Examiner s General Comments

Transcription

1 Examiner s General Comments Section A (one compulsory question) Question One focuses on the valuation of a proposed acquisition company. This is a key syllabus area and tests the ability to apply and understand core valuation models based on actual selling price, asset values, P/E ratio of acquirer (bootstrapping) and discounted cash flow analysis. The question also examined the strategic and financial implications of the acquisition and alternative forms of consideration. The discounted cash flow analysis was generally addressed well, but many candidates appeared to be less familiar with alternative methods and struggled to evaluate the consideration proposals. Section B (choice of two from three questions) The optional questions provided a broad coverage of the syllabus, ranging from cost of capital and the role of treasury in Question Two to the determination of share prices, dividend policy and lease versus buy decisions in Questions Three and Four. Some of the strengths shown by candidates in Section B included: Ability to ungear and regear betas. Calculation of the weighted average cost of capital. Understanding key share price drivers. Discounted cash flow analysis. Key weaknesses included: Understanding of the meaning of beta and systematic risk. Evaluation of dividend strategies from the viewpoint of shareholder wealth. Evaluation of a finance lease versus buy/borrow alternative. Use of Computer There was a marked disparity in the way candidates used EXCEL in this exam. Many candidates did not appear to realise that it is quite acceptable to type a formula directly into a cell and spread formulae over up to a dozen cells, gradually building up the answer. This creates a long audit trail that is time consuming to construct and to mark. This was a common approach in the calculation of WACC in Question Two (a). Note that it was sufficient to type the formula into a single cell, saving a huge amount of time and allowing EXCEL to calculate the answer. The Chartered Institute of Management Accountants

2 Please turn over this page for Question One The Chartered Institute of Management Accountants

3 Question One Required: Assume that you are an external consultant advising the Board of P on the proposed acquisition. Write a report addressed to the directors of P in which you: (a) (i) Calculate a value for H s equity as at 1 April 2014 using each of the following methods: Private sale Asset basis P/E basis DCF at P s WACC DCF using certainty equivalents (14 marks) (ii) Advise P on: The validity of the valuation methods used in part (a)(i). TWO additional valuation approaches that could be used to take risk into account. (10 marks) (b) (i) Evaluate EACH of the forms of consideration A and B taking into account the impact on: P s debt covenant P s shareholders H s shareholders Up to 6 marks are available for calculations. (12 marks) (ii) Recommend how P should structure the bid offer. (4 marks) (c) Advise P of THREE key financial and strategic implications of the proposed acquisition of H. (7 marks) Additional marks available for structure and presentation: (3 marks) (Total for Question One = 50 marks) The Chartered Institute of Management Accountants

4 Rationale Question One focuses on an external party, a hotel chain, which is hoping to set up a hotel in the vicinity of the Games Park in advance of the Games. It requires an evaluation of a possible takeover candidate and the risks and opportunities that such an acquisition might create. The question concludes by considering how best to structure the consideration package, taking into account the impact on the acquirer and also the shareholders of both the acquirer and the target company. Question One tests syllabus areas A2(d), C1(c),(d) and C2(a). Suggested Approach Part (a)(i) requires a valuation of the target company on a number of different bases. Efficient use of EXCEL can help with this process. Keep workings simple and, preferably, build them into the spreadsheet itself. Remember that formulae can be typed straight into a cell markers mark on PC and can therefore uncover the formula used. When carrying out the DCF analysis using certainty equivalents, either pick up the net cash flow figures from the first DCF calculation and use this as your starting point, or, possibly quicker still, copy and paste the whole of the initial DCF calculation and then make appropriate changes to that table. Don t forget to deduct borrowings from your DCF result to obtain the equity value. In part (a)(ii), consider the validity of each method in turn. Then identify two alternative valuation approaches, explaining the advantages of each one. In part (b)(i), begin by carrying out appropriate calculations such as gearing under payment structures A and B and the value of the share offer at today s share price as compared to the cash offer. Then consider each bullet point in turn. In part (b)(ii), summarise your findings in (b)(i), stating which scheme would be preferable and why. Then think about any possible alternatives, e.g. a combination of the two schemes where H s shareholders are offered a choice of cash or shares in the hope that at least some of them would choose shares. In part (c), consider the bigger picture and longer timeframe, picking out three (and no more than three) key financial and strategic implications of the proposed acquisition of H. Don t forget to consider real options in this section. The Chartered Institute of Management Accountants

5 Marking guide (a)(i) (a)(ii) (b)(i) (b)(ii) Calculate DCF Renovations and tax depreciation 2.0 Operating revenue and costs 3.0 Tax on net operating cash flow 1.0 Discounting DCF using Certainty equivalents Apply CEs 1.0 Discount at risk free rate Other valuation methods Private sale 1.0 Asset basis 1.0 P/E approach (bootstrapping) Maximum for part (a)(i) Up to 2 marks per valid point Validity of methods Private sale Asset basis Bootstrapping DCF with and without CEs Two alternative valuation methods Risk-adjusted discount rate Probabilities/decision trees Maximum for part (a)(ii) Calculations (including gearing) max 6.0 Evaluation of schemes A and B Up to 2 marks per valid point P s debt covenant P s shareholders H s shareholders max 9.0 Maximum for part (b)(i) Recommendation Maximum for part (b)(ii) 14 marks 10 marks 12 marks 4 marks (c) Up to 3 marks per valid issue up to a maximum of 3 issues Key issues include: Enhanced global image as a result of being associated with the Games. Financial challenges due to large cash demand. Uncertainties involved in the estimates used to value the project. Real options. Maximum for part (c) 7 marks Structure and presentation 3 marks Total for Question One = 50 marks The Chartered Institute of Management Accountants

6 Examiner s comments on Question One Part (a) was generally handled satisfactorily. Common errors were: Adding debt to the value of equity in the private sale. Ignoring liabilities when using the Asset basis. Incorrect tax depreciation allowances (TDA) in the DCF calculations, or treating the TDA itself as a cash flow, including the whole TDA above the tax calculation but failing to subsequently deduct the TDA from the cash flow analysis. Ignoring the perpetuity or simply dividing by the discount rate of 8% and overlooking the need to then discount back to the present time from year 6. Using WACC rather than the risk free rate in the certainty equivalents analysis. Inappropriate additional approaches suggested. Note that no credit was given for discussion of the dividend valuation model in this context. Part (b) was often not attempted at all. Common errors were: Incorrect gearing calculations in the evaluation of the debt covenant; either using market values or, in a few cases, making things worse by adding reserves to market values. Absence of any calculations apart from gearing. Part (c) was often not attempted, or very briefly. Many candidates repeated much of the answer they had given in part (b)(ii), advising on an appropriate bid offer price rather than the broader financial and strategic implications of the proposed acquisition as was clearly stated in the requirement. The Chartered Institute of Management Accountants

7 Question Two Required: (a) Explain: The meaning of an equity beta that is greater than 1. What key factors determine a company s equity beta. (7 marks) (b) (i) Explain to the trainee accountant the FOUR errors in his computation. (5 marks) (ii) Produce a corrected calculation of VV s WACC based on proxy company ZZ s equity beta. (5 marks) (c) Advise VV on the role of the treasury department in the evaluation and implementation of Project X. (8 marks) (Total for Question Two = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Rationale Question Two tests understanding and application of CAPM to derive a WACC in the context of a project. A particular focus is the meaning and interpretation of the equity beta value used in CAPM. The question tests analytical ability by requiring candidates to review a given computation and identify and correct the errors it contains. Question Two tests syllabus areas B1(c), B2(a) and C3(a). Suggested Approach In part (a), begin by explaining the significance of an equity beta greater than 1 in connection with the market as a whole. Then identify and then explain the key factors which determine a company s beta. In part (b)(i), work through the trainee accountant s computation to identify the four errors it contains and list these. Explain each error as if addressing the trainee accountant. In part (b)(ii), re-produce the WACC calculation, correcting each individual error identified above. In part (c), consider the main roles of the treasurer and how each might be required during both the evaluation and implementation stages of the project. Consider first the evaluation stage and then the implementation stage. The Chartered Institute of Management Accountants

8 Marking guide (a) Up to 2 marks each issue Meaning of beta value above 1 Meaning of beta value Implication of beta value above 1 Max 4.0 Factors that affect equity beta: Business risk for the industry sector in which it operates Financial risk Max 4.0 Maximum for (a) 7 marks (b)(i) (b)(ii) Identify four errors 2 marks for the missing debt beta 1 mark for each other error Maximum for (b)(i) Correct four errors 1 mark each Plus 1 mark for completing the computation Maximum for (b)(ii) 5 marks 5 marks (c) Up to 2 marks per valid issue: Evaluation Affordability WACC Capital structure Implementation Arranging funding Risk management/hedging Cash management issues Maximum for (c) 8 marks Total for Question Two = 25 marks Examiner s comments on Question Two This was the best answered of the optional questions and also the most popular. In part (a), a number of candidates confused systematic and unsystematic risk and failed to recognise that the equity beta is only concerned with systematic risk. Part (b) was generally well answered. Most candidates recognised the need to include a tax adjustment and debt beta. Surprisingly, the most common error was to incorrectly calculate the value of equity as the market capitalisation (share price x number of shares) plus reserves. It is clearly unnecessary to add reserves to the market value of shares. Reserves are only relevant when calculating the book value of equity. Part (c) was well answered and most identified the key points. A small minority confused the role of the treasury with that of a financial controller. The Chartered Institute of Management Accountants

9 Question Three Required: (a) Evaluate the market reaction to the government announcement, as evidenced by movements in LL s share price in the past week. Up to 3 marks are available for calculations. (7 marks) (b) (i) Evaluate each of dividend strategies A, B and C from the viewpoint of a typical shareholder who holds 120 shares in LL. Up to 6 marks are available for calculations. (11 marks) (ii) Advise LL which dividend strategy A, B or C to adopt, considering all relevant factors. (7 marks) (Total for Question Three = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Rationale Question Three tests understanding of the trade-off between investment, financing and dividend policies. It also tests the ability to interpret market price movements and hence company value as a result of the imposition of a regulatory constraint. This scenario allows candidates to evaluate alternative strategies for financing the capital expenditure forced on the company by a regulatory change, considering waiving a dividend versus a scrip dividend. Question Three tests syllabus areas A1 (b), (c) and 2 (d). Suggested Approach In part (a), there is a hint in the question that calculations are required and it is best to start with these. LL s market capitalisation can be calculated at the start and end of business on 21 February and also on 28 February. It is then a simple step to compare this with the extra cost arising from the regulatory change. This shows that the fall in market capitalisation exceeds the expected incremental costs. This observation should be clearly stated and then explained. Part (b)(i) can be addressed in a number of different orders. Perhaps the most logical is to look at each of the dividend strategies in turn. For each dividend strategy, begin by calculating shareholder wealth before and after the dividend and explain your findings. Next, consider the implications for LL, focussing particularly on the impact on its cash position. Dividend irrelevancy theory and the effect of tax differential between gains and income and also signalling issues can be useful when examining the impact on a typical shareholder. Avoid repetition by just covering these in detail once and just making reference to them in other parts of your answer. In part (b)(ii), summarise your findings in b(i) and provide a recommendation. The Chartered Institute of Management Accountants

10 Marking guide (a) Calculations (1 mark per separate calculation): 1 mark each max 3 marks Narrative answer up to 2 marks per valid issue Key issues: Pointing out that the fall in market capitalisation is greater than the capex estimate. Explanations of why the share price has fallen in the manner shown in the graph, Maximum for (a) 7 marks (b)(i) Up to 2 marks per valid issue Shareholder evaluation: Calculation of shareholder status in each case Other relevant issues: Dividend irrelevancy/tax assumptions Signalling issues Financial and strategic implications max 8.0 Maximum for (b)(i) 2.0 marks each max 6.0 marks in total 11 marks (b)(ii) Up to 2 marks per valid issue Advise which dividend strategy LL should adopt. Relevant factors Advice Maximum for (b)(ii) Total for Question Three = 25 marks up to 6 marks up to 3 marks 7 marks Examiner s comments on Question Three Question Three proved to be the least popular of the optional questions. Most candidates started well with a reasonable evaluation of the market reaction to a recent pricesensitive announcement. Candidates were rewarded for including calculations of the movement in share price and market capitalisation in money and/or percentage terms. Part (b) proved to be more of a challenge. Very few candidates recognised that the payment of a dividend simply transforms the nature of shareholder wealth, reducing the value of shares and increasing cash by the value of the dividend. Similarly, waiving a dividend or issuing a scrip dividend has no direct effect on shareholder wealth. Only a few candidates referred to the theory of dividend irrelevancy which would clearly support such a position. The Chartered Institute of Management Accountants

11 Question Four Required: (a) (i) Calculate the net present value (NPV) of the incremental financial benefit or cost of Scheme A in comparison with Scheme B. Use GG s cost of debt as the discount rate. (12 marks) (ii) Discuss the appropriateness of using GG s cost of debt to evaluate the financing decision. (4 marks) (b) Evaluate financing schemes A and B from the viewpoint of GG, taking all relevant factors into account. (9 marks) (Total for Question Four = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Rationale Question Four tests the ability to evaluate a lease versus buy decision. It requires a calculation of the incremental benefit of leasing versus outright purchase and understanding of the rationale for that calculation in respect of the choice of discount rate. The question also tests understanding of other factors that might affect the decision. Question Four tests syllabus areas B1 (b) and (d). Suggested Approach In part (a)(i), a preliminary calculation is required to calculate the implied interest charge under the lease for each year. A sum-of-digits approach is acceptable. However, as the question gives the implied interest rate of 9%, it is arguably faster to apply this interest rate to the outstanding balance year on year in this instance. The next step is to set out a table, labelling columns with item, data and then years. Relevant cash flows, including tax relief on payments can then be included here. An incremental benefit or cost is required, so payments under the buy/borrow scheme should have a different +/- sign to those under the lease. Remember to exclude actual interest costs. Only tax relief on implied lease interest is relevant here. In part (a)(ii), explain why GG s cost of debt has been used, distinguishing this financing decision from an investment appraisal analysis where a WACC-based discount rate would normally be more appropriate. In part (b), consider which of the two financing schemes appears to be the most cost efficient on the basis of your results in (a)(i) and then consider other distinguishing factors. The Chartered Institute of Management Accountants

12 Marking guide (a)(i) NPV calculation: Implied interest charge calculation 3.0 Asset purchase and tax relief 2.0 Lease payment 1.0 Tax relief on interest charge 1.0 Tax on depreciation 1.5 DCF 2.0 Correct timings of cash flows 1.0 Calculation of incremental benefit or cost Maximum for (a)(i) 12 marks (a)(ii) Up to 2 marks per valid issue Distinguish financing decision from investment decision Measuring opportunity cost of leasing against base line of bank debt Maximum for (a)(ii) (b) Up to 2 marks per valid issue Key issues, from the viewpoint of GG: Cost Timing of cash flows Ease of arranging finance Flexibility Residual value of equipment Maintenance Conclusion/summary of the evaluation (max 2 marks) Maximum for (b) 4 marks 9 marks Total for Question Four = 25 marks Examiner s comments on Question Four Many candidates were unable to distinguish between a finance lease and an operating lease, treating the finance lease as if, indeed, it was an operating lease. Specific issues included: Omission of implied interest calculation. Omission of tax relief on depreciation. Incorrect addition of interest in the borrow scenario. Discounting at the pre-tax cost of debt rather than the post-tax cost of debt. Lack of understanding that cost of debt IS the most appropriate discount rate to use in a financing decision. Lack of understanding about the difference between a financing decision and an investment decision. Misunderstanding of the accounting treatment of finance leases, incorrectly stating that the lease would not impact on gearing. The Chartered Institute of Management Accountants