The Examiner's Answers. Financial Strategy 1

The Examiner's Answers F3 - Financial Strategy Some of the answers that follow are fuller and more comprehensive than would be expected from a well-prepared candidate. They have been written in this way to aid teaching, study and revision for tutors and candidates alike. SECTION A Answer to Question One (a) Three alternative uses of the funds have already been suggested by the Board of the Newspaper Division. These are: Reinvest in a new project. Repay debt. Pay a one-off dividend. Investments, funding and dividend decisions are the main financial decisions facing all companies and are closely interrelated as each decision affects the others. Reinvest in a new project Reinvestment of the funds into a new project that has a positive NPV would help M plc achieve its growth targets as stated in its financial objectives. As we know from the pre-seen material, the key shareholders (that is, the bank, charity and financial institution) are putting pressure on the Board to devise a strategic plan aimed at achieving M plc s stated financial objectives. Growth in revenue and profits between 2011 and 2012 met profit growth targets but not revenue growth targets as the following analysis shows: 2011 2012 Growth achieved Target growth per financial objectives Revenue 274 200 2.2% 4.0% Operating profit 68 73 7.3% 4.0% A company such as M plc is likely to have a wide range of projects with positive NPVs to consider. These need to be assessed as to their contribution towards meeting M plc s financial and strategic objectives. With the disposal of FR, M plc will lose control over the pan European newspaper that FR produces and which helps to meet one of its strategic objectives (strategic objective number 3). M plc may therefore wish to consider whether it is possible to provide a news service to native English speakers over a wide geographical spread (strategic objective number 2) by some other means and evaluate projects that might help meet those objectives. For example, M plc could consider launching a web version to reach this readership group. Financial Strategy 1

Reduce debt levels We know from the pre-seen material that 83 million of loan capital is due for repayment on 1 April 2013, that is, in 16 months time. The sale proceeds could therefore be retained and invested for use in repaying the loan capital at that time or at an earlier date if early redemption is allowed without penalty. Alternatively, other debt could be repaid now and separate arrangements made to repay the loan capital of 83 million due in 16 months. The current gearing level of M plc based on the latest forecast statement of financial position is 33.8%. This is reasonably comfortably within the gearing target of 40% and so there is no urgent need to repay debt in order to keep within the gearing target. Workings: Market capitalisation is GBP 490.00 million = 140 x GBP 3.50. So gearing (D/D+E) is currently 33.8%, ( 0.338 = GBP 250/(250 + 490). If the full value of the anticipated proceeds of EUR 75 million were to be used to repay debt, and assuming M plc s share price were to remain unchanged at 3.50, M plc s gearing level would fall to 27.2%. However, this would reduce shareholder returns due to loss of tax relief on debt interest and heavier reliance on more expensive equity capital. Workings: New gearing (D/D+E) = 0.272 = (250.00 66.75)/(250.00 66.75 + 490.00) where 66.75 = 75 x 0.8900 Note that all these calculations assume no change in the share price as a result of changes in gearing. This is unlikely in practice due to changes in risk and return required to debt and equity holders arising from a change in gearing. Another important consideration is the likely success of rollover negotiations regarding the borrowings due for repayment in a year s time. If the company is considered to be likely to face refinancing risk, the sales proceeds should be retained to help meet the forthcoming debt repayment. Pay one-off dividend At first sight, this may appear to be an attractive option from the point of view of the shareholders, providing an immediate cash benefit. However, this is only a short term view and is likely to lead to comparatively lower shareholder wealth over the longer term due to the higher cost of capital that would result (as discussed above). A one-off dividend would only be beneficial to shareholders in the longer term if the funds can be invested at higher returns by the shareholders than by the company. Funds should only be returned to shareholders if they cannot be reinvested in the business to produce a higher return than the shareholders could create themselves. Indeed, a one-off dividend might send a signal to the market that there are no profitable investment opportunities available and hence the share price could actually fall. An added risk is that paying a one-off dividend may create an expectation that dividends will also be higher in the future. This would create problems in the future if M plc is not in a position to satisfy such expectations. 2 Financial Strategy

Conclusion In this scenario, the highest priority would appear to be to reinvest in positive NPV projects in order to boost future earnings streams. (b) (i) PP's bond cost of debt Time CF DF PV DF PV EUR 5% 3% MV 0-103.00 1-103.00 1-103.00 Net interest (6% x (1 0.70) 1 to 3 4.20 2.723 11.44 2.829 11.88 Redemption 3 100.00 0.864 86.40 0.915 91.50-5.16 0.38 So the current post tax cost of the bond is 3.1% ( = 3% + 2% x (0.38/(5.16 + 0.38))) Examiner s note: A calculation based on total values is equally acceptable and produces the same result. C MV C x MV cost of capital value (EUR m) Bond 3.10% 123.6 3.83 W3 Preference shares 5.93% 27.0 1.60 W4, W5 Ordinary shares 10.50% 290.0 30.45 W1, W2 440.6 35.88 So WACC is 8.143% ( = 35.88/440.6 x 100%) Workings W1 Cost of equity is 3% + 1.5 x 5% = 10.5% W2 Market capitalisation is 50 million x EUR 5.80 = EUR 290.0 million W3 MV of bonds is 120 million x EUR 103/100 = EUR 123.6 million W4 Cost of preference shares is EUR 8.0/EUR 135 x 100% = 5.93% W5 MV of preference shares is EUR 1.35 x 20.0 million shares = EUR 27.0 million shares Valuation of FR Net assets EUR million Non current assets 56 Net current assets 2 Value 58 Note: no deduction for debt is necessary as the net assets of FR are being acquired, free of debt. Financial Strategy 3

Earnings valuation based on P/E Using M's P/E ratio: Equity: EUR 44.6m = 4 x 11.14 Using M's P/E of 11.14 (= 3.50 x 140/44) Total value: EUR 69.6m after adding debt of EUR 25 million to obtain the combined debt plus equity value of FR Using PP's P/E ratio: Equity: EUR 52.0m = 4 x 13 Using PP's P/E of 13 given in the question Total value: EUR 77.0m after adding debt of EUR 25 million DCF of pre-interest and post-tax free cash flows at WACC Free cash flow (FCF) is: EUR million Earnings 4.0 Add back finance charge 1.4 Deduct tax relief on finance charge (at 30% of 1.4) -0.4 Add back depreciation 0.5 Deduct funds reinvested -1.8 FCF pre-financing cash flows 3.7 Giving a value of EUR 61.4m (= 3.7(1.02)/(0.08144-0.02)) at a WACC of 8.144% and growth rate of 2% Alternative approach to calculating FCF: Free cash flow (FCF) is: EUR million Operating profit 6.7 Deduct tax charge -1.3 Deduct tax relief on finance charge (at 30% of 1.4) -0.4 Add back depreciation 0.5 Deduct funds reinvested -1.8 FCF pre-financing cash flows 3.7 Additional value from synergistic benefits Annual benefit of EUR 0.7 million after tax That is, a total PV of EUR 8.6 million ( = EUR 0.7 million/0.08144 where 0.08144 is the value of WACC calculated earlier) taking future years into account. The expected value of the synergistic benefits can then be added to each of the valuations already obtained above. Summary of range of values of the assets employed in FR (that is, assuming that the assets employed in FR are sold without debt attached): Pre-synergistic benefits EUR million Post-synergistic benefits EUR million Net assets 58.0 66.6 P/E ratio M plc 69.6 78.2 P/E ratio PP 77.0 85.6 DCF 61.4 70.0 4 Financial Strategy

Examiner s note: Note that it is the net assets employed by FR, without debt attached, that are being sold in this scenario. That is, the price paid must cover the value of both the equity AND the debt in this case. Therefore: Net assets have been calculated without deduction of debt. Debt has been added back to the standard P/E ratio valuation (which values the equity alone). No adjustment has been made to the DCF calculation since, in this example, this was based on the cash flows attributable to all providers of finance, both lenders and shareholders. The DCF calculation specified in the requirement was based on pre financing cash flows discounted at the (combined) weighted cost of capital. (b) (ii) Net asset valuation The net asset valuation based on market values gives a value of EUR 58 million. This is the minimum value that PP should consider paying but gives a useful indication of the assets employed in the business. However, this valuation is not relevant when acquiring a company as a going concern, with the intention of retaining the assets and continuing to operate the business, as is the case here. The value underestimates the value of the business as it does not take into account intangible assets such as the newspaper brand name that clearly have a value, despite the disappointing recent results. Earnings valuations There are two main issues to consider when valuing FR based on earnings: Choice of earnings figures. Choice of P/E ratio. We have used historic earnings from a single year in the valuation and do not have sufficient information with which to judge whether or not these are representative of sustainable future earnings. We have been given two different P/E ratios in the question and have used each of these in the earnings valuation: Using M plc s P/E ratio, FR has a value of EUR 69.6 million. Using PP s P/E ratio gives a much higher value of EUR 77.0 million. It is likely that PP s P/E ratio is more appropriate than M plc s P/E ratio in this scenario as we know that PP operates in the same market as FR whereas M plc operates in a number of different market sectors and geographical locations that are likely to have a different earnings and risk profile. In applying PP s P/E ratio, we are assuming that PP can produce the same rate of return from FR as from its current business activities. The validity of this valuation therefore largely depends on to what extent the relatively poor recent performance of FR is due to poor management by M plc rather than the popularity and future growth potential of the newspaper titles themselves. The indication is the former that M plc acquired foreign titles that it was not able to develop to their full potential, possibly due to lack of local knowledge or sufficient management supervision. The valuation of FR using PP s P/E ratio is based on the assumption that PP s management can turn round FR s performance and achieve the same returns as PP s current business. It also assumes that PP and FR carry the same level of risk. Financial Strategy 5

DCF valuations DCF valuations are generally considered to be the most appropriate method of valuation as they are based on the actual forecast free cash flows (before interest) of the business. These have been discounted at PP s WACC adjusted for risk on the assumption that M plc has a similar gearing ratio to PP and give a valuation of EUR 61.4 million. Note that the DCF approach gives a lower value than the P/E approach, raising further doubts over the validity of applying M or PP s P/E ratio to FR. Note that using WACC and pre-financing cash flows is superior to using cost of equity and post-financing cash flows because FR s gearing ratio is determined by M plc in line with the group s requirements rather than being representative of how this type of business would be financed. In any case, without a quoted share price for FR it is not possible to determine FR s WACC. (b) (iii) In terms of negotiating a price, PP would be expected to offer a reasonable price at the bottom end of the valuation range in order to maximise profits and give room for manoeuvre. This gives an indication of the likely minimum price that M plc is likely to achieve. The price should not be lower than the net assets value (before synergies) of EUR 58 million. The DCF valuation gives a slightly higher value of EUR 61.4 million. PP s starting offer is likely to be somewhere between these two valuations. The maximum price M plc could hope to achieve can be estimated based on the DCF valuation of EUR 61.4 million plus synergistic benefits estimated at EUR 8.6 million. This gives a top price of EUR 70.0 million. Synergistic benefits are notoriously difficult to achieve in practice and so PP is unlikely to agree to a price as high as EUR 70.0 million even if it is extremely confident that the synergistic benefits can be achieved. This is because PP would expect to take the benefit of the majority of those synergistic benefits. The price of EUR 75 million that M plc hope to attain would, however, appear to be far too high and unlikely to be achieved. M plc will need to be prepared to accept a lower price. (c) Competition authorities generally justify intervention in a proposed merger or takeover if they consider it to be against the public interest. For example, if the takeover would restrict competition in the market. As a rule of thumb, competition authorities may investigate an acquisition if it will result in the combined entity acquiring 25% or more of market share. It is highly likely that this will be true in this scenario, although we cannot be certain without additional information regarding PP and FR s share of the French newspaper market. Investigations can take several months to complete. The result of the investigation may be to allow the acquisition to proceed. However, there is a risk that the authorities could reach a less favourable verdict such as: Allow the acquisition to proceed subject to certain conditions designed to help protect the consumer, or Block the acquisition altogether. Conditions imposed by the regulator in this scenario might include limiting the number of additional newspaper titles that PP is permitted to acquire or guaranteeing the continuation of the pan European English language paper. 6 Financial Strategy

There is also a risk that the prospect of a substantial delay while the investigation is conducted, together with the time required to cooperate with the investigation, may lead to PP abandoning the bid if the competition authorities decide to conduct an investigation into the bid. The level of interest that PP has in acquiring FR will affect to what extent PP is likely to pursue the bid even if there is an investigation. Financial Strategy 7

SECTION B Answer to Question Two (a)(i) FInancial objective 1: To increase dividends by 10% a year. Before the acquisition, TTT s earnings have grown by 8% per annum on average. The target growth in dividends of 10% is therefore is not sustainable over the long term without significant growth in earnings in the future. Note that the variation in dividend pay-out between 30% and 50% of earnings may indicate an attempt to smooth dividend levels. WWW s long term earnings growth prospects are lower than TTT s at 6% per year and so the acquisition risks reducing long term earnings growth. However, the target earnings growth of 10% can be expected to be achieved in the year of acquisition due to the addition of WWW s earnings. Growth in earnings is expected to be boosted by 4.6% if funded by debt and by 10.85% if funded by equity (see workings). Note that the impact on earnings per share varies considerably according to how the deal is financed. If financed by equity, earnings per share can be expected to fall as a result of the acquisition due to the greater number of shares in issue. Workings: Earnings per share calculations Earnings Pre acquisition TTT: EUR 2,000m WWW: SKR 2,000m, or EUR 217m (where SKR 2,000 = 20,000m/10 based on a P/E = 10, and EUR 217m =SKR 2,000/9.2) Earnings per share for TTT Eps: 40 cents = 16 cents/40% Post acquisition, funded by debt (at 5% post tax interest) Post acquisition, funded by equity (assuming no change in share price) EUR 2,092m, 4.6% increase (2,092 = 2,000 + 217 (5% x 2,500)) EUR 2,217m, 10.85% increase (2,217 = 2,000 + 217) Eps: 41.8 cents, 4.5% increase (0.418 = 2,092/5,000) Eps: 37.8 cents, 5.25% decrease (0.378 = 2,217/(5,000 + (2,500/2.90)) FInancial objective 2: To keep gearing below 40% (where gearing is calculated as debt/(debt + equity)). Based on market values the current gearing is 39.6%, which is only just under the target level of 40%. Gearing exceeds the limit if the acquisition is funded by debt (at 45.3%) but falls markedly to 35.8% if funded by equity. (See workings below.) Using book values of equity, the gearing target is exceeded in all cases. Gearing improves if the acquisiton is funded by equity but remains well above the target level of 40%. 8 Financial Strategy

Workings: Gearing calculations Pre acquisition 39.6% = Post acquisition funded by debt (at a cost of EUR 2,500m - that is SKR 23,000m/9.2) Gearing based on market values (workings in EUR) 9,500m/(9,500m+14,500m) 45.3% = (9,500m + 2,500m)/ (9,500m+2,500m+14,500m) Gearing based on book values (workings in EUR) 51.4% = 9,500m/ (9,500m +5,000m +4,000m) 57.1% = (9,500m + 2,500m)/ (9,500m +2,500m +9,000m) Post acquisition funded by equity (assuming no change in share price) 35.8% = 9,500m/ (9,500m+2,500m+14,500m) 45.2% = 9,500m/ (9,500m +2,500m +9,000m) FInancial objective 3: To expand by internal growth and/or by horizontal integration via acquisition of companies operating in the same industry sector. The acquisition clearly helps towards the growth target. WWW represents horizontal integration in the same broad energy industry sector. (a)(ii) The financial objectives are a rather strange combination. Dividend growth is a useful target but appears to be too high at 10% per annum and is not linked to company performance. It may be better replacing this objective with a lower minimum dividend growth figure coupled with a dividend payout target and an earnings or earnings per share growth target. A dividend growth target without an earnings target could lead to payment of dividends in excess of what the company can afford it is an easy target to meet if sufficient retained profits and cash are available or investments are cut but is not sustainable over the longer term if not underpinned by earnings growth. The gearing target objective is reasonable, although it would be better if it defined whether gearing was based on book values or market values. Debt covenants may require this target to be met. Interest cover may also be important to lenders and may be stated in debt covenants. TTT should consider adding an interest cover target to its financial objectives. The general growth target does not have any numbers attached. An earnings growth target or a growth in market capitalisation target could be added in order to enable this target to be quantified and success measured in financial terms. Financial Strategy 9

(b) Candidate answers should include a full description of any THREE of the following key roles of treasury during the evaluation and implementation of the acquisition: Advise on an appropriate discount rate for use in the evaluation of WWW with regard to: o Risk appetite of TTT and risk profile of WWW. o Currency profile of WWW s cash flows. o Cost of capital of TTT. Advise on appropriate funding of bid, including: o The choice of debt versus equity funding. o Choice of actual sources of finance. Liaise with 3 rd parties: o Negotiate with lenders over interest rate, fees and covenants for bank debt. o Liaise with intermediaries regarding the issuance of bonds, including costing, publicity and other arrangements. o Liaise with intermediaries regarding the costing and arrangements for a rights issue or placement of shares. o Controlled release of information to the market. Risk management aspects of the proposed acquistion, including: o Managing exchange rate risk (for example, through hedging or foreign currency borrowing). o Managing interest rate risk (for example, by choice of interest profile and/or interest rate swap). o Manage liquidity risk forecast liquidity needs and ensure that sufficient liquidity is available at all times. Assess reaction of the market in terms of: o Impact on credit rating and credit worthiness in general. o Impact on share price. o Impact on debt covenants. Integration of WWW into central treasury systems. This might include: o Pooling of bank accounts. o Standardising bank relationships. o Regular cash forecasts. o Reporting exchange rate risk. o Controlling working capital. 10 Financial Strategy

Answer to Question Three (a) (i) Terms of the rights issue Terms of share issue required (see working) Total shares Suggested rights Funds raised issue price 25% discount $4.5 2 for 5 $252m 196 40% discount $3.6 1 for 2 $252m 210 Workings: At 25% discount Number of shares to be issued is $250m/$4.5 = 55.6m rounded to 56m. This gives terms of 56m/140m = 0.4 to 1 or 2 for 5 and funds raised of 56m x $4.5 = $252m At 40% discount Number of shares to be issued $250m/$3.6 = 69.4m round to 70m. This gives terms of 0.5 to 1 or 1 for 2 and funds raised of 70m x $3.6 = $252m (ii) Yield adjusted TERP calculation Number of shares Total value of shares ($) Value per share ($) At 25% discount 2 new shares at $4.50 x 20/15 2 12.00 5 old shares at $6.00 5 30.00 Total 7 42.00 6.00 So yield adjusted TERP = $6.00 At 40% discount 1 new share at $3.60 x 20/15 1 4.80 2 old shares at $6.00 2 12.00 Total 3 16.80 5.60 So yield adjusted TERP = $5.60 Financial Strategy 11

(b) Assume a shareholder has 100 shares in DCD: $ Before rights issue Value of shareholding before rights issue (100 x $6.00): 600 After rights issue at 25% discount $ Existing share value 100 x $6.00 600 New shares 40 x $6.00 240 840 Less capital to buy shares 40 x $4.50 Value of shareholding after rights issue: (180) 660 After rights issue at 40% discount $ Existing share value 100 x $5.60 560 New shares 50 x $5.60 280 840 Less capital to buy shares 50 x $3.60 Value of shareholding after rights issue: (c) The concerns of Director A seem to be valid as the higher discount of 40% results in the yield adjusted TERP of $5.60 falling below the current market price of $6.00 whilst the current market price would be maintained using the lower discount of 25%. This is because at a 25% discount the impact of this discount on new shares would be exactly offset by the greater return projected from the new investment. However, as demonstrated in part (b) theoretically the level of discount makes no difference to shareholder value. The point made by Director B has no validity in theory. A higher discount would require a larger number of rights to be issued. The total new investment required from each investor would be identical whichever discount rate is chosen and therefore have no impact on the extent of take up of the offer. However, in practice, a high discount rate can give the impression that the new shares are priced at a bargain level and take up can be higher. This also has implications for underwriting costs that can be lower if rights are issued at higher discount rates. Director C is also correct in that the choice of discount will impact on the dividend payable per share because it will affect the number of shares in issue. However, the level of discount should have no impact on the total dividend paid to each shareholder (before considering issue costs see below). The cost of underwriting the rights issue may also be relevant to the choice of discount. On average this would be expected to be $5.04m (2% of $252m) but the agreed cost will depend on the terms of the issue and the level of discount. A higher discount may result in lower underwriting costs as the risk of the rights issue failing should be lower. It is recommended that a discount of 25% is used since this avoids a fall in the share price assuming that project returns are achieved as forecast and may allow the company to continue with a more stable dividend policy. (180) 660 12 Financial Strategy

(d) The extent to which the share price is affected immediately before and in the 12 months following the announcement of the investment and the rights issue, will depend upon many factors including: The efficiency of the market. To what extent the market agrees with the company evaluation of project benefits. The degree to which the market supports the rights issue. The efficient market hypothesis states that if a market is semi strong then it will react immediately to information as it is made public. A market in weak form means that the share price will react very slowly to new information and a market in strong form means that the share price will already reflect all information whether publicly or privately available. It is generally believed that markets are of a semi-strong form. The share price has increased by 11% in the past three months which could be due to many factors including general market confidence, the release of good results or speculation that an investment needs to be made. Some information concerning the investment may have already leaked into the public domain and be reflected in the share price. The extent to which the share price moves after the announcement depends on the extent to which the impact of the investment has already been anticipated correctly. In the 12 months following the announcement further information about the project will be made publicly available and share prices should adjust to reflect this new information. There may also be speculation about a potential rights issue and share prices may fall if there are any doubts about whether it will be fully subscribed. Answer to Question Four (a) (i) Calculation of NPV based on GBP discount rate Year ended 31 December 2012 2013 2014 Time 0 1 2 3 Net operating cash flow (A$m) 200.00 250.00 350.00 Investment stores (A$m) (415.00) 450.00 Investment refurb (A$m) (170.00) Investment in working capital (A$m) (150.00) (15.00) (16.50) 181.50 A$ cash flows (735.00) 185.00 233.50 981.50 Exchange rate 1.300 1.370 1.444 1.522 GBP remitted cash flows (565.38) 135.04 161.70 644.88 Additional UK costs (GBP) (14.00) (14.00) (14.00) Net GBP cash flows (565.38) 121.04 147.70 630.88 Discount factor at 10% 1.000 0.909 0.826 0.751 Present value (GBP) (565.38) 110.03 122.00 473.79 NPV GBP 140.4 million Financial Strategy 13

Exchange rates workings Date Spot Workings 01-Jan-12 1.300 31-Dec-12 1.370 =1.300 x 1.075/1.02) 31-Dec-13 1.444 =1.370 x 1.075/1.02) 31-Dec-14 1.522 =1.444 x 1.075/1.02) Working capital workings Balance Movement 01-Jan-12 150.0 150.0 31-Dec-12 165.0 15.0 31-Dec-13 181.5 16.5 31-Dec-14 - (181.5) (a) (ii) Calculation of NPV based on A$ discount rate Calculation of A$ discount rate (1 + A$ discount rate) = (1 + A$ interest rate) (1 + GBP discount rate) (1 + GBP interest rate) So, 1 + A$ discount rate = 1.10 x 1.075/1.02 = 1.1593 So use A$ discount rate of 16% Alternative approach: 1 + A$ discount rate = future spot rate x (1 + GBP discount rate) current spot rate = 1.300 x 1.075/1.02 1.300 x 1.10 = 1.1593 So use A$ discount rate of 16% Discounting A$ cash flows at A$ discount rate of 16% Year ended 31 December 2012 2013 2014 Time 0 1 2 3 A$m A$m A$m A$m A$ cash flows (735.00) 185.00 233.50 981.50 UK CF translated into A$ (19.18) (20.22) (21.30) Total A$ cash flows (735.00) 165.82 213.28 960.20 Discount factor at 16% 1.000 0.862 0.743 0.641 Present value (735.00) 142.93 158.47 615.49 NPV in A$ A$ 181.89 million Translate at spot of GBP/A$ 1.3000 giving a GBP value of: GBP 139.93 million 14 Financial Strategy

(b) The reason why the two calculations for NPV are almost the same (and indeed had a discount rate and discount factors been used to an accuracy of five decimal places, the answers would have been exactly the same) is because of the interest rate parity theory upon which the predictions of exchange rate are based. Interest rate parity states that there is a relationship between foreign exchange rates and money markets. Other things being equal the currency with the higher interest rate will be at a discount in the forward market against the currency with the lower interest rate. In terms of the approaches adopted in (a) both use interest rate parity, but in different ways. The first approach uses it to adjust future exchange rates and the second uses it to adjust the discount rate. Because both are based on the same theory, ultimately they give the same answer. (c) The additional risks involved in foreign investment include: Exchange rate sensitivities. Less certainty over costs and revenues due to lack of familiarity with the market. Uncertainty over management time and cost involved in overseeing the development and subsequent operations. These can be taken into account using: (d) Sensitivity analysis (of exchange rates and property values after 3 years and other individual costs and revenues). Certainty equivalents (applied to net operating cash flows to allow for lower returns). Using a risk-adjusted discount factor in the npv analysis, based on an assessment of additional risk and an analysis of the beta of businesses in the same sector. Assessing alternative possible outcomes by applying probability of outcome to different scenarios. Lessons learnt from previous UK projects could be useful to a certain extent. The basic implementation framework for UK projects can be applied to foreign projects but foreign investments have many additional complications which need careful monitoring and control. Similar items include: Trial run. Project team. Budget control. However, the whole structure of the project team may need to be different. Decisions will need to be taken on, for example: The location of the project team(s). Role of local management in the implementation. Financial Strategy 15

New items that will need to be added to the project team s agenda will include: Regulatory risk (working within a new regulatory regime eg different employment law and health and safety regulations). Human resource issues (employees in Asia may be used to different working arrangements). Control over foreign travel and accommodation costs. 16 Financial Strategy

Brief guide Question One Question One concerns the evaluation of a proposed disposal of a subsidiary company to a competitor company. The question begins with a consideration of how the seller might make best use of the funds acquired. Extensive information is provided regarding the seller in the pre-seen material and this part of the question tests candidates ability to identify and apply relevant information such as financial and strategic objectives contained in the pre-seen material to the evaluation of the best use of funds in this particular scenario. The focus of the question then shifts from the seller to the bidder. The question tests the ability to value the bid target using a number of different valuation techniques. The DCF valuation requires calculations of free cash flows generated by the bid target and also of the cost of debt and the WACC of the bidder. An understanding of the valuation results and use the results to produce an appropriate initial bid offer is also tested here. The question concludes by looking at the risk of investigation and intervention by the competition authorities in the proposed acquisition. Question One examines Syllabus sections: Topic A Learning outcomes 1 (b) and (c) Topic B Learning outcome 2 (c) Topic C Learning outcomes 1 (c), 2(a) and (b) Question Two Question Two focuses on the evaluation of the financial objectives and the impact of a proposed acquisition on the attainment of those objectives. Candidates are also required to consider the appropriateness of the financial objectives themselves and how they could be improved. The question concludes by testing the ability to understand the key roles of the treasury function in this particular takeover scenario. The question examines Syllabus sections: Topic A Learning outcomes 2 (b) and (d) Topic B Learning outcome 2 (a) Question Three Question Three focuses on a rights issue. It tests the ability to work out the terms of the issue and the yield adjusted TERP. It also tests the understanding of the issues relating to the choice of an appropriate discount rate and the impact of a rights issue in general on shareholder wealth and a company s share price. The question focuses on Syllabus sections: Topic B Learning outcomes 1 (a) and (b) Question Four Question Four concerns the investment appraisal of foreign projects. It tests the ability to adjust the discount rate used for foreign projects to take account of currency movements and an understanding of the meaning and use of the interest rate parity theory in this manner. It also tests understanding of the particular risks and implementation and control issues faced when investing in a foreign country and how these can be taken into account. The question examines Syllabus sections: Topic C Learning outcomes 1 (a) and (b) and 3(a) Financial Strategy 17