Professional Level Financial Management - September 2016

MARK PLAN AND EXAMINERS 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: 30

General comments
This question had easily the highest percentage mark on the paper. Overall, the candidates performance
was very good.

This was a three-part question which tested the candidates understanding of the risk management
element of the syllabus. In the scenario a UK electricity generator was considering hedging (1) the interest
costs of a large loan and (2) its exposure to foreign exchange rate risk on a planned purchase from an
American supplier. In part 1.1, for nine marks, candidates were required to calculate the interest payments
that would arise on its planned loan were it to make use of an FRA, an option or a swap. Two different
rates of LIBOR were given to the candidates. Candidates were then required to recommend which of the
hedging techniques the company should choose at each of the LIBOR rates. Part 1.2 was worth 13 marks
and asked candidates to calculate the sterling cost arising from a range of hedging techniques applied to
the American purchase. Finally in part 1.3, for eight marks, candidates were required to advise the
companys board whether it should hedge the American (dollar) payments.

1.1

LIBOR + 2 7% 9%

FRA
Pay at LIBOR +2 (7.00%) (9.00%)
(Payment to)/receipt from bank (0.25%) 1.75%
(7.25%) (7.25%)
Total interest payment over 12 months (on 9.5m) (688,750) (688,750)

Option
Exercise? Yes Yes
Rate (6.5%) (6.5%)
Premium (1.0%) (1.0%)
(7.5%) (7.5%)
Total interest payment over 12 months (on 9.5m) (712,500) (712,500)

No hedge
Pay at LIBOR + 2 (7%) (9%)
Total interest payment over 12 months (on 9.5m) (665,000) (855,000)

If LIBOR is 5% then it would be best not to hedge. If LIBOR is 7% the FRA gives the lowest interest figure.
So the figures are not conclusive and the boards attitude to risk will be important.

The FRA eliminates downside risk (rates rising) as well as upside risk (rates falling).

An interest rate swap would not be appropriate here as it is short-term and would in all likelihood be very
difficult to arrange.

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 Professional Level Financial Management - September 2016

Part 1.1 was answered well by many candidates. However, common errors made were:
Candidates based their calculations on a borrowing period of six months rather than twelve (the loan
was to be taken out for 12 months, starting in 6 months time).
The majority of candidates failed to calculate the implications of not hedging the borrowing and so
comparisons were difficult.
A significant number of candidates abandoned the option when LIBOR was 5% because they
compared 5% v 6.5% instead of 7% v 6.5% i.e. they failed to recognise that the company was
borrowing at LIBOR + 2% pa.

Very few candidates spotted that the swap was irrelevant because it was a short-term borrowing
(i.e. 12 months).

Total possible marks 9

Maximum full marks 9

1.2
(a) Currency futures contracts
Dollars will be purchased. Therefore sell on futures exchange.

Contracts to be sold = 4.8m/1.5095/62,500 = 50.9, (round to 51 [or 50])

At 31/1/17 Buy futures at 1.4945

Sell futures at 1.5095
Profit 0.015 x 51 x $62,500 $47,813

$
Cost of consignment (4,800,000)
Profit on futures 47,813
Net cost (4,752,187)
Net cost at spot rate (31/1/17) ($4,752,187)/1.4895 (3,190,458)

(b) OTC currency option

If the spot rate at 31/1/17 was $1.4895 then the option would be exercised.

A call option would be used (i.e. at $1.5020/)

Receipt in sterling would be $4.8m (3,195,739)

1.502

plus: Option premium 4.8m x 0.011 (52,800)

(3,248,539)

(c) Forward contract

Payment in sterling $4.8m $4.8m (3,191,913)
(1.5150 0.0112) 1.5038

plus: Arrangement fee 4.8m x 0.004 (19,200)

(3,211,113)

(d) Money market hedge

Payment in sterling would be $4.8m $4.8m $4,743,083 lent
[1 + (3.6%/3)] 1.012

Converted at spot rate $4,743,083 (3,130,748)

1.5150

Borrowed at 6.9% p.a. 3,130,748 x (6.9%/3) (72,007)

(3,202,755)

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 Professional Level Financial Management - September 2016

Most candidates answers to part 1.2 were very good, but the most common errors noted were:
Currency futures many chose the wrong date for calculating the number of futures contracts, bought
futures instead of sold them and calculated the profit on the futures trade in instead of $.
OTC currency options far too many candidates exercised puts rather than calls.

The forward contract calculations were generally very good as were those for the money market hedge.
The main stumbling blocks with the latter were (1) choosing the wrong interest rate and (2) using three
months rather than four.

Total possible marks 13

Maximum full marks 13

1.3

Sterling payment at spot rate 30/9/16 4.8m (3,168,317)

1.5150

Sterling payment at spot rate 31/1/17 4.8m (3,222,558)

1.4895

The forward contract premium suggests a strengthening of the $. A weaker means a higher payment
and vice versa for a stronger .

Order (cheapest first)

Spot at 30/9/16 3,168,317
Currency futures contracts 3,190,458
MMH 3,202,755
Forward contract 3,211,113
Spot at 31/1/17 3,222,558
OTC option 3,248,539

Thus three of the four hedging results lie between the two spot rates.

The futures contracts give gives best outcome (lower than the MMH, FC and OTC). However, if the dollar
were to weaken by January 2017 (against expectations) then it might be best to not hedge at all.

Option gives flexibility (abandon, upside) unlike MMH or FC (fixed, binding, no upside/downside). Futures
contracts can be cheaper (lower transaction costs), but contracts cannot be tailored to users exact
requirements.

The directors attitude to risk is important.

The advice given by candidates on the foreign exchange hedging in part 1.3 was generally good, but, if
candidates did not calculate the relevant spot rates then they will have lost marks. The performance of
overseas candidates in this section was, overall, very poor.

Total possible marks 8

Maximum full marks 8

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 Professional Level Financial Management - September 2016

Question 2

Total marks: 35

General comments
This question had, marginally, the lowest percentage mark on the paper. The majority of candidates
achieved a pass standard in the question, however.

This was a five-part question that tested the candidates understanding of the financing options element of
the syllabus. It was based around a UK engineering company which was planning to diversify into the UK
fracking industry. As a result various calculations regarding its current and future cost of capital were
deemed necessary. Part 2.1 of the question, for 13 marks, required candidates to calculate the current
weighted average cost of capital (WACC) of the company using (1) the dividend growth model and (2) the
CAPM. In part 2.2, for three marks, candidates were asked to explain whether the company should
continue to use its existing hurdle rate for its decisions on large-scale investments. Part 2.3, for five marks,
required candidates to explain the underlying logic of employing the CAPM within a WACC calculation.
Part 2.4 was worth ten marks. Here, candidates were tested on their ability to re-work their CAPM
calculations, which was necessary because of the companys proposed diversification into fracking, which
would alter the level of systematic risk. Finally, in part 2.5, for four marks, candidates were asked to
explain the circumstances in which it would be appropriate to use the adjusted present value approach to
investment appraisal.

2.1(a)

Ordinary dividend per share in 2016 (3,797,500/15,500,000) 24.5 pence

Ordinary dividend growth rate = 0.201/0.245, which over four years 5% p.a.

Cost of equity (ke) = (d1)+g (0.245 x 1.05) + 5% 9.95%

MV 5.20

Cost of preference shares (k p) d = (540,000/9m) 0.06 5.55%

MV 1.08

Cost of redeemable debt (kdr)

Year Cash Flow 2% factor PV 3% factor PV
0 (103.00) 1.000 (103.00) 1.000 (103.00)
1-3 4.00 2,884 11.54 2.829 11.32
3 100.00 0.942 94.20 0.915 91.50
NPV 2.74 NPV(0.18)

IRR = 3% - (0.18/(2.74 + 0.18)) = 2.94%

less: Tax at 21% (2.94% x 79%) = 2.32%

Cost of irredeemable debt (k di) 5 x 79% 4.11%

96

WACC
Total MVs
000 Cost x weighting WACC
Equity 15.5m x 5.20 80,600 9.95% x 80,600/106,615 7.52%
Pref. shares 9m x 1.08 9,720 5.55% x 9,720/106,615 0.51%
Red. debt 6.5m x 103/100 6,695 2.32% x 6,695/106,615 0.15%
Irred. debt 10.0m x 96/100 9,600 4.11% x 9,600/106,615 0.37%
26,015 1.03%
Total market value 106,615 8.55%

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 Professional Level Financial Management - September 2016

Most candidates did well in part 2.1, but common errors were:
Inaccurate (and, at times, inappropriate) calculations of the dividend growth rate.
Not using the market value (MV) when calculating the cost of preference shares.
For the cost of redeemable debentures - not using the ex-interest MV, choosing four years to
redemption rather than three, inaccurate IRR calculation from NPVs.
Irredeemable debentures - not using the ex-interest MV, using the post-tax coupon rate as the cost of
debt.
Combining the costs of the redeemable and irredeemable debt, rather than treating them separately.

Total possible marks 11

Maximum full marks 11

2.1(b)

Cost of equity (1.2 x (9.5%-1.9%)) + 1.9 = 11.02%

Weighted cost of equity 11.02% x 80,600/106,615 8.33%

Weighted cost of debt (as above) 1.03%
WACC 9.36%

This part was done very well. Only a few candidates failed to calculate the CAPM correctly.

Total possible marks 2

Maximum full marks 2

2.2

Roper is using 7% as its hurdle rate. In fact a more accurate figure would be 8.55% (say 9%) or 9.36%
(say 10%). This means it could be making poor investment decisions. If it takes on a project with an IRR of
8% this will be destroying shareholder value as the IRR is < the companys cost of capital.

Part 2.2 was generally well answered and most candidates were able to identify the key issue i.e. Roper
could be making poor investment decisions.

Total possible marks 3

Maximum full marks 3

2.3

CAPM theory:
Systematic vs unsystematic risk and portfolio theory
Beta a measure of systematic risk against market average
CAPM gives an alternative cost of equity which is used to calculate the WACC

In part 2.3 too few candidates answered the question fully and concentrated more on a discussion of de-
gearing/re-gearing.

Total possible marks 5

Maximum full marks 5

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 Professional Level Financial Management - September 2016

2.4

New market geared beta = 1.9

New market ungeared beta = 1.9 x 90 (1.9 x 90) 1.56

(90 + (25 x 79%)) 109.75

Better Deals geared beta = 1.56 x (80.600m + 9.720 + (16.295m x 79%)) 2.00
80.600m

So, cost of equity = (2.00 x (9.5%-1.9%)) + 1.9 = 17.1%

Cost of debt = 6% x 79% 4.74%

WACC = (17.1% x 80,600/106,615)) + (4.74% x 26,015/106,615)) = 14.09%

It would be unwise to use the existing WACC (9.36%) as Ropers plan involves diversification and
therefore a change in the level of systematic risk. Thus a new WACC must be calculated. Systematic risk
is accounted for by taking into account the beta of the petroleum market and this is then adjusted to
eliminate the financial risk (level of gearing) in that market. The resultant ungeared beta is then re-
geared by taking into account the level of gearing of the new funds being raised.

Cost of new debt (which is higher than existing because of the increased risk discussed above) is used.

Using this, the new WACC can be calculated.

In this part the de-gearing/re-gearing calculations were mostly done well, but too many candidates
explanation of their approach here concentrated on how rather than why it was done.

Total possible marks 10

Maximum full marks 10

2.5

Adjusted PV (APV) if the capital structure changes maybe the cost of capital will as well (M&M 63). If
new debt is raised to finance/part-finance a new investment, what is the new cost of capital? To find this
one needs to know the new MV of the companys shares and to know this one needs to know the NPV.
This cant be calculated without the new cost of capital. So its a conundrum unless a simplifying
assumption is made as in this question i.e. the finance is issued in such a way as to leave the gearing
unchanged.

Thus use the APV approach:

1. Calculate the base cost of the project assume that the company is not geared.

2. Calculate the PV of the tax shield (tax saved via interest payments)

Combine 1 and 2. If APV is positive, then proceed and vice versa.

Part 2.5 was, overall, done well and candidates demonstrated a reasonable understanding of APV

Total possible marks 4

Maximum full marks 4

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 Professional Level Financial Management - September 2016

Question 3

Total marks: 35

General comments
Most candidates demonstrated a good understanding of this area of the syllabus.

This was a three-part question that tested the candidates understanding of the investment decisions
element of the syllabus and there was also a small section with an ethics element to it. In the scenario a
software development company was considering investing in a company that designs games for use on
computers and mobile phones. Candidates were given financial information relating to the target company.
Part 3.1 was worth 14 marks and required candidates to calculate the value of one share in the target
company using five different valuation methods. In part 3.2, for ten marks, candidates had to explain,
making reference to their previous calculations, the advantages and disadvantages of using each of the
valuation methods. In part 3.3, for eight marks, candidates were required to explain the reasoning
underpinning the shareholder value analysis (SVA) method of valuation. They also had to explain whether
SVA could be used to value this particular target company, bearing in mind the information provided.
Finally, in part 3.4, for three marks, candidates had to explain the ethical issues arising for an ICAEW
Chartered Accountant who is privy to price-sensitive information which is not in the public domain.

3.1(a)
Per share
Net Assets (historic cost) 4,998 10.00
500

Net Assets (revalued) (4,998 + 3,150 + 3,370 2,400 3,200) 5,918 11.84
500 500

P/E ratio (2,227 x 10) 22,270 44.54

500 500

Less (say) 30% for lack of marketability of shares 31.18

Dividend yield (740/8%) 9,250 18.50

500 500

Less (say) 30% for lack of marketability of shares 12.95

PV of future cash flows y/e 2017 y/e 2018 y/e 2019 Total
000 000 000 000 000
Pre-tax cash profits 2,900 3,000 3,100
Tax at 21% (W2) (574) (601) (521)
Net cash flow 2,326 2,399 2,579
x x x
12% factor 0.893 0.797 0.712
PV 2,077 1,912 1,836 5,825

Post 2019 net cash inflows 2,000

Discounted to infinity x 1/12%
16,667
Discounted to PV from 2019 x 0.712
11,867
Total PV of future cash flows 17,692

17,692/500 35.38
W1
WDV b/f 920 754 618
WDA @ 18%/Bal All (166) (136) (618)
WDV c/f 754 618 0

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 Professional Level Financial Management - September 2016

W2
Pre-tax cash profits 2,900 3,000 3,100
WDA/BA (W1) (166) (136) (618)
Taxable profits 2,734 2,864 2,482

Tax due at 21% (574) (601) (521)

Generally this was answered well. Common errors noted were:

A surprising number of candidates were unable to calculate the share value based on the net asset
basis (historic cost), but were able to calculate it with the net asset basis revalued).
The P/E and dividend yield valuations were generally done very well.
Most candidates scored well using the PV of future cash flows method of valuation.

Total possible marks 14

Maximum full marks 14

3.1(b)

Net Assets (historic cost) tends towards low historic values, so an undervaluation. Intangibles are
ignored. Earnings potential and future earnings are ignored.
Net Assets (revalued) as above except that the asset values used are at least current.
P/E ratio - Looks at earnings. Will it be a majority stake? If so, then control will be gained, so shares for
this controlling stake should cost more. In this scenario it gives a much higher value than assets.
However are these earnings stable into the future? Is the company over-reliant on the two
successful games from 2013? Future earnings - are there new games planned? Will they be
successful?
Dividend yield this is based on dividend income and is applicable where its to be a minority stake. Are
these dividends stable? Will there be dividend growth?
PV of future cash flows - considers cash flows not profits and estimates forwards. These are large
estimates, especially the terminal value. Is it over-reliant on the two successful games (as above)?
Overall - a value close to 30/share should be a minimum price.

Candidates discussion was limited to mainly knowledge few considered whether the techniques were
suitable for a majority/minority holding despite being guided in that direction in the question. The vast
majority of candidates ignored the elephant in the room, i.e. the fact that the target companys computer
games had a limited life of three to five years and the successful games were three years old.

Total possible marks 10

Maximum full marks 10

3.2
SVA is an alternative method of calculating the value of a company, based on future cash flows & seven
value drivers. These value drivers can, in most cases, be managed by the company and so the influence
of company strategy will be evident.

Value driver Information available

Length of project Yes
Sales growth rate Implied
Profit margin Implied
Fixed assets investment Implied
Working capital investment No
Tax rate Yes
Discount rate Yes

In general candidates understanding of the theory of SVA was good, but too few were able to explain
adequately whether it could be used in this particular scenario.

Total possible marks 8

Maximum full marks 8

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 Professional Level Financial Management - September 2016

3.3

An ICAEW Chartered Accountant should assume that all unpublished information about a prospective,
current or previous clients or employers affairs, however gained, is confidential. That information should
then:
Be kept confidential
Not disclosed, even inadvertently such as in a social environment
Not be used to obtain personal advantage

Candidates understanding of the ethical issues was generally good.

Total possible marks 3

Maximum full marks 3

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