FINANCIAL MANAGEMENT PROFESSIONAL 2 EXAMINATION - APRIL 2009 NOTES: Section A - Answer all three questions. Section B - Answer two questions only. (If you provide answers to more questions than required in Section B, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first two questions to hand will be marked.) 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, 17 Harcourt Street, Dublin 2.
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND FINANCIAL MANAGEMENT PROFESSIONAL 2 EXAMINATION - APRIL 2009 Time Allowed: 3 hours, plus 10 minutes to read the paper. Section A - Answer all three questions. Section B - Answer two questions only. SECTION A - ATTEMPT ALL THREE QUESTIONS 1. Your client J Limited expects to win a tender for a contract to supply tables for South African schools. The tender will be for the supply of 40,000 tables in three months time and a further 60,000 tables in nine months time. The tender price was quoted at 750 South African Rand (ZAR) per table. If J Limited wins the tender, the South African schools department will pay for the tables in South African Rand three months after the receipt of each batch of tables. J Limited has sourced the tables in Australia. If they are successful in winning the tender their Australian supplier will charge $100 (Australian) per table. All tables will be dispatched directly to South Africa. The Australian supplier has agreed that full payment (for all tables) will be made by J Limited in 12 month s time. You have researched the relevant exchange rate information which is summarised in the following table: Exchanges Rates ZAR/ Aus $/ Spot 12.5 13 1.9 1.95 3 Month Forward 30 cent premium 32 cent premium 10 cent discount 15 cent discount 6 Month Forward 40 cent premium 44 cent premium 12 cent discount 16 cent discount 9 Month Forward 60 cent premium 68 cent premium 14 cent discount 18 cent discount 12 Month Forward 80 cent premium 90 cent premium 18 cent discount 20 cent discount Your bank has quoted the following standardised currency options rates; Currency Options Option Type Exercise Price 6 Month Premium 9 Month Premium 12 Month Premium Contract Size ZAR Put 12 0.25 0.4 0.55 500,000 ZAR Aus $ Call 2 0.4 0.6 0.8 100,000 Aus $ Each premium is quoted in s per 100 units of the relevant foreign currency. REQUIRED: a) If J Limited is successful in winning the tender, advise on the profit it will secure if the foreign exchange risk is hedged using the forward exchange market. (Ignore the time value of money, taxation and transaction charges). (8 Marks) b) Advise on the appropriateness of a Forward Exchange Contract hedge for these related South African and Australian transactions. (5 marks) c) Determine the profit on the contract if the foreign currency transaction risk relating to all potential transactions is hedged using standardised currency options. (6 Marks) d) Set out three limitations of using Currency Options as a method of hedging foreign currency transaction risk. (6 Marks) [Total: 25 Marks] Page 1
2. F PLC is in negotiations with a German based company in relation to a proposed investment in an advanced plastics extrusion line. The line will be used exclusively for the production of plastic window frames. In addition to the cost of the extrusion line, F PLC will also have to pay transportation and commissioning costs, estimated to total 400,000. It is expected that the extrusion line will have an estimated life of three years. F PLC s Sales Manager estimates that the company could sell up to 400,000 such frames per year without affecting sales of other products. A summary of the business proposal relating to the extrusion line is as follows; The extrusion line will operate for 50 hours per week (50 weeks per year) and can produce 20 window frames per hour. It is expected that 5% of output will be scrapped at a cost of 10 per frame. This cost will remain fixed for three years. Maintenance is expected to cost 600,000 fixed per annum commencing in year 2. The labour cost in year 1 is expected to be 10 per frame produced. A 1 increase per frame is expected each year thereafter. Materials are estimated to cost 120 per frame. This cost is expected to increase by 10% per year thereafter. The extrusion line could be sold for scrap at the end of the third year for 500,000. Each frame will sell for 200 in year 1, increasing by 5% per annum thereafter. The extrusion line will cost 100 per hour in utility costs, remaining static over the next three years. If F PLC decides to purchase the extrusion line, full payment must be made in advance of delivery. F PLC s pre tax cost of capital is 8%. REQUIRED: As Finance Manager for F PLC: a) Calculate the price that could be paid for this proposed technology investment (ignore taxation). (13 Marks) b) Discuss four strategic factors F PLC should consider in making it s final decision whether or not to invest in the proposed technology. (12 Marks) 3. Write a brief note outlining the meaning and significance of any five of the following terms: [Total: 25 Marks] The stages in an effective foreign exchange transaction risk strategy. Adjusted Present Value. The Benefits of Centralised Treasury Management. The Residual Theory of Dividends. Financial Risk. Business Risk. Co-efficient of Correlation of an Investment Portfolio. [Total: 20 Marks] SECTION B ANSWER TWO QUESTIONS ONLY 4. The Irish Manufacturing sector has suffered significant closures and job losses over the last 12 months e.g. Waterford Crystal, Dell etc. Having regard to the companies referenced above, or corporate failures with which you are familiar, explain in detail four reasons why such failures occur. Your answer should have particular regard to the financial dimension of corporate management and should advise on steps that manufacturing firms might take to reduce the risk of closure. [Total: 15 Marks] Page 2
5. B PLC sells Irish grown flower bulbs to international markets, particularly China and Japan. The company was floated on the Irish Stock exchange on 18th March 2007 with shares priced at nominal value. Since flotation, the company s share price has fallen significantly and are currently trading at 2 per share. The company s most recent annual report includes the following quote the Managing Director. B PLC has reported trading losses for the first time in its trading history. Due to reduced demand the company continues to experience difficulty in retaining market share in the Chinese market Extracts from the most recent audited financial statements of the company are as follows: B PLC Balance Sheet as at 28th February 2009 000s Non-Current Assets at NBV Property and Plant 12,500 Other Assets 1450 Total Non-Current Assets 13,950 Current Assets Inventories 6,500 Trade Receivables 2,500 Cash & Cash Equivalents 0 Total Current Assets 9,000 Total Assets 22,950 Equity & Liabilities Equity Attributable to Equity Holders Share Capital (@ 5 each) 10,000 Other Reserves 450 10,450 Non-Current Liabilities Long term borrowings 5,000 Current Liabilities Trade payables 4,000 Short Term Borrowings 1000 Current portion of long term borrowings 2,500 Total Current Liabilities 7,500 Total Equity & Liabilities 22,950 B PLC Summary Income Statement Year Ended 28th February 2009 2009 000s Revenue 9,875 Cost Of Sales (7,600) Gross Profit 2,275 Less: Expenses (2,400) Net Loss (125) Your friend owns 50,000 shares in B PLC and is concerned about the increasing number of high profile corporate collapses. She has been reading widely on reasons for corporate collapse and is somewhat confused by the Altman Z Score Model. She has asked your advice on whether or not to retain the shareholding in B PLC. Page 3
REQUIRED: Prepare a briefing for your friend that: a) Explains Altman s Z Score model for predicting corporate failure. (6 Marks) b) Calculates B PLC s Z Score (by reference to 28/2/2009) and interprets same. (9 Marks) 6. Extracts from your client, Big Limited s recently audited Balance Sheet read as follows: Big Limited Balance Sheet as at 31st March 2009 2009 000s Total Non-Current Assets 3,600 Total Current Assets 1,400 Total Assets 5,000 Equity & Liabilities Equity Attributable to Equity Holders Ordinary Share Capital (@ 1 each) 1,400 10% 1 Cumulative Irredeemable Preference Share Capital 600 Other Reserves 800 2,800 Non Current Liabilities 6% 100 Irredeemable Loan Stock 1,000 Total Current Liabilities 1,200 Total Equity & Liabilities 5,000 [Total: 15 Marks] Notes: The ordinary shares are trading at 6.30 cum div. The 10% preference shares are quoted at 4.20 ex div. The current price of the loan stock is 110. For the year ended 31/3/2009, an ordinary dividend of.30 cent per share was declared (not paid as yet). The preference dividend for the year ended 31/3/2009 has been paid. Profit before interest and tax for the year ended 31/3/2009 was 800,000. Big Limited pays corporation tax at 20%. You have calculated that the average compound rate of growth in dividends on ordinary shares over the last four years has been 2%. This growth rate is expected to continue. REQUIRED: a) Calculate the retained profit for the year ended 31/3/2009. (3 Marks) b) Calculate Big Limited s Weighted Average Cost of Capital and list two reasons why it is important for company s to understand their WACC. (12 Marks) END OF PAPER [Total : 15 Marks] Page 4
SUGGESTED SOLUTIONS SOLUTION 1 THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND FINANCIAL MANAGEMENT PROFESSIONAL 2 EXAMINATION - APRIL 2009 1) The profit on the tender (if J Limited is successful in winning) is calculated as follows: Details Amount Forward Rate Value Receipt 1 300,000,000 ZAR (40,000*750) 12.56 (13.00 -.44) 2,388,535 Receipt 2 450,000,000 ZAR (60,000*750) 12.1 (13.00 -.9) 3,719,008 Payment 10,000,000 AD (100,000*100) 2.08 (1.9 +.18) -4,807,692 Profit On Contract 1,299,851 2) The use of FECs to hedge the foreign currency risk would be inappropriate for transactions of this nature. This is primarily because whilst J Limited may not even win the contract it will have committed itself to the execution of three FECs. If they are unsuccessful in winning the tender it will be obliged to sell ZAR and buy Australian Dollars at spot on the dates on which the FECs must be executed. This will create foreign exchange transaction risk and incur significant transaction charges/commissions. Given the inherent uncertainty of the ZAR receipts and Australian Dollar payments J Limited would be best advised to hedge the foreign currency transaction risk using internal methods (if possible) and if not possible by using more flexible external methods e.g. currency options or a money market hedge. 3) Currency & Amount of Exercise Options Value Commission Final Exercise Date Foreign Currency Price Purchased Receipt/Cost 6 Month ZAR Put 300,000,000 ZAR 12 60 2,500,000-75,000 2,425,000 12 Month ZAR Put 450,000,000 ZAR 12 90 3,750,000-247,500 3,502,500 12 Month AD Call 10,000,000 AD 2 100-5,000,000-80,000-5,080,000 Profit On Tender 847,000 4) Limitations of using Currency Options as a method of hedging foreign currency transaction risk. 1) they can be expensive (perhaps prohibitively so), particularly OTC options 2) the premium must be paid immediately and whether or not the option is ultimately exercised 3) standardised (exchange traded) options may not achieve a perfect hedge for a transaction (if not exactly divisible by the standardised option size) resulting in some residual foreign exchange risk 4) standardised (exchange traded) options are not available in all world currencies Page 7
SOLUTION 2 The maximum affordable for the extrusion line is 5,571,932 calculates as follows; F PLC - Extrusion Line - Net Present Value Computation Cashflow Year 0 Year 1 Year 2 Year 3 Transportation -400,000 Sales 9,500,000 9,975,000 10,473,750 Scrappage Cost -25,000-25,000-25,000 Maintenance -600,000-600,000 Labour -500,000-550,000-600000 Materials -6,000,000-6,600,000-7260000 Residual Value 500,000 Electricity -250,000-250,000-250,000 Net Cashflows -400,000 2,725,000 1,950,000 2,238,750 Discount Factor 1 0.9259 0.8573 0.7938 Present Value -400,000 2,523,078 1,671,735 1,777,120 Net Present Value 5,571,932 Other Factors to Consider: how technically reliable is the proposed technology? Who will carry out the maintenance and will it require downtime to do so? how financially stable is the company that is selling the new technology? will it be possible to extend the life of either/or the proposed technology and if so by how long? how do we plan to satisfy window frame customers after three years? can we acquire the skills to maintain the proposed technology? is there a limit to the capacity of the extrusion line if we decide to work further shifts? SOLUTION 3 Steps in an effective foreign exchange risk management policy 1. Establish the net transaction risk exposure for each currency and endeavour in the first place to minimise this net exposure using internal hedging mechanisms 2. If internal hedging mechanisms cannot be used then external mechanisms may be used subject to adherence to a clear policy on the risk management mechanisms that can be employed 3. Implement the hedges according to the external hedging policy 4. At all times controls should be in place to ensure that an organisation is not risk exposed as a result of speculative positions. 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. Page 8
Benefits of Centralised Treasury Management Centralised treasury management involves the corporate handling of all financial matters including, the generation of external and internal funds for business, the management of currencies and cash flows. The benefits of doing so centrally include; Economies of scale Expertise more affordable More effective treasury management e.g. forex netting Cheaper hedging e.g. forex matching Enables divisional management to concentrate on the core business by removing a potential distraction Residual Theory of Dividends There are many contrasting theories as to how dividend policy does or does not impact on shareholder wealth e.g. Modigliani and Miller s dividend irrelevance theory. The residual theory of dividends argues that in order to maximise shareholder wealth that management should continue to invest profits in investments that deliver a positive NPV at the company s cost of capital. In an efficient capital market the NPV delivered will increase share value. It is only after all such investments are exhausted that the company should pay dividends to shareholders. Financial Risk The risk that an investment strategy/organisation is too highly geared i.e. funded by debt capital. A highly geared investment will increase the risk of illiquidity i.e. the ability to service the debt and make capital repayments as expected. Providers of equity capital will require a higher return for the increased financial risk they suffer as a company becomes more highly geared. Business Risk This is the inherent investment risk that is specific to an industry. Some investments/sectors e.g. commercial property (in the current economic climate) are considered to be more risky than others. The business risk of a proposed investment will consider the track record and experience of operating within a specific industry Co-efficient of Correlation of an Investment Portfolio A measure of the relationship between two (or more) investments in a portfolio. It is measured using a score between -1 (perfect negative correlation) to 0 (no correlation) to +1 (perfect positive correlation). To reduce overall portfolio risk through diversification the relationship between the investments in the portfolio should be of an inverse (negative) nature. Thus, the fortunes of one investment will be the opposite of the other. SOLUTION 4 1) Inability to raise funds in the equity markets due to depressed markets and/or lack of investor appetite. Steps to Manage - Borrow (subject to availability) rather than raise equity in the depressed equity market 2) Reluctance of banks to provide loan financing due to concerns regarding repayment confidence and/or their own need for liquidity Steps to Manage - Maintain as strong a record as possible with bankers. 3) Increasing exposure to bad debts and late non payment of invoices Steps to Manage Employ effective credit control (including credit vetting). 4) Adverse movement in foreign exchange rates making imported competitors more competitive and exports more expensive Steps to Manage - Very little except to build up strong customer relationships based on quality of product/service. 5) Foreign currency transaction losses due to volatile currency exchange rates. Steps to Manage - Companies can hedge foreign currency transactions to reduce the transaction risk associate with adverse currency movements. 6) Cost Inflation leading to increasing lack of international competitiveness Steps to manage - Maintain as lean and efficient an organisation as possible. Page 9
SOLUTION 5 Introduction Professor Ian Altman developed the Z Score model to predict corporate failure. The model which is used by investors involves the following three steps; Step 1: Calculate the following five ratios from the most recent available financial statements of the company being assessed: Ratio Return on Total Assets Sales to Total Assets Equity to Debt Working Capital to Total Assets Retained Earnings to Total Assets Definition EBIT Total Assets Sales Total Assets MV Equity Total Liabilities Working Capital Total Assets Retained Earnings Total Assets Step 2: Weight the ratios calculated in step 1 to arrive at a weighted average Z-Score. Ratio Weighting Return on Total Assets 3.3 Sales to Total Assets 1 Equity to Debt 0.6 Working Capital to Total Assets 1.2 Retained Earnings to Total Assets 1.4 Step 3: Interpret the Z score as follows: Z-Score Interpretation 2.99 and above No imminent danger. Collapse Unlikely 1.81 to 2.98 A Warning Sign that collapse is a possibility. Manage(and invest) carefully below 1.81 Collapse/Bankruptcy is likely Page 10
B PLC s Z Score can be calculated as follows: B PLC Z Score Calculation (as at 28/2/2009) Score Formula Calculation Score Weight Result ROTA EBIT/TA -125/22950-0.01 3.30-0.02 Sales to TA TO/TA 9875/22950 0.43 1.00 0.43 Equity to Debt MVE/MVD 4000/5000 0.80 0.60 0.48 Working Capital to TA WC/TA (9000-7500)/22950 0.07 1.20 0.08 RE to TA RE/TA -450/22950 0.02 1.40 0.03 Z Score 1.00 Interpretation As B PLC has a Z-score significantly lower than 1.8 Altman s Z score model would indicate that corporate collapse is imminent. On that basis, your friend should seriously consider selling their shares in B PLC. SOLUTION 6 Big Limited Projected Retained Profit - Y/E 31st March 2009 2009 000s PBIT 800 Interest Payable -60 Profit after Interest but before tax 740 Tax @ 20% -148 Profit after Interest and tax 592 Preference Dividend -60 Ordinary Dividend -420 Retained Profit 112 2) WACC Calculation WACC Note MV % Cost % Weight Weighted Ordinary Shares (ex div) 1 8,400,000 7.10% 69.88% 4.96% Preference Shares (ex div) 2 2,520,000 2.38% 20.97% 0.50% Irredeemable Loan Stock 3 1,100,000 4.36% 9.15% 0.40% Weighted Average Cost of Capital 12,020,000 100.00% 5.86% Note 1)Cost of Equity (Gordon's Growth Model) [.30*(1+.02)/(6.30-.60)] +.02 = 7.10% Note 2)Cost of Preference Shares Dividend Payable/Ex Div. Market value = 60/2520 * 100 = 2.38% Note 3)Cost of Loan Stock (Interest Payable - Tax)/Market value = (60*.8)/1100 * 100 = 4.36% Reasons for Understanding WACC include; 1) To determines if cheaper sources of funds are available 2) To consider the impact that a new source of capital has on the WACC 3) To consider the company s market value 4) To use as a discount rate for capital investment appraisal Page 11