Financial Management - Professional Stage – June 2011

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: 22

General Comments
This three-part question was generally very well answered. It combined the investment appraisal and
business restructuring elements of the syllabus, the former being a staple element of every Financial
Management paper. The average mark achieved was 15.5/22 (70.5%).
(a)
2011 2012 2013 2014 2015 2016
Incr. Rev. - 127,500 416,160 745,493 1,131,462 1,266,750
Components - (59,400) (188,160) (327,084) (477,342) (513,450)
Labour - (15,000) (48,000) (84,300) (124,200) (135,000)
Cash flows - 53,100 180,000 334,109 529,920 618,300
Tax @ 28% - (14,868) (50,400) (93,551) (148,378) (173,124)
Investment (2,000,000)
CA 112,000 89,600 71,680 57,344 45,875 183,501
NCF (1,888,000) 127,832 201,280 297,902 427,417 628,677
DF 1 0.916 0.840 0.769 0.698 0.633
PV (1,888,000) 117,094 169,075 229,087 298,337 397,953
NPV (676,454)

On the basis of this negative NPV, the recommendation should be to reject the investment.

Sales: 2012 2013 2014 2015 2016

With new facilities: 1,100 1,210 1,331 1,464 1,500 (max.)
With old facilities 1,050 1,050 1,050 1,050 1,050
Increase in unit sales 50 160 281 414 450
Revenue:
Selling price/unit: 2,550 2,601 2,653 2,733 2,815
Incremental revenue 127,500 416,160 745,493 1,131,462 1,266,750
Components:
Cost/unit 1,188 1,176 1,164 1,153 1,141
Incremental cost (59,400) (188,160) (327,084) (477,342) (513,450

Labour:
Labour (units x 300) (15,000) (48,000) (84,300) (124,200) (135,000)

Gross Figures would have been as follows:

Revenue:
2012 2013 2014 2015 2016
2,805,000 3,147,210 3,531,143 4,001,112 4,222,500
2,677,500 2,731,050 2,785,650 2,869,650 2,955,750
127,500 416,160 745,493 1,131,462 1,266,750
Components:
2012 2013 2014 2015 2016
1,306,800 1,422,960 1,549,284 1,687,992 1,711,500
1,247,400 1,234,800 1,222,200 1,210,650 1,198,050
(59,400) (188,160) (327,084) (477,342) (513,450)
Labour:
2012 2013 2014 2015 2016
330,000 363,000 399,300 439,200 450,000
315,000 315,000 315,000 315,000 315,000
(15,000) (48,000) (84,300) (124,200) (135,000)

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 Financial Management - Professional Stage – June 2011

Capital Allowances: CA (28%)

31 Dec 2011 Cost 2,000,000
31 Dec 2011 WDA 400,000 112,000
1,600,000
31 Dec 2012 WDA 320,000 89,600
1,280,000
31 Dec 2013 WDA 256,000 71,680
1,024,000
31 Dec 2014 WDA 204,800 57,344
819,200
31 Dec 2015 WDA 163,840 45,875
31 Dec 2016 Bal. All. 655,360 183,501

Discount Factors:
2012: 1/(1.07 x 1.02) = 1/1.0914 = 0.916
2
2013: 1/1.0914 = 0.840
3
2014: 1/1.0914 = 0.769
2015: 0.769 x 1/(1.07 x 1.03) = 0.769 x 1/1.1021 = 0.698
2
2016: 0.769 x 1/1.1021 = 0.633
The first part of the question required candidates to calculate the net present value of a proposed
investment aimed at increasing a firm’s productive capacity. The question incorporated tax and capital
allowances, inflation and the analysis of relevant cash-flows on an incremental basis. Candidates
generally coped effectively with the demands of this part of the question, although a surprising number
completely overlooked the incremental aspect of the investment appraisal. Weaker candidates were also
often exposed by their inability to calculate accurate discount factors that took account of changing
inflation rates.
Total possible marks 16
Maximum full marks 16
(b)
The obvious problem is that the negative NPV arises principally because the almost 50% increase in
production capacity is not fully used until the final year of the project
However, the investment in additional production capacity therefore comes with the real option of finding
new customers for the spare capacity in the first four years of the contract
This is an example of a ‘follow-on’ (growth) option and if this could be achieved then the whole project has
the potential to be financially viable from a shareholder wealth perspective
The second part of the question required candidates to explain the potential relevance of real options to
the scenario they had been presented with, in light of the preceding net present value calculation. For the
majority of candidates this proved relatively straightforward although too often whilst a real option was
identified it was insufficiently explained. The weakest candidates were again exposed by their lack of any
knowledge of real options.
Total possible marks 3
Maximum full marks 3
(c)
Synergistic savings may be achieved (administration, leaner management structures)
Risk reduction (lower risk may create a lower WACC)
Backward vertical integration gives control over supply (quantity/quality)
The third part of the question required candidates to discuss the potential advantages of a business
combination between the two firms in the scenario. Again, for the majority of candidates this proved
relatively straightforward.
Total possible marks 3
Maximum full marks 3

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 Financial Management - Professional Stage – June 2011

Question 2

Total Marks: 28

General Comments
This four-part question that combined the cost of capital, sources of finance and firm valuation elements of
the Financial Management syllabus was the question that candidates by far the most challenging. The
average mark achieved was 16.7/28 (59.6%).
(a)
Cost of equity = D0 (1+g) / P0 + g
Where g = rb

Retention rate (b) = 489/922 x 100 = 53%

Return on capital (r) = 922/(4,250 – 489) = 24.5%
g = 0.53 x 0.245 = 13%
D0 = 433/2,000 = 21.65p
P0 = 400
Cost of equity = 21.65(1.13)/400 + 0.13 = 0.191 = 19.1%

The dividend valuation model has been used to calculate the cost of capital because there is no debt
within current liabilities so the firm is all-equity financed

The dividend growth rate uses the Gordon growth model, which can be justified by the figures being
consistent with previous years and likely to continue in future

The proposed expansion is into related activities with no consequent change in business risk and so the
current cost of equity capital is appropriate

£4 per share is a recent valuation and is therefore approximate to current market value
The first part of the question required candidates to calculate a firm’s cost of equity using the dividend
valuation method (incorporating the Gordon growth model). Whilst elements of the calculation were
invariably done accurately, weaker candidates often struggled to calculate accurately a return on capital
figure to underpin the calculation of the annual dividend growth rate and there was great variability in the
quality of responses to the second section of part of the question, which called for a discussion of
assumptions underlying the methodology employed in calculating the cost of equity.
Total possible marks 8
Maximum full marks 7
(b)
1. A rights issue:
No change in control if fully taken up by existing shareholders (but not if not taken up)
Flexible nature of dividend payments as opposed to a fixed interest commitment
How will existing shareholders react and do they have access to the required funds?
Any new shareholders might find the firm’s unlisted status unattractive
No listing and reporting requirements

2. AIM listing:
Increased marketability of shares (exit route for owners)
Listing and reporting requirements
Cost involved
Dilution of control
The second part of the question required candidates to identify and discuss the issues surrounding two
potential non-debt sources of finance (rights issues and AIM) with regard to a firm’s proposed expansion.
A key aspect of examination technique often came to the fore here – not answering the question set
Weaker candidates insisted on comparing equity to debt rather than one form of equity raising with
another. Well prepared candidates, however, coped easily with the question.
Total possible marks 8
Maximum full marks 8

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 Financial Management - Professional Stage – June 2011

(c)(i)
HH would obtain finance at a lower rate of interest than on an ordinary bank loan, provided that the firm’s
prospects were considered to be good post-expansion
This might encourage future outside investors with the prospect of a future share in profits
This would also introduce an element of short-term gearing, with potential beneficial cost of capital
implications
If the debt was subsequently converted it would also avoid subsequent redemption problems
If the debt was subsequently converted it would enable HH to issue equity relatively cheaply
There may be an argument that a convertible loan would come with fewer covenants than a bank loan
(ii)
The revised debt/equity ratio is not to be changed in future
The firm’s operating and business risk is not to be changed in future
The new finance is not project specific
Weaknesses in many candidates’ technical knowledge were also exposed in the third part of the question
which required candidates to discuss the advantages of convertible loans over a bank loan. This part of
the question was not, overall, well answered, which is surprising as it was very much a ‘knowledge’
question with only limited analytical demands being placed on candidates.
Total possible marks 9
Maximum full marks 7
(d)
Historic cost (book) valuation (the balance sheet value of equity)
Net realisable value of assets less net realisable value of liabilities (market value)
Replacement cost (the cost of setting up such a business from scratch)
Income-based approaches:
(i) the present value of future cash flows
(ii) use of the P/E ratio of similar quoted firms (P/E ratio x earnings)
(iii) dividend valuation method
The final part of the question required candidates to identify valuation methods that the firm’s accountants
may have employed in providing a recent share valuation. Generally candidates scored well on this part of
the question.
Total possible marks 6
Maximum full marks 6

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 Financial Management - Professional Stage – June 2011

Question 3
Total Marks: 30

General comments
This two-part question combined the interest rate and exchange rate risk management elements of the
Financial Management syllabus and was generally well answered by the well-prepared candidates. There
is now significant evidence that candidate performance in this relatively new area is increasing to the
levels seen in other areas of the syllabus. The average mark achieved was 20.3/30 (67.6%).
(a)(i)
(i)
Bank sells £ at €1.1856/£
Forward rate = €1.1797 (1.1856 – 0.0059)
So €2,960,000/1.1797 = £2,509,112.49

(ii)
To hedge a euro receivable, Fratton needs to create a euro liability which, with interest, will exactly equal
the receivable in three months’ time:
€2,960,000/1.004 = €2,948,207.17
Convert to £ at spot (1.1856) to give £2,486,679.46
Which with three months’ interest at 0.2875% gives £2,493,828.66

(iii)
Fratton should enter into a call option to buy £ at €1.18/£
Number of contracts = €2,960,000/1.18 = £2,508,475/62,500 = 40.14 = 40 contracts
The premium would be €60,000 (0.024 x 62,500 x 40)
Which at spot would cost £50,654.29 (60,000/1.1845)
Scenario 1:
Spot on expiry €1.12/£ - Exercise price €1.18/£ - intrinsic value: nil – exercise? NO
£ receipt at spot = €2,960,000/1.12 = £2,642,857.14 (net £2,592,202.85)
Scenario 2:
Spot on expiry €1.20/£ - Exercise price €1.18/£ - intrinsic value: €0.02 per £ - exercise? YES
Gain on option of €50,000 (0.02 x 62,500 x 40)
Sell €3,010,000/1.20 = £2,508,333.33 (net £2,457,679.04)
The first part of the question required candidates to illustrate how they would hedge foreign exchange risk
in the scenario set out in the question using the forward market, the money market and the options
market. For the most part, this was well answered although weaker candidates often made fundamental
errors in the choice of exchange rate in the first part and then often chose the wrong type of option to
hedge the foreign exchange exposure.
Total possible marks 14
Maximum full marks 14
(ii)
Advantages:
Transaction costs of futures should be lower and they can be traded
The exact date of receipt or payment of the foreign currency does not need to be known because the
futures contract does not have to be closed out until the underlying transaction takes place (subject only to
the expiry date of the futures contract)
Disadvantages:
The contracts cannot be tailored to the user’s exact requirements
Hedge inefficiencies are caused by standard contract sizes and basis
Only a limited number of currencies are available with futures contracts
The procedure for converting between two currencies neither of which is the $ is more complex with
futures compared to a forward contract
This second part of the question required candidates to discuss the advantages and disadvantages of
using futures contracts as opposed to forward contracts to hedge foreign exchange risk. For the most part
this posed few problems for stronger candidates.
Total possible marks 7
Maximum full marks 7

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 Financial Management - Professional Stage – June 2011

(b)(i)
As a borrower Fratton should buy a 3-6 FRA and can thereby fix a borrowing rate of 2.60%
At 3.00% rates have risen, so the bank will pay Fratton £2,500 (2.5m x {3.00%-2.60%} x 3/12) Payment on
the underlying loan will be 3% x 2,500,000 x 3/12 = £18,750
Net payment on the loan: £16,250 (18,750–2,500) – an effective rate of 2.60%
The second part of the question required candidates to illustrate the use of a forward rate agreement to
manage interest rate risk. Again, this was generally well answered and confirmed the continuing
improvement amongst most candidates in this area of the syllabus.
Total possible marks 4
Maximum full marks 4
(ii)
Fratton will need to sell three-month £ interest rate futures contracts
Fratton will need to sell 5 contracts (2,500,000/500,000 x 3/3)
Sell at 97.20 and buy at 97.00 for a gain of 0.20%
Futures outcome: 0.20% x 500,000 x 3/12 x 5 = £1,250
Payment in the spot market: 2,500,000 x 3% x 3/12 = £18,750 - £1,250 = £17,500 (= 2.80%)
The final part of the question required candidates to illustrate the use of interest rate futures contracts to
manage interest rate risk. The vast majority of candidates scored well on this question, although the most
common omission was the identification of the actual interest rate achieved as a result of the transaction.
Total possible marks 5
Maximum full marks 5

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