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(2 hours)

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.


Question papers contain confidential You MUST enter your candidate number in this
information and must NOT be removed box.
from the examination hall.



Copyright ICAEW 2016. All rights reserved. Page 1 of 8

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.
Northerns 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.
Northerns 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.

Northerns 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.
Northerns board is concerned that in recent months the Indian and Chinese exchange rates
have become more volatile. As a result Northerns board is considering buying coal from the

Earlier this month Northerns 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. Northerns 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
Northerns finance team and have been asked to prepare workings to help Northerns 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
Sterling interest rate (lending) 5.4% pa
Sterling interest rate (borrowing) 6.9% pa

Copyright ICAEW 2016. All rights reserved. Page 2 of 8


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
Northerns board whether it should hedge against interest rate movements using a FRA,
an option or an interest rate swap. (9 marks)

1.2 Calculate Northerns 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 Northerns board the
implications of hedging or not hedging the payment to ACT. (8 marks)

Total: 30 marks

Copyright ICAEW 2016. All rights reserved. Page 3 of 8

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 Ropers 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.

Ropers 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 Ropers 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.

Ropers 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, Ropers finance director,
has agreed to present relevant figures and advice at the next board meeting. Becky has
asked you, as a member of Ropers finance team, to work with her on this.

Details of Ropers capital structure at 31 August 2016 are shown below:

Total nominal value Market Value

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)

Ropers 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%

Copyright ICAEW 2016. All rights reserved. Page 4 of 8

Fracking industry market data at 31 August 2016
Average equity beta 1.9
Ratio of longterm 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.


2.1 Ignoring the investment in fracking services, calculate Ropers 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 Ropers 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 companys 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

Copyright ICAEW 2016. All rights reserved. Page 5 of 8

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 Darlos issued
share capital and are part of its executive management team. The remainder of Darlos
share capital is owned by Michelle and Robs 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
Darlos 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. Im 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.
Ive extracted the key figures from our most recent management accounts in the
document attached to this email. Ive also provided you with some working assumptions.

Could you please prepare a range of prices for the Darlo board to consider? Also Im
keen to know if we could value Darlo using Shareholder Value Analysis (SVA).

Email attachment:

Income Statement for the year ended 31 August 2016

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

Freehold land and buildings (original cost 2.8 million) 2,400
Equipment (original cost 4.5 million) 3,200
Working capital 148
4% debentures (redeemable in 2023) at nominal value (750)

Ordinary shares of 1 each 500

Retained earnings 4,498

Copyright ICAEW 2016. All rights reserved. Page 6 of 8

Working assumptions

(1) Darlos fixed assets were revalued at 31 August 2016 as follows:

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 Darlos industrial sector
is 10 and the average dividend yield is 8%.

(3) A discount rate of 12% pa appropriately reflects the risk of Darlos cash flows.

(4) Darlos pre-tax net cash inflows (after interest) for the next three years are
estimated to be:

Year to 31 August 2017 2,900
Year to 31 August 2018 3,000
Year to 31 August 2019 3,100

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 Darlos 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 equipments 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

(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.

Copyright ICAEW 2016. All rights reserved. Page 7 of 8


3.1 Prepare a report for Darlos 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 Tanns email. (3 marks)

Total: 35 marks

Copyright ICAEW 2016. All rights reserved. Page 8 of 8