six part question that tested the candidates’ understanding of the financing options element of
the syllabus.
The scenario of the question is that a company is raising finance to fund a diversification.
Part 2.1 of the question required cost of equity calculations using different models.
Part 2.2 of the question required a WACC computation for the company before the diversification.
Part 2.3 of the question required a WACC computation that reflects the risk of the diversification.
Part 2.4 of the question required computations and discussion regarding a new issue of debentures.
Part 2.5 of the question discussed dividend policy.
Part 2.6 of the question considered an ethical and legal problem.
2.1
Ignoring the special dividends
Number of shares in issue £40/£0.10 = 400 m
Dividends per share 2019 £48/400 = 12p
Growth (48/43)^(1/3) = 3.74%
Ke using Gordon growth model = (12(1.0374))/405) + .0374 = 6.81%
Ke using CAPM = 2 + 0.5 x 5 = 4.5%
This area has been examined many times before and there are many adequate examples in the learning
materials. However this part of the question was not well answered and common errors were: not stating
that the special dividend should be ignored when calculating growth from past dividends; calculating
growth from past dividends and using the 4th root rather than the 3th root; inverting the growth computation;
confusion of digits between £ and pence; incorrect dividend per shares calculations; poor maths eg many
expressed an answer which should have been 34% based on their figures as 3.4%.

2.2
Market values:
Equity 400m x 405p = £1620 m
Debt:
The ex-interest price of the debentures is £104 (109 – 5)
The market value of the debt = £410.8 m (395 x 1.04
The redemption yield of the current debentures can be calculated as follows:
Timing Cash flow Factors at Pv £ Factors at Pv £

£ 1% 5%
0 (104) (104.00) (104.00)
1-4 5 3.902 19.51 3.546 17.73
4 100 0.961 96.10 0.823 82.30
11.61 (3.97)

Redemption yield = 1 + (11.61/(11.61+3.97)) x 4 = 3.98%
Kd = 3.98 (1-0.17) = 3.30%

WACC = (4.5 x 1620 + 3.3 x 410.8)/(1620 + 410.80) = 4.26%
Answers to this part of the question were often weak common errors were: incorrect market value
computations; when calculating the IRR of the debentures: using the cum interest price, incorrect number
of years to maturity, incorrect coupon, incorrect computations with two negative NPVs, incorrect IRR
computation and omitting tax: when using the CAPM for ke deducting the risk free rate from the market
risk premium.

2.3
De-gear Exito’s beta equity:
1.2 = Ba (1+ (40x0.83)/60)) . Ba = 0.773.
Re-gear using Stable’s gearing:
Be = 0.773 (1+ (410.8 x 0.83)/1620). Be = 0.936.
Ke = 2 + 0.936 x 5 = 6.681%
WACC = (6.68 x 1620 + 3.3 x 410.80)/(1620 + 410.80) = 6%
Stable’s current WACC is 4.26% and the WACC used to calculate the PV of the free cash flows of Exito is
6%. The increase in the WACC, from 4.26%, reflects the increase in the systematic business risk of Exito.
This is reflected in the higher Be of 0.942 compared to Stable’s Be of 0.50 at the same level of financial
(gearing) risk.
Disappointing answers and common errors were: inadequate narrative on why Exito’s equity beta should
be used; incorrect computations when degearing the equity beta, in some cases ending up with a higher
asset beta than the equity beta; degearing Stable’s equity beta; regearing; attempting to use book values
when regearing the asset beta; using clearly impossible equity betas in the CAPM.

2.4
Using Stable’s pre-tax redemption yield of 3.98% (full marks if 4% used):
The annuity factor at 3.98% for 5 years = 4.454.

The year five pv factor at 3.98% = 0.823.
The issue price = 3 x 4.454 + 100 x 0.823 = £95.66.
The total nominal value that will have to be issued to raise £80 million = £83.63 m (80/0.9566)
Using the redemption yield on Stable’s existing debentures is not likely to be correct since they have a
higher coupon than the new debentures and a redemption date one year earlier than the new debentures.
This topic has been examined many times and there were some disappointing responses, common errors
were: using Stables post tax cost of debt as the discount rate; using the coupon rate to calculate the issue
price; attempting to calculate a YTM computation for the new debentures; incorrect computations of the
total nominal value; unclear explanations of the appropriateness of using the YTM from the existing
debentures to price the new debentures.


2.5
Theoretical considerations: Candidates will be given marks for an understanding of M & M’s theory of the
irrelevancy of dividend policy.
For practical considerations candidates should mention and expand on: Traditional theory/resolution of
uncertainty; signalling; the clientele affect; preference for current income; taxation; cash.
Conclusion: For practical considerations it would not be appropriate for Stable to miss paying a dividend to
fund the purchase of Exito. The finance should be raised from debt and equity sources.
Well answered by many candidates however common errors were: brief explanation of the theory; few
practical considerations; no conclusion.

2.6
Acting on the sales director’s suggestion would be insider trading and illegal, so don’t!.
The finance director should act with integrity and display professional behaviour with regard to the
suggestion made by the sales director and he should advise him and the board accordingly.
Many good answers but poorer candidates did not discuss the legal implications.


Question 3
Total Marks: 30
General comments
This was a three part question that tested the candidates’ understanding of the
The scenario of the question is that a company is importing goods from the Eurozone and exporting them
to the USA.
Part 3.1 required computations using various forex hedging instruments.

Part 3.2 required a discussion regarding the use of the hedging instruments used in the first part of the
question.
Part 3.3 required a discussion regarding economic risk.
3.1
Forward contract:
The forward rate is: $/£ 1.3214 (1.3159 + 0.0055)
The sterling receipt is : $6,000,000/$1.3214 = £4,540639
Money market hedge:
Borrow in $ against the receipt. Borrow: $6,000,000/(1+0.062x3/12)= $5,908,419
Buy £ spot: $5,908,419/$1.3159 = £4,490,021
Total receipt with interest on deposit: £4,490,021 x (1+0.044x3/12) = £4,539,412.
Currency futures:
Buy September futures on 30 June.
The number of contracts: $6,000,000/$1.3200/£62,500 = 72.73. Round to 73.
Close out the contracts on 30 September.

Gain per £ = 1.3206 – 1.3200 = $0.0006.
Total gain: $0.0006 x 73 x £62,500 = $2,737.5
Total receipt: $6,000,000 + $2,737.5/$1.3220 = £4,540,649.
Put options to sell $ with and exercise price of $1.3210.

The premium will be: $6,000,000 x £0.04 = £240,000.
The premium plus interest foregone will be: £240,000 x (1+0.0440x3/12) = £242,640.
If the spot is $1.3220 on 30 September we would exercise the options.
The receipt will be: $6,000,000/$1.3210 - £242,640 = £4,299,374
using the incorrect exchange rate and deducting instead of adding the forward discount; for the money
using the incorrect spot rate; for the futures, using the spot rate rather than the futures price to calculate
the number of contracts, treating the gain on futures as £ rather than $, closing out the contracts using the
future spot price rather than the futures price; for the OTC option choosing the call rather than the put, not

taking account of the interest on the option premium, treating the OTC option as a traded option and
incorrect exercise or abandon decisions.

3.2
The forward contract, money market hedge and futures contracts lock TE into an exchange rate and do
not allow for upside potential.
Forwards:
Tailored specifically for TE
Money Market:
Tailored specifically for TE
In the case of a receipts, accelerates receiving the home currency
However there is no secondary market and it may use up credit lines.
Currency futures:
Basis risk is an issue

However the options allow TE to exploit upside potential and protect downside risk
Advice:
Without hedging the sterling receipt would be £4,538,578.
Forward contract: £4,540,639
Money market: £4,539,412.
Futures: £4,540,649.
OTC options: £4,299,374
The forward contract, money market hedge and futures are not materially different.
TE has surplus funds so there is no need to accelerate receiving £. With currency futures there is basis
risk and rounding the number of contracts. The OTC option allows for upside potential but it is expensive.
Therefore the forward contract is recommended. Also TE’s attitude to risk can be mentioned by
candidates. Candidates may mention that not hedging gives a very similar result and opt for that
alternative, however the future spot rate is only an estimate and the forward rate indicates that the market
shows that the $ is weakening against the £. Therefore a strategy of not hedging is not recommended for
an exporter.
(Alternative supported conclusions to the advice are awarded marks)
Some good responses but some of the errors that poorer candidates made include: just stating
advantages and disadvantages; not showing the result of not hedging; not considering the direction of
currencies shown by the forward discount; no recommendation.

3.3
Economic risk is the risk that longer-term exchange rate movements might reduce the international
competiveness of a company. It is the risk that adverse exchange rate movements might reduce the
present value of a company’s future cash flows.

TE is an importer and exporter. It buys its products in euros, exports to the USA and receives payment in
dollars.
If over a period of several years the pound appreciates against the dollar and depreciates against the euro
the sterling value of TE’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.
Responses to this part of the question were poor with quite a lot of candidates showing a lack of
understanding of what economic risk is and how it might be reduced despite this being tested in many
recent papers.


WEDNESDAY 11 SEPTEMBER 2019
(2.5 HOURS)
Marks breakdown
Question 1 35 marks
Question 2 35 marks
Question 3 30 marks
application.
personal nature, this includes your name or any other identifying content. A student
survey is provided post-exam for feedback purposes.
Copyright © ICAEW 2019. All right reserved. Page 1 of 7

Question 1
Hodder Specialist Engineering Ltd (Hodder) is a UK company with a financial year end of
31 October. Hodder provides a powder-coating service for its UK-based customers that
require a protective finish on their products. Powder coating is applied as a free-flowing, dry
powder producing thicker coatings than conventional liquid coatings such as paint. At present,
all of Hodder’s customers operate in the consumer goods sector of the UK market.
Diamond Cars Ltd (DC) is a UK manufacturer of sports vehicles. DC’s board has approached
Hodder and asked it to provide a powder coating service for DC’s vehicles over a three-year
period.
The majority of Hodder’s board members want to accept the contract as DC is a well-
established and very profitable company. However, two of Hodder’s directors feel that this
diversification carries excessive risk. At Hodder’s most recent board meeting they proposed
that the company would be better served by expanding its existing operations overseas,
citing India and China as two mass markets for consumer goods.
You work in Hodder’s finance team and have been asked to advise Hodder’s board on the
DC proposal and overseas expansion.
You have been given these estimates with regard to the DC proposal:
Year to 31 October 2019 2020 2021 2022

£’000 £’000 £’000 £’000
Purchase of new machinery

(note 1) (1,200)
Trade-in value of
new machinery (note 2) 140
Depreciation of new machinery (265) (265) (265) (265)
Interest costs (note 3) (54) (54) (54) (54)
Additional fixed costs (note 4) (35) (35) (35)
Additional direct labour
and materials (note 4) (162) (162) (162)
Additional working capital
(note 4) (50) (5) (5) 60
Note 1
The new machinery would be purchased on 31 October 2019. Hodder charges a full years’
depreciation in the year of acquisition and disposal.
The machinery attracts 18% (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 treated by the company either as:
- a balancing allowance, if the disposal proceeds are less than the tax written down value,
or
- a balancing charge, if the disposal proceeds are more than the tax written down value.

Note 2
The trade-in value of the new machinery on 31 October 2022 is expressed in 31 October
2022 prices.
Note 3
This represents the interest cost on a loan to part-finance the purchase of the new machinery.
Note 4
The figures for fixed costs, direct labour, materials and working capital are stated in
31 October 2019 prices. The inflation rate applicable to these flows is 2% pa. The
outstanding working capital balance will be released on 31 October 2022.
Other information
DC has offered Hodder the choice of two contract prices:

 £550,000 pa on 31 October in each of the three years 2020-2022; or
 a lump sum of £1.9 million receivable on 31 October 2022.
These amounts are expressed in money terms.
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant
financial year.
Hodder’s money weighted average cost of capital is 9% pa.
Requirements
1.1 Using the NPV of money cash flows at 31 October 2019, advise Hodder’s board
whether it should accept the DC proposal if the agreed price is:
(a) £550,000 pa receivable on 31 October in each of the years 2020-2022 or
(b) £1.9 million receivable on 31 October 2022. (22 marks)
1.2 Compare the strengths and weaknesses of sensitivity analysis and simulation as
methods of assessing the risk of the DC proposal. (5 marks)
1.3 Explain what is meant by the term ‘real options’ and identify one real option that could
apply to the DC proposal. (3 marks)
1.4 Outline the potential risks that Hodder could face were it to expand its operations into
China and India. (5 marks)
Total: 35 marks

Question 2
Jackett Clarke Travel plc (Jackett) is a UK-listed company, founded in 1999. Jackett is a
travel agency and tour operator. It arranges flights and package holidays to destinations
across Europe and North America. You are an ICAEW Chartered Accountant and are a
member of Jackett’s finance team. Extracts from Jackett’s management accounts for the
financial year to 30 September 2019 are shown below:
Income Statement for the year to 30 September 2019
£’000
Sales 43,500
Variable costs (23,925)
Fixed costs (9,500)
Interest (805)
Profit before tax 9,270
Taxation (17%) (1,576)
Dividends paid (2,400)
Balance Sheet at 30 September 2019
£’000
£1 ordinary shares 16,000
24,750
7% Debentures (redeemable in 2021) 11,500
36,250
Jackett’s board is keen to explore the implications of expanding the company’s operations
into South East Asia and Australia. The demand for package holidays to these areas has
grown steadily in the past five years and this is expected to continue, but at a slower rate, for
at least another five years. The board commissioned market research and the key financial
implications noted in the research report are shown below:
Table
Initial cost of investment £7 million
Impact on sales and variable costs 20% increase pa
Impact on fixed costs Increase by £1.5 million pa
Other information
Jackett’s board plans to maintain the dividend per share payout for at least another twelve
months.
Corporation tax will be payable at the rate of 17% for the foreseeable future.

The board has decided that, were this investment to proceed, it would commence on
1 October 2019 when the £7 million required for the initial investment would be raised via:
 a 1 for 4 rights issue of ordinary shares or
 an issue of 5% debentures (redeemable in 2028) at par.
The current market values of Jackett’s shares and debentures are:
Ordinary shares £2.58 (ex-div)
7% debentures £105% (ex-int)
Emails
You have recently received emails from Jackett’s sales director, Michael Ayres and a
colleague in the finance team, Ann Baker. An extract from each email is shown below:
Michael Ayres:
I’m an amateur investor and have been tracking the Jackett share price for about
four years. Past patterns suggest that it will decrease by about 25% in the next
quarter, so we need to make sure that we don’t overprice any rights issue.
Ann Baker:
I’m worried that Jackett’s share price will fall if debt is used to finance the
expansion. Please let me know what the board decide so I can sell my Jackett
shares if necessary before the market finds out.
Requirements
2.1 For both the 1 for 4 rights issue and the 5% debenture issue, prepare forecast
income statements for Jackett for the year to 30 September 2020. (9 marks)
2.2 For both the 1 for 4 rights issue and the 5% debenture issue, calculate Jackett’s:
 Earnings per share for the year to 30 September 2020.

 Gearing ratio (long-term borrowings/total long-term funds at book value) as at 30
September 2020. (5 marks)
2.3 Discuss the implications for Jackett’s shareholders of the company choosing equity or
debt to raise the £7 million required for the investment. You should make reference to
your calculations in 2.1 and 2.2 above. (7 marks)
2.4 Assuming that Jackett chooses the rights issue, calculate the theoretical ex-rights price
of one ordinary share and explain why this may be different to the actual ex-rights price.
(6 marks)
2.5 Discuss Michael Ayres’ views on the Jackett share price making reference to relevant
theory on efficient markets. (5 marks)
2.6 Identify the legal and ethical issues arising for you as an ICAEW Chartered Accountant
as a result of Ann Baker’s email request. (3 marks)
Total: 35 marks

Question 3
Assume that the current date is 31 August 2019
Barratt Waters Shine plc (Barratt) is a UK-listed manufacturer of pharmaceuticals. It has

traded since 1994 and it sells its products worldwide. You are a member of Barratt’s finance
team and are currently working on three tasks.
3.1 Task 1
Barratt has agreed to sell a large consignment of pharmaceuticals to DMBJ, an Argentine

wholesaler. The agreed price is 22.4 million Argentine pesos (AP). The consignment will
leave the UK on 31 October 2019 and DMBJ will pay for the goods on 30 November 2019.
Barratt’s board has to decide whether to hedge this transaction and you have been asked to
provide advice. You have collected the following data at the close of business on 31 August
2019:
Spot rate (AP/£) 46.22 – 46.85

AP interest rate (lending) 4.4% pa
AP interest rate (borrowing) 6.0% pa
Three-month forward contract discount (AP/£) 0.10 – 0.13
Forward contract arrangement fee
(per one million pesos converted) £260
Three-month OTC call option on pesos
– exercise price (AP/£) 44.30
Three-month OTC put option on pesos
– exercise price (AP/£) 46.05
Relevant OTC option premium
(per one million pesos converted) £740
Requirements
(a) Calculate Barratt’s sterling receipt for the DMBJ consignment if it uses the following to
hedge its foreign exchange rate risk:
 A forward contract
 A money market hedge
 An OTC currency option (8 marks)
(b) With reference to your calculations in 3.1(a), advise Barratt’s board whether it should
hedge against movements in the value of the Argentine peso. (6 marks)
(c) Identify the key differences between forwards and futures as a means of hedging foreign
exchange rate risk. (3 marks)
3.2 Task 2
Barratt has built up a portfolio of UK FTSE100 shares over a number of years. The portfolio is
worth £8,350,000 on 31 August 2019. The company’s board is considering using FTSE100
index futures to hedge against a fall in the value of the portfolio over the next four months.

You have the following information available to you on 31 August 2019:
 The FTSE100 index is 7,130

 The price for December 2019 FTSE100 index futures is 7,115
 The face value of a FTSE100 index futures contract is £10 per index point
Requirements
(a) Calculate the outcome of hedging the portfolio using December 2019 FTSE100 index
futures. Assume that on 31 December 2019 both the FTSE100 index and the
FTSE100 index futures price will be 7,055 and that the portfolio value changes exactly
in line with the change in the FTSE100 index. (6 marks)
(b) Explain why the hedge will not be 100% efficient. (2 marks)
3.3 Task 3
Barratt is expanding its manufacturing and warehousing capacity and needs a bank loan to
finance this. Construction work will start in January 2020 and Barratt’s bank has agreed to
lend the company £12.5 million for a five-year period, commencing on 1 March 2020. The
bank will charge interest at LIBOR + 1.5% pa. The board wishes to explore whether it would
be worth taking out an interest rate option to hedge against increases in LIBOR. Barratt’s
bank has offered it an option at 5.3% pa plus a premium of 1% of the sum borrowed.
Requirement
Calculate the annual interest payment if Barratt takes out the interest rate option and advise
the board whether it should hedge against increases in LIBOR.
For your calculations, assume that on 1 March 2020 LIBOR will be:
(a) 3.5% pa or
(b) 5.5% pa (5 marks)
Total: 30 marks


Question 1
Total marks: 35
General comments
This question was had the highest percentage mark on the paper. The vast majority of candidates
achieved a “pass” standard in this question.
The scenario was based around a UK engineering company, which provides a powder-coating service for
UK customers in the consumer goods sector. This company was considering diversifying its operations via
a three-year contract with DCL, a UK car manufacturer. An alternative plan was to expand its existing
market into India and China. Candidates were cast as an employee in the company’s finance team and
were given relevant data. In part 1.1, for 22 marks, candidates were required to prepare NPV calculations
for the DCL proposal. This would enable them to advise the company’s board whether it was worth
proceeding with the contract. In part 1.2, for five marks, candidates had to compare the strengths and
weaknesses of sensitivity analysis and simulation as methods of assessing the risk of the DCL proposal.
In part 1.3, for three marks, candidates were asked to explain real options and to identify a real option that
could apply to the DCL scenario. Finally, part 1.4, for five marks, asked candidates to outline the potential
risks that the company could face were it to expand its existing operations into China and India.
1.1
(a) 2019 2020 2021 2022
£’000 £’000 £’000 £’000
Machinery (1,200.000) 140.000
Tax saved via CA’s (W1) 36.720 30.110 24.691 88.679
Labour/Materials (W2) (165.240) (168.545) (171.916)
Fixed costs (W3) (35.700) (36.414) (37.142)
Sales income 550.000 550.000 550.000
Tax on profit (W4) (59.340) (58.657) (57.960)
Working Capital (W5) (50.000) (6.100) (6.324) 62.424
TCF (1,213.280) 313.730 304.750 574.085
Discount factors 1.000 0.917 0.841 0.772
PV (1,213.280) 287.691 256.295 443.194
NPV - Decision (a) (226.100)
Ignore depreciation as it’s not a cash flow
Ignore interest cost as it’s in discount rate (WACC)
Decision (a) – do not invest. NPV is negative. Shareholder wealth would decline
(b)
2019 2020 2021 2022
Machinery (1,200.000) 140.000
Tax saved via CA’s 36.720 30.110 24.691 88.679
Labour/Materials (165.240) (168.545) (171.916)
Fixed costs (35.700) (36.414) (37.142)
Sales income 1,900.000
Tax on profit (W6) 34.160 34.843 (287.460)
WC (50.000) (6.100) (6.324) 62.424
TCF (1,213.280) (142.770) (151.749) 1,694.585
1.000 0.917 0.841 0.772
PV (1,213.280) (130.920) (127.621) 1,308.220
NPV - Decision (b) (163.601)

Alternative presentation for Decision (b) with changes from original NPV:
2019 2020 2021 2022

£’000 £’000 £’000 £’000
Change in annual income (550.000) (550.000) 1,350.000
x x x
less: Tax at 17% 0.830 0.830 0.830
x x x
Discounted at 9% 0.917 0.841 0.772
PV change (418.611) (383.917) 865.030
Overall change to NPV 62.499
NPV in (a) (226.100)
Amended NPV (163.601)
Decision (b) – do not invest. NPV is still negative. Shareholder wealth would decline
Workings
W1 2019 2020 2021 2022
£’000 £’000 £’000 £’000
Machinery cost/WDV b/f 1,200.000 984.000 806.880 661.640
WDA @ 18% (216.000) (177.120) (145.238) (521.642)
WDV/Sale proceeds 984.000 806.880 661.640 140.000
WDA x 17% 36.720 30.110 24.691 88.679
W2 2020 2021 2022

£’000 £’000 £’000
Labour and materials costs (162.000) (165.240) (168.545)
Inflated at 2% x 1.02 x 1.02 x 1.02
Money cash flow (165.240) (168.545) (171.916)
W3 2020 2021 2022

£’000 £’000 £’000
Fixed costs (35.000) (35.700) (36.414)
Inflated at 2% x 1.02 x 1.02 x 1.02
Money cash flow (35.700) (36.414) (37.142)
W4 2020 2021 2022

£’000 £’000 £’000
Sales income 550.000 550.000 550.000
Fixed costs (W3) (35.700) (36.414) (37.142)
Profit 349.060 345.041 340.942
Tax on profit at 17% (59.340) (58.657) (57.960)
W5 2019 2020 2021 2022

£’000 £’000 £’000 £’000
Working capital investment 50.000 5.000 5.000
Total Working Capital (WC) 50.000 55.000 60.000
x 1.00 x 1.02 x (1.02)2
Total WC (inflated) 50.000 56.100 62.424
(50.000) (6.100) (6.324) 62.424
W6 2020 2021 2022

£’000 £’000 £’000
Sales income 0.000 0.000 1,900.000
Fixed costs (W3) (35.700) (36.414) (37.142)
Profit (200.940) (204.959) 1,690.942
Tax on profit at 17% 34.160 34.843 (287.460)

Most candidates scored well on the NPV calculation. Errors made by weaker candidates included inflating
sales figures already given in money terms and inflating costs a year too early/late. In addition many
candidates included interest costs when they were covered by the WACC and included depreciation which
isn’t a cashflow. Regarding the tax charge, a common error made was the taxing of capital and working
capital flows. Some candidates started WDAs a year too late. The working capital calculation was difficult
and many candidates inflated the working capital increments rather than the balances. Finally, some
candidates inflated the discount rate – it was already given in money terms.

1.2
It identifies areas critical to the success of a project, e.g. sales volume, materials price
But
Simulation
But
Reasonable marks were earned here by most candidates, as expected. Weaker candidates were too brief
and often excluded comments on probability.

1.3
NPV analysis only considers cash flows related directly to a project. However, a project with a negative (or
low) NPV could be accepted for strategic reasons. This is because of (real) options associated with a
project that outweigh the poor NPV.
Follow-on option. Initial NPV is negative, but future contracts could be profitable
Candidates continue to be poor at defining what is meant by ‘real options’ despite the number of times this
has been examined in recent exams. There was a clear requirement for the identification of one option
that could apply in the scenario. Weaker candidates gave two or more or picked an inappropriate one such
as abandonment or delay.

1.4
There will be risks trading overseas - local finance costs, tax systems, dividend restrictions.
Also, there are political risks, e.g. import quotas, tariffs, nationalisation, minimum shareholding for local
residents.
Finally, there could be cultural risk – business practices, social mores may be very different.
This was, generally, done well.


Question 2
Total marks: 35
General comments
This question was had the lowest percentage mark on the paper. A considerable proportion of candidates
scored less than a pass mark (55%) in this question.
This was a six-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus and there was also a small section with an ethics element to it.
In the scenario, the candidate (an ICAEW Chartered Accountant) was employed in the finance team of
Jackett, a UK-listed travel agency and tour operator. Currently Jackett arranges flights and package
holidays in Europe and North America. The company’s board was keen to explore the implications of
expanding its operations into South East Asia and Australia. This would cost an initial £7 million, to be
raised via a rights issue or a debenture issue. Jackett’s board had commissioned a market research
report. Candidates were given the key financial implications noted in the report.
Part 2.1 was worth nine marks and required candidates to calculate the next year’s profit figures under the
two alternative funding methods. Using these figures, candidates were required in part 2.2, for five marks,
to calculate the amended earnings per share figures and gearing ratios. Part 2.3 was worth seven marks.
It asked candidates to make use of their calculations and discuss the implications for Jackett’s
shareholders of the company using equity or debt to raise the £7 million required. For six marks, part 2.4
required candidates to (i) calculate the theoretical ex-rights price that would arise with the equity issue and
(ii) explain why this might be different to the actual ex-rights price. Part 2.5 was worth five marks and it
tested, via the scenario, candidates’ understanding of the efficient market theory. Finally, for three marks,
part 2.6 tested, via the scenario, candidates’ understanding of ethical guidance.
2.1
Stewart - Income Statement for the year to 30 September 2020

£’000 £’000
Sales 52,200 52,200
Variable costs (28,710) (28,710)
Fixed costs (11,000) (11,000)
Profit before interest and tax 12,490 12,490
Interest (W1) (805) (1,155)
Profit before tax 11,685 11,335
Taxation (17%) (1,986) (1,927)
Profit after tax 9,699 9,408
Dividends paid (W2) (3,000) (2,400)
Retained profit 6,699 7,008
Workings
W1 Rights Debt
£’000 £’000
Current interest cost 805 805
Extra interest cost (£7m x 5%) 0 350
Total interest cost 805 1,155
W2 £’000 £’000
Current dividend (16m x £0.15) 2,400 2,400
Extra dividend ([16m/4] x £0.15) 600 0
Total dividend 3,000 2,400
In part 2.1 many candidates scored full marks (nine). Weaker candidates failed to calculate the extra
interest (new debt) correctly - this was simply 5% of £7m. Also with the dividend calculation, a common
failing was the maintenance of a constant payout ratio rather than dividend per share as specified in the
question.


2.2
Rights Debt
Earnings per share £9,699/20,000 £0.485
£9,408/16,000 £0.588
Rights Debt
£’000 £’000
Current debt 11,500 11,500
Extra debt 0 7,000
New total debt 11,500 18,500
Current long-term funds 36,250 36,250

Extra funds raised 7,000 7,000
Retained profit 2020 6,699 7,008
Current long-term funds 2020 49,949 50,258
Gearing ratio £11,500/£49,949 23.0%

£18,500/£50,258 36.8%
There were very mixed responses here. A small minority of candidates continue to calculate EPS using
retained earnings. Many candidates could not calculate the gearing ratios correctly. Errors included the
use of market values when book values were required; using debt/equity when debt/debt+equity was
specified; not including the share premium account when issuing new shares; not including retained
earnings in the equity book value.

2.3
Current EPS £7,694/16,000 £0.481
Current gearing £11,500/£36,250 31.7%
Other points for consideration by shareholders:

The EPS will be higher with an issue of debt, but gearing will be higher as well, which
increases financial risk.
Interest cover (currently 12.5 [£10,075/£805]) will be lower if the debt issue is chosen (10.8),
but it will increase with a rights issue (15.5). In both cases the cover figure is sufficient.
A rights issue could lead to a dilution of control for the shareholders.
An issue of debt issue could give a tax shield advantage.
An equity issue would be more expensive.
The existing debt is due to be repaid 2021 – this has cash flow implications for the company
in the near future.
The board's attitude to risk is important.
This was, overall, disappointing as most candidates did not calculate the current year EPS and gearing
and so had nothing meaningful to compare their figures with. A significant number of candidates wasted
time going through the M&M and traditional capital structure theories when they were not required.


2.4
Current market capitalisation 16,000 £2.58 £41,280
Rights issue 4,000 £1.75 £7,000
Totals 20,000 £2.41 £48,280
So theoretical ex-rights price = £2.41
Reasons for differences between the theoretical and the actual ex-rights market price:
The project NPV is not included in the ex-rights price
Information released by Jackett regarding the use of funds raised
Additional information re Jackett or the market
Market expectations regarding the expansion
Level of take up of rights issue
General market conditions
Events (macro) – e.g. interest rates
Events (micro) – e.g. new managers at the company
Events (industry) – e.g. takeovers
A rights issue might give a negative signal and a lowering of the market value
Level of market efficiency
Most candidates could calculate the theoretical ex-rights price correctly, but a significant minority couldn’t
because they used the nominal value of the existing and/or new shares. Many candidates were too brief in
explaining why the actual price might be different to the theoretical price in a four-mark requirement.

2.5
Michael Ayres is, wrongly, proposing a Chartist approach to share prices. He is
assuming that the market is not efficient at all and that prices follow pre-set patterns.
The Efficient Market Hypothesis (EMH) posits that there are no patterns to share prices.
Markets have no memory. Past prices have no influence on future prices. Efficiency
means that shares cannot be bought cheaply and then sold quickly at a profit. Share
prices are “fair” and investment returns are those expected for the risks undertaken.
When share prices at all times rationally reflect all available information, the market in
which they are traded is said to be efficient. In efficient markets investors cannot make
consistently above-average returns other than by chance.
There are three levels of market efficiency: - weak form, semi strong form and strong form.
Behavioural finance is an alternative view to the EMH. This considers investors’ irrational
tendencies, leading to a weakening of market efficiency.
This was also disappointing. Many candidates asserted that the employee was using weak form efficiency
as he’d identified patterns in share price movements, yet in their explanation of weak form efficiency they
stated that this couldn’t be done. Few identified that the employee was promulgating the Chartist theory.

2.6
Legal – this is insider trading so is illegal
Ethics - you are an ICAEW Chartered Accountant. The ICAEW’s ethical guidance includes:
 A member should behave with integrity – i.e. be honest and truthful. The member’s advice
and work should not be influenced by the interests of other parties.
 A member should strive for objectivity in all professional and business judgements – i.e.
there should be no bias, conflict of interest or undue influence of others.
 A member should behave professionally – i.e. avoid any action that discredits the
profession.
Ann Baker’s request would be counter to all three of these elements of the ethical guidance.
This was, generally, done well.


Question 3
Total marks: 30
General comments
This question had the second highest percentage mark on the paper. The majority of candidates achieved
a “pass” standard in this question.
This was a five-part question which tested the candidates’ understanding of the risk management element
of the syllabus.
In the scenario, the company (Barratt) is a UK-listed manufacturer of pharmaceuticals. Candidates, again,
were employed in the finance team and were asked to work through three tasks and advise senior
management accordingly. Part 3.1 considered the first task – foreign exchange hedging for a large export
contract. Part 3.1(a) was worth eight marks and asked candidates to calculate the sterling receipt for the
export contract using three different hedging techniques. In part 3.1(b), for six marks, candidates were
required to advise the board whether it should hedge against exchange rate movements for the contract in
question. Part 3.1(c) asked candidates to compare forward contracts and futures as hedging techniques.
Part 3.2 was worth eight marks and considered the second task – using FTSE100 index futures to hedge
the value of Barratt’s investment in a portfolio of UK shares. Part 3.3, for five marks, considered the final
task – the implications of taking out an interest rate option. Barratt was borrowing a large amount from its
bank at a variable rate. Candidates had to prepare calculations of the costs of hedging the interest
charges and advise the board.
3.1a
Forward contract (FC)
46.85 + 0.13 = 46.98 AP 22,400,000 £476,799
46.98
Fee AP 22,400,000 = 22.4 x £260 (£5,824)

AP 1,000,000 £470,975
Money market hedge (MMH)

Borrow AP AP 22,400,000 AP 22,068,966
1.015
Convert @ spot AP 22,068,966 £471,056

46.85
Lend @ UK £471,056
x 1.009 £475,295
Option
Selling AP’s, so a November put option
Use option AP 22,400,000 £486,428

46.05
Premium AP 22,400,000 = 22.4 x £740 (£16,576)

AP 1,000,000 £469,852
In part 3.1 most candidates scored well. Common errors were adding rather than deducting fees and
premiums; using the wrong interest rates in an MMH; using a call rather than a put.


3.1b
Sterling receipt at spot rate = AP 22,400.000 £478,122
46.85
Summary of range of sterling receipts from hedging.

MMH gives highest receipt, but it’s a fixed amount.
Current spot rate gives high receipt, but the forward rate suggests a strengthening of sterling
against the peso. This would be bad news for Barratt, an exporter.
Management’s attitude to risk is important.
General points about various hedging techniques.
There were some very good answers here, but many candidates asserted doing nothing as using the
current spot rate produced the highest income despite the money not being received for three months.
The discussion section for weaker candidates was often very brief.

3.1c
A forward contract is a binding agreement to buy/sell a specified quantity of one currency in exchange for
another item for settlement at a future date at a price agreed today. Forward contracts are not always
easily available.
A currency future is a standardised exchange-traded contract to buy/sell a quantity of one currency in

exchange for another for notional delivery at a set date in the future. The contracts cannot be tailored to
the user’s exact requirements. There may be hedge inefficiencies – rounding of contracts and basis risk
(pricing differences between spot and futures markets). Limited currency availability.
Most candidates produced satisfactory answers here.

3.2a
Barratt concerned about an index fall, so sell futures
Portfolio value £8,350,000
Futures price 7,115

Price/index point x 10
Value/contract = 71,150
No of contracts £8,350,000 117.4

71,150
Rounded to 117
In three months' time £

Closing portfolio value (£8,350,000 x 7055/7130) 8,262,167
Opening portfolio value (8,350,000)
Loss in value (87,833)
Futures position
Sell at 7,115
Buy at (7,055)
Change 60
x
No of contracts 117
x
£10
Gain on future 70,200
Net decrease in portfolio value (£17,633)

Most candidates scored adequately on the index futures calculations. Common errors were using the
wrong price to calculate the number of contracts; not specifying the need to sell first; miscalculating the
new portfolio value and the profit on the futures contracts.

3.2b
The hedge will not be 100% efficient because of:
Basis risk and
Rounding contracts
Most candidates identified correctly why the hedge would be inefficient but weaker candidates rolled the
two separate reasons into one.

3.3
(a) (b)
LIBOR 3.5% 5.5%
plus 1.5% 1.5%
Total cost 5.0% 7.0%
Option cost 5.3% 5.3%

Exercise option? NO YES
Rate 5.0% 5.3%

Premium 1.0% 1.0%
Total cost 6.0% 6.3%
Borrowed £12,500,000 £12,500,000

x x
6.0% 6.3%
Annual cost £750,000 £787,500
Note: Annual cost of no hedge (at 5% & 7% pa) £625,000 £875,000
At low interest rates, it’s better not to hedge

At high interest rates, it’s better to hedge
The option premium is expensive
What is the board’s attitude to risk?
There was much variation in the marks here. This was due to many candidates not reading the question
carefully enough. It specified that the interest option had already been taken out whereas many candidates
answered as if that decision was still to be made.


WEDNESDAY 11 DECEMBER 2019
(2.5 HOURS)
Marks breakdown
Question 1 35 marks
Question 2 35 marks
Question 3 30 marks
application.
Question 1
Packaging Innovations plc (PI) is listed on the London Stock Exchange and is a
manufacturer of packaging products. One of PI’s objectives is to become more
eco-friendly. The board of PI feels that by entering the sustainable packaging
market it will meet this objective, by showing due regard for the environment
and its wider stakeholders.
PI has carried out research and development, at a cost of £90,000, into the
production of a new eco-friendly range of food packaging products to be called
‘Ecopacks’. The board asked the finance director, Chan Lee (Lee), who is an
ICAEW Chartered Accountant, to carry out an NPV analysis of the Ecopacks
project assuming a three-year time horizon to 31 December 2022.
At the end of three years the Ecopacks project could sold to a management
team made up of current PI employees led by Lee. He feels, however, that the
management team might struggle to raise the necessary funds. Some members
of PI’s board think that there might be alternatives available, at or after
31 December 2022, instead of selling the project to the management team.
The sales director of PI is concerned about the production of Ecopacks as they

are expensive and he feels that it will be difficult to sell them to food producers.
He would rather continue with the production of less eco-friendly packaging,
which is cheaper and easier to sell.
Information relating to the Ecopacks project:
 In the year to 31 December 2020 it is estimated that 3,000 batches of

Ecopacks per month will be sold and then increase by 10% pa in the two
years to 31 December 2022.
 The selling price will be £266 per batch in the year to 31 December 2020
and then increase by 3% pa in the two years to 31 December 2022.
Contribution is expected to be 30% of the selling price.
 Selling and administration expenses for the year to 31 December 2020 are
estimated to be £1.5 million and are expected to increase by 4% pa in the
two years to 31 December 2022.
 Fixed production costs, 50% of which are centrally allocated, are estimated
to be £0.60 million for the year to 31 December 2020. These costs are
expected to remain constant in the two years to 31 December 2022.
 PI will rent factory space on 31 December 2019 for three years to
manufacture Ecopacks at a cost of £0.2 million pa. This will be payable in
advance on 31 December and will increase by 3% pa.
 Lee has estimated that the price the management team could afford to pay
to PI for the Ecopacks project on 31 December 2022 is two times the pre-
tax contribution for the year to 31 December 2022. PI would pay
corporation tax on the sum received.
 On 31 December 2019 the project requires an investment in working capital

of £1.9 million. This will increase at the start of each year in line with sales
volume growth and sales price increases. Working capital will be fully
recoverable on 31 December 2022.
 The Ecopacks project will require an investment of £2 million in plant and

machinery on 31 December 2019. The plant and machinery has a life of
three years and the estimated scrap value is £0.25 million on 31 December
2022 (in 31 December 2022 prices).
 The plant and machinery will attract 18% (reducing balance) capital
allowances in the year of expenditure and in every subsequent year of
ownership by the company, except in the final year.
At 31 December 2022, the difference between the plant and machinery’s

written down value for tax purposes and its disposal proceeds will be
treated by the company as either 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 Ecopacks project is 7% pa.

The general level of inflation is expected to be 2.4% pa.
Requirements
1.1 Using money cash flows and assuming that the Ecopacks project is sold to
the management team, calculate the project’s NPV on 31 December 2019
and advise PI’s board whether it should proceed with the project.
(19 marks)
1.2 Ignoring the effects on working capital, calculate and comment upon the
sensitivity of the project’s NPV in part 1.1 above to changes in sales
volume. (5 marks)
1.3 Using the NPV in your answer to 1.1 above and assuming now that the
Ecopacks project is not sold to the management team, calculate the
project’s revised NPV on 31 December 2019. (2 marks)
1.4 Explain what is meant by ‘real options’ and, using your answer to 1.3
above, their relevance to the Ecopacks project. Identify and discuss one
real option that PI has as an alternative to selling the Ecopacks project to
the management team. (4 marks)
1.5 Briefly evaluate the sales director’s comments regarding the production of
Ecopacks in relation to the board’s sustainability objective. (2 marks)
1.6 Identify the ethical issues for Lee regarding his involvement in setting the
price at which the Ecopacks project would be sold to the management
team. (3 marks)
Total: 35 marks
Question 2
Wizard plc (Wizard) is listed on the London Stock Exchange and is an

entertainments company operating in the UK. The board of Wizard is
considering diversifying by purchasing Merlin Ltd (Merlin) which runs a chain of
hotels. The cost of purchasing Merlin is estimated to be £735 million and this
will be financed entirely by new 5% coupon debentures issued at par.
Wizard’s board has asked you, the finance director, to make a presentation at
the next board meeting on:
 Why the purchase of Merlin should be evaluated using the Adjusted

Present Value (APV) technique.
 How the new debt finance raised would affect certain key financial ratios
and the likely reaction of shareholders and the capital markets.
 Wizard’s current dividend policy and whether this should be continued in

future.
Extracts from Wizard’s most recent management accounts are shown below:
Income Statement for the year ended 31 December 2019
£m
Profit before interest and tax 395
Interest 55
340
Taxation @ 17% 58
Profit after tax 282
Balance Sheet at 31 December 2019

£m
Ordinary share capital (10p nominal value) 140
2,240
4% Redeemable debentures at nominal value 1,375
3,615
On 31 December 2019 Wizard’s ordinary shares each have a market value of

£4.79 (ex-div). The 4% debentures are redeemable at par (£100) in four years’
time and their current market price is £93 (ex-interest).
Profit after tax and dividends for the 5 years to 31 December 2019 are shown
below:
Year 2015 2016 2017 2018 2019

£m £m £m £m £m
Profit after tax 238 236 226 240 282
Dividends 119 118 113 120 141
Other information and assumptions
 Wizard’s equity beta on 31 December 2019 is 0.79.

 Listed companies operating in similar areas to Merlin:
Equity Market Market

Main beta value of value
Company activity equity of debt
£m £m
Spell
Hotels plc Operating hotels 0.92 1,950 1,050
Magic Operating hotels and
Resorts plc entertainment venues 1.10 610 152
Cauldron Operating travel
Travel plc companies and hotels 0.66 806 269
 The market risk premium is expected to be 7% pa.
 Assume that corporation tax will be at the rate of 17% for the foreseeable
future.
 The number of ordinary shares has not changed in the last 5 years.
 Data regarding gearing ratios (measured as debt/equity by market values)

and interest cover in Wizard’s current industry (ie entertainments) are as
follows:
Maximum Minimum Average

Gearing ratio 30% 15% 18%
Interest cover 9 times 4 times 7 times
Requirements
2.1 Calculate Wizard’s compound annual dividend growth rate for the following
periods and discuss which of the rates is most appropriate for calculating
the cost of equity in the dividend valuation model:
(a) 31 December 2015 to 31 December 2019
(b) 31 December 2017 to 31 December 2019
(3 marks)
2.2 Ignoring the Merlin purchase, calculate:

(a) Wizard’s WACC at 31 December 2019 using the CAPM.
(b) Wizard’s cost of equity at 31 December 2019 using the dividend
valuation model and the growth rate that you have chosen in 2.1
above. (9 marks)
2.3 Explain why APV should be used to appraise the purchase of Merlin and
outline the main elements of the technique.
(4 marks)
2.4 Calculate the cost of equity that should be used in an APV appraisal of the
Merlin purchase. Explain, and give two examples of, the type of risk this
cost of equity reflects.
(5 marks)
2.5 Calculate Wizard’s gearing ratio (measured as debt/equity by market

values) and interest cover before and after the purchase of Merlin.
(3 marks)
2.6 Discuss the likely reactions of both the shareholders and the capital
markets to the purchase of Merlin being financed entirely by debt. You
should refer to your answer to 2.5 above and the industry data provided.
(6 marks)
2.7 Discuss, with reference to both theory and practical factors, whether
Wizard’s dividend policy over the last 5 years is appropriate for a listed
company. (5 marks)
Total: 35 marks
Question 3
Your firm advises Moon Sport Ltd (Sport) and you are working on three tasks.
3.1 Task 1 Foreign exchange rate risk
Sport imports rock climbing equipment from the USA and uses forward
contracts to hedge its foreign exchange rate (forex) risk. The board of Sport
would like to investigate using money market hedges and over the counter
(OTC) currency options as alternatives. Sport is due to make a payment of
$1,550,000 in four months’ time on 30 April 2020.
You have the following information available to you at the close of

business on 31 December 2019:

4-month forward contract premium ($/£) 0.0059 – 0.0053
Annual borrowing and depositing interest rates:
Dollar 3.20% – 2.70%

Sterling 4.10% – 3.70%
4-month OTC currency options:
 Call options to buy $ have an exercise price of $/£1.3200 and a

premium of £0.03 per $ converted.
 Put options to sell $ have an exercise price of $/£1.3050 and a

premium of £0.05 per $ converted.
The option premium is payable on 31 December 2019. Sport has an overdraft.
Requirements
(a) Calculate Sport’s sterling cost of the $1,550,000 payment using:
Assume that the spot rate on 30 April 2020 will be $/£ 1.3080 – 1.3090.
(9 marks)
(b) Explain the relative advantages and disadvantages of each of the hedging
techniques in 3.1 (a) above and advise Sport’s board as to which technique
would be the most beneficial for hedging its forex risk. (8 marks)
3.2 Task 2 Bitcoin price risk
Sport is intending to sell one of its surplus buildings for £0.5 million in the near
future and the purchaser would like to make payment in a cryptocurrency such
as Bitcoins instead of sterling.
The Sport board is worried about the volatility of the Bitcoin price between the
time that the sale proceeds are received and the time that the Bitcoins are
subsequently sold.
Using Bitcoin prices on 31 December 2019 you have been asked to illustrate for
the Sport board the potential losses that could occur if the value of Bitcoins
decreases before they are sold for sterling.
You have the following information available to you on 31 December 2019:
31 December 2019 £ equivalent of one Bitcoin

Time
09.00 £2,733.29
10.00 £2,740.30
11.00 £2,698.44
Requirements
(a) Calculate the gains or losses if the purchaser had paid in Bitcoins at 09.00
on 31 December 2019 and those Bitcoins had then been sold for sterling at
either 10.00 or 11.00. (2 marks)
(b) Advise Sport on whether to accept the payment for the building in sterling
or Bitcoins. (2 marks)
3.3 Task 3 Interest rate risk
Sport is buying new factory premises and arranged to borrow £1,240,000 on

31 March 2020. The loan will be for an eighteen month period at an interest rate
of LIBOR + 4% pa. The Sport board is concerned about potential increases in
LIBOR over the next three months, to 31 March 2020, from its current level of
0.90% pa.
You have the following information available to you on 31 December 2019:
Traded sterling interest rate futures: March three-month futures price = 98.80
Standard contract size = £500,000
Requirements
(a) Calculate the interest cost of Sport borrowing £1,240,000 for eighteen
months if it does not hedge its interest rate risk and LIBOR remains at
0.90% pa. (1 mark)
(b) Calculate the interest cost of Sport borrowing £1,240,000 for eighteen
months if it uses traded sterling interest rate futures to hedge its interest
rate risk, if by 31 March 2020:
 LIBOR increases to 1.50% pa and the futures price moves to 98.30
 LIBOR decreases to 0.75% pa and the futures price moves to 99.00

(6 marks)
(c) Explain why the interest rate risk of Sport borrowing the £1,240,000 is not
perfectly hedged by the futures contracts in 3.3 (b) above. (2 marks)
Total 30 marks
Question 1
Total Marks:
General comments
The scenario of the question is that a company is launching a new product onto the market.
Part 1.1 of the question requires candidates to calculate the project’s NPV.
Part 1.2 of the question requires candidates to calculate how sensitive the project is to certain inputs in to
the NPV analysis.
Part 1.3 of the question requires candidates to calculate the project’s NPV if one element of the original
analysis changes.
Part 1.4 of the question requires candidates to describe and identify real options.
Part 1.5 of the question requires candidates to discuss sustainability.
Part 1.6 of the question requires candidates to consider an ethical issue.
1.1
0 1 2 3
£000s £000s £000s £000s
Sales 9,576.00 10,849.61 12,292.61
cost of
Sales (6,703.20) (7,594.73) (8,604.82)
Contribution 30% 2,872.80 3,254.88 3,687.78
Selling and admin (1,500.00) (1,560.00) (1,622.40)

Fixed production costs (300.00) (300.00) (300.00)
Rent (200.00) (206.00) (212.18)
Sale to management 7,375.56
Taxable cash flows (200.00) 866.80 1,182.70 9,140.95
Tax 34.00 (147.36) (201.06) (1,553.96)
Working Capital (1,900.00) (252.70) (286.31) 2,439.01
Plant and Machinery (2,000.00) 250.00
Tax saved on WDA 61.20 50.18 41.15 144.97
Total cash flows (4,004.80) 516.93 736.48 10,420.96
PV factors at 10%
((1.07 x 1.024)-1) 1.00 0.91 0.83 0.75
PV (4,004.80) 469.89 608.34 7,826.14
NPV 4,899.56
The project is positive and should be accepted which will improve s/h wealth.
The research and development costs and centrally allocated costs are a sunk costs and should not be
included.
Sales
T1 3 x 266 x 12 = 9576
T2 9576 x 1.10 x 1.03 = 10849.61
T3 10849.61 x 1.1 x 1.03 = 12292.61

Working Capital
Increment
£000s £000s
T0 (1,900.00) (1,900.00)
T1 (2,152.70) (252.70)
T2 (2,439.01) (286.31)
T3 2,439.01
Capital Allowances
Cost/WDV C.A Tax
£000s £000s £000s
t0 2,000.00 360.00 61.20
t1 1,640.00 295.20 50.18
t2 1,344.80 242.06 41.15
t3 1,102.74
t3 Sale (250.00) 852.74 144.97
Most of the attempts at this part of the question were good however common errors were: Not stating why
the research costs should be ignored ie that they are sunk costs; not stating the reason why 50% of the
fixed costs should be ignored i.e. that they are centrally allocated; inflating cash flows when it is stated that
they remain constant; incorrect timing of cash flows; inflating the net cash flows by the general level of
inflation; not using the Fisher formulae to calculate the nominal cost of capital and merely adding the
general level of inflation to the real cost of capital; discounting money net cash flows by the real cost of
capital. Using one month’s volume and not multiplying by 12.

1.2
Sensitivity to Sales volume

1 2 3
£000s £000s £000s
Contribution 2,872.80 3,254.88 3,687.78
Price 7,375.56
Tax (488.38) (553.33) (1,880.77)
2,384.42 2,701.55 9,182.57
PV factors at 10% 0.909 0.826 0.751
PV 2,167.44 2,231.48 6,896.11
Total PV 11,295.03
Sensitivity 4899.56/11295.0 43%
Not very sensitive to sales volume changes
Again some candidates attempted to calculate sensitivity using units (rather than £ contribution), going as
far as taxing them and discounting them. Other, common, errors were: calculating sensitivity using sales
rather than contribution; ignoring tax; inverting the sensitivity calculation; inadequate narrative and not
stating whether the project is or is not sensitive to changes in volume.


1.3
7375.56(1-0.17)x0.751=4597.41
4899.56-4597.41=302.15
Generally ok with follow through from 1.1. However some candidates wasted time by recreating the whole
NPV minus the sale to management.

1.4
(a) NPV analysis only considers the cash flows related directly to the project. However there are options
associated with a particular project which outweigh the conventionally calculated NPV so a negative NPV
project may be acceptable once the value of any options is added.
In Pi’s case without selling to the management team the project has a small positive NPV of 302.15 and is
risky. However real options might make it more acceptable.
Even though the Ecopacks project has a small NPV without selling to the management team it has a
Follow-on option in this growing market. Therefore by launching the Ecopacks project PI will have later
opportunities to launch further versions, which could be highly profitable.
Candidates might also mention and discuss Growth options, which will be awarded marks.
Poor definitions of real options across the board with hardly any reference to the answer to 1.3. Too many
abandon and delay choices, which were not appropriate given the scenario of the question.

1.5
The sales director’s comments are not in line with PIs objectives regarding sustainability. Companies are
to act ethically in relation to the impact they have on the environment and PI needs to take into account
sustainability in its decisions and actions. PI also has a corporate responsibility to take the needs of their
wider stakeholders into account. If Pi does this it may end up improving shareholder wealth by having a
positive effect on its economic performance.
Generally well answered.

1.6
There is a clear conflict of interest in Chan setting the price that his management team should buy the
Ecopacks project at from PI. Chan should be acting on behalf of the shareholders of PI and ensuring that
he is maximising their wealth.
If he is involved in setting the price he is not action professionally and not being objective. He would not be
acting with Integrity and there is a self-interest threat.
Chan should take no part in setting the price at which his team could buy the Ecopacks project from PI.
Lack of the language of ethics, also many candidates did not mention the conflict of interest.


Question 2
Total Marks:
General comments
The scenario of the question is that a company is diversifying. The board of the company would like the
finance director to make a presentation on certain matters connected to the diversification.
Part 2.1 of the question requires candidates to calculate growth rates.

Part 2.2 of the question requires candidates to calculate the WACC of the company.
Part 2.3 of the question requires candidates to explain why a certain capital investment appraisal
technique should be used.
Part 2.4 of the question requires candidates to calculate the discount rate to be used in the capital
investment appraisal technique explained in the third part of the question.
Part 2.5 of the question requires candidates to calculate key financial ratios.
Part 2.6 of the question requires candidates to discuss the likely reactions of stakeholders to changes in
the key financial ratios calculated in the fifth part of the question.
Part 2.7 of the question requires candidates to discuss dividend policy.
2.1
Growth 2015 – 2019 (141/119)(1/4) - 1 = 4.33%
Growth 2017 – 2019 (141/113)(1/2) - 1 = 11.70%
The 11.70% growth of dividends from 2017 to 2019 is distorted by the fall in 2017 and increase in 2019
and this period is unlikely to be representative.
It is more appropriate to take a longer term view of past dividend growth and it is advisable to use the
4.33% growth in dividends from 2015 to 2019. Although this figure is also distorted by the sharp increase
in 2019.
It was disappointing to see that a lot of candidates could not calculate compound growth rates correctly,
even with the correct figures in the formulas. Also the incorrect number of years was often used. Also the
commentary on which growth rate to use was poor with many candidates picking the distorted figure of
11.7%.

2.2
(a) ke using the CAPM = 2 + 0.79 x 7 = 7.53%
kd
Time Cash flow Factors at PV Factors at PV

£ 5% £ 10% £
0 (93) 1 (93) 1 (93)
1-4 4 3.546 14.18 3.170 12.68
4 100 0.823 82.30 0.683 68.30
3.48 (12.02)
YTM = 5 + ((3.48/(3.48+12.02))5) = 6.12%
Kd = 6.12 (1-0.17) = 5.08%
Market values:
The number of shares in issue = 1,400m (140/0.10)
Equity 1,400m x £4.79 = £6,706m

The total market value of debt = 1,375 x 0.93 = £1,279 (rounded)
WACC = (7.53 x 6706 + 5.08 x 1279)/(6706 + 1279) = 7.14%

(b) ke using the dividend growth model
Dividends per share = £141m/1,400 = 10p
ke = ((10 x 1.0433)/479) + 0.433 = 6.51%
Answers to this part of the question were often weak. Common errors were: Incorrect computation of ke
when using the CAPM; no tax deducted from kd; incorrect IRR computations; picking the wrong discount
and annuity factors in the IRR computation; incorrect market values, often confusing the number of zeros
between the market value of debt and equity; fudging figures where an unrealistic result was obtained i.e.
In DVM 223% stated as 2.23%; incorrect result for ke when using DVM despite correct numbers in the
formula.

2.3
To use the current WACC to appraise the Merlin purchase would be inappropriate since the gearing in
particular (as well as the systematic business risk) is going to materially change, the new capital values
are needed for a new WACC but equity requires the NPV which requires the WACC and a circular
argument ensues. Instead the project should be appraised using Adjusted Present Value (APV).
In the APV technique the base case cash flows are discounted using an all equity discount rate to produce
the base case present value. The base case present value is then adjusted by the present value of the
financing side affects such as the tax shield on debt interest. For example in the Merlin project that would
be the present value of the tax saved on interest paid on the new debentures. Issue costs are then
deducted.
Poor explanations of why APV should be used with little mention of the fact that the project would be
finance entirely by debt. Quite poor descriptions of the main elements of the APV technique. Although
there were some very good answers.

2.4
The all equity discount rate should reflect the systematic (business) risk of Wizard’s diversification into the
hotel industry. Unlike unsystematic risk, systematic risk can not be diversified away. It is the risk to which
all companies are exposed, although individual companies carry different amounts of this systematic risk.
Examples of systematic risk are: Interest rate changes; Oil price fluctuations; Changes in Government.
Spell Hotels plc is a pure hotel operating company and its equity beta reflects the systematic risk of
Wizard’s diversification. However the equity beta reflects Spell Hotel’s financial risk and this must be
stripped out by calculating the asset beta. This asset beta can then be used in the CAPM to calculate an
all equity discount rate that can be used in the APV evaluation of the Merlin project.
De-gearing the Spell Hotels equity beta=
0.92 = Ba (1 + (1050(1-0.17))/1950) = 0.64

ke = 2 + 0.64 x 7 = 6.48%
Answers to this part of the question were often weak common errors were:
Picking the incorrect equity beta; lack of precision in ungearing the equity beta; gearing up the asset beta
and using this to calculate the cost of equity to be used in APV; few comments on systematic risk; few
valid examples of systematic risk.


2.5
Gearing without the Merlin project = 1279/6706 = 19.7%
Gearing with the Merlin project = (1279 + 735)/6706 = 30%
Interest cover without the Merlin project = 395/55 = 7.18 times
Interest cover with the Merlin project = 395/(55 + 735 x 0.05) = 4.30 times

2.6
With the project Wizard’s gearing at 19.7% will increase from a little over the industry average of 18% to
30%, which is the industry maximum.
With the project Wizard’s interest cover of 7.18 times will decrease form a little over the industry average
of 7 times to 4.30 times which is approaching the industry minimum of 4 times.
The financial markets and shareholders may not be encouraged by these changes and they will need to
have information about the profitability of the Merlin purchase. If their reaction is favourable then these
financial ratios may improve after the purchase and moves into profitability.
Many good answers but poorer candidates reverted to capital structure theory when it was not asked for.

2.7
It can be seen from the calculating the dividend payout ratio that Wizard is employing a dividend policy of
keeping the payout ratio constant over the last five years at 50%. This means that dividends will rise and
fall with profits.
Most listed companies attempt to keep dividends at a level where they can give some growth each year
and so it would seem that Wizard’s current dividend policy is inappropriate for a listed company. However
this will depend on the shareholder base and what they prefer.
However Modigliani and Millar in their Dividend Irrelevancy Theory stated that the pattern of dividends
over time is irrelevant in determining shareholder wealth. The further stated that dividends should only be
paid when there are no positive NPV projects to invest in. However practical issues are that dividends are
important signals to the financial markets and also there is a clientele effect and different shareholders will
have different preferences in terms of income and taxation.
Generally good answers.


Question 3
Total Marks:
General comments
The scenario of the question is that you work for a firm that is giving advice to a client. You are tasked with
giving advice on three risk management areas.
3.1 Foreign exchange rate risk
Part 3.1 (a) of the question requires candidates to calculate the sterling cost of a payment in $ using
various hedging techniques.
Part 3.1 (b) of the question requires candidates to discuss and give advice on the techniques used in the
first part of the question.
3.2 Bitcoin price risk
Part 3.2 (a) of the question requires candidates to illustrate gains and losses if a payment is received in a
cryptocurrency.
Part 3.2 (b) of the question requires candidates to discuss the risk of accepting payment in a
cryptocurrency.
3.3 Interest rate risk
Part 3.3 (a) of the question requires candidates to calculate the interest cost of borrowing for a certain
period.
Part 3.3 (b) of the question requires candidates to calculate the interest cost of borrowing using a certain
interest rate risk hedging technique.
3.1 (a)
The forward rate is: $/£ 1.3097 (1.3156-0.0059)

This is result in a sterling payment of: $1,550,000/$1.3097 = £1,183,477
Using the money markets, Moon will invest in $, buy $ at the spot rate and borrow in £.
Invest $1,550,000/(1+0.027x4/12) = $1,536,174
Buy $ spot $1,536,174/$1.3156 = £1,167,660
Borrow in £ to give total cost £1,167,660 x (1+0.041x4/12) = £1,183,618
Over the counter option. Using a call option to buy $:

Exercise price $1.3200. If spot is $1.3080 exercise the option.
The option premium is $1,550,000 x £0.03 = £46,500.
The premium with interest is £46,500 x (1+0.041x4/12) = £47,136
The sterling payment will be ($1,550,000/$1.3200) + £47,136 = £1,221,378
using the incorrect exchange rate and adding instead of deducting the forward premium; for the money
using the incorrect spot rate; for the OTC option choosing the put rather than the call, picking the call and
using the put premium; not taking account of the interest on the option premium, treating the OTC option
as a traded option and incorrect exercise or abandon decisions.

3.1 (b)
The forward contract = £1,183,477

The money market hedge = £1,183,618
The OTC option = £1,221,378

No hedge = $1,185,015 (1,550,000/1.3080)
The forward contract and money market hedge lock Moon into an exchange rate. The options however
protect Moon against the downside risk of the £ weakening more than expected against the $ and allow for
the upside potential of the $ weakening against the £, however the option premium is expensive.

Forwards:
Tailored specifically for Moon
However there is no secondary market. .
Money market hedge:
The money market hedge is more difficult to arrange than a forward contract and might use up Moon’s
credit lines.
It is unlikely that the $ is going to weaken against the £ and, even if it did, it is unlikely to weaken enough
to cover the cost of the option premium, therefore it is not recommended that the company use OTC
foreign currency options. The forward contact and money market hedge are both better than the spot rate,
however the forward is the cheapest. It is recommended that Moon use a forward contract to hedge the
forex. Attitude to risk can also be mentioned.
Some good responses but some of the errors that poorer candidates made include: just stating
advantages and disadvantages; not showing the result of not hedging; not considering the direction of
currencies shown by the forward premium; no recommendation.

3.2 (a)
09.00 The receipt in Bitcoin will be = B182.93
10.00 Sale proceeds = £501,283 (182.93 x 2,740.30). A gain of £1,283.
11.00 Sale proceeds = ££493,625.63 (182.93 x 2,698.44). A loss of £6,374
Mostly fine but some candidates used £ x £ (price x rate), which was clearly incorrect.

3.2 (b)
It can be seen from the calculations in (a) above that in a matter of only two hours the volatility of the price
of Bitcoins is high moving from either a gain of £1,283 to a loss of £6,374.
Unless Moon can hedge the risk of the Bitcoin price moving against it, it is not recommended that the
company accepts payment in Bitcoins. Attitude to risk can also be mentioned.
Generally ok.


3.3 (a)
If LIBOR remains at 0.9% Moon will pay 4.9% interest, which is a total cost of:
£ 91,140 (1,240,000 x 0.049 x 18/12)
It was disappointing to see that some candidates could not calculate 18 month’s interest on a loan.

3.3 (b)
Using interest rate futures to hedge Moon will SELL March futures at 98.80.
The number of contracts = 14.88 (1,240,000/500,000 x 18/3) Round to 15 contracts.
LIBOR 1.5% 0.75%

LIBOR + 4% 5.5% 4.75%
Futures sold at 98.80 98.80
Futures bought at 98.30 99.00
Gain (Loss) 00.50 (00.20)
Futures total position Gain £1,875,000 x 0.5% = Loss £1,875,000 x 0.2% =
15 x £500,000 x 3/12 = £9,375 £3,750
£1,875,000
Interest cost £1,240,000 x 5.5% x 18/12 £1,240,000 x 4.75% x 18/12
= £102,300 = £88,350
Total cost £92,925 (102.300-9,375) £92,100 (88,350 + 3,750)
Generally ok but common errors included: Incorrect number of contracts, often 2 or 3 instead of 15; buying
initially instead of selling; can not calculate 0.5% and 0.2% of the futures gain or loss; can not calculate the
interest cost i.e taking the full 18 months into account.

3.3 (c)
The interest cost of the loan if LIBOR remains constant is £91,140. In both cases where LIBOR increase
or decreases the interest cost is more at £92,925 and £92,100 respectively.
The reason why the hedge is not perfect is twofold namely:
 The number of contracts - Because the contracts are a standard size it is not possible to hedge a
perfect amount and the number of contracts’ will have to be rounded.
 Basis risk – The price of futures will normally be different from the spot price on any given date.
This difference is called the basis. The effect of basis is to prevent hedges from being 100%
efficient.
Generally ok.


WEDNESDAY 11 MARCH 2020
(2.5 HOURS)
Marks breakdown
Question 1 30 marks
Question 2 35 marks
Question 3 35 marks
application.
3. Click on the Start Test button to begin the exam. The exam timer will begin to count
Question 1
Assume that the current date is 1 April 2020.
Engavon plc (Engavon) is a UK engineering company which has been trading since 1992. It
has a financial year end of 31 March. Engavon’s main source of income is the manufacture
and sale of emergency vehicles. Its major customers are the British and European
governments. 90% of its vehicle components are imported from EU suppliers and paid for in
euro.
You are a member of the company’s finance team. Two days ago, you received an email
from the finance director. Below is an extract from her email:
………….. I agreed to make a brief presentation on risk management to the board at next
week’s meeting. However, I must now visit two of our key European customers and so I won’t
be able to attend. I need you to present for me. The directors’ particular concern was the
possible hedging of the foreign exchange rate risk on the dollar income from a contract with
the Australian government. Please explain to the board the financial implications of using the
following hedging methods:

(2) Money market hedge
(3) Sterling traded currency options
Since receiving the email, you have researched the Australian contract and have established
that Engavon’s board is actively seeking to expand the company’s operations into the Asia
Pacific market. In October 2019 it signed a contract to supply the Australian government with
a consignment of emergency vehicles. This contract is worth A$2.9 million.
The vehicles will be shipped to Australia in late April 2020 and Engavon will receive
settlement on 30 June 2020. You have collected the following information at close of
business on 1 April 2020:
Spot rate (A$/£) 1.8495 – 1.8585

Three-month forward contract discount (A$/£) 0.0102 – 0.0117
Australian dollar interest rate (lending) 5.2% pa
Australian dollar interest rate (borrowing) 6.6% pa
Arrangement fee for
forward contract £10 per A$1,000 converted
Sterling traded currency options (standard contract size £10,000) are priced as follows on
1 April 2020 (premiums are quoted in cents per £ and are payable in advance):
April 2020 June 2020

contracts contracts
Exercise price (A$/£) Calls Puts Calls Puts

1.862 1.49 3.26 2.74 5.09
Requirements
1.1 Calculate Engavon’s net sterling receipt for each of the three hedging methods listed in
the finance director’s email, assuming that on 30 June 2020 the spot exchange rate will
be:
(a) A$/£ 1.8270 – 1.8345

(b) A$/£ 1.8730 – 1.8810
Note: Interest on option premiums should be ignored.

(14 marks)
1.2 With reference to your calculations in 1.1, advise Engavon’s board whether it should
hedge the receipt from the Australian government contract. (7 marks)
1.3 Explain, with relevant workings, why the three-month forward rate is expressed at a
discount to the spot rate on 1 April 2020. (5 marks)
1.4 Explain whether the board’s plans to expand the company’s operations into the Asia
Pacific market will expose Engavon to economic risk. (4 marks)
Total: 30 marks
Question 2
Assume that the current date is 1 April 2020.
AOS Energy plc (AOS) manufactures and erects wind turbines. The company has traded
since 2002, is listed in the UK and its financial year-end is 31 March. AOS is involved in
energy projects across the world, but most of its work is within Europe.
To date the company has increased in size and value by organic growth. AOS’s board is now
investigating the acquisition of 100% of the share capital of Pentmarine Power Ltd
(Pentmarine), a manufacturer of wave energy converters.
You are a member of AOS’s finance team and the company’s finance director has sent an
email to you, extracts from which are shown below:
………….. I’m really busy with year-end work and would value your input regarding
the Pentmarine acquisition. This would be a big investment for us and owning
Pentmarine would mean that AOS was operating in a different technology sector.
One of our board members is keen for AOS to develop a portfolio of investments in
order to reduce our shareholders’ risk. However, two others are worried about this
and need some reassurance as they feel that buying Pentmarine is too risky.
Were AOS to buy Pentmarine it would cost in the region of £30 million, which we
would need to borrow. Our bankers are willing to lend us that sum, but at an interest
rate of 10.5% pa. I want to explain to the board the implications of the investment,
based primarily on its estimated NPV. Can you calculate an up to date cost of capital
figure for me?
Also, we’ve never used the CAPM method, so I’d be interested to see if this would
show much of a difference. …………..
AOS’s management accounts at 31 March 2020 included the following:
£’000
£1 ordinary shares 20,500
6% £1 preference shares 4,300
4% irredeemable debentures 5,100
3% redeemable debentures (note 1) 6,800
Note 1
These debentures are redeemable at par on 31 March 2023.
The market values of AOS’s capital at 31 March 2020 are:
Ordinary shares (note 2) £4.20/share (cum-div)

Preference shares £1.33/share (ex-div)
Irredeemable debentures £102% (ex-interest)
Redeemable debentures £101% (cum-interest)
Note 2
AOS’s ordinary dividend for the year to 31 March 2020 totals £5,125,000 and this is due to be
paid in full on 14 April 2020. AOS’s ordinary dividends have been increasing at a steady
annual rate since the year ended 31 March 2015 when they totalled £4,428,000. AOS’s
issued ordinary share capital has not changed since 2014.
Additional information at 31 March 2020:
AOS’s equity beta 1.30

relates.
Requirements
2.1 Calculate AOS’s WACC on 31 March 2020 using:
(a) The dividend valuation model (16 marks)

2.2 Compare and contrast the dividend valuation model with the CAPM as alternative
means of calculating the cost of equity. (5 marks)
2.3 Advise AOS’s directors whether they should use the WACC figure calculated in 2.1
when appraising the Pentmarine purchase. (4 marks)
2.4 Explain the adjusted present value (APV) technique and indicate whether it is applicable
to the Pentmarine purchase. (4 marks)
2.5 Explain the portfolio effect and discuss the board member’s contention that AOS’s
development of a portfolio of investments would reduce the risks to its shareholders.
(4 marks)
Total 35 marks
Question 3
Assume that the current date is 31 March 2020
Greene & Banks plc (Greene) is a listed UK producer of dairy products. Its headquarters are
in Bristol and its financial year-end is 31 March. You are an ICAEW Chartered Accountant
and are employed in Greene’s finance team.
Currently Greene has four regional factories which produce and sell milk, yoghurt and cheese
within their region. Greene’s board has decided to rationalise its operations. Production and
retailing will be moved into one factory in Bristol, whilst the other three factories will be
closed. The Bristol factory output will be expanded via the use of sophisticated technological
developments. It will then make sales to the three regions once their own factories have
closed. It is forecast that the company’s total sales will increase following the rationalisation.
These plans have not yet been made public.
The factory in Hawten is one of those that will close and its factory will be sold to Sharpe
Manufacturing Ltd (Sharpe). However, Greene’s board is unsure whether to close it in one
year’s time on 31 March 2021 or in three years’ time on 31 March 2023. Sharpe would prefer
to purchase the factory on 31 March 2023 and is prepared to pay an additional £500,000 if
Greene agrees to that date.
You have been asked to prepare calculations to enable Greene’s board to make a decision
on the preferred closure date for Hawten and have been given the following estimates:
Table
Year to 31 March
2021 2022 2023
Hawten factory
Sales (£’000) £1,200 £1,220 £1,250
Variable costs as a % of sales 55% 55% 55%
Fixed costs (£’000) £200 £200 £200
Bristol factory
Sales to Hawten’s region

after closure (£’000) £1,280 £1,360
Variable costs as a % of sales 45% 45%
Incremental fixed costs (£’000) £320 £320
All figures in this table are in 31 March 2020 prices. Sales will not increase with inflation. The
inflation rate applicable to all costs in this table is 2% pa.
Additional estimates
At 31 March 2021 2023
£’000 £’000
Factory selling price (note 1) 7,700 8,200
Plant and machinery
disposal proceeds (note 2) 900 780
Redundancy payments (note 3) 2,000 2,150
Note 1
The factory selling prices are stated in money terms. Greene’s board wishes to provide for a
corporation tax charge of 17% on the agreed selling price of the factory.
Note 2
The plant and machinery disposal proceeds are stated in money terms. The plant and
machinery will have a tax written down value of £740,000 on 1 April 2020. It attracts 18%
(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 plant and machinery’s written down value for tax
purposes and its disposal proceeds will be treated by the company either as:
 a balancing allowance, if the disposal proceeds are less than the tax written down
value, or
 a balancing charge, if the disposal proceeds are more than the tax written down value.
Note 3
The redundancy payments are stated in money terms.
Other information
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant
financial year.
Greene’s money cost of capital is 8% pa.
Requirements
3.1 (a) Calculate the relevant money cash flows associated

with closing Hawten on:
(1) 31 March 2021

(2) 31 March 2023
and use these to calculate the NPV at 31 March 2020 for each of these possible
closure dates.
In both of these calculations you should ignore any opportunity cash flows
associated with the alternative closure date. (17 marks)
(b) Advise Greene’s board as to the preferred closure date for Hawten. (1 mark)
3.2 Calculate the selling price of the factory on 31 March 2023 that would make Greene’s
board indifferent to which of the two possible closure dates to choose. (5 marks)
3.3 Explain what is meant by the term ‘real options’ and identify one real option that could
apply to Greene’s board’s plans.
(4 marks)
3.4 Compare the strengths and weaknesses of sensitivity analysis and simulation as means
of assessing the risk of a project. (5 marks)
3.5 Explain the ethical implications for you, as an ICAEW Chartered Accountant, of having
knowledge of potentially price-sensitive information about Greene’s plans.
(3 marks)
Total 35 marks

Question 1
Total marks: 30
General comments
This question was had the lowest percentage mark on the paper. However, the majority of candidates
scored a “pass” mark (55%) in this question.
of the syllabus.
In the scenario, the company (Engavon) was a UK manufacturer of emergency vehicles. Its main
customers were the British and European governments. Candidates were cast as an employee in the
company’s finance team and were asked to advise the board on a contract with the Australian
government, settlement of which was due on 30 June 2020. Part 1.1 was worth 14 marks. Candidates had
to calculate the June 2020 sterling receipt (using two alternative spot rates) for the Australian contract,
making use of three different hedging techniques. In Part 1.2, for seven marks, candidates were required
to advise the board whether it should hedge against exchange rate movements for the Australian contract.
In Part 1.3 (five marks) candidates had to explain, with workings from the data provided, why the three-
month forward contract rate was expressed as a discount to the current spot rate. Finally, for four marks,
Part 1.4 tested candidates’ understanding of the economic risk associated with currency movements.
1.1
A$
Spot rate 1.8585
1.8702
£
Translation of A$ A$2.9m/1.8702 1,550,636
plus: Arrangement fee A$2.9m/ x £10/1,000 (29,000)
£1,521,636
Borrow A$ now A$2.9m A$2.9m A$2,852,927

1 + (6.6%/4) 1.0165
Convert at spot rate A$2,852,927 £1,535,070

1.8585
Sterling invested at 3% pa (£1,535,070) x [1 + (3%/4)] £1,546,583
(3) Traded Option
Engavon will buy £ so it’s a June call option
No of contracts A$2.9m 1,557,465 156 contracts

1.8620 10,000
Cost of option 156 x $.0274 x 10,000 $42,744
$42,744 £23,111
1.8495

Spot rate at 30/6/20 1.8345 1.8810

Bought for (1.8620) (1.8620)
(Loss)/Profit (0.0275) 0.0190
Abandon Exercise
Contracts 156
x
10,000
x
0.0190
Total profit A$29,640
A$ A$
Sum due from customer 2,900,000 2,900,000
plus: Profit 0 29,640
2,900,000 2,929,640
£ £
At relevant spot rate 1,580,812 1,557,491
less: Cost of option (23,111) (23,111)
Sterling receivable 1,557,701 1,534,380
In Part 1.1 most candidates scored well on the forward contract (FC) and MMH calculations. Errors made
by weaker candidates included the wrong rate for the FC, subtracting, not adding, the FC discount,
adding, not subtracting, the FC fee. A small number of candidates worked out two answers for the FC
(from the two spot rates) and will have scored zero. With the MMH the most common error was to use the
wrong (i) number of months or (ii) interest rates. For the sterling traded currency options, it was very
pleasing to see a fair number of good scripts. Overall, however, as expected, this section proved to be a
key discriminator. Many candidates failed to provide sufficient workings and so will have lost marks. Also it
was quite common to see candidates using only two decimal places, rather than four, in their calculations.
This, again, will have cost them marks. Quite a few candidates chose put, rather than call, options and
then, subsequently, made the wrong abandon/accept decision. Typical smaller errors noted were: (i) the
use of the current spot price rather than exercise price when calculating the number of contracts, (ii) the
calculation of A$ premium using A$2.9m rather than the number of contracts just calculated, (iii) not
recognising that the premium was in A$ and then not converting or converting at wrong rate. Many
candidates lost marks because they exercised the option, but then then treated it as an OTC, rather than a
traded, option.

1.2
Current spot Spot rate at 1/4/20 A$2.9m

1.8585 £1,560,398
Spot rate at 30/6/20 A$2.9m A$2.9m

1.8345 1.8810
£1,580,812 £1,541,733
SUMMARY STERLING COSTS £

3-month spot (weak £) 1,580,812
Current spot 1,560,398
Traded option (weak £) 1,557,701
MMH 1,546,583
3-month spot (strong £) 1,541,733
Traded option (strong £) 1,534,380
Forward contract 1,521,636

A weakening £ would favour Engavon – an exporter. The best outcome is the 3-month spot rate, i.e. do
nothing (the other 3-month spot rate gives a sterling receipt that is 2.5% lower). The traded option (weak £)
gives the best hedged outcome.
The forward contract (A$ discount) suggests that sterling will strengthen.
MMH and FC give fixed amounts - what is the management’s attitude to risk? Staff time and costs will be
incurred if Engavon hedges.
Other general points on the three hedging methods.
Overall Part 1.2 was done well and many candidates were able to link theory to the scenario and provide
useful advice.

1.3
Av spot rate x Av A$ rate (3 mos.) = Av f’wd rate = Av discount

Av sterling rate (3 mos.) given in qn.
1.8540 x 1.01475 = 1.8650 0.01095 OK

1.00875
Theory Interest rate parity (IRP) links currency & money markets.
Money market interest rates explain difference between forward and spot rates
No gain can be made on interest rates of different currencies
In Part 1.3 too few candidates were able to explain IRP adequately. Weaker scripts used annual rather
than quarterly rates and didn’t use averages, where necessary. Marks were lost if a candidate failed to
explain whether IRP held up in the scenario.

1.4
Economic risk: Engavon’s value = PV future of future cash flows. These may be adversely impacted by
forex movements.
Asia Pacific exports e.g. in A$
EU imports and exports – either net receipt or payment in €
So, currencies (A$ & €) could both move adversely against sterling - A$ weakens and, (if a net payment in
euros). € strengthens.
Part 1.4, overall, was poor. Too few candidates were able to explain what economic risk is, concentrating,
wrongly, on political, physical and/or transaction factors. A lot of candidates wasted time on how to protect
against economic risk, which wasn’t the question.


Question 2
Total marks: 35
General comments
This question was had the highest percentage mark on the paper. A considerable majority of candidates
This was a six-part question that tested the candidates’ understanding of the investment decisions
In the scenario, candidates were cast as an employee in the finance team of AOS plc, a UK-listed
manufacturer and constructor of wind turbines. The company’s board was investigating the 100%
acquisition of Pentmarine Ltd, a manufacturer of wave energy converters. Candidates had been asked by
their line manager to provide workings and advice to the board on a range of matters regarding the
Pentmarine purchase. Part 2.1 was worth 18 marks and required candidates to use the data provided to
calculate AOS’ current WACC figure. Two models were required: (a) dividend valuation [16 marks] and (b)
the CAPM [2]. In Part 2.2, for five marks, candidates were required to compare and contrast those two
models as alternative means of calculating the cost of equity. Part 2.3 was worth four marks and it
required candidates to explain to the board whether it would be wise to use the WACC figure calculated in
Part 2.1 when appraising the Pentmarine purchase. In Part 2.4, also for four marks, candidates had to
explain the adjusted present value technique and then indicate whether it was applicable to the
Pentmarine purchase. Finally, for four marks, Part 2.5 asked candidates to explain the portfolio effect and
apply it to the scenario.
2.1a
Cost of equity (ke)
Latest dividend (d0) £5.125m/20.5m = £0.25
Dividend growth rate = £5.125m = 1.1574 over 5 years so 1.15741/5-1 =3% pa

£4.428m

MV (£3.95)
Cost of preference shares (kp) d £0.06 4.51%

MV £1.33

MV £102

0 (98) 1.000 (98.000) 1.000 (98.000)
1-3 3 2,723 8.169 2.941 8.823
3 100 0.864 86.400 0.971 97.100
NPV (3.431) NPV 7.923
IRR = 5% - (4% x (3.431/(3.431+ 7.923))) = 3.79%
less: Tax at 17% (3.79% x 83%) = 3.15%

WACC
Total MV’s
Equity (20.5m x £3.95) 80.975 9.51% x 80.975/98.560 7.81%
Pref. Shares (4.3m x £1.33) 5.719 4.51% x 5.719/98.560 0.26%
17.585 0.64%
In Part 2.1a many candidates scored full marks. Errors were most common with the calculation of (i) the
dividend growth rate, (ii) the IRR for the cost of redeemable debt, (iii) using the par value of shares/debt
rather than market value.

2.1b

Applying EP’s beta to the risk premium 1.30 x 6.1% 7.93%

WACC
Total MV’s
Equity (20.5m x £3.95) 80.975 10.53% x 80.975/98.560 8.65%
Pref. Shares (4.3m x £1.33) 5.719 4.51% x 5.719/98.560 0.26%
17.585 0.64%
98.560 9.29%
In Part 2.1b most CAPM calculations scored full marks.

2.2
DVM – shareholders benefit from owning a share by (i) receiving dividends into the future and (ii) a capital
gain on the value of the shares. The PV of these benefits creates the current price of the shares. This
share price is determined by expected future dividends discounted at the investor’s required rate of return
(ke)
CAPM - specific/unsystematic risk can be diversified away by investors, so it’s assumed that investors are
rational and that they have a diversified portfolio. Systematic risk can’t be diversified away – macro-
economic factors. A company’s beta is calculated from the performance of its share price against the
market average and is taken as a measure of the market’s view of the risk attached to the security in
question. The higher the perceived risk, then the higher the beta figure and thus the higher the equity
return required by investors.
Part 2.2 was done poorly. Too few candidates were able to explain how the two models calculate the cost
of equity.


2.3
WACC (DVM) = 8.5%, CAPM = 9.3%. Bank loan = 10.5%, which exceeds both of these so both WACCs
likely to rise.
Three assumptions re maintaining WACC:
1. Historic debt/equity unchanged - NO. Extra gearing via loan (30% of current Total Mkt Value (£98.56m).
The 10.5% bank loan is expensive – is AOS’ gearing deemed too high?
2. Systematic business risk unchanged – possibly, although different technology. Is sea technology
riskier.? The two companies might have different cost structures and break-even points. Pentmarine
might have higher business risks and higher beta.
3. Finance not project-specific - OK
It would be unwise to use 8.5% or 9.3% as the discount rate. AOS should be discounting using a risk-
adjusted WACC that includes the cost of the new debt.
There were some very good, well-argued answers to Part 2.3. Weaker scripts, typically, only looked at one
aspect of the Pentmarine purchase, i.e. systematic risk, and ignored the vast change in gearing.

2.4
Adjusted Present Value (APV)

AOS’ increased gearing (£30 million in extra borrowings) is likely to alter the company’s WACC. To find
AOS’ new WACC requires the new MV of its shares. However this requires the NPV of the proposed
investment in Pentmarine to be known, which needs the new WACC. To avoid this circular argument one
could use the APV technique to appraise the Pentmarine purchase. This technique:
1. Calculates a base case value at ungeared cost of equity

2. Calculates the PV of the tax shield arising from the extra debt
3. Adjusts for issue costs
Add 1, 2 and 3 to give APV - if positive then proceed with investment.
Most candidates scored well in Part 2.4. Others were vague about the “base case” and having to use k eu,
some subtracted the tax shield and many ignored issue costs.

2.5
A portfolio of investments helps to spread risk.

Investors can usually spread risk themselves – they don't need managers to do it for them. However
Pentmarine is not listed and shareholders might not be able to buy shares in sea-based energy.
Increasing the renewable industry investments might be OK for investors, subject to changes in business
risks. Do AOS managers know how to run a wave power business?
There may be synergies which shareholders can't achieve for themselves, but the companies can.
Part 2.5 was reasonably answered. Weaker scripts, typically, only dealt with the reduction in unsystematic
risk.


Question 3
Total marks: 35
General comments
This question had the second highest percentage mark on the paper. A good majority of candidates
This was a five-part question which tested the candidates’ understanding of the risk management element
of the syllabus and there was also a small section with an ethics element to it.
The scenario was based around Greengrass Dairies plc, a UK-listed UK producer of dairy products.
Candidates were cast as an ICAEW Chartered Accountant and were employed in the company’s finance
team. Greengrass was planning to rationalise its operations by centralising and modernising its production
into one dairy (rather than having four). Part 3.1, for 18 marks, asked candidates to recommend to the
board a closure date for Hawten, one of the diaries. From the data given they had to calculate the relevant
money cash flows associated with closing Hawten in 2021 or 2023 and then calculate the NPV at 31
March 2020 for each of these possible closure dates. Part 3.2, worth five marks, tested candidates’
practical understanding of sensitivity analysis by requiring them to re-work their figures, taking account of,
inter alia, the tax rate and the time value of money. For four marks, Part 3.3 examined real options, in
theory and then applied to the scenario. Part 3.4 was worth five marks and required candidates to
compare the strengths and weaknesses of sensitivity analysis and simulation as means of assessing the
risk of a project. Finally, for three marks, Part 3.5 tested, via the scenario, candidates’ understanding of
ethical guidance.
3.1
CLOSE 2021 2020 2021 2022 2023

Y0 Y1 Y2 Y3
£ £ £ £
P&M sale 900,000
P&M tax (W2) (27,200)
Factory sale 7,700,000
Tax on sale (17% x £7.7m) (1,309,000)
Bristol sales 1,280,000 1,360,000
Bristol variable costs (W1) (599,270) (649,459)
Fixed costs (W1) (332,928) (339,587)
Redundancy (2,000,000)
Tax on profits (W4) 340,000 (59,126) (63,062)
Total Cash Flows 0.000 5,630,800 288,676 307,892
8% discount factor 1.000 0.926 0.857 0.794
PV 0.000 5,189,119 247,395 244,466
NPV 5,680.980
CLOSE 2023 2020 2021 2022 2023

Y0 Y1 Y2 Y3
£ £ £ £
P&M sale 780,000
P&M tax (W3) 22,644 18,568 (48,012)
Factory sale 8,200,000
Tax on sale (17% x £8.2m) (1,394,000)
Shop sales 1,220,000 1,250,000
Variable costs (W1) (698,108) (729,581)
Fixed Costs (W1) (208,080) (212,242)
Tax on profits (W5) (53,348) 313,110
Total Cash Flows 0.000 22,644 279,032 6,009,276
8% discount factor 1.000 0.926 0.857 0.794
PV 0.000 20,968 239,130 4,771,365
NPV 5,031,463

The NPV is higher with a closure date of 31/3/21 and so this should be chosen. This will lead to a greater
increase in shareholders’ wealth.
W1 2022 2023
CLOSE 2021 £’000 £’000
Sales (£’000) 1,280 1,360
VCs 45% 45%
VCs (£’000) (576.000) (612.000)
VCs Inflated (£’000) (599.270) (649.459)
FCs (£’000) (320.000) (320.000)
FCs Inflated (£’000) (332.928) (339.587)
CLOSE 2023
Sales (£’000) 1,220 1,250
VCs 55% 55%
VC (£’000) (671.000) (687.500)
VC Inflated (£’000) (698.108) (729.581)
FC (£’000) (200.000) (200.000)
FC Inflated (£’000) (208.080) (212.242)
2021 2022 2023

W2 £’000 £’000 £’000
WDV b/f 740.000
Sale proceeds 900.000
Balancing charge (BC) (160.000)
Tax on BC 27.200
W3 £’000 £’000 £’000

WDV b/f 740.000 606.800 497.576
WDA (18%) (133.200) (109.224) 282.424
WDV/sale 606.800 497.576 780.000
Tax on WDA 22.644 18.568 (48.012)
W4 £’000 £’000 £’000

Bristol sales 1,280.000 1,360.000
Bristol variable costs (W1) (599.270) (649.459)
Fixed Costs (W1) (332.928) (339.587)
Taxable profit – Close 2021 (2,000,000) 347.802 370.954
Tax due on profit (@17%) 340.000 (59.126) (63.062)
W5 £’000 £’000 £’000

Shop sales 1,220.000 1,250.000
VCs (W1) (698.108) (729.581)
Fixed Costs (W1) (208.080) (212.242)
Redundancy (2,150.000)
Taxable profit – Close 2023 0 313.812 (1,841.823)
Tax due on profit (@17%) 0 (53.348) 313.110
Candidates, as expected, found Part 3.1 very testing and it was good discriminator. There were some
really good answers. Quite a few candidates scored 100%, which was very impressive. Common errors
made were: (i) incorporating both closure dates into one NPV, (ii) only doing one year of cash flows for the
2021 closure, (iii) inflating fixed costs, but not variable costs, (iv) ignoring redundancy costs, (v) not taxing
sales income and/or redundancy costs, (vi) inflating “money” cash flows and/or the discount rate, (vii)
adding £500,000 to the £8.2 million factory price.


3.2
£
NPV 2021 5,680,980
NPV 2023 (5,031,463)
NPV difference 649,517
Tax adjustment (@17% rate) £649,517/83% 782,551
Discount adjustment to Y3 £782,551/0.794 985,580
Extra cash flow to “break-even” 985,580

Current factory sale price 2023 8,200,000
Factory sale price required 2023 9,185,580
Part 3.2 was another good discriminator. Many candidates scored full marks here, but the weakest scripts
failed to answer this section at all.

3.3
NPV analysis only considers cash flows related directly to a project. However, a project with a negative
NPV could be accepted for strategic reasons. This is because of (real) options associated with a project
that outweigh the negative NPV. In other words, there is extra value in a project that needs to be
considered and evaluated.
Greene’s board could decide to abandon its plans to rationalise. For example, Brexit might affect dairy
prices and it could then be worth keeping the regional factories open. Greene has a put option to sell the
regional factories at a price known today. If Brexit pushes prices up then the company could abandon its
plans. If prices go down it can sell after one year or three. The sale of the factory may cause a problem –
is there a signed contract with Sharpe?
If candidates mention a delay option (e.g. option to close in two years rather than one), they should note
that beyond 2023 would cause a problem with Sharpe.
Responses to Part 3.3 were, overall, disappointing. This topic has been examined regularly recently, but
there were too many poor definitions of real options. Also many candidates chose an inappropriate option
by not focussing on the board’s plans, i.e. closure.

3.4
It identifies areas critical to the success of a project, e.g. sales volume, materials price
But
Simulation
But

Part 3.4 was done well and a majority of candidates scored full marks.

3.5
You are employed by Greene and are party to confidential information which, if made public, could
influence the market price of Greene’s shares.
current or previous client’s or employer’s affairs, however gained, is confidential.
That information should then:
 Not be used to gain personal advantage
In addition an ICAEW Chartered Accountant should:

Act with integrity – i.e. avoid self-interest and
Be aware of his/her professional behaviour - comply with laws, don't damage the reputation of the
profession
Part 3.5 was done well and a majority of candidates scored full marks.


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2. Answer each question in black ballpoint pen only.

DO NOT TURN OVER UNTIL YOU

Copyright © ICAEW 2016. All rights reserved. Page 1 of 7

Considerable development time is required for the production of new pharmaceutical

Year to Year to Year to Year to

Total working capital required (note 5) 0 260 70 0

AP depreciates its equipment on a straight-line basis. A full year’s depreciation is charged in

Copyright © ICAEW 2016. All rights reserved. Page 2 of 7

An appropriate money cost of capital for the project is 8% pa.

Copyright © ICAEW 2016. All rights reserved. Page 3 of 7

Par Value Market Value Total market

Note 1: OW’s retained earnings at 29 February 2016 were £43.8 million.

Copyright © ICAEW 2016. All rights reserved. Page 4 of 7

(a) takes up all of the rights

Copyright © ICAEW 2016. All rights reserved. Page 5 of 7

At a recent board meeting one of TC’s directors commented:

Spot exchange rate at 31 December 2014 (R/£) 79.45 – 91.34

Copyright © ICAEW 2016. All rights reserved. Page 6 of 7

Copyright © ICAEW 2016. All rights reserved. Page 7 of 7

MARK PLAN AND EXAMINER’S COMMENTARY

General point about candidates’ handwriting

Year to Year to Year to Year to

Ignore depreciation as it’s not a cash flow.

Copyright © ICAEW 2016. All rights reserved. Page 1 of 10

Year to Year to Year to Year to

Tax (21% x balancing charge) 14,700

Tax reclaim/(payable) @ 21% 16,800 51,408 (252,721) (68,798)

Incremental working capital 0 (267,800) 193,537 74,263

Copyright © ICAEW 2016. All rights reserved. Page 2 of 10

Total possible marks 18

Total PV of variable costs (£847,548 + £150,793) £(998,341)

% change in variable costs required £(69,902) 7%

Total possible marks 5

Total possible marks 6

Copyright © ICAEW 2016. All rights reserved. Page 3 of 10

Total possible marks 9

Copyright © ICAEW 2016. All rights reserved. Page 4 of 10

Total fixed return capital (debs + PSC) 188.0 218.4

Gearing % 188.0 57.4% 218.4 40.1%

Total possible marks 3

Total possible marks 6

Copyright © ICAEW 2016. All rights reserved. Page 5 of 10

Value of a right = £1.5429 - £1.15 £0.3929

Current wealth 10,000 x £1.70 17,000

(a) Take up rights £ £

(b) Sell rights

(c) Ignore rights

Total possible marks 9

OW’s current p/e ratio £1.70/£0.11 15.5

OW’s new earnings per share (EPS) £23.332m/268.8m £0.0868

OW’s MV/share post-rights £0.0868 x 15.5 £1.35

Total possible marks 7

Copyright © ICAEW 2016. All rights reserved. Page 6 of 10

Supplementing these main theories:

Total possible marks 7

Total possible marks 3

Copyright © ICAEW 2016. All rights reserved. Page 7 of 10

plus: Arrangement fee 145.6 x £40 (£5,824)

Converted at spot rate R143,589,740 (£1,821,9743)