Financial Management - Professional Stage – September 2012

PROFESSIONAL STAGE - FINANCIAL MANAGEMENT OT EXAMINER’S COMMENTS

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

How well candidates answered each syllabus area

Syllabus area Number of questions Well answered Poorly answered*

1 6 5 1

2 5 5 0

3 4 4 0

Total 15 14 1

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

Details of the question with a facility of less than 40% are shown here:

1. Candidates were given details relevant to a CAPM calculation for a company, i.e. the risk-free rate of return,
the market portfolio rate of return and the company’s current beta factor. They were also informed that the
company was planning a new project which would be funded by an equity issue and were given details of
the weighting of this issue within the total market capitalisation of the company. By taking on the project the
company’s beta factor would increase. Candidates were asked to calculate the required rate of return for the
new project. The majority of those students who answered the question wrongly failed to take into account
the weighting of the equity issue within the company’s new market capitalisation.

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 Financial Management - Professional Stage – September 2012

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

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: 30

General comments
The average mark for this question equated to a clear pass and so, overall, was done well.

This was a five-part question that tested the candidates’ understanding of the investment decisions and
valuations element of the syllabus. It was a good discriminator between those students who have learned
the calculations and underlying theory by rote and those who really understand the topic.

In the scenario a company was considering whether or not to proceed with the construction of a dam in
South America. Part (a) for 13 marks was a fairly standard NPV calculation. Candidates had to deal, inter
alia, with inflation, working capital and capital allowances. Part (b) for three marks involved sensitivity
analysis and was a good discriminator. In part (c) for five marks candidates had to discuss the impact of an
underestimate of inflation rates on the cash flows, the discount rate and the NPV of the dam project. Again,
this was a good discriminator. Part (d) for four marks required candidates to value a maintenance contract
by discounting a delayed, growing perpetuity. Finally part (e) for five marks, asked candidates to discuss the
types of political risk that the company might encounter were it to proceed with the overseas project.

1(a)
2012 2013 2014 2015
Year 0 Year 1 Year 2 Year 3
£’000 £’000 £’000 £’000
Machinery (30,000) 5,000
Tax saving (Working 1) 1,680 1,344 1,075 2,901
Income 10,000 85,000
Materials and labour (W2) (7,280) (8,653) (10,124)
Overheads (W3) (2,600) (3,245) (3,937)
Lost contribution (W4) (4,200) (4,410) (4,631)
Tax on extra profit (W5) (2,800) 3,942 4,566 (18,566)
Working capital (W6) (5,000) (1,240) (1,331) 7,571
Total Cash Flows (26,120) (10,034) (11,997) 63,214
8% factor 1.000 0.926 0.857 0.794
PV (26,120) (9,291) (10,282) 50,192
NPV 4,499

As the NPV is positive GMI should proceed with the investment as this will enhance shareholder wealth.

Working 1
Year 0 Year 1 Year 2 Year 3
£’000 £’000 £’000 £’000
Cost of machinery 30,000 24,000 19,200 15,360
WDA @ 20% (6,000) (4,800) (3,840) (10,360)
WDV/sale 24,000 19,200 15,360 5,000
Tax saving @ 28% (WDA x 28%) 1,680 1,344 1,075 2,901

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 Financial Management - Professional Stage – September 2012

W2
Year 0 Year 1 Year 2 Year 3
£’000 £’000 £’000 £’000

Materials and labour (7,000) (8,000) (9,000)

2 3
Inflation @ 4% pa x 1.04 x 1.04 x 1.04
(7,280) (8,653) (10,124)

W3
Overheads (excluding Head office costs) (2,500) (3,000) (3,500)
2 3
Inflation @ 4% pa x 1.04 x 1.04 x 1.04
(2,600) (3,245) (3,937)

W4
Lost contribution (4,000) (4,000) (4,000)
2 3
Inflation @ 5% pa x 1.05 x 1.05 x 1.05
(4,200) (4,410) (4,631)

W5 - Tax on extra profit

Income 10,000 85,000
Materials and labour (7,280) (8,653) (10,124)
Overheads (2,600) (3,245) (3,937)
Lost contribution (4,200) (4,410) (4,631)
Profit/(loss) 10,000 (14,080) (16,308) 66,308

Tax @ 28% on profit/(loss) (2,800) 3,942 4,566 (18,566)

W6 – Working capital
Total investment (money terms) 5,000
£6,000 x 1.04 (Y1) 6,240
2
£7,000 x 1.04 (Y2) 7,571 0
(Increase)/decrease in WC (5,000) (1,240) (1,331) 7,571

In general, in part (a), a fairly standard NPV calculation, most candidates scored high marks. The most
common errors were made with regard to working capital investment and the corporation tax flows.
Total possible marks 13
Maximum full marks 13

1(b)
For NPV to fall to zero then the second instalment will need to fall by:
£
£4,499,000/0.794/0.72 = (7,869,787)
Estimated second instalment = 85,000,000
Minimum value of the second instalment 77,130,213

Part (b) was done reasonably, but a surprising number of candidates forgot to take taxation into account in
their calculations.
Total possible marks 3
Maximum full marks 3

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 Financial Management - Professional Stage – September 2012

1(c)
GMI’s money cost of capital already takes into account GMI’s estimated inflation rate. So if the cash flows
are inflated at the same rate then the correct NPV will be calculated.

If the South American inflation rates are higher than predicted then inflate further the money cost of capital
and the estimated cash flows. NPV will not be affected.

However, for the WDA, equipment resale and the second instalment, the NPV will fall as the money discount
rate rises. These are in money terms already.

The discursive nature of this part caught out many candidates - they failed to adequately explain the impact
of using an erroneous inflation rate and therefore to demonstrate that they fully understood this part of the
syllabus. A common error made by candidates was to forget that revenue from the project was fixed.
Total possible marks 5
Maximum full marks 5

1(d)
£’000
Annual income from 2016 (Year 4) 5,000
Annual costs from 2016 (3,000)
Annual surplus from 2016 2,000
less: Tax @ 28% (560)
1,440
Perpetuity factor (1.08/1.03) 4.85%
PV of future cash flows at Year 3 [end 2015] (£1,440/4.85%) 29,691
Discount to PV (from Year 3 [end 2015]) x 0.794
PV of future cash flows (minimum selling price of the maintenance contract) 23,575

This was done poorly and too few candidates were able to adequately deal with the discounting techniques
required.
Total possible marks 4
Maximum full marks 4

1(e)
Political risk is the risk that political action will affect the position and value of a company.

Candidates’ discussion should be based on the following possible risks:

 Quotas/tariffs/barriers imposed by the overseas government
 Nationalisation of assets by the overseas government
 Stability of the overseas government
 Political and business ethics
 Economic stability/inflation
 Remittance restrictions
 Special taxes
 Regulations on overseas investors

This final part was generally done well, but candidates would have lost marks if their discussions moved
away from straightforward political risk.
Total possible marks 5
Maximum full marks 5

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 Financial Management - Professional Stage – September 2012

QUESTION 2 Total marks: 25

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

This was a three-part question that tested the financing element of the syllabus. It was a mixture of fairly
straightforward calculations and a more testing, discursive section where candidates were required to
discuss the implications of those calculations for the company’s shareholders.

In the scenario a company wished to raise £15 million to finance its investment in new technology. This was
to be raised by either (i) a rights issue or (ii) a debenture issue. Part (a) was worth seven marks and
candidates had to produce a forecast income statement for the company for each of the financing methods
(equity and debt). In part (b) for five marks candidates were asked to calculate three common ratios based
on the forecasts in (a). Both parts were very straightforward and should have caused few problems. Part (c)
for 13 marks was the most difficult section of the question and will have been a good discriminator. Rote
learning was of little help here as candidates were expected to assess the impact of each of the schemes
from a shareholder’s point of view and to apply their understanding of gearing and dividend theory to the
scenario.

2(a)
Projected Income Statements for the year to 31 October 2013 Rights Debenture
Issue Issue
£m £m
Sales 148.500 148.500
Variable costs (96.525) (96.525)
Fixed costs (27.725) (27.725)
Profit before interest 24.250 24.250
Interest (1.500) (2.700)
Profit before tax 22.750 21.550
Tax (6.370) (6.034)
Profit after tax 16.380 15.516
Dividends (6.300) (5.400)
Retained profit 10.080 10.116
Part (a) was generally answered well, but a surprising number of candidates failed to increase the variable
costs in line with an increase in sales. In addition too many candidates were unable to calculate the new
total dividend figure following the rights issue.
Total possible marks 7
Maximum full marks 7

2(b)
Rights Debenture
Earnings/share Current EPS = £15.048/36m = £0.418
Earnings/share £16,380m/42m £0.390
£15.516m/36m £0.431

Dividend p/o ratio Current (£5.400/£15.048) 35.9%

£6.300/£16.380 38.5%
£5.400/£15.516 34.8%

Gearing ratio Current gearing = £20.0/(£31.6+£20.0) 38.8%

New gearing = £20.0/(£51.6 + 10.08 + £15.0) 26.1%
New gearing = (£20.0 + £15.0)/(51.6 + 10.116 +15.0) 45.6%
Part (b) was disappointing - too many candidates used retained profits in their earnings per share
calculations and too many were unable to calculate a relatively simple gearing ratio (book values) from the
information made available.
Total possible marks 5
Maximum full marks 5

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 Financial Management - Professional Stage – September 2012

2(c)
Rights issue Debenture issue
EPS (2011 = 41.8p) Decrease Increase
Dividend payout ratio Increase Decrease
Gearing Decrease Increase

CCC’s gearing with the rights issue seems reasonable at 26.1%, but with the issue of extra debt it is close
to 50% (i.e. 45.6%), which may be considered rather high.

CCC’s shareholders will see that, despite the extra income generated from the new technology, with the
rights issue the extra shares have diluted the EPS figure and may react negatively. However, there is an
increase in EPS with the issue of debt.

The changes to the dividend payout ratio are not significant, however, and may not have much of an impact
on the shareholders.

Rights Debenture
Market price per share Current EPS £0.418
Current MV/share = £3.34
Current P/E = 334/41.8 = 8

MV = 8 x £0.39 = £3.12
MV = (8 x 85%) x £0.431 = £2.93

Thus CCC’s share price would fall in both cases, but this is based only on the directors’ P/E estimates.

Capital structure
Traditional theory - as gearing climbs then, initially, because of the introduction of comparatively cheap
debt, CCC’s WACC figure will fall and its market value will rise. This will continue until the optimal level of
gearing is achieved, but beyond that equity holders will demand a higher yield and the WACC will
increase. At higher gearing levels the debt holders will also demand a higher yield because of the
increasing risk of bankruptcy.
M&M theory – the level of gearing is irrelevant, other than for the impact of tax shield. So geared
companies will have a higher value than ungeared companies, but at higher levels of gearing the market
value of the company will fall as the the benefits of tax relief are balanced by potential costs of bankruptcy and
interest rate increases - here WACC will be at a minimum and value of the business at a maximum.
Dividend policy
Traditional theory - Shareholders would prefer dividends today rather than dividends or capital gains in
future. Cash now is more certain than in future
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. Any loss in dividend income will be offset by gains in share price.
Clientele effect seems to operate – so dividends don’t affect value of shares provided the shareholders
know the dividend policy of the company. CCC should establish a consistent policy and stick to it. A lack
of consistency means that CCC shareholders will sell their shares and as a result share price would fall.

Many candidates found part (c) very challenging and too few of them were able to comment effectively on
the outcome of the scenario [parts (a) and (b)] and concentrated on gearing and dividend theory only.
Total possible marks 13
Maximum full marks 13

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 Financial Management - Professional Stage – September 2012

QUESTION 3 Total marks: 25

General comments
This question was generally done very well and had the highest average mark on the paper.

This was a three-part question that tested the financial risk elements of the syllabus. The scenario was
based on a UK engineering company and it divided the question into two types of risk management – (a)
foreign exchange and (b) interest rate.

Part (a) for eleven marks required students to calculate the outcome of four forex strategies - an OTC
option, a money market hedge, a forward contract and no hedge. This was straightforward and should not
have caused candidates too many problems. Part (b) was worth eight marks and here candidates had to
advise the company’s board as to which hedging technique was best, based on their previous calculations.
Part (c) was worth six marks and required candidates to outline the pros and cons of interest rate hedging
techniques. A well prepared student would have done well here.

3(a)(i)
Sterling equivalent at current spot rate €5.3m £4,576,857
1.1580

1. Option
December 2012 spot rate €1.2190/£ €1.1310/£
Exercise option (put)? Yes No
Put option (sell €) exchange rate is €1.1450/£ Spot rate €1.1310

Sterling receipt €5.3m Sterling receipt €5.3m

1.1450 1.1310

£4,628,821 £4,686,118
less: Premium cost (€5.3m/€100 x £0.50) (26,500) (26,500)
Sterling receipt – net £4,602.321 £4,659.618

2. Money market hedge

€ borrowed now (@ 3.6% pa) €5.3m €5.3m €5,252,725
(1 + 0.9%) 1.009

Sterling receipt, converted at spot rate €5,252,725 £4,536,032

1.1580

Sterling invested at 4.0% pa £4,536,032 x (1 +1.0%) £4,581,393

3. Forward contract
Sterling receipt: €5.3m €5.3m £4,599,497
(1.1580 – 0.0057) 1.1523
less: Arrangement fee (£5,000)
£4,594,497

4. No hedge
December 2012 spot rate €1.2190/£ €1.1310/£
€5.3m
1.2190 £4,347,826
€5.3m
1.1310 £4,686,118

This was answered well, but a quite a number of candidates treated the currency option as if it were traded
rather than OTC as in the question. Also a small number of candidates failed to account for the cost of the
forward contract.
Total possible marks 11
Maximum full marks 11

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 Financial Management - Professional Stage – September 2012

3(b)
The directors’ attitude to risk will be an important factor.

Weaker sterling at 31 December would suit JHL.

With an exchange rate of €1.2190/£

The option produces a sterling receipt of £4,602.321, which is higher sterling receipt than the forward
contract and the money market hedge (in that order). Both of these latter two hedging methods will produce
a fixed sterling amount, known at the start of the hedging period, which may be preferred by JLH’s
management.

The option (once the fee of £26,500 is taken into account) represents an exchange rate of €1.1516/£. If
sterling were to drop below this figure then it would not be worthwhile taking up the option.

With an exchange rate of €1.1310/£

No hedge would be necessary.

Part (b) was slightly disappointing in that too few candidates produced answers of sufficient depth and
structure.
Total possible marks 8
Maximum full marks 8

3(c)
(i) FRA – this would fix the rate of interest receivable by JHL. Upside potential is therefore removed. It can
be tailored to the exact amount to be invested by JHL.
(ii) Interest rate future – JHL would buy interest rate futures, but these are for standardised amounts, which
could be impractical.
(iii) Interest rate option – JHL would have the right to deal at an agreed interest rate at maturity date. JHL
would buy traded call options, but these are for standardised amounts and may not be suitable. So, for
more flexibility, JHL could purchase a tailored over the counter (OTC) option.
(iv) Interest rate swap – it would be impractical as a long term hedge for a large deposit. It would be difficult
to find a counterparty.

In this final part, as expected, most candidates produced sound answers.

Total possible marks 6
Maximum full marks 6

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