Paper P9 Management Accounting - Financial Strategy. Examiner s Brief Guide to the Paper 19

November 2008 Examinations Strategic Level Paper P9 Management Accounting - Financial Strategy Question Paper 2 Examiner s Brief Guide to the Paper 19 Examiner s Answers 21 The answers published here have been written by the Examiner and should provide a helpful guide for both tutors and students. Published separately on the CIMA website (www.cimaglobal.com/students) from February is a Post Examination Guide for the paper which provides much valuable and complementary material including indicative mark information. The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recorded or otherwise, without the written permission of the publisher. The Chartered Institute of Management Accountants 2008

Financial Management Pillar Strategic Level Paper P9 Management Accounting Financial Strategy 19 November 2008 Wednesday Morning Session Instructions to candidates 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 open the answer book and start writing or 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). The question requirements are highlighted in a dotted box. ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking. Answer the ONE compulsory question in Section A on pages 2 to 5. Answer TWO of the four questions in Section B on pages 8 to 15. Maths Tables and Formulae are provided on pages 17 to 21. The list of verbs as published in the syllabus is given for reference on page. Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered. P9 Financial Strategy P9 2 November 2008

SECTION A 50 MARKS [the indicative time for answering this Section is 90 minutes] ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One KEN is a property development company located in country A whose currency is A$. KEN specialises in the construction of domestic housing in country A and is listed on the local stock exchange. KEN has been highly successful in recent years and has built a strong reputation based on high build quality and meeting deadlines. However, in recent months house prices have fallen and interest rates have risen, making it harder to sell houses, even at significantly lower prices. Domestic housing construction project One of KEN s current projects is the construction of 300 houses. This project has been planned in three distinct phases, each in a self-contained plot of land. Good progress has been made with the development since work began in 2006. The position at 1 January 2009 is expected to be as follows: Phase 1 80 houses Construction completed and all houses sold and occupied. Phase 2 100 houses 30 houses were sold in 2008 Remaining 70 houses in this Phase to be actively marketed in 2009 Phase 3 120 houses Planning approval obtained but no construction work or marketing begun at 1 January 2009 Forecast figures for 2009-2011: 2009 2010 2011 House sales (number of houses) Phase 2 70 - - Phase 3-80 40 Cost of running the sales office (A$) Salaries and other staff costs 100,000 140,000 80,000 Other 30,000 30,000 30,000 November 2008 3 P9

Other financial information on the domestic housing project: The forecast average selling price per house BEFORE the recent fall in house prices was as follows: o Phase 2: A$350,000 o Phase 3: A$400,000 However, due to the recent fall in house prices in country A, the forecast average selling prices listed above are considered to be overstated by 20% on unsold houses at 1 January 2009. A 10% deposit is received on agreeing a house sale and the selling price is agreed at this stage. The remaining 90% is due on completion a year later. Construction costs are, on average, 60% of the forecast selling price. 70% of the construction costs are incurred in the year in which the sale is agreed and 30% are incurred in the following year. These costs already take into account government estimates of inflation and are not expected to be affected by the recent fall in house prices. Construction costs should therefore be calculated on the forecast selling prices before the recent fall in house prices. All sales office costs forecast for 2009 relate to Phase 2 and forecast costs for 2010 and 2011 relate to Phase 3. Business tax is 30% on profits and capital gains, payable one year in arrears. All cash flows should be assumed to arise at the end of the year. Strategic choices for KEN The fall in house prices has created potential liquidity problems for KEN and KEN is considering what its strategic response should be at this time. The following strategies are being considered: Strategy 1: Abandon Phase 3 and sell the land Strategy 2: Merge with another property development entity Strategy 1: Abandon Phase 3 of the domestic housing project If KEN were to abandon Phase 3 of the project, the land would be sold and the sales office staff would be made redundant. All this would be expected to take place at the end of 2009. Phase 2 of the project would continue as planned since KEN is already committed to completing this phase of the project. The land for Phase 3 was purchased in 2006 at a cost A$2 5 million without planning permission. Planning permission was obtained in 2006 at a cost of A$100,000 and the land could be sold in 2009, with planning permission, for A$4 4 million. It is estimated that it would cost A$60,000 to make the sales office staff redundant at the end of 2009. Normal running costs and salaries would be paid up to the end of 2009, at which point the sales office would be closed. Strategy 2: Merger KEN has also been approached by another property development entity located in country A that is interested in merging the businesses. Discussions are still at a very early stage but KEN is interested in investigating this possibility further. Investment appraisal KEN uses DCF to evaluate investments at an after-tax nominal discount rate of 12%. P9 4 November 2008

Required: (a) (b) For Phase 2 of the project, calculate the fall in after-tax sales receipts in each of the years 2009 and 2010 as a result of the fall in house prices. Ignore the time value of money. (4 marks) Discuss the industry, economic and market factors that affect KEN s business cash flows and liquidity and funding issues. (6 marks) (c) Explain the role of the treasury function in liquidity management, and funding management. (6 marks) (d) Assume you are the Finance Director of KEN and write a report to the Board of Directors of KEN on the strategic choices facing KEN at this time. Your report should address the following issues: Strategy 1: (i) Calculate the net present value of the Phase 3 cash flows AFTER the fall in house prices and compare this with the net present value of the cash flows associated with selling the land. (17 marks) (ii) Strategy 2: (iii) Advise whether or not to proceed with Strategy 1. As part of your answer discuss what other real options are available to KEN, and what other factors should be taken into account. (7 marks) Identify and explain the possible reasons why KEN might consider a merger at this time and the potential problems with such a merger. (7 marks) Additional marks for structure and presentation in part (d) (3 marks) (Total for Question One = 50 marks) November 2008 5 P9

SECTION B 50 MARKS [the indicative time for answering this Section is 90 minutes] ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two BG is a privately-owned transport entity based in country B, which has the euro ( ) as its currency. BG had revenue in the last financial year of 65 million and earnings of 14 5 million. The directors of the entity, who are also the major shareholders, have been evaluating the replacement of a number of vehicles, which will be purchased in country C, which has the C$ as its currency. BG has a number of customers based in country C. The vehicles will have a capital cost of C$1 6 million and the directors expect these new vehicles to provide after-tax cash flow benefits (including tax depreciation benefits) of 160,000 each year. Cash flows beyond five years are ignored by BG in all its investment decisions. The vehicles are estimated to have a resale value at the end of five years of 15% of the original purchase price. BG is currently all-equity financed. Some directors believe this should continue and the new vehicles should be financed with a rights issue (that is, they are prepared to inject more capital into the business themselves). However, the Chief Executive has suggested this capital structure fails to take advantage of the tax benefits of debt and has requested the Finance Director to evaluate two methods of financing the new vehicles. These are: 1. Debt, raised in the entity s own country (country B) and secured on its assets The debt would be denominated in euro and repayable in five years time. The current pre-tax rate of interest required by the market on corporate debt of this risk is 9 2% per annum. Interest payments would be made at the end of each year. 2. A finance lease raised in country C from where the vehicles will be supplied The terms would be five annual payments of C$320,000 payable at the beginning of each year. The vehicles could be bought by BG from the finance entity at the end of the lease contract for a nominal amount of C$1. Assume the whole amount of each annual payment is tax deductible. Other information relevant to the decision is as follows: The discount rate that BG applies to replacement investment decisions is 12%; BG s marginal rate of tax is 35%. This rate is not expected to change in the foreseeable future. Tax is payable in the year in which the liability arises and tax depreciation allowances are available at 25% per annum on a reducing balance basis; The spot rate C$ to the is 2 45; Interest rates are 4 5% per annum in country B and 3 5% per annum in country C. These rates are not expected to change in the foreseeable future. P9 6 November 2008

Required: (a) (i) (ii) Calculate the NPV of the investment in euro; Calculate the most advantageous method of finance, if the choice is between debt repayable in five years time or a finance lease, and advise which is the cheaper. Assume all cash flows and interest rates given in the question are in nominal terms. (16 marks) (b) Assume you are the Finance Director. Advise the CEO of BG on The advantages and disadvantages to BG of financing the vehicles with debt or a finance lease compared with new equity raised via a rights issue; The reasons for the choice of discount rates used in your calculations for part (a); Whether the choice of method of finance should affect the investment decision. (9 marks) (Total for Question Two = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION November 2008 7 P9

Question Three Entity A A is a publicly listed entity operating largely in the field of training and education. Its sole financial objective is the maximisation of shareholder wealth. It has a cost of capital of 12% and evaluates all its investments using this as the discount rate. This cost of capital is typical of publicly-listed entities in this sector, although analysts believe there is a range of between 10% and 15%. Entity B B is a state-owned educational entity. A substantial proportion of its funding is provided by the government, which requires such entities to operate as commercial entities. All investments are evaluated at a standard discount rate of 7%, a rate determined by the government and applied to investments by all state-owned entities. Most of B s objectives are qualitative, such as provide a high quality of education to a diverse body of students. It has no financial objective other than to stay within cash funding limits. Required (a) (i) (ii) (b) Discuss how the financial objective of entity A might be achieved and measured. (5 marks) Evaluate how the achievement of this financial objective might also benefit other stakeholders in entity A. (8 marks) Analyse the differences between the objectives of public and private sector entities that could explain the different discount rates between Entity A and Entity B given in the scenario. Include in your analysis some discussion of the apparent contradiction between the government requiring state-owned entities to operate as commercial entities yet instructing them to use a discount rate substantially below that typically used by private sector entities. (12 marks) (Total for Question Three = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION P9 8 November 2008

Question Four LUG manufactures furniture for major retailers and independent customers in country D, which has the euro ( ) as its currency. Until this year it sold its products only in its own country. LUG finances major changes in its investment in working capital by medium-term loans, which often result in short-term cash surpluses. Short-term cash deficits are financed by overdraft or delayed payments to creditors, usually by agreement. Assume today is 1 January 2009. Selected forecast financial outcomes (country D only) are as follows: 12 months ended 30 September 2009 000 Revenue 2,585 Cost of goods sold 1,551 Purchases 1,034 As at 30 September 2009 000 Accounts receivable 350 (54 9 days) Accounts payable 205 (72 4 days) Inventory 425 (Raw material = 45%, WIP = 22%, Finished goods = 33%) Operating cycle = 105 days Terms of trade of 90% of sales in country D are 30 days credit. The remaining 10% is paid by cash, debit or credit card. Card payments are considered the equivalent of cash. Sales are spread roughly evenly throughout the year. This pattern is not expected to change. New customers On 1 October 2008, LUG entered into contracts with customers in country E, whose currency is the E$. Forecast figures for the year ended 30 September 2009 will be affected as follows: Sales to country E are likely to be affected by economic and political factors. There is a 60% probability sales will be E$750,000 and a 40% probability they will be E$950,000. All sales will be on credit, invoiced in E$, and the accounts receivable of these customers is expected to be 20% of revenue on average. Sales are spread evenly throughout the year. The spot rate E$ to the euro on 1 October 2008 was 1 43. The E$ is expected to weaken against the euro by 3% gradually through the year. Total inventory figures are expected to be as follows to accommodate sales in country E: As at 30 September 2009 000 Raw material 245 WIP 120 Finished goods 208 November 2008 9 P9

Required (a) (i) Calculate the revised operating cycle for the year ended 30 September 2009 to incorporate sales made to customers in country E. Assume a full year s trading and sales spread evenly throughout the year. (ii) Explain, briefly, the main causes of the increase in the operating cycle over the forecast. (Total for part (a) = 12 marks) (b) Discuss the benefits and risks of invoicing overseas customers in their own currency and explain what methods are available to help minimise the risks. (6 marks) (c) Discuss the advantages and disadvantages of financing net current operating assets with medium-term loans compared with short-term financing, in general and as appropriate to LUG. Include in your discussion a diagrammatic explanation of aggressive and conservative working capital financing policies. (7 marks) (Total for Question Four = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION P9 10 November 2008

Question Five SB plc (SB) is an unquoted entity that provides technical advisory services and human resources to the oil exploration industry. It is based in the UK, but operates worldwide. It has been trading for 15 years. The four founding directors work full time in the business. Other employees are a combination of full time technical consultants and managers, and experts retained for specific contracts. Recruiting and retaining qualified consultants is a challenge and SB has to offer very competitive remuneration packages. The market for the type of services that SB offers is growing. The large multinational oil entities are currently looking at exploration possibilities in the Caribbean. This will open up substantial new opportunities for SB which will require additional funding. However, the concessions for operating in this region are still under discussion with the various Caribbean governments and the oil multinationals have not yet started formal bidding. In recent years, SB has been informally approached by some of its competitors and also its major customers to sell out. The directors have so far rejected these approaches but are now re-considering the possibilities. An alternative also being considered is an InitiaI Public Offering (IPO), that is, a stock market flotation. Assume today is 1 January 2009 Current Financial information Revenue in the year to 31 December 2008 was 40,250,000 and earnings (profit after tax) were 20,188,000. There are five million shares in issue owned equally by the four directors. No dividends have been paid in any year to date. Net book value of buildings, equipment and vehicles plus net working capital is 22,595,000. The book valuations are considered to reflect current realisable values. SB is currently all equity financed. Forecast Financial information Sales revenue for the year to 31 December 2009 is expected to be 52,250,000. Growth in revenue in the years to 31 December 2010 and 2011 is expected to be 20% per annum. Operating costs, inclusive of depreciation, are expected in the future to average 60% of revenue each year. Assume that book depreciation equals tax depreciation and that profit after tax equals cash flow. The marginal rate of tax is expected to remain at 28% per annum, payable in the year in which the liability arises. Assume from 2012 onwards that the 2011 pre-discounted cash flow will grow at 6% per annum indefinitely. This assumes that no new long-term capital is raised. If the entity is to grow at a faster rate then new financing will be needed. Industry statistics The average P/E ratio for the industry, using a very broad definition, is 12 with a range of 9 to 25. The average cost of capital for the industry is 12%. Cost of capital figures by individual entity are not available. November 2008 11 P9

Required Assume you are a financial advisor to SB. (a) (i) (ii) (iii) Calculate a range of values, in total and per share, for SB. Advise the directors of SB on the relevance and limitations of each method of valuation to an entity such as theirs, and in the circumstances of the two alternative disposal strategies being considered. Recommend a suitable valuation figure that could be used for a trade sale or an IPO. Use whatever methods of valuation you think appropriate and can be estimated with the information available. (18 marks) Note: Calculations in part (i) count for up to 10 marks. (b) Advise the directors of SB on the advantages and disadvantages of a trade sale compared with a stock market flotation at the present time, and recommend a course of action. (7 marks) (Total for Question Five = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION End of Question Paper P9 12 November 2008

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% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065 16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026 November 2008 13 P9

Cumulative present value of 1.00 unit of currency per annum n Receivable or Payable at the end of each year for n years 1 (1+ r ) r Periods Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514 Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870 P9 14 November 2008

FORMULAE Valuation models (i) (ii) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the ex-div value: d P 0 = k pref Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the ex-div value: P 0 = d (iii) Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P 0 is the ex-div value: (iv) P 0 = d k g e 1 k e or P 0 = d [1 + g ] 0 k g Irredeemable bonds, paying annual after-tax interest, i [1 t], in perpetuity, where P 0 is the ex-interest value: P 0 = i[1 t] kdnet e or, without tax: P 0 = i k d (v) Total value of the geared entity, V g (based on MM): V g = V u + TB c (vi) (vii) 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 [1 + n r ] (viii) (ix) 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: PV = 1 1 1 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 FORMULAE CONTINUE ON THE NEXT PAGE November 2008 15 P9

Cost of capital (i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current exdiv price P 0 : k pref = d P 0 (ii) Cost of irredeemable bonds, paying annual net interest, i [1 t], and having a current ex-interest price P 0 : k d net = i [1 t ] P 0 (iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P 0 : k e = d P 0 (iv) (v) (vi) (vii) 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 P Cost of ordinary (equity) shares, using the CAPM: 0 d [1 + g] 0 or k e = + g P k e = R f + [R m R f ]ß Cost of ordinary (equity) shares in a geared entity (no tax): k eg = k 0 + [k o k d ] Cost of ordinary (equity) share capital in a geared entity (with tax): V V D E 0 k eg = k eu + [k eu k d ] V [1 t ] D V E (viii) Weighted average cost of capital, k 0 : (ix) (x) k 0 = k eg V E V V E D + kd + V V + V D E D Adjusted cost of capital (MM formula): K adj = k eu [1 tl] or r* = r[1 T*L] In the following formulae, ß u is used for an ungeared ß and ß g is used for a geared ß: ß u from ß g, taking ß d as zero (no tax): ß u = ß g V V E E + V D (xi) If ß d is not zero: ß u = ß g V V E E + V D V + ß d D V D + V E (xii) ß u from ß g, taking ß d as zero (with tax): ß u = ß g V E V + V [1 t ] D E P9 16 November 2008

(xiii) Adjusted discount rate to use in international capital budgeting using interest rate parity: 1+ 1 + annual discount rate C$ annual discount rate euro = Exchange rate in12 months' time C$/euro Spot rate C$/euro Other formulae (i) Interest rate parity (international Fisher effect): Forward rate US$/ = Spot US$/ x 1+ nominal US interest rate 1+ nominal UK interest rate (ii) Purchasing power parity (law of one price): Forward rate US$/ = Spot US$/ x 1+ US inflation rate 1+ UK 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: Equivalent annual cost = PV of costs over n years n year annuity factor (v) Theoretical ex-rights price: TERP = 1 [(N x cum rights price) + issue price] N + 1 (vi) Value of a right: Value of a right = Rights on price issue price N +1 or Theoretical ex rights price issue price N where N = number of rights required to buy one share. November 2008 17 P9

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 1 KNOWLEDGE What you are expected to know. List Make a list of State Express, fully or clearly, the details of/facts of Define Give the exact meaning of 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 of Identify Recognise, establish or select after consideration Illustrate Use an example to describe or explain something 3 APPLICATION How you are expected to apply your knowledge. 4 ANALYSIS How are you expected to analyse the detail of what you have learned. 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 Produce Advise Evaluate Recommend To put to practical use To ascertain or reckon mathematically To prove with certainty or to exhibit by practical means To make or get ready for use To 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 To build up or compile To examine in detail by argument To translate into intelligible or familiar terms To create or bring into existence To counsel, inform or notify To appraise or assess the value of To advise on a course of action P9 18 November 2008

The Examiner for Financial Strategy offers to future candidates and to tutors using this booklet for study purposes, the following background and guidance on the questions included in this examination paper. Section A Compulsory Question One This concerned the financial consequences of a rapid fall in house prices on KEN, a property development company and, in particular, the implications for liquidity and funding of the fall in house prices. The second part focuses on an evaluation of impact of the price fall on Phase III of a house building project and a discussion of alternative financial strategies and, in particular, Strategies 1 and 2 outlined in the question. In parts (a) to (c), the question focused on liquidity and funding issues, including a calculation of the fall in after-tax sales receipts as a result of the fall in house prices. Candidates were also required to discuss broader industry, economic and market factors that might affect KEN s liquidity and funding position, together with a general explanation of the role played by the treasury function in these areas. In part (d), the question moved on to look at the strategic choices facing the company. Assuming the role of the Finance Director, candidates were required to write a report to the Board which included a detailed financial evaluation of Strategy 1 and the identification and explanation of the reasons for and potential problems with a merger as proposed in Strategy 2. This question tested knowledge and understanding of learning outcomes A (iii), (iv), B (iii), C (iii), D (i) and (ii). Section B Choice of two from four questions Question Two This question concerned BG, a privately-owned transport entity, who was considering replacing a number of vehicles. The question concerned both the evaluation of the replacement project itself and also how to finance the project. In part (a), candidates were required to evaluate the investment project itself and then to evaluate two alternative financing structures. The choice of financing required a standard lease versus buy decision. In part (b) candidates, in the role of the Finance Director, were required to advise the CEO on other issues that might affect the financing decision. These included a discussion of the use of debt as compared with new equity raised via a rights issue, the choice of discount rates and whether or not the choice of method of finance would affect the investment decision. This question tested knowledge and understanding of learning outcomes B (i) and D(i). Question Three This question concerned a discussion of the differences in the financial objectives of a publicly listed entity operating largely in the field of training and education (Entity A) versus a state-owned educational entity (Entity B). In part (a) candidates were required to discuss how the financial objective of entity A might be achieved and measured and to evaluate how the achievement of this objective might also benefit other stakeholders in the entity. In part (b) candidates were required to analyse the differences between the objectives of public and private sector entities that could explain the different discount rates between Entity A and Entity B given in the scenario. The question tested knowledge and understanding of learning outcomes A(i), A(ii) and A(iii). Question Four Question four concerned the operating cycle and working capital financing policy of LUG, a furniture manufacturer based in Country D and with as the functional currency. The scenario involved the use of two currencies, with new export sales to Country E denominated in E$. In part (a) candidates were required to calculate the revised operating cycle incorporating sales in country E and to provide a brief explanation of the main causes of the increase in the operating cycle over the forecast. In part (b) candidates were required to discuss the benefits and risks of invoicing overseas customers in their own currency and explain what methods are available to help minimise the risks. In part (c) candidates were required to discuss the advantages and disadvantages of financing net current operating assets with medium-term loans compared with short-term financing. The question tested knowledge and understanding of learning outcome B (i). November 2008 19 P9

Question Five This question concerned the valuation of SB, an unquoted entity that provides technical advisory services and human resources to the oil exploration industry. In part (a) candidates, in the role of a financial advisor, were required to calculate a range of values for SB and discuss both the relevance and limitations of those valuations, concluding with a recommendation. Part (b) focussed on the best type of sale, advising the directors of SB on the advantages and disadvantages of a trade sale, as against a stock market flotation. Candidates were also required to recommend a course of action. The question tested knowledge and understanding of learning outcomes C(i) and C(viii). P9 20 November 2008

Strategic Level Paper P9 Management Accounting Financial Strategy Examiner s Answers SECTION A Answer to Question One (a) The calculation of the fall in after-tax sales receipts as a result of the fall in house prices is as follows: 2009 2010 House sales 70 0 Fall in sales receipts for house sales in 2009 A$000 A$000 490 4,410 (= 10% x 70 x 350 x 20%) (= 90% x 70 x 350 x 20%) Reduction in tax payable (147) (= 490 x 30%) (1,323) (= 4,410 x 30%) Net fall in cash flows for Phase 2 343 3,087 Examiner s Note: Candidates who took a cash flow approach and showed tax in the subsequent year were given full credit. (b) KEN operates in a market that requires significant up-front funding on all projects. Funding is required both to purchase land for development and to pay for construction costs in advance of receiving payment from customers. Typically, KEN has to pay 70% of construction costs in the year of sale but only receives a 10% deposit in that year. Large values of funding are therefore required on every house constructed for approximately one year until full settlement is received. In addition, KEN will experience volatile revenue and cost streams due to economic factors affecting the housing sector that are beyond its control and largely unpredictable. It will therefore need a large amount of headroom to ensure that sufficient funding is in place even if net revenues are much lower than expected. November 2008 21 P9

In particular, KEN s cash flows will be affected by: (c) House prices which will affect its revenue streams. If the cost base cannot be reduced to match any fall in house prices, its profits will be affected. The analysis in part (a) illustrates the impact that changes in house prices can have on cash flows. The same analysis shows a reduction in cash flows in excess of A$3 million as a direct result of the fall in house prices, with the greatest impact arising in 2010. Interest rates which will affect demand for housing. A rise in interest rates will have a direct impact on the cost of mortgage borrowing and can be expected to reduce the number of first time buyers entering the market and also reduce the number of home owners considering moving up the property ladder by selling their property and buying a larger property. Other economic factors that can be expected to impact on liquidity include: General economic confidence and job prospects people need to feel confident in their long-term employment position before committing to purchasing a house; Inflation figures people will have less disposable income available to invest in the housing market if living costs are rising faster than employment income; Non-availability of financing (loans, mortgages). The role of the treasury function in liquidity and funding management is as follows. Liquidity management. To ensure that the entity has the liquid funds it needs and to invest surplus funds. For this project, only 10% of sales revenues are received in year one, even though 70% of construction costs are incurred in the first year. There is therefore a one year funding gap on all house sales and this represents a significant funding requirement. There could also be a significant time delay between acquiring land for development and the commencement of that development once planning permission has been obtained. Also to ensure there is sufficient headroom, that is, additional borrowing facilities in place to cover any unforeseen circumstances, such as a sudden rise in interest rates. Funding management. This is closely linked to liquidity management and is concerned with identifying suitable sources of funds and the management of interest rate risks. The treasurer will also be involved in strategic issues concerning the capital structure of the entity and distribution/retention polices which also affect funding requirements. (d) (i) See Appendices on pages 5, 6 and 7 P9 22 November 2008

REPORT TO THE DIRECTORS OF KEN From: Finance Director Date: 19 November 2008 STRATEGIC CHOICES RE DOMESTIC HOUSING CONSTRUCTION PROJECT Purpose The purpose of this report is to consider the strategic choices facing the entity at the present time with regard to the domestic housing construction project in order to enable the Board to determine the best way to proceed. In particular, the report will consider whether it would be financially beneficial to continue with Phase 3 of the current housing project or to abandon the project at the end of Phase 2 and sell the land. Alternative options will also be considered. Strategy 1: Abandon Phase 3 and sell the land (requirement (d)(ii)) See the Appendices for an analysis of the cash flows of Phase 3 of the project and of the alternative proposal to sell the land and end the project at the end of Phase 2. This shows only a marginal financial benefit from proceeding with Phase 3 under current market conditions. The NPV of the cash flows involved in selling the land is A$3 46 million (see Appendix B). This compares with the NPV of the cash flows for Phase 3 of A$3 69 million (see Appendix A). Therefore the marginal financial benefit of proceeding with the project is only 6 6%. (workings: 6 6% = (AS$(3 69 million 3 46 million)/3 46 million)) x 100%) When deciding whether or not to proceed, it must be remembered that the cash flows for the sale of the land are considerably more reliable than those for proceeding with Phase 3 of the project. Phase 3 cash flows are heavily dependent on the accuracy of the underlying assumptions such as forecast selling prices and construction costs and forecast sales volumes. Risks arising from Phase 3 of the project that would prompt the sale of the land rather than proceeding with Phase 3 include: Whether it is realistic to assume that construction costs remain as forecast even a small increase in inflation or in interest rates could prompt suppliers to increase prices or construction workers to demand a wage increase. Whether house prices have reached their lowest level or are likely to fall even lower On the other hand, both construction costs and house prices could move in our favour and the NPV could be considerably higher than currently predicted. One real option, therefore, is to wait and see what happens to house prices and construction costs in the next 12 months, delaying the decision on Phase 3 for the time being. The risk with this option is, of course, that we lose the potential purchaser of the land or that the price of the land drops before it is eventually sold. It may also be possible to find an alternative use of the land that could produce higher returns. Commercial structures should be investigated and planning permission sought for alternative uses. This could increase the value of the land by a significant amount. Strategy 2: Merger (requirement (d)(iii)) With the large liquidity issues and uncertain future that the entity faces, it may be possible to strengthen the financial position by merging with another entity in a similar line of business. The type of entity that KEN should consider merging with would need to have strong cash reserves or headroom for further borrowings to support KEN s projects. However, this entity November 2008 23 P9

would also need to benefit from merging with KEN and may be attracted by KEN s excellent reputation and track record in the market. Mergers can provide several advantages to the two merged entities. These include: Increased market share and a greater ability to influence house prices; Economies of scale, avoiding duplication of head office and other support functions that are not located on site; Improved efficiency where one management team is weak but not an attractive proposition for the potential merger partner if the management of one of the entities risk losing their jobs as a result of the merger; Lack of profitable investment opportunities the ideal merger candidate will have surplus cash and be interested in using that cash to fund Phase 3 of KEN s house project. There are also a number of potential problems with the proposed merger. These include: Problem in finding a merger candidate which is willing to take on the liquidity problems and obligations of KEN at this time of uncertainty over future prospects for the industry sector; Risk that expected economies of scale or other synergies are not achieved by the merger; Problems in merging management and systems. Conclusion KEN faces many financial and strategic challenges at the present time. The fall in house prices has created a huge funding gap for Phase 2 of the project which will be difficult to fill. It also results in Phase 3 being only marginally beneficial financially and subject to significant risk of cash flows not materialising as forecast. This may be a sensible time to consider a merger with a cash-rich entity that is lacking in investment opportunities and would therefore be mutually beneficial to both entities and supply the additional financial strength that is needed at the present time. Alternatively, KEN could either go ahead with Phase 3 as originally planned and negotiate with suppliers in an attempt to reduce construction costs or wait a few months in the hope that house prices will bounce back up and that Phase 3 would become more profitable. P9 24 November 2008

APPENDIX A: FINANCIAL ANALYSIS OF PROCEEDING WITH PHASE 3 2010 2011 2012 2013 House sales 80 40 Sales receipts for 80 houses sold in 2010 2,560 (= 10% x 80 x 400 x 80%) A$000 A$000 A$000 A$000 23,040 (= 90% x 80 x 400 x 80%) for 40 houses sold in 2011 1,280 (= 10% x 40 x 400 x 80%) 11,520 (= 90% x 40 x 400 x 80% Gross sales receipts 2,560 24,320 11,520 Construction costs for 80 houses sold in 2010 13,440 (= 60% x 70% x 80 x 400) 5,760 (= 60% x 30% x 80 x 400) for 40 houses sold in 2011 6,720 2,880 (= 60% x 70% x 40 x 400) (= 60% x 30% x 40 x 400) Total construction (13,440) (12,480) (2,880) Salaries and other (170) (110) Pre-tax cash flows (11,050) 11,730 8,640 Tax (1-year later) 3,315 (3,519) (2,592) Net cash flow (11,050) 15,045 5,121 (2,592) Discount factor (at 12%) 0 797 (2 years) 0 712 0 636 0 567 NPV (8,807) 10,712 3,257 (1,470) Total NPV to the nearest A$000 A$3,692,000

APPENDIX B: FINANCIAL ANALYSIS OF SALE OF LAND AT THE END OF PHASE 2: 2009 2010 A$000 A$000 Sale of land 4,400 Redundancy costs (60) Pre-tax cash flows 4,340 Tax (1-year later) (522) (= 30% x (4,400-2,600-60)) Net cash flow 4,340 (522) Discount factor (at 12%) 0 893 0 797 NPV 3,876 (416) Total NPV to the nearest A$000: A$3,460,000

APPENDIX C: ALTERNATIVE APPROACH BASED ON INCREMENTAL BENEFIT/(COST) OF SALE OF LAND Benefit of Sale of Land continuing with Phase 3 A$000 2009 2010 2011 2012 2013 A$000 A$000 A$000 A$000 A$000 Sales receipts lost for 80 houses sold in 2010 2,560 (10% x 80 x 400 x 80%) 23,040 (90% x 80 x 400 x 80%) for 40 houses sold in 2011 1,280 (10% x 40 x 400 x 80%) Construction costs saved 11,520 (90% x 40 x 400 x 80%) for 80 houses sold in 2010 13,440 (60% x 70 x 80 x 400) 5,760 (60% x 30% x 80 x 400) for 40 houses sold in 2011 6,720 (60% x 70% x 40 x 400) 2,880 (60% x 30% x 40 x 400) Salaries and other saved 170 110 Net construction cash flow 11,050 (11,370) (8,640) Tax (1-year later) (3,315) 3,519 2,592 Sale of Land 4,400 Redundancy costs (60) Tax on capital gain (1-year later) (522) (30% x (4,400-2,600-60)) Net cash flow 4,340 10,528 (15,045) (5,121) 2,592 Discount factors (@ 12%) 0 893 0 797 0 712 0 636 0 567 NPV 0 893 0 797 0 712 0 636 0 567 Total NPV to the nearest S$000 A$(232,000)

SECTION B Answer to Question Two (a) (i) Calculate NPV of investment Capital cost C$1 6 million @ 2 45-653,061 (1 6 million/2 45) Residual Value 15% of cost in Year 5 55,543 ( 653,061 x 15% x 0 567) Cost Savings for five years 576,800 ( 160,000 x 3 605) NPV -20,718 This suggests the investment, evaluated at the discount rate BG uses for replacement investment decision, 12%, is not advantageous. However, the financing of the investment might convert the investment into a positive NPV. (ii) Finance with long term debt or Finance lease The most appropriate method of evaluation of debt versus a finance lease is to compare the cash flows associated with debt with the cash flows associated with leasing. Preliminary workings Calculation of exchange rates C$ to Spot 2 450 Year 1 2 427 (2 450 x 1 035/1 045) Year 2 2 403 (2 427 x 1 035/1 045) Year 3 2 380 (2 403 x 1 035/1 045) Year 4 2 358 (2 380 x 1 035/1 045) Calculation of tax depreciation allowances Purchase cost 653,061 Tax Relief Year 1 allowance @ 25% 163,265 57,143 WDV end of Year 1 489,796 Year 2 allowance @ 25% 122,449 42,857 WDV end of Year 2 367,347 Year 3 allowance @ 25% 91,837 32,143 WDV end of Year 3 275,510 Year 4 allowance @ 25% 68,878 24,107 WDV end of Year 4 206,632 Residual Value 97,959 Balancing Allowance 108,673 38,036 Total Relief given 194,286 Check: [(653,061-97,959) x 35%] = 194,286 P9 28 November 2008

Discount rate to use The discount rate to use is the after tax cost of debt, that is 9 2% x (1 0 35) = 6% (or close enough to 6% to warrant use of this rate in the evaluation.) Year 0 1 2 3 4 5 Lease cash flows Lease payments in C$ -320,000-320,000-320,000-320,000-320,000 Exchange rate 2 450 2 427 2 403 2 380 2 358 Lease payments in -130,612-131,850-133,167-134,454-135,708 Tax relief @ 35% 45,714 46,148 46,608 47,059 47,498 Net cash flows -130,612-86,136-87,019-87,846-88,649 47,498 DF @ 6% 1 0 943 0 890 0 840 0 792 0 747 DCF -130,612-81,226-77,447-73,791-70,210 35,481 NPV = -397,805 Debt Capital costs -653,061 Residual value 97,959 Tax depreciation allowances 57,143 42,857 32,143 24,107 38,036 Net cash flows -653,061 57,143 42,857 32,143 24,107 135,995 DF @ 6% 1 0 943 0 890 0 840 0 792 0 747 DCF -653,061 53,886 38,143 27,000 19,093 101,588 NPV = -413,351 Financing with a lease is the most advantageous although other considerations might change the decision, for example a revised residual value or lower interest rates. Also, exchange rates are a more significant factor with leasing as they change every year. For a purchase with borrowed funds only the spot rate might change. These issues are discussed later in part (b). (b) Leasing may be considered a direct alternative to medium-term debt. The advantages and disadvantages of a finance lease compared to equity are therefore similar to those for the debt being considered here. Advantages and disadvantages of debt/lease over equity Advantages Interest or lease payments are tax deductible; Does not dilute share ownership or EPS, although in the case here this is probably not a concern; Cheaper and easier to raise and to administer than equity. Leasing is often considered an easier option than debt, which would be a further advantage to financing with lease rather than debt. Disadvantages Risk of bankruptcy if interest or lease payments not met. BG has revenue of 65 million and earnings of 14 5 million. Lease payments are therefore comfortably covered; Consideration would have to be given to how the debt would be serviced or repaid at the end of the investment s life, if financing was with debt; November 2008 29 P9