F3 - Financial Strategy - Pdfs

CIMA 2010 Chartered Management Accounting Qualification Specimen Examination Paper F3
Published November 2009

The Chartered Institute of Management Accountants 2009

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Pillar F
F3 Financial Strategy
Specimen Examination Paper

Instructions to candidates
You are allowed three hours to answer this question paper.
You are allowed 20 minutes reading time before the examination begins
during which you should read the question paper and, if you wish, highlight
and/or make notes on the question paper. However, you will not be allowed,
under any circumstances, to open the answer book and start writing or use
your calculator during this reading time.
You are strongly advised to carefully read ALL the question requirements
before attempting the question concerned (that is all parts and/or sub-
questions). The requirements for all questions are contained in a dotted box.
ALL answers must be written in the answer book. Answers or notes written
on the question paper will not be submitted for marking.
Answer ALL compulsory questions in Section A on page 9.
Answer TWO of the three questions in Section B on pages 10 to 16.
Maths Tables are provided on pages 17 to 21.
The list of verbs as published in the syllabus is given for reference on the
inside back cover of this question paper.
Write your candidate number, the paper number and examination subject title
in the spaces provided on the front of the answer book. Also write your
contact ID and name in the space provided in the right hand margin and seal
to close.
Tick the appropriate boxes on the front of the answer book to indicate which
questions you have answered.


Specimen Exam Paper 2 Financial Strategy

Power Utilities

Pre-seen Case Study

Background
Power Utilities (PU) is located in a democratic Asian country. Just over 12 months ago, the
former nationalised Electricity Generating Corporation (EGC) was privatised and became PU.
EGC was established as a nationalised industry many years ago. Its home government at that
time had determined that the provision of the utility services of electricity generation
production should be managed by boards that were accountable directly to Government. In
theory, nationalised industries should be run efficiently, on behalf of the public, without the
need to provide any form of risk related return to the funding providers. In other words, EGC,
along with other nationalised industries was a non-profit making organisation. This, the
Government claimed at the time, would enable prices charged to the final consumer to be
kept low.
Privatisation of EGC
The Prime Minister first announced three years ago that the Government intended to pursue
the privatisation of the nationalised industries within the country. The first priority was to be
the privatisation of the power generating utilities and EGC was selected as the first
nationalised industry to be privatised. The main purpose of this strategy was to encourage
public subscription for share capital. In addition, the Governments intention was that PU
should take a full and active part in commercial activities such as raising capital and earning
higher revenue by increasing its share of the power generation and supply market by
achieving growth either organically or through making acquisitions. This, of course, also
meant that PU was exposed to commercial pressures itself, including satisfying the
requirements of shareholders and becoming a potential target for take-over. The major
shareholder, with a 51% share, would be the Government. However, the Minister of Energy
has recently stated that the Government intends to reduce its shareholding in PU over time
after the privatisation takes place.
Industry structure
PU operates 12 coal-fired power stations across the country and transmits electricity through
an integrated national grid system which it manages and controls. It is organised into three
regions, Northern, Eastern and Western. Each region generates electricity which is sold to 10
private sector electricity distribution companies which are PUs customers.
The three PU regions transmit the electricity they generate into the national grid system. A
shortage of electricity generation in one region can be made up by taking from the national
grid. This is particularly important when there is a national emergency, such as exceptional
weather conditions.
The nationalised utility industries, including the former EGC, were set up in a monopolistic
position. As such, no other providers of these particular services were permitted to enter the
market within the country. Therefore, when EGC was privatised and became PU it remained
the sole generator of electricity in the country. The electricity generating facilities, in the form
of the 12 coal-fired power stations, were all built over 15 years ago and some date back to
before EGC came into being.
The 10 private sector distribution companies are the suppliers of electricity to final users
including households and industry within the country, and are not under the management or
control of PU. They are completely independent companies owned by shareholders.
The 10 private sector distribution companies serve a variety of users of electricity. Some,
such as AB, mainly serve domestic users whereas others, such as DP, only supply electricity
to a few industrial clients. In fact, DP has a limited portfolio of industrial customers and 3
major clients, an industrial conglomerate, a local administrative authority and a supermarket
chain. DP finds these clients costly to service.


Financial Strategy 3 Specimen Exam Paper

Structure of PU
The structure of PU is that it has a Board of Directors headed by an independent Chairman
and a separate Managing Director. The Chairman of PU was nominated by the Government
at the time the announcement that EGC was to be privatised was made. His background is
that he is a former Chairman of an industrial conglomerate within the country. There was no
previous Chairman of EGC which was managed by a Management Board, headed by the
Managing Director. The former EGC Managing Director retired on privatisation and a new
Managing Director was appointed.
The structure of PU comprises a hierarchy of many levels of management authority. In
addition to the Chairman and Managing Director, the Board consists of the Directors of each
of the Northern, Eastern and Western regions, a Technical Director, the Company Secretary
and the Finance Director. All of these except the Chairman are the Executive Directors of PU.
The Government also appointed seven Non Executive Directors to PUs Board. With the
exception of the Company Secretary and Finance Director, all the Executive Directors are
qualified electrical engineers. The Chairman and Managing Director of PU have worked hard
to overcome some of the inertia which was an attitude that some staff had developed within
the former EGC. PU is now operating efficiently as a private sector company. There have
been many staff changes at a middle management level within the organisation.
Within the structure of PUs headquarters, there are five support functions; engineering,
finance (which includes PUs Internal Audit department), corporate treasury, human resource
management (HRM) and administration, each with its own chief officers, apart from HRM.
Two Senior HRM Officers and Chief Administrative Officer report to the Company Secretary.
The Chief Accountant and Corporate Treasurer each report to the Finance Director. These
functions, except Internal Audit, are replicated in each region, each with its own regional
officers and support staff. Internal Audit is an organisation wide function and is based at PU
headquarters.
Regional Directors of EGC
The Regional Directors all studied in the field of electrical engineering at the country's leading
university and have worked together for a long time. Although they did not all attend the
university at the same time, they have a strong belief in the quality of their education. After
graduation from university, each of the Regional Directors started work at EGC in a junior
capacity and then subsequently gained professional electrical engineering qualifications. They
believe that the experience of working up through the ranks of EGC has enabled them to
have a clear understanding of EGCs culture and the technical aspects of the industry as a
whole. Each of the Regional Managers has recognised the changed environment that PU now
operates within, compared with the former EGC, and they are now working hard to help PU
achieve success as a private sector electricity generator. The Regional Directors are well
regarded by both the Chairman and Managing Director, both in terms of their technical skill
and managerial competence.
Governance of EGC
Previously, the Managing Director of the Management Board of EGC reported to senior civil
servants in the Ministry of Energy. There were no shareholders and ownership of the
Corporation rested entirely with the Government. That has now changed. The Government
holds 51% of the shares in PU and the Board of Directors is responsible to the shareholders
but, inevitably, the Chairman has close links directly with the Minister of Energy, who
represents the major shareholder.
The Board meetings are held regularly, normally weekly, and are properly conducted with full
minutes being taken. In addition, there is a Remuneration Committee, an Audit Committee
and an Appointments Committee, all in accordance with best practice. The model which has
been used is the Combined Code on Corporate Governance which applies to companies
which have full listing status on the London Stock Exchange. Although PU is not listed on the
London Stock Exchange, the principles of the Combined Code were considered by the
Government to be appropriate to be applied with regard to the corporate governance of the
company.
Currently, PU does not have an effective Executive Information System and this has recently
been raised at a Board meeting by one of the non-executive directors because he believes


this inhibits the function of the Board and consequently is disadvantageous to the governance
of PU.
Remuneration of Executive Directors
In order to provide a financial incentive, the Remuneration Committee of PU has agreed that
the Executive Directors be entitled to performance related pay, based on a bonus scheme, in
addition to their fixed salary and health benefits.
Capital market
PU exists in a country which has a well developed capital market relating both to equity and
loan stock funding. There are well established international institutions which are able to
provide funds and corporate entities are free to issue their own loan stock in accordance with
internationally recognised principles. PU is listed on the countrys main stock exchange.
Strategic opportunity
The Board of PU is considering the possibility of vertical integration into electricity supply and
has begun preliminary discussion with DPs Chairman with a view to making an offer for DP.
PUs Board is attracted by DPs strong reputation for customer service but is aware, through
press comment, that DP has received an increase in complaints regarding its service to
customers over the last year. When the former EGC was a nationalised business, break-
downs were categorised by the Government as urgent, when there was a danger to life, and
non-urgent which was all others. Both the former EGC and DP had a very high success rate
in meeting the governments requirements that a service engineer should attend the urgent
break-down within 60 minutes. DPs record over this last year in attending urgent break-
downs has deteriorated seriously and if PU takes DP over, this situation would need to
improve.
Energy consumption within the country and Government drive for increased efficiency
and concern for the environment
Energy consumption has doubled in the country over the last 10 years. As PU continues to
use coal-fired power stations, it now consumes most of the coal mined within the country.
The Minister of Energy has indicated to the Chairman of PU that the Government wishes to
encourage more efficient methods of energy production. This includes the need to reduce
production costs. The Government has limited resources for capital investment in energy
production and wishes to be sure that future energy production facilities are more efficient and
effective than at present.
The Minister of Energy has also expressed the Governments wish to see a reduction in
harmful emissions from the countrys power stations. (The term harmful emissions in this
context, refers to pollution coming out of electricity generating power stations which damage
the environment.)
One of PUs non-executive directors is aware that another Asian country is a market leader in
coal gasification which is a fuel technology that could be used to replace coal for power
generation. In the coal gasification process, coal is mixed with oxygen and water vapour
under pressure, normally underground, and then pumped to the surface where the gas can be
used in power stations. The process significantly reduces carbon dioxide emissions although
it is not widely used at present and not on any significant commercial scale.
Another alternative to coal fired power stations being actively considered by PUs Board is the
construction of a dam to generate hydro-electric power. The Board is mindful of the likely
adverse response of the public living and working in the area where the dam would be built.
In response to the Governments wishes, PU has established environmental objectives
relating to improved efficiency in energy production and reducing harmful emissions such as
greenhouse gases. PU has also established an ethical code. Included within the code are
sections relating to recycling and reduction in harmful emissions as well as to terms and
conditions of employment.


Introduction of commercial accounting practices at EGC
The first financial statements have been produced for PU for 2008. Extracts from the
Statement of Financial Position from this are shown in Appendix A. Within these financial
statements, some of EGC's loans were "notionally" converted by the Government into
ordinary shares. Interest is payable on the Government loans as shown in the statement of
financial position. Reserves is a sum which was vested in EGC when it was first nationalised.
This represents the initial capital stock valued on a historical cost basis from the former
electricity generating organisations which became consolidated into EGC when it was first
nationalised.
Being previously a nationalised industry and effectively this being the first "commercially
based" financial statements, there are no retained earnings brought forward into 2008.


APPENDIX A

EXTRACTS FROM THE PRO FORMA FINANCIAL STATEMENTS OF THE ELECTRICITY
GENERATING CORPORATION

Statement of financial position as at 31 December 2008
P$ million
ASSETS
Non-current assets 15,837
Current assets
Inventories 1,529
Receivables 2,679
Cash and Cash equivalents 133
4,341
Total assets 20,178

EQUITY AND LIABILITIES
Equity
Share capital 5,525
Reserves 1,231
Total equity 6,756

Non-current liabilities
Government loans 9,560
Current liabilities
Payables 3,862
Total liabilities 13,422
Total equity and liabilities 20,178

End of Pre-seen Material



SECTION A 50 MARKS
[Note: The indicative time for answering this section is 90 minutes]
ANSWER THIS QUESTION
Question One
Unseen material for Case Study
Background
Assume today is 20 May 2009.

Power Utilities (PU) is located in an Asian country. It is planning to diversify its business
activities by moving away from total reliance on coal fired power stations and building a
hydroelectric power station to produce electricity using natural resources. A dam would need
to be constructed to create a reservoir of water above the dam. Electricity would be
generated by releasing water from the upper reservoir through the dam. Modern
hydroelectric power stations can be very responsive to consumer demand and it is expected
that the power station would be able to generate up to 100 megawatts of electricity within 60
seconds of the need arising.

Hydroelectric power stations do not directly produce harmful emissions such as carbon
dioxide. However, some carbon dioxide will be produced during the construction phase.
There is also a potential source of harmful greenhouse gases in the form of methane gas
from decaying plant matter in flooded areas.

Public opinion on the project has been very mixed and there is a significant risk of opposition
to the project from local people. Their housing and farming businesses will be seriously
affected by the proposed development which will require flooding of local land to construct the
dam.

Corporate objectives

Corporate objectives in line with a recent government drive include:

- Improved efficiency of energy production;
- Reduction in harmful emissions such as greenhouse gases.

Financial objectives include maintaining group gearing (debt:debt plus equity) below 40%
based on market values.

Hydroelectric power station project

Initial research has shown that a major river in the south of the country may be suitable for
use in this project.

Extensive engineering and environmental studies have already begun to assess the viability
of the project. These are expected to cost US$15,000,000 in total, payable in three equal
instalments at the end of the calendar years 2008, 2009 and 2010. The payment for 2008
has already been made. PU is committed to pay the 2009 instalment but a clause in the
contract would enable it to cancel the payment due in 2010 if it decides to withdraw from the
project and future viability studies before the end of 2009.

Construction costs will be payable in US$. Other project costs and all project revenue will be
in PUs functional currency, P$.



Construction and operating cash flows for the project are as follows:

Year(s) US$ million P$ million

Construction costs 3 and 4 60 payment
each year
-
Pre-tax net operating cash flows 5 to 24 - 150 receipt
each year

Additional information:
- Time 0 is 1 January 2010;
- Cash flows should be assumed to arise at the end of each year;
- Business tax is 30% and is payable a year in arrears; also note that the government
has announced plans to reduce the tax rate to 10% from 1 January 2014 on clean
energy schemes such as this one (and would therefore only affect the tax position of
the operating cash flows); however, this still needs to be approved by parliament and
there is a risk that approval will not be obtained;
- Tax depreciation allowances of 100% can be claimed on construction costs but no tax
relief is available on the cost of the engineering and environmental studies;
- The assets of the project have no residual value;
- Exchange rate as at today, 20 May 2009, is US$/P$6.3958 (that is, US$1 = P$6.3958).
Some economic forecasters expect this exchange rate to remain constant over the
period of the project but other forecasts predict that the US$ will strengthen against the
P$ by 5% each year;
- PU normally uses a cost of capital net of tax of 10% to assess investments of this type.

Financial information for PU

Extracts from the latest available financial statements for PU are provided in the pre-seen
material. The ordinary share capital consists of P$1 shares and the current share price on
20 May 2009 is P$2.80. The long term government borrowings shown in the statement of
financial position are floating rate loans and the amount borrowed is unchanged since
31 December 2008

Financing the project

Two alternative financing schemes are being considered which would each raise the
equivalent of US$130 million on 1 January 2012. These are:

(i) A five-year P$ loan at a fixed interest rate of 5% per annum;

(ii) A subsidised loan denominated in US$ from an international organisation that
promotes clean energy schemes. There would not be any interest payments
but US$145 million would be repayable at the end of the five year term.

The requirement for Question One is on page 9


Required:

(a) Calculate the NPV of the project as at 1 January 2010 for each of the two
different exchange rate forecasts and the two tax rates.

(14 marks)

(b) Write a report to the Directors of PU in which you, as Finance Director,
address each of the following issues:

(i) Explain your results in part (a) and explain and evaluate other relevant
factors that need to be taken into account when deciding whether or
not to undertake the project. Conclude by advising PU how to proceed;
(15 marks)

(ii) Explain and evaluate the costs and risks arising from the use of foreign
currency borrowings as proposed by financing scheme (ii) and advise
PU on the most appropriate financing structure for the project. Up to 7
marks are available for calculations;
(11 marks)

In the event, the Board of Directors of PU decided to go ahead with the project and
it has now been operational for six years. The Board has, however, now decided to
dispose of the hydroelectric power station. To assist with these plans, a new entity,
PP, has been formed and the plant and its operations have been transferred to PP.

(c) Discuss why PU might wish to dispose of the hydroelectric power station and
advise the Directors of PU on alternative methods for achieving the
divestment.

(10 marks)

(Total for Question One = 50 marks)

End of Section A
Section B starts on page 10

TURN OVER


SECTION B 50 MARKS
[Note: The indicative time for answering this section is 90 minutes]
ANSWER TWO OF THE THREE QUESTIONS 25 MARKS EACH

Question Two
AB is a large retailing organisation with revenue in the last financial year exceeding 1 billion.
Its head office is in a country in the euro zone and its shares are listed on a major European
stock exchange. Over the last few years AB has opened several new stores in a number of
European capital cities, not all of them in the euro zone. AB is planning to allow all of its
stores to accept the worlds major currencies as cash payment for its goods and this will
require a major upgrade of its points of sale (POS) system to handle multiple currencies and
increased volumes of transactions

AB has already carried out a replacement investment appraisal exercise and has evaluated
appropriate systems. It is now in the process of placing an order with a large information
technology entity for the supply, installation and maintenance of a new POS system. The
acquisition of the system will include the provision of hardware and software. Routine
servicing and software upgrading will be arranged separately and does not affect the
investment appraisal decision.

AB is considering the following alternative methods of acquiring and financing the new POS
system:

Alternative I

- Pay the whole capital cost of 25 million on 1 January 2010, funded by bank
borrowings. This cost includes the initial installation of the POS system.
- The system will have no resale value outside AB

Alternative 2

- Enter into a finance lease with the system supplier. AB will pay a fixed amount of
7.0 million each year in advance, commencing 1 January 2010, for four years.
- At the end of four years, ownership of the system will pass to AB without further
payment.

Other information

- AB can borrow for a period of four years at a pre-tax fixed interest rate of 7% a
year. The entitys cost of equity is currently 12%.
- AB is liable to corporate tax at a marginal rate of 30% which is settled at the end
of the year in which it arises..
- AB accounts for depreciation on a straight-line basis at the end of each year
- Under Alternative 1, tax depreciation allowances on the full capital cost are
available in equal instalments over the first four years of operation.
- Under Alternative 2, both the accounting depreciation and the interest element of
the finance lease payments are tax deductible.
- Once a decision on the payment method has been made and the new system is
installed, AB will commission a post completion audit (PCA).

The requirement for Question Two is on the opposite page



Required:

(a)

(i) Calculate which payment method is expected to be cheaper for AB and
recommend which should be chosen based solely on the present value of the
two alternatives as at 1 January 2010
(10 marks)

(ii) Explain the reasons for your choice of discount factor in the present value
calculations.
(3 marks)

(iii) Discuss other factors that AB should consider before deciding on the method
of financing the acquisition of the system
(3 marks)

(Total for part (a) 16 marks)

(b) Advise the Directors of AB on the following:

- The main purpose and content of a post completion audit (PCA).
- The limitations of a PCA to AB in the context of the POS system.

(9 marks)

(Total for Question Two = 25 marks)

NOTE: A REPORT FORMAT IS NOT REQUIRED IN THIS QUESTION

Section B continues over the page

TURN OVER


Question Three
CD is a privately-owned entity based in Country X, which is a popular holiday destination. Its
principal business is the manufacture and sale of a wide variety of items for the tourist market,
mainly souvenirs, gifts and beachwear. CD manufactures approximately 80% of the goods it
sells. The remaining 20% is purchased from other countries in a number of different
currencies. CD owns and operates 5 retail stores in Country X but also sells its products on a
wholesale basis to other local retail outlets.

Although CD is privately owned, it has revenue and assets equivalent in amount to some
entities that are listed on smaller stock markets (such as the UK's Alternative Investment
Market (AIM)). It is controlled by family shareholders but also has a number of non-family
shareholders, such as employees and trade associates. It has no intention of seeking a listing
at the present time although some of the family shareholders have often expressed a wish to
buy out the smaller investors.

CD has been largely unaffected by the recent world recession and has increased its sales
volume and profits each year for the past 5 years. The directors think this is because it
provides value for money; providing high quality goods that are competitively priced at the
lower end of its market. Future growth is expected to be modest as the directors and
shareholders do not wish to adopt strategies that they think might involve substantial increase
in risks, for example by moving the manufacturing base to another country where labour rates
are lower. Some of the smaller shareholders disagree with this strategy and would prefer
higher growth even if it involves greater risk.

The entity is financed 80% by equity and 20% by debt (based on book values). The debt is a
mixture of bonds secured on assets and unsecured overdraft. The interest rate on the
secured bonds is fixed at 7% and the overdraft rate is currently 8%, which compares to a
relatively recent historic rate as high as 13%. The bonds are due to be repaid in 5 years time.
Inflation in CDs country is near zero at the present time and interest rates are expected to
fall.

CDs treasury department is centralised at the head office and its key responsibilities include
arranging sufficient long and short term financing for the group and hedging foreign exchange
exposures. The Treasurer is investigating the opportunities for and consequences of
refinancing.

CDs sole financial objective is to increase dividends each year. It has no non-financial
objective. This financial objective and the lack of non-financial objectives are shortly to be
subject to review and discussion by the board. The new Finance Director believes
maximisation of shareholder wealth should be the sole objective, but the other directors do
not agree and think that new objectives should be considered, including target profit after tax
and return on investment.

The requirement for Question Three is on the opposite page


Required:

(a) Discuss the role of the treasury department when determining financing or re-
financing strategies in the context of the economic environment described in the
scenario and explain how these might impact on the determination of corporate
objectives.
(15 marks)

(b) Evaluate the appropriateness of CD's current objective and of the two new
objectives being considered. Discuss alternative objectives that might be
appropriate for CD and conclude with a recommendation.
(10 marks)

(Total 25 marks)

Section B continues over the page

TURN OVER


Question Four

EF is a distributor for branded beverages throughout the world. It is based in the UK but has
offices throughout Europe, South America and the Caribbean. Its shares are listed on the
UK's Alternative Investment Market (AIM) and are currently quoted at 180 pence per share

Extracts from EFs forecast financial statements are given below.

Extracts from the (forecast) income statement for the
year ended 31

December 2009

000
Revenue 45,000
Purchase costs and expenses 38,250
Interest on long term debt 450
Profit before tax 6,300
Income tax expense (at 28%) 1,764
Note: Dividends declared 1,814

EF - Statement of financial position as at 31 December 2009

000
ASSETS
Non-current assets 14,731
Current assets
Inventories 5,250
Trade receivables 13,500
Cash and bank balances 348
19,098
Total assets 33,829

EQUITY AND LIABILITIES
Equity
Share capital (ordinary shares of 25
pence) 4,204
Retained earnings 16,210
Total equity 20,414

Non-current liabilities
(Secured bonds, 9% 2015) 5,000

Current liabilities
Trade payables 8,415
Total liabilities 13,415
Total equity and liabilities 33,829



You have obtained the following additional information:

1. Revenue and purchases & expenses are expected to increase by an average of 4%
each year for the financial years ending 31 December 2010 and 2011.

2. EF expects to continue to be liable for tax at the rate of 28 per cent. Assume tax is
paid or refunded the year in which the liability arises.
3. The ratios of trade receivables to sales and trade payables to purchase costs and
expenses will remain the same for the next two years. The value of inventories is
likely to remain at 2009 levels for 2010 and 2011.
4. The non-current assets in the statement of financial position at 31 December 2009
are land and buildings, which are not depreciated in the company's books. Tax
depreciation allowances on the buildings may be ignored. All other assets used by
the company are currently procured on operating leases.

5. The company intends to purchase early in 2010 a fleet of vehicles (trucks and vans).
These vehicles are additional to the vehicles currently operated by EF. The vehicles
will be provided to all its UK and overseas bases but will be purchased in the UK. The
cost of these vehicles will be 5,000,000. The cost will be depreciated on a straight
line basis over 10 years. The company charges a full year's depreciation in the first
year of purchase of its assets. Tax depreciation allowances are available at 25%
reducing balance on this expenditure. Assume the vehicles have a zero residual
value at the end of ten years.

6. Dividends will be increased by 5% each year on the 2009 base. Assume they are
paid in the year they are declared.

EF plans to finance the purchase of the vehicles (identified in note 6) from its cash balances
and an overdraft. The entitys agreed overdraft facility is currently 1 million.

The company's main financial objectives are to earn a post-tax return on the closing book
value of shareholders funds of 20% per annum and a year on year increase in earnings of
8%

Assumption regarding overdraft interest

It should be assumed that overdraft interest that might have been incurred during 2009 is
included in expenses (that is, you are not expected to calculate overdraft interest for 2010 and
2011).

The requirement for Question Four is on the next page

TURN OVER


Required:

Assume you are a consultant working for EF

(a) Construct a forecast income statement, including dividends and retentions for
the years ended 31 December 2010 and 2011.
(6 marks)
(b) Construct a cash flow forecast for each of the years 2010 and 2011. Discuss,
briefly, how the company might finance any cash deficit.
(9 marks)
(c) Using your results in (a) and (b) above, evaluate whether EF is likely to meet
its stated objectives. As part of your evaluation, discuss whether the
assumption regarding overdraft interest is reasonable and explain how a
more accurate calculation of overdraft interest could be obtained.
(10 marks)

(Total for Question Four = 25 marks)

End of Question Paper

Maths Tables and Formulae are on Pages 17 - 21


MATHS TABLES AND FORMULAE

Present value table
Present value of 1.00 unit of currency, that is (1 + r)
-n
where r = interest rate; n = number of
periods until payment or receipt.

Periods
(n)
Interest rates (r)
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Periods
(n)
Interest rates (r)
11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026


Cumulative present value of 1.00 unit of currency per annum
Receivable or Payable at the end of each year for n years
(

+
r
r
n
) (1 1

Periods
(n)
Interest rates (r)
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Periods
(n)
Interest rates (r)
11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870


Formulae
Valuation models

(i) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P
0
is the ex-
div value:

P
0
=
pref
k
d

(ii) Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P
0
is the ex-div
value:
P
0
=
e
k
d

(iii) Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g,
where P
0
is the ex-div value:
P
0
=
g k
d
e
1
or P
0
=
g k
g d
+
e
0
] [1

(iv) Irredeemable bonds, paying annual after-tax interest, i [1 t], in perpetuity, where P
0
is the ex-interest
value:
P
0
=
net d
] [1
k
t i

or, without tax: P
0
=
d
k
i

(v) Total value of the geared entity, V
g
(based on MM):
V
g
= V
u
+ TB
(vi) Future value of S, of a sum X, invested for n periods, compounded at r% interest:
S = X[1 + r]
n
(vii) Present value of 100 payable or receivable in n years, discounted at r% per annum:
PV =
n
r ] [1
1
+

(viii) Present value of an annuity of 100 per annum, receivable or payable for n years, commencing in one
year, discounted at r% per annum:
PV =
(
n
r r ] [1
1
1
1

(ix) Present value of 100 per annum, payable or receivable in perpetuity, commencing in one year,
discounted at r% per annum:
PV =
r
1

(x) Present value of 100 per annum, receivable or payable, commencing in one year, growing in perpetuity
at a constant rate of g% per annum, discounted at r% per annum:
PV =
g r
1



Cost of capital
(i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a
current ex-div price P
0
:

k
pref
=
0
P
d

(ii) Cost of irredeemable bonds, paying annual net interest, i [1 t], and having a current ex-interest price
P
0
:
k
d net
=
0
P
t i ] [1

(iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div
price P
0
:
k
e
=
0
P
d

(iv) Cost of ordinary (equity) shares, having a current ex-div price, P
0
, having just paid a dividend, d
0
, with
the dividend growing in perpetuity by a constant g% per annum:
k
e
=
g
P
d
+
0
1

or k
e
=
g
P
g d
+
+
0
0
] 1 [

(v) Cost of ordinary (equity) shares, using the CAPM:
k
e
= R
f
+ [R
m
R
f
]

(vi) Cost of ordinary (equity) share capital in a geared entity :
k
eg
= k
eu
+ [k
eu
k
d
]
E
D
V
t V ] [1

(vii) Weighted average cost of capital, k
0
or WACC
WACC = k
e
(
+
+
+

D E
D
D E
E
V V
V
t
V V
V
d
k ] [1
(viii) Adjusted cost of capital (MM formula):
K
adj
= k
eu
[1 tL] or r* = r[1 T*L]

(ix) Ungear :
u
=
g
(
+ ] [1 t V V
V
D E
E

+
d
(
+ ] [1
] [1
t V V
t V
D E
D

(x) Regear :
g
=
u
+ [
u

d
]
E
D
V
t V ] [1

(xi) Adjusted discount rate to use in international capital budgeting (International Fisher effect)

A$/B$ rate Spot
time months' 12 in A$/B$ rate spot Future
A$ rate discount annual 1
B$ rate discount annual 1
=
+
+

where A$/B$ is the number of B$ to each A$


Other formulae

(i) Expectations theory:
Future spot rate A$/B$ = Spot rate A$/B$ x
rate interest nominal 1
rate interest nominal 1
countryA
countryB
+
+

where:
A$/B$ is the number of B$ to each A$, and
A$ is the currency of countryA and B$ is the currency of country B

(ii) Purchasing power parity (law of one price):
Future spot rate A$B$ = Spot rate A$/B$ x
rate inflation 1
rate inflation 1
countryA
countryB
+
+

(iii) Link between nominal (money) and real interest rates:
[1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate]

(iv) Equivalent annual cost:
Equivalent annual cost =
factor annuity year
years over costs of
n
n PV

(v) Theoretical ex-rights price:
TERP =
1
1
+ N
[(N x cum rights price) + issue price]

(vi) Value of a right:
N
price issue price rights ex l Theoretica

where N = number of rights required to buy one share.


LIST OF VERBS USED IN THE QUESTION REQUIREMENTS
A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for
each question in this paper.

It is important that you answer the question according to the definition of the verb.
LEARNING OBJECTIVE VERBS USED DEFINITION
Level 1 - KNOWLEDGE

What you are expected to know. List Make a list of
State Express, fully or clearly, the details of/facts of
Define Give the exact meaning of
Level 2 - COMPREHENSION

What you are expected to understand. Describe Communicate the key features
Distinguish Highlight the differences between
Explain Make clear or intelligible/State the meaning or
purpose of
Identify Recognise, establish or select after
consideration
Illustrate Use an example to describe or explain
something
Level 3 - APPLICATION

How you are expected to apply your knowledge. Apply
Calculate/compute
Put to practical use
To ascertain or reckon mathematically
Demonstrate Prove with certainty or to exhibit by
practical means
Prepare Make or get ready for use
Reconcile Make or prove consistent/compatible
Solve Find an answer to
Tabulate Arrange in a table
Level 4 - ANALYSIS

How are you expected to analyse the detail of
what you have learned.
Analyse
Categorise
Examine in detail the structure of
Place into a defined class or division
Compare and contrast Show the similarities and/or differences
between
Construct Build up or compile
Discuss Examine in detail by argument
Interpret Translate into intelligible or familiar terms
Prioritise Place in order of priority or sequence for action
Produce Create or bring into existence
Level 5 - EVALUATION

How are you expected to use your learning to
evaluate, make decisions or recommendations.

Advise
Evaluate
Recommend
Counsel, inform or notify
Appraise or assess the value of
Propose a course of action



Financial Pillar

Strategic Level Paper

F3 Financial Strategy

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Thursday Morning Session

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CIMA 2010 Chartered Management Accounting Qualification Specimen Examination Paper F3

Published November 2009

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