DO NOT OPEN THIS QUESTION PAPER UNTIL YOU ARE TOLD TO DO SO. Financial Pillar F3 Financial Strategy 22 May 2014 Thursday 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 this 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 written in the answer book. Answers written on the question 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. 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. F3 Financial Strategy TURN OVER The Chartered Institute of Management Accountants 2014
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 May 2014
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. May 2014 3 Financial Strategy
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 234 213 Assets employed: Plumbing and heating GBP million Building materials GBP million Non-current assets: Intangible assets 781 967 Property, plant and equipment 597 729 Trade and other receivables 65 70 Current assets: Inventories 930 854 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 May 2014
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. May 2014 5 Financial Strategy
Appendix 1 P plc ORGANISATION STRUCTURE Financial Strategy 6 May 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. Retail Outlets Financial Strategy 6 May 2014
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 PROFIT FOR THE YEAR 116 263 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 Total equity 3,396 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 May 2014 7 Financial Strategy
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 22 May 2014. P plc s strategic objectives The strategic objectives of P plc include: 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. Strategic objective 1 to be the market leader P plc has achieved greater market share in the regions in which it operates over the past five years by acquiring a number of businesses in target markets. Newly acquired businesses are set up as separate business units or maintained as individual retail outlets (where a single retail outlet is purchased). They continue to trade under their original trading names. Customers will not usually notice much change in the retail outlets except for some new investment in modern displays and upgraded IT support systems where necessary. With regard to plumbing outlets, customers will also benefit from a more efficient distribution network and a wider range of products after the newly acquired showrooms are integrated into P plc s central distribution network. Many functions such as finance and human resources are centralised and would be disbanded on acquisition by P plc. In many cases, profitability of retail outlets has increased following acquisition by P plc. However, there are some acquisitions which have not met expectations. Strategic objective 2 deleverage by disposing of business units or individual retail outlets P plc disposes of business units or retail outlets which have either not met performance expectations or are located in a region where P plc does not expect to be able to become market leader. This policy allows P plc to deleverage (that is, reduce financial gearing) by using cash generated from disposals to pay down borrowings. The value of disposals was greater than the value of acquisitions in the 12 months ended 31 December 2013, leading to a build-up of cash balances and a reduction in gearing levels. Smart Bathrooms Smart Bathrooms operates a number of bathroom showrooms in the south of the UK and was acquired by P plc on 30 June 2013. The business performed reasonably well in the half year to 31 December 2013. However, the Finance Director (FD) has become aware that the performance of Smart Bathrooms and a number of other recently acquired businesses has markedly deteriorated since 31 December 2013 and expects to need to account for a significant impairment of goodwill charge in the interim financial statements for the half year ending 30 June 2014. The FD wishes to plan ahead and estimate the likely size of the impairment of goodwill charge for the half year ending 30 June 2014. All business units, except for Smart Bathrooms, have been analysed and so far a total impairment of goodwill charge of approximately GBP 80 million is expected in the half year to 30 June 2014. The impairment of goodwill charge for Smart Bathrooms now has to be calculated to complete the picture, which will require calculation of the fall in value of Smart Bathrooms between 31 December 2013 and 30 June 2014. Financial Strategy 8 May 2014
On 31 December 2013, Smart Bathrooms was valued at GBP 2,300,000. Smart Bathrooms is to be revalued as at 30 June 2014 using a discounted cash flow (DCF) approach based on forecast cash flows for the 10 years from that date. Forecast data for Smart Bathrooms as at 30 June 2014 is as follows: Item Next 12 months Annual growth Forecast unit sales 8,200 units 3% in years 2,3 and 4 and 0% in years 5 to 10 Average unit selling price GBP 130 2% in years 2,3 and 4 and 0% in years 5 to 10 Contribution margin 45% None margin remains unchanged Fixed costs GBP 120,000 None fixed costs remain unchanged Assumptions to be used in the valuation of Smart Bathrooms: All sales and costs are equivalent to cash inflows and outflows. Corporate income tax of 30% is payable at the end of the period in which it arises. P plc s equity and non-current liabilities are unchanged since 31 December 2013 and are set out in the pre-seen material on page 7 under statement of financial position. P plc shares are currently trading at GBP 8.50 per share. P plc pays interest of 4% on the bank loans shown as non-current liabilities in the statement of financial position in the pre-seen material. Current liabilities can be ignored for the purposes of calculating P plc s Weighted Average Cost of Capital (WACC). P plc has a published equity beta of 1.31 and a debt beta of 0.625. A risk-adjusted discount rate of P plc s WACC plus 2% is considered appropriate. The UK has a risk-free rate of 1.5% and market premium of 4%. Special dividend Some directors have suggested that a special dividend of GBP 350 million should be paid to reduce the large cash balance that has accumulated following the disposal of a number of business units. Surplus cash on 30 June 2014 is forecast to be GBP 350 million even after putting aside enough funds to pay an interim dividend of GBP 0.11 per share which has just been declared. The requirement for question one is on page 11 TURN OVER May 2014 9 Financial Strategy
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Required: Assume you are the FD of P plc. Write a report to the Board of P plc in which you: (a) Discuss the likely impact on shareholder wealth of: Strategic objective 1 Strategic objective 2 (7 marks) (b) (i) Calculate P plc s WACC. (6 marks) (ii) Calculate a best estimate of the fall in value of Smart Bathrooms between 31 December 2013 and 30 June 2014. Your valuation as at 30 June 2014 should be based on discounted cash flow analysis over a 10 year period at a discount rate of P plc s WACC plus 2%. (10 marks) (iii) Advise how a total impairment of goodwill charge of the order of GBP 80 million in the interim financial statements of P plc might affect: Performance measures The share price (7 marks) (c) (i) Advise on the arguments for and against using the GBP 350 million surplus cash to pay a special dividend in addition to the interim dividend of GBP 0.11 per share which has just been declared. (10 marks) (ii) Advise on possible alternative uses by P plc of the GBP 350 million surplus cash. (7 marks) Marks for structure and presentation: (3 marks) (Total for Question One = 50 marks) (Total for Section A = 50 marks) End of Section A Section B begins on page 14 TURN OVER May 2014 11 Financial Strategy
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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 BB is a listed company located in Country B. BB is a retail clothing business which operates a large number of branded retail stores throughout Country B. Its functional currency is the B$. BB currently has five distinct brands, each owned and managed by a separate business unit. Each business unit runs its own chain of retail stores. BB is seeking to sell QQ, one of these business units. QQ QQ owns a fashion brand that is aimed at the younger end of the fashion market. It was only formed three years ago. The management team of QQ is young and dynamic like the brand and has become frustrated by the constraints imposed on it by BB in managing the brand and developing the business. The management team believes that there is huge potential for developing the brand beyond simply fashion to include home furnishings labelled with a common brand name aimed at both individuals and families with young children. The management team of QQ has decided to purchase the business from BB under a Management Buy Out (MBO). BB has accepted this proposal as QQ has not proved to be a good fit with the rest of the business and has agreed a selling price of B$ 450 million. It is anticipated that the effective date of the disposal would be 1 July 2014. The MBO team has been in initial discussions with a venture capitalist and a bank which are interested in helping to finance the acquisition. The proposed financing arrangement is as follows: Amount invested B$ million Form of investment MBO team equity finance 45.0 B$ 1 A equity shares, full voting rights Venture capitalist equity finance 180.0 B$ 1 B equity shares, limited voting rights Venture capitalist debt finance 112.5 Unsecured loan at 11% interest a year, repayable 30 June 2018 Bank loan 112.5 Secured loan at 7% interest a year, repayable 30 June 2025 The venture capitalist expects a return on the equity portion of its investment of at least 25% a year on a compound basis over the first 4 years of the MBO. The venture capitalist also expects QQ to be listed using an Initial Public Offering (IPO) after 4 years to provide an exit route at that time. Additional data for QQ following an MBO: Profit before interest and tax is forecast to be B$ 72 million in the first year of the MBO and grow by 12% a year in each of the subsequent three years. Corporate income tax is payable at a rate of 30% in the year in which it arises. No dividends would be paid in the first four years of the MBO. Under the planned IPO on 30 June 2018, the A and B shares would be converted into new ordinary shares and these shares would be offered for sale to the public. The A and B shares would be converted into new shares at the same ratio; that is, the A and B shares would have the same value at the time of the IPO. Based on a review of the P/E ratios of companies operating in a similar market sector, the MBO team anticipate that QQ would achieve an IPO share price equivalent to a P/E ratio in the range 8.5 to 12.0. Financial Strategy 14 May 2014
Required: (a) Discuss the factors that are likely to affect the success of the MBO. (7 marks) (b) Calculate: (i) The minimum total equity value of QQ on 30 June 2018 required in order to satisfy the venture capitalist s expected return. (3 marks) (ii) The best estimate of the total equity value of QQ on 30 June 2018 based on forecast earnings for the year ended 30 June 2018 using each of the following P/E ratios: 8.5 12.0 (6 marks) (c) Evaluate the proposed financing arrangement from the viewpoint of the venture capitalist. Your answer should include reference to your results in part (b). Up to 4 marks are available for calculations. (9 marks) (Total for Question Two = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION TURN OVER May 2014 15 Financial Strategy
Question Three DD is a company based in Country D in Asia. It manufactures office furniture for commercial properties. Sales are made directly to large companies or office outfitter companies. DD is listed on the local stock exchange and uses currency D$, the domestic currency of Country D. Despite a strong underlying business, DD suffered from a fall in sales during the recent and continuing economic downturn in the region. As a result, it has severe liquidity problems and has fallen behind with supplier payments. In addition, a significant proportion of DD s borrowings need to be refinanced or repaid in a year s time. The Board has therefore decided to raise additional equity via a rights issue to put the company on a stronger financial footing. Timeline (year 2014) 30 April At close of business on 30 April 2014, DD had 77 million D$ 1 ordinary shares in issue and the share price was D$ 25.00. 1 May DD announced a rights issue at the beginning of the day. Under the rights issue, DD offered new shares at D$ 20.00 per D$1 ordinary share on the basis of 12 rights per 25 shares held. Any unwanted rights could be sold back to DD for D$ 1.50 each. 2 May Rights offer opened. 10 May Rights traded at D$ 3.60 each. 14 May Rights offer closed and the quoted share price was D$ 24.00. The share price has been highly volatile in recent weeks, as shown in the following chart: Figure 1 Share price (D$) 28 27 26 25 24 23 22 21 Market price of D$ 1 ordinary shares in DD 9 16 23 30 7 14 April May Date There was some discussion by the Board on 20 May 2014 concerning the outcome of the rights issue. In particular, directors A and B made the following comments: Director A voiced the opinion that the rights should have been issued at a lower discount in order to protect shareholder wealth. Director B expressed the opinion that the D$ 1.50 price offered for unwanted rights was too low and that DD could have offered a much higher price of D$ 3.00 without jeopardising the success of the rights issue. The Finance Director has been asked to respond to the comments made by Directors A and B. Financial Strategy 16 May 2014
Required: (a) (i) Calculate the theoretical ex-rights price per share on 1 May 2014. (3 marks) (ii) Explain the likely reasons behind the movement in the share price of DD as shown in the chart at Figure 1. Your answer should include reference to your results in part (a)(i). (7 marks) (b) Evaluate the impact of the rights issue on the wealth of a typical shareholder who holds 100 shares in DD on 14 May 2014, assuming the quoted share price on that date is D$ 24.00. Consider each of the following alternative shareholder responses: Subscribe to the rights shares. Sell the rights at a market price of D$ 3.60 each. Do nothing and allow DD to buy back the rights at D$ 1.50 each. (8 marks) (c) Produce a response to Director A and Director B s comments, assuming you are the Finance Director. (7 marks) (Total for Question Three = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION TURN OVER May 2014 17 Financial Strategy
Question Four FF is a listed company which operates private hospitals in a number of different countries in Europe and North America. Each hospital is owned and managed by a separate subsidiary company that is wholly owned by FF. The parent company is located and listed in Country F which is in Europe and within the eurozone. FF is currently considering purchasing a hospital in Country G. Country G is in a fairly unstable region of the world and this would be the first time that FF has run a hospital outside Europe and North America. Under FF s ownership, the hospital would seek to treat new patients such as foreigners living in the country and wealthy local business owners. A new wholly owned subsidiary company would be set up by FF in Country G to acquire and run the hospital. The currency of Country G is the G$. The project team is currently evaluating the proposed purchase, looking at the financial appraisal and also the wider implications. Proposed acquisition FF expects to pay G$ 50 million for the hospital. FF plans to spend G$ 15 million to upgrade the facilities to an acceptable standard plus G$ 8 million for new medical equipment. It should be assumed that all these payments would be made on 1 July 2014. Projected operating cash flows for the target hospital as at 1 July 2014 are as follows: Year 1 2 3 4 5+ Sales receipts (G$ million) 15 20 25 28 28 Purchase payments (G$ million) 7 7 8 10 12 Other cash outflows (G$ million) 5 5 5 5 5 Additional information: The corporate income tax rate is 40% in Country G and 25% in Country F. Cash flows that are taxed in Country G and then remitted to Country F are not subject to any additional tax charge or refund in Country F. Tax is payable or recoverable in the year in which it is incurred. Tax written down allowances can be claimed on the new medical equipment at 25% a year on a straight line basis. Working capital investment cash flows can be ignored. For the purpose of the investment appraisal exercise, assume that FF borrows G$ to finance 50% of the investment and pays G$ 1.5 million a year in interest on those borrowings. Assume all cash flows arise at the end of a year unless stated otherwise. Assume that EUR/G$ = 1.000 on 1 July 2014 and that the G$ is expected to depreciate against the EUR at a rate of 1.9% a year from that date. A trainee accountant has prepared computations of the net present value of the projected cash flows of the target hospital using each of the following two approaches: Approach 1: Apply FF s weighted average cost of capital (WACC) of 6% to EUR equivalent cash flows. Approach 2: Apply the equivalent G$ cost of capital to G$ cash flows. The Board of FF is currently discussing how best to structure the funding for the new subsidiary. The following three financing issues are being considered: A. Should the new subsidiary be funded mainly by equity or mainly by debt? B. Should debt be raised in G$ or EUR? C. Should the debt be raised by the new subsidiary or by FF? Financial Strategy 18 May 2014
Computations provided by the trainee accountant: Approach 1: Discount EUR cash flows at EUR discount rate Time 0 1 2 3 4 5+ Line EURm EURm EURm EURm EURm EURm Workings 1 Initial investment -73.00 2 Net operating cash flows 3.06 8.31 12.70 14.02 12.09 Cash flow before tax -73.00 3.06 8.31 12.70 14.02 12.09 3 Taxation at 40% -1.22-3.32-5.08-5.61-4.84 4 WDA 0.80 0.80 0.80 0.80 Cash flow after tax -73.00 2.64 5.79 8.42 9.21 7.25 5 Discount factor at 6% 1.000 0.943 0.890 0.840 0.792 13.202 =0.792/0.06 6 PV -73.00 2.49 5.15 7.07 7.30 95.76 7 NPV (EUR million) 44.77 Approach 2: Discount G$ cash flows at G$ discount rate G$m G$m G$m G$m G$m G$m 8 Initial investment -73.00 9 Interest paid -1.50-1.50-1.50-1.50-1.50 10 Net operating cash flows 3.00 8.00 12.00 13.00 11.00 Cash flow before tax -73.00 1.50 6.50 10.50 11.50 9.50 11 Taxation at 40% -0.60-2.60-4.20-4.60-3.80 12 WDA 0.80 0.80 0.80 0.80 Cash flow after tax -73.00 1.70 4.70 7.10 7.70 5.70 13 Discount factor at 6% 1.000 0.943 0.890 0.840 0.792 13.202 = 0.792/0.06 14 PV -73.00 1.60 4.18 5.96 6.10 75.25 15 NPV (EUR million) 20.10 Convert at spot Required: (a) Discuss the limitations of using FF s WACC to value the new subsidiary. (7 marks) (b) (i) Identify THREE errors of principle in the trainee accountant s computations. (3 marks) (ii) Explain how each of the three errors identified above should be corrected. (6 marks) (c) Evaluate how best to structure the funding of the new subsidiary, including consideration of financing issues A, B and C. (9 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 May 2014 19 Financial Strategy
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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 0.705 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 May 2014 21 Financial Strategy
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% 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 (n) Interest rates (r) 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 4.793 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 Financial Strategy 22 May 2014
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 = 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 May 2014 23 Financial Strategy
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) 1 + 1 + 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 May 2014
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. May 2014 25 Financial Strategy
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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 May 2014 27 Financial Strategy
Financial Pillar Strategic Level Paper F3 Financial Strategy May 2014 Thursday Morning Session Financial Strategy 28 May 2014