The Examiner's Answers Specimen Paper F3 - Financial Strategy

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1 The Examiner's Answers Specimen Paper F3 - Financial Strategy SECTION A Answer to Question One Requirement (a) Appendix A 1. Assume constant exchange rate Project years to 24 6 to 25 Calendar years (31 December) from 2014 from 2015 for 20 years for 20 years US$m US$m US$m US$m US$m US$m Final payment for engineering/environmental (5.0) Initial investment (60.0) (60.0) US$ cashflows (5.0) (60.0) (60.0) FX rate (P$ per US$) P$m P$m P$m P$m P$m P$m P$ equivalent of US$ cashflows (32.0) (383.7) (383.7) Tax relief on initial investment W Operating net cash inflows in P$ Less tax at 30% (45.0) Net total cashflows expressed in P$ (32.0) (383.7) (268.6) (45.0) Discount factor at 10.0% W W3 PV (29.1) (288.2) (183.5) (237.9) Total NPV in P$ millions: W1: = x 30% W2: = x W3: = x Assume that the US$ will strengthen against the P$ by 5% each year P$m P$m P$m P$m P$m P$m Project years to 24 6 to 25 Calendar years (31 December) from 2014 from 2015 for 20 years for 20 years P$ equivalent of US$ cashflows (above) (5.0) (60.0) (60.0) FX rate reflecting 5% increase in US$ value W Adjusted US$ cash flows expressed in P$ (34.6) (457.8) (480.7) Tax relief on initial investment W P$ cash flows (from above) (45.0) Total cashflows expressed in P$ (34.6) (457.8) (343.4) (45.0) Discount factor at 10.0% (from above) PV (31.5) (343.8) (234.5) (237.9) Total NPV in P$ millions: The Chartered Institute of Management Accountants 2009

2 In both cases: Saving if tax rate dropped to 10% is P$ 158.6million where = x (30 10)/30 So result in 1 above becomes P$363.7m (= ) and result in 2 above becomes P$272.7m (= ) W4: Exchange rates Assuming the US$ strengthens against the P$ by 5% a year, future rates are: Date Year FX Rate Workings 01 January ^(225/365) where 225 days is: 31 December x 1.05 May December x 1.05 Jun December x 1.05 Jul December x 1.05 Aug December x 1.05 Sep 30 Oct 31 Nov 30 W5: = x 30% and = x 30% Dec Requirement (b) To: From: Date: The Directors of PU Finance Director Today s date Subject: Hydroelectric power station project project appraisal Introduction The purpose of this report is to present the findings of recent exercises to evaluate: the likely financial contribution of the proposed project and examine other relevant factors that might affect the decision on whether or not to undertake the project; and suitable financing structures to fund the project. Investment appraisal Financial appraisal based on project cash flows A full financial appraisal has been undertaken based on the present value of future cash flows arising from the project. There are several important uncertainties surrounding the project. In particular: a large proportion of US$ costs are involved which could vary in P$ terms, and it is possible that the tax rate for such projects may fall from 30% to 10% from 2014 The investment appraisal model was therefore run for each combination of these base assumptions. Summary results are given below. Summary of results - NPV as at 1 January 2010 of forecast project cash flows: Tax rate 30% Tax rate 10% Constant exchange rate P$205.1 million P$363.7 million US$ strengthening by 5% per annum P$114.1 million P$272.7 million Full results of the exercise are attached at Appendix A. Specimen Exam Paper 2 Financial Strategy

3 Other relevant factors to take into consideration Impact of movement in exchange rate If the US$ were to strengthen against the P$ by 5% a year, the NPV of the project would fall by approximately P$90 million under both tax rate scenarios. For example, assuming a tax rate of 30%, the NPV of the project falls to P$114.1million from P$205.1million once the strengthening of the US$ has been taken into account. This is a very large exchange rate risk and could be hedged by the use of short-term hedging instruments such as forward contracts. These forward exchange rates can then be used in the investment appraisal of the project and a revised NPV result obtained based on the hedge cash flows. Forward contracts cannot be cancelled, so they should only be entered into if and when a firm decision has been taken to proceed with the project. Impact of tax rates The results in part (a) show that a fall in the tax rate in 2014 from 30% to 10% would result in a large increase in the NPV of the project from P$205.1million to P$363.7million, assuming a constant US$/P$ exchange rate. A real option open to PU is to delay the project until a decision has been made on the future tax rate. In the meantime, the entity should lobby the government to try and influence the decision in its favour. Reliability of base data The investment appraisal exercise has been based on best estimates. Changes to the estimates could occur as a result of changes in underlying data such as: construction costs; market demand/prices for electricity that would impact on operating revenues; accuracy of estimates of maintenance costs; possible delays due to local objection to the scheme and how that might impact on costs and viability of the project; accuracy of estimates of relocation costs for people who are living or working on land that will be flooded as a result of the construction of the dam. Sensitivity analysis would be useful to examine the impact of changes in the underlying data on the financial appraisal. Suitability of the discount rate The discount rate should be reviewed to see if: it meets the underlying risk expectations of the project; it needs to be adjusted to reflect a change in capital structure of PU as a result of proceeding with the project. The project is not large enough to change the capital structure of the entity and so this is not a relevant issue here. However, the project is moving the entity into a completely new and untested area of business and the discount rate may therefore need to be adjusted upwards to reflect the higher risks arising from this project. Results of the environmental studies exercise The environmental studies investigation is still on-going. Although it is considered highly unlikely that the project will be cancelled at this stage, final approval to proceed can only be made once the full results of the studies are known. Financial Strategy 3 Specimen Exam Paper

4 Impact on corporate and financial objectives Financial objective: Gearing Gearing is currently 38% (based on market values at 20 May 2009) against a maximum gearing target of 40%. The project is so small in size in relation to the entity as a whole that it would not be expected to have a major impact on gearing levels. However, the size of the borrowing is still sufficient to push the gearing level just above the maximum gearing target of 40%. The new gearing level is estimated as 40.4%, an increase of approximately 2% from the current level of 38.2%. Workings: Current Gearing: Equity P$15,470million (= 5,525million x P$2.80) Debt P$9,560million So, current gearing is 38.2% (= 9,560/(9, ,470)) New gearing after taking into account the project and the following additional assumptions: tax rate of 30%; an increase of 5% a year in the value of the US$ against the P$; a share price that has already moved to reflect the increase in shareholder value as represented by the NPV of the project. So new figures for equity and debt are: Equity P$15,584million (= 5,525million x P$ P$114.4million (the project NPV) Debt P$10,552million (= P$9,560million + P$992 (see workings W1)) So the new gearing level is: 40.4% (= 10,552/(10, ,584)) W1: US$130million x = P$992million Other corporate objectives The new power station is unlikely to improve efficiency rates of energy production but it would make a major contribution to reducing harmful emissions such as greenhouse gases when generating electricity. It is inevitable that some harmful emissions will be emitted during the construction process and there may also be some carbon dioxide emitted from decomposing vegetable matter that is flooded as part of the project. Overall, however, the hydroelectric power station would be expected to generate only a very small proportion of the harmful emissions that would have been generated by a coal fired power station with a similar output. Conclusion whether or not to undertake the project It is recommended that PU should: wait for the full results of the environmental studies exercise before reaching a decision; recalculate the investment appraisal using forward exchange rates; perform a sensitivity analysis to determine the results under a worst case scenario and determine the probability of the project showing a loss if some of the key assumptions are changed; If a decision is taken to proceed with the project, all US$ cash flows should be hedged using forward contracts to fix the exchange rate on these cash flows. Overall recommendation: Only proceed with the project if satisfactory outcomes are obtained from all the above research and if the revised figures for the project using forward exchange rates still show a profit, even under a worst case scenario. Specimen Exam Paper 4 Financial Strategy

5 Financing structure A significant exchange rate risk would arise in respect of US$ borrowings as proposed in financing structure (ii). At a constant exchange rate, the US$ borrowings are very attractive and have a significantly lower cost than the P$ borrowings. However, if the US$ were to strengthen by 5% a year against the P$, the US$ borrowings becomes comparatively more expensive. The cash flows arising under the US$ borrowings and the effective cost of the borrowings (on a yield to maturity basis) under each exchange rate scenario are shown below: US$ loan assuming a constant exchange rate Year Cash flow Exchange Cash flow 3% 3% 2% 2% US$ million rate Local $ million YTM by interpolation: 2.2% = 2% + 1% x 8.7/( ) US$ loan assuming the US$ strengthens against the local $ by 5% a year Year Cash flow Exchange Cash flow 6% 6% 8% 8% US$ million rate Local $ million (W1) (W2) YTM by interpolation: 7.3% = 6% + 2% x 59.9/( ) Workings: W is the exchange rate on 1 January 2012 (see workings W4 in part (a)) W = x 1.05^5 Ignoring any investment income on funds that are not needed in the first year, and assuming exchange rates stay constant, the US$ borrowings have an effective cost of 2.2% but this rises to an effective cost of 7.3% if the US$ were to strengthen against the P$ by 5% a year. This compares with a known cost of 5% under alternative financing structure (i). If such a high risk is unacceptable, US$ borrowings should only be considered if it is possible to guarantee the exchange rate for the interest and capital repayments used to service the borrowings. This may be possible to arrange by using hedging instruments such as forward contracts or a cross currency swap. Note that there is no US$ income that could be used to set off against US$ payments to service the borrowings. Recommendation Exchange rate risk arising on the borrowings could be effectively eliminated if PU were to enter into a cross currency swap contract to fix the exchange rate on the US$ borrowings. Calculations should be performed of the cost of debt for the hedged borrowings and this should be compared to the cost of the P$ borrowings. The calculations should also be adjusted to take account of any investment income that could be earned before the funds are required in the project. The cheapest method should then be chosen. Financial Strategy 5 Specimen Exam Paper

6 Requirement (c) Possible reasons for disposing of the hydroelectric power station. There are a number of possible reasons why PU might wish to dispose of the hydroelectric power station. The most likely reason is one of strategic planning: to refocus the business on coal fired power stations and concentrate on the main area of management expertise - the hydroelectric power station may not have proved to be a good fit of business alongside the coal fired power stations; to raise funds for use in moving into new business areas such as developing new power stations using alternative fuels; to lower cost of capital by disposing of a high risk business. PU may also have encountered problems in running the hydroelectric power station such as a failure to manage it efficiently or realise its full profit potential. There may be a potential buyer who has the expertise to run the hydroelectric power station more efficiently. PU itself may have suffered a fall in business and need to raise cash by selling the hydroelectric power station. Methods for achieving the divestment 1. Sell-off In a sell-off, PP would be sold to another entity, usually in return for cash. This is most likely to be achieved by setting up PP as a separate subsidiary entity and selling the entire entity as a going concern. Shares in the acquirer would be of no interest to PU if its objective is to move out of this area of business and use the cash raised for other purposes. 2. Spin-off In a spin-off, PP would be constructed so that it is owned by the same shareholders as PU. This is normally known as a demerger. A spin-off can lead to a clearer management structure as management of PP can concentrate solely on that business without reference back to PU. 3. Management buyout A management buyout is where the business is purchased by members of the management team, generally in association with a financing institution. Specimen Exam Paper 6 Financial Strategy

7 SECTION B Answer to Question Two Requirement (a)(i) The discount rate to be used in this type of evaluation is the after-tax cost of debt, which is 7% x (1-03 = 4.9%) say 5%. Alternative 1 Evaluation of borrow and buy Year 0 1 to 4 million million Purchase cost (25) Tax relief on tax depreciation allowances (W1) DCF (25) Present value (18.4) W1: million = 30% x 25 million/4 Alternative 2 Evaluation of the finance lease Base data million Lease payments in advance 7.0 pa Total payments: 4 x 7 = 28 million Cost of leased asset 25 but use 18m in the calculations because the first lease payment is made in advance and should be deducted from the cost Finance charge 3 = Number of interest periods 3 Ignore the final period as there is no interest element Examiner s note: As the question does not specify which method to use to allocate implicit interest between years, either the actuarial method or the sum of digits method would be acceptable. Both are shown here as a guide to students. Financial Strategy 7 Specimen Exam Paper

8 Method 1 Actuarial method Firstly, calculate the implied interest rate using IRR: The annuity factor for the interest can be found by dividing the cost of the asset by the annual lease payment. We will use a net cost of 18million and 3 interest periods. So three year annuity factor = 18/7.0 = This approximates to an interest rate of 8% (which has a three year annuity factor of 2.577). Examiner's note: if there is no exact match, use interpolation to find the implied interest rate. Actuarial method interest allocation (and proof of interest allocation) Accounting year million million million Opening balance Interest (add) 1.44 (=8% x 18.0) 1.00 (=8% x 12.44) 0.52 (=8% x 6.44) Repayment (lease rental) (7.0) (7.0) (7.0) Closing balance (0.04) Actuarial method present value calculation of finance lease Time million million million million million Calculation of tax shield based on accounting figures: Depreciation 0 (6.25) (6.25) (6.25) (6.25) Implicit interest 0 (1.44) (1.00) (0.52) 0 Total eligible for tax relief 0 (7.69) (7.25) (6.77) (6.25) Cash flows: Tax relief at 30% Finance lease (7.0) (7.0) (7.0) (7.0) 0 Total cash flows (7.0) (4.69) (4.82) (4.97) DCF (7.0) (4.46) (4.37) (4.29) 1.54 Present value (18.6) Method 2 - Sum of digits Base the sum of digits calculation on three interest periods as before. The sum of digits is 6. Workings: 6 = n (n+1)/2 = 3 x (3 + 1)/2 So the interest in the first period is 3m x 3/6 and in the 2 nd period is 3m x 2/6 etc. Sum of digits interest allocation (and proof of interest allocation) Accounting Year million million million Opening balance Interest (add) 1.5 (=3m x 3/6) 1.0 (=3m x 2/6) 0.5 (=3m x 1/6) Repayment (lease rental) (7.0) (7.0) (7.0) Closing balance Specimen Exam Paper 8 Financial Strategy

9 Sum of digits present value calculation of finance lease Time million million million million million Calculation of tax shield based on accounting figures: Depreciation 0 (6.25) (6.25) (6.25) (6.25) Implicit interest 0 (1.5) (1.0) (0.5) 0 Total eligible for tax relief 0 (7.75) (7.25) (6.75) (6.25) Cash flows: Tax relief at 30% Finance lease (7.0) (7.0) (7.0) (7.0) 0 Total cash flows (7.0) (4.67) (4.83) (4.97) DCF (7.0) (4.45) (4.38) (4.29) 1.54 Present value (18.6) (Which gives the same result as that obtained using the actuarial method) On the basis of the present value analysis, there is a marginal benefit from choosing alternative 1, giving a relatively small saving of approximately 200,000. However, this is small in relation to the size of the project and other factors may have a greater impact on the choice of financing structure. Requirement (a)(ii) The two main possible discount rates to consider are: The cost of capital to the entity (which has presumably been used to evaluate the decision to acquire the POS) or The cost of the next best alternative means of finance (here, bank borrowings). The discount rate that should be used in financing decisions is the opportunity cost. Finance leases are considered a direct substitute for borrowing, the opportunity cost of leasing is the after-tax cost of borrowing. Requirement (a)(iii) Consideration must be given as to how or when the borrowings are to be repaid if alternative 1 is chosen. Tax benefits appear to have a significant influence on the decision; a sensitivity analysis should be carried out to determine the impact on the decision if tax rates or regulations change. Requirement (b) The main purpose of a PCA: A post-completion audit (PCA) can be defined as an objective and independent appraisal of all phases of the capital expenditure process as it relates to a specific project. The main purposes include: project control; improving the investment process; and assisting the assessment of performance of future projects. A major requirement of a PCA is that the objectives of the investment project must be clear and an adequate investment proposal should have been prepared. The objectives should also be stated, wherever possible, in terms that are measurable. If these have not been done before the POS system was acquired then a PCA is not possible. Financial Strategy 9 Specimen Exam Paper

10 The PCA should provide a source of information that will help future management decision making and should include an assessment of the reasons for any variance from the expected performance, cost and time outcomes. This should improve project control and governance and enable changes to be introduced to put the project back on track in a timely manner. The key factors of importance of a PCA to AB: It enables a check to be made on whether the performance of the system corresponds with the expected results. If this is not the case, the reasons should be sought. This could form the basis for improvements in development of the system. It generates information, which allows an appraisal to be made of the managers who took the decision to upgrade the system. Managers will therefore tend to arrive at more realistic estimates of the advantages and disadvantages of the proposed investments. It can provide for better project planning in the future. If, in the evaluation, it is found that the planning of the investment programme was poor, provision can be made to ensure that it is better for future acquisitions. The limitations of a PCA to AB in the context of the POS system: Sufficient resources are often not allocated to the task of completing PCAs so often are not undertaken. They can be time consuming and costly to complete. They are sometimes seen as tools for apportioning blame, so even where undertaken the lessons are often not disseminated and are not then embedded in future projects. If undertaken by the managers of the project, they may claim credit for all that went well and blame external factors for everything that did not. Specimen Exam Paper 10 Financial Strategy

11 Answer to Question Three Requirement (a) The scenario in this question concerns a privately owned entity based in a holiday destination. Inflation is near zero and interest rates are expected to fall. The treasury department needs to decide how to deal with the challenges and opportunities the specific set of circumstances provide and evaluate the impact on the entity s capital structure. Finance theory suggests that entities should use a certain amount of debt in their capital structure to lower the cost of capital. Debt is cheaper than equity because interest payments (usually) attract tax relief and expected returns are lower. This is because interest is (usually) secured and providers of debt do not participate in profits. Here we have a mixture of secured and unsecured debt, but the entity appears sound and of high credit worthiness so should be able to borrow at comparatively favourable rates. This might even be an argument in favour of increasing gearing which will provide the ability to undertake a share buyback, as seems to be the desire of the major, family shareholders. The opposite argument is that in a period of low and falling interest rates, fixed rate debt becomes a burden. Some of the reasons are as follows: The real value of debt is not being eroded when there is low or no inflation, so one of the benefits of debt disappears. If growth is expected to be modest, debt interest may have to be paid out of static (or even falling) profits, lowering returns to shareholders. Although nominal interest rates may fall, they never become negative, so the real cost of borrowing increases. Raising equity is safer if profits are falling as dividends do not have to be paid and the shareholders do not get their money back in a liquidation. However, raising new equity in a private entity is more difficult than in a public entity and this method of raising new capital raises many additional issues such as whether to plan for a public listing or a rights issue and how to value the shares. In theory (according to Modigliani and Miller), the mix of debt and equity does not affect the value of the entity, other than the value of the tax shield, but it does have an effect on the attribution of profits to three groups of stakeholders: lenders, government and owners (shareholders). The main issue for the treasury department to decide is what combination of dividend policy and capital structure is likely to maximise the present value of cash flows to shareholders. This is where the financing strategies adopted contribute to the determination of the objectives of the entity. The treasury department needs to specifically: Look at the terms of existing borrowing to see if refinancing at lower rates is feasible, recognising any possible penalties for early retirement of loans. Discuss with the major shareholders the possibility (or even probability) that returns are likely to be lower; the lower the rate of interest, the lower the cost of capital and therefore the lower the returns that can be expected. Requirement (b) Theory supports the Finance Director, suggesting that maximisation of shareholder wealth is the only true objective of the entity but this is now considered an extreme view. Many entities now establish objectives that aim to maximise shareholder wealth while recognising constraints, legally enforceable or voluntary, imposed by society. A major problem with this Financial Strategy 11 Specimen Exam Paper

12 objective in the circumstances of CD is that this is a private entity that does not have a quoted share price. Shareholder wealth, as traditionally valued, is difficult to determine. In addition, although dividend levels may have no direct impact on shareholder wealth, there may well be private family shareholders who rely on a steady and predictable dividend stream from entity CD. Looking only at dividends as an objective has its limitations, for example dividends could increase while earnings fall. The dividend ratio therefore needs to be considered alongside dividend payout. Other objectives mentioned such as profitability as measured by returns after tax and return on investment have some advantages. For example they are well understood measures and recognised guidelines are available in the form of International Accounting Standards. Also, shareholders expect and understand profitability. Disadvantages of accounting-based measures include: They are historic and backward-looking; They can be subject to manipulation; A variety of accounting policies are available even within Accounting Standards; Tax can be affected by factors outside the control of managers; They do not take account of non-financial objectives. Recommendation Maximisation of shareholder wealth, using the theoretical definition, is difficult to apply in the circumstances of CD. However, it would be worth introducing an objective that incorporates earnings growth as well as dividend growth. A range of objectives could be considered, such as risk-related returns to investors, but again this is more difficult with a private entity than one with a share listing. The entity needs to consult its shareholders and, possibly, consider using a balanced scorecard approach to determine a range of objectives appropriate for an entity such as CD. Specimen Exam Paper 12 Financial Strategy

13 Answer to Question Four Requirement (a) Forecast income statements for the years ended 31 December Revenue 45,000 46,800 48,672 Purchase costs and expenses Depreciation (38,250) 0 (39,780) (500) (41,371) (500) Profit before finance costs 6,750 6,520 6,801 Less: Interest on long term debt (450) (450) (450) Profit before tax 6,300 6,070 6,351 28% (see note) (1,764) (1,490) (1,656) Profit after tax (earnings) 4,536 4,580 4,695 Dividends declared and paid (1,814) (1,905) (2,000) Retained earnings for year 2,722 2,675 2,695 Examiner s Note: the question did not require candidates to show the figures for 2009, they are shown here in italics for convenience. Tax depreciation allowances: Cost of vehicles 5, % (1,250) Written Down Value 3, % (938) Written Down Value 2,812 Note: Tax is calculated on profit before tax and depreciation less capital allowances: 2010 (6, ,250) x 28% = 1, (6, ) x 28% = 1,656 Examiner s note: it was not intended that candidates should consider the impact of deferred taxation in their answer here. Credit was available for those who did so. Requirement (b) Cash flow forecasts for 2010 and 2011 Calculations of cash receivable and cash payable: Revenue 46,800 48,672 O/B trade receivables 13,500 14,040 C/B trade receivables at 30% (14,040) (14,602) (13,500/45,000 x 100) Cash receivable 46,260 48,110 Costs and expenses 39,780 41,371 O/B trade payables 8,415 8,752 C/B trade payables (8,752) (9,102) (at 22% of costs and expenses = 8,415/38,250 x 100) Cash payable 39,443 41,021 Financial Strategy 13 Specimen Exam Paper

14 Cash flow forecasts Cash received from sales 46,260 48,110 Costs and expenses 39,443 41,021 Vehicles 5,000 0 Tax 1,490 1,656 Dividends 1,905 2,000 Interest Total outflows (48,288) (45,127) Net cash flows (2,028) 2,983 Opening cash balance 348 (1,680) Closing cash balance (1,680) 1,303 An alternative, equally acceptable, approach to presenting the cash flow forecasts is as follows. Note that IAS7 allows for some discretion in the presentation format of cash flow statements. The question here required a forecast rather than a published statement and any sensible format gained credit Operations Profit before financing costs 6,520 6,801 Add back depreciation Change in receivables (540) (562) Change in payables Subtotal 6,817 7,089 Interest paid (450) (450) Taxation (1,490) (1,656) Net cash flows from operations 4,877 4,983 Investments New vehicles (5,000) 0 Financing Dividends paid (1,905) (2,000) Total net cash flows (2,028) 2,983 Opening cash balance 348 (1,680) Closing cash balance (1,680) 1,303 There is need to finance a cash shortfall of 1,680,000 by the end of Of course, if the vehicles are bought early in 2010, there may well be a requirement to finance a much greater cash shortfall earlier in the year. There is insufficient information in the question to comment further on this. By the end of 2011 there is a positive cash balance of 1,303,000 by just over half way through the year (if cash flows are spread more or less evenly throughout the year). If sales increase as forecast the cash balance is likely to become positive earlier. As the shortfall is caused by the purchase of new assets, there should be no problem increasing the overdraft limit given the size of the entity and the relatively short period of time this facility is needed. Other possibilities include supplier credit or short-term leasing. It could be argued that as these are long term assets they should be funded by long-term finance but the amount is relatively small compared to the value of the entity. A problem that needs to be addressed is the disparity between the ratio of trade receivables to sales and trade payable to purchase costs & expenses. The former is 30% and the latter 22%. However a breakdown between cost of sales and operating expenses is necessary to analyse the problem further. Specimen Exam Paper 14 Financial Strategy

15 Requirement (c) Key aspects and implications Preliminary calculations: Total equity: Share capital 4,204 4,204 4,204 Retained earnings 16,210 18,885 21,580 Total equity 20,414 23,089 25,784 Return on shareholders funds 22.2% 19.8% 18.2% EPS pence % increase DPS pence Return on shareholders funds: EF met this objective in 2009 but narrowly falls short in 2010 and the ratio declines even further in The new assets might begin to contribute to an improvement but they are clearly replacement assets for an existing facility and as such are unlikely to have a significant impact. The management of working capital needs to be addressed as noted above. Investment and financing: No investment appraisal appears to have been carried out for the purchase of the new assets. This should be done before the investment is made, even though the entity appears more than capable of funding the purchase. Increase in earnings: The increase in earnings is well below EF s target for 2010 and 2011 but is moving in the right direction. The main impact in 2010 was the sudden increase in depreciation (although there was a tax benefit as tax depreciation allowances were higher than book depreciation). EF needs to examine its costs and expenses as these are increasing in line with sales. There might be scope for reducing costs by reviewing its suppliers and/or terms of trade, and possible elimination of some expenses. Dividends: DPS are growing at 5% as per the scenario. If earnings increase in the future at the target rate of 8% then this implies EF will build up its retained earnings for future investment (assuming finance is available). The entity should perhaps review its dividend policy in the light of investment opportunities. Key assumption regarding overdraft interest: The removal of the simplifying assumption regarding overdraft interest can be expected to have a significant effect on forecast cash flows after tax. Indeed, the increase in earnings that is observed above is so small that an increase in overdraft interest in 2010 could reduce earnings to the point at which earnings actually decline in 2010 from 2009 levels. I would advise the compilation of a more accurate calculation of overdraft interest (or deposit interest if there is a positive cash balance) and the associated tax benefit (or tax expense). This would involve identifying the timing of large items such as tax and dividend cash flows in order to calculate an average cash balance for each year. An estimate of overdraft interest or deposit interest could then be calculated based on that average cash balance and an Financial Strategy 15 Specimen Exam Paper

16 assumed average overdraft or deposit rate. Note that any overdraft or deposit interest and associated tax cash flows will affect the closing cash balance for the year and therefore also impact on average cash balance and interest and tax cash flows in the following year. The Chartered Institute of Management Accountants 2009 Specimen Exam Paper 16 Financial Strategy