DO NOT OPEN THIS QUESTION PAPER UNTIL YOU ARE TOLD TO DO SO. Financial Pillar. F3 Financial Strategy. Saturday 30 August 2014

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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 Saturday 30 August 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 7. 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 P plc is based in the UK. It is one of the world s leading distributors of plumbing, heating and building materials employing over 35,000 people. It operates its own retail outlets, some of which share a common trading name and are organised as separate business units. P plc also sells directly to building and plumbing contractors and merchants through its external direct sales units. P plc was founded in the early 20 th Century as a plumbing and buildings materials manufacturing business and enjoyed very rapid growth in the 1970 s and 1980 s. In 1985, P was listed on the UK stock exchange and at this time first ventured into the USA by acquiring a building materials distribution company based in New Jersey. In 1990, P plc acquired a building supplies business in the UK and, later in that decade, made acquisitions of other European based plumbing and heating and building materials distribution companies. In the early years of the 21 st Century, P plc sold off all its manufacturing business units and concentrated solely on being a distributor and retailer of plumbing, heating and building materials. Corporate values P plc is proud of its history and traditions of distributing and retailing good quality products in locations which are convenient to its customers. It has developed a series of core values which are: Trading fairly and honestly; Being responsive to customer needs and market changes and not being satisfied with standing still, but seeking to continuously improve; Employing committed people and providing training opportunities to develop their skills; Having respect for cultural diversity across all the company s stakeholders. Business operations P plc s head office is in the UK which also contains its centralised treasury. It has two operating divisions which are: Plumbing and heating Building materials Products: Baths, showers, toilets, sinks, heating systems, general plumbing parts such as water taps, pipes and drainage systems. Products: Concrete building blocks, bricks, tiles, flooring products, roofing materials and wooden roof beams and other timber, as well as upvc products, such as doors and window frames. Each division s operating arrangements are similar. Each division has two distribution warehouses, one each in Europe and the USA. Each division uses these warehouses to fulfil sales orders placed by its external direct sales units and retail outlets. The external direct sales units sell to building contractors, plumbing contractors and merchants who supply small building and plumbing companies with materials and parts. P plc s retail outlets sell directly to the public and to the building and plumbing trades. Some of these retail sales outlets were set up or acquired as chains of retail outlets each with a common trading name and these have been retained as separate business units. The retail outlets that have been acquired continue to operate under their own trading names so that P plc can retain the benefit of the goodwill the retail outlets developed. Each has a specific line of business, such as the sale of complete bathrooms and kitchens through chains of showrooms. Financial Strategy 2 September 2014

3 The plumbing and heating division carries out its retail operations through established chains of showrooms. These showrooms sell products to local tradesmen and also directly to the public. The building materials division s retail activities are carried out through small-scale retail outlets which are usually located on industrial estates and those that have been acquired retain their local building supply trading names. Overall, P plc has well over 90,000 suppliers and sells to over 1.2 million customers across the world. Each of the two divisions operates its own large logistics and distribution network. They operate their own fleet of road transport vehicles to distribute products in Europe and the USA and use rail, sea and air networks for distribution to their external direct sales units and retail outlets in other parts of the world. Board of Directors and Executive Board composition The Board of Directors comprises a Non-executive Chair, a Chief Executive, the five directors covering the functions of Finance, Logistics, Procurement, Marketing and Information Systems, the Managing Directors of the two divisions, the Company Secretary and six nonexecutive directors. In addition, P plc has an Executive Board comprising the Chief Executive, the five functional executive directors, the Managing Directors of the two divisions and also the Chief Human Resources Officer, who is not a main board member. The Executive Board reports to the Board of Directors. Divisional Management Structure Each of the two divisions operates with a Divisional Executive Management Team (DEMT), based in the UK. These comprise chief divisional officers for the functions of finance, human resources, information systems, logistics, marketing and procurement. Each DEMT is led by the relevant Divisional Managing Director. In the USA, there is also a Senior Executive Team for each division which comprises chief officers covering the same functions as are represented on the DEMT and chaired by the company s divisional Vice President (Plumbing and Heating or Building Materials as appropriate) for US sales. The senior executive teams in the USA report to their appropriate DEMT in the UK. An organisational structure chart is presented at Appendix 1. Financial structure There are 500 million GBP 0.10 shares in issue. The ownership of the company is split in the following proportions: Financial institutions: 90% Individual investors: 9.5% Board members and employees: 0.5% The share price has ranged between GBP 9 and GBP 6 over the last year. The dividend in the last financial year was GBP 0.25 per share and represented an increase of 20% over the previous year. The Chairman commented on this improved dividend stating that the Board had strong confidence that the company would continue to grow. September Financial Strategy

4 Chairman s statement on P plc s strategic objectives P plc s Chairman has declared three strategic objectives for the company which all combine with the aim of improving shareholder value. These three strategic objectives of P plc are: 1. To be the market leader in the regions of the world in which it operates; 2. To deleverage the company by disposing of business units or individual retail outlets which do not contribute sufficiently to the aim of P plc becoming market leader or are failing to meet minimum performance targets; 3. To continuously strive to improve its products and customer services. The business acquisition strategy employed by P plc has led to high levels of goodwill. In some cases, newly acquired businesses have underperformed and not met profit expectations. Some impairment of goodwill has been necessary in respect of certain business units. Those which have seriously underperformed have been disposed of. The net value of goodwill, after impairment, is shown in the company s statement of financial position in Appendix 2. Comparative performance and assets employed by the divisions The divisions measure performance at external direct sales unit and individual retail outlet level. Where retail outlets are organised into business units under a common trading name, then the performance of the retail units are consolidated enabling performance to be measured at the business unit level. The performance of the divisions for the financial year 2013 and the assets they employed as at 31 December 2013 are as follows: Performance: Plumbing and heating Building materials GBP million GBP million Revenue 7,040 6,837 Operating profit Assets employed: Plumbing and heating Building materials GBP million GBP million Non-current assets: Intangible assets Property, plant and equipment Trade and other receivables Current assets: Inventories Trade and other receivables 1,075 1,052 Non-current assets employed by P plc at its head office were GBP 40 million at book value. Source of products P plc prides itself on operating an efficient supply chain and developing strong relationships with a wide range of suppliers across the world which offer quality products. It grants preferred supplier status to most of its suppliers and enters into long-term supply contracts. All P plc s external direct sales units and retail outlets are supplied from its warehouses in Europe or the USA. This means that some of its products which are sourced from Asia and Africa are shipped to the company s warehouses in Europe and the USA. External direct sales units and retail outlets in Asia and Africa then receive shipments from the company s warehouses. This means that some products, which P plc sources from suppliers located in Asia and Africa, cross the world, are stored in warehouses and then cross the world again to be delivered to their destinations in Asia and Africa. Financial Strategy 4 September 2014

5 Corporate Responsibility Aims P plc aims to provide excellent customer service across its two divisions. This excellence in customer service is underpinned by its: provision of high levels of staff training and development, with strong concentration on safety management; adherence to the highest ethical standards both internally and with respect to supplier relationships; concern to cause the least environmental damage possible within its operations in terms of emissions, waste management and recycling activities by employing environmental performance management methods; promotion of product integrity through selling only safe and reliable products which are of the required standard of quality and partnering with key suppliers. Strategic developments P plc aims to increase its market share by making repeat sales through its external direct sales units and retail outlets to existing customers and attracting new customers away from competitors. It places customer service as its key critical success factor. The Board is constantly seeking improvements in the company s logistics particularly in sourcing products and their delivery to its external direct sales units and retail outlets wherever they are in the world. It is actively considering acquiring logistic resources in parts of the world where it does not own warehousing and distribution facilities at present and also pursuing the concept of virtual warehousing by which its external direct sales units and retail outlets will still place their orders with P plc but will obtain their supplies directly from the manufacturer. Other areas of strategic development concern reviewing the life expectancy of its products so as to give greater value for money to final customers and benchmarking its performance in different countries in order to improve operating efficiency. September Financial Strategy

6 Appendix 1 P plc ORGANISATION STRUCTURE Financial Strategy 6 September 2014 USA Plumbing and Heating Division Senior Executive Team External Sales USA Warehouses Retail Outlets Plumbing and Heating Division Divisional Executive Management Team Europe Warehouses External Sales Retail Outlets P plc Board of Directors Executive Board Building Materials Division Divisional Executive Management Team Europe Warehouses External Sales Retail Outlets USA Building Materials Division Senior Executive Team External Sales USA Warehouses Note: Some of the retail outlets were established, or were acquired as chains of retail outlets, operating as business units with a common trading name. The remaining retail outlets are individual business units in their own right comprising a single outlet. Financial Strategy 6 September 2014 Retail Outlets

7 Appendix 2 Extracts from P plc s statement of profit or loss and statement of financial position Statement of profit or loss for the year ended 31 December 2013 GBP million Revenue 13,877 Cost of sales 10,128 Gross profit 3,749 Operating costs 3,302 Operating profit 447 Net finance costs 68 Profit before tax 379 Tax 116 PROFIT FOR THE YEAR 263 Statement of financial position as at 31 December 2013 GBP million ASSETS Non-current assets Intangible assets: goodwill (net) 1,748 Property, plant and equipment 1,366 Trade and other receivables 135 Total non-current assets 3,249 Current assets Inventories 1,784 Trade and other receivables 2,127 Cash and cash equivalents 418 Total current assets 4,329 Total assets 7,578 EQUITY AND LIABILITIES Equity Share capital (GBP 0.10 shares) 50 Share premium 25 Retained earnings 3,396 Total equity 3,471 Non-current liabilities Bank loans 1,000 Current liabilities Trade and other payables 2,905 Bank loans and overdrafts 202 Total current liabilities 3,107 Total liabilities 4,107 Total equity and liabilities 7,578 End of Pre-seen Material The unseen material begins on page 8 September Financial Strategy

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 material Today is 30 August The Executive Board of P plc has identified Country C as a priority location for expansion of the Plumbing and Heating Division. Country C uses currency C$. Company B3, located in Country C, has been identified as a potential acquisition target. The Plumbing and Heating Division already manages two business units in Country C, named B1 and B2, and these have shown strong performance under P plc s ownership. B3 is particularly attractive to P plc because it has its own warehouse and distribution and logistics network, all of which could be used by B1 and B2 if the acquisition goes ahead. Currently, B1 and B2 send goods to customers from P plc warehouses located in the UK or USA. This involves considerable cost and delay in delivery. B3 is a private company and 100% of its shares are owned by the family that founded it. Many shareholders are keen to realise their investment by selling the company to P plc. Both companies are working towards an effective date for the sale of B3 to P plc of 1 January Financial data for B3 for 2013 The statement of financial position of B3 as at 31 December 2013 showed the following balances: C$ million Long term borrowings 375 Share capital (C$1 ordinary shares) 90 Reserves Additional information: B3 reported an operating profit of C$ 75 million in the year ended 31 December 2013 and declared a dividend of C$ 30 million on 20 December 2013 which was paid on 30 January B3 pays 7% interest on long term borrowings. The corporate income tax rate in Country C is 30%. Forecast financial data for B3 for year 2015 onwards, following acquisition by P plc Following consultation with the directors of B3, P plc s Finance Director has prepared the following forecast data for B3 assuming it is acquired on 1 January Forecast data for B3: After tax free cash flow, ignoring synergistic benefits, of C$ 54.6 million in 2015, growing by 4% a year in perpetuity. One-off synergistic cash flow benefit of C$ 8.0 million after tax in After tax annual synergistic cash flow benefit, starting with C$ 5.0 million in 2016 and then increasing by 4% a year in perpetuity. Financial Strategy 8 September 2014

9 In any discounted cash flow analysis, cash flows should be assumed to arise at the end of the year to which they relate. On acquisition, B3 would be transferred to P plc free of debt because B3 s lenders would only agree to the sale on condition that their borrowings are repaid prior to the sale. After acquisition, new borrowings would be arranged in addition to the equity investment by P plc and structured so that B3 would have approximately the same capital structure as P plc. That is, gearing (debt/debt+equity) would be 25% based on market values. P plc would guarantee B3 s new debt which can be assumed to have the same risk profile as P plc s debt. A proxy company has been identified which is also located in Country C and has a similar business model to B3. Proxy company data: P/E ratio of 12. Equity beta of 1.7 and debt beta of 0.4. Gearing (debt/debt+equity) based on market values of 35%. Country C has a risk free rate of 5% and a market premium of 4%. Financial data for P plc Latest data available for P plc shows: P/E ratio of 14. Equity beta of 1.5 and debt beta of 0.3. Gearing (debt/debt+equity) based on market values of 25%. P plc pays 6.2% interest on its long term borrowings. The UK has a corporate income tax rate of 30% and uses currency GBP. The UK has the same risk free rate and market premium as Country C. The spot rate for C$ against GBP is, today, GBP/C$ 7.00 (that is, GBP 1 = C$ 7.00) and is not expected to change in the foreseeable future. Referral to the competition authorities A competitor to B3 has raised objections about the takeover bid with Country C s competition authorities, claiming that the acquisition of B3 by P plc would result in P plc controlling approximately 70% of all plumbing product sales in Country C. Referral of the planned acquisition to the competition authorities is a major set-back for P plc since it has already invested considerable time and resources in preparing to bid for B3. The requirement for question one is on page 11 TURN OVER September Financial Strategy

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11 Required: Assume you are the Finance Director of P plc. Prepare a report addressed to the Board of P plc in which you: (a) Advise on: The types of synergistic benefit that might arise from the acquisition of B3. Possible reasons why both one-off and ongoing synergistic benefits might not be achieved to the extent expected. (12 marks) (b) (i) Calculate a Weighted Average Cost of Capital (WACC) for use in valuing B3 based on the proxy company s business and country risk and P plc s capital structure. (7 marks) (ii) Calculate a range of values for the equity of B3 in C$ as at 1 January 2015 using the following methods: (iii) Asset basis. P/E (including bootstrapping). DCF (with and without synergistic benefits). Advise on the validity of the valuation methods used in (b)(ii) when setting an appropriate C$ initial offer price for the purchase of the equity of B3. (11 marks) (11 marks) (c) Advise on the implications of the bid for B3 being referred to the Competition Authorities of Country C. (6 marks) Additional marks for structure and presentation (3 marks) (Question One = 50 marks) (Total for Section A = 50 marks) End of Section A Section B begins on page 14 TURN OVER September Financial Strategy

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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 E is a company that develops computer software and is located in the eurozone. This is a fast growing, high risk industry sector. The company was recently listed on a major stock exchange. The EUR 1 ordinary shares are currently quoted at EUR Extracts from E s recently published financial statements show the following: EUR million EUR million Bank borrowings 300 Earnings for the year 50 Share capital (EUR 1 ordinary shares) 100 Dividends paid in the year 30 Reserves 200 Bank borrowings totalling EUR 200 million are due for repayment in 12 months time. The following three alternative refinancing schemes are being considered, each with a principal of EUR 200 million, to replace the EUR 200 million bank borrowings that are due for repayment in 12 months time: Scheme 1. Bank borrowings Arrange new bank borrowings for a 5 year term at an interest rate of 4.5% with interest paid annually. Scheme 2. Public bond issue. Issue a bond with a 5 year term and a 4% coupon paid annually. Scheme 3. Convertible bond. Issue a convertible bond with a 5 year term and a 3% coupon paid annually. The convertible bond would include a conversion option of 22 ordinary EUR 1 shares per EUR 100 nominal bond at the end of year 5. If the holder chooses not to take up the conversion option, no shares would be issued and the principal would be repaid in full at the end of year 5. Financial Strategy 14 September 2014

15 Required: (a) (b) Calculate each of the following, assuming a share price at the end of year 5 of each of EUR 4.00, EUR 5.00 and EUR 6.00: Total interest cost for the whole 5 year term for each of refinancing schemes 1, 2 and 3. The conversion premium in scheme 3, where conversion occurs. The yield to maturity up to and including conversion for scheme 3. Ignore taxation. (11 marks) Evaluate the potential impact on E s shareholders of choosing refinancing scheme 3 rather than scheme 1 or 2. Your answer should include reference to your results in part (a). (5 marks) (c) Advise the directors of E of factors that should be taken into account when choosing between the refinancing schemes under consideration in addition to those considered in part (b). (9 marks) (Total for Question Two = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION TURN OVER September Financial Strategy

16 Question Three G is a listed multinational group. The parent company is located in the USA. G manufactures spectacles and contact lenses. Designs and technical specifications are constantly changing and G needs to invest heavily in research and development in order to remain competitive. G has 31 December as its financial year end. Financial data for the last 3 years is given below: Year to 31 December: USD million USD million USD million Dividend Profit/(loss) after tax (100) Depreciation included in profit/(loss) On-going capital expenditure Data as at 31 December: Long term borrowings USD 2,000 million USD 1,820 million USD 2,090 million Share price USD 4.00 USD 3.50 USD 3.00 Additional information: On 1 January 2011, G had 600 million USD 1 shares in issue. On 1 January 2012, there was a 1 for 3 rights issue at an issue price of USD 3.20 per share. There were no other changes to share capital in the 3 year period shown above. Assume that depreciation is the only non-cash item included in profit/(loss) after tax above. Over two-thirds of the shares are held by large financial institutions such as pension funds, insurance companies and investment vehicles. The remaining shares are held by directors of the company and private individuals. Financial Strategy 16 September 2014

17 Required: (a) (i) Analyse G s dividend policy in the years 2011, 2012 and 2013 based on the data provided. Support your answer with calculations of: Dividend cover based on profit/(loss) after tax. Dividend per share. Free cash flow generated in the year (before dividend payments). Up to 5 marks are available for calculations (7 marks) (ii) Advise G on the benefits and drawbacks of the current dividend policy AND possible alternative policies. (9 marks) (b) Discuss the interrelationship between financing decisions and, investment and dividend decisions. Illustrate your answer with reference to G. (9 marks) (Total for Question Three = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION TURN OVER September Financial Strategy

18 Question Four Company MV owns a number of motor vehicle retail showrooms in its home country, Country H. It has grown rapidly in recent years, largely by acquiring land and building new showrooms. The directors of MV are currently considering a number of possible sites for development to achieve further expansion. One or more of these sites may be developed up to a maximum overall capital budget of H$ 100 million. One of the sites being considered is located in a neighbouring country, Country J. If selected, this would be the first showroom to be opened in a foreign country. Four possible sites have been identified, each of which would support a certain size of showroom. It would not be possible to change the plans so that only part of a site is developed. Each possible site has been allocated a project name as shown below. Single period capital rationing is to be applied when selecting projects. Project data is given below: Project Initial investment Forecast after tax net cash inflow each year for a 10 year period Risk adjustment (to be added to the H$ WACC) Project net present value (NPV) Undiscounted payback period Profitability index H$ million H$ million % H$ million Years Project A Project B Project C J$ million J$ million % To be To be To be Project D calculated calculated calculated Note that projects A, B and C are located in MV s home country, Country H and project D is located in neighbouring Country J. Additional data: Based on its target gearing, MV has an after tax Weighted Average Cost of Capital (WACC) of 9.5%. The risk free rate is 2% in Country H and 4% in Country J. The spot rate is currently H$/J$ (that is, H$ 1 = J$ ). Each project has a 10 year term. The residual value of each project at the end of its 10 year term should be assumed to be equal to the value of the initial investment. A separate decision has yet to be made about how best to finance the selected project or projects. Financial Strategy 18 September 2014

19 Required: (a) Calculate the following in respect of project D: An appropriate J$ based discount rate to use in calculating the Net Present Value (NPV) of project D s J$ cash flows. The project NPV stated in terms of H$. Undiscounted payback period. Profitability index. (8 marks) (b) Advise the directors of MV on: (i) (ii) The project or combination of projects which is expected to maximise shareholder wealth based on a single period capital rationing model. (2 marks) Other financial and strategic factors that should be taken into account when deciding which project or projects to select. (10 marks) (c) Discuss TWO key issues that MV should consider when deciding how best to finance a foreign investment such as project D. (5 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 September Financial Strategy

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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% September Financial Strategy

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% Financial Strategy 22 September 2014

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 September Financial Strategy

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 K adj = k eu [1 tl] or r* = r[1 T*L] + V k d [1 t ] V 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$/B$ Financial Strategy 24 September 2014

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. September Financial Strategy

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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 September Financial Strategy

28 Financial Pillar Strategic Level Paper F3 Financial Strategy September 2014 Saturday Financial Strategy 28 September 2014