(a) (ii) There are some problems with the DVM s underlying assumptions, as follows:

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1 MARK PLAN AND EXAMINER S COMMENTARY Financial Management - Professional Stage December 2011 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: 2 A question that exposed weaknesses in both technical knowledge and in the ability of candidates to reflect accurately on the methodologies they have employed. (a)(i) Ordinary shares K e = D 0 (1 + g) / P 0 + g K e = 0.10( )/( ) K e = 8.7% MV e = 138.9m (ex-div share price 231.p x 0m) 5% irredeemable preference shares K p = D / P 0 K p = 5 / x 100 K p =.83% MV p = m ( x 25m) 9% redeemable loan stock Cashflows 1%df PV 5%df PV T 0 Ex-interest market price (117.00) 1 (117.00) 1 (117.00) T 1-7 Interest (after-tax 9 x 0.72) T 7 Repayment of capital (8.1) K d = {(19.90/( ) x 0.0} K d = 3.8% MV d = 23.m WACC (MV e x K e ) + (MV p x K p ) + (MV d x K d ) / MV e + MV p + MV d (12,089, ,29, ,200) / 188,235,000 WACC = 7.5% (a) (ii) There are some problems with the DVM s underlying assumptions, as follows: 1. Shares have value because of the dividends, which is not always true some firms have a deliberate policy of no or low dividend payouts, which would render any valuations using the methodology rather unrealistic 2. Dividends do not grow or grow at a constant rate, but the former is unrealistic, and whilst the latter may be realistic in the long term it can be subject to short-term fluctuations which undermine calculations of the cost of equity 3. Estimates of dividend growth rates tend to be based on historic patterns rather than the actual future facing the firm and its likely future earnings, consideration of which might produce more meaningful cost of equity calculations. Share prices are constant, which is clearly not the case In the first section, the most common error in calculating the cost of equity was failure to deduct the dividend from the cum-dividend share price. In calculating the cost of the irredeemable preference shares, many candidates incorrectly incorporated tax into their answers. Most candidates coped well with the remaining sections of this part of the question Copyright ICAEW All rights reserved Page 1 of

2 (b) 1. There may be changes in future sources of finance or capital structure 2. The new project may be in a different risk class to the firm s existing activities 3. The tax rate may alter during the course of the project. There may be changes in the dividend growth rate in future 5. The finance for the new investment may be project-specific The vast majority of candidates picked up the first two marks here but a much lower number went on to pick up either of the last two marks. 5 (c) 1. The cost of equity indicates the shareholders required rate of return and so acts as a minimum required rate of return for investment projects 2. Knowledge of the cost of equity enables managers to determine which prospective projects should be accepted and which should be rejected based on the shareholders minimum required rate of return 3. Knowledge of the cost of equity enables managers to make investment decisions that maximise shareholder value. Managers can use knowledge of the cost of equity in their financing decisions Generally well answered. (d) In theory, according to Modigliani and Miller (with taxes) the larger loan stock issue should lower the firm s WACC and increase shareholder wealth as the value of the additional tax relief is transferred to the shareholders However, in practice, financial risk may increase as the existence of greater fixed return commitments would have the effect of making returns to shareholders more variable without any alteration in business risk Taken to high levels the risk of bankruptcy could adversely affect share prices and actually lower shareholder value, ultimately to a greater extent than the tax relief would increase it (as also evidenced in traditional theory) Appropriate reference to the following issues was also rewarded: Agency costs Tax exhaustion Generally well answered. 8 Copyright ICAEW All rights reserved Page 2 of

3 Question 2 Total Marks: 28 Very much the question most to the liking of the majority of candidates sitting the paper. (a) Revenue (W1) 5,005,800 8,593,290 10,21,30 Port charges (11,820) (80,233) (85,0) Administration costs (111,20) (190,92) (23,029) Labour costs (18,000) (3,50) (55,3) Advertising (123,00) (127,308) (131,127) Servicing/maintenance (103,000) (10,090) (109,273) Pre-tax net cash flow 3,38,10,92,157 8,23,801 Tax (28%) (92,79) (1,873,80) (2,1,) Subsidy 250,290 29,5 Ferry purchase/disposal (8,000,000),000,000 Capital allowances (W2) 8, ,00 28,720 2,880 Post-tax net cash flow (7,552,000) 3,08,151 5,53,738 10,23,017 Discount factor (W3) PV (7,552,000) 2,722,072,311,51 7,037,22 NPV,518,895 Omission of the 18,000 annual interest charges Omission of the 3,000 consultancy fee Positive NPV, therefore accept the project W1: Sales revenue 2013: 50 x 100 x 90 =,80,000 x : 720 x 125 x 90 = 8,100,000 x : 720 x 150 x 90 = 9,720,000 x W2: Capital allowances 2012: 8,000,000 WDA 1,00,000 (20%) Tax saving (28%) 8, :,00,000 WDA 1,280,000 (20%) Tax saving (28%) 358,00 201: 5,120,000 WDA 1,02,000 (20%) Tax saving (28%) 28, :,09,000 Proceeds,000,000 Balancing allowance 9,000 Tax saving (28%) 2,880 W3: Discount factors 2013: 1/(1.1 x 1.03) = : 1/(1.1 x 1.03) 2 = : 1/(1.1 x 1.03) 3 = There were very many instances of full marks on this part of the question. Where candidates did fall short of that, however, it tended to be as a result of one or more of the following errors: 1. Including irrelevant costs (interest charges and the consultancy fee). 2. Correctly calculating capital allowances but starting them in 2013 rather than Choosing to completely omit the effects of inflation on cash flows.. Failing to adjust the discount factors correctly to reflect the impact of inflation. Candidates must also take care, when giving their final recommendation, to not only state what their recommendation is (too many candidates fail to do even this), but to specifically state why (i.e. positive NPV, increase in shareholder wealth) in order to gain full marks Copyright ICAEW All rights reserved Page 3 of

4 (b) (i) PV of sales revenue: Rev 5,005,800 8,593,290 10,21,30 Tax (1,01,2) (2,0,121) (2,973,9) Sub 250,290 29,5 NCF 3,85,,1,83 7,7,30 df PV 3,01,952 5,15,51 5,257,5 NPV 13,81,012 Sensitivity = Project NPV/PV of the uncertain cash-flow x 100 Sensitivity =,518,895/13,81,012 x 100 = 7.2% The PV of sales revenue could fall by 7.2% before the NPV = 0 (ii) Even if the residual value of the ship fell to zero (its maximum possible fall which would reduce the project s NPV by {0.875 x m} alongside which there would be an increase in the balancing allowance of 1.12m) the project would still retain a positive NPV The NPV is, therefore, not at all sensitive to changes in the residual value of the new ship This part of the question was, again, generally well answered although taxation and the subsidy were often omitted from answers to section (i), thereby losing half the available marks. In the second section, even without making any calculations at all, it should have been apparent that the project was not at all sensitive (in the traditional sense of generating an NPV of zero) to a fall in the estimated residual value of the ship. (c) Advantages: It enables any number of variables to be amended simultaneously, unlike sensitivity analysis which changes just one variable at a time It gives more information about the possible outcomes and their relative probabilities It is useful for problems which cannot be solved analytically (ie. those that cannot be reduced to a precise mathematical solution) Limitations: It is not a technique for making a decision, only for obtaining more information about the possible outcomes It can be expensive and very time-consuming with or without a computer Some simulations depend on assumptions regarding probability distributions and the relationships between variables that may not be appropriate in a given scenario It is difficult in practice to implement Generally well answered, although some candidates insisted on discussing either sensitivity analysis or NPV analysis instead of simulation. The answer was drawn directly from the learning materials and consequently rewarded those candidates who had learnt them too many hadn t. 7 5 Copyright ICAEW All rights reserved Page of

5 Question 3 Total Marks: 28 Performance on this question was generally satisfactory, although as has been the case in the past, it polarised performance between those with a firm grasp of the material (who scored strongly) and a significant minority who have little grasp at all of the mechanics of the subject. (a)(i) 1.170/ x 95% = / 35,000,000/ = 31,328,321 (a)(ii) Bank buys (sells ) at = 1.173/ 35,000,000/1.173 = 29,827,851 (a)(iii) Borrow 35, /1.01 = 3,53,5 Convert 3,53,5/1.170 = 29,7,232 x ( ) = 29,798,738 Effective forward rate = 35,000,000/29,798,738 = 1.175/ (a)(iv) The real cost of the up-front premium is 100,000 x = 101,125 If the spot rate is 1.1/ The amount received at spot is 35,000,000/1.1 = 30,701,75 compared to 29,91,530 under the option so the option will not be exercised The net receipt will be 30,00,29 If the spot rate is 1.20/ The amount received at the exercise price is 35,000,000/1.17 = 29,91,530 compared to 29,1,7 at spot so the option will be exercised The net receipt will be 29,813,05 (a)(v) The principle of interest rate parity holds that, when foreign exchange markets are in equilibrium, the forward premium or discount between two currencies is reflective of the interest rate differential between the two countries differences in interest rates are offset by differences between the spot and forward rates of exchange, such that an investor would be indifferent between investing one currency at that country s interest rate or converting the currency at spot into a second currency and investing that second currency at its country s interest rate, whilst selling the proceeds forward on day one Using average spot ({bid+offer/2)} and interest rates, IRP suggests x ( (euro)/ (UK)) = ie. a forward premium of = or 0.29 cents Average premium in data given is 0.30 so IRP very nearly holds (which is why the forward and money market hedges give similar results) (a)(vi) Economic exposure is the risk that longer-term exchange rate movements might reduce a firm s international competitiveness or its value Translation exposure is the risk that a firm will incur exchange losses when the accounting results of its foreign branches or subsidiaries are translated into the firm s home currency (a)(vii) 1. International diversification of sales, production, supplies and finance sources 2. Market and promotional management (balancing market risks and potential) 3. Product management decisions (launch, drop, not launch etc. in response to actual and anticipated exchange rate changes). Pricing management decisions (in response to actual and anticipated exchange rate changes) Copyright ICAEW All rights reserved Page 5 of

6 In the first part of the question, the majority of candidates betrayed their lack of understanding of depreciation of a currency - a reduction in its purchasing power, not an increase as most candidates suggested when they multiplied the spot rate by The second part posed less problems for candidates, although a small number continued to add rather than deduct the forward premium. The third part of the question was generally well answered. Part four however proved more of a challenge. Disappointingly, many candidates chose to address this question as if they were dealing with a traded option rather than an over-the-counter option. The vast majority of candidates also understated the premium at 100,000. In the following part, there was a generally firm grasp of IRP theory although few scripts gained full marks due to a lack of detail and, very often, a failure to answer the precise question asked. There was a very mixed response to part six for the most part either full marks or none at all, whilst part seven had very few good answers too many candidates listed a range of short term measures and scored zero marks (b)(i) Value of portfolio as at 31 December = 8,000,000 Spot value of FTSE 100 index = 5,000 Value of each point = 10 Therefore, value of a contract = 50,000 Therefore, number of contracts required is 8,000,000/50,000 = 90 Futures position: In December the investor sells 90 September In September the investor buys 90 September Therefore, the drop in price of the FTSE index futures = 100 points Value of futures gain = 100 x 10 x 90 = 90,000 Overall position in September: Value of portfolio,980,000 Gain on futures 90,000 Overall position 7,90,000 (b)(ii) Efficiency: gain on futures/loss on portfolio = 90,000/1,020,000 x 100 = 9.1% The hedge inefficiency arises due to the incidence of basis risk A surprising number of candidates calculated the value of a single contract incorrectly. In addition, in the final part of the question too many candidates referred to standardised contract sizes (not an issue in this case) rather than basis risk (which was the issue here). The majority of candidates also calculated the hedge efficiency incorrectly, failing to use the approach adopted in the learning materials. (c)(i) Fulton needs to use a 3 9 FRA at 2.9% If the rate is 3.5%, the bank will pay Fulton 12,150 ( 3m x {3.5%-2.9%} x /12) Fulton will pay 52,500 on its loan at the market rate ( 3m x 3.5% x /12) Net payment on the loan is 0,350 (= 2.9%) (c)(ii) If the rate is 1.5%, Fulton will pay the bank 17,850 ( 3m x {1.5%-2.9%} x /12) Fulton will pay 22,500 on its loan at the market rate ( 3m x 1.5% x /12) Net payment on the loan is 0,350 (= 2.9%) The majority of candidates knew what to do here and did it accurately. However, even some of the candidates who knew this area of the syllabus let themselves down by either failing to answer the question, which specifically asked for a calculation of interest cash flows (not merely a statement of interest rates) and/or working with full-year rather an six-month figures. Copyright ICAEW All rights reserved Page of