Financial Pillar. F3 Financial Strategy

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1 DO NOT OPEN THIS QUESTION PAPER UNTIL YOU ARE TOLD TO DO SO. Instructions to candidates Financial Pillar F3 Financial Strategy Friday 28 February 2014 You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to begin using your computer to produce your answer or to use your calculator during the reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or subquestions). ALL answers must be submitted electronically, using the single Word and Excel files provided. Answers written on the question paper and note paper will not be submitted for marking. You should show all workings as marks are available for the method you use. The pre-seen case study material is included in this question paper on pages 2 to 6. The unseen case study material, specific to this examination, is provided on pages 8 and 9. Answer the compulsory question in Section A on page 11. This page is detachable for ease of reference. Answer TWO of the three questions in Section B on pages 14 to 19. Maths tables and formulae are provided on pages 21 to 25. The list of verbs as published in the syllabus is given for reference on page 27. Your computer will contain two blank files a Word and an Excel file. Please ensure that you check that the file names for these two documents correspond with your candidate number. F3 Financial Strategy TURN OVER The Chartered Institute of Management Accountants 2014

2 Pre-seen case study Introduction The Games is an international multi-sport event that is held within a region of the world every four years. It attracts competitors from 10 different countries within the region and is held at a different time from the Olympic Games. The Games are held in each of the countries within the region in turn. The next Games are scheduled to take place in Country C in October There are 25 sports included within the Games ranging from archery through to weightlifting. The Games were first held in 1979 and this is the first time that Country C has hosted them. Games Co-ordinating Committee (GCC) The Games Co-ordinating Committee was established to set out the framework within which the individual country organisations should work in delivering the Games. Membership of the GCC is drawn from all the countries within the region which take part in the Games. Its aim is to promote the Games throughout the region of the world in which the Games take place. It is also responsible for setting out the mission under which the Games are established in each country. Mission of the GCC The mission of the GCC is to: Encourage and promote ethical competition in sport; Encourage and co-operate with public and private organisations in the preparation for and staging of the Games; Achieve high levels of sustainability for the infrastructure of the Games and the environment in which they take place; Promote sport and healthy lifestyles amongst young people; Promote the Games values of excellence, unity and achievement. The mission of the GCC is untouchable in the sense that all who are involved in the Games, in whatever role, must adopt and promote it. Organisation of the Games within Country C In 2010, the Parliament in Country C passed an Act creating GAMESCO, a company limited by guarantee to organise and deliver the Games on time and within budget. GAMESCO also has responsibility for disposal of assets after the Games and selling any surplus land which is not retained for sporting purposes. The Minister of Sport in Country C and the elected Mayor of the city in which the Games are due to take place are the only two shareholders of GAMESCO. Governance of the Games is carried out entirely by GAMESCO. In carrying out this role, it co-ordinates the activities of all people and organisations engaged in preparing for and operating the Games and it is responsible for the subsequent liquidation of all the Games assets. The Government of Country C believes that the Games will provide a major boost to Country C by providing commercial opportunities for enterprises such as hotels and retail outlets and enabling the re-generation of the current dilapidated land on which the Games will take place. It is expected that the prosperity of Country C and, in particular, the whole area in which the Games will take place, will increase. Mission, Vision and Values of GAMESCO The Board of GAMESCO is committed to meeting the mission of the GCC. It has established its own mission and values as follows: Mission: To deliver the Games successfully on time and on budget in accordance with the expectations of our stakeholders and in accordance with the mission of the GCC. GAMESCO is responsible for preparing, operating and winding up the Games, all within its budget. Country C s Government provided capital to GAMESCO for building work to proceed. However, Country C s Government is clear that it does not intend to support the Games beyond the funding it March Financial Strategy

3 has already invested. This places a large responsibility on GAMESCO to ensure that its overall expenditure does not exceed the revenue it generates from its activities and the government grants it has received. Values: GAMESCO will work tirelessly towards achieving the mission set out by the GCC. In striving to achieve the GCC s mission, GAMESCO will act fairly and responsibly with all its stakeholders, in particular its employees and partners, in order to generate trust and transparency. GAMESCO s organisational structure GAMESCO has a Board of Directors comprising: Chairman, Chief Executive, Directors for Finance, Sponsorship, Operations, Marketing, Commercial Activities, Estates, Communications, Human Resources, Information Systems, Venues, Athletes Services, a representative from each of the Minister of Sport and the Mayor, a sports representative drawn from each of the sporting activities which will be competed in during the Games and a representative of the GCC. GAMESCO s financial structure and budget Country C s currency is C$. GAMESCO s financial structure is different from most commercial organisations. Under the Act of Parliament which set the company up, a provision was made that GAMESCO would not be subject to corporate tax. Revenue is generated by a mixture of government grants, sponsorships, ticket sales for the Games, rental of accommodation and broadcasting and other commercial fees. All capital works relating to the Games themselves, such as the athletics stadium, the cycling velodrome, the gymnastics arena and the swimming pool, are funded by government grants. However, construction of buildings for commercial activities such as cafes and restaurants is funded by the commercial organisations themselves and is not the responsibility of GAMESCO. The budget for the expected final cost of the Games is shown at Appendix 1. Project management An overarching supervisory consortium of experts in project management has been engaged by GAMESCO as an outsourced service. The role of the consortium is to prepare and monitor construction work on the whole of the Games Park site. The Games Park site will accommodate such buildings as the athletics stadium, the cycling velodrome, the gymnastics arena and the swimming pool. In addition, the consortium will ensure that utilities are installed, plans for construction works are approved, construction work progresses according to schedule and that contractors are able to access the site when building work takes place. GAMESCO employs independent project management teams with project managers responsible for each major building construction on-site. These project managers report directly to the consortium on the progress of the construction project for which they are responsible. An Information Systems Project Manager has been appointed by GAMESCO, whose role is to co-ordinate the provision of information systems on the site and to liaise with all the project managers on their information systems requirements for the construction projects for which they are responsible. A project management team has also been established to market the Games. All GAMESCO s marketing staff, with the exception of the Marketing Director, are attached to this project team. Service provision Professional architects, engineers and building companies are all engaged in developing the Games Park. In addition, land on which buildings will be erected must be clear of pollution. Utility services, such as water and electricity supplies to all venues involved with the Games are in the process of being provided. On the Games Park site itself, there will be a number of fast-food outlets, cafes and restaurants as well as ice cream parlours, sweet stores and souvenir shops. Hygiene facilities, such as toilets, will need to be provided. All of these will remain on-site for the duration of the Games and will be demolished afterwards. Some parks and gardens will be constructed within the Games Park. The parks and gardens will not be demolished but remain as amenities for the local population after the Games have finished. Financial Strategy 3 March 2014

4 Security for the Games will be tight. It is proposed that GAMESCO will engage a highly reputable security services contractor to provide security at all the Games venues, around the perimeter as well as within the grounds of the Games Park. It will be essential for the security contractor to engage sufficient staff to carry out this very large security service. Staffing While GAMESCO does employ its own staff, the majority of people working on-site are contractors. At present most of the activity being undertaken on-site is construction work. GAMESCO does employ its own Human Resource Management, Information Technology support and accounting staff. Senior staff and project managers are contracted for the duration of the Games and in some cases beyond. They are paid at a competitive rate. However, most staff are employed on temporary contracts on a month-to-month basis and generally receive relatively low pay compared with unskilled labour in Country C which has a high level of unemployment. When the Games begin, it is expected that most ancillary staff on-site, who will direct spectators to venues and facilities, will be volunteers. Many of these volunteers will take annual leave from their places of work in order to carry out this task. Sponsorship A major source of revenue for GAMESCO is sponsorship deals with major business organisations and this is therefore crucial to the successful staging of the Games. Sponsors are required to provide a guarantee of a minimum payment of C$ 1 million to GAMESCO. For this, sponsors become official partners of the Games and acquire marketing rights. This enables sponsors to build their brands and customer relationships, increase their revenue and enhance their own commercial reputation. Sponsorship can be divided into two types, direct and indirect. Direct sponsorship - gold sponsorship There are two levels of direct sponsorship, gold and silver. Gold is the highest level of sponsorship and gives sponsors major marketing rights. Gold sponsors are drawn from businesses such as electronic equipment suppliers, soft drink manufacturers and fast-food chains which can provide products and services to support the staging of the Games, in addition to providing a financial contribution. Gold sponsors are also expected to promote the Games by engaging in the development of sporting events across the region of the world in which the Games take place. For this, gold sponsors are entitled to use the Games logo on their products and services. Gold sponsors are required to engage in a range of activities to support the mission of GCC at the Games. See page 2 for details of the mission of the Games. Direct sponsorship - silver sponsorship Silver sponsors are only required to make a financial contribution to the staging of the Games. However, they too, are able to use the Games logo. Indirect sponsorship A form of indirect sponsorship which takes place when the Games are in progress is hospitality. Hospitality sponsorship relates to large businesses hiring facilities on-site in the Games Park to entertain their own customers and clients while the Games are in progress. These facilities mainly consist of hospitality rooms and boxes. The hospitality rooms and boxes in prestige venues, such as the athletics stadium, the cycling velodrome, the gymnastics arena and the swimming pool, will command a higher price on days when popular Games events are being held and also when medals are being awarded. Brand Leases One significant area of revenue generation is the opportunity for GAMESCO to lease its brand to all organisations engaged in supplying products and services to the Games. It is a condition for all goods and service suppliers that they must display the Games brand in all the venues in which they operate and in doing this, they incur a leasing charge which is directly payable to GAMESCO. In addition, any other organisation wishing to use the Games brand must also pay a leasing charge to GAMESCO for permission to do so. March Financial Strategy

5 Marketing GAMESCO has carried out considerable press and television advertising and intends to increase this as the Games draw closer in order to stimulate public enthusiasm and ticket sales. Television rights to broadcast the Games have been agreed and GAMESCO has invested in stocks of merchandise which it has distributed to retailers around Country C. Games Village The athletes will be accommodated in the Games Village which is located in the Games Park. The Games Village will consist of several purpose built blocks of accommodation which provide hotel services in respect of individual bedrooms with en-suite toilet and shower facilities. The Games Village will also have its own catering and laundry facilities, using locally contracted staff. The daily cleaning of the rooms will also be contracted out to a local company. The Games Village will provide a regular bus shuttle service for the use of athletes to and from the city centre in which the Games are being held and also to and from the airport. After the Games, the Games Village will be converted into apartments to house local people. Drug testing and medical facilities A specific building will be constructed to enable appropriately qualified experts to carry out internationally approved drugs tests on athletes. The drug testing facility will be located close to the medical centre which will be specifically built for treating the athletes. If any spectator requires medical attention beyond basic first-aid, he or she will be taken to the nearest hospital as will any athlete if he or she requires treatment which cannot be provided at the medical centre. After the Games have finished, it is expected that the medical centre will be converted into a health clinic which will provide services to local residents. Business opportunities and legacy Much has been made in Country C about the huge opportunities for local businesses and the legacy of the Games. There is a range of contracts and work being done or still to be undertaken by businesses in Country C. These include construction, land regeneration, the provision of utility supplies and catering facilities before and during the Games. After the Games have finished, there will still be much work particularly for construction companies in reinstating land and undertaking buildings alteration work. Construction works including hotels and shopping facilities are now planned to be built on derelict land and all will be within easy reach of the Games Park. The hotels and shopping facilities are particularly attractive to developers as it is expected that the regeneration of the land, parks, gardens and sports facilities which remain after the Games will attract visitors and tourists. A major legacy is that many new homes and amenities will become available after the Games. For example, the athletes accommodation in the Games Village will replace much sub-standard accommodation in which many local people are currently housed. The Government thinks that the Games, which will be televised across the region and in other parts of the world, will showcase the country in general, attracting visitors and businesses not just for the duration of the Games but afterwards as well. In addition to the economic benefits, the Government hopes that the Games will inspire the public in Country C to take more physical exercise which it anticipates will bring health benefits to the population. Some of the facilities which will be constructed for the Games, such as the cycling velodrome, the gymnastics arena and the swimming pool, will become available for public use after the Games, enhancing the amenities for the local population. Financial Strategy 5 March 2014

6 APPENDIX 1 Budget for the delivery of the Games Preparation of the Site and Infrastructure C$ million Power and utilities 550 Preparatory construction work 370 Structural work including access roads 760 Landscaping 250 Other preparation and infrastructural works 185 Total preparation of site and infrastructure 2,115 Venues Athletics stadium 500 Swimming pool 260 Cycling velodrome 50 Gymnastics arena 45 Venues operations control centre 20 Other Games Park venues 100 Total venues 975 Transport Transport capital projects 300 Transport operating costs 350 Total transport 650 Games Park Operations and Security Games Park Operations 220 Security for Games Park construction 240 Security during Games 70 Insurance 80 Total Games Park Operations and Security 610 Games Village and Media Centre Games Village construction 750 Media Centre construction 300 Total Games Village and Media Centre 1,050 Total expected final cost before contingency 5,400 Contingency 540 Total expected final cost 5,940 End of Pre-seen Material The unseen material begins on page 8 March Financial Strategy

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8 SECTION A 50 MARKS [You are advised to spend no longer than 90 minutes on this question.] ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 11, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One Unseen case material Today is 28 February The development of the Games Park to accommodate the Games is expected to boost the local economy, both during the Games themselves (with the temporary influx of spectators and other visitors) and also in the longer term. Regeneration of the area around the Games Park, including new leisure facilities, modern housing and pleasant green surroundings is expected to attract new business and higher income households into the area. Several companies are considering setting up or acquiring businesses in the local area to take advantage of the new business opportunities. P is an example of such a business. P already operates a chain of 9 up-market hotels in Country C under the brand name Park and is considering establishing a tenth Park hotel in the vicinity of the Games Park by acquiring and refitting an existing hotel. The Board of P has identified H, an unlisted, family-run company that owns and operates Hotel Lodge, as a potential acquisition target. Hotel Lodge is H s sole business. On enquiry by P s Board, H s shareholders expressed an interest in selling the company. Most of H s shareholders are either retired or nearing retirement and see the forthcoming Games as an ideal opportunity to sell the business and realise their investment. H s shareholders hope to raise C$ 2.7 million for the equity plus C$ 2.2 million to repay H s borrowings. Valuation of H by P P s directors are preparing their own valuation of H s equity and have collected the following relevant data on H: In H s latest financial statements, the hotel building was valued at C$ 3.8 million. The building is mortgaged, with C$ 2.2 million still owed to the bank. This loan is secured against the property and H has no other debt. Note, however, that the valuation of the hotel building was undertaken before it was known that the Games would be located in Country C. The other assets held by H were approximately equal to H s liabilities excluding borrowings. In the last financial year, H reported after tax earnings of C$ 270,000. Last month, 1,000 ordinary shares in H were sold privately at a price of C$ 2.50 each. P has produced the following cash forecasts for H assuming that H is acquired on 1 April 2014 (Time 0): Time 0 Year 1 Year 2 Year 3 Year 4 Year 5 Years 6+ Renovation cost, C$ 000 (8,000) Fixed annual costs, C$ 000 (1,200) (1,200) (1,200) (1,200) (1,200) (1,200) Revenue per hotel guest per day, C$ Variable cost per hotel guest per day, C$ (60) (60) (60) (60) (60) (60) Average number of guests per day Note: Year 1 is the year ended 31 March 2015, year 2 is the year ended 31 March 2016 etc. March Financial Strategy

9 Additional information: The renovation costs will attract 25% tax depreciation allowances on a straight line basis. The corporate income tax rate in Country C is 30%. Tax can be assumed to be payable on operating cash flows at that rate and settled in the year in which it is incurred. All cash flows, other than the renovation costs, should be assumed to arise at the end of the year. The hotel will be open 365 days a year. It can be assumed that cash flows will remain constant (ie: with no growth) from year 6 onwards into perpetuity. P has a weighted average cost of capital (WACC) of 8% and a P/E of Adjusting the valuation of H to take risk into account The Finance Director of P has pointed out that the valuations for H need to be adjusted for risk. There are a number of new risk factors that make it very difficult to create a reliable cash forecast for Hotel Lodge under P s ownership. The Marketing Director of P has suggested that a discounted cash flow (DCF) calculation should be adjusted by applying the following certainty equivalents to the forecast post tax cash flows for H: 90% in year 1 80% in year 2 70% in year 3 60% from year 4 onwards Assume that the risk free rate of return in Country C is 4%. Form of consideration H has suggested a target price of C$ 2.7 million to acquire all 1 million C$ 0.50 ordinary shares in issue plus a sum of C$ 2.2 million to repay borrowings. That is, a total of C$ 4.9 million to purchase the company, free of all debt. The repayment of the borrowings will need to be in cash but H has not specified whether payment for the shares should be in the form of cash or P s ordinary shares. P would prefer to offer shares rather than cash and is therefore prepared to make a share-based offer slightly more generous than a cash offer. The two alternative forms of consideration proposed are: A: P to pay C$ 4.9 million in cash (C$ 2.7 million cash to H s shareholders PLUS C$ 2.2 million to finance the repayment of H s borrowings). B: Exchange two P C$ 0.50 ordinary shares for each H ordinary share held PLUS P to pay H C$ 2.2 million in cash to finance the repayment of H s borrowings. The directors of P wish to finance any cash payment by increasing P s borrowings if possible. P currently has 17 million C$ 0.50 ordinary shares in issue and they are currently trading at C$ 1.40 per share. P also has reserves of C$ 10 million and borrowings of C$ 16 million. The borrowings are subject to a gearing covenant of 55% (debt/debt+equity at book values). P can borrow at a post-tax cost of 4.5%. Financial Strategy 9 March 2014

10 This page is blank The requirement for question one is on page 11 TURN OVER March Financial Strategy

11 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) (Total for Section A = 50 marks) End of Section A Section B begins on page 14 TURN OVER Financial Strategy 11 March 2014

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14 SECTION B 50 MARKS [You are advised to spend no longer than 45 minutes on each question in this section.] ANSWER TWO OF THE THREE QUESTIONS Question Two Company VV manufactures components and spare parts for mid-priced cars. It has two manufacturing facilities based in Country A. Almost all sales and costs are in the local currency, A$. VV is considering extending the business into the luxury-end of the market by building a third manufacturing facility which would produce components and spare parts for high-priced cars. This would open up new markets for VV both in Country A and abroad. It is expected that at least 30% of sales will be priced in foreign currency within two years. This project is code-named Project X. VV has a central treasury department which is responsible for all VV s funding, cash management and hedging activities. The Treasurer also advises the Board on strategic financial decisions such as target capital structure. Project X The Finance Director (FD) of VV has asked a trainee accountant to calculate an appropriate weighted average cost of capital (WACC) for use in valuing Project X. Due to the different market sector involved, the FD has instructed the trainee accountant to base the cost of equity on the beta of proxy company ZZ, located in Country A. ZZ specialises in the luxury-end spare car parts market. Relevant data: Company VV ZZ Equity beta Debt beta Gearing (debt/debt+equity) at market values % 35% Forecast annual growth in revenue % 4.0% 7.0% Additional information: VV has 3 million A$ 0.50 ordinary shares in issue which are currently trading at A$ 2.30 and also reserves of A$ 2.2 million. VV has A$ 2.80 million bank borrowings at an interest rate of 4.5%. Both VV and ZZ pay corporate income tax at 30%. Country A has a risk free rate of 2% and a market risk premium of 5%. The trainee accountant has produced the following calculation of VV s WACC: Line 1 ß u = ß g x V E /(V E + V D ) = 1.3 x = Line 2 k eu = r f + ß u (r m r f ) = 2% + (0.9 x 5%) = 6.50% Line 3 WACC = k eu [1 tl] = k eu [1 (t x V D /V E )] = 6.50% x (1 30% x ) = 5.90% March Financial Strategy

15 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 Section B continues on the next page TURN OVER Financial Strategy 15 March 2014

16 Question Three Today is 28 February LL is a large electricity generator and distributor located in Country L. LL was privatised 5 years ago and its $1 ordinary shares are quoted on the local stock exchange. Equity comprises: $ million Ordinary share capital ($1 shares) 1,500 Reserves 500 A week ago, on 21 February, there was an unexpected announcement from the Government of Country L that all electricity generators would be required to adopt more environmentally friendly processes by March This would require significant capital investment to adapt the current generators. This resulted in a large one-day fall in LL s share price from $2.20 to $1.95 on 21 February. The share price continued to fall over the next few days and is now $1.90 per share. The Board of LL held an emergency meeting to discuss the situation and how best to raise the estimated $350 million needed to upgrade its generators. Some directors suggested that cash should be raised by either waiving the dividend due in April or offering a scrip dividend instead of a cash dividend, hence reducing the level of debt finance needed. Profit after tax and interest is forecast to be $380 million in the current financial year, ending 31 March Market analysts are expecting a dividend of the order of $200 million to be paid in April The three alternative dividend strategies being evaluated by LL are: A. Pay a cash dividend of $200 million. B. Pay no dividend. C. Declare a scrip dividend in April 2014 of 1 share for every 12 shares held. March Financial Strategy

17 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 Section B continues on the next page TURN OVER Financial Strategy 17 March 2014

18 Question Four GG is a manufacturing company based in Europe with the euro (EUR) as its functional currency. It has a year end of 30 June. GG is considering the best way to finance the replacement of a particular high-specification piece of equipment that has become too costly to maintain. The replacement equipment is estimated to have a useful life of 6 years with no residual value after that time. GG depreciates its non-current assets on a straight line basis over their estimated useful lives. Two alternative financing schemes being evaluated are: Scheme A: Buy the equipment outright, funded by a bank loan. Scheme B: Enter into a six year finance lease. Scheme A: Buy outright, funded by a bank loan GG could purchase the equipment outright at a cost of EUR 6.0 million on 1 July GG can normally borrow at an annual interest rate of 7% a year. Scheme B: Six year finance lease The equipment would be delivered on 1 July 2014 and GG would pay 6 annual payments of EUR 1.34 million under a finance lease. Lease rentals would be payable on 30 June each year, with the first payment on 30 June The lease has an implied interest rate of 9.0%. GG would have the option of extending the lease beyond the initial 6 year term at a peppercorn rent. Tax regime GG pays corporate income tax at a rate of 30%. Tax is paid or recovered a year in arrears. If purchased outright the equipment would be eligible for 100% tax depreciation allowances in the financial year in which it was acquired. GG has adopted international financial reporting standards and the tax treatment of the finance lease follows the accounting treatment for finance leases detailed in IAS 17: Leases. That is, tax relief is given for depreciation and implied interest. Assume that GG has sufficient taxable profits to be able to benefit from any tax savings arising. March Financial Strategy

19 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 (Total for Section B = 50 marks) End of Question Paper Maths tables and formulae are on pages 21 to 25 Financial Strategy 19 March 2014

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21 MATHS TABLES AND FORMULAE Present value table Present value of 1.00 unit of currency, that is (1 + r) -n where r = interest rate; n = number of periods until payment or receipt. Periods Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% Financial Strategy 21 March 2014

22 Cumulative present value of 1.00 unit of currency per annum Receivable or Payable at the end of each year for n years 1 (1+ r ) r n Periods (n) Interest rates (r) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Periods (n) Interest rates (r) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% March Financial Strategy

23 FORMULAE Valuation models (i) (ii) (iii) (iv) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the ex-div value: P 0 = k pref Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the ex-div value: d P 0 = d k e Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P 0 is the ex-div value: d d [1 + g] 1 0 P 0 = or P 0 = k g k g e e Irredeemable bonds, paying annual after-tax interest, i [1 t], in perpetuity, where P 0 is the ex-interest value: i[1 t] P 0 = k dnet or, without tax: P 0 = i k d (v) (vi) (vii) Total value of the geared entity, V g (based on MM): V g = V u + TB Future value of S, of a sum X, invested for n periods, compounded at r% interest: S = X[1 + r] n Present value of 1 00 payable or receivable in n years, discounted at r% per annum: PV = 1 n [1 + r ] (viii) Present value of an annuity of 1 00 per annum, receivable or payable for n years, commencing in one year, discounted at r% per annum: (ix) PV = n r [1 + r ] Present value of 1 00 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV = 1 r (x) Present value of 1 00 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV = 1 r g Financial Strategy 23 March 2014

24 Cost of capital (i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P 0 : d k pref = P 0 (ii) Cost of irredeemable bonds, paying annual net interest, i [1 t], and having a current exinterest price P 0 : i [1 t ] k d net = P 0 (iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P 0 : d k e = P 0 (iv) (v) Cost of ordinary (equity) shares, having a current ex-div price, P 0, having just paid a dividend, d 0, with the dividend growing in perpetuity by a constant g% per annum: k e = d 1 + g or d [1 + g] 0 k e = + g P P Cost of ordinary (equity) shares, using the CAPM: 0 k e = R f + [R m R f ]ß 0 (vi) Cost of ordinary (equity) share capital in a geared entity : k eg = k eu + [k eu k d ] V [1 t ] D V E (vii) Weighted average cost of capital, k 0 or WACC WACC = k e (viii) Adjusted cost of capital (MM formula): V E V E + V D + V k d [1 t ] V K adj = k eu [1 tl] or r* = r[1 T*L] E D + V D (ix) Ungear ß: ß u = ß g V E V V [1 t ] E D + ß d [1 t D V + V [1 t ] E D + V ] (x) Regear ß: ß g = ß u + [ß u ß d ] V [1 t ] D V E (xi) Adjusted discount rate to use in international capital budgeting (International Fisher effect) annual discount rate B$ annual discount rate A$ where A$/B$ is the number of B$ to each A$ = Future spot rate A$/B$ in12 months' time Spot rate A$/B$ March Financial Strategy

25 Other formulae (i) Expectations theory: Future spot rate A$/B$ = Spot rate A$/B$ x 1+ nominal countryb interest rate 1+ nominal countrya interest rate where: A$/B$ is the number of B$ to each A$, and A$ is the currency of Country A and B$ is the currency of Country B (ii) Purchasing power parity (law of one price): Future spot rate A$B$ = Spot rate A$/B$ x 1+ countryb inflation rate 1+ countrya inflation rate (iii) Link between nominal (money) and real interest rates: [1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate] (iv) Equivalent annual cost: PV of costs over n years Equivalent annual cost = n year annuity factor (v) Theoretical ex-rights price: TERP = 1 N + 1 [(N x cum rights price) + issue price] (vi) Value of a right: Theoretical ex rights price issue price N where N = number of rights required to buy one share. Financial Strategy 25 March 2014

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27 LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb. LEARNING OBJECTIVE VERBS USED DEFINITION Level 1 - KNOWLEDGE What you are expected to know. List Make a list of State Express, fully or clearly, the details/facts of Define Give the exact meaning of Level 2 - COMPREHENSION What you are expected to understand. Describe Communicate the key features Distinguish Highlight the differences between Explain Make clear or intelligible/state the meaning or purpose of Identify Recognise, establish or select after consideration Illustrate Use an example to describe or explain something Level 3 - APPLICATION How you are expected to apply your knowledge. Level 4 - ANALYSIS How are you expected to analyse the detail of what you have learned. Level 5 - EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations. Apply Calculate/compute Demonstrate Prepare Reconcile Solve Tabulate Analyse Categorise Compare and contrast Construct Discuss Interpret Prioritise Produce Advise Evaluate Recommend Put to practical use Ascertain or reckon mathematically Prove with certainty or to exhibit by practical means Make or get ready for use Make or prove consistent/compatible Find an answer to Arrange in a table Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between Build up or compile Examine in detail by argument Translate into intelligible or familiar terms Place in order of priority or sequence for action Create or bring into existence Counsel, inform or notify Appraise or assess the value of Advise on a course of action Financial Strategy 27 March 2014

28 Financial Pillar Strategic Level Paper F3 Financial Strategy March 2014 March Financial Strategy