Financial Management - Professional Level and Stage – September 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. 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

As in previous papers, 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: 35

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

This was a six-part question that tested the candidates’ understanding of the financing options element of
the syllabus.

In the scenario a manufacturing company was planning to raise additional funding for an expansion of its
product range and was considering whether to use equity (via a share issue) or debt (via debentures). Part
(a) for four marks required candidates to highlight the factors to consider when deciding between a rights
issue and a debenture issue. Part (b) for nine marks asked them to prepare next year’s income statement
using both methods of funding. In part (c) [5 marks], they were required to calculate the resultant earnings
per share figures under both methods. Part (d) for eight marks asked candidates to calculate the gearing
figures for both schemes (at book value and market value). In part (e) [5 marks] candidates had to advise
the company’s directors of the merits of both schemes, based on their calculations in (b) to (d) above.
Finally, for four marks, in part (f) they had to explain the differences between convertible loan stock and loan
stock with warrants.

1(a)
(a)
 Issue costs – these are high compared for equity with debt
 Shareholder reactions – they may react badly if the firm makes regularly makes rights issues. They may
sell their shares as a result, which will adversely affect the share price.
 Control – should not be affected by a rights issue unless a considerable number of existing
shareholders sell their rights.
 Unlisted companies – shareholders may not be able to sell their rights (if unlisted) and so a rights issue
would not be practical.
There was a variable performance in this part and the weakest scripts re-hashed/embellished existing points
in the question.
Total possible marks 8
Maximum full marks 4

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 Financial Management - Professional Level and Stage – September 2013

1(b)
Rights issue Debenture issue
£m £m
Sales 65.280 65.280
less: Variable costs (39.168) (39.168)
less: Fixed costs (8.700) (8.700)
Profit before interest 17.412 17.412
Debenture interest (0.930) (1.770)
Profit before tax 16.482 15.642
Taxation (at 21%) (3.461) (3.285)
Profit after tax 13.021 12.357
Dividends (2.016) (1.728)
Retained 11.005 10.629
This was very straightforward and most candidates scored full marks. The most common errors were made
with the interest and dividend calculations. A disappointing number of students failed to increase the sales
and/or variable costs figures correctly.
Total possible marks 9
Maximum full marks 9

1(c)
Current EPS £0.346 (£9.978m/28,800)

Rights issue Debenture issue

Extra shares £12.0m None

£2.50

4.8m shares None

New total shares in issue 28.8m 28.8m

4.8m 0.0m
33.6m 28.8m

Earnings per share £13.021m £12.357m

33.600m 28.800m

38.8p 42.9p
Part (c) was, again, very straightforward and the average mark here reflects that. It was good to see that
fewer candidates than previously had (incorrectly) used the retained earnings figure for the EPS calculation.
Total possible marks 5
Maximum full marks 5

1(d)
Based on DEBT/TOTAL LONG TERM FUNDS
Current gearing (book value) 20.6% (£15.500/£75.150)
Current gearing (market value) 14.8% [£15.500/([£3.10 x 28.800] + £15.500)

Gearing ratio (book value) £15.500 £27.500

£75.150 + £12.000 + £11.005 £75.150 + £12.000 + £10.629

15.8% 28.1%

Gearing ratio (market value) £15.500 £27.500

(33.600 x £3.30) + £15.500 (28.800 x £3.30) + £27.500

12.3% 22.4%

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 Financial Management - Professional Level and Stage – September 2013

OR
Based on DEBT/TOTAL EQUITY
Current gearing (book value) 26.0% (£15.500/£59.650)
Current gearing (market value) 17.4% [£15.500/([£3.10 x 28.800])

Gearing ratio (book value) £15.500 £27.500

£59.650 + £12.000 + £11.005 £59.650 + £10.629

18.8% 39.1%

Gearing ratio (market value) £15.500 £27.500

(33.600 x £3.30) (28.800 x £3.30)

14.0% 28.9%
This part was poorly done in general. A majority of students failed to deal correctly with retained profits in
the book value and market value calculations for gearing.
Total possible marks 8
Maximum full marks 8

1(e)
Current Rights Issue Debenture Issue
EPS £0.346 £0.388 £0.429
P/E ratio 8.95 8.52 7.69
Gearing (BV) 20.6% or 26.0% 15.8% or 18.8% 28.1% or 39.1%
Gearing (MV) 14.8% or 17.4% 12.3% or 14.0% 22.4% or 28.9%

EPS increases in both cases. It is highest with debenture issue. However gearing (BV) is now nearly 30%,
which might be too high and could have an adverse effect on share price if investors worry about level of
financial risk. If one takes the MV then the gearing level is more moderate (22.4% with issue of extra debt).

Important point regarding share price - £3.30 has been used (as per MC’s quote). Is this achievable? The
theoretical ex-rights price is £3.01 because of the dilution caused by the rights issue. Thus an extra 29p
would need to be added to the actual share price ex-rights, i.e. the NPV of the expansion would need to be
at least 29p per share. If it’s a debt issue – would the market react favourably to the increase in gearing?
Part (e) was reasonably well answered, but too few candidates considered the validity of the £3.30 share
price (it’s only the director’s opinion) given in the question.
Total possible marks 5
Maximum full marks 5

1(f)
Convertible Loan Stock (CLS)
Fixed return securities which may at the discretion of the holder be converted into ordinary shares of the
same company. (2)

Loan stock with warrants

Loan stocks which give the holder the right to subscribe at a fixed future date for ordinary shares at a
predetermined price. Debt is not converted, but remains as such.
This final part tested the candidates’ knowledge and there was a wide range of marks here. Few candidates
were able to explain how loan stock with warrants operates
Total possible marks 4
Maximum full marks 4

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 Financial Management - Professional Level and Stage – September 2013

QUESTION 2 Total marks: 35

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

This was a three-part question that tested the candidates’ understanding of the investment decisions and
valuation element of the syllabus.

In the scenario an airline company was considering whether or not to proceed with the purchase of three
new aircraft. In addition its management was concerned that the company might be the subject of a
takeover bid and wanted guidance. Part (a) for 16 marks was a fairly traditional NPV calculation and
required candidates to deal with capital allowances (including the trade-in of old aircraft), incremental cash
flows with regard to contribution and fixed costs, inflation and working capital. Part (b) for nine marks tested
candidates’ ability with sensitivity analysis, i.e. how sensitive was the investment to changes in (i) the trade-
in value of the aircraft and (ii) the incremental profits arising. Part (c) for ten marks examined candidates’
understanding of shareholder value analysis (SVA) and to what extent the NPV calculations in part (a) could
be employed if the company was the subject of a takeover bid.

2(a)
Y0 Y1 Y2 Y3
£ £ £ £
Old aircraft 760,000
Tax cost (W1) (159,600)
New aircraft (3,000,000) 600,000
Tax saved (W2) 113,400 92,988 76,250 221,362
Extra profit (W3) 566,475 594,799 624,539
Tax (W4) (118,960) (124,908) (131,153)
Working Capital (W5) (80,000) (4,000) (4,200) 88,200
TCF (2,366,200) 536,503 541,941 1,402,947
8%factor 1.000 0.926 0.857 0.794
PV (2,366,200) 496,801 464,443 1,113,939
NPV (291,017)

Negative NPV and so don’t proceed as shareholders’ wealth would fall

Working 1 Y0
£
WDV b/f 0
Balancing charge 760,000
Sale proceeds 760,000

Tax due (balancing charge x 21%) 159.600

Working 2 Y0 Y1 Y2 Y3
£’000 £’000 £’000 £’000
Cost/WDV 3,000.000 2,460.000 2,017.200 1,654.104
WDA @18% (540.000) (442.800) (363.096) (1,054.104)
WDV/sale 2,460.000 2,017.200 1,654.104 600.000

Tax saving (WDA x 21%) 113.400 92.988 76.250 221.362

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 Financial Management - Professional Level and Stage – September 2013

Working 3 Y0 Y1 Y2 Y3
£ £ £ £
Current profit 987,500
Estimated profit 1,527,000
Increase 539,500
x 1.05 = 566,475
x 1.05 = 594,799
x 1.05 = 624,539

Working 4 Y0 Y1 Y2 Y3
£ £ £ £
Extra profit (W3) 566,475 594,799 624,539

Tax @ 21% (118,960) (124,908) (131,153)

Working 5 Y0 Y1 Y2 Y3
£ £ £ £
Extra working capital £80,000 x1.05
£84,000 x1.05
88,200

Increment (£80,000) (4,000) (4,200) 88,200

This was generally answered well, but too few candidates were able to correctly calculate the incremental
change in contribution and fixed costs. Not many candidates scored full marks with regard to the balancing
charge arising on the sale of the old aircraft. A majority of candidates failed to calculate the working capital
figures correctly.
Total possible marks 16
Maximum full marks 16

2(b)(i)
£291,017/79%/0.794 £463,950 Extra income needed in Y3
£600,000 Estimated trade-in value in Y3
£1,063,950 Trade-in value required to break even (NPV = 0)
When testing the sensitivity of the NPV with regard to the trade-in value of the old aircraft, few candidates
took into account the impact of taxation/capital allowances.
Total possible marks 4
Maximum full marks 4

2(b)(ii)
Y1 Y2 Y3
£ £ £
Pre-tax extra profit 566,475 594,799 624,539
less: Tax at 21% (118,960) (124,908) (131,153)
Post-tax extra profit 447,515 469,891 493,386
8% factor 0.926 0.857 0.794
PV 414,399 402,697 391,748
Total NPV 1,208,844

Sensitivity: £291,017/£1,208,844 = 24.1%

Thus post-tax profits would need to increase by 24.1% for the project to be taken on, i.e. where NPV = 0
Candidates generally did better when calculating the sensitivity of the incremental profits, but their
interpretation of the results was often rather weak.
Total possible marks 5
Maximum full marks 5

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 Financial Management - Professional Level and Stage – September 2013

2(c)
Theory
Shareholder value analysis (SVA) concentrates on a company’s ability to generate value and thereby
increase shareholder wealth. SVA is based on the premise that the value of a business is equal to the sum
of the present values of all of its activities. SVA posits that a business has seven value drivers:

Relevance to GTA figures

1. Life of projected cash flows Three year projection – so relevant in part but not to infinity
2. Sales growth rate Not used – no growth rate other than inflation
3. Operating profit margin Yes, relevant. Margin and fixed costs used
4. Corporate tax rate Yes, relevant
5. Investment in non-current assets Not used as in usual SVA approach (% of change in sales)
6. Investment in working capital Not used as in usual SVA approach
7. Cost of capital Yes, a discount rate of 8% was used

The value of the business is calculated from the cash flows generated by drivers 1-6 which are then
discounted at the company’s cost of capital (driver 7). A terminal/residual value is also calculated to cover
the period from the end of competitive advantage to infinity. This can create major problems with estimating
a PV of future cash flows. However, SVA links a business’ value to its strategy (via the value drivers).

Practical
Some of the information in part (a) is relevant to a SVA calculation (see relevance column in bold above),
but part (a) is looking at a specific investment (three new aircraft) - no terminal/residual value has been
calculated, i.e. the PV of future cash flows once the period of competitive advantage lapses.
This was not done well, even the theoretical aspects of SVA, which should have been straightforward. Too
many candidates explained the value drivers and how the company’s value could be increased as these
changed. There were few attempts to explain the relevance of SVA to candidates’ calculations in part (a).
Total possible marks 10
Maximum full marks 10

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 Financial Management - Professional Level and Stage – September 2013

QUESTION 3 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 four-part question that tested the financial risk element of the syllabus.

The scenario was based on a UK crane manufacturer and included relevant exchange rates and interest
rates. The question tested candidates’ understanding of foreign exchange risk management and how to use
an interest rate swap. Part (a)(i) for eleven marks was straightforward as it required candidates to calculate
the outcome of three hedging strategies with two future spot rates given. Part (a)(ii) was worth eight marks
and here candidates had to advise the company’s board as to which hedging technique were preferable (if
any), based on their calculations in part (i). Part (a)(iii) for five marks asked candidates to explain the
concept of interest rate parity, with reference to the figures given in the scenario. Finally, in part (b) for six
marks, candidates had to suggest an interest rate swap arrangement and calculate the net effect of the
swap on the company’s interest payable figure.

3(a)(i)
Due in To pay Net (to pay)
€2,600,000 -€ 3,350,000 (€750,000)

Forward contract €750,000/(1.2055) (£622,148)

plus : Cost (0.8% x 750,000) (£6,000)
(£628,148)

Money Market Hedge

Lend in euros €750,000 €744,786
€1.007

Convert @ spot rate €744,786 £616,545

€1.2080

Borrow in sterling £616,545 x 1.011 (623,327)

Option (@ exercise price) €750,000/1.2070 (£621,375)

plus: Cost (2.5% x 750,000) (£18,750)
(£640,125)
st
Option @31 December spot rate (1) €750,000/1.1850 (£632,911)
plus: Cost (2.5% x 750,000) (£18,750)
(£651,661)
Option exercised
st
Option @31 December spot rate (2) €750,000/1.2570 (£596,659)
plus: Cost (2.5% x 750,000) (£18,750)
(£615,409)
Option not exercised
This was straightforward and many candidates scored full marks. However, a number of candidates used
(wrongly) a traded currency option rather than an over the counter option. A few candidates failed to
calculate the net payment figure of €750,000 at the start of this part.
Total possible marks 11
Maximum full marks 11

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 Financial Management - Professional Level and Stage – September 2013

3(a)(ii)
ADVICE
st
Spot on December 31 1.1850 1.2570 Average
No hedge (£632,911) (£596,659) (£614,785)
OTC option (OTC) (£640,125) (£615,409) (£627,767)
Money market hedge (MMH) (£623,327) (£623,327) (£623,327)
Forward contract (FC) (£628,148) (£628,148) (£628,148)

(ii) Cost @ current spot €1.2080 (£620,861)

Cost @ spot €1.1850/£ (£632,911)
Cost @ spot €1.2570/£ (£596,659)

Thus a strengthening of sterling would lead to a fall in the cost of the net payment.
The markets suggest a weakening of sterling (premium on euro), however.
MMH and FC give fixed cost – MMH is cheaper (£623k compared to £628k)
OTC is expensive unless sterling does strengthen.

What if the receipt isn’t received or is delayed? Option offers greater flexibility – the FC and the MMH are
fixed and for wrong amount
Part (a)(ii) was done reasonably well, but too few candidates considered (i) what would happen if the euro
receipt wasn’t received and (ii) given the forward rates in the question, whether sterling appreciation or
depreciation was more likely.
Total possible marks 8
Maximum full marks 8

3(a)(iii)
Interest rate parity (IRP) is a method of predicting foreign exchange rates based on the hypothesis that the
difference between the interest rates in two countries should offset the difference between the spot rates
and the forward foreign exchange rates over the same period.

In the table in part (a) the forward contract is at a premium, i.e. the euro will appreciate in value (sterling will
depreciate). This means that interest rates in the UK must be higher than in the Eurozone.

Average interest rates per quarter are 3.9%/4 = 0.975% UK and 3.2%/4 = 0.8% Eurozone. Average spot is
1.2125 and average forward rate is 1.21025. Using IRP
1.2125 x 1.008 / 1.00975 = 1.2104, i.e. IRP holds in this case.
Candidates did well here if they made good use of the figures given in the scenario.
Total possible marks 5
Maximum full marks 5

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 Financial Management - Professional Level and Stage – September 2013

3(b)
CB MNI DIFF
Fixed 6.50% 5% 1.5%
Variable L + 2.5 L + 1.5 1.0%
0.5%

This 0.5% saving will be split between the two companies, i.e. 0.25% pa each.

CB MNI
Current (L + 2.5%) (5.00%)
Move 1 L (L)
Move 2 (3.75%) 3.75%
Final (6.25%) (L + 1.25%)

£
CB’s current interest payment £6.3m x 7.5% (472,500)
CB’s new interest payment 6.3m x 6.25% (393,750)
Saving 78,750
In part (b) most candidates did well, but too many failed to use LIBOR as the variable leg, despite
instructions to the contrary. In general candidates found the interest saved calculations more difficult than
constructing the swap.
Total possible marks 6
Maximum full marks 6

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