Financial Management - Professional Stage – June 2013

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.
More marks were available than could be awarded for each requirement. This allowed credit to be given for a
variety of valid points which were made by candidates.

Question 1

Total Marks: 29

General comments
The first question on the paper was a standard investment appraisal question, supplemented by tests of
technical knowledge and its practical application. For the most part, candidates scored strongly on the first
part of the question, the majority clearly being well-drilled in the quantitative techniques involved in this
part of the question. Equally apparent was that the majority of candidates were ill-equipped in terms of
simple technical knowledge to pick up full or even high marks in the second and third parts of the question,
with many scripts scoring zero or at most very low marks on both parts.

(a)
Best case scenario
2013 2014 2015 2016 2017
Plant & Equipment (1,500,000) 100,000
Capital Allowance (W1) 84,000 67,200 53,760 43,008 144,032
Operating Cash Flow (W2) 1,173,000 1,196,460 1,220,389 1,244,797
Tax (28%) (328,440) (335,009) (341,709) (348,543)
Working Capital (W3) (163,200) (3,264) (3,329) (3,396) 173,189
(1,579,200) 908,496 911,882 918,292 1,313,475
Discount Factor (W4) 1 0.9337 0.8636 0.7911 0.7250
(1,579,200) 848,263 787,501 726,461 952,269
NPV £1,735,294

Worst case scenario

2013 2014 2015 2016 2017
Plant & Equipment (1,500,000) 100,000
Capital Allowance (W1) 84,000 67,200 53,760 43,008 144,032
Operating Cash Flow (W2) 499,800 509,796 519,992 530,392
Tax (28%) (139,944) (142,743) (145,598) (148,510)
Working Capital (W3) (97,920) (1,958) (1,998) (2,038) 103,914
(1,513,920) 425,098 418,815 415,364 729,828
Discount Factor (W4) 1 0.9337 0.8636 0.7911 0.7250
(1,513,920) 396,914 361,689 328,594 529,125
NPV £102,402

Workings:

1. Capital Allowances (£)

2013 Cost 1,500,000
WDA 300,000 x 28% = 84,000
1,200,000
2014 WDA 240,000 x 28% = 67,200
960,000
2015 WDA 192,000 x 28% = 53,760
768,000
2016 WDA 153,600 x 28% = 43,008
614,400
2017 Disposal 100,000
514,400 x 28% = 144,032

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 Financial Management - Professional Stage – June 2013

2. Operating Cash Flows

Best Case Scenario: 2,000,000 – (500,000 + 350,000) = 1,150,000
2014: 1,173,000 (1,150,000 x 1.02)
2
2015: 1,196,460 (1,150,000 x 1.02 )
3
2016: 1,220,389 (1,150,000 x 1.02 )
4
2017: 1,244,797 (1,150,000 x 1.02 )
Worst Case Scenario: 1,200,000 – (360,000 + 350,000) = 490,000
2014: 499,800 (490,000 x 1.02)
2
2015: 509,796 (490,000 x 1.02 )
3
2016: 519,992 (490,000 x 1.02 )
4
2017: 530,392 (490,000 x 1.02 )

3. Working Capital
Best Case Scenario:
2013: (2,000,000 x 1.02 x 0.08) = (163,200)
2
2014: (2,000,000 x 1.02 x 0.08) - 163,200 = (3,264)
3
2015: (2,000,000 x 1.02 x 0.08) - 166,464 = (3,329)
4
2016: (2,000,000 x 1.02 x 0.08) - 169,793 = (3,396)
2017: 173,189
Worst Case Scenario:
2013: (1,200,000 x 1.02 x 0.08) = 97,920
2
2014: (1,200,000 x 1.02 x 0.08) - 97,920 = (1,958)
3
2015: (1,200,000 x 1.02 x 0.08) - 99,878 = (1,998)
4
2016: (1,200,000 x 1.02 x 0.08) – 101,876 = (2,038)
2017: 103,914

4. Discount Factor
2014: 1/(1+0.05)(1.02) = 0.9337
2015: 1/(1+0.05)(1+0.06)(1.022) = 0.8636
2016: 1/(1+0.05)(1+0.06)(1+0.07)(1.023) = 0.7911
2017: 1/(1+0.05)(1+0.06)(1+0.07)2(1.024) = 0.7250

Probably the most common error was inaccurate calculation of the inflation-adjusted discount factors.
However, there were many instances of full marks.
Total possible marks 17
Maximum full marks 17

(b)
Decisions are usually said to be subject to uncertainty if the possible outcomes of a decision are known
but the probabilities attaching to each possible outcome are unknown.

Decisions are usually said to be subject to risk if, although there are several possible outcomes of a
decision, these outcomes as well as the respective probabilities attaching to each of these possible
outcomes are known.

The calculations undertaken in part (a) have been made under conditions of uncertainty as the directors
do not have details of the probabilities attaching to the two scenarios. So they need to establish such
probabilities and then calculate expected values for each variable (the arithmetic mean of possible
outcomes weighted by the probability of each outcome).
The second part of the question was a straightforward test of knowledge of elements from the Learning
Materials, but many candidates were completely unacquainted with them and consequently there was
much waffling and little accuracy and substance to many of the candidates’ responses.
Total possible marks 6
Maximum full marks 6

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 Financial Management - Professional Stage – June 2013

(c)
The concept of ‘real options’ relates to the strategic implications attaching to undertaking a particular
project - the value of such ‘real options’ would not ordinarily be included in a traditional NPV calculation –
consideration of ‘real options’ leads to a revised decision model:

Project Value = Traditional NPV + the value of any ’real options’

Two obvious ‘real options’ applicable to Brixham’s acquisition of Cabin are:

1. Follow-on option: for example, the opportunity to add further acquisitions in due course to gain the
benefits of increased economies of scale/market share;
2. Growth option: for example, the opportunity to broaden the range of services on offer in due
course.
In the final part of the question, many candidates were completely unaware of what a ‘real option’ was in
an investment decision-making context, with many candidates incorrectly interpreting ‘real’ as meaning
after taking account of the effects of inflation, thereby betraying their lack of study of the Learning
Materials. The last part of the question was of a different character to the second part in that it was not
merely looking for technical knowledge, but also the application of that knowledge to the scenario in the
question and weaker candidates too often simply presented theory rather than practical application.
Total possible marks 6
Maximum full marks 6

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 Financial Management - Professional Stage – June 2013

Question 2

Total Marks: 27

The second WT question on the paper covered elements of the ‘risk management’ area of the syllabus, in
particular the hedging of a company’s exposure to interest rate risk.

For the most part, candidates did cope well with the techniques and calculations involved in the first part of
the question and there were many instances of high marks. However, where candidates had only a weak
grasp of the topic, then their marks fell way very significantly and for that reason there were a meaningful
proportion of low marks in the first part of the question.

(a)
(i)
No hedging

Rates remain unchanged:

H1 - 3.25% x 40m x 6/12 debt = (650,000)
H2 - 3.25% x 70m x 6/12 deposit = 1,137,500
Net interest received = £487,500

Rates rise to 5.00%

H1 - 5.00% x 40m x 6/12 debt = (1,000,000)
H2 - 5.00% x 70m x 6/12 deposit = 1,750,000
Net interest received = £750,000

Rates fall to 1.50%

H1 - 1.50% x 40m x 6/12 debt = (300,000)
H2 - 1.50% x 70m x 6/12 deposit = 525,000
Net interest received = £225,000

(ii)
Interest Rate Options

H1
Take out September put option (right to borrow) @ 96.75 (160 contracts {40m/0.5m x 2})
Premium: 160 x £500,000 x 0.42% x 3/12 = £84,000
H2
Take out March call option (right to deposit) @ 96.75 (280 contracts {70m/0.5m x 2})
Premium: 280 x £500,000 x 0.81% x 3/12 = £283,500

Total cost of premiums = £367,500

Rates remain unchanged:

No action required in any quarter
Net interest received = 487,500 – 367,500 = £120,000

Rates rise to 5.00%

H1
Profit on options = 1.75% x £500,000 x 160 x 3/12 = 350,000
Actual interest paid = 5% x 40m x 6/12 = (1,000,000)
Net interest paid = £(650,000)
H2
Let option lapse
Actual interest received = 5% x 70m x 6/12 = £1,750,000
Net interest received = 1,100,000 – 367,500 = £732,500

Rates fall to 1.50%

H1
Let option lapse
Actual interest paid = 1.50% x 40m x 6/12 = £(300,000)

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 Financial Management - Professional Stage – June 2013

H2
Option exercised at 96.75
Profit on option 1.75% x 280 x 3/12 x £500,000 = 612,500
Actual interest received 1.5% x 70m x 6/12 = £525,000
Net interest received = 837,500 – 367,500 = £470,000

(iii)
Forward Rate Agreements

For all three scenarios:

H1 - 3v9 FRA – 2.91% x 40m x 6/12 debt = (582,000)
H2 - 9v15 FRA – 2.55% x 70m x 6/12 deposit = 892,500
Net interest received = £310,500
Choosing the incorrect month for the interest rate futures contract, incorrect calculation of the premium
(multiplying by half a year rather than a quarter of a year) and the simple confusion of call and put options
were the most common errors among weaker candidates.
Total possible marks 20
Maximum full marks 20

(b)
Compared to hedging with forward rate agreements, hedging with interest rate futures:

1. involves standardisation as regards amount, terms and periods;

2. involves contracts which are traded on exchanges;
3. involves (usually) closing out the contract before maturity;
4. involves the potential for basis risk;
5. involves the potential for hedge inefficiency;
6. involves a different mechanism for quoting prices.

In the second part of the question, whilst many candidates scored strongly, many others were let down
(and wasted time) by not precisely answering the question – marks were available for identifying the
differences (not the similarities) between the two hedging techniques and certainly not for listing the
characteristics of forward rate agreements, which many candidates did.
Total possible marks 7
Maximum full marks 7

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 Financial Management - Professional Stage – June 2013

Question 3
Total Marks: 24

The third WT question focused on the cost of capital and financing sections of the syllabus. Once again
there was a clear divergence between the often perfect quantitative elements of the question and the
much weaker performance on discursive and evaluative answers and with the balance of this question so
heavily weighted in favour of the latter, weaker candidates were often exposed.

(a)
Assuming an underlying dividend growth rate of g per annum, the average growth rate between 2008 and
2012 is given by:
4
(1 + g) = 13.6/10
(1 + g) = 1.0799
g = 8%

Cost of equity

ke = Do(1+g)/Po + g
= (13.6 x 1.08)/250 + 0.08
= 13.88%

Cost of debt (assuming the debentures are ‘ex int’)

df @ PV df @ PV
1% 10%

to (98.00) 1 (98.00) 1 (98.00)

t1 – t5 2.88 4.853 13.98 3.791 10.92
t5 100.00 0.951 95.10 0.621 62.10
11.08 (24.98)

IRR = 1.00 + 11.08 x9 = 3.76%

(11.08 + 24.98)

Therefore, the WACC is given by:

(MVe x ke) + (MVd x kd) = (325.0 x 0.1388) + (122.5 x 0.0376) = 11.1%
MVe + MVd (325.0 + 122.5)

Calculation of the cost of capital caused few difficulties for the vast majority of candidates.
Total possible marks 6
Maximum full marks 6

(b)
The calculation of both the WACC and the ke is based on the assumption that the value of an ordinary
share is the discounted present value of the future dividend stream, but the market may be using a
different method of valuation such as an earnings multiple, which may undermine the validity of the
calculations.

In order to estimate ke, it is necessary to know or estimate do, Po and g. Of these, only do can be
determined with confidence.

For the model to give an accurate estimate of k e, the ex-dividend market value of the share must be in
equilibrium, but in practice market values fluctuate daily.

Estimating g is difficult and can be based on either past dividend growth or the Gordon growth model.

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 Financial Management - Professional Stage – June 2013

Simply using an average of past dividend growth might produce a figure that is somewhat misleading. In
addition, extrapolating future growth rates based on past growth rates assumes that past growth rates will
be sustained into the future.

Use of the Gordon growth model to estimate g will only give a useful approximation where the company’s
retention rate and rate of return are stable.

In practice, companies use sources of finance other than debt and equity, which makes the computation of
WACC more complicated. Unlisted preferences shares, overdrafts or convertible loan stock, for example,
can pose problems in terms of establishing a market value, whilst leases or loans denominated in foreign
currencies can provide additional challenges.

Credit was also given for reference to changing tax rates and the complication of interim dividends.
In this second part of the question many candidates were again guilty of not precisely answering the
question set – they often listed the issues that might make the calculated WACC an inappropriate discount
factor for use in investment appraisal rather than listing the practical difficulties that may be faced by a firm
such as Bayton when calculating its WACC. This was clearly a case of some candidates choosing the
answer the question they wish had been set rather than the one that had been set.
Total possible marks 9
Maximum full marks 7

(c)
The comments of the finance director:

The cost of capital should reflect future costs of finance because in decision-making concern is only with
the future. Here the future financing mix is not known precisely.

We do not, therefore, know whether the gearing ratio will remain the same or not.

Cost should be derived from the future financing mix and cost rather than using a cost derived from the
current financing situation.

In addition, there is an assumption that the systematic business risk of the company will not be changed
by making this latest investment, which is described as ‘significant’. However, if there is a consequent
change in business risk, then this will also affect the cost of the constituents of the WACC calculation.

The comments of the managing director:

The cost of an individual source of finance should not be associated with an individual project – the cost of
the overall pool of funds should be considered.

The comments of the production director:

It is inaccurate to assert that retained profits are a costless source of finance. There may be no issue
costs but shareholders will still expect a return on the funds re-invested in the business – they will expect
the funds to be invested in projects that increase their wealth.

Throughout, up to 3 marks were available for relevant discussion of traditional and Modigliani & Miller (with
and without tax) theories on capital structure and dividend policy.
In the final part of the question, whilst strong candidates often scored well, many weaker candidates failed
to apply theory meaningfully to the scenario and too often merely dumped knowledge rather than used it
insightfully to answer the question.
Total possible marks 14
Maximum full marks 11

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