Financial Management Professional Stage December 2010

PROFESSIONAL STAGE - FINANCIAL MANAGEMENT OT EXAMINERS COMMENTS

The following table summarises how well candidates answered each syllabus content area.

How well candidates answered each syllabus area

Syllabus area Number of questions Well answered Poorly answered*

1 5 5 0

2 5 5 0

3 5 5 0

Total 15 15 0

* If 40% or more of the candidates gave the correct answer, then the question was classified as well
answered.

There were no questions with a facility of less than 40%.

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 Financial Management Professional Stage December 2010

MARK PLAN AND EXAMINERS COMMENTARY

The marking plan set out below was that used to mark this question. Markers were encouraged to use
discretion and to award partial marks where a point was either not explained fully or made by implication.
More marks were available than could be awarded for each requirement. This allowed credit to be given for a
variety of valid points which were made by candidates.

Question 1 Total Marks: 25

General comments
Overall, candidates found this question much to their liking, with many very high marks being recorded. It
is clear that most candidates are very well drilled in the mechanics of NPV calculations and have a firm
grasp of the principles involved.

(a)
Tax Effect
2010 Cost 900,000
WDA (20%) 180,000 50,400
720,000
2011 WDA (20%) 144,000 40,320
576,000
2012 WDA (20%) 115,200 32,256
460,800
2013 WDA (20%) 92,160 25,805
368,640
EITHER
2014 Disposal 150,000
Bal. All. 218,640 61,219
OR
2014 WDA (20%) 73,728 20,644
294,912
2015 Disposal 150,000
Bal. All. 144,912 40,575

Disposal should not be delayed until 2015 identical capital allowances arise under each option but the
larger positive cash flow in 2014 under the first option means disposal in 2014 should be selected as the
preferred option.
Most well-prepared candidates scored full marks on this question. However some weaker candidates lost
their way towards the end of the calculation through a misunderstanding of how to deal accurately with the
balancing allowance. Some candidates recorded only the final tax effects in their answers without setting
out in full the capital allowances from which those tax effects arose credit was, however, given for clearly
correct underlying calculations.
Total possible marks 5
Maximum full marks 5

(b)
2010 2011 2012 2013 2014
Investment (900,000) 150,000
Capital allowances 50,400 40,320 32,256 25,805 61,219

SG Contribution (W1) 412,500 660,000 825,000 412,500

Lost M contribution (W2) (135,000) (216,000) (270,000) (135,000)
Development (20,000)
Redundancy 60,000 (80,000)
Salaries (90,000) (90,000) (90,000) (90,000)
Tax (28%) (11,200) (52,500) (99,120) (130,200) (30,100)
Working capital (W3) (52,500) (31,500) (21,000) 52,500 52,500
Net cash flow (873,300) 143,820 266,136 413,105 341,119
df 1 0.909 0.826 0.751 0.683
Present value (873,300) 130,732 219,828 310,242 232,984
NPV 20,486
Omission of market research report costs (1) and recommendation to proceed (0.5)

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 Financial Management Professional Stage December 2010

Workings:
W1: SG contribution = (Annual demand x 55)

W2: Lost M contribution

2011 7,500 x 100 = 750,000 x 30% = 225,000 x 60% = 135,000
2012 12,000 x 100 = 1,200,000 x 30% = 360,000 x 60% = 216,000
2013 15,000 x 100 = 1,500,000 x 30% = 450,000 x 60% = 270,000
2014 7,500 x 100 = 750,000 x 30% = 225,000 x 60% = 135,000

W3: Working capital required is 0.1 x 0.7 x SG sales revenue

2010 0.1 x 0.7 x 750,000 = 52,500 Cash flow = (52,500)
2011 0.1 x 0.7 x 1,200,000 = 84,000 Cash flow = (31,500)
2012 0.1 x 0.7 x 1,500,000 = 105,000 Cash flow = (21,000)
2013 0.1 x 0.7 x 750,000 = 52,500 Cash flow = 52,500
2014 0.1 x 0.7 x Nil = Nil Cash flow = 52,500
Many strong responses were again in evidence on this part of the question. Indeed, there were many
instances of full marks being achieved. Where this was not the case, the following were the most common
errors errors in the calculation of both the lost contribution and the working capital requirements due to
overlooking the need to include appropriate adjustments eg. 0.7 in the latter calculation; miscalculation of
the relevant development cost; incorrectly including the sunk cost; failure to bother doing the discounting
or to make a final recommendation.
Total possible marks 14
Maximum full marks 14

(c)
There may be a conflict between the shareholders required pursuit of wealth maximisation by directors
and the directors actual pursuit of managerial objectives (pay, job security, prestige, power, working
conditions).

Directors adopting a multiple stakeholder perspective as opposed to a pure shareholder perspective.

A difference in risk appetite between shareholders and directors shareholders viewing risk from the
perspective of their portfolio of investments, whilst the perspective of directors may be purely based on the
firm. This may, for example, lead to directors raising less debt than is optimal for shareholders.

A short-term perspective by directors (possibly created by their remuneration mechanism) versus a long-
term perspective expected by shareholders.

Dividends versus retentions.

Issues around information asymmetry.

Instances of full marks were, in contrast, much less common on this part of the question. Weaker
candidates were often restricted to making just one or two of the above points and too often they failed to
develop the point in a way that illustrated their full grasp of the point being made.
Total possible marks 8
Maximum full marks 6

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 Financial Management Professional Stage December 2010

Question 2 Total Marks: 30

General Comments:
Candidates found this question by far the most challenging on the paper, possibly reflecting the fact that
this was one of the first instances of a question being solely devoted to the valuation area of the syllabus.
The question was a clear indication that candidates can expect such questions to require of them, not only
accurate calculations, but also detailed commentary on issues surrounding the various valuation methods.
It was in this latter area that weaker candidates were exposed.

(a)
(i)
Net asset (book) value: 22.5m (the book value of equity).

(ii)
Valuation = d0 (1 + g)/(ke g) = (0.50 x 1.06)/(0.08 0.06) = 0.53/0.02 = 26.50 per share x 750,000 =
19,875,000.

(iii)
Valuation = P/E ratio x earnings
Current = 618.5/56.25 x (0.765 x 750,000)= 6,308,700
Forecast = 618.5/56.25 x 2m = 21,991,111
The net asset value is potentially useful here in view of the high proportion of non-current assets, but even
in this scenario its usefulness is limited as a balance sheet is constructed using costs (rather than market
values) and usually excludes many valuable intangible assets. Unless the balance sheet reflects the
market value of all the firms assets it will be of limited use as historic cost is not market value. It
completely ignores the firms future potential.

The dividend valuation method is useful for valuing non-controlling interests, but there are problems in
respect of estimating future dividends, the future growth rate, the cost of equity and the adjustments to
reflect non-marketability with unquoted firms (the adjustments can be somewhat arbitrary). It also uses
certain simplifying assumptions that Becal is a typical firm for its sector and that next years dividend will
be this years dividend increased by the forecast growth rate; and that past performance is a reliable
indicator of future performance. It also ignores any potential post-acquisition synergies.

The earnings-based valuations have a problem with regard to estimating maintainable future earnings.
One also has to be aware that accounting policies can be used to manipulate earnings figures. Selecting a
suitable p/e ratio to value unquoted firms is also a problem area (again, arbitrary adjustments for non-
marketability) are the listed companies also ungeared? The acquiring firm is also being asked to rely on
the target firms own earnings forecast how reliable is this forecast (as use of the current years earnings
yields a very different valuation)? Does the eps require adjustment?
Weaker candidates often found even the earnings and dividend valuations beyond them. They also failed
to reflect the marks attributed to the second part of the question in the depth of their responses to that part
of the question, often making only a very limited commentary on the issues surrounding each valuation
method.
Total possible marks 16
Maximum full marks 16

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 Financial Management Professional Stage December 2010

(b)
Rights Issue
1. May dilute ownership of existing shareholders, if rights are not exercised
2. More expensive than debt finance (riskier and not tax-deductible)
3. Relatively high issue costs (compared to the loan)
4. May cause a fall in eps (especially in the short-term)
5. Reduced gearing will lower financial risk and anticipated returns
6. Shareholder reaction could be adverse
7. Flexibility of dividend payments compared to a fixed interest commitment

Floating Rate Term Loan

1. Increased gearing may increase financial risk and the cost of equity capital (although this is probably
not a major issue in this scenario)
2. No dilution of existing shareholding
3. Cheaper (lower risk and tax deductible)
4. Potential for enhanced eps
5. Potential exposure to interest rate risk with floating rate debt
6. The possible impact of covenants in the loan agreement or security requirements
7. Inflexibility interest payments
Most well-prepared candidates were able to cope comfortably with this question, although the potential
impact on eps was a fairly rare inclusion in candidates answers. It should be noted that whilst 14 marks
appear to be available (with a maximum of 8 to be awarded), in reality this was not the case as mirror
points (ie. making the same point under each heading eg. one is cheaper; one is more expensive) would
only earn one mark.
Total possible marks 14
Maximum full marks 8

(c)
Relative advantages of organic growth:
1. Costs of growth spread over time/often cheaper than growth by acquisition
2. Rate of change within the firm is likely to be slower (avoids disruption and behavioural and cultural
problems less risky)
3. Synergies anticipated with acquisition often fail to materialise

Relative advantages of growth by acquisition:

1. Synergy (a better rate of return is achieved than would be achieved by the same resources being used
independently)
2. Risk reduction via diversification (more stable cash flows as no two firms will have perfectly correlated
cash flows), which will reduce the firms cost of capital and increase its value
3. Competition potentially reduced/eliminated
4. Benefits of vertical integration
5. Quicker method of growth and increase in market share
Most well-prepared candidates were also able to cope comfortably with this question, and, indeed, there
were many instances of full marks being achieved.
Total possible marks 8
Maximum full marks 6

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 Financial Management Professional Stage December 2010

Question 3 Total Marks: 25

General Comments:
Although the majority of candidates performed well on this question, it was the question that most
polarised performance between strong and weak candidates, particularly in the final part of the question.

(a)
(i)
1. To obtain a lower rate of interest on its preferred type of debt by exploiting the
quality spread differential between two counterparties
2. To achieve a better match of assets and liabilities
3. To access interest rate markets that might otherwise be closed to the firm (or only accessible at
excessive cost)
4. To hedge interest rate exposure by converting a floating rate commitment to a
fixed rate commitment (or vice versa)
5. To restructure the interest rate profile of existing debts (avoiding new loans/fees)
6. To speculate on the future course of interest rates
7. They are available for longer terms than other methods of hedging interest rate exposure
Too often among weaker candidates, responses were restricted to issues surrounding the type of interest
rate achieved (fixed or floating) and the savings in borrowing costs, but the use of interest rate swaps for
both hedging and speculation were often overlooked, as was the fact that swaps are the best way of
hedging and speculating in the longer term.
Total possible marks 7
Maximum full marks 5

(ii)
Springfield has a comparative advantage in floating rate borrowing, whilst Faversham has a comparative
advantage in fixed rate borrowing so Springfield should borrow 20m at LIBOR + 2.25%, whilst
Faversham should borrow 20m at 5.50%.

The quality spread differential = 1.00% - 0.75% = 0.25% (saving 0.125% each)

Springfield:
Pay LIBOR + 2.25%; Pay Faversham 5.50%; therefore Receive from Faversham LIBOR + 1.375% - net
borrowing cost 6.375% (saving 0.125% on its own fixed rate borrowing cost)

Faversham:
Pay 5.50% fixed, Pay Springfield LIBOR + 1.375%, Receive from Springfield 5.50% - net borrowing cost
LIBOR + 1.375% (saving 0.125% on its own floating rate borrowing cost)
The most common error here was the failure of candidates to structure the swap around the stated fixed
interest leg of the swap this instruction in the question was often ignored. Also, weaker candidates failed
to correctly calculate the potential savings from such a swap.
Total possible marks 5
Maximum full marks 5

(iii)
Springfield will be disadvantaged as it has contracted to make fixed rate payments under the interest rate
swap agreement and will, therefore, not see its payments benefit from the reduction in interest rates during
the term of the swap agreement.
No problems evident for the vast majority of candidates.
Total possible marks 2
Maximum full marks 2

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 Financial Management Professional Stage December 2010

(iv)
The risk that the other counterparty to the swap agreement will default on their commitment before
completion of the swap agreement

The risk of unfavourable changes in market interest rates after entering into the swap

Transparency risk: the risk that the impact of the swap transaction will be to undermine the clarity and
transparency of the firms financial statements
Again, few problems evident here for the vast majority of candidates
Total possible marks 3
Maximum full marks 2

(b)
Which contract? March
Which type? A put option (the right to sell a future)
Strike price? 95.25 (sets a cap at 4.75%, as required)
How many? 6m/500,000 x 6/3 = 24 contracts
Premium? At 95.25 = 0.12% x 24 x 500,000 x 3/12 = 3,600

Closing prices (i) (ii)

Benchmark 5.4% 3.1%
Futures price 94.30 96.70

Option market outcome

Strike price (right to sell at) 95.25 95.25
Closing price (buy at) 94.30 96.70
Exercise? Yes No
Gain on exercise 0.95% -
Outcome of option position 28,500 -
(0.95% x 500,000 x 3/12 x 24)

Net position
Borrow 6m at benchmark rate 162,000 93,000
(6m x 6/12 x 5.4% or 3.1%)
Option (28,500) -
Premium 3,600 3,600
137,100 96,600

Effective interest rate 137,100/6m x 12/6 x 100 96,600/6m x 12/6 x 100

= 4.57% = 3.22%
This part of the question polarised performance between those with a firm grasp of the principles and
methodology and those who clearly had not studied the learning materials in the required depth. Principle
failings among weaker candidates were an uncertainty as to which months contract to enter into; failure to
select a put option; and failure to calculate the premium or number of contracts correctly, invariably due to
misunderstanding surrounding the correct adjustments for the number of months involved in each case.
This latter point was also relevant to common miscalculations of the effective interest rate. There were
also quite a number of instances of candidates failing to select a specific choice of option and using that
specific choice to illustrate to management the outcome that could be achieved. Rather, some candidates
saw fit to cover every possible course of action by doing calculations for each one, and whilst this did earn
some marks where there was evidence that candidates were aware of the methodology, it did not earn full
marks as it failed completely to provide any specific advice or recommendation to management as to the
precisely appropriate course of action to pursue in the situation set out in the question.
Total possible marks 11
Maximum full marks 11

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