FINANCIAL MANAGEMENT

Transcription

1 FINANCIAL MANAGEMENT PROFESSIONAL 2 EXAMINATION - APRIL 2007 NOTES Answer all three questions from Section A. Answer two questions only from Section B. FINANCIAL MANAGEMENT TABLES ARE PROVIDED TIME ALLOWED: 3 hours, plus 10 minutes to read the paper. INSTRUCTIONS: During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page. You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted. The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2.

2 THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND FINANCIAL MANAGEMENT PROFESSIONAL 2 EXAMINATION - APRIL 2007 Time Allowed: 3 hours, plus 10 minutes to read the paper. Answer all three questions from Section A. Answer two questions only from Section B. SECTION A - ATTEMPT ALL THREE QUESTIONS 1. Sandyford Ltd., a long established private third level art college wishes to pursue corporate growth. It has identified Greece and Sweden as potential markets for private education provision. Greek Market Sandyford Ltd. s management has carried out detailed market research into the Greek market. It's findings were as follows: The plan is to test the Greek market for a period of three years. The total market for third level art education in Greece is 4000 students per year, of which 20% are expected to use private (non-state) colleges. Due to a lack of competition in the private college market Sandyford estimates it could capture one quarter of the private market in it s first year of operation. It estimates that it could grow these numbers by 10% annually thereafter as a result of the quality of its tuition. The potential fee income for each student is estimated at 5,000 per annum in the first year of operation. It is planned to increase fees by 2% each year thereafter. The college has agreed with the relevant Greek and Irish tax authorities that there will be no corporation tax payable in respect of the proposed venture. In addition, in order to promote international competition within the sector, the Greek Department of Education will pay a fixed grant to Sandyford Ltd. of 200,000 per annum starting in year 2. An ideal location for the college has been identified. The building will be leased for a three year period at a year 1 annual rental of 400,000. The lease allows for a 20% annual increase thereafter. The annual overhead cost of running and maintaining the college will total 40,000 in the first year of operation. This cost is likely to increase by 10,000 each year thereafter. The teaching staff will be seconded from Dublin for the initial three years. Six teaching staff will work in Greece. Average annual teaching salaries are presently 50,000. The college has agreed a 5% cumulative salary increase per annum. Each of the teaching staff will receive a year 1 travel and accommodation allowance of 10,000. The annual increase in this allowance will be inflation linked. Each member of the teaching staff will receive an annual bonus equating to 30% of their basic salary in any year where gross college income from the Greek market exceeds 1,100,000. These bonus payments are paid one year in arrears. A local interpreter will be employed at an annual cost of 20,000 per annum, fixed for the three year term. Inflation is expected to run at 10% per annum. Swedish Market Sandyford Ltd. s management are giving serious consideration to buying a Swedish college for the purposes of entering that market. The Swedish college s assets will be denominated in the local currency, the Swedish Krone. Page 1

3 REQUIRED Part A Prepare a report for the Board of Sandyford Ltd. which: Assesses the Net Present Value (NPV) of the Greek proposal, using a discount rate of 7%. (12 Marks) Considers four non-financial factors to be considered when making the decision whether or not to enter the Greek market. (6 Marks) Part B Prepare a briefing note for Sandyford Ltd. s management explaining the foreign currency translation risk it would face in relation to the proposed entry to the Swedish market. (7 Marks) [TOTAL: 25 Marks] Page 2

4 2. (a) A client company Sunny PLC has asked you to help management better understand the cost of financing the company. You have recently prepared the accounts for Sunny PLC. Relevant extracts from the Balance Sheet are as follows: Sunny PLC Balance Sheet as at 31st March 2007 Assets Non Current Asset 000s 000s Land and Buildings 900 Plant and Equipment 320 Fixtures and Fittings 80 1,300 Current Assets Inventories 120 Trade Receivables 180 Cash and Cash Equivalents Total Assets 1,850 Equity and Liabilities 2 ordinary shares 500 Accumulated Profits Non Current Liabilities 10% Debentures Redeemable Current Liabilities Trade Payables 200 Short Term Borrowings Total Equity and Liabilities 1,850 Your investigations have revealed the following relevant information: The most recent dividend declared was 50 cent per share. This dividend will be paid on 20th June You have calculated that the average compound rate of growth in dividends over the last five years has been 20%. This growth rate is expected to continue. Sunny PLC s ordinary shares presently trade at 5.50 cum div. Sunny PLC debentures are presently valued at 90% of their par value. All interest due on debentures to 31st March 2007 has been paid in full. The prevailing corporation tax rate is 40%. REQUIRED: Calculate Sunny PLC s Weighted Average Cost of Capital. (11 Marks) Page 3

5 (b) Sunny PLC s management has recently been approached by Rainy PLC who have expressed an interest in buying Sunny PLC. You have reviewed their offer letter and consider the following information to be relevant: All assets with the exception of Fixtures and Fittings will be taken over by Rainy PLC s. Rainy PLC will not assume liability for any short term borrowings. Rainy PLC plans to deliver synergistic benefits as a result of the combination of 100,000 per annum pre tax. Rainy PLC plans to close the production facility, which is presently losing 30,000 per annum post tax. The related cost of closure is estimated at 500,000. This cost will not be tax deductible. Rainy PLC will immediately redeem debentures at par. This has been agreed with the debenture holders. Sunny PLC agreed to the commencement of the financial due diligence audit by Rainy PLC s accountants. The audit has now been concluded. From your inspection of the report the salient factors are: Obsolete inventories included on the 31st March 2007 Balance Sheet total 20,000. These will not be taken over by Rainy PLC. An estimated 10,000 of trade receivables are unlikely to be recoverable. These will not be taken over by Rainy PLC. They agree that the production facilities are presently losing 30,000 per annum post tax. Further analysis of Sunny PLC s financial history reveals the following: Sunny PLC Income Statement Extracts Pre-Tax Tax Post-Tax Year Ended 000s 000s 000s 31st March st March st March st March st March Sunny PLC s accounting policies are as follows: Plant and Machinery is depreciated at 25% p.a. straight line. Fixtures and Fittings are depreciated at 20% p.a. straight line. Depreciation charges are exactly the same as the tax deductible capital allowances on the assets. Land assets are recorded at their historical cost. Other relevant information is as follows: Sunny PLC s management have acquired an independent valuation of Land and Buildings. The report values them at 2,000,000. The generally accepted P/E multiple for companies in Sunny PLC s industry is 8 times. REQUIRED: Provide an indication of the per share valuation of Sunny PLC that would be arrived at by Rainy PLC using the following valuation bases: Asset basis (5 Marks) Earnings basis (9 Marks) [Total: 25 Marks] Page 4

6 3. Write a brief note outlining the meaning and significance of any five of the following terms: Value Gap Management Buyouts (MBOs) Adjusted Present Value Cumulative Preference Shares Portfolio Theory Treasury Management Financial Due Diligence (In context of a proposed takeover) [Total: 20 Marks] SECTION B - ANSWER TWO QUESTIONS ONLY 4. The flotation of Aer Lingus in 2006 was one of the highest profile public flotations in Ireland in recent years. REQUIRED: Based on your understanding of the Aer Lingus flotation, identify and describe three elements of the Financial Management Syllabus, that you have studied, that enable you to comprehend the sequence of steps/events which occurred from initial preparation through to the final execution of the flotation. [Total: 15 Marks] 5. Many trading organisations experience business failure and ultimately a total corporate collapse. REQUIRED: a) Briefly explain six reasons why organisations may experience such failure/collapse. (9 Marks) b) List eight actions which can be taken by an organisation to help avoid imminent collapse. (4 Marks) c) Provide examples of organisations which have experienced such corporate collapse/decline. (2 Marks) [Total: 15 Marks] Page 5

7 6. (a) Briefly describe the meaning of the term Efficient Market Hypothesis. (5 Marks) (b) Kinsale PLC a quoted company on The Irish Stock Exchange has 5,000,000 shares in issue. Their current market price is 4 per share. Bantry PLC another Irish quoted company has 4,000,000 shares in issue currently trading at 10 each. This may be taken as the situation on day 0. On day 3 the Board of Bantry PLC decide at a private meeting to make a takeover bid for Kinsale PLC. At the Board meeting Bantry PLC s Financial Director informs her fellow board members that a detailed assessment of the synergistic benefits of the takeover is estimated at having a Net Present Value of 10,000,000. The Board agrees to propose a cash offer to shareholders in Kinsale PLC of 6 per share. There will be no paper consideration. On day 6 the board of Bantry PLC publicly announce the terms of their offer. They do not release details as to the potential synergistic benefits. On day 10 Bantry PLC s Board announce publicly details of the potential synergistic benefits. REQUIRED: Ignoring tax and the time value of money between day 0 and 10, and assuming that no other factors have influenced the share price of both Bantry PLC and Kinsale PLC, determine the: Day 0 Day 3 Day 6 Day 10 share price of both companies if, The Irish Stock Exchange is considered to display: (a) (b) Semi-strong Form Efficiency Strong Form Efficiency (8 Marks) (2 Marks) [Total: 15 Marks] END OF PAPER Page 6

8 SUGGESTED SOLUTIONS Solution 1 Report THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND To: Management Team, Sandyford Limited From: A.N. Other, Accountant Date: 30th April 2007 Subject: Proposed Entry to Greek Market. Introduction FINANCIAL MANAGEMENT PROFESSIONAL 2 EXAMINATION - MAY 2007 This report considers the potential financial results and the non financial factors to be considered in relation to your proposed entry to the Greek market. Financial Analysis Approach Results As the proposed entry to the Greek market will be for an initial period of three years I have used the technique of discounting to allow for the time value of money over those three years. I have set out all the relevant cash-flows relating to the project and discounted each year s net cash-flow at 7% your company s cost of capital, to arrive at the Net Present Value (NPV) of the proposal. Detailed workings and supporting notes can be found at Appendix 1 to this report. The proposal has a positive Net Present Value of 683,028. Whilst this sum is not particulary significant, the wider considerstions in relation to the proposal should be carefully considered. Non-Financial Considerations The wider (non-financial) factors which should be considered by the management team prior to making a decision whether or not to enter the Greek market should include the following: will entry into the design education market open the door for the wider opportunities presented by the Greek market? will the migration of staff from Dublin damage the college in any way? will staff be willing to transfer to Greece for the three years? will the proposal prove a distraction for your management team? are there any other competitors likely to enter the Greek market? how will the language differences be overcome? Conclusion The proposal does not present a significant financial risk. However, both the potential for market development and the potential impact on operations in Dublin are of prime importance in making the decision whether or not to enter the Greek market. Page 8

9 Appendix 1) Net Present Value - Greek Proposal Details Note Yr1 Yr 2 Yr 3 Yr 4 Government Grant Fee Income Annual Premises Rental Annual Premises Maintenance Translator Salary Lecturer Staff Salaries Staff Travelling Costs Staff Bonus Net Annual Cash Flows Investment Criterion - Net Present Value (NPV) Net Annual Cash Flows Discount 7% Present Values Net Present Value Financial Projections - Greek Proposal Yr 1 Yr 2 Yr 3 Note 1 Total Market Size (All Students) 4000 n/a n/a Private Student Percentage 20% n/a n/a Total Market Size Private Students 800 n/a n/a Sandyford's Expected Market Share 25% n/a n/a Sandyford' Expected Market Size (increased 10% p.a.) Market Size Price Per Unit (2% rise each year) Gross Revenues Note 2 Lecturers Staff (6 * p.a. uplifted 5% p.a.) Note 3 Lecturers Bonus Payments (30% base Salary) Note 4 Lecturers Travel Payments (6 * uplifted 10% p.a.)) Page 9

10 Part B Briefing Note To: Management Team, Sandyford Limited From: A.N. Other, Accountant Date: 30th April 2007 Subject: Foreign Exchanges Risk Foreign exchange risk is a term used to describe the potential adverse financial impact on organisations as a result of movements in foreign exchange currency rates over time. In relation to your proposed investment in the Swedish market the main type of foreign currency risk that you may face is Foreign Currency Translation Risk. Foreign Currency Translation Risk If Sandyford Limited was to purchase a Swedish based college it will have to include the assets and liabilities of that college in its year end Balance Sheet. For the purposes of inclusion it will have to convert the Krone value of the assets and liabilities into Euros at the exchange rate between Krone and the Euro that prevails at each Balance Sheet date. Where this investment is held for more than one year there is a risk that the value of the investment (for inclusion in Balance Sheet) may suffer a diminution in value. This could occur if the Krone has weakened relative to the Euro between year end dates. It should be noted that the opposite effect can occur. The most effective way of eradicating the potential for such translation risk would be to fund the purchase of the Swedish company/college by raising a loan denominated in Krone. The effect on the Balance Sheet would be to cancel out any potential diminution in the value of the college s net assets as a result of the adverse movement in the exchange rate between Krone and the Euro. Solution 2 Part A WACC Note MV % Cost Weighting % Weight Weighted Ordinary Shares (ex div) % 1250/ % 23.53% Debentures at MV % 450/ % 3.17% Market Value Weighted Av. Cost of Capital 26.70% Note 1) Cost of Equity (Gordon's Growth Model) [.50*(1+.2)/( )] +.2 = 32.00% Note 2)Cost of Debentures (IRR Calculation) Year Value Interest Tax Relief Redeem Net C flow 000 s 00 0s 000s 000s 000s Page 10

11 10% 15% Year Net C flow D factor PV Net C flow D factor PV 0 00s 00 0s 000s 000s Net Present Value Net Present Value IRR(Cost of Debentures)=10%+[15.27/( )]*(15%-10%) =11.99% Q2 Part B Sunny PLC - Company Valuation Asset Based Valuation Land & Buildings at current value Plant & Machinery Fixtures and Fittings 0 Not taken over Inventories (less obsolete of ) Trade Receivables (less bad debts of 10000) Cash and cash equivalents Trade Payables Short Term Borrowings 0 Not taken over Debentures Redeemable at par Net Assets Shares In Issue Asset Based Share Value 8.56 Earnings Based Valuation Averaged post tax profits over last five years Post tax synergystic benefits (100000@60%) Production losses avoided post tax Tax relief on production losses 40% Savings on depreciation of Fixtures and Fittings Capital allowances forgone on Fixtures & 40% Annual Debenture Interest Saved ( @10%) Tax savings forgone on debenture interest Indicative Annual Recurrent Post Tax Earnings Price Earnings Multiple 8 Capitalised Earnings Less: production facility closure costs Adjusted Capitalised Earnings Shares In Issue Earnings Based Share Value Page 11

12 Solution 3 Value Gap This relates to a situation where the publicly quoted price for a company s ordinary shares differs from the value which is attributed to it based on conventional share valuation models e.g. earnings or assets basis. Such gaps may arise where the market price does not reflect all available information, which has a bearing on the value of the share i.e. in a weak-form or semi-strong market. A value gap may also arise in the context of mergers and acquisitions whereby a predator expects to make up the gap by improving post merger/acquisition performance. Management Buyouts (MBOs) When an organisation decides to divest itself of part of its business for whatever reason (cash absorber, lack of strategic fit etc.) it may receive offers from many parties. Occasionally, the management of the part of the business being sold may decide to mount a bid for the purchase. This is known as a management buyout. Research has shown than MBOs tend to be more successful than 3rd party acquisitions. This is for many reasons including: knowledge of the industry and the specific business being bought increased levels of motivation to make the business a success. Often with MBOs the most difficult challenge is to raise sufficient finance. Adjusted Present Value Adjusted Present Value (APV) is an alternative approach to the Net Present Value (NPV) approach to investment appraisal. The valuation approach taken by APV is to separate the operational and financial effects of a proposed capital investment. It firstly discounts the investment at a base-line cost of capital, as if it was fully equity financed in order to arrive at a base cost net present value. As a separate and subsequent step the cash flow consequences of the alternative financing options are discounted and added to the base cost present value to arrive at the APV. The NPV technique allows for the financing effects by adjusting the discount rate to be applied for the purpose of the NPV calculation. Cumulative Preference Shares A cumulative preference share avoids the loss of dividends by ensuring that in a year where no fixed rate preference dividend is paid, then the right to payment of such unpaid dividends accumulates to future years. Usually the holders of such cumulative preference shares whose dividends are in arrears become entitled to a vote in the affairs of the company. Portfolio Theory A portfolio is a collection of different investments that comprise an investor s total holding. Such a portfolio may include different types of investments e.g. property, equities and government bonds and/or, a portfolio of different investments within the same investment type e.g. a property portfolio consisting of different type properties e.g. residential and industrial located perhaps in different countries. Portfolio theory is concerned with setting guidelines for selecting a portfolio of investments and the measurement of risk and return of a portfolio and, understanding the impact that diversification will have on the risk and return of a portfolio. Treasury Management The corporate handling of all financial matters, the generation of external and internal funds for business, the management of currencies and cash flows and the complex strategies, policies and procedures of corporate finance. The following functions will normally be carried out by treasury management: liquidity management funding management currency management corporate finance Financial Due Diligence (In context of a proposed takeover) When a company makes a formal takeover bid which is welcomed by the target company, the predator company will require a degree of assurance that the financial position and financial performance of the target company are as indicated in their financial and management accounts. To gain this assurance (or otherwise) the predator company will typically request that it s accountants carry out a financial due diligence audit of the target company. The due diligence auditors will typically carry out the following tests: Verify the accuracy of profits reported in financial and management accounts Review the value of non current assets Check trade receivables for any potential bad debts Check inventories for any obsolete/spoiled items The due diligence auditors will furnish their client with a due diligence report which will have an impact on whether the takeover bid will proceed or not and if so, as to the indicative value to be placed on the target company. Page 12

13 Solution 4 The Aer Lingus flotation may be related to the financial management syllabus in the following areas/ways: Initial Public Offering Process In September 2006 the Initial Public Offering Prospectus was made publicly available by The Aer Lingus Group PLC. This document set out the details of the offer including: the flotation date the flotation offer price range potential bonus issue details the minimum subscription level Company Valuation For the purposes of the flotation the value of Aer Lingus PLC had to be ascertained. It is likely that the following valuation bases will have been considered: an earnings based approach (recurrent Earnings Per Share * Price Earnings multiple) net assets basis (current value of the net assets of Aer Lingus PLC) It is unlikely that the Dividend Valuation Model would have been used because no past dividends had been paid by the company Efficient Market Hypothesis Within hours of the flotation the price of Aer Lingus PLC s shares increased significantly. This reflects the market s reaction to the generally held view that the offer price of 2.20 slightly undervalued the company. This reaction supports the view that The Irish Stock Exchange displays semi-strong form market efficiency in that the price of any share quoted thereon reflects both: all past information pertaining to a share s valuation, plus All publicly available information pertinent to a share s valuation. Solution 5 Part a) Reasons for corporate collapse may include the following: Ineffective financial risk assessment and management (hedging etc) Ineffective Working Capital Management Illiquidity/Overtrading Inadequate Financial Planning and Budgetary Control e.g. Fraud eg.enron, Worldcom etc. Inadequate corporate governance Unsuccessful acquisitions e.g. Baltimore Technologies Loss of key management and staff Poor industrial relations e.g. Aer Lingus Over-dependence on a single supplier/product Legislation changes e.g. smoking in the workplace ban Legal Settlements Quality problems e.g. Honda Entry of a new competitor Technical obsolescence Loss of customer/marketplace focus e.g. IBM Unsuccessful mergers/acquisitions e.g. Baltimore Securities Loss of a major customer, franchise or patent Research and development failure e.g. Elan Corporation Part b) Actions with the potential to avoid imminent corporate collapse/decline include: Appoint corporate recovery specialists Strict financial control Capital Restructuring Defer debt repayment Cost reduction targets Drop any loss making products/services/customers Flatten organisation structure Defer research and development projects Replace/rotate top management Page 13

14 Strategic alliances Increased customer/marketplace focus mprove quality of products/services Solution 6 Part A) Efficient Market Hypothesis The efficiency of a capital market relates to the ability of the market to price securities quickly and fairly in order to reflect all the relevant publicly available information in respect to each security. The Efficient Market Hypothesis indicate three levels of processing efficiency namely: Weak form Prices reflect all past information. Semi strong form Prices reflect all past information and publicly available information. Strong form - Prices reflect all past information, publicly available information and inside information. There has been considerable research carried out on the topic of measuring market efficiency with varying findings. However, it is considered that capital markets today tend to display semi-strong form efficiency. Part B) Semi Strong Form Efficiency BANTRY PLC KINSALE PLC Day Note Price per share Price per share Strong Form Efficiency BANTRY PLC KINSALE PLC Day Note Price per share Price per share Note 1) Note 2) As the proposal was discussed on day 3, the day 1 price of each share price of each company will remain unchanged. As the proposal was discussed in private on day 3 and the Irish Stock Market is considered to display semistrong form efficiency, the day 3 share price of each company will remain unchanged as the detail discussed is not publicly available. Note 3) Day 6 value of Bantry PLC Euros Intrinsic value of Bantry PLC (4m shares at 10 euro each) Intrinsic value of Kinsale PLC (5m shares at 4 euro each) Less:Cash Payment to Kinsale PLC Shareholders (5m 6) INDICATIVE DAY 6 VALUE OF BANTRY PLC Divided by:bantry PLC shares in issue INDICATIVE DAY 6 VALUE OF EACH BANTRY PLC SHARE 7.5 Note 4) Day 10 value of Bantry PLC Euros INDICATIVE DAY 6 VALUE OF BANTRY PLC (per note 3) Add:Synergystic benefits of combination INDICATIVE DAY 10 VALUE OF BANTRY PLC Divided by:bantry PLC shares in issue INDICATIVE DAY 10 VALUE OF EACH BANTRY PLC SHARE 12.5 Page 14