PROFESSIONAL STAGE APPLICATION EXAMINATION

WEDNESDAY 13 JUNE 2012

(2½ hours)

FINANCIAL MANAGEMENT
This paper is made up of FIFTEEN objective test (OT) questions (20 marks) and THREE
written test questions (80 marks).

1. Ensure your candidate details are on the front of your answer booklet.

2. Answer each question in black ball point pen only.

Objective Test Questions (1 – 15)

3. Record your OT responses on the separate answer sheet provided: this must not be
folded or creased. Your candidate details are printed on the sheet.

4. For each of the FIFTEEN OT questions there are four options: A, B, C, D. Choose
the response that appears to be the best and indicate your choice in the correct box,
as shown on the answer sheet.

5. Attempt all questions: you will score equally for each correct response. There will be
no deductions for incorrect responses or omissions.

Written Test Questions (1 – 3)

6. Answers to written test questions must begin on a new page and must be clearly
numbered. Use both sides of the paper in your answer booklet.

7. The examiner will take account of the way in which answers are presented.

A Formula 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 2012. All rights reserved. Page 1 of 7

1. Newmarket plc (Newmarket), a listed company, has recently developed a new lawnmower,
the NL500. Development of the NL500 was supported by market research which was
undertaken by an external agency who agreed that their £10,000 fee would only be payable if
the NL500 was actually launched, with payment due at the end of the NL500’s first year on
the market.

Newmarket’s directors estimate that the market life of the NL500 will be five years but they
would be willing to launch the NL500 only if they were satisfied that the required investment
would generate a net present value of at least £300,000, using a discount factor of 10% pa.

Production and sale of the NL500 would commence on 1 July 2012 and would require
investment by Newmarket in new production equipment costing £750,000, payable on
30 June 2012. On 30 June 2017 it is expected that this equipment could be sold back to the
original vendor for £50,000. Newmarket depreciates plant and equipment in equal annual
instalments over its useful life.

The company’s directors would like to assume that the corporation tax rate will be 28% for
the foreseeable future, and it can be assumed that tax payments would occur at the end of
the accounting year to which they relate. The directors are also assuming that the new
production facilities would attract capital allowances of 20% pa on a reducing balance basis
commencing in the year of purchase and continuing throughout the company’s ownership of
the equipment. A balancing charge or allowance would arise on disposal of the equipment on
30 June 2017. It can be assumed that sufficient profits would be available for Newmarket to
claim all such tax allowances in the year they arise.

Purchase of the new production equipment would be financed by a five-year fixed rate bank
loan which will be drawn down on 30 June 2012 at an interest rate of 6% pa. Interest on the
loan would be payable annually, with repayment of the capital being made in full on 30 June
2017.

Newmarket’s marketing director has estimated annual demand for the NL500 to be 2,000
units and on that basis the finance department has estimated the unit cost of the NL500 as
follows:

£
Labour (4 hours @ £12 per hour) 48.00
Components 32.00
Loan interest 22.50
Depreciation 70.00
Variable energy costs 5.00
Share of Newmarket’s fixed costs 20.00
197.50

If the NL500 is launched, a manager already employed by Newmarket would be moved from
his present position to manage production and sale of the NL500. This existing manager’s
position would consequently have to be filled by a new recruit, specifically employed to
replace him, on a five-year contract at a fixed annual salary of £35,000. The launch of the
NL500 would have a negligible impact on both Newmarket’s working capital requirements
and on its fixed costs.

Newmarket’s accounting year end is 30 June and it can be assumed that all cash flows would
occur at the end of the year to which they relate.

Copyright © ICAEW 2012. All rights reserved. Page 2 of 7

Requirements

(a) Calculate (to the nearest £) the minimum price per unit that Newmarket should charge
for the NL500 if a net present value of at least £300,000 is to be achieved. (15 marks)

(b) Identify and describe TWO quantitative techniques that Newmarket could use to assess
and adjust for the various risks to which launching the NL500 would expose the
company. (6 marks)

(c) Distinguish between systematic risk and non-systematic risk and explain, using
examples, how each of these types of risk might apply to the launch of the NL500.
(6 marks)

(27 marks)

Copyright © ICAEW 2012. All rights reserved. Page 3 of 7

2(a). Throughout both parts of this question you should assume that today’s date is
30 June 2012.

Lambourn plc (Lambourn) is a UK company that trades in a range of pharmaceutical

products. It buys and sells these products in the UK and also in the USA, where it trades with
three companies – Biotron Inc., Hope Inc. and USMed Inc.

In the past, the relatively low level of trading with US companies has meant that Lambourn
has not hedged its foreign currency exposure. However, due to increases in the level of trade
conducted in the USA, Lambourn’s finance director is now considering the use of a variety of
hedging instruments.

Receipts and payments in respect of the following exports and imports (designated in the
currencies shown) are due in six months’ time:

Receipts due from exports to:

Biotron Inc. $600,000
Hope Inc. £400,000
USMed Inc. $200,000

Payments due on imports from:

Biotron Inc. $1,100,000
Hope Inc. £900,000
USMed Inc. $1,250,000

Exchange rates at the present time are as follows:

Spot $1.6666 - 1.6720/£

3-month forward premium 0.90c - 0.98c
6-month forward premium 2.49c - 2.65c

Sterling currency options (standard contract size £31,250) are currently priced as follows
(with premiums, payable up front, quoted in cents per £):

Calls Puts
Strike Price September December September December
$1.63 3.67 4.59 0.06 1.69
$1.65 2.35 3.07 1.63 3.43
$1.67 1.82 2.65 2.04 5.55

Sterling currency futures (standard contract size £62,500) are currently priced as follows:

September $1.6555/£
December $1.6496/£

Annual borrowing and deposit interest rates at the present time are as follows:

Sterling 3.00% - 1.70%

Dollar 1.50% - 0.50%

Copyright © ICAEW 2012. All rights reserved. Page 4 of 7

 Requirements

Assuming the spot rate in six months’ time will be $1.6400 - 1.6454/£, calculate Lambourn’s
net foreign currency exposure, and the outcome achieved, using:

(i) a forward market hedge;

(ii) exchange-traded currency options (hedging to the nearest whole number of contracts)
so as to guarantee no worse an exchange rate than the current spot rate;
(iii) currency futures contracts (hedging to the nearest whole number of contracts) and
assuming the relevant futures contract is trading at $1.6400 in six months’ time;
(iv) a money market hedge. (17 marks)

2(b). In six months’ time (ie, in December 2012), Lambourn will need to borrow £1.5 million for a
period of six months at a fixed rate of interest. The company’s finance director is keen to
ensure that the interest rate on the loan does not exceed 3.75% pa. The spot rate of interest
is currently 3% pa. The finance director intends to use three-month sterling traded interest
rate options on futures to hedge the company’s interest rate exposure.

The current schedule of prices (premiums are in annual % terms) for these contracts
(standard contract size £500,000) is as follows:

Calls Puts
Strike Price Sept Dec Mar Sept Dec Mar
96.25 0.20 0.23 0.25 0.19 0.96 1.66
96.50 0.09 0.10 0.11 0.32 1.19 1.89
96.75 0.05 0.06 0.07 0.53 1.43 2.14

Requirement

Calculate the outcome of the hedge and the effective annual rate of interest achieved if
prices in December 2012, when Lambourn negotiates the six-month fixed rate loan with its
bank, are either:

(i) a spot interest rate of 4.4% pa and a futures price of 95.31; or

(ii) a spot interest rate of 2.1% pa and a futures price of 97.75. (10 marks)

(27 marks)

Copyright © ICAEW 2012. All rights reserved. Page 5 of 7

3. Middleham plc (Middleham) is a company involved in the production of printing inks used in a
wide range of applications in the food packaging industry. The directors of Middleham are
currently considering a £2 million investment in new production facilities. At the present time,
the company’s finance director is seeking to establish an appropriate cost of capital figure for
use in the appraisal of the proposed investment. Extracts from Middleham’s most recent
financial statements for the year ended 31 March 2012 are shown below:

£’000
Ordinary share capital (50p shares) 3,200
5% irredeemable preference share capital (50p shares) 1,400
Reserves 7,000
11,600
7% debentures (at nominal value) 1,500
13,100
Current liabilities 3,700
Total equity and liabilities 16,800

£’000
Profit before taxation 3,000
Taxation (800)
Preference share dividends (70)
Ordinary share dividends (1,088)

The market prices for the company’s shares and debentures on 31 March 2012 were:

1. Ordinary shares: £1.42 each (cum-div)

2. 5% irredeemable preference shares: £0.20 each (ex-div)
3. 7% debentures: £105.00 (per £100 nominal)

The ordinary dividend for the year ended 31 March 2012 is due to be paid shortly. This is the
first dividend paid since the year ended 31 March 2008, when the dividend payout ratio was
40% and the earnings per share were £0.35. Middleham’s directors expect future dividends
to grow at the annual growth rate implied by the dividends paid in 2008 and 2012. The
number of ordinary shares in issue has not changed since March 2007.

The annual debenture interest has recently been paid. The 7% debentures are redeemable
at par in 10 years’ time.

Shares in the industrial sector in which Middleham operates typically have an equity beta of
1.3. The risk free rate is 6% pa and the return from the market portfolio is 14% pa.

The company’s finance director has proposed that, if the investment is undertaken, then an
issue of redeemable debentures is used to finance it. However, Middleham’s chief executive
has expressed concerns about the possible use of redeemable debentures. His view is that
increasing the number of debentures issued by the company will increase the company’s
gearing dramatically and the increased financial risk associated with this could easily lead to
a fall in the company’s share price and, therefore, its market value.

The directors wish to assume a rate of corporation tax of 28% for the foreseeable future.

Copyright © ICAEW 2012. All rights reserved. Page 6 of 7

Requirements

(a) Calculate (using the dividend growth model) a weighted average cost of capital that
could be used to appraise Middleham’s proposed investment. (13 marks)

(b) Explain the underlying assumptions and any other relevant factors that may mean it is
inappropriate to use the cost of capital figure calculated in requirement (a) in the
appraisal of Middleham’s proposed investment. (5 marks)

(c) (i) Calculate Middleham’s cost of equity using the capital asset pricing model.

(ii) Explain two key assumptions that would underpin the use of this cost of
equity in the calculation of the weighted average cost of capital. (3 marks)

(d) Comment on the views expressed by Middleham’s chief executive. (5 marks)

(26 marks)

Copyright © ICAEW 2012. All rights reserved. Page 7 of 7